Financial Crisis 2008-2009, The Seeds of the Credit Crunch

By: Akhil_Khanna

Currently the whole world is in the midst of a financial crises. The crises began with the sub-prime housing problem in the US and over the last two years has spread to the rest of the world. The problem is huge to such an extent that we are currently seeing an unprecedented economic slowdown and talks of a global recession are gathering steam.

All the Central Bankers around the world are following the US in declaring stimulus packages worth Trillions of Dollars in order to jump start their economies. Countries are taking over their banks who are unable to smoothly run their traditional business of lending which in turn are slowing down their economies at grass root level, hence forcing companies to cut jobs or declare bankruptcies. The banks have trillions of dollars worth of bonds on their books which they cannot sell as the demand for those bonds have almost vanished.

Originally Written During March 2009

The demand for all products and the world trade has fallen off the cliff. IMF is cutting their projections for the growth rates of various countries and the global trade figures on a monthly basis. The ability for companies to role over their existing loans has diminished substantially and if they can actually role it over the costs involved have increased. Manufacturing and exporting companies, on one hand, are bearing the brunt of slowing down of demand of their products and on the other, booking losses on account of exotic products sold to them by banks and financial institutions in boom times.

The consumers in the developed countries like US, UK, Europe are facing the brunt of falling asset prices, real estate, stocks, commodities on one hand and the increasing debt levels in their house hold balance sheets while banks withdraw or draw down their lines of credit. The banks are faced with rising defaults by customers on their loans on one hand and non saleable assets like bonds on the other. The developing countries like China, Japan, India are faced with slowing demand for their products leading to increasing trade deficits, weakening currencies etc. Apart from these problems most of the problems faced by developed countries are similar to ones being faced by the developing countries as well.

We are trying to pen down the reasons which attributed to the evolving of this financial crises and the abnormal changes in the world businesses in the last 5 years. The language and terms used are kept simple and are intended to make sense to a person not too well versed with the world of Finance. The aim of this article is to keep the explanations and reasoning simple and easy to understand. This is to educate the man on the street on the happenings in the Financial world which directly or indirectly will effect the lives of almost every human being on this planet.

Introduction

The World is Financial going through unprecedented times. There has been the biggest boom in the history of capitalism in the last five years from 2003 – 2008 and currently we are going through the unwinding of the same since the beginning of last year.

The stock markets around the world have crashed by an average of 50% from their peaks, the volume of transactions in properties have fallen by 75% and the prices of the same have sharply corrected after rising multifold in the last few years. The interest rates around the world have fallen sharply, most of the developed countries have already cut their interest rates to zero or are almost there. Many Banks around the world are faced with the prospects of rising defaults and falling value of asset prices below the value of loans outstanding against them putting them in the high risk area.

The Central Bankers around the world who were earlier dealing with the problems of rising inflation are now using all their monetary and fiscal policies to prevent the onset of deflation around the world. The developed countries were facing the brunt of strengthening currencies during the last few years resulting in inflation in their respective countries are now seeing their currencies depreciating to all time lows against the Yen and USD.

The first portion of this write up tries to identify the main reasons for the creation of this abnormal boom in asset prices during the last five years. The three reasons we identified were the Derivatives, Leverage and Commission based remuneration system. The first two were extensively used by the speculators to distort the pricing mechanism of every tradeable asset and the third resulted in the short term approach / outlook to businesses without taking the long term risks in consideration. These three reasons are not exhaustive but played a major role in the current crises.

We then go on to see the effects of the boom in the behavioural patterns of the boom on households, corporates, bankers and the government in the U.S. The boom changed the way they managed their individual budgets and altered the way they viewed risk and debts. We also try to see the effects of the boom in a country like India. We will use India as an example but the same applies to all the nations supplying goods or services to the developed world.

We then proceed to write about the current state of affairs and the effects of the busting of the credit bubble on all the effected parties namely households, corporates, bankers and the government. We conclude by taking a brief as to where we are heading a few years down the line. This article intends to get everyone who invests their hard earned money or runs their businesses to give more thought to the investing process and not to follow the crowd blindly or hand over your savings to someone else in the hope that they will earn money for you.

