Bracing up for Recession

Looks like this is gonna be recession year in the US. Recession means a drop in economic activity and associated with drop in investments, company profits and employment rates. How this going to affect various people?

First, interest rates will significantly drop as a reaction to recessionary pressures, and couple with high unemployment rates and inflation, this looks to be bad for saving money :-(. However, this seems to be right time to take a look on basic things. Based on my readings I find the following to be the reasonable advice for people like me.

1. Dont leave secure jobs, as job market will go south this year.
2. This is not the best time to go to school for doing MBA and such, as markets might tighten up in the next year. But, a lot of experienced folks who can untangle the mortgage mess and stuff will find great jobs.
3. Maintain 6 month emergency fund that should take care of ourself even if we dont have job for a long period. This fund must be maintained separately in money market or savings accounts.
4. Reconsider the portfolio. While stocks do better in the long term, it is time to reduce the risk by taking bit more of bonds and other secure avenues. I moved mostly to secured investments last October, and could wither some of the drop in my retirement plan.
5. Rethink investments. As big ticket investments like starting companies or building houses will be hit during this recession, it is time to reconsider those things for now.

If we are able to maintain jobs and have savings cushion, recession could also be a great time. A lot of great investment opportunites will be available at the later part of recession when everybody else will run out of cash. Houses and companies could be got for dirt-cheap prices and the recession will also help the economy overall by cutting down wasteful expenditures and over consumption while moderating the prices (of oil, houses etc that had runaway inflation during the current boom).

In terms of countries, the expectation seems to be that China and India will cool down affording them to rethink their policies and priorites. China will be hit by drop in exports, while India will be hit by drop in investments. So, its time for China to put renewed focus on domestic consumption (including by appreciating Yuan) and India to start second wave of reforms. When India badly needs money it can no longer afford to keep sectors like Banking, Aviation, Retail stores under tight leash and might be forced to open these to foreign investments. Dollar looks to get weakened more as there is a substantial interest rate gap between India and US, and IT companies will be hit both by strong rupee and a drop in US economic activity. Its time to rein in the India's runaway salary growth and diversify beyond IT.

India can gain a lot. First, if IT weakens a bit and salaries start cooling down, other Indian sectors like Auto and manufacturing can pick up as they can get quality engineers at affordable salaries. It makes no sense for the nation to train a mechanical engineer only to lose to Infosys to do some payroll processing. Also, this recession could get the hell out of Ford and GM who would be forced to do a lot of offshoring and India seems to be the best choice. Already Tata Motors and Hyundai and have begun huge expansionary cycles. And healthy Indian companies can get great bargains with a weak western economy. I wont be even surprized if a group of Indian companies together buy up Ford in the next decade. Also, its time to realize our strengths in Finance and Banking. Its illustrative to note that almost all of the Citi's current top management are Indians and we have similiar loads of talent hidden in our moribund banking sector. Its time to get to Basel-II banking standards and open them to International capital and competition. Maybe, someday we could see a ICICI or a privately owned SBI could take on Citi or Bank of America in head on competition in international turf.

Second, Indian economy can also gain by cooling down of real-estate markets at home. Just like Americans, Indians seem to harbor the thought that house prices can never go down. Americans have learnt the lesson and Indians have still not. Just like any investment, house prices can as much go up as down. A lot of houses are priced at 100 times the annual per-capita income of Indians and the development looks unsustainable as a lot of them were made with unreasonable expectations of salary growth. Now, house prices can go down significantly in a lot of over-priced markets and this will improve affordability for common man.

Third, the market crash will make people rethink consumption. While too much dropping of consumption is bad, too much of consumption is even more bad. Indians are consuming rather too much for their salary levels and savings are not as great as Asian levels. This can hurt a lot of people in the forthcoming real-estate and stock crash, and if managed correctly this could lead to a long term balance between savings and consumption.

Third Wave of Cricket

I used to be a big fan of cricket and the last couple of years, I had not been watching much, not the least because of lack of access to Cricket Channels sitting at Seattle. And Indian team had a few debacles and Australia has become predictable. Now I started watching Cricket again starting with the current India-Aussie series and boy the game changed so much.

