Why are we looking at a melt down?

March 5, 2009 – 11:55 pm – No Comment

All around the world, the recession is eating millions of jobs every month. The United States, being the largest economy, is facing the heat of this meltdown the most and is the epicenter of this disaster. This recession is the result of excessive greed. In the late 1990′s real estate prices starting appreciating in the USA and by mid 2000 they skyrocketed. Let’s understand how this led the world into the present recession.

The skyrocketing real estate prices gave the common American a unique way to make easy money. He could now buy a house and after a couple of years sell it at an appreciation of almost 50%. He could then repeat it over and over again. Since buying a house and reselling it in a couple of years was giving enormous returns, almost like guaranteed returns, individuals started borrowing heavily to buy 2-3 properties simultaneously. Banks started funding money as if they would never have to bother about being repaid. Everyone was making money in this system without any actual production or value addition taking place. In this way money was being made without much effort and the basics of economics started shattering. As it goes, excess of anything and everything is bad. Since the banks had limited money, they decided to create money. How? By securitization. They created complex derivative instruments to get more money to lend and get more returns…the page with, basics of banking in terms of leverage, was torn away from the banker’s dictionary and a new page of securitisation was added.

On the other hand, as the prices of real estate started appreciating, the owners decided that the properties were revenue machines. They started borrowing against the appreciated value of the properties thus leaving little margin for bankers to get money back in case of default.

Let us understand this entire exercise with a concrete example.

A bank X started lending heavily to all home loan borrowers without looking caring to bother about the basics of lending, that is to look at the repayment capacity of the borrower. The Bank was sure that the prices of this property would appreciate and the money would be safe. Thus bank lent its money to create a home loan portfolio. First of the problems started to arise as money which came in as monthly repayment (EMI) was less than the amount the bank was lending. The Bank then came up with another mechanism of creating money with the loan portfolio. They bundled these home loan portfolios in 2-3 segments. Segment A consisted of borrowers who had a repayment track record of more than 5 years (AAA – safest category), segment B consisted of borrowers with a repayment track of 2-5 years (AA – safe category), segment C consisted of borrowers with a repayment track of less than 2 years but more than 6 months (A – risky category). They bundled these loan portfolios and started selling them to people who were looking for prolonged stable incomes mostly in the form of pension funds. In came the role of Investment bankers, they transformed this simple instrument into more complex instruments by further dividing these portfolios into principal payments and interest payments. Thus the entire portfolio was divided into complex securities bearing different interest rates as per the category rating (AAA/ AA or A). Investors like pension funds, HNI and others bought these securities considering them safe bets as they were backed by real estate. Bankers now had more money and could lend more and repeat the whole process all over again. Thus creating a vicious circle of lending, then creating complex securities from portfolio and selling them in market for more money to lend; assuming that this money making fairy tale would last forever.

On the other hand the consumer (home loan borrower) became greedier; he devised a new strategy to make more money from his property. He started treating the home / property as an enterprise. He borrowed $800 against the property when the price of the property was say $1000 and paid only 100$ annually. The value of his property rose to $1500, so off he goes to the bank and borrows another $600 against the new value. He is easily lent the money, thanks to his good track record and also the appreciated value. At this point the Bank stopped looking at the earning capacity of the borrower and assumed that in case of default it would recover by selling the property.

The boom encouraged real estate companies to make more houses. Soon the market reached a saturation point and now there were houses that nobody wanted. The inevitable happened. Real estate prices started to fall. An average consumer in US of A spends more than he earns thus living on debt. So when the banks stopped giving more loans he had no option but to default on his EMIs. This created a panic in the market as HNI/ pension funds and other investors didn’t get their promised returns. As soon as this happened the bankers started recalling of loans, this did not work as the borrower had no savings. This led to the possession of borrower’s property by the banker, who wanted to sell it in the open market. Thus adding to the glut of houses for sale. The whole market now collapsed like dominoes, leading to total lack of confidence in the markets. this paved the way to today’s recession.