CHAPTER 1 : The Weapons of Mass Destruction in the World of Finance

The Prime reason of the Boom in all Stocks, Real Estate and Commodities (Anything that has an element of derivative trading in it) of last few years and the Current Financial Crises can be attributed to the following three weapons of mass destruction (WMDs) which George W. Bush was looking for in Iraq.

Financial Derivatives

According to the Dictionary “Financial Derivatives are financial instruments whose value is derived from the value of something else. They generally take the form of contracts under which the parties agree to payments between them based upon the value of an underlying asset or other data at a particular point in time. The main types of derivatives are futures, forwards, options and swaps.”

Example of Derivative
If we buy 100 shares at $50 and the price appreciates to $75, we have made $2500 on a mark-to-market basis. If we buy the shares at $50 and the price depreciates to $25, we have lost $2500 on a mark-to-market basis.

Instead of buying the shares in the cash market, we could have bought a 1 month call option on ABC stock with a strike price of $50, giving us the right but not the obligation to purchase ABC stock at $50 in 1 month's time. Instead of immediately paying $5000 and receiving the stock, we might pay $700 today for this right. If ABC goes to $75 in 1 month's time, we can exercise the option, buy the stock at the strike price and sell the If the ABC stock price goes to $25, we have only lost the premium of $700. If ABC trades as high as $100 after we have bought the option but before it expires, we can sell the option in the market for a price of $5300. The option in this case gives us a great deal of positional flexibility with a different risk/reward profile.

If the ABC stock price goes to $25, we have only lost the premium of $700. If ABC trades as high as $100 after we have bought the option but before it expires, we can sell the option in the market for a price of $5300. The option in this case gives us a great deal of positional flexibility with a different risk/reward profile.

The Derivatives were basically evolved as financial instruments in order to hedge risks or act as an instrument to insure against risks. Over the years these instruments became the prime source of speculation and as they were high risk / high returns financial trading instruments.

Financial Leveraging

The Dictionary defines Financial Leveraging as The use of credit or borrowed funds to improve one's speculative capacity and increase the rate of return from an investment, as in buying securities on margin. You can clearly understand the concept of leverage by going through this example :

Let's say you open a stock-market trading account with a bank. You send them $50,000 and they deposit that money into your account. You use that money to buy $50,000 in stocks You now have assets worth $50k. The bank will lend you up to 50% of the value of those assets (if you don't pay them back, they'll sell your stock to cover it. If the value of your stock goes down, there's enough "room" in there -- 50% -- that they can always sell off your assets if things start going badly in the stock market). This is called a "margin loan"... You decide to do this, so your bank writes you a check for $25,000.

You decide to take your $25,000 and open another investment account at another bank. You deposit your money, buy more stocks, and, once again, take out another margin loan. They send you a check for $12,500. You take this check to E-Trade and open another brokerage account, buy more stock, and take out ANOTHER margin loan for $6,250…. You see where we’re going. The term for this is "leveraging up". Your $50,000 allowed you to own nearly $100,000 REAL assets.

Speculators used this concept alongwith the derivatives to destroy the pricing mechanism of a product or services on the basis of the traditional concept of demand and supply. The price of any product which had element of futures, options, swaps had the turnover in derivatives eight to ten times the normal demand on cash basis (payment of full price). There was trading of paper in everything and the price spiral built upwards fueled by derivatives and leverage in the last five years.

We are now on the other side of the tornado and seeing the spiral unwind since the beginning of 2008. Leverage is an excellent profit multiplier in good times (if you are on the right side of the movement in prices) and it is your worst enemy at the times of if the prices move against your position.

If you are leveraged 10 times to your capital deployed, a rise in 10% will double your profits as calculated on the basis of capital invested. On the other hand a fall of 10% in the prices of the asset can wipe out your capital. A fall in 20% will wipe out your capital and leave you with a debt payable equal to the value of capital deployed.

