Back to the Basics: Important Lessons from the Recession

At last some good news! The recession seems to be over. Experts have started to speculate a recovery of the global economy soon. Some might contradict that, but it is a breather considering the notion that at least the global economy will not fall anymore. But before breathing easy we might want to look back and learn a few lessons from the turbulent periods. After all difficult times teach us far better lessons than our heady days. A look back into how it all started. It sounds a little queer and even silly when we think about how this globally tumultuous recession started rather small. Nobody could have imagined that home loans (the safest of all bets in debt market) could have crippled the whole world for a couple of years.

In US, in the midst of housing boom (early 2000s), no bank was ready to say no to a home loan seeker. And the result was the accumulation of what we now call us sub-prime loans. The vicious circle started like this: Small banks which gave loans to people, sold their loans to bigger investment banks (like Lehman brothers or Goldman Sachs) who pay them upfront for house loans. The investment banks in turn break these loans and structure them into a fund and sell it to their investors. These instruments are called Collateralized Debt Obligations (CDOs). The investors get a part of the interest paid by the debtor to the bank and the investment banks get a fat commission from the investors. The banks which are now rich in cash (because of selling loans to investment banks) begin to give more and more house loans (who cares about the credit worthiness of the debtor? We can always sell it to the investment banks). So anyone can get a home loan, without any collateral. This doesn’t stop here. The CDOs are insured with the insurance companies (like AIG, which was heavily hurt when the housing boom burst). And the insurance companies were ready to insure such loan funds (technically called as Credit default swaps) as they thought house loans are low risk high return investments. All these transactions were based on two assumptions: the defaulter rate in home loans has always been as low as 2-3% in the past; and housing prices will always rise. So even if large numbers of people default, the bank/insurance company can just seize the house and sell it to repay the loan; in fact may even make a smart profit out of it. The first assumption failed because it never took into account the credit worthiness of the individuals. The second assumption failed because bankers never imagined that a situation would come when everybody is a debtor and there is nobody to buy a house. But that is exactly what happened. As more and more people defaulted on their loans, more and more homes were seized from the debtors to repay the loan. Finally the banks and insurance companies had so many houses to sell, but nobody was there to buy; everybody was a debtor. The house prices fell dramatically and banking system lost most of its money. The tremor reverberated through the system: the investors across the world lost their money, the insurance companies who insured the CDOs went bankrupt, industries couldn’t raise money because of the liquidity crunch in the banking sector and finally America, the biggest consumer in the world was brought down to its knees along with numerous industries in the developing world which fed and grew on America’s consumption.

The global economy is clawing its way back to recovery, thanks to some exigent measures taken across the world. These measures include injecting massive amounts of liquidity into the system, partial nationalization of banks and pre-liberalization era kind of protectionism. Whether these measures favour recovery and growth in long term is once again debatable. This question can be answered only by the lessons learnt in the recession itself. The most important emphasis to the financial world is “get back to the basics”. Get a copy of Adam Smith’s Wealth of Nations. The financial sector has become so complex with its tools, instruments, derivatives, stocks, funds, et al. It has become too knotty that our bankers, financial managers have become muddled with too much jargon that they forget that real economy should drive the financial sector. Not the vice-versa. Resources are the basics of an economy. Resources should determine the wealth or the value; not paper money. The government can inject lots and lots of paper money into the pockets of people but it doesn’t mean that a nation is rich. For instance, if gold prices are increasing because of supply crunch, we can temporarily offset the effect by increasing the interest rates, reducing the cash reserve ratio and increasing the purchasing power of people. But in the end, one can only inject money into the system; one cannot increase the amount of gold available in the planet. Gold will still remain a rare commodity. Financial instruments can never change the reality. Lets us realize that and allow the real economy to drive the finance sector. Lets us not allow the mumbo-jumbo of the financial world confuse and mislead us. Let the tail not wag the dog!

Nallasivan V

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