The Global Financial Meltdown - By Ashima Sekhri

What is happening these days in the financial markets is by no means new or unheard of. It has happened before and is likely to repeat itself again in another few decades. Yet, the world and every adult individual in it, is appalled at the sheer ease with which the world’s financial house of cards is crumbling. At a speed.

But what exactly is happening? Everyone knows banks are falling down, deposits are no longer ‘safe’ as banks holding them go down themselves, high-flying professionals are scared of losing jobs, companies are cutting spends in anticipation of a drop in business, asset classes across the board are jumping up and down giving ‘volatility’ a new meaning. But what exactly has happened? Not many people understand. But many wish to understand how this has come about, and whether it is likely to repeat itself by sheer logic of cyclicity.

What is ‘Recession’?

A recession is the contractionary phase of the business cycle in an economy.  A recession, more technically is indicated by a less than 10% reduction in GDP in more than 2 consecutive quarters. A ‘severe’ recession is termed a ‘depression’. A depression has far more long-lasting effects with impact trickling down to the average man on the street. Job-cuts, inflation and default – all personify a depression.

The Great Depression of 1929

When one talks of recession and depression, the most prominent recollection that most people have is that of the Great Depression in the United States that prevailed from 1929 to early 1940s. During this time, the GNP of the economy went down by more than 1/3rd. It was the worst and the longest lasting depression in a few centuries and led to long lasting implications on all households in America and associated economies in Europe. There was a point in 1933, with the depression at its most severe, when almost a quarter of the American population was unemployed. As is the case with most recessions and depressions, the first casualty is always sales for businesses, which results in losses and lay-offs.

At the time of the Great Depression, too, many banks and businesses were forced to close down due to lack of business. In some cases, a ‘run on the banks’ led to a shut down. ‘Run on the bank’ was a term used to describe a situation where a rumour or a suggestion that a particular bank was going down led to all its customers wanting to withdraw their deposits. Technically, banks retain only a proportion of their deposits in cash and hence never have enough at any point to cater to a vast majority of investors turning up to withdraw their entire deposits. Run on multiple banks was responsible in huge part for the financial breakdown in 1929 of the financial system and hence, of the economy.

Causes of Depression

It is often believed that the stock market crash in 1929 was the cause for the Great Depression. This is a myth, as both the stock market crash and the depression were results of long standing issues in the American economy. Post the First World War (1914-1918), the 1920s seemingly emerged to be a period of prosperity with consumerism rising to its peak. Advertising was used to the hilt to convince the average consumer of needs he never knew he had. It was a time to create needs and fulfill them. Automobiles, radios and new household appliances & gadgets were made must-haves in the eyes of the average consumer. The result was that the inflated consumption patterns kept the economy roaring during the 1920s. However, the income in America was unevenly split and this split widened further during the time. The wealthy made larger profits and the farmers went into heavier debt than before.  

Increasingly there came a time when those who couldn’t afford were the ones who were lured into buying the same as a result of advertising. Around this time the new concept of ‘credit’ or ‘buy now, pay later’ was introduced. This is primarily what led to the financial crisis in 1929, as all those who had taken the ‘buy now’ option, were no longer in a position to ‘pay later’.

The rising incomes of the wealthy led to a rapid growth in stock market prices, much above fair valuations. People began to believe that stock markets were bound to keep growing and hence more and more people began investing their life savings in the same. Many were so convinced about the possibility of making huge bucks by investing in stocks, that they began investing ‘on margin’; this meant paying a certain amount and investing in multiples of the same without actually having the money in hand. Till the fateful crash of 1929, this was indeed a profitable strategy.

On the fateful Tuesday of October 29, 1929, the stock markets stumbled and the ‘bubble’ burst. An estimated $30 billion was lost in this crash. During this time, people in large numbers defaulted on their margin calls, the demand for the money staked or lost while playing ‘on margin’ in stocks. Consumer credit piled up and led to a point when people were paying from current earnings for their past expenses and not for current or future needs.

Boom in Asia 

Times changed and the world has, in general, been on an up-swing over the last few decades, with mild recessions now and then. But overall, world economies have been growing consistently, particularly so, the ‘developing nations,’ which have now been re-christened ‘emerging markets’. Classic examples of this would be China, India, Brazil etc.

The rise of Asia has been the most dramatic economic development in the second half of the 20th century, with most of this growth being domestically led as opposed to export-driven growth thanks to Western economies. Through the 1990s, the low-cost labour advantage led to China emerging as a low-cost manufacturing hub of the world, while India emerged as the low-cost services hub of the world.