The 1990s look nostalgic to me, when every team had an equal probability to win. Back then, Australia was not so strong and West Indies was not so pathetic. South Africa and Sri Lanka were at their peaks, while India and Pakistan had extremely good players. New Zealand and England were getting as they always were, disciplined but not too threatening. In terms of fun - 1993 Hero Cup,1994 Wills Trophy, 1996 Wills World cup, 1996 Titan Cup and 1998 Sharjhah cup were so unforgettable and times seems to have change a lot. The atmosphere and celebration no longer seems to be there. Even the world cups like those in England (1999), South Africa(2003) and West Indies (2007) looked a lot sedate in comparison. Looking a bit deep, I see a pattern. I always wondered how cricketers world over seem to reach to the top in unison and get out in unison. At one point in 1996 almost the entire Indian team was 23-24 years old, all of them trying to cement their position. And like high school graduation, there seems to be a batch of people who come in at the same time and graduate at the same time.

The first wave took in the 1970s with the coming of Kapil Dev, Gavaskar, Viv Richards, and so on. The first wave of cricket ended after the 1992 when a ton a great players left the game. Viv Richards, Desmond Haynes, Krish Srikanth, Kapil Dev, Ravi Shastri, Javed Miandad, Imran Khan, David boon... all who made the first wave of ODI cricket were gone. Their age of ODI cricket was just a shortened version of the Test match. Bowlers were still at the top, batsmen tried to be cautious and concentrated more on techniques. At one point Desmond Haynes, 17 centuries and 7000 odd runs were insurmountable. But a new wave of cricket took place just before the 1996 world cup. With 15 over field restrictions and the retirement of many great bowlers, a new age of young cricketers took to challenge every possible batting record. Sachin, Jayasurya, Kirsten, Anwar, Ganguly and later Hayden and Gilchrist, totally changed the role of openers. Big hundreds were no longer the issue and once improbably 300+ scores on a 50 over game became the norm. Explosive people like Afridi made cricket look like baseball with a do-or-die hits for every ball. And the once improbable Hayne's record was beaten by almost every credible batsman of the era. In fact, Tendulkar has now 41 centuries and 16000 odd runs, something unimaginable 10 years ago.

Now all these greats of second wave seem to be going off at the same time, just like the first wavers did a 15 years ago. Kirsten, Wasim Akram, Lara, Walsh, Warne, McGrath, Srinath... have all gone. Soon, there wont be Dravid, Ganguly, Tendulkar, Gilchrist, Ponting, McGrath, Inzamam Ul Haq, Jayasurya and world cricket will look a lot different. As this third wave begins cricket seems to get more equalized. Australia dominated entirely during the late second wave with the peaking of all their greats - Warne, McGrath, Ponting, Gilchrist, Hayden, Symonds... Now, already with teh first two gone the bowling looks weak and with Gilchrist gone the top order and wicket-keeping will take a hit. And there is no credible alternative to the top three batsman. Clark, Hussey, Haddin look nowhere near the greats and with a weak bowling Australia looks to be beatable once again as India has shown. India seems to be positive with the third wave with the historic failures of Indian team like running between the wickets, pace bowling and fielding have changed the lot, while there must definitely be worries on historic Indian spin department. It looks the weakest in India's cricket history.

Time will tell how man of the current batch will replace the records set by the second wave guys like those of Tendulkar and Muralidharan. At school, we used to spend hours speaking of the great comparisons like batting of Mark Waugh-Sachin-Lara, spinning of Kumble-Muralidaran-Mustaq-Warne, fast bowling of Akram-Srinath-McGrath-Walsh. A lot of these people including Tendulkar, Kumble, Walsh and Akram were splendid ambassadors of the game with their exemplarily on-field behavior. Compared with those, the current behavior on the field looks uncouth and barbaric. When people Tendulkar, Kumble and Warne celebrated their victories there was a touch of grace. It was fun and even the appealing to the umpire was amazing. But, with the unrefined third wave, the appeals and celebration had to be restrained by ICC so much that the match looks sedate.

