Recession
exposes inefficiency
Compiled by
Sohail Moughal
10 February 2009
Recession is a
period of reduced economic activity. The period is visible across the length
and breadth of a country and has to be more than a few months. Julius Shiskin,
in a 1974 New York Times article, suggested a thumb rule to identify recession,
which is most accepted now a days. This rule says that the recession starts
when two successive quarterly declines occur in gross domestic product (GDP)
of a country.
Even though Julius's thumb rule is accepted globally, many other professionals
believe that the roots of a recession and its true starting point actually rest
in the several quarters of positive but slowing growth before the recession
cycle really begins. Often in a mild recession the first quarter of negative
growth is followed by slight positive growth, then negative growth returns and
the recession trend continues.
Julius's thumb rule relies on the GDP, but does not take into account the current
national unemployment rates or consumer confidence and spending levels, which
are all a part of the economic system and must to be taken into account when
defining a recession and its attributes.
There are various economic research agencies in a country which collect, analyze,
and produce figures, sometimes taking a number of months, which means we do
not get the official word of an economic recession, until we are several months
into it. This does not mean that economic recessions are not foreseeable, but
they are generally not detected until already in motion.
In simpler terms, economies rely on a degree of overconfidence. The overconfidence
builds due to a gap between present realities and future expectations. This
gap is good in a sense, because without this gap there would be no entrepreneurs,
enterprise, no investment, no credit, no commerce, and no currency. However,
at a certain point, the gap between reality and expectation becomes excessively
large, and there is a need for a readjustment. Recession is that readjustment.
It is a natural result of the economic cycle and will adjust for changes in
consumer spending and consumption or increasing and decreasing prices of goods
and labor.
There are mainly two types of recessions. Most recessions are mild, "cyclical".
They come around regularly, as reactions to periods when growing confidence
gets out of control. Confidence, like fear, breeds on itself - the fact that
one is confident makes one more confident - until one becomes detached from
all sense of proportion. Sooner or later, there must be a reality check. A mild
recession is experienced by many countries on regular basis. Its the deep recession
or long economic recession that hurts all of us. A cyclical recession occurs
when a whole economy effectively looks at its credit card statement and decides
it needs to reduce its outstanding balances a bit. They stop spending and saving
more.
The more serious class of recessions are "structural". A structural
recession is more than a crisis of confidence. It occurs when a deep, underlying
problem in an economy can no longer be denied. For example, for many years,
British industry tolerated lax management and labor practices, in denial about
the fact that the British Empire was gone, and its captive markets with it.
Sooner or later, British business had to come to terms with the new reality.
That realization was the recession of the early 1980s.
It seems that almost anything related to buying and selling can trigger a recession
or a stage of no confidence. In North America, especially USA, an influx of
foreign investment, demand for more housing, and also probably influx of immigrants,
created a boom in the housing sector. This created low interest rates and very
very easy credit conditions and this more and more people bought homes. Customer's
repaying capacity was ignored by banks and many subprime loans were dished off
in many cases.
A subprime loan is not a technical term but a journalism phrase for borrowers
who do not meet prime underwriting guidelines. The term subprime often correlates
with non-conforming loans, or those that do not meet Fannie Mae or Freddie Mac
guidelines. Those guidelines may be the size of the loan, a high debt-to-income
ratio or lack of income documentation provided. Subprime borrowers have a heightened
perceived risk of default, such as those who have a history of loan delinquency
or default, those with a recorded bankruptcy, or those with limited debt experience.
The subprime loan was about 2% higher than the regular interest on prime loans,
owing to their risky nature.
The Federal National Mortgage Association, commonly known as Fannie Mae, was
was founded in 1938 during the Great Depression as part of Franklin Delano Roosevelt's
New Deal in order to facilitate liquidity within the mortgage market. It was
chartered by Congress in 1968 as a government sponsored enterprise (GSE), a
stockholder-owned corporation but the corporation's purpose was to purchase
and scrutinize mortgages in order to ensure that funds are consistently available
to the institutions that lend money to home buyers. Consequently, Fannie Mae
ceased to be the guarantor of government-issued mortgages, and that responsibility
was transferred to the new Government National Mortgage Association, commonly
known as Ginnie Mae. In 1970, the US government created the Federal Home Loan
Mortgage Corporation, commonly known as Freddie Mac, to compete with Fannie
Mae and, thus, facilitate a more robust and efficient secondary mortgage market.
