The Bubble that Burst

An Anecdote


When your neighbor loses his job , it is economic slow down . When you lose your job , it is a recession. But, when an economist loses his job, it becomes a depression .

The Great Depression of 1929

  

 

Bank failures Men in threadbare clothes Shoe stuffed with newspaper to plug holes in the sole Unemployment Poverty

The theory of a free market



The economic system of USA believes the less government intervention ; the better The mantra is that markets know best !!

Flash back USA , The Super Power

  

Growth in the financial sector Profits in millions Shareholders and senior executives at an enviable position A strong nation, world superpower

The Asian financial crisis of 1997



Arose due to the de- linking of the baht from the dollar The crisis spread to South East Asia,Russia , Latin America and finally to USA . This led to the failure of the hedge fund , LTCM

The Crisis of September, 2008



Fall of Bear Stearns and take over by JP Morgan Nationalizing of two failing mortgage re-financing institutions ,Freddie Mac and Fannie Mae Lehman Brothers filed for bankruptcy and sold part of its shares to Barclays

September 2008


Merrill Lynch filed for bankruptcy and was taken over by Bank of America Government bailed out AIG , the giant insurance company as it involved the trust of a large number of people Long standing companies are redefining themselves by trying to merge .

Where did it all begin ??

Problem with sub prime mortgages Mortgaged backed securities landed in trouble This spread to assetbacked commercial paper and auction rate securities The problem spread like a virus and started swallowing whole firms

 

The subprime Loans  

It is the latest development of 1990s Loans were offered to borrowers with poor credit history These carried a high rate of interest and penalties than the traditional mortgages Non payment of interest led to sale of houses

    

The no of defaulters began to rise There was a feeling that the home prices would increase Rather , the prices fell sharply and the markets crashed The parties blamed each other The borrower contended that he did not understand the complicated mortgage process The lenders vehemently denied about the ignorance of the borrower

The Saviour


The Federal Reserve has stepped in to save the firms, to help the financial markets as they were linked across the world . Bad financial practices created the bubble that led to the origin of the new crisis of 2008.

The lessons not learnt



The US government failed to understand that the system of taking deposits and issuing mortgages has failed . In the late1980s and early 1990s they had to use 100 billion dollars of tax payers money to rescue the financial markets. The financial institutions were dabbling in securities and derivatives that very few people understood

The accounting systems were shady as it allowed the firms to keep some items off their balance sheets . Rating agencies were dodgy as they were accepting the ratings that the bundlers gave them without verifying them independently.

The debate continued



The government in US convinced the nation that the social security in the country should be privatized In the year 1999 , they went ahead and gave up all the safeguards that the GlassSteagall Act had put together learning lessons from the Depression of 1929 to separate investment banks and commercial banks .

Soon the bankers realized though quite late that they had over-borrowed and they had no reserves to fall back on Growing credit losses and delinquencies have caused the banks to tighten credit standards The businessmen found that it was becoming difficult to get loans

The bail out plan Is it the right move ??



  

The moral hazard The government s support in such a situation will remove limitations on future risk takings It will look like a free -for -all and make the risk look like childs play The philosophical role Raise questions about the functioning of a free enterprise

The Priority The Question of Moral Hazard or Preservation of the Society and the System

The decisive force

   

What if the government always comes to the rescue when the chips are down What does it matter if one puts the system over the edge --So long as UNCLE SAM will take care Could any individual pass up those kind of opportunities???

Then what next ?



  

The conflict of interests can be avoided by refusing to bail out the risk takers Let the financial miscreants squirm in their own juice . This can provide satisfaction to the moralists But , is life so simple ??

The Bail Out

 

 

The bail out costs $700 billion It contemplates the creation of a special entity It will acquire all the distressed assets It will recover the costs when the assets are finally sold out at appropriate occasions

The Ripple Effect on the Indian Economy

Bail Out and the Indian Economy The Impact



Low liquidity in the US will reduce the capital inflow in India Reduce access to foreign credit source for the corporates As capital inflow dries up , whether FDI or FII , the rupee will drop as dollar supply decreases

The Impact


Import will become costlier and the burden on the government to maintain subsidies will increase Tight liquidity position in the Indian market may require the RBI to ease the constraints on CRR Decline in the crude oil price does not mitigate the situation as the price that the consumer pays has not shown any change

Should reforms be eased in India ??



Should the RBI ease up on financial reforms ? Should further liberalization of FDI norms be considered for the insurer ?

The well placed regulatory system in India

 

NPAs at an appropriately low level Commercial banks with distinct characteristics The regulation laid by the RBI reposes faith and confidence This is necessary for social and financial inclusion in the countryside

Message to take away



Markets have a tendency to fall since times change and behavior changes too When the markets show signs of weakness , governments must be ready to intervene A wise government must have the discipline to leave the markets alone when they are working fine and vice versa . Innovation for the sake of innovation should definitely be avoided

Names to remember in the US Crisis

 

Alan Greenspan Head of the US central bank form 1987-2006 Henry Paulson-Current Secretary of the US Treasury ( the head of Goldman Sachs for many years ) Mr Warren Buffet head of Berkshire Hathway, who said ,I told you so long ago The warning about the slide of the dollar and serious consequences for the economy