Liberalization of economies like India has even given the western world a chance to invest and grow along with these Asian economies. And as is usually the case in such fast-track economies, the stock markets have been simultaneously moving upwards. The average man on the street developed interest and invested in stocks and expected the appreciation in stocks to make him rich. Which it did, but only till a point.

How it all began: The Sub-Prime Crisis

Owing to the over-emphasis on credit by banks and the comfort of individuals availing the same to fund expenses, surfaced the sub-prime crisis. The sub-prime mortgage crisis is an ongoing problem in the American economy, which only got severely aggravated during 2007 and 2008. Banks, in a bid to meet internal revenue targets, over-lent and lowered the emphasis or attention on credit-worthiness of the borrower in the process. This led to the average American funding homes, cars, household appliances and everything imaginable by taking credit for the same. Easy lending terms and the ability to easily refinance un-payable mortgage worsened the problem.

The high-end financial institutions on Wall Street further clubbed together these loans and sold them as complicated financial products to other banks, thus increasing the exposure of the same to higher levels. The downturn in the US housing market coupled with this risky, uncreditworthy lending by banks and the excessive corporate and individual borrowing all came together to create a series of adverse impacts on the American economy.

The crisis first began to emerge in 2005-06 when interest rates started to rise and the US housing markets saw drops in prices. This was coupled with high default rates on the credit taken by individuals and corporates in America. This proved to be disastrous, as these very loans had also been sold as chunks to other financial institutions as complicated financial structures. No one knew, at that point, which loans out of which chunk given to which bank had gone bad or been defaulted upon. As a result, in general, all such financial structures saw tremendous erosion in paper value in apprehension of future expected defaults.

Even the biggest and oldest banks and financial institutions began to show losses with increased defaults on money previously lent-out.  This also affected the banks’ ability to raise capital through the issuance of commercial papers. This result was a major shortage of funds in banks and severe crunch in liquidity.

A landmark fall: Lehman Brothers

Lehman Brothers, among the top-five financial institutions on Wall Street, fell prey to such severe liquidity crunch. It declared itself bankrupt, while another financial institution in the top-five league, Merrill Lynch, was bought over by Bank of America. Both fatalities marked the beginning of a global economic blood bath. Another financial institution that showed cracks during this process was Wachovia which was bought out by Citigroup, itself rumoured to be struggling under a massive crisis, having posted close to $18 billion in losses over the past three quarters.

The reasons behind these crises were the same as those that were being faced by scores of other financial institutions – bad loans, default rates, investor withdrawal and a huge crunch on liquidity. This also seemed to indicate that more institutions would fall prey to this eventuality of buy-us-out-with-cash or declare-bankruptcy. Stock markets across the world tumbled in free-fall, scaring individual and institutional investors into withdrawing money from everywhere they could, further deepening the liquidity crunch. The US Federal Reserve, the European Central Bank, Bank of England and other central banks of the western economies intervened in the markets by injecting millions of dollars in an attempt to restore market confidence and create liquidity to prevent other financial institutions from falling.
 
What is scary is that the effects of this entire phenomenon are not restricted to the financial world alone. Scores of companies, now, in apprehension of bad times to come, have already started laying-off employees to cut costs. This is perceived to be necessary in order to stay cost-competitive in times to come. Gone are the days of multi-fold salary jumps, as has been the case in Asian economies over the last few years. Now, holding on to a job itself might be a prime concern.

The Rise and Fall of Indian Markets

Along with the boom in the rest of Asia, Indian markets had also seen a great upward movement in the equity markets. At 1000 levels in 1990, the Sensex moved 20-fold by Jan 2008! Ten months later in October 2008, the Sensex stands halved at 10,800. The following graph illustrates the dramatic rise and fall of the Sensex and with it, the fortunes of millions of Indians:

In reality, the Indian Sensex, Japan’s Nikkei, the Hong Kong Market and all Asian markets have just echoed the fall in Dow Jones, the stock index in the US. The crisis in the American economy is bound to have an impact on Asian economies with scores of businesses already feeling the heat. Property prices are down while banks are unable to find depositors. Investments have slowed and people are being laid-off in anticipation of bad times to come. Nervousness about the fallout from the escalating credit and liquidity crisis is being compounded by concerns about the impact of the US sliding into recession.

Investors, who had got used to putting all their wealth in the stock markets over the last few years, now find the same reduced to half in a span of one month. Fortunes made earlier have been wiped off for the average investor. Most investors are not cutting losses and dumping shares in stock markets, further aggravating the stock market tumble.

Only time can tell what turn global markets will take in the days to come, but experienced investors and analysts are certainly not optimistic!

Chronology of Events