The three organizations played an integral part in the development of what was
the most successful mortgage market in the world which has allowed U.S. citizens
to benefit from one of the highest home ownership percentages in the world.
Till the start of 2006, the housing prices kept soaring and many home owners
used the increased property value to refinance at a lower rate. Adjustable rate
mortgages were introduced. The subprime loan portfolios were profitable for
both parties. The lender was sure to make money if the borrower keeps paying
or even if a default occurs. On the other hand the lenders were confident of
making money too due to soaring prices.
Overbuilding continued till 2006 when the boom met its bust as it always does
sooner or later. There were no more buyers and home prices started to decline
and the interest rates started soaring. It became very difficult to pay the
higher interest rate and many opted to default on the home loans. It may have
happened otherwise too, where the borrowers with no credit histories were unable
to meet with the loan payments for longer periods. Foreclosures started and
prices went down. In both cases, the lenders were now in a situation where the
loaned amount was much more than the cost of the house. Eventually, there remained
no option but to write off losses on these loans. Hence the subprime mortgage
crisis began in 2007. Stricter lending standards were implemented and interest
rates went up, and buyers became less, the housing prices went down even further.
It seems that the crises should have been a localized issue within the United
States. However, it did not stay local and spread all over the world. Many investment
companies and Banks all over the world saw the subprime loan portfolios in the
US as an excellent investment opportunity and started buying these loan portfolios
(called MBS, Mortgage Backed Securities) from the original lenders. MBS's lost
their value when the housing prices went down in the US and foreclosures started,
lenders lost money and all the greedy banks in the world got hit hard. The terms
of the MBS's were so complicated, as to who was to manage which side of the
risk in case of a default, it took months before the banks (buying or selling
MBS's) could realize how much had they actually lost. Global banks and brokerages
have had to write off an estimated $512 billion in subprime losses so far, with
the largest hits taken by Citigroup ($55.1 billion) and Merrill Lynch ($52.2
billion). A little over half of these losses, or $260 billion, have been suffered
by US-based firms, $227 billion by European firms and a relatively modest $24
billion by Asian ones. It has led to the collapse of Bear Sterns, one of the
world’s largest investment banks and securities trading firms. The crisis
has also seen Lehman Brothers file for bankruptcy. This fourth largest investment
bank in the US had survived every major upheaval for the past 158 years. Merrill
Lynch has been bought out by Bank of America. Freddie Mac and Fannie Mae, two
giant mortgage companies of US, have effectively been nationalized to prevent
them from going down the drain.
The confidence and of course the over confidence all over the world has been
shattered. Banks wont provide loans or guarantees easily, even with normal procedures.
Every bank has gone on the back foot, playing safe as much as possible. Credit
facilities between companies and banks doing business together for centuries
have been revoked. Banks
borrow from each other on regular basis, to meet thier short term needs, even
that has stopped. Banks dont know which bank to trust and grew increasingly
suspicious about each other’s solvency and ability to honour commitments.
This has triggered a meltdown of the global stock markets. No one wants to invest
in risky business.
On the other hand consumers have started saving. They are not buying, they are
miserly maintaining and renovating. Markets have a lot of surplus goods and
sellers are finding hard to sell, buyers are not spending. A chain reaction
of panic has started. As the banks are the back bone of industries and businesses
and have stopped backing the corporate sector, a cash crunch has emerged. Industries,
plants and businesses are closing down and filing for bankruptcy. People are
loosing their jobs and the unemployment rate is soaring setting highest records
everywhere in the world.
In this age of globalisation, every economy of the world is being effected.
Governments and central banks are trying hard to stabilize the markets. They
have pumped hundreds of billions of dollars into their money markets to try
and unfreeze their inter-bank and credit markets.