A life jacket for US and China

The US remains locked into a policy mode of punishing savers and rewarding borrowers with low interest rates, first to borrow and second, to bail them out.
Many commentators were shocked and are still in awe of the US Federal Reserve after its decision last week to purchase many debt securities, including US treasurys, to the tune of nearly a trillion dollars. Mainstream financial media in the West closed ranks behind the Federal Reserve. In particular, the Financial Times called it an act of “prudent boldness”. The Economist wrote that Ben Bernanke had done his part. Those who would like to learn more about what the Fed had done before reading further should click on this link:
www.ft.com/cms/s/0/8ada2ad4-f3b9-11dd-9c4b-0000779fd2ac.html
This newspaper noted that the purchase of long-term debt securities by the Fed would bring down the interest rates and thus reduce the margin that banks enjoy by borrowing short and lending long. It is insightful, but this is not a new situation. The yield curve in the US was mostly flat between 2004 and 2006. Banks, in theory, should have had it tough. But their profits were booming. How? They made up in volume what they lacked in prices. That is why we had the credit boom up to 2007 followed by the bust. Now, Bernanke wants them to repeat the same pattern of behaviour.
Lower interest rates are not only meant to support households with their existing debt obligations but also to encourage them to borrow more. Otherwise, banking will not return to health. Normally, households must pay down their debt by saving more out of their current income. That means savings rates of US households must rise. Lower interest rates discourage savings. The US remains locked into a policy mode of punishing savers and rewarding borrowers with low interest rates, first to borrow and second, to bail them out. It is unable to muster and articulate the case for bearing the pain required to break free of this unhealthy policy shackle.
Further, for savings to rise, jobs with incomes must be available. The last economic expansion from 2001 to 2007 was the weakest on record for job creation. Further, three categories—financial activities, professional and business services and construction—created nearly 43% of the incremental private sector jobs, in the US, in the six years ending in December 2007. These three sectors will be shedding jobs for at least a couple of years more. Manufacturing must pick up the job slack. That requires the sector to be competitive which, in turn, requires a substantial devaluation of the dollar.
The announcement by the Fed on Wednesday to engage in asset purchases did just that. The dollar fell sharply against most currencies after the announcement. Well, not so fast. If the dollar decline spirals out of control, then its global reserve currency status and its seigniorage benefits would be lost. The idea is to get the dollar to depreciate, but not crash. Quite simply, the dollar must depreciate gently, but persistently as it did between 2002 and 2007. How to go about it?
Consider the fact that a weakness of the dollar bails out China’s export sector as it weakens the yuan, too, given the country’s tight peg to the dollar. If China’s exports pick up or do not fall further, China would have to continue to channel the trade surplus into US assets. That would grow China’s reserves again, helping to cover the fact that the dollar decline depletes China’s foreign exchange reserves.
Given the weak global demand, other countries will have to work harder to protect their export competitiveness in the face of this lifeline thrown by the US to China’s exports. They will have to make sure that their currencies do not appreciate against the dollar too much. They too will have to buy dollar assets. Significantly, the Fed’s action came after the treasury report on net foreign purchase of US assets showed a precipitous decline in January. Moreover, in the three months ending in January, money fled all long-term US bonds (source: blogs.cfr.org/setser/2009/03/18/a-bit-more-to-worry-about-foreign-demand-for-long-term-treasuries-has-faded/).
The US corned global savings for the better part of this decade. Some American commentators have tried to blame foreign savers for that. This move helps to quash such arguments. The quantitative easing programme launched by the Fed reinforces the Faustian bargain it had stuck with China on supporting the latter’s export sector in return for its support (directly and through distorting other nations’ exchange rate policies) in financing excess demand in the US. The source of excess demand has shifted now to the public sector. The problem remains. America’s claim on savings in rest of the world is set to increase. The Fed’s move is central to its success.
In short, America is trying to erase 2008 and restore the world of and up to 2007. Rising global incomes helped to gloss over the unsustainability and dangers of that world order. In its absence, a big question mark hangs over the success of the latest audacious Fed move. Hence, to be safe, private investors, too, should help America achieve its aim of weakening the dollar.
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What is subprime crisis? How it caused financial mayhem?

