The Crisis in the US Financial Markets

The international financial market is currently in a crisis the intensity of which is unprecedented since the Great Depression of 1929-30. Within a week we have witnessed the serial closing down of the biggest investment banks in the USA and the world, some of which, like the Lehman Brothers, survived the aftermath of the Great Depression. In order to put breaks to this slide, the US Government has been forced to intervene in the market in a big way. Even then, nobody is sure whether this crisis will end or not; nobody is even sure whether we have witnessed the worst phase of the crisis or more is yet to come. In this context the following questions are being raised:

How severe is the crisis?

It is argued by certain sections of the media that ultimately, the world has witnessed such crises in the past. In 1997-98 there was the East Asian financial crisis. So the present crisis is no different. This argument is way off the mark because of the following. To be sure, the East Asian financial crisis was very serious and affected a large number of countries, including Brazil and Russia. But it originated and caused problems for countries which were in the periphery of capitalism. Ultimately, the origin of the crisis and its effect were largely limited to developing countries, with limited impact on developed countries. Even India and China, although so close to the East Asian theatre were not affected by it. But the present crisis has taken place in the heart of modern capitalism, the USA. This alone points to the fact that this crisis is of a qualitatively different nature.

In contrast to this, it is also being argued that this is not the first financial crisis that the USA has faced. Even in the recent past, during the late ‘90s and early part of this century, the USA economy witnessed similar problems following a period of relatively better economic performance. Thus, this crisis will not pose serious problems for the US too. What is missed in this type of analysis is the fact that the present crisis engulfs not only the financial sector of the US economy but has serious repercussions for the real sector of the economy also. While this will be taken up later, it suffices here to point out that the biggest investment banks in the USA have collapsed and the government has come out with the biggest bail out plan in the history to save the financial sector in the USA and the world. At least, the US Government knows how serious the crisis is. According to renowned economist Paul Krugman, the broadest measure of unemployment in the USA, has risen from 8.3 percent to 10.3 percent over the past year, roughly matching its high point five years ago.

How did it all go so wrong?

Let us first look into the functioning of banks. If the banks are giving loans to the public they have an expectation and assessment regarding the public’s credibility to pay back the loans. This expectation is backed by the collateral of the loan or the valuation of the project for which the loan is claimed. As long as the banks have correct estimations regarding the valuation of the mortgage or the project, its expectation will be realized. If due to some reason, the value of the mortgage or the project suffers drastic decline, then the possibility of the banker getting back the loan reduces greatly. Now, loans given by banks are assets to them. In case of defaults, this financial asset for the banks becomes essentially valueless. On the other hand, based on these assets, banks take credit from other agents for various purposes. Now, if the asset position of banks weaken then there exists a risk that the Bank will not be able to pay back to its creditors. If this happens in a large enough scale then the bank has to go bankrupt.

Let us now see what happened in the US markets. Firstly, it should be noted that the economic growth in the USA is largely consumption driven, with housing forming a very important part of consumption demand. Owning a house in the USA is a matter of social prestige and security. But every individual who is investing in housing does not necessarily build it in order to stay but sell it at a future date to gain profit. There was huge housing price inflation in the USA, which was largely based on speculations and higher demand for houses. As a result of this high price of houses, many more individuals started to invest in housing.

Now, in order to invest, the investors needed loans from the banks, which were provided against a mortgage. Since there was a housing price inflation, many borrowers managed to pay back the loans between 2000 and 2003. This increased the expectation of the banks that giving loans for the housing sector is actually profitable, since in the past loans were recovered based on the housing price inflation. Moreover, with the housing price inflation continuing, the banks estimated that by selling the houses, in case of default, the loan could be reclaimed. This reduced the bank’s scrutiny of the mortgages and resulted in giving more loans to borrowers whose creditworthiness was low, which are essentially the sub-prime loans. In 2006, 20.1% of all mortgage backed loans were sub-prime.