Commission / Fees based earnings

This model of earnings too played a big role in the creation of the biggest credit bubble in history. All the parties to the credit circulation namely

CEOs and Traders at the Banks/Financial Institutions/Hedge Funds
Distributors of Financial Products like Mortgage Backed Securites
Rating Agencies
Loan Approvers / Asset Valuers
Property Agents

were earning their income based on Commission / Fees model of remuneration. Their main motive was to sell as many products as they could irrespective of the quality of the products they sold. There was no accountability as to the risk involved in transferring the assets. The common belief was that if the asset has been sold to another party the risk to the selling party has been eliminated.

There was also conflict of interest involved. For eg. The credit rating agencies who were responsible for rating the corporates performance and their bond issues were earning their income from the same corporates which the corporates used it to their advantage using the carrot and stick rule. Higher the rating, higher the fees earned by the Credit Rating Agencies.

This was also evident in the conduct of agencies who were employed by Banks /Financial Institutions to verify and collect income proofs for housing loan approvals. They were paid on the basis of no. of application approvals they brought. So they indulged in creation of fake documents or misrepresenting the facts which led to loans being made to consumers who were not in a position to repay the loans they were given. The agents were off the hook with their earnings in their pockets once the loan was approved.

This short term outlook on businesses was visible in the attitudes of banks who packaged mortgaged loans into bundles, got them rated AAA from rating agencies by paying them higher fees and then sold them off to hedge funds or insurance companies as safest bond investments thereby pocketing hefty fees on trading of such securities. Their main motivation was maximizing their short term returns by hook or crook and getting the risk involved in holding the assets (mortgage backed securities) on someone else’s balance sheet.

CHAPTER 2 : Creation of World Credit Bubble

In 2003 the world was just recovering from the after effects of the Bust of Dot Com Bubble. In order to revive the US Economy, which is considered as the engine of the World Economy, Fed had cut interest rates down to 1% in the middle of 2003.

This led to the belief that the USD was a weakening currency and there was a great rush of investment bankers, hedge funds and financial companies to invest their funds in emerging markets, Europe and U.K. There was a huge outflow of funds from US to the rest of the world which resulted in the weakening of USD against all currencies.

Some examples are :

Euro strengthened from around 1.2 to 1.6 to a USD
UK Pound strengthened from 1.8 to 2.1 to a USD
Indian Rupee strengthened from 44 to 39 to a USD

Similarly all the currencies worldwide strengthened against the USD and the USD index fell from 100 to a low of 75. This marked the creation of asset bubbles across the world. The money which moved from US was converted to other currencies and invested in stocks, bonds, commodities and real estate all around the world.

Meanwhile due to the low interest rates and lax lending standards of banks, the surplus money in the financial system in the U.S. too started flowing to the assets like stocks and real estate thus creating the biggest credit bubble in the history of the world.

The Capital flow worldwide was multiplied by using the system of Financial Leverage (Hedge Funds and Financial Institutions were leveraged to the extent of anywhere between 20 and 50 times at the peak of the boom in the beginning of 2008) and lead to a substantial rise in the values of all asset classes like Stocks, Bonds, Commodities and Real Estate.

Speculative Derivative trading (whereby a small capital was invested resulting in multiplying the returns) too fueled the fire with creating credit out of thin air to purchase more and more assets.

This resulted in stock market indexes in various countries running up more than 300% – 700% within a span of four - five years. The commodities index too increased multifold with oil shooting up to almost $150 from less than $30 during the same period. Similar case was with commodities like industrial metals like copper and precious metals like gold, silver etc. The bond yields too fell to historic lows (Bond yields are inversely proportional to the prices of Bonds). Real Estate prices too rose three fold in this short duration surpassing all historic parameters of rental to capital value and affordability index.

Effects of the Creation of U.S. Credit Bubble

The increase in asset prices led the U.S. population to believe that all asset prices can only rise and the speed of increase in prices fueled greed even in the most conservative investor/household. They started leveraging their positions by taking loans and mortgages and further fueled the massive credit bubble leading to substantial increase in inflation.

