Current global economy scenario - similar to market crash of 1929

The main cause of the 1929 Great Depression was the expansion of liquidity in the 1920s that led to a credit-driven boom which was not sustainable. The American government's efforts to prop up the economy after the crash of 1929 made things worse. Some experts believe that the government's intervention delayed the market's adjustment and made the road to recovery harder.

The root cause of the current crisis has a similar pattern. It all started a decade back with a booming housing market in America. This boom was later fueled by expansion of liquidity in the system in the form of 'mortgage-backed securities' and 'collateralised debt obligations (CDO)' invented by Wall Street.

In the first few years of the boom, there was just too much demand for all 'investment-grade' properties as the same were used as underlying assets for CDOs. When the 'investment grade' CDOs saturated, investors started looking for sub-prime borrowers. Mortgage brokers and mortgage lenders were more than happy to look for 'anybody and everybody' who wanted a mortgage, (which, in simple terms, means a home loan.)

As a normal lending practice, banks or financial institutions ask for documents to verify income levels, ability to service installments, credit history and a lot more. One can also be asked to arrange for a down payment as margin money between 30 to 40 per cent of the asset value to cover the downside risk.

In case of sub prime lending the borrowers were always given favorable lending terms to the extent that in some cases neither margin money nor credit history were asked for. And most of the borrowers probably had no ability to service the installments either. It was a perfect recipe for disaster.

Is sub-prime lending only about the American housing sector? And if yes, does it mean once Capitol Hill clears the '700 billion Wall Street bailout plan', all the problems will be solved and we'll be back on track? The answer is a BIG NO.

Though we were led to believe that sub-prime lending so far is about American housing and mortgage repayment problems, it is one of the biggest lies of our times. There was simply too much liquidity in the system which forced bankers to fund sub-prime borrowers. The same practice helped banks inflate their earnings and profit forecasts and in-turn their valuations. The same bankers diversified globally into practically 'anything and everything' and funded or helped fund virtually 'anything and everything'. A case in point is emerging countries and BRIC countries.

The bankers came up with all kinds of synthetic swaps and credit swaps to cover the risk of funding such economies. In the last ten years alone, BRIC and other emerging nations raised more than 1 trillion USD of capital most of which originated in Europe and America. The bankers used 'convertible bonds', which were covered mostly by a 'credit linked note' or 'credit default swap'.

It is this market which may create the next round of heart-burn as the credit quality of assets funded by such instruments in a lot of the cases is below par and risky in nature. This is a virtually unregulated market with no fair value accounting practices being followed by a lot of the participants.

Unlike the sub-prime housing market, it is easy to price such instruments at par to markets? Should it be at par? But most of the below par papers are priced at par assuming the risk is covered by 'credit linked notes' or 'credit default swaps'.

It is this assumption which may go wrong assuming a global economic downturn and a continued squeeze of the credit markets takes place. Rolling over them will become impossible. Instance of borrowing entities defaulting will be on the rise, resulting in more and more Investment Banks, Commercial Banks and Participating Swap Dealers raising capital and writing off potential losses which could be in billions of dollars.