The downward slide has been arrested, thanks to unconventional measures, but recovery is still fragile and regaining of pre-recession pace of economic activity, particularly employment, seems quite far off. - Illustration by Khalida Haq.

The recent Great Recession has amply demonstrated the utter failure of interest-based debt-driven capitalism.

The downward slide has been arrested, thanks to unconventional measures, but recovery is still fragile and regaining of pre-recession pace of economic activity, particularly employment, seems quite far off.

The US economy is highly leveraged. In 2002, credit market debt outstanding of domestic non-financial sectors was $ 20,716 billion, or 197.8 per cent of GDP and rose to $ 33,601 billion, or 233.8 per cent of GDP 2008 and was $ 36,296 billion, or 247.6 per cent of GDP at the end of 2010. Households account for the bulk, their share being 41.1 in 2008 and 36.8 per cent in 2010.

The American economy was in good shape in first half of the first decade of the 21st Century but the boom had the seeds for bust in housing mortgage, an important determinant of economy activity. There was a reckless lending on this account and many naive persons were coerced into borrowing through “predatory lending”. And phenomenal expansion in sub-prime mortgage triggered the financial meltdown.

Owning a house has been the American dream, also encouraged through financing facilities and fiscal incentives. Providing “affordable housing” makes a very catchy political slogan. President George W. Bush promised in June, 2002 in his “A Blue Print of American Dream” addition of 5.5 million houses in minority house ownership by 2010. With real estate prices rising and higher interest rate for sub-prime mortgage, banks threw care to the wind and rushed into this lending.

The term “sub-prime mortgage” means lending to those who do not fulfill the normal requirements and hence not credit worthy. This means not caring for the capacity of the borrower to repay the loan in terms of income and other obligations, the extent of the burden reflected in down payment, amortisation and the ratio of the amount of the loan to value of the property. In many cases, the former exceeding the latter by a big margin, if second mortgage was included. With practically no personal stake at the moment, a borrower could just sign the paper, regardless of the consequences, and walk away with a house to live in or rent out. For financing, banks relied more on short-term market borrowing than on their own limited deposits, hence the problem of mismatching.

Banks could reduce their risk by securitising the debt-packaging mortgages into a bond and sell that to other investors, who would, in turn, repackage them according to the market. The process could be very long, rather endless. This has created a huge inverted pyramid of secondary securities. Asset-backed securities (ABS) in the US increased from $1,872 billion in 2002 to $ 4,541 billion in 2007 and were $ 2,454 billion in 2010.

The government supported enterprises (GSE), mainly Fannie Mae and Freddie Mac, issued securities rose from $5,556 billion to $8,168 billion and were $7,569 billion on these dates. Home mortgage-backed securities accounted for $480 billion, $2,177 billion and $1,266 billion, respectively.

It was in this perspective that mortgage lending in the US shot up from $879 billion in 2002 to $1,462 billion in 2005 and tapered off to $90 billion in 2008 followed by contraction thereafter. The outstanding amount rose from $8,268 billion in 2002 to $14,442 billion in 2008, and was $13,666 billion in 2010. Home mortgages were the main component rising from $732 billion per annum to $1,128 billion in 2005 and coming down to $712 billion during 2007 followed by gradual contraction of $ 312 billion during 2010.

Home mortgages taken out by the household sector first rose from $ 631 billion per annum to $1,074 billion but subsequently declined by $ 269 billion. The outstanding amount thus rose from $6,171 billion to $11,069 billion and then fell back to $10,547 billion. Mostly these were in the sub-prime category. Most mortgages were at adjustable rate which was, in fact, encouraged by authorities.

As real estate prices began to decline, the period of “teasing rates”--unusually low rate in the initial period to entice the borrower,-- expired and the new adjustable rates were enhanced, servicing of loans became difficult. An indication of the problem in the making was actually there in increasing non-performing loans whose ratio had increased from just one per cent in 2002 to eight per cent in 2007. Delinquencies soon became alarming.

With little or no personal stake, many borrowers preferred either not to move into or to simply walk away from mortgaged homes. The foreclosures were difficult in a situation of sharp fall in prices and discovery of defective entitlements carelessly prepared by “robo signers” on a large scale. In many states moratorium was imposed on foreclosure process pending rectification of the titles. The number of foreclosure cases stands as high as eight million.