The effects of this bubble will be classified into the following categories

• Effect on Banks/Financial Institutions
• Effect on Households
• Effect on Corporates
• Effect on Government

Effect on Banks/Financial Institutions

Banks were flushed with funds at the cost of 1% which they had to lend to customers in order to improve their profitability. They lend funds to customers to buy houses without appropriately verifying their documents the responsibility of which they had outsourced to external agencies who were just concerned about earning their commissions.  

These agents first exhausted the consumers who were genuinely qualified to avail the loans and pocketed the commissions (The Prime Loans). Once that market got tapped out they started enticing consumers who were not able to service the loans and staying on rent to buy houses. They helped them with fake documents and qualified them for the housing loans. As their commissions were based on the value of the loans disbursed, they roped in the Property Valuers into giving higher valuation for the properties that their customers were planning to buy. This led to increase in property prices on paper and banks made bigger loans on the same properties.

To top it all the speculators moved in large numbers armed with some capital and lots of bank loans getting financial leverage to play its role in increasing the demand resulting in the increase in the price of real estate all over the country and hence increasing the returns of speculators.

This spiral continued to build upwards like a pack of cards resulting in a general feeling of wealth creation between 2003 – 2007.
The banks now faced with increasing demand for loans were pressurized to increase their lending capital. They bundled up the loans given to the consumers got them the best rating from the Credit Rating Agencies and sold them off to the Agencies handling investments for the Public Funds like Insurance companies, Hedge funds etc. This enabled them to free more capital to lend and also earn fees in trading those securities. The income of banks was being generated by just trading paper, no productive activity was being done which would enhance the value of the services or be useful to society at large.

Now the banks were armed with more capital to lend and most of the people who could qualify for loans and lots of people who could barely manage to pay the installments had already availed the loans. Keeping the commissions to be earned on giving loans in view and that housing prices were continuously rising, the banks enhanced their innovative lending practices and came up with interest only or teaser loans.

These interest only were loans in which the consumers only paid interest only on loans for the first few years and then paid the full installment including the principal. The teaser loans were loans in which the consumers paid only part of the interest and the balance of the unpaid interest component was added back to their loans a few years down the line. This reduced the installment required to avail the housing loans substantially and hundreds of thousands of consumers qualified for the loans on the basis of their earnings. Another round of commissions/ bonuses earnings were generated for everyone involved in approving and disbursing these loans which are now classified as the Sub-Prime Loans.

The real estate prices at the peak of the bubble had risen to 3-5 times their value in the last 3 years. The bank earnings and bonuses for their senior executives were growing leaps and bounds alongwith everyone involved in the racket like the Credit Agencies, Property Valuers, Loan Approvers, Property Agents etc. and everyone was enjoying the best party of their lifetime.

The Credit Card companies who are basically into the business of giving loans to people at an interest of 36% plus per annum too played an important role in expanding the credit bubble. The US passed a law in 2005 making bankruptcy for citizens and small businesses a more expensive and difficult task. This led the Credit Card companies to increase the credit lines of the customers believing that as bankruptcy was a difficult option, the consumers would have no other option but to keep on paying their minimum balances. These companies would increase their profitability by increasing the amount due by customers on levying higher fees, interest and  faulty interest calculation methods. They intended to create debt slaves on the lines of which the Zamindars in Indian villages make bonded labourers of farmers who borrow from them and lifelong are unable to make themselves debt free.

Effects on Households

The normal consumers, who were living in their own homes, suddenly woke up and found that the value of their houses have started going up first gradually and then at a reckless speed. They found sudden confidence in their being wealthy. The banks too started marketing refinance of mortgages (to earn higher fees and commissions) at attractive terms. The consumers calculated that refinancing the mortgages would lower their mortgage payments and they would have spare funds to spend even though their incomes remained the same. They also saw that saving was not a fruitful exercise because they hardly got any returns in fixed deposit with banks. Some of them even took a fresh mortgage on their existing house and used it as a down payment for a new house. Leveraging themselves to maximize their returns.

The consumers who did not have a house and lived on rent got enticed in the attractive housing loan schemes and went in for housing loans for the fear that if they were too late in buying their dream home they would not be able to afford it in future because of the speed at which the real estate prices were increasing. They stretched themselves to the limit and bought houses.