Are petrol prices in India cheap??

($1 = Rs.39, approximately)

Recently, I had been going through a number of articles in Indian media, claiming that oil companies are losing Rs.9/liter of petrol due to global oil price rise. The reports seem to convey the message that Indian motorists are somehow paying very low than what they should. Reality is otherwise, as I noted in one of the earlier articles here.

Indian motorists pay around Rs.52/liter ($1.3/liter or around $4.93/gallon). Do you think this is subsidized and cheap?? See what India's peers in far more wealtheir nations with greater purchasing power pay in CNN.com. I think the petrol subsidy debate is misguided, because of the absence of discussion of taxes. Are Indians paying less for Petrol than we living in the US? I fill my tank at $3.2/gallon (before getting 5% cashback with my credicard) because my state of washington has one of the highest sales taxes, but it is still equivalent approximately Rs.30/liter which is half what an Indian motorist pays in India. Does it mean 76, Chevron and other places where I fill gasoline from are making losses?? Looking at their stock prices doesn't make me think so. US oil companies are having windfall profits.

And Indian purchase basket of crude is about 8 dollars cheaper per barrel than international price and Indian refineries are more efficient. So, shouldn't Indian motorist deserve a much lower gas/petrol price than us in the US? So ideally the petrol prices could be in Rs.20s per liter and still the companies coulde make profits and government to earn taxes, if US prices are a guide.

Basically, Indian governments at various levels tax petrol and gain over Rs.35/liter and at the end they claim they are losing Rs.9/liter due to subsidies. With proper math, it would come to Indian government gaining Rs.25+/liter on petrol, after taking up a loss of Rs.9 loss per liter given to oil companies in bonds and other forms of subsidies. Simple. So, nobody is doing charity in India with petrol. Its just that government has odd tax policies that end up taxing much more than required and in the end share a part of spoils with oil companies by taking their losses.

For Diesel and LPG, if you factor out the taxes the government breaks even and only on Kerosene the government, loses overall. But, eventually the hope is that more of rural people would be moved to LPG. And since Diesel is more efficient and used mainly for public transportation there is a better rationale for selling it cheap. For LPG and Kerosene the rationale is that India should have its priority of moving people from highly polluting wood, cowdung and other materials that are burnt in rural places for cooking. So, having it cheap makes sense, though eventually I would prefer Kerosene to go around Rs.25/liter that would break even for the government at the current $100/bbl global prices.

I would prefer a more transparent mechansism in which government strips all its taxes - from excise duty to sales taxes on petrol and diesel, along with subsidies for marketing companies, align the prices to vary daily with global prices and then over it add some minor taxes that can vary based on international prices. This will be pretty transparent and allow people to see how much of the price rise is due to interntional prices and how much is due to their government, and unless the oil prices goes to extremes the government should not meddle with the prices. So, a gas filler can see his Rs.52 payment for a liter is due to Rs.25 for Saudi Arabia/OPEC, Rs.5 for refining and transportation cost, and Rs. 20 for government taxes, and the rest for the profit of the oil marketing company. Same with all other petroleum products and it will remove politics from pricing, and only simple economics will rule.

Here is one chart of global and Indian petrol prices in 2006: http://www.kshitij.com/research/petrol.shtml

HEre is another slightly older (2005) prices of gasoline around the world:
http://bigpicture.typepad.com/comments/2005/05/gas_prices_from.html

Again India was just below the European countries and much ahead of rest of the world in its prices.

India's retail revolution

This is regarding the retail article in IEB. Two of the things that are often missed in the road towards modern retail is the expansion of organized labor and the addition tax base. The fragmentation of current retail system makes it easier to evade taxes at various levels and almost all the labor belong to the unorganized sector with no mentionable rights. One of the goals for India is to move its massive unorganized labor into organized sector where they could get more rights and the same time there will be better accountability. Also, with bar-coding and automatic billing the modern retail aids in tax collection - sales, corporate taxes and employee income taxes.

