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years. In US, a boom in the housing sector was driving the economy to a new level. Acombination of low interest rates and large inflows of foreign funds helped to create easy creditconditions where it became quite easy for people to take home loans. As more and more peopletook home loans, the demands for property increased and fueled the home prices further. Asthere was enough money to lend to potential borrowers, the loan agencies started to widen their

loan disbursement reach and relaxed the loan conditions.

The loan agents were asked to find more potential home buyers in lieu of huge bonus andincentives. Since it was a good time and property prices were soaring, the only aim of mostlending institutions and mortgage firms was to give loans to as many potential customers aspossible. Since almost everybody was driving by the greed factor during that housing boom period, the common sense practice of checking the customer‟s repaying capacity was alsoignored in many cases. As a result, many people with low income & bad credit history or thosewho come under the NINJA (No Income, No Job, No Assets) category were given housing loansin disregard to all principles of financial prudence. These types of loans were known as sub-prime loans as those were are not part of prime loan market (as the repaying capacity of the

borrowers was doubtful).

Since the demands for homes were at an all time high, many homeowners used the increasedproperty value to refinance their homes with lower interest rates and take out second mortgagesagainst the added value (of home) to use the funds for consumer spending. The lendingcompanies also lured the borrowers with attractive loan conditions where for an initial period theinterest rates were low (known as adjustable rate mortgage (ARM). However, despite knowingthat the interest rates would increase after an initial period, many sub-prime borrowers opted forthem in the hope that as a result of soaring housing prices they would be able to quicklyrefinance at more favorable terms.

Bubble that burst… 

However, as the saying goes, “No boom lasts forever”, the housing bubble was to bursteventually. Overbuilding of houses during the boom period finally led to a surplus inventory of homes, causing home prices to decline beginning from the summer of 2006. Once housing pricesstarted depreciating in many parts of the U.S., refinancing became more difficult. Home owners,who were expecting to get a refinance on the basis of increased home prices, found themselvesunable to re-finance and began to default on loans as their loans reset to higher interest rates andpayment amounts.

In the US, an estimated 8.8 million homeowners – nearly 10.8% of total homeowners – had zero

or negative equity as of March 2008, meaning their homes are worth less than their mortgage.This provided an incentive to “walk away” from the home than to pay the mortgage. 

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Foreclosures ( i.e. the legal proceedings initiated by a creditor to repossess the property for loanthat is in default ) accelerated in the United States in late 2006. During 2007, nearly 1.3 millionU.S. housing properties were subject to foreclosure activity. Increasing foreclosure rates and

unwillingness of many homeowners to sell their homes at reduced market prices significantlyincreased the supply of housing inventory available. Sales volume (units) of new homes droppedby 26.4% in 2007 as compare to 2006. Further, a record nearly four million unsold existinghomes were for sale including nearly 2.9 million that were vacant. This excess supply of homeinventory placed significant downward pressure on prices. As prices declined, more homeownerswere at risk of default and foreclosure.

Now you must be wondering how this housing boom and its subsequent decline is related tocurrent economic depression? After all it appears to be a local problem of America.

What complicated the matter?… 

Unfortunately, this problem was not as straightforward as it appears. Had it remained a matterbetween the lenders (who disbursed risky loans) and unreliable borrowers (who took loans andthen got defaulted) then probably it would remain a local problem of America. However, thiswas not the case. Let us understand what complicated the problem.

For original lenders these subprime loans were very lucrative part of their investment portfolio asthey were expected to yield a very high return in view of the increasing home prices. Since, theinterest rate charged on subprime loans was about 2% higher than the interest on prime loans(owing to their risky nature); lenders were confidant that they would get a handsome return ontheir investment. In case a sub-prime borrower continued to pay his loans installment, the lender

would get higher interest on the loans. And in case a sub-prime borrower could not pay his loanand defaulted, the lender would have the option to sell his home (on a high market price) andrecovered his loan amount. In both the situations the Sub-prime loans were excellent investmentoptions as long as the housing market was booming. Just at this point, the things startedcomplicating.

