Recession – Causes and Solutions

This blog is my understanding on why the United Stated/World is in recession. I have tried to keep this as simple as possible and explained financial terms wherever used.

Causes

Sub Prime Mortgage Crisis:

Sub Prime Mortgages is the root cause for the economic meltdown. Subprime mortgages simply mean mortgages that do not meet prime standards. It is a financial term which involves financial institutions lending money to home owners without ensuring borrowers credit ratings1, ratio of borrower’s debt to income2 and/or reasonable documentation that meet underwriting3 guideline.

Booming US economy and housing market coupled with growing competition between financial institutions lead to institutions following subprime standards to ensure borrowers get the loans quickly and with the least documentation. Most of these borrowers have low FICO4 scores and/or excessive debt, history of missed payments etc. Subprime lending led to easily available loans fuelling the housing market boom thus driving housing prices up. Finally the housing bubble had to burst when most of the home owners started defaulting their payments which led to foreclousers5.

Securitization:

Securitization is the process of converting cash flow producing financials assets to securities6 that can be sold to investors. Mortgage loans cannot be traded in the secondary market hence financial institutions (investment banks, government agencies) started purchasing these loans from banks/Mortgage companies and converted them to securities. These securities are called Mortgage backed securities (MBS). These loans are converted to MBS or other securities called CDO’s7 and then sold out to the investors. The investors then receive their monthly payments indirectly by the home owners who make payments against their mortgage.

Securitization also led to transferring the risk of mortgages from banks to investors. This made financial institutions offer more loans and transfer a part of the risk to these investors. Such securities are traded across the world. Financial institutions that issued these securities also retained most of them for investment purposes. Once home owners started defaulting investors/investment banks/mortgage lenders who invested in them, which was most of the world’s leading financial institutions, started booking losses. This wiped out most of the institutions assets/cash reserves and some of them had to file for bankruptcy.

Credit Default Swaps (CDS):

CDS is a contract between two parties whose purpose is to either hedge8 from the risk of default or to profit from speculation. These contracts can be compared to insurance against an asset. It’s similar to the insurance you take against your car (underlying instrument/asset), i.e. you pay the insurance company a premium and if anything happens to the car the insurance company pays you for the damages. In a CDS contract the buyer pays a premium to the seller for insuring the underlying instrument and in turn the seller pays the buyer if the instrument defaults.

During the end of 2007 most of the financial institutions realized that they have huge amounts of risky instruments such as MBS/CDOs/Bonds9 in their books. They created CDS contracts to hedge this risk. With the bankruptcy of major companies such as Lehman brothers, Washington Mutual etc there were billions of dollars to be paid by CDS sellers, which further created holes in the deep pockets of financial companies.

Government Regulations:

CDS/MBS and other such credit instruments are very lightly regulated by the government. The market has no transparency and all of the contracts are negotiated privately. Moreover these instruments are traded over the counter i.e. there is no exchange that monitors/facilitates these trades. Due to this the credit market grew exponentially and was one of the reasons leading to the demise of companies.

Credit Rating Agencies:

There is lot of criticism surrounding the formulas used by rating agencies that rate credit instruments. Most of these instruments where given high ratings thus encouraging investors to invest more into them. During the end of 2007 the rating agencies lowered ratings on MBS after home owners started defaulting and housing prices started crashing. Due to this the financial companies had to acquire additional capital through the issue of fresh stocks thus lowering the existing share prices and fuelling their existing financial problems.

Losses and Unemployment:

Financial institutions started announcing losses due to all of the above reasons. They started laying off employees and postponing projects to cut costs. Since banks did not have cash reserves other sectors started feeling the pinch. Unemployment and the fear of being laid off kept employees from buying less, spreading the downturn to the other sectors. Credit crunch clubbed with lower purchasing power further fuelled the recession.

Solutions

The governments across the world have taken steps to combat recession. They have announced huge bailout packages to companies (mainly mortgage companies, banks and auto sector) and also secured toxic/bad assets. Government passed fresh immigration and outsourcing laws to increase employment within the country. They are also considering tax reliefs and helping distressed home owners.

1. Credit ratings – Ratings computed by agencies to assess borrower’s probability to repay the loan.

2. Ratio of borrower’s debt to income – Amount the Borrowers has in debt compared to his income

3. Underwriting – It is the process that a large financial institution uses to assess the eligibility of a customer to receive their products

4. FICO – Fico scores is the best know credit scoring system in the US. They are calculated based on complex formulas that weigh the amount of debt you carry to your available credit, the timeliness of your payments, the type of debt you carry, and other factors.

5. Foreclosures – Process by which the holder of a mortgage seizes the property of a homeowner who has not paid interest and/or principal payments on time.

6. Securities – Instruments that are traded and represent some financial value.

7. CDO’s – Collateral debt obligations are asset backed securities whose value is derived from the underlying asset. A pool of underlying assets is assembled and securities called CDO’s are created out of them.

8. Hedge – Offset

9. Bonds – Is a security where the bond issuer pays the bond holder interest on a periodical basis and repays the principal amount on the maturity of the bond.