The Subprime Crisis

By Soumya Gupta

Everywhere you see especially in any financial paper or journal, seem to be harping on the fact of Credit Crunch and the subprime crisis. I realised how big it is when it started affecting an everyday person, be it through market chaos, lowering growth rates or simply the market uncertainty underlying the economic situation.

What actually happened?

How can some defaults on mortgages affect the economy on such a huge scale!!! Its all thanks to the new and innovative financial instruments which have been developed uniquely to make money for the big banks and hedge funds and other financial intermediaries.

House Mortgages were being provided on a large scale, even to consumers whose paying back capacity was really low. This is basically what a sub prime loan is, that is the risk is extremely high. All was hunky dory, as house prices were rising, making mortgages attractive to buyers and sellers. Subprime borrowers paid a higher rate of interest which benefited the lenders. Thus demand was high and supply was very forthcoming.

Now the banks wanted all this debt out of their balance sheets, so they created Special Purpose Vehicles (SPV’s), which took on the debt, securitised it and sold it in forms of bonds and securities. A lot of big investors invested in these, like pension funds, hedge funds, who had personal investors, corporate investors and leveraged debt.

This turmoil spread like wild fire because if one sector that is the mortgage holders get hit and cannot cough up the interest payments or the principle amount, the repackaged securities/ derivatives called the Residential Mortgage backed securities (RMBS) which were sold to a variety of investors don’t get their returns and this one glitches turns into an ugly vicious cycle resulting in chaos and like this time a credit squeeze. A credit squeeze because most of these SPV’s lent long and borrowed short, now the investors know about the instability and lack of return and unwilling to lend further accentuating losses.

What it resulted in?

Well as can be observed, there is major chaos in the financial sector. Stability has been undermined, the U.S.A. has sneezed and the world is catching the cold. The risk was so widespread that no one knows the extent of the loss. No one is willing to lend, the consumer confidence is dipping like the house prices further leading to lowering of growth rates and spreading of recessionary tendencies.

What is forecasted?

The Federal Reserve is trying its best to counter the situation by lowering interest rates, making money more easily available, and instructing big market players to come to rescue. The big problem; the big market players themselves are suffering. Everyday the papers talk about write off or a series of top officials resignation. The situation is predicted to last until next Christmas and be multi-national in nature. However, the thing that is strange is even though there has been massive globalisation with India and China massively relying on Foreign Investment to grow, they don’t seem to have suffered.

Impact on EME’s

I believe we can observe here the phenomena of decoupling on economies. Decoupling basically means the lessening of correlation or dependency between variables. This seems to be the case presently, that though the U.S. economy is suffering, that is low consumer and investor confidence, low growth and hence low exports etc, the EME’s do not seem to have taken the hit that badly. The EME’s are steadily growing and have ever increasing growth projections.

There could be many reasons for this. Though we are moving towards a more globalised world, the dependency between developing EME’s and the U.S. is decreasing. These countries are indulging in bilateral and multi lateral trade treaties where USA is not necessarily a party. They are increasingly trading with other growing economies and the ROW and not only the USA. Therefore this just mellows down the impact that the export oriented industries would have suffered previously, where a USA recession would have meant a world recession.

Also the growth in EME’s, commenting on India is more fundamental than financial. That is there is real growth in production, consumption and investment through growth in own population income and production as well. With extremely low labour cost and other incentives given by the government it is easier and cheaper for many multi nationals to actually shift parts of business to India. This helps in raising employment, income and overall consumer confidence and economic growth.

Taking the BPO industry, for example, that is the call centres been outsourced to India for its large, extremely cheap English speaking labour force. It was affected as the companies which had outsourced suffered, this Indian industry suffered, the IT industry suffered. However this was not large scale enough to offset the gains from increasingly effective manufacturing and the growing services industry.

Also since the developed world has been hit, and with returns higher from India and China and other fats growing, recently called the 3rd world, suddenly seem extremely exciting and safer. With the tax payer’s money being used to save Northern Rock, the better investment opportunity seems like the country who is galloping towards growth and overtaking the mighty-but-in-trouble big brothers. This flow of investment and growth in real sector has definitely been termed as fundamental and hence will aid the EME’s progress and prosper.

Some authors have gone to the extent of concluding that the growth of the EME’s is good enough to offset the recession in the developed world market. This might not be the case though, but it is fundamental enough to give back steady and high returns for a long period of time to come. It is just proving to be that stage on scene when it is end of Act 1 and the actor is refusing to leave, but Act 2 players are already on stage giving a brilliant performance.
The Emerging Economies are coming of age.

Impact on Students in the U.K.

I-banking seemed extremely lucrative to pay back the student debt… think again, I believe the opportunity cost to applying to these big banks is greater than attending that Econometric lecture as they are not recruiting very few anyway.

Those of us from the EME’s trade off between staying and earning in pounds is definitely decreasing as compared to returning home to better jobs. Our IC is becoming steeper.

Hoping the pound will follow the dollar in decreasing, we can spend more on clothes and parties....