The consumers who, because of their lower income, would never dream of owning a home got lured by the interest only and teaser loans which on the face of it appeared affordable to them without giving much thought to the consequences which would take place when the loan installments were set to the original (Principal plus unpaid interest) a few years down the line.

So everyone started buying properties leading to a surge in demand and eventually fueling the unreasonable increase in price of real estate. Owning the dream home not only became a right for every household, it also started being used as an ATM to fulfill immediate desires. With extra disposable income people started buying everything that they wanted and moresoever everything else that they did not need. Money was easily available at amazingly low interest by refinancing their homes and multiple credit cards available to every individual.

Savings became a thing of the past and judicial spending out of fashion. What anyone wanted had to be purchased immediately and funded through borrowings. The rising stock markets and asset prices gave the consumers confidence to be sucked deeper into debt. Mr. Jones, with an annual income of $100,000/- p.a before tax, who wanted to spend $50,000/- to renovate his kitchen would do it without a second thought. The renovated kitchen (granite slabs, modular cupboards etc) would now require latest gadgets, new household appliances, expensive TV etc immediately, so another $20000/- for that and getting the house hold renovated is tiring so a family vacation to an exotic place, $30000/- spent. The whole annual earnings gone in a couple of months. Expenses, no problem, there is the Credit Card and if it maxed out, refinance the mortgage on the home or take out a new loan on the same house. No need or want has to be postponed even for a day. If Mr. Jones got all this done, his neighbor, Mr. Smith would want to outshine him and the whole cycle is repeated. Get the picture that was playing in 2006. Typically Punjabi.

The households were burying themselves in debt with the firm belief that the housing prices only go up and in case of shortfall of funds they could always use their house as an ATM or get a new credit card. The thought process of saving and earning became an alien concept which was so old fashioned. At the peak of the bubble in 2007, people started rethinking of the concept of working to earn a living. Why do you have to work for a living, if your house value only goes up and you can refinance your home anytime you want??

Effect on Corporates

The demand for houses was shooting up. The existing houses were already sold and reselling at unheard of prices. There was an acute shortage of houses. The construction industry started building like there was no tomorrow. This led to a substantial demand for cement, steel, copper, wooden board, granite etc. Subsequently these industries too started operating at full capacities. When the demand could not be met from the domestic industry these items started being imported from other countries. The demand for engineers, contractors, laborers too shot up. The construction ancillary industries started taking debt (at rock bottom interest rates) and started expanding their capacities.

The surge in housing demand and the spending habits of the people gave way to the idea that there was a huge demand for commercial property. Malls and Restaurants for the consumers and office space for the corporates. The same herd mentality which was working for housing started working for the commercial projects. Land was acquired at absurd prices and commercial space was being sold / rented at even more absurd prices. The leverage and commission based incentive structure contributed to this spiral in prices and demand for commercial space.

This surge in demand caused a huge demand of raw materials. People and Corporates got more confident in emerging themselves deeper in debt with a view that the demand for all items can only go up. The demand for Cars, Consumer Durables, Furniture etc started hitting the roof due to the spending habits of Consumers and the Corporates. As business incomes were growing cost monitoring became out of fashion. Corporates spent hundreds and thousands of dollars for meetings in exotic locations, traveling first class for employees etc. The higher the sales more support staff was required for telemarketing, book keeping, compilation of data etc.

The Corporates came up with the idea that in order to increase their profitability, they should get their goods manufactured in other countries with cheaper manpower. This would save them huge investment costs, setting up gestation period, operational hassles and they would make money just by getting it manufactured in some developing country like China and sell them to the US citizens who were spending like there was no tomorrow. For marketing and follow-ups they would use a country which has English speaking population like India. The wide spread use of internet and technology enabled them to outsource manufacturing activities to countries like China and telemarketing, back office operations to India.

This led to a drastic improvement in the profitability of companies and their share prices rose adjusting to the revised price earning ratio. The prices of commodities too rose multifold due to the increased demand in the construction, car, consumer durables industries. The unemployment was low, confidence was high amongst the population of the country that their wealth is for real and is a never ending phenomenon. Copper prices rose from about $1000/lb to $4000/lb, lead rose from under $0.5/lb to more than $1.5/lb. Similarly all metal prices shot up multifold partly due to increase in demand and mainly because of speculation using leverage and derivatives.

