The economic crisis: systemic failure or predictable cycle?

The current economic crisis has clear reasons that can be examined and analyzed. All the warning signs were "on the wall" but the "herd phenomenon" won, and people and institutions chased the returns and did not pay attention to the risks. The economic cycle of ebb and flow is known and predictable, as in nature, even if we cannot always predict its times and causes

A few weeks after the outbreak of the economic crisis, when it seemed that some of the dust had cleared and it was possible to try to partially see the "picture of the battle", we turned to Prof. Eugene Kendall from the School of Business Administration and the Department of Economics and Prof. Dan Galai from the School of Business Administration, well-known experts in the market The capital, so that they can explain to us what actually happened here.

Prof. Kendall believes that indeed, as reported in the press, the crisis broke out because of the American real estate market, which is known to go through cyclical periods of ups and downs; This time the drop was stronger because it came after a period of dizzying increases. "You have to understand that the real estate market in the United States has risen by 115% in real terms in the last ten years. Everything was based on the expectation of continued increases in real estate prices, a situation that cannot "continue forever".

"Everyone is talking about the sub-prime market," Prof. Kendall adds, "and that is true, but it must be remembered that there were other weighty factors that operated in the classic real estate and mortgage market (prime market), while taking risks and creating complex 'financial instruments'" . The main ones are the CDO instrument and the Tranches method. In this method, a package of mortgages, known as MBS, is "packaged" again and divided into rating groups according to the probability of non-payment. Although the group on average is not good, it certainly does not meet the high rating of AAA (with a reasonable return and with low risk, its "upper part" of at least 60%, will pay the mortgages, which makes it AAA. And this is just one example. It must be remembered," Kendal adds, "that the pressure to create such instruments comes not only from the mortgage banks who realized that the financial management of the mortgage is not their relative advantage; but also from financial institutions and banks that are constantly looking for investment properties, mainly AAA type properties. All over the world, Money looks for assets to invest in. And the whole world invests, in the end, a large part in the United States, which is still the No. 1 economic power."

"The big problem arose when these financial instruments began to operate in the subprime market as well. This market pre-serves low-income people who have a high risk of not being able to repay a mortgage, people who are not eligible for a mortgage in the prime market. What drove the subprime market is the constant rise in real estate prices and low interest rates. A strange situation has arisen according to which the private person, the purchaser of the property, always benefits. If the market goes up, and the house is now worth more, he swaps the subprime mortgage for a prime mortgage and moves on. And if the market goes down, he returns the keys to the mortgage bank. Add to that the aforementioned CDO financial instruments, and you will get a very dangerous situation where there is a market with apparently high returns, a market that does not really embody the risk premium", Prof. Kendall concludes.

Is the real estate and mortgage market big enough to drag the United States, and following it the rest of the world, into such a severe crisis?

"Yes," believes Prof. Kendall, "the CDO market held the entire mortgage market. The scope of this market was seven trillion dollars, which is half of the American GDP and a third of the total value of residential real estate in the United States. And when he died, everything stopped. 'And suddenly', it turns out that respected investment banks, such as Merrill Lynch and Lehman Brothers, played very actively in this market and even copied the CDOs method for corporate bonds. There, too, they tried to operate with the magic method of mixing bonds and dividing them into groups, the alchemy of creating AAA-type papers from papers each of which individually is BB or BBB at most."

Is there not a systemic failure of the capitalist system here?

Prof. Kendall thinks not. "Right now the situation is not pleasant, and it is still not clear how long it will take until we get out of this crisis. What is clear is that we learn from crises and grow. Even in the exact sciences, where there are fixed laws, we don't know everything, especially in economics, where the laws change all the time and navigation is like shooting at a moving target. Crises set the goal and open up a good opportunity for us to learn from mistakes and not repeat them. The next crisis will come, but for different reasons."

There is no society and economy without crises

What caused the economic crisis that "suddenly fell upon us" we also asked Prof. Dan Galai from the School of Business Administration. "In order to understand what happened," Prof. Dan Galai tells us, "the hands of time must be moved to the years 1988 to 1991 - to the last great recession in the United States. The American economy emerged from this recession strengthened by streamlining, layoffs, closing of failed factories, etc., and with the high-tech locomotive driving it forward."