With stock markets booming and the system flush with liquidity, many big fund investors likehedge funds and mutual funds saw subprime loan portfolios as attractive investment

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opportunities. Hence, they bought such portfolios from the original lenders. This in turn meantthe lenders had fresh funds to lend. The subprime loan market thus became a fast growingsegment. Major (American and European) investment banks and institutions heavily boughtthese loans (known as Mortgage Backed Securities, MBS) to diversify their investmentportfolios. Most of these loans were brought as parts of CDOs (Collateralized Debt Obligations).

CDOs are just like mutual funds with two significant differences. First unlike mutual funds, inCDOs all investors do not assume the risk equally and each participatory group has different risk profiles. Secondly, in contrast to mutual funds which normally buy shares and bonds, CDOsusually buy securities that are backed by loans (just like the MBS of subprime loans.)

Owing to heavy buying of Mortgage Backed Securities (MBS) of subprime loans by majorAmerican and European Banks, the problem, which was to remain within the confines of US propagated into the word‟s financial markets. Ideally, the MBS were a very attractive option aslong as home prices were soaring in US. However, when the home prices started declining, theattractive investments in Subprime loans become risky and unprofitable.

As the home prices started declining in the US, sub-prime borrowers found themselves in amessy situation. Their house prices were decreasing and the loan interest on these houses wassoaring. As they could not manage a second mortgage on their home, it became very difficult forthem to pay the higher interest rate. As a result many of them opted to default on their homeloans and vacated the house. However, as the home prices were falling rapidly, the lendingcompanies, which were hoping to sell them and recover the loan amount, found them in asituation where loan amount exceeded the total cost of the house. Eventually, there remained nooption but to write off losses on these loans.

The problem got worsened as the Mortgage Backed Securities (MBS), which by that time hadbecome parts of CDOs of giant investments banks of US & Europe, lost their value. Falling

 prices of CDOs dented banks‟ investment portfolios and these losses destroyed banks‟ capital.The complexity of these instruments and their wide spread to major International banks created asituation where no one was too sure either about how big these losses were or which banks hadbeen hit the hardest.

Mayhem in the banks…. 

The effects of these losses were huge. Global banks and brokerages have had to write off anestimated $512 billion in subprime losses so far, with the largest hits taken by Citigroup ($55.1billion) and Merrill Lynch ($52.2 billion). A little over half of these losses, or $260 billion, havebeen suffered by US-based firms, $227 billion by European firms and a relatively modest $24

billion by Asian ones.

Despite efforts by the US Federal Reserve to offer some financial assistance to the beleagueredfinancial sector, it has led to the collapse of Bear Sterns, one of the world‟s largest investmentbanks and securities trading firm. Bear Sterns was bought out by JP Morgan Chase with somehelp from the US Federal Bank (The central Bank of America just like RBI in India)

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The crisis has also seen Lehman Brothers – the fourth largest investment bank in the US and theone which had survived every major upheaval for the past 158 years – file for bankruptcy.Merrill Lynch has been bought out by Bank of America. Freddie Mac and Fannie Mae, two giantmortgage companies of US, have effectively been nationalized to prevent them from goingunder. Reports suggest that insurance major AIG (American Insurance Group) is also under

severe pressure and has so far taken over $82.9 billion so far to tide over the crisis.

From this point, a chain reaction of panic started. Since banks and other financial institutes arelike backbone for other major industries and provide them with investment capital and loans, aloss in the net capital of banks meant a serious detriment in their capacity to disburse loans forvarious businesses and industries. This presented a serious cash crunch situation for companieswho needed cash for performing their business activities. Now it became extremely difficult forthem to raise money from banks.

What is worse is the fact that the losses suffered by banks in the subprime mess have directlyaffected their money market the world over.

Now what is a money market?