In the end it would benefit everybody - farmers, investors, infrastructure developers, laborers and also the government would have more tax revenue at its coffers to spend on the people. The jobs of few middlemen are not worth to stop such a massive potential to change the contours of Indian economy. If the middlemen are enterprizing enough they could adapt to the new India that will enable the creation thousands of new opportunities for entrepreneurship - supply chain management, cold storage, back end data processing.

Crouching Dragon and the Hidden Tiger

Browse any newspaper or magazine discussing on Politics or Economics and China is spoken atleast 10 times as much as India. In fact, India has started to get mention only in the last couple of years and mentioned only in a few selected instances and in most contexts taken as a passenger in the sentence about China. But, Indians are far more aggressive and everywhere you see an Indian comparing China to India. This is a dramatic turnaround from our past, when India had an indifferent attitude towards the world. When Chinese, Arabian and European sailors came observed and wrote scholarly works, Indians were living in their own world. And we know the history, dont we? We paid the price of not knowing about our neighborhood. Now, we have made a 180 degree turn. We speak about other nations more than any other culture in the world. An average illiterate in a tea shop in rural India could talk about the politics of dozen nations and a cheap regional magazine could carry as much foreign news as some of the top newspapers in the US. We are in a constant state of comparison and China has taken most of our debate space. After all, it was a poor buddy of ours 2 decades back and now sits with rich nations. Thus, nothing moves Indian society or polity than a talk about China. Without China, it is doubtful whether we even could have got so many economic reforms in India.

Given that Indians have the highest sense of self-pride and over-confidence, most of the comparison between India and China specifies only three things - English language proficiency, Democracy and Demographic dividends. And all of them are tricky and India might not be strong in any of the three, compared to all hype. English can we well spoken and written by probably 10 million people - less than 1% of population, and the kind of politcal system in major states like Bihar and Uttar Pradesh can be anything but democracy. And the demographic dividends can do far more harm given the dozens of separatist organizations in India, unless it is handled with high care. But, with all that in future India can still grow substantially, not because of these 3 factors but that we are so low in every indicator that is there is no room to go further down.

So lets take other things into comparison with China and as usual for an Indian we will beat China down (!).

Looking at the overall numbers, China's GDP measure both in current exchange and PPP is only between 2 to 3 times as big as India. And given that it has 30% more population, 3 times more area, 13 year headstart in reforms and a history of never ever been ruled long by aliens, it is not that impressive. It is ok. In fact if India had slightly started early by around 80 and increased the growth rate by 2% in that decade, the GDP numbers wont be too different.

And Indian numbers were achieved with just 65% literacy and a miniscule share of world trade and investment. Given such a low baseline, there is an enormous headroom for India. Even If we manage to increase literacy by 10% every 5 years, we could still have 10% growth rate irrespective of what happens in global economy. And this is not such an impossible task given the technology and resources we have. One good example to see is the rise of telecom. 6 years back we had probably 1 to 2 % teledensity and now we are adding that many every month. So, we can attack our social problems like illiteracy with tools that no other advanced nation had the benefit of. And miniscule upper middle class could multiple many times over the next decade leading to an exponential growth in many other sectors.

And if the last 2 years is any indication, the share of India in world trade and investment has only one direction to move. And India has a lot more cards kept close to its chest. Most of the bigger sectors are still unopened and only the soup has come out so far. The meal is still in the kitchen. Retail, transporation, banking, agriculture education and dozens of major sectors are still locked and as they keep getting out of state control, growth could accelerate and may more than compensate for any loss in US slowdown or even if IT sector dies.

And more importantly India is still under the radar and treated as innocent observer. China with a percapita income 3 times less than a poor European country - Romania, is under attack from around the world, accused with tampering the world economy. No one has taken note of the threat India could possess. All the extremities - Iran & Israel, US & Russia, China & Japan have started enormous startegic partnerships with India and none of the major nations nowadays even criticize India openly.