Banks began to fail. The number of closing banks insured with FDIC increased from 25 in 2008 to 140 in 2009 and 157 in 2010. These were small banks. The real crisis developed when an investment bank by the name of Lehman Brothers became bankrupt in September 2008. It had assets of $ 400 billion with leverage ratio of 30 to 1 and suffered a loss of $3.9 billion in one quarter, thanks to a $ 5.6 billion write down of its real estate holdings.

Soon it became obvious that a giant firm with multifarious economic operations, American International Group (AIG) of the world stature was in real trouble along with some other “too big to fail” financial institutions. As this threatened seriously the very financial system, warning bells began to ring in official circles-Federal Reserve Board (FRB) as well as the Treasury, and there were desperate knee- jerk operations. For instance, AIG needed $187 billion to keep it afloat, of which the government initially provided $85 billion as equity investment.

The FRB first tried the traditional easy monetary policy by drastically reducing the discount rate from 5.25 in June 2007 to just 0.25 per cent in June 2009 but this did not work as the resort to discount window was quite limited. This effectively discredited interest as an instrument of monetary control.

The Fed. had earlier stood on formality in case of Lehman Brothers and did not help, but was now compelled to resort to unconventional means of injecting liquidity in the economy on a massive scale to save the situation. This involved lending to or investing in all sorts of entities and even buying “toxic assets”, mostly based on sub-prime mortgages.

As a result, total financial assets of the Fed., shot up from $951 billion in 2007 to $2,270 in 2008 and to $ 2,453 billion in 2010. This added to reserve money creating massive liquidity in the economy. Credit market instruments acquired by the Fed. were $629 billion in 2002, $986 billion in 2008, $1,988 billion in 2009 and $2,259 billion in 2010.

The government also launched its own bailout package of $787 billion. Due to extra expenditure for rescuing the economy and the adverse effect of the recession on tax revenues, fiscal deficit of the federal government rose sharply. This necessitated borrowing, the outstanding amount of the federal government liabilities rising from $611 billion in 2002 to $7,888 billion in 2008 and $11,148 billion in 2010, the ratio to GDP rising from 5.8 to 77.6 per cent.

Interest is supposed to simplify life by creating some certainty in an uncertain world by specifying in advance the terms of loans and assuring payment of interest as well as principal. This is a simplistic view not supported by ground realities. Emergence of financial derivates is a proof of perceived risk regarding interest and repayment of principal, hence interest- and credit-default swaps. According to the Bank for International Settlements (BIS) at Basel in Switzerland, worldwide notional value of over the counter transactions (OCT) increased from $595,738 billion in 2007 to $614,674 billion in 2009 when the total world output was $57,843 billion.

Interest rate swaps increased from $393,138 billion to $449,793 billion over this period when credit-default swaps fell from $58,242 billion to $32,693 billion. With the crisis and enforcement of contracts, these swaps began to fall. The AIG, which had a separate wing for financial products, got into trouble because of these swaps. Who takes the ultimate beating?

The damage by the recession to the US economy has been very extensive and certainly an eye opener to those who care to see. The growth, which was 3.6 per cent in 2004 gradually became zero in 2008 and negative by as much as 2.7 per cent in 2009, the rate of unemployed rising from four to 10.5 per cent, sticking around nine per cent despite the recovery. The number of unemployed has touched 15 million.

The household sector has been the worst sufferer. Those rendered unemployed lost income, though partly compensated by limited social security, while those lucky to keep their jobs had sharply reduced income due to wage cut and reduction in time to work. The return on bank deposits has been reduced to virtually zero. The household sector also suffered wealth loss on a large scale. The value of assets owned by the household and non-profit organisations fell from $78,546 billion in 2007 to $65,535 in 2008 and was $70,740 in 2010.

Real estate-household was down from $22,688 in 2006 to $17,470 in 2008 and $16,370 billion in 2010. Meanwhile, financial assets fell from $50,550 billion to $ 41,176 billion and were $7,639 billion in 2010. Millions have been pushed below the poverty line and many also rendered homeless.

Once bitten twice shy, the household sector has become cautious and its behaviour has changed radically. It has come to realise the importance of saving and ratio of saving to personal disposable, which was hardly 1.9 in 2006 and has improved to 8.8 per cent in 2010. At the same time, the household sector has started retiring debt. Home mortgage outstanding fell from $10,496 billion in 2008 to $10,007 billion while consumer credit was down from $2,594 billion to $2,436 billion, a total contraction of $746 billion.