Money Market is actually an inter-bank market where banks borrow and lend money amongthemselves to meet short-term need for funds. Banks usually never hold the exact amount of cashthat they need to disburse as credit. The „inter - bank‟ market performs this critical role of bringing cash-surplus and cash-deficit banks together and lubricates the process of creditdelivery to companies (for working capital and capacity creation) and consumers (for buyingcars, white goods etc). As the housing loan crisis intensified, banks grew increasingly suspiciousabout each other‟s solvency and ability to honour commitments. The inter -bank market shrank asa result and this began to hurt the flow of funds to the „real‟ economy. Panic begets panic and as

the loan market went into a tailspin, it sucked other markets into its centrifuge.

The liquidity crunch in the banks has resulted in a tight situation where it has become extremelydifficult even for top companies to take loans for their needs. A sense of disbelief and extremeprecaution is prevailing in the banking sectors. The global investment community has becomeextremely risk-averse. They are pulling out of assets that are even remotely considered risky andbuying things traditionally considered safe-gold, government bonds and bank deposits (in banksthat are still considered solvent).

As such this financial crisis is the culmination of the above mentioned problems in the globalbanking system. Inter-bank markets across the world have frozen over. The meltdown in stock markets across the world is a victim of this contagion.

Governments and central banks (like Fed in US) are trying every trick in the book to stabilize themarkets. They have pumped hundreds of billions of dollars into their money markets to try andunfreeze their inter-bank and credit markets. Large financial entities have been nationalized. TheUS government has set aside $700 billion to buy the „toxic‟ assets like CDOs that sparked off thecrisis. Central banks have got together to co-ordinate cuts in interest rates. None of this has

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stabilized the global markets so far. However, it is hoped that proper monitoring and controllingof the money market will eventually control the situation.

How it has affected India?

In the age of globalization, no country can remains isolated from the fluctuations of worldeconomy. Heavy losses suffered by major International Banks is going to affect all countries of the world as these financial institutes have their investment interest in almost all countries.

As of now India is facing heat on three grounds: (1) Our Share Markets are falling everyday, (2)Rupee is weakening against dollars and (3) Our banks are facing severe crash crunch resulting inshortage of liquidity in the market.

Actually all the above three problems are interconnected and have their roots in the above-mentioned global crisis.

For the last two years, our stock market was touching new heights thanks to heavy investmentsby Foreign Institutional Investors (FIIs). However, when the parent companies of these investors(based mainly in US and Europe) found themselves in a severe credit crunch as a result of sub-prime mess, the only option left with these investors was to withdraw their money from IndianStock Markets to meet liabilities at home. FIIs were the main buyers of Indian Stocks and theirexit from the market is certain to wreak havoc in the market. FIIs who were on a buying spreelast year, are now in the mood of selling their stocks in India. As a result our Share Markets aretouching new lows everyday.

Since, the money, which FIIs get after selling their stocks, needs to be converted into dollarsbefore they can sent it home, the demands for dollars has suddenly increased. As more and more

FIIs are buying dollars, the rupee is loosing its strength against dollar. As long as demands fordollars remain high, the rupee will keep loosing its strength against dollar.

The current financial crisis has also started directly affecting Indian Industries. For the past fewyears, the two most preferred method of raising money by the companies were Stock Marketsand external borrowings on low interest rates. Stock Markets are bleeding everyday and it is notpossible to raise money there. Regarding external borrowing from world markets, this option hasalso become difficult.

In the last fiscal year alone, India borrowed $29 billion from foreign lenders and got $34 billionof foreign direct investment. A global recession has hurt external demand. International lenders

who have become extremely risk aversive can limit access to international capital. If thathappens, both India‟s financial markets and the real economy will be hurt in the process.Suddenly, the 9% growth target does not seem that „doable‟ any more; we should be happy toclock 7% this fiscal year and the next.

However, one positive point in favor of India is the fact that Indian Banks are more or lesssecured from the ill-effects of sub- prime mess. A glance at Indian banks‟ balance sheets wouldshow that their exposure to complex instruments like CDOs is almost nil. In India, still the major

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banking operations are in the hands of Public Sector Banks who exercise extreme cautions indisbursing loans to needy people/companies. As a result, we are not likely to see a repeat of sub-prime crisis in India. Though there have been a presence of big US/European Banks in India andeven some Indian banks (like ICICI) have some foreign subsidiary with stake in the sub-primelosses, there presence is miniscule as compare to the overall size of Indian banking industry. So

at least on this major front we need not worry much.