The current upheaval in the global financial markets has caused more mayhem in a fortnight than the world has seen in its entire economic history.
Although there are many reasons responsible for bringing the world to the doorstep of financial doom, the main cause of this financial disaster is said to be the ?sub-prime loan.'
So what is this sub-prime loan? And why has it caused global panic? If it is related to the American housing sector, why should it affect Indian and other markets?
A sub-prime loan
Sub-prime mortgage loans (or housing loans or junk loans) are very risky. But since profits are high where the risk is high, a lot of lenders get into this business to try and make a quick buck.
Sub-prime loans are dicey as they are given to people with unstable incomes or low creditworthiness. These individuals are not financially sound enough to be given a loan when judged under the strict standards that should normally be followed by a bank or lending institution.
However, there's more to it. Let us simplify this issue to understand better how sub-prime loans work and how they brought the world down to its knees.

It all begins with an American wanting to live the famed American dream.
So he seeks a housing loan to give shape to his dream home. But there is a slight problem. He doesn't have good credit rating. This means that he is unable to clear all the stringent conditions that a bank imposes on an individual before it sanctions a loan.
Since his credit is not good enough, no bank will give him a home loan as there is a fear that the chances of a default by him are high. Banks don't like customers who default on their payments.
But lo!, before the American dream can fade away, there enters a second American -- usually a robust financial institution -- who has good credit rating and is willing to take on some amount of risk.

Given his good credit rating, the bank is willing to give the second American a loan. The bank gives the loan at a certain rate of interest.
The second American then divides this loan into a lot of small portions and gives them out as home loans to lots of other Americans -- like the first American -- who do not have a great credit rating and to whom the bank would not have given a home loan in the first place.
The second American gives out these loans at a rate of interest that is much higher rate than the rate at which he borrowed money from the bank. This higher rate is referred to as the sub-prime rate and this home loan market is referred to as the sub-prime home loan market.

Also by giving out a home loan to lots of individuals, the second American is trying to hedge his bets. He feels that even if a few of his borrowers default, his overall position would not be affected much, and he will end up making a neat profit.
Now if this home loan market is sub-prime, what is prime? The prime home loan market refers to individuals who have good credit ratings and to whom the banks lend directly.
Now let's get back to the sub-prime market. The institution giving out loans in the sub-prime market does not stop here. It does not wait for the principal and the interest on the sub-prime home loans to be repaid, so that it can repay its loan to the bank (the prime lender), which has given it the loan.

So what does the institution do?
It goes ahead and ?securitises' these loans. Securitisation means converting these home loans into financial securities, which promise to pay a certain rate of interest. These financial securities are then sold to big institutional investors.
Many investment banks (or institutions like the ?second American' in our story) sold complicated securities that were backed by debt which was very risky.
And how are these investors repaid? The interest and the principal that is repaid by the sub-prime borrowers through equated monthly installments (EMIs) is passed onto these institutional investors.

The institution giving out the sub-prime loans takes the money that it gets by selling the financial securities and passes it on to the bank he had taken the loan from, thereby repaying the loan. And everybody lives happily ever after. Or so it would have seemed.
The sub-prime home loans were given out as floating rate home loans. A floating rate home loan as the name suggests is not fixed. As interest rates go up, the interest rate on floating rate home loans also go up. As interest rates to be paid on floating rate home loans go up, the EMIs that need to be paid to service these loans go up as well.

With US interest rising, the EMIs too increased. Higher EMIs hit the sub-prime borrowers hard. A lot of them in the first place had unstable incomes and poor credit rating.
They, thus, defaulted. Once more and more sub-prime borrowers started defaulting, payments to the institutional investors who had bought the financial securities stopped, leading to huge losses.
The problem primarily began with the United States keeping its interest rates very low for a very long time, thus encouraging Americans to go in for housing loans, or mortgages. Lower interest rates led to buyers wanting to take on bigger loans, and thus bigger and better homes.