In comparison, China has already started to face resistance in too many quarters and could threaten its future growth. It has done the simple things well - made its people literate and provide basic health care, but how about future challenges as a first world country. Given its current growth pattern, if China has to grow even to the economic level of Turkey, it has to completely take over world trade and investment and to keep yuan week it has buy the entire debt of whole world, that looks a tough task (!). So, it has to find new ways to grow and the old ways of low cost production, high foreign investment and bulging exports but may not scale to China's ambitions.

So, China is charting an untravelled territory and faces with questions on how sustainable its growth will be, given it has maxed out on most items. How many more toys can it produce or how much more foreign direct investment will get? How long will Yuan remain weak and withstand world pressure?

China is definitely ahead of India in most aspects, but can keep it that way?

Lead India

If nation's tastes and interests were determining its destiny then India is on the right track. The extremely popular Lead India Campaign by Times of India (the tabloid finally woke up to do finally something worthful) is really ennervating. The image is really powerful. And this is not at all impossible. If at all, it just reminds of Mahatma's struggle. The struggle of the rich and educated elite became a national freedom struggle by one man's lead. And as he lead, entire India followed like in the video below. And among them we found the finest of leaders who were previously trapped in their everyday trappings.

Will we shake up ourselves in this video's style? Chances are slim. But, it is still possible.



For a long time we have been cribbing on our environment. But as Sharukh and Amitabh say, we have no right to complain about the Traffic Jam. We are that Jam.
See Sharukh's and Amitabh's Videos below:




And here is an older nice video with the "Ye Jo Desh Hai Tera" song in Swades. So Nostalgic.

Do Indian sports deserve better treatment?

We had a big argument at work on whether India recognizes other sport equally compared to cricket. Agreed, Cricket is major sport in India, but are we not recognizing other sports even if they do good? Do you think Ranji and Duleep Tropies get crowds, even in Cricket mad cities? If you look closely, Cricket is not popular in India - it is patriotism that is popular. Did you see what national recognition a single Bronze medalist Malleshwari got after Sydney Olympics? Even the 11 Gold Medalist Phelps didn’t get that much even in his native Baltimore. Or how about Sania Mirza and Leander Paes? How many nations keep track and celebrate the 50th and 100th ranked Tennis players? Or how about legendary PT Usha and Milka Singh? How many nations make a national heroine out of an athlete who has not won an Olympic gold? And a lot of great players in other fields like Vishwanathan Anand and Narain Karthikeyan are very well recognized.

So, its untrue that we are not recognizing other sports, and we have some special affection towards cricket. Honestly we given other sports enough chance and most nations don’t recognize the bronze winners and 100th ranked players like we do. We are plain pathetic in most sports and people don’t want to keep seeing a losing home nation. Would Cricket be so much of fun if we have 75 to 100 nations play competitively? Would an Indian still watch the sport after being routinely drabbed by 50 other sides consistently? This hockey victory is good, but the performance over the last 50 years is not enough for something that is recognized as a National sport.

Look at India – most Indians don’t care about the game or its funky rules, they just want India to win. Whether you score a cover drive with a straight bat or an edge beaten clear by an outswing it doesn’t matter. For Indians, Cricket is kind of a pain releaser where they want to see their fragile nation win in something. If India were winning so much in Ice-hockey, maybe they would watch that . It doesn’t require great marketing (Indian athletics didn’t do much marketing before PT Usha’s Athletic prowess in the Asiad) - it just require quality stuff. Without quality stuff, in the long run, product wont sell and that’s what most sports are finding now.

Seriously, India is pretty pathetic in most sports and probably recognition is a bit to blame. But, looking at whole of South Asia, it is peculiar region in the world where all countries are poor in most sports (that’s why we have SAARC games as Morale events). Africa, North America, Europe, South America, East Asia, Middle east are all good in atleast a couple of sports and are fiery in it – Olympic medals and Soccer World Cups are a good indicator. May be some researcher should start exploring the genetic makeup to see, why a poor South American or an African with probably as bad facilities are able to play well, while South Asians are not .