However, a global depression is likely to result in a fall in demand of all types of consumergoods. In 2007-08, India sold 13.5% of its goods to foreign buyers. A fall in demand is likely toaffect the growth rate this year. Our export may get affected badly.

A negative atmosphere, shortage of cash, fall in demands, reducing growth rate and uncertaintiesin the market are some of the most visible aspects of an economic depression. What started as asmall matter of sub-prime loan defaulters has now become a subject of global discussion and hasengulfed the global economy scenario.

Greed of some…woes of billions 

If you think about this with a cool mind, you will find that the underlying cause of thisdepression is the greed of those who failed to anticipate the consequence of their actions. On amore ideological front, it is high time to have a rethink on the very idea of free markets andcapitalism. I think the time has come to evolve a capitalism where everything works under abroad regulatory framework and we do not see a repeat of this condition where greed of somepeople can affect the lives of billions.

So here concludes my attempt to explain the current economic crisis which has started to affectthe lives of all of us. The above explanation is very simple and by no means it presents an

accurate picture (i.e the one that includes all the micro/macro factors) of the crisis. However, Ihope that it must have given you a broad idea of the reasons behind current economic depression.Feel free to post your comments on this issue.

Update : Owing to the overhelming questions/suggestions of the readers, I have written a secondarticle in this series : Reasons for Global Recession – Part Two. This article tries to explain thereason for easy credit situation in US that leads to the emergence of sub-prime mess. It alsooffers comments on why curbing the recession is taking longer than expected. Read it here. 

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Related posts:

1.  Reasons for Global Recession – Part Two2.  Amazing Globalization: How defaulters in US are fueling the Indian Economy3.  Positive effect of a US depression on India4.  Effect of fluctuation on Indian stock market

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5.  What Warren Buffets Does When Stock Market Falls ?

{ 284 comments… read them below or  add one }

← Previous Comments 

subash August 26, 2010 at 12:11 pm

nice one … looking forward for blog on “2010 pakistan floods and their affect on people”. I‟l help a lot… 

adit jain August 31, 2010 at 2:06 am

Your simple and concise interpretation for the worldwide recession is absolutelyAMAZING….Superb work!! 

Christine Savva September 4, 2010 at 5:29 pm

I have read many articles on the causes of global recession and your article simplified itso well. Fantastic. With my new found understanding of what caused the globalrecession,I now feel confident to hold/join/voice an opinion on the subject thanks to yourarticle. Very well written and put together indeed. Thank you.

arif ahmed September 11, 2010 at 6:15 am

mind blowing efforts you did…………………keep it up 

Tarun Pratap September 20, 2010 at 8:21 am

Fantastic Article. The best I‟ve ever read on the topic. 

Moghis Jalal September 20, 2010 at 12:49 pm

Marvellous! very nicely and beautifully explained each and every segment of globaleconomic crisis. Keep it up!

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Paul September 22, 2010 at 6:06 pm

this country wasn‟t in a fix until the fuel prices went over $2 a gal. when the fuel went to$3 and $4 and higher, the truckers had to raise the cost of shipping, which raised the cost

of food, clothing and everything else so much that after people paid for the fuel to go towork and feed themselves they didn‟t have enough to pay the mortgage. And until thecost of fuel comes back down to where it was in 2007, this country will never get anybetterThe goverment needs to get their head out of their ass‟s and do something to lower thefuel back down

Ajith September 27, 2010 at 12:51 am

GREAT JOB MAN!!!!!!! KEEP IT UP.

shrikar October 1, 2010 at 3:20 am

great job dude :::::the best article i have ever read about the recession, in a very simple and meaningfulmanner you have designed the content.it has really enhanced my knowledge about the topic… 

thank you ::::::::::::

shubham jain October 10, 2010 at 12:08 pm

great job man……….  best article about recession…… wanna sleep with u…. 

pratik October 15, 2010 at 4:32 am

sir please give me possible information on market u have really described this article insimple language and i want to learn more things feom you!!pls send information on my email id!!!!

pete October 19, 2010 at 8:05 am

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Like most other people said: GREAT JOB!!