But life was fine. With the American economy doing well at that time and housing prices soaring on the back of huge demand for real estate and bigger and better homes, financial institutions saw a mouthwatering opportunity in the mortgage market.
In their zeal to make a quick buck, these institutions relaxed the strict regulatory procedures before extending housing loans to people with unstable jobs and weak credit standing.
Few controls were put in place to handle the situation in case the housing ?bubble' burst. And when the US economy began to slow down, the house of cards began to fall.
The crisis began with the bursting of the United States housing bubble.

A slowing US economy, high interest rates, unrealistic real estate prices, high inflation and rising oil tags together led to a fall in stock markets, growth stagnation, job losses, lack of consumer spending, a virtual halt to new jobs, and foreclosures and defaults.
Sub-prime homeowners began to default as they could no longer afford to pay their EMIs. A deluge of such defaults inundated these institutions and banks, wiping out their net worth. Their mortgage-backed securities were almost worthless as real estate prices crashed.
The moment it was found out that these institutions had failed to manage the risk, panic spread. Investors realised that they could hardly put any value on the securities that these institutions were selling. This caused many a Wall Street pillar to crumble.

As defaults kept rising, these institutions could not service their loans that they had taken from banks. So they turned to other financial firms to help them out, but after a while these firms too stopped extending credit realizing that the collateral backing this credit would soon lose value in the falling real estate market.
Now burdened with tons of debt and no money to pay it back, the back of these financial entities broke, leading to the current meltdown.

The problem worsened because institutions giving out sub-prime home loans could easily securitise it. Once an institution securitises a loan, it does not remain on the books of the institution.
Hence that institution does not take the risk of the loan going bad. The risk is passed onto the investors who buy the financial securities issued for securitising the home loan.
Another advantage of securitisation, which has now become a disadvantage, is that money keeps coming in.
Once an institution securitises the first lot of home loans and repays the bank it has borrowed from, it can borrow again to give out loans. The bank having been repaid and made its money does not have any inhibitions in lending out money again.

Given the fact that institutions giving out the loan did not take the risk, their incentive was in just giving out the loan. Whether the individual taking the home loan had the capacity to repay the loan or not, wasn't their problem.
Thus proper due diligence to give out the home loan was not done and loans were extended to individuals who are more likely to default.
Other than this, greater the amount of loan that the institution gave out, greater was the amount it could securitise and, hence, greater the amount of money it could earn.
After borrowers started defaulting, it came to light that institutions giving out loans in the sub-prime market had been inflating the incomes of borrowers, so that they could give out greater amount of home loans.
By giving out greater amounts of home loan, they were able to securitise more, issue more financial securities and earn more money. Quite a vicious cycle, eh?

And so the story continued, till the day borrowers stop repaying. Investors who bought the financial securities could be serviced.
Well, that still does not explain, why stock markets in India, fell? Here's why. . .
Institutional investors who had invested in securitised paper from the sub-prime home loan market in the US, saw their investments turning into losses. Most big investors have a certain fixed proportion of their total investments invested in various parts of the world. So...

Once investments in the US turned bad, more money had to be invested in the US, to maintain that fixed proportion.
In order to invest more money in the US, money had to come in from somewhere. To make up their losses in the sub-prime market in the United States, they went out to sell their investments in emerging markets like India where their investments have been doing well.
So these big institutional investors, to make good of their losses in the sub-prime market, began to sell their investments in India and other markets around the world. Since the amount of selling in the market is much higher than the amount of buying, the Sensex began to tumble.
The flight of capital from the Indian markets also led to a fall in the value of the rupee against the US dollar.

Any other reason, apart from sub-prime crisis?
Of course! Sub-prime crisis alone could not have caused such mayhem, although it is to blame for the beginning of the end.
This crisis is spreading from sub-prime to prime mortgages, home equity loans, to commercial real estate, to unsecured consumer credit (credit cards, student loans, auto loans), to leveraged loans that financed reckless debt-laden leveraged buy outs, to municipal bonds, to industrial and commercial loans, to corporate bonds, to the derivative markets whose risk are indeterminate, etc.
It has been a total systemic failure that has its roots in the US real estate and the sub-prime loan market.
Note: Some analysts say that the worst might not be over. . .