And to add further proof (or flame) immigrant Indians who have settled in Europe and North America have excelled in almost all fields – from winning Oscars to becoming a deans at institutions like CMU and Kellogg to becoming powerful board-members of most Corporations. But, even among immigrant Indians and overseas born Indians (who are grown in the same environment as other ethnics) we don’t have top soccer players or F1 champions or Olympic winners.

So are we sure recognition is the most to blame? I’m not saying that something is written in our gene that is setting the Boolean value for Sports to FALSE. But, we must sincerely start looking in and find out what our real problems and how we can solve them. Probably there are unique issues in our social culture that are not valuing sports and economical conditions are forcing people out of sports. Still looking at our big North neighbor winning so much medals (the only field India is not competing with China) with similar social values and economical constraints, I’m pretty frustrated.

The extraordinary lectures of Hans Rosling

Hans Rosling has given an amazing presentation that debunks some of the myths about Third World. It is presented so beautifully that even total strangers to economics and public policy can understand every part of it. It should be a bible for all powerpoint presenters and those want to present analysis on the data. Watch the presentation and enjoy.

See this followup presentation on poverty:

A third video about the beauty of statistics

Will US go into recession? Part 2

Now, the last few weeks of hearing all bad news all around financial markets, made me think is the world is going to be destroyed pretty soon. Is this the Apocalypse? I mean, why is there so much of panic when a casual glance at the current situation doesn’t seem to be bad, at all. Notwithstanding the subprime case that we saw in the part 1 of this series, the tide might not be big enough to rock the boat. Here's why:

1. In most subprime hit localities, American households earn average of 75K/year and buy house at an average rate of $300K that is just 4 times the annual income, and in many rich neighborhoods that earn in 6 digits this ratio could be even less. So, is the house price sky-high? Is the ratio change too much in America’s history? Are other countries better? Brits and Europeans whose average house price is like 10 times the annual house-hold salary seem to worry much less even at the back of a 3x price growth in 10 years. In Asian countries like India, this ratio could get even higher. I don’t know about Africa and South America, but think that they wont be any better in owning houses than America.
2. Current America has a very healthy corporate cycle and unemployment rates are almost historically low. The last housing bust was at the back of big unemployment.
3. The subprime mortgages are still a small portion of total value of American housing assets and not all of them are defaulting and not all the defaulted properties have a value of 0.
4. By the very nature of the American economy, the risks are well spread out and markets are pretty deep and matured compared to almost any other country. Agreed that there is a lot of unnecessary froth at the top, but derivatives in essence builds a very strong foundation and links the stakeholders.
5. The world economy never looked so better and not all of it is based on cheap mortgage. There are quite a bit of fallbacks, unlike the previous times. Even taking the factors that are dependent on US consumption, the consumption of many Asian countries have increased sharply and Russia is back on its knees.
6. Most importantly, unlike in most other times of American history, there are a quite of bit of non-market entities that are extremely powerful and they would like to maintain status quo and have the means to do it. The foreign reserves of Japan, China, India and Korea alone are in the range of $3 trillion and each of them is much bigger than any institutional or individual player in the market and they understand the stakes. If US goes into recession or if there is a reduction in interest rates, there could be losses of hundreds of billions here alone. So, would it be stretch to assume that a couple of hundred billion dollars could get diverted by these power central banks into US mortgage and bonds to save American economy from collapsing, while making strategic buys with high yielding interests. For these central banks few billion dollars are pocket change and they have quite a bit of powers in their arms. They are silently watching and if there is a definite case of collapse, there could be a lot of invisible hands at work to clean the mess.

US is so crucial to the world economy that not many of the powerful hands will allow it to drop. And the fundamentals seem to be good – its not like inflation is going into double digits or corporate are throwing out people in mass numbers. Few hedge fund owners and a few greedy subprime buyers are fried, but I don’t understand why the market value should drop by few trillion dollars.