A great role in the increasing the values of share markets and the commodities markets around the world can be attributed to the use of derivatives in speculation. A small capital is required to be invested to take a substantial portion of exposure in any of the markets. As the markets were moving in one direction and the volatility was low the returns made by speculators on their capital invested were enormous. The speculation was done by individuals, financial institutions and hedge funds which were flushed with funds.

The increase in stock market and commodity markets fueled the rise of mutual fund industry and the markets trading businesses like brokerages. The companies who did not want to take any risks with their surplus funds were investing them in debt funds which in turn were investing in the mortgage backed securities which the banks were selling. The debt and bond markets around the world are much bigger than the stock and commodities markets. The consumers too seeing the stock markets rally started taking low interest loans and investing in the stock markets, leveraging their bets and creating a house of cards on the foundations of debt.

So in the end we had all the industries doing well like banks, construction, raw materials, metals,  brokerages, mutual funds, heavy equipment manufacturers, consumer durables, retailers etc. Everyone was expanding their capacities, by taking on huge debts, based on future expectations of the same growth rate of demand of their products. The world wide trade was booming to such an extent that the Baltic Dry Index (the index for movement of goods around the world) increased from a level of 1600 in 2003 to a high of 11600 in 2008.

Effect on Governments

The industrial growth picked up speed as demand for all products started rising in a chain reaction due to the increase in availability of credit to one and all. Inflation was on the rise. In order to control the increasing inflation, the FED started increasing the interest rates and increased them from 1% to 5.25%. As usual they were too slow in increasing the interest rates and could not prevent the credit bubble from expanding.

The increased industrial activity, rising stock markets, commodities markets lead to the increase of revenues for the govt. in the form of increased income and property taxes, sales tax etc. The manufacturing basis had shifted to China and due to the increased imports of consumer and capital goods into the US the trade trade deficit of the United States with the rest of the world expanded to more than $800 billion in 2008 from $532 billion in 2003 (Source : Foreign Trade Statistics) and increase of more than 50% within a span of 5 years. The main imports of goods into US was from Japan and China and import of services was from countries like India.

The increasing US deficits were being funded by the same countries who were supplying goods and services to the US. Countries like China, Japan and India who were selling goods and services to the US were being paid for in USD. They took the USD and paid their domestic corporates in their local currencies (This was the cause of inflation in these countries). These govts. had to do something with the trillions of USD they had. They in turn invested them in US treasury bonds.

The increase in govt. revenues did not prompt the govt. to save or put the earnings to good use like to improve the  infrastructure of the country. They spent the money in unproductive areas like increasing the cost of their own setup by increasing the salaries and benefits to govt. employees or in fighting meaningless wars in Iraq.

As the increased economic levels were benefiting the government and they could take the credit for all the good sentiment prevailing in the economy they were not interested in identifying the root cause of this heightened economic activity. They did not want to be seen as party stoppers when every one was having so much fun even though the basis of this whole setup was easy credit, speculation and fraud.

We have used U.S. as an example to explain the effects of the creation of the Credit Bubble. Such bubbles were being created in all the Developed Countries, namely U.K., Europe, Canada, Gulf etc. Easy Credit availability and the spending boom it unleashed spread throughout the World. The reasons of bubbles were different, in the U.S. it was the credit availability, in the Middle East and U.S.S.R. the earnings were fueled by the higher sale proceeds of Crude Oil, in Australia the rise and demand of commodities led to rise in Exports.

Effects of the Credit Bubble on India

We are using India as an example to explain the effects of the US bubble on a country which emerged as a back end services provider to the US and the western world. The effect would more or less be similar to the countries like Korea, Japan, China who evolved as the hub for manufacturing products for the consumers in U.S. and the western world.

As the credit bubble expanded in the western countries and the companies in the developed countries decided to increase their profitability by shifting manufacturing and back end work to countries with lower manpower costs, India evolved as a major contender for back end work like data processing and tele-support functions for consumers in U.S. This was due to the availability of low cost English speaking population in the urban cities of India.

