Thursday, 3 October 2013

Recession - where did it start from and whose fault is it ???

Recession - where did it start from and whose fault is it ???

Recession if you haven’t heard this word until now in your life you must be toddler. The impact that this word has brought upon our life is unimaginable. Print media, television, the Obama’s and everyone is speaking about this new phenomenon. The corporate world in the US especially those from the financial and automotive sectors are in queue for getting a Bailout because of recession.
I first heard about recession during the end of year 2007 I thought, “I am in the Software engineering it is something that is not related to me”. Later One of my friend who was working in a project for the mortgage industry told that his project has been shelved because of recession in US. Then it dawned on me that one day or the other it is going to get me.
I came to know more about this trend from the web and magazines ( written by Industry experts. Earlier I used to think economics as a wasteful human expenditure. I used to infer the charts, graphs and pie diagrams that they show as an art form rather than information. However, this quest for knowledge changed my notion about economics.
The Oxford dictionary explains Recession as “a period of temporary economic decline during which trade and industrial activity are reduced”. Economy goes into this cycle due to various reasons like famine, flood and war. What is the reason for the current Recession?
This is the gift of Globalization to the world economy. Due to globalization the recession which started in the US during the mid 2006 has transformed into a world crisis. How come recession started in the US in the first case? Recession in the US was the result of another phenomenon called Sub-Prime Mortgage crisis. 
Sub means lower in Importance and Prime means Main. So, Sub-prime mortgage plainly translates to money lent to a person who, in simple terms, is unfit to borrow. (Quoted from The world is yet to come into terms of how much money was really lost due to this. The losses suffered by US due to sub-prime mortgage crisis have dawned on the heads of banks from different parts of the world. The Swiss bank UBS alone has written off $13.5 billion dollars till date (write off: - a cancellation from an account of a bad debt or worthless asset). The negligence and mismanagement of funds by the US has put the world economy into a toss. I may sound anti-American but that is the truth. I will explain this later, for the time being, let us be stuck up with sub-prime mortgage crisis 

For knowing more, we have to do time traveling to the beginning of the last decade of the earlier millennium . It was during this period the senators and the economic gurus of the US where rejoicing in the thought that the communism has died and their way of life has prevailed and will prevail. They even felt that no one else is equal to them. This false confidence made the government encourage people to indulge in wasteful expenditures on luxurious items. 
During the end of 1995 not only America but everyone in the world was expecting that a big change is going to come because of Software engineering and e-commerce. Because of this, the American Share market rose to unattainable heights. As the price of shares rose the Americans where given the chance of spending based on the increased value of their shares. This was done by the American government and the MNC banks which operated over there by means of credit cards.
Their party came to an end in 1999. The dot com bubble bursted and along with brought down the hype created by it in the stock market. From then on the recession started to set in to American Economy. The growth, which was achieved by spending the temporary increased value in the Stock market suddenly, stopped. To add fuel to the fire on 9/11 Muslim terrorists from Afghanistan attacked America.
Recession on one side and terrorism on the other brought down the American economy to its knees. The American Industry experts thought unless the Americans started spending again there was no way to revive the economy . Out of desperation, to make the people spend they came up with an outlandish Idea called “SHOP FOR AMERICA”.

The spendings worked and the American economy and along with it the world economy started to climb up in the year 2002. Shopping was preached as the national duty of every US citizen.
Where did the Americans found money to fulfill their national duty? The entire Government machinery stepped in to this regard. The American Central Bank, popularly known as Federal Reserve slashed down the interest to 1%. It was cheap money for the people but it made the life of Investors and Lenders terrible. “The drop in interest rates forced the investors to seek returns through riskier investments and lenders took even greater risks”-Investopedia
All this cheap money entered the real estate market. Due to the sudden infusion of this money the price of housing properties sky rocketed. 

The consumerism, which was preached as a solution for recession gave birth to Sub-prime mortgage lending on houses. How come the rise in value of houses promotes spending? As the price of their house, rose people went to the bank, got loans against the increased price of their house as an additional equity and spent them in malls and other extravagant activities. 
For example a house which was priced at Rs 50 Lakhs pre recession rose to Rs 1 crore because of additional demand. The House owner took a loan on this increased value of Rs 50 Lakhs and complted his national duty of shopping.
When the prices shot up he did the same again. He did this repeatedly until their complete house was spent.
Almost, all the households in the US where turned into borrowers rather than money savers. In actual terms US family savings which were $299 billion in 1990 fell to nil and then turned into a negative figure of $112 billion in 2006. With the protection, net called “social security” provided by the state saving money was considered foolish.
In the US, the recession will not be allowed to set in on the consumers’ front. They will print more dollars, put it in people’s pocket and ask them to buy.’ S.Gurumuthy
From the year 2002-2006 Rs.60 Lakh crores was left into circulation in the form of Sum-Prime mortgage. Out of this, a considerable portion was lent to unworthy borrowers. In the beginning of 2007 the demand for houses started to fall sharply. The house prices nose dived by 8% in 2006 and by 10% in 2007. This automatically reduced the security for the loans the people had taken. The banks started forcing the people to either increase the security for their loans or repay the loan. This is when the financial sector started to melt. All other sectors where in queue to be pulled down because of this mismanagement of money by the US govt and its irresponsible citizens.
The majority of money spent by the Americans in malls left US and went to countries like Japan and China. This is how it all started.How did this crisis for which the US has the right to stake full claim got converted into a global crisis? 
The money lent on sub-prime basis was not American money. The mortgaged loans of the US banks belong to banks in the Middle East, in Korea, in Taiwan or even in India.It is a US crisis at global cost. That is why it affected the world. 
Globalisation helped America to make the local loans, global loans.Out of the $1.5 trillion risk loans, the EU Central Bank issued a cheque for $512 billion in December 2007. The EU money was lent in the US, not in the EU. Today, America has become a burden on the world.They have over $7 trillions debt to the world and they are borrowing at the rate of $2 billion a day (courtesy:"America has become a burden on the world"-S Gurumurthy)
US squandered money by other means like Sub-Prime credit cards. There are varying estimates of how much was lost to this sub-prime crisis. The estimates aggregate to a startling $5.6 Trillion.
Money Borrowed Through Amount in Trillion $
Sub-Prime Mortgage Loans 1.30
Sub-Prime credit cards 2.46
Other mortgages not considered as prime 1.50
Total $ 5.26 Trillion
Currently America is borrowing at a rate of $2 Billion a day

This is how America transferred its problem into a global problem. 

Well I will be writing more about this in the next part of this blog.

……To be continued.

Surbhi Maheshwari [MBA Fin / Mktg ] 
Manager Finance
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