I agree that the Mortgage lenders have tightened up and its hard to get loans now. But, this can’t go on forever. The fundamental money generation engines have not gone away. Asian and European countries are still generating billions of surplus cash that eventually finds its way to US economy. And those sitting on fences now with hoards of treasuries cannot afford to sit there forever. At somepoint those money will get back into bonds and asset backed securities. The lending standards won’t be as lax as last year, but still I don’t think that the complete opposite that is happening now can be there forever. In fact this crisis could become a like a vaccine that has inserts weak pathogens and arouses the immune systems. A lot of countries are happy that the flood of investment has slowed down and began to take a hard look at the economy fundamentals. For example, Indian central bank was so concerned that it gets so much of portfolio investment that has started hurting the export competency by strengthening the currency and China was constantly expressing fears of a stock market bubble. Now they breath relief. A lot of corporations were very concerned by the overarching powers of Private Equity players and now don’t need to spend as much energy in warding of the PE eagles or making synthetic modifications. And prospective home buyers in US who were getting pushed out of the market are now considering a serious comeback. And banks and financial institutions that have been over enthusiastic will be concentrating on their core businesses realistically. If it is going to be just a blip will it make much sense to close up all the investment positions that have been painstakingly made, just to watch from the sidelines that the markets get back to their bull runs?

And slightly OT here… does the periodicity of business cycles and recession cycles for US still valid? I mean, many of those researches were made before 1990 when significant changes occurred in world economy that multiplied market sizes by many times. In just year 1989 Berlin Wall collapsed, USSR pulled out of Afghanistan leading an eventual collapse of the soviet, China had Tianenmen Square massacre that forced it to join market forces, Indian elected a moribund coalition eventually leading to a bankruptcy and opening of economy…. And thus from start of 1990 the recession cycles are way off and even the Asian crisis of 1997 or dot com crash didn’t dent economy too much and house prices didn’t dent.

Will US go into a recession? - Part 1

The last few weeks of credit crunch has made people to start thinking about a recession. If you go by the historical periodicity of economic cycles, a recession is a long overdue in the US. The last one in 2001-02 was not a big one, and a lot of believers have come to predict that next year might be a recession year. The biggest factor this time seems to be the mortgage crisis, in particular, the subprime mortgage crisis where lenders were very lax in providing loans to people with spotty credit history. So, this part would focus on that.

A background on Subprime crisis:
In US, home loans, like those in most other countries, used to be a direct relation between a lender and the borrower. The borrower puts up some money and approaches a bank and if he has good financial track record and has the means to pay the loan, the bank gives a loan for the rest; and this is given from the deposits made by its customers. The borrower puts atleast 20% of the amount and has about 30 years to repay the remaining 80%. Usually, home prices doesn't go down more than 20% in normal circumstances and hence the bank always have the option of pulling the loan from the borrower and selling it in the market, if the borrower ever defaults. Since, the borrower puts 20% and takes a risk of losing the entire investment in case of crisis, looks carefully before buying and make sure he could pay the loan for atleast 2-3 years down the road. And normally, the rental cost is not too much more than the interest paid on the loan and so there is always an option of renting the home and pay the lender from the rental returns. So far, so good.

Now, the lenders wanted to expand their businesses and bring more liquidity. After all, if they just lend with the savings deposits they get from retail investors, they would still be a small business. And its risky too. What if all the customers want the deposits immediately (savings deposits are for shorter term) while the bank cannot get loans in a split second from the borrowers who have a period of 30 years to pay. This situation is called the "run-on-the-bank" and during the 1929-33 depression, a lot of banks failed because the depositors wanted money too quickly sensing a panic. So, to reduce the risk and save their asses, banks wanted to marriage the borrowers with those who could invest for pretty long and who might not want the money immediately in case of a crisis. Enter bond markets and institutional investors.

Now, the bank makes ten loans for say $1 million and then packages them into a bond. This bond would yield at a rate slightly less than the rate charged by the bank to the borrower and the bond is secured by the ten homes for which the loan was given. This bond would be bough by big brokerae firms and other big institutions who might slice them into say 1000 pieces of $1000 each and so on. At some point retail investors who plan for retirement or want to invest for their kids education would buy these bonds and they look long term. In the long term, houses always appreciate usually with the rate of inflation. So, even if the borrower's default, the house could be sold and the bond repaid. And the chances of borrower default is very low given that it is given to only good people and the borrower has significant equity that he doesn't want to lose on foreclosure. Given that less than 5% of borrowers would ever foreclose and the individual piece you buy is so spread-out (your $1000 bond piece might contain $1 pieces of 1000 loans) that the risk is not too much. The lender is now just a conduit who needs to lend to good borrowers and package the loans to long-term investors and so has very little no-risk. For the borrower, the loan interest rate goes lower as he could choose from the huge pool of liquid options. So, its a win-win for everybody.