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A first person account from Wall Street

Wall Street will never forget Monday, September 29, when the lords of high finance were rudely reminded that it isn't easy to get away with imprudent investments, no matter which Ivy League degree they possess.
In a major setback to not only the Bush administration, but also to global markets, the US House of Representatives on Monday rejected the $700 billion emergency rescue package to bailout bankrupt American financial institutions. The House voted against the package 228 to 205.
The bailout plan was nixed not only because the figure of the financial assistance -- $700 billion -- was almost pulled out of thin air without solid basis, but also because the American taxpayer was supposed to fund it. The anger that bubbled over and poured onto the streets in the form of protests and demonstrations across the United States was one of the main reasons why the plan was vetoed.
The consequences were instant. The benchmark Dow Jones Industrial Average fell by a whopping 777.68 points, the highest ever in American history, to touch 10,365.45. The Nasdaq fell by 199.61 points to settle at 1,983.73.

The meltdown in the US markets has been stunning. And while Americans try to come to terms with the bloodbath, rediff.com spoke to a senior employee of Bank of America about the blackest day in US stock market history.
This is what he had to say:
"I usually go to my office at Times Square at 7 a.m. As usual, I first checked my mails when I reached the office. When the market opened, it was already down by some 300-plus points. We have a huge trading research staff which supports trading activities. In our office we have a couple of floors for trading activity. On the fifth floor, some 400 terminals are located with 4-5 huge screens showing the market movements and also CNBC."
"When the market was down, we understood that long-term and short-term sentiments were affecting it. One of the reasons why the bailout plan was rejected was because of the uncertainty it carried."
"Nobody is sure whether or not the bailout plan will really help. Global equity markets are going to be hit by American developments. Our trading floor was buzzing with activity. Our terminals were showing an unprecedented flow of transactions."
"By 11 a.m. speculation was there that the bailout bill may not help, it may not solve the current financial problems. Some 400 traders of our bank were being aided by internal commentary of our seniors. They were relaying messages after messages to the trading heads. They were trying to understand the situation."
"By noon, as the news came that the bill to rescue the market had been rejected, there was complete silence on the entire floor for a few moments. We were trying to digest what had just hit us. Everybody was awestruck!"
"Our senior managers went into the conference room. When they came out, the market had plunged and lost almost 700 points. The market had overreacted. After lunch, there was feeling that we had overreacted. Maybe, things may not be that bad, after all."
"News from Washington had settled in by then. People just gave up. Whatever strategy they had, it couldn't save the day. The entire trading floor was excited. The move sent shock waves across the financial markets, including the Wall Street, plunging stocks by 778 points (at close of trading)."
"After the rejection of the bailout plan, every face wore an uncertain look on the trading floor. We bankers didn't lose money because we are using clients' money and on a day like this too, we earn money through commission. We made money! My own terminal had 10,000 trades worth over $40 million. We are not worried about what happened today. We are worried what will happen tomorrow."
"People left the trading floor thinking that tomorrow will be another miserable day."
"Some people thought that the bailout was the last chance to stop the United States from sliding into recession. Others think that the bailout plan will help managers. They will correct their own positions and continue to thrive. The bailout plan would have given liquidity to the market. We are not worried about losing one day or gaining one day."
"But America's biggest finance market, market technicals and fundamentals are failing. Were we wrong all these years? We face this question today. We also ask does this bailout rejection mean it is the end of capitalism? Will New York lose its economic edge? Some believe that it is unethical for the US government to bailout failing companies."
"If the US preaches that countries should not intervene in such crises and let market forces take their own course, how can it do the opposite? It is unethical to rescue failing banks. If elections were not round the corner, the bailout plan would have been different."
"Things are looking hopeless because everything is so wrong that it is difficult to keep up hope. We know it will take a long time to rescue the economy. Meanwhile, people will suffer. America has not declared it yet, but it is facing a recession."
"I still think, and would like to think, that America has not failed yet. It is 15 years ahead (of the world) in whatever it does. Only that gap is now reducing. America is innovative and knows how to use others."

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