The Multinational Companies set up their own back offices/call centres in India. As more and more business started to flow in, new back offices mushroomed in areas like Gurgaon, Banglore, Chennai etc. Alongwith it the spending boom of consumers in the Western Countries caused the exports of items like Gem and Jewellery, Textiles etc to explode.

So there was a rush my companies to expand facilities by taking on loans, setting up infrastructure/manufacturing facilities. The export orders kept on increasing leading to increased demand in steel, cement, office space etc. These industries too started expanding their capacities by taking on additional loans with a view that the demand would keep on increasing and servicing of the loans taken by the increased profitability would not be a problem.

The demand for manpower increased multifold due the demand from all the industries. The call centre exports required a large no. of trained English Speaking employees while the exporters required large no. of laborers for production. The Call Centres started recruiting graduates and trained them to speak various accents and put them on the job. A graduate who used to get Rs. 5000/- p.m. started getting Rs. 25,000/- as soon as he finished basic education. The profit margins were so huge due to the rush of orders that the corporates did not mind paying such salaries.

These fresh out of college students started getting salaries their parents got after decades of service had no financial obligations at home. Most of them were low on Financial Literacy and used the additional earnings to spend in buying branded products, pubs and eating out, movies, taking cars and houses on loans etc. This in turn led to a boost in the development of Malls, Pizza Huts, Cafés etc.

The property rates soared and land was being acquired left, right and centre from villagers outside the metro cities for office space, malls and export manufacturing units (S.E.Z.s). The construction and infrastructure industry started booming. Land was being purchased from villagers at unheard of prices and they were flushed with money. Most of them spent the sale proceeds on buying the latest fleet of cars, building bigger houses and reaching their own marriage ceremonies in helicopters etc basically on one time non productive assets.

Every 1$ of exports creates $4-$5 demand for domestic products. The manufacturing sector too was facing an increased demand for their products for exports as well as domestic consumption. They started increasing salaries of their employees in order to retain the efficient ones. The salaries of the employees increased 5-10 times the 2003 levels within a span of 5 years, thus leaving a lot of disposable income for spending. Cars were selling like hot cakes and more and more expensive models were being launched. The demand for houses alongwith with  too soared on the basis of easy installment on loans.

The chain reaction which started increased the production/exports of all the industries resulting in the Indian GDP growing by more than 9%, a level never ever seen before. Indian stock markets shot up from 3000 levels in 2003 to 21000 in 2008. The effects of this increased business activity on the households, corporates, Banks and Governments similar to the ones experienced by their counterparts in the U.S. Hence we are not going to repeat the effects here.

The effects of the worldwide credit boom effected various countries in a similar manner. The shopping spree of western countries increased the demand for finished products and services produced in China and India. This increased the demand for raw materials which were the prime exports of the Gulf Countries and Australia and led to an increase in oil production, mining etc giving a boost to the economies of these countries alongwith other Asian countries like Thailand, Korea etc. This in turn led to the domestic industry boom in their respective countries.

A classic example of the role of derivatives and leverage in increase in prices without much increase in physical demand is the story of Oil. The price of oil increased from $30 in 2003 to $147 in 2008 whereas the Oil consumption increased from 79 million barrels per day in 2003 to  85 million barrels per day, an increase of 7.5% over a span of 4 years. The production of Oil increased from 77 million barrels per day to 81.5 million barrels per day. (Source : www.bp.com)

The brunt of the rise in prices of oil due to large scale speculation was borne by the countries importing oil whereas the fruits were enjoyed by the oil exporting countries mainly OPEC and countries like Russia. These exporting countries in turn used their increased incomes to leverage their capital though the hedge funds and financial companies to engage in large scale investment and speculative activities around the world leading to increase in all asset prices like real estate, shares etc and tradeable commodities. This fueled the feeling of wealth creation and richness in consumers and corporates around the world, in turn increasing the spending boom and the confidence to take on more debt.

