How did the current economic crisis happen?

"Prediction is very difficult, especially if it's about the future." - Niels Bohr 2000
The best way to understand the current recession is to actually start with the previous recession the Silicon Valley Dot Com boom and bust in the year 2000. Stock markets crashed, lead by American technology companies whose valuations did not justify the underlying revenue and profits -$5 trillion of market capitalization and 6 million jobs were destroyed within 18 months.

2001, 2002
9/11 terrorist attacks on the World Trade Centre dragged down an already stagnant economy. The American government and the Federal Reserve headed by Alan Greenspan were furiously looking for solutions to stem the recession and get back to growth as usual. One popular way to stimulate growth in an economy is to encourage people to spend more. How do you encourage people to spend more? - by giving them cheap money. How do you give people cheap money? You reduce interest rates, so people and companies can borrow more money cheaply. This has been the solution of choice to fix recessions for over a century now.

2002, 2003
The American government followed suit and reduced the federal funds interest rate from 6% in 2000 to a low of 1.3% in 2005. When federal funds rate drops, all other dependent rates such as interest rates on personal loans, corporate loans also drop. Now suddenly, that 6% interest on a car loan is only 4%, that 8% interest on a home mortgage is only 5%. American companies and people are flush with money and splurging on new homes, second homes and even third homes. Interest rates in fixed deposits are only 2% anyway so why would anyone save money in the bank. People did the most natural thing - to invest the extra money in real estate, stocks etc. This had the desired purpose of snapping the US economy out of the 2000 dot com bust. However, unknown to a lot of people and ignored by many others, the seeds of the 2008 devastating economic collapse were being planted.

2003, 2004
This deluge of new cheap money into real estate sharply increased prices of properties. Once the banks appetites where wetted by the huge profits from giving loans to creditworthy customers they were hungry for more. But even the most optimistic American citizen probably dont want to own more than 2-3 homes.

2004, 2005

So the banks turned their focus to less credit worthy people the ones with unstable jobs, lower incomes, little or no education. This group of customers were called the Sub-Prime indicating their inability to pay back these huge home loans. Banks in their infinite wisdom, incentivised these Sub-Prime customers with teaser rates on their loans. Teaser rates just like the name, tease you into believing that your interest rate on the home loan is initially only 1% or 0% before suddenly shooting up to 6%. So, on a $1 million loan, thats an extra $60,000 that has been suddenly added to a familys expense!! Customers lapped up these loans, betting that their homes would rise in value just like all other homes had in the last 5 years. During these years, buying a house in the USA was like buying an expensive TV no down payment and very minimal documents required. To reduce the risk on retail banks such as Wells Fargo and Bank of America, these high risk home loans where packaged and sold off to Wall Street Investment Banks such as Lehman Brothers and Morgan Stanley. This musical chair continued with the Investment Banks repackaging these loans and selling them off again using MBS (Mortgage Backed Securities), CDS (Credit Default Swaps) and other complex derivatives. Even to the brightest minds, MBS and CDS are a mystery wrapped in a riddle inside an enigma!! Warren Buffett called them instruments of nuclear destruction!! The end result of all this financial engineering was that somehow the American public through their pension funds and retirement savings, unknowingly became the holders of these high risk home mortgage loans.

2005, 2006
The teaser rates of the loans issued over the last few years are over and the normal 6% interest rates kick in. Not surprisingly, blue collar workers owning homes way beyond their means, suddenly find themselves unable to pay their monthly EMIs. So, default rates increase and hence the supply of homes in the market also increases. As supply increases, real estate prices crash from an average price of $275,000 in 2006 to $160,000 in 2010 - Americans loose more than half their life savings and net worth in a matter of months.

2007, 2008, 2009 This sets of a powerful and devastating ripple effect. The banks feel it first. Rest of the economy will feel it in about 8 months. The legendary and storied Investment Bank Bear Stearns collapses, then the trading powerhouse Lehman Brothers is next. Its rumours galore that Morgan Stanley and Goldman Sachs are next. Why does this happen? Why does Mr. Mark Jacob in Florida not paying his $2,000 monthly EMI bring down entire banks worth tens of billions of dollars? The answer is LEVERAGE (technical term for debt). Not only did the average american borrow for his home loan, but so did all the banks the banks borrowed from each other to fund the loans of millions of such Mark Jacobs. So when the customers stopped paying their monthly EMIs, the banks couldnt pay their EMIs to their lenders. The following is one example of how such a chain reaction could have occurred - Mark Jacobs borrows from his local Wells Fargo Bank, Wells Fargo borrows from Bear Stearns in New York, Bear Stearns is trading with Goldman Sachs, Goldman Sachs is trading with Credit Suisse in Switzerland, Credit Suisse is trading with Barclays in London, Barclays is trading with Banco Santander in Spain, Banco Santander is trading with HSBC in Hong Kong, HSBC is trading with ICICI and State Bank of India in Mumbai. So on and so forth until the entire financial system came down like a pack of cards in what is called a systemic failure.
So how did all of this end up affecting you someone whose only exposure to the complex financial markets, was to own a few shares of Infosys? Since Americans (similar real estate crashes played out in other countries

as well) lost a lot of their net worth -> stock markets crashed -> psychologically people are scared of investing and spending money anytime soon -> demand for consumer goods crashes -> companies make lesser revenue and banks cant lend them anymore since the banks already have high defaults on their existing loans -> Companies have lesser money to spend on IT outsourcing and FDI -> owing to psychological factors, lesser outsourcing business and lesser capital expenditures Infosys revenue growth decreases in India -> end result is that your Infosys shares crashed 40% from 2007 to 2009 because Mark Jacobs in Florida did not pay his $2,000 EMI on time. Niels Bohr, had he been alive, could have found comfort in a sadistic way that he predicted well. Binny Mathews, Co-Founder & CEO, www.dezyre.com The author was an Investment Banker on Wall Street from 2004-2007.The views expressed here are his own and do not represent the views of his past employers. www.DeZyre.com is an Online Academy that provides job relevant finance certifications. Expert faculty from industry teach through recorded videos using real-life case studies.

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