Recession

Many of you have been asking me questions about recession. This is what I think [ based on inputs of professors(especially Sam Thomas), friends and newspapers ]


Every business has a cycle. - Innovation, growth, maturity decline. Initially profit margins are high in innovation and growth stage. Later at maturity stage profit margins are low. US is a developed country. Overall industry of US was at maturity stage. So investors were not able to find many +ve NPV projects with high margins in US (NPV - http://en.wikipedia.org/wiki/Net_present_value finance term- don’t go in details in short it means- returns are higher than costs in +ve NPV projects). The attention of investors got diverted towards developing countries which were full of such projects as the overall industry in these countries was at innovation or growth stage. Wealth of US investors increased drastically through these projects. Developing countries earned dollars. They invested those dollars in treasury bonds n bills. So that money also came back to US. So US wealth increased rapidly without any net outflow of money from US to developing countries.

Investors, thanks to lack of +ve NPV projects, invested their dollars in banks. Banks had to pay investors some interest rate. Banks lend money to +ve NPV projects. But there was dearth of +ve NPV projects. Money cannot just stay in bank accounts. Otherwise bank has to pay for it. There was increased competition among banks. All this situation made banks think of subprime borrowers who would pay huge interest rates. Banks thought they could eliminate the risk by diversification and securitization (securitization - http://en.wikipedia.org/wiki/Securitization - to make it simple say something like insurance- if ur home burns , insurance company will pay. Similarly if borrower defaults, someone else pays u for that. This grossly undermined default risk and encouraged banks to take more risk and lend more money.)

This is background.

Now let us discuss about dollars and bubble. Dollar will settle in the most lucrative area for itself. Commodity bubble, technology bubble, Gas n Oil prices related bubble etc. Around 2000 technology bubble was busted. Money started looking for new sector now. That new sector was housing industry. In 2001, there was 9/11. Panic was set and trade slowed due to the attack. To stimulate the economy interest rate cuts were utilized. Banks had more money to lend in the midst of less number of +NPV projects in developed economy.

Huge amount of subprime lending was done as a result of all this and lots of money was invested in housing industry. Since people were getting finance from bank, they bought houses even after knowing that they may not be able to repay the debt. American dream became a reality for them.

Later housing bubble busted. The apartment worth $250,000 was now just $50,000. People being rational started surrendering their home of $250000 to banks and bought 2nd hand home at 50,000 from the market. This in turn triggered the decline of house prices further. People preferred to return houses to banks than to repay loan amount which is no more consistent with the value of house. Now banks have all these houses whose value is drastically reduced. They did not get their money back. This lead write offs and huge losses to banks.

Auto industry- US auto industry concentrated on luxury cars which were costly and consume more gas (petrol, diesel). Consumers could buy these cars as banks would lend them money and gas was cheap. In similar way, US businesses flourished more in luxury segments. High networking capital was needed to run such businesses thanks to high costs.

Subprime borrowers started defaulting. Banks suffered losses. They became extremely cautious about lending money as a response to that. Companies were denied loans. Companies had to finance their high costs through these borrowings. Because of credit crunch, companies had to reduce their borrowings. So they had to cut their costs. This resulted in job cuts all across the US. People lost jobs and so they had no money to pay EMI of their houses - default - banks in loss- vicious cycle was set.

Due to job cuts, people had less money to spend. Consumer spending reduced. Consumption of goods and services reduced. Demand for products and services reduced. Since no one was buying companies had to reduce their production. To produce less, they needed less manpower - further job cuts. 2.6 million people lost their jobs in a year. Companies have frozen their hiring. So these people are not getting jobs anywhere else. Banks, companies and people have lost their trust and optimism which is making this recession deeper.