But, human greed sometimes can blind objectivity and when the risk is not directly visible the greed directly takes over sanity. This win-win equation seems to suit everybody and it looks like irrespective of who the loan goes to, the final investor gets his return. To make matters worse, at each level, the reputation of previous level adds up thereby reducing the risk (apparently). So, John Doe goes for $1 million loan. This is a bit risky, so the lender charges slightly higher. The lender, a small and reputable bank can get a much better rate for its Mortgage backed security and sells it to say, Fidelity*. Now, when the final investor buys from Fidelity he thinks of all the great corporations involved in the chain and agrees for a much lesser interest rate for his bond, than what he would give it to John Doe directly. Since, he agrees for much lesser interest rate, Fidelity can give the next loans to the local lender at a much lower rate and the lender hence gives the borrower a lower rate. This chain of lowering interests come to point where the interest rate between what you get in super-safe Government bonds and treasuries and what you give it to a spotty borrower like John Doe is infinitesimally small. And the investor keeps full faith on housing market that always seems to go up and thus the spottiness of John Does doesn't matter. You can always get the house from him and sell it in the market.

Now, the lender doesnt need to ask for any income proof or repay ability from the borrower. The average investor Jane Smith doesn't plan to ask that and if the final investor is not asking, why bother. The lender and broker could happily loan to any shabby, shady little person with just a couple of document signatures and pass the securities to final investor. How better you business could get? Every body is happy in this land of paradize. To make it worse, the Fed (American central bank) reduced interest rates so low that now its barely above zero. So, anybody could be given a loan with almost no interst rates and since house prices *always* go up (short or long term doesn't matter), every Tom, Dick and Harry jumped into the game. They didnt have to put 20% from their pockets, didnt have to worry about planning for payments 2 years down the line or even worry abount Rental incomes. HOUSE PRICES ALWAYS GO UP YOU MORON. And the lower interest rates are taken for granted and people went for Adjustable rate mortgages where interest rates go with the market rates, rather than one fixed rate for entire duration of the loan.

So, what if the housing markets start going down, interest rates start going up and the poor investors like Jane Smith start using their brain? You will get the current crisis. Those who got million dollar loans with no income, start suddenly thinking that they cannot repay. So, they go to the market and sell the home and pocket gains after repaying the lender. It turns out that every other moron tries to do the same, and just as in the "Emperor without any clothes" fable, suddenly people start realizing they are all naked. The house prices start falling down. Now the big brokerage houses start waking up (aroused by Jane Smiths) and they start asking the lender to give back teh bond amount or foreclose those houses that are not paying interest. When they try to foreclose they realize that the house is worth just 75% of what the loan is and everybody start scrambling. The investors threaten the brokerages and big banks and they inturn put their hands in the lender's throats. Result: Lenders start closing down, and brokerages are hit big and have to take some of the losses and pass the rest to its investors, starting a chain. Now, many people who thought they were loaning Fidelity* or Bank of America*, realize they were in fact loaning the shady loan applications of Joe Does who wont repay. Thus, this whole mess.

This subprime market is more than $2 trillion and no one is sure how many of their famed institutions are involved in what amounts. As uncertainity is the mother of bears, we are feeling this great pinch and the dormat investors are now suddenly running helter-skelter to get their investments back.

Next: Would it really cause a recession?

* This is taken just as an example. It is not to be taken literally to mean that Fidelity has very high mortgage exposure.

http://en.wikipedia.org/wiki/Subprime_lending
http://onlinejournal.com/artman/publish/article_2341.shtml