This did not cause any alarm, as long as the housing price inflation continued. But this could not continue for long due to a simple economic factor. With the housing price inflation a large number of investors invested in the housing market which resulted in a steep increase in the supply of houses. At the same time the demand for houses could not increase more since there was a slow down in the growth rate of GDP and increase in unemployment between 2001 and 2005. Both these factors had to bring the price of houses down which started to decline sharply from December 2005. This resulted in problems for the banks through two routes. Firstly, the valuation of the project (houses) for which the loans were taken declined. Secondly, loans were issued against mortgages of lower valuations to begin with. This resulted in a situation where the banks could not recover their loans and suffered losses.

The above discussion raises two issues. Firstly, why were such sub-prime loans given in the first place? Secondly, how did the problem in the housing market and the sub-prime mortgage market become such an all encompassing problem for the financial sector?

The answer to the first question lies in two facts. One is that there have been substantial de-regulations in the USA following the decline in the earnings of commercial banks in the United States in the 1980s. Secondly, the unbridled quest for profits is also responsible. Every bank is thinking that if I do not give the loans somebody else will give and earn profits. Hence, in the end, every bank starts to provide these sub-prime loans.

On top of this, the banks engaged in myriad forms of financial innovations which resulted in contagion of the problem in the housing and the sub-prime mortgage markets to other financial segments. What was essentially been done is the following. Suppose person A takes a sub-prime loan from a bank. Now for the bank this is an asset, since this will generate a future stream of income. Subsequently, the Bank floats another subsidiary or the Special Purpose Vehicle (SPV) to which it sells this asset. With the selling off of this asset the risk associated with it is also transferred by the bank. The SPV issues papers called securities to sell in the market and mobilize funds to buy the asset. The return to these papers is linked with the performance of the original asset. Moreover, these papers are itself assets to its holders against which loans can be taken. (This process is called securitization. It is estimated that 80.5% of the sub-prime loans were securitized in 2006.)

Now, if the person A defaults in his payment commitment to the bank, then there is no income flow that is coming from the loan as an asset. If the mortgage is not securitized then the initial bank from which the loan is taken suffers loss. On the other hand, if it is securitized, all those who are holding securities on this asset do not get any return. As a result with the initial asset becoming valueless, a chain of assets become valueless. This results in problems for large section of the players in meeting their payment commitments. More financial instruments such as these were produced in the US market which resulted in the contagion of the problem of the housing and sub-prime mortgage markets to the entire financial architecture resulting in bankruptcies as has been mentioned above.

In short the financial de-regulation of the financial sector along with the banks’ profligacy in providing sub-prime loans, based on wrong assessment, along with the innovations of various financial instruments led to the massive crisis in the financial sector in USA.

This crisis essentially has resulted in a loss of confidence in the financial sector, resulting from massive defaults, where people are not sure whether they will get back the money that they are lending. As a result people who are willing to borrow money from the market are not being able to get it. This is harming investment prospects in the economy. Moreover, massive job cut in the financial sector is also causing a decline in the aggregate demand in the economy. Both of these are slowing down the US economy.

What does the crisis signify?

There is a theory in economics which says that the Government is inefficient and can never be a solution to economic problems. In fact it was believed that the Government is a problem and not a solution as far as working of markets is concerned. The first casualty of this crisis, apart from the US economy and the banks, is this orthodox belief in the ultimate efficacy of the market mechanism. This economic myth was proved wrong during the Great Depression and again has been proved wrong today. The crisis proves that unbridled free market orthodoxy results in massive crises. Now, it is the US Government which has to step in with a massive bailout plan of $700 billion to save the private banks and other players in the financial market.

Secondly, the invincibility of American capitalism has been questioned like never before, at least not since the Second World War. For all those, who are talking about how good the US economic system is, please hold your breath and look at the mess that the US is in right now. The present crisis should also be a wake up call for all those who want to mould the Indian economy like that of the USA.

Thirdly, for Indian Government this is a wake up call against the policies of financial liberalization that it wants to pursue. Clearly, the model of unbridled financial liberalization has failed in the USA. It is high time that our Government drops the idea of putting us voluntarily into the possibility of a crisis that the USA is currently faced with.