The Bursting of the Credit Bubble (2008 – Present)

The world economies, stock markets, commodities and real estate markets were booming. The castle of pack of cards kept on growing on mountains of debt and speculation. The feeling of well being and wealth was widespread and optimism about the future was at its best level ever. Incomes were growing rapidly and low cost debt was available in abundance at the drop of a hat with the friendly banks all willing to calculate the installments at the convenience of the customers. Life was one big party with borrowed money to spend and speculate.

The busting of the credit bubble was triggered by the action of U.S. corporates in shifting the manufacturing and services jobs abroad. U.S. Citizens, who account for more than 25% of the world spending, started feeling the pinch of lack of job opportunities as their jobs had been exported to Asian countries at fraction of the salaries paid to them. The corporates in the aggressive bid to maximize their own profits had reduced the spending powers of their own customers.

The high paying manufacturing jobs were being replaced by low paying jobs at retail stores like Walmart, Pizza Huts, Starbucks. U.S. had started only selling finished goods so these were the industries expanding and these were the jobs left with the local population. Other industries booming in the U.S. were the export of arms and ammunitions, banks and financial sector, construction and their affiliated industries.

We will now discuss the effects of the bursting of the credit bubble on the following segments of the society.

• Effect on Households
• Effect on Corporates
• Effect on Banks/Financial Institutions
• Effect on Government

The reasons for the credit created boom was different for different countries but the effects of their busting are similar worldwide. So we are trying to illustrate the effects on various segments of the society using the U.S as an example, but the effects apply to the same segments in every country of the world with varied degree of impact. The degree of negative impact is more or less directly proportional to the rise they enjoyed during the boom time of the credit bubble.

Effect on Households

The consumers started availing more and more debt my maxing their credit cards and refinancing their homes to maintain their standard of living which they had become accustomed to. Soon a stage was reached that their loan outstandings increased to such an extent that even with the lax lending standards they could not qualify for more debt on their current reduced levels of earnings.

That is when the default rates started to pick up on credit cards and bank loans. For many of the consumers the teaser rate loans were now being revised to the installments based on their original loans outstanding. The monthly payments increased 2-3 times their earlier levels which they were in no position to pay. The media started covering these defaults as the sub-prime mortgage problem in 2007. It was vastly believed that these defaults were small in no. and would not pose a risk to the banks.

Gradually, more and more consumers started defaulting on their loan obligations as they were up to their eyeballs in debt with no means to either pay or role over their debts. They started handing over their homes to the banks and the foreclosure rates started increasing. On the other hand unemployment rate too was picking up and from a low of 4% we are now at a rate of 8.5%. This created a negative loop which started feeding on itself.

Lower income / loss of jobs ----
Lower spending -----  Higher defaults -----
Lower corporate / bank profits -----
Lower income / loss of jobs.

The consumers who were unable to pay their mortgages tried to sell their homes and found that no. of transactions had gone down by more than 75% and the prices were in most cases lower than the amount of debt they owed on the house. Their household balance sheets had lower value of assets and higher value of debt, a negative balance. Their savings rates during the boom had fallen to zero so they had nothing to fall back on. They saw their share market investments loose more than 50% of their value within a year.

All these factors turned their greed into fear which was the factor which accelerated the unwinding of their credit bubble. Their attitude changed from spenders to that of savers. Any tax benefit they got from the govt., they either used to pay back their existing loans or to save having realized the negative effects of living beyond their means for a long duration of time. They sold off their investments in stock markets, commodities and real estate and started paying off their debts or investing in safe Govt.. Treasury Bonds because their motives of Investment had changed from Return on Capital to Return of Capital.

The consumers who were accustomed to fulfilling all their desires instantly without bothering about the prices they paid, stopped discretionary spending immediately and started to hunt for bargains on goods that were necessities. Living within their means of earning and reduction of debt returned with a vengeance. Those who had over extended themselves beyond repair and had the courage, chose to mail their house keys to the bank they had a mortgage with and walk away. Life and attitudes had changed big time for the foreseeable future.

Continues in Part 2 Here

By Akhil Khanna

© 2009 Copyright Akhil Khanna - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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