Simple put and in words us humans can understand free from medial and politicaltwisting.

If you could toss me some links to some of your sources, it would be most appreciated,since I‟m probably choosing a similar topic in an MA essay about global media (in short;about how one nation‟s banking system was communicated as the whole west‟s – or eventhe whole world‟s – problem and how the workes and regular employed people now haveto clean up the mess with banks still paying out huge bonuses while sacking employees ).

 /Peter

Veena Venugopal November 9, 2010 at 11:37 pm

A good article which has been written in a simple manner made me to know aboutrecession easily…. 

Neha January 5, 2011 at 12:31 am

very nicely written , finally i am able to understand recessionthank u..

Dheeraj January 14, 2011 at 8:45 am

nice work really appreciable……….. congratulation for doing such a nice work. 

Priyo January 16, 2011 at 10:18 am

Great job…Keep it up… 

prashant rai January 19, 2011 at 10:36 pm

thanq sir nw i hav clearly uderstud the reason behind the economic rec. ur presentation ismean for apreciating.gud job sir.

Venkata laxma Reddy January 20, 2011 at 4:53 pm

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Excellent!!! the Explanation is very Precise. Thank You.

Vaibhav Jain January 29, 2011 at 3:51 am

Amazing explanation man…gd goin!! Thanks.

vikram February 1, 2011 at 9:53 am

thanx for sharing your knowledge looking forward to read more about new topics.

varinder waris February 3, 2011 at 2:11 pm

Ur article is easy to understand for all but particularly for students like methanksfriend

Dolly February 10, 2011 at 5:08 am

Excellent efforts….. the best and simplest article that i read about The Subprime Crisis….. great help … Thanks …. keep writing and en lighting… ! 

Mohammad Asif February 13, 2011 at 7:10 am

I have read so many article to understand the root of recession but m nt getting itproperly,but now i knw n understood very much about this.Really its great work done byu.

in the last,i can say that ur article is”SHORT AND SWEET” 

tsewang phuntsog February 14, 2011 at 5:00 am

thanks…. an illustration explain…. keep it up 

tsewang phuntsog February 14, 2011 at 5:01 am

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thanks…. an illustration explain…. very helpful… keep it up

Tushar February 16, 2011 at 11:48 am

It could have not been more lucid than this. I‟v read so many articles but none has beenso simple, yet so damn explanatory. GREAT WORK

Engr Usman March 20, 2011 at 4:10 pm

well-done jawaan!

Isha March 22, 2011 at 2:41 pm

Stupendo, Fantanbulously, Fantastical…… Amazing explanation in a simple language.. this article has solved all my queries ndoubts in my mind regarding recession 2008… thankyou so much n keep being the way u r ………. 

natasha April 7, 2011 at 6:55 am

Thank you for easy understanding article.Wow, why they couldn‟t see this result in the past? Such a stupid thing, they employmany economists who should have seen this danger. We never will restore these lostmoney, market lessened. Big stap back. But we are just people

Shimanj April 7, 2011 at 4:04 pm

Great work, The best related to the topic I have ever seen.

Congrats for the nice piece of work 

Shimanj April 7, 2011 at 4:05 pm

Great work Eklavya

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Dr Owais Qadir Jan August 15, 2011 at 11:01 pm

ya de articlez simple in language nd underlines the basics of recession.Gud move

satish sehwag August 19, 2011 at 4:09 am

relly great , ………… bhai 

arpita August 20, 2011 at 5:39 am

awsome is the word!!no book or magzine could explain it so precisely and clearly as u did.Im very thankful to u fr enriching my knowledge.

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