Global economic imbalances

One of the most important and immediate causes of the real estate bubble is the US and a lot of other economies, was low interest rates for remarkably long period of time. While there have been several reasons cited for this phenomenon, the most plausible answer seems to be the global economic imbalances starting in the 90’s. Both the theory and the practice of these imbalances is fairly intricate & a very recent economic development.  

Theory of Economic Imbalances

In a closed economy with zero mobile capital, the income levels are fine tuned to domestic demand. Any sudden decrease or increase in this demand or supply alters the incomes of all participants in the economy and establishes a new equilibrium.

Without capital flows, it’s impossible to have a current account deficit or surplus. In this case, the exports and the imports are merely terminologies to describe overseas flow of goods. For all other purposes, the exporters and importers in the faraway country are another element of the domestic economy itself.

Even with capital flows, there is an upper limit on the time for which a country can have trade deficit- since with each year, the capital flows from deficit country to surplus country. There has to be a way of getting the capital back for the next round of deficit.  Thos is the famous imbalance described above in which the capital does flow back from Asia to the US as a credit. Till here, fluid currencies are not required.

Even with gold standard currencies, a country can have sustained deficits if the surplus country is willing to lend money to the deficit country (the mechanism of this can be detailed) – the question is why would it do that?

The Asian attempt to hold the dollar already versus their currencies was a strategy in effect to enforce the gold standard on the dollar. In purchasing dollars to prop it, the Asians did two things – one was to lend money to US to fund its deficit & two, was to  signal the US that it would print more dollars if it wished and that dollar would still be held in a  certain value range by them.

The Asians were propping up the dollar to ensure that the Americans have something to pay with for their imports of Asian goods .Why did Asians need American consumers? Were they an easy target than domestic?

Source : Anatomy of froth

Lehman Brothers & The Great Wall Street Fall

September 15, 2008 was recorded as a Black Day in history of American Economy, as world’s 4th largest Investment Banking firm “Lehman Brothers” filed for bankruptcy leaving 25000 employees worldwide in absolute dismay.
With $639 billion in assets and $619 billion in debts making it the largest victim of the “Subprime crisis”. Lehman's collapse was a seminal event that greatly intensified the 2008 crisis and contributed to the erosion of close to $10 trillion in market capitalization from global equity markets in October 2008, the biggest monthly decline on record at the time.


The Prime Culprit
In 2003 and 2004, with the U.S. housing boom well under way, Lehman acquired five mortgage lenders, including subprime lender BNC Mortgage and Aurora Loan Services, which specialized in Alt-A loans (made to borrowers without full documentation). Lehman's acquisitions at first seemed prescient; record revenues from Lehman's real estate businesses enabled revenues in the capital markets unit to surge 56% from 2004 to 2006, a faster rate of growth than other businesses in investment banking or asset management. The firm securitized $146 billion of mortgages in 2006, a 10% increase from 2005. Lehman reported record profits every year from 2005 to 2007. In 2007, the firm reported net income of a record $4.2 billion on revenue of $19.3 billion.


Lehman's Colossal Miscalculation
In February 2007, the stock reached a record $86.18, giving Lehman a market capitalization of close to $60 billion. However, by the first quarter of 2007, cracks in the U.S. housing market were already becoming apparent as defaults on subprime mortgages rose to a seven-year high. On March 14, 2007, a day after the stock had its biggest one-day drop in five years on concerns that rising defaults would affect Lehman's profitability; the firm reported record revenues and profit for its fiscal first quarter.


The Beginning of the End
As the credit crisis erupted in August 2007 with the failure of two Bear Stearns hedge funds, Lehman's stock fell sharply. During that month, the company eliminated 2,500 mortgage-related jobs and shut down its BNC unit. In addition, it also closed offices of Alt-A lender Aurora in three states. Even as the correction in the U.S. housing market gained momentum, Lehman continued to be a major player in the mortgage market. In 2007, Lehman underwrote more mortgage backed securities than any other firm, accumulating an $85-billion portfolio, or four times its shareholders' equity. In the fourth quarter of 2007, Lehman's stock rebounded, as global equity markets reached new highs and prices for fixed-income assets staged a temporary rebound. However, the firm did not take the opportunity to trim its massive mortgage portfolio, which in retrospect, would turn out to be its last chance.
Lehman's collapse roiled global financial markets for weeks, given the size of the company and its status as a major player in the U.S. and internationally. Many questioned the U.S. government's decision to let Lehman fail, as compared to its tacit support for Bear Stearns (which was acquired by JPMorgan Chase) in March 2008. Lehman's bankruptcy led to more than $46 billion of its market value being wiped out...So was only Subprime Mortgage responsible for this colossal loss or there was more to it?


Source: Economist, Investopedia and Anatomy of Froth (Swapnil Pawar)