From 1991, there was a constant increase in GDP and housing prices and even good growth in the American economy, but in 2000 the Nasdaq crashed, and in November 2001 there was the terrorist attack on the Twin Towers, and once again the shadow of recession hovered over the head of the American economy. The industrial sector started to decline, and the solution is found in the form of strengthening the consumer sector. Federal Bank Governor Alan Greenspan started the process of lowering the interest rate which reached a low of 1% and thereby gave a boost to the consumer sector which of course gave a boost to the productive sector (but not to its efficiency). The thought was that when the productive sector rises it will cool down the consumer one and a balance will be created. Israel, by the way, went into recession in October 2000, and this is what is actually helping it today, as we will see.

This plan went awry when Greenspan kept interest rates very low for too long. The interest rates were worthwhile for loans. The housing sector rose steeply, and this also affected cars and other consumer goods. The use of credit cards has increased by 50% in five years. The amount of consumer debt has increased. It was only at the end of 2004 that Greenspan started raising interest rates, but the effect of this increase took time. At the same time, the influence of the entire world economy began. In the years 2003-2007 there was the highest global growth in the entire world, Asia, South America, Western Europe and more - annual growth of 5% on average! A huge stock of capital and liquidity was created, a significant part of which was drained in the United States.

Everyone was looking for additional sources of profit and one of them was the subprime mortgage market in the United States. Gradually, a "monster" of subprime was created from lenders who under normal conditions would not accept loans. Sometimes we gave them 90%, 100% and even 110% (!) of the value of the apartment! The assumption was that the real estate market would continue to grow and prices would rise, then the borrower could take a new loan in the prime market and exit the subprime. Another "monster" was leverage through soft loans. The hedge funds, for example, which grew to a trillion and a half dollars, were required to achieve a high return and the leverage created a situation as if it were four times as much capital, we were about 6 trillion dollars looking for investment and return! The banks and the capital market lent without asking too many questions.

Already during the year 2006 the change was felt. Real estate prices stopped, the new loans that came for repricing were already worth more than the value of the apartments, and then a wave of bankruptcies began. In July 2007, reports arrived that showed a problem had arisen - 25% went bankrupt (as opposed to the average forecast of 5%), and at the end of 2007 things began to shake. The subprime crisis was the first victim of the macroeconomic crisis and the sharp recession that was coming, and of a broader phenomenon of a sharp increase in the risk premium. "In the end," Prof. Glai concludes, "the laws of economics win." If you want more profit, you have to take more risk." There is no profit without risk.

Prof. Galai also believes in cycles in the economy and in recovering from a crisis. "There is no society and economy without crises," he says, "a crisis is a good time to repair malfunctions. No successful company does a recovery plan during high tide and "voluntarily". A recession creates an opportunity to stop and think about repairs and improvements. It's painful but essential for society in the long term."

And the future? We asked Prof. Galai, what do you think the economic picture of the world will look like in the next decade?

According to Gelai, there is a great chance that we will see a process of transition from the American hegemony to Asia. It is difficult to predict, but it is worth remembering that Asia today has three elements that strengthened the power of the United States in the 19th and 20th centuries: control over raw materials and natural treasures, cheap labor and basic education. These three things are disappearing in the United States, but rising in Asia, and especially in China.

And in Israel?

In Israel the situation is completely different. The real estate market, which was in crisis in 1995-2005, has only been growing for the past two or three years. If you check against the parameters of the crisis in the United States and measure in shekels, you can see that the increases in apartments for the middle class were not dizzying, and the decreases now will not be significant either. There are not many construction starts and there is no excess supply. And of course there is no loan market that gives 100% mortgage, which serves as an incentive to go bankrupt.

"Banking in Israel is more stable," says Prof. Galai, "the banks did not have leveraged products. No unreasonable loans. In recent years, several things have happened that help banks overcome the crisis. Following the Bacher reforms, the banks came out stronger because they had to sell the provident funds and trust funds. Moreover, the opening of the capital market, which created competition for banks, reduces their credit exposure." Prof. Glai adds and says: "However, there is a panic of liquidity and nervousness in the market. About NIS 30-40 billion have already been redeemed from the provident funds and training funds, and all the pressure falls on bonds and other papers, including government bonds. Small companies are affected by the liquidity crisis and there are strange phenomena in the capital market. Stocks rise (or suffer less) while bonds fall because there are redemptions by the provident funds. Israel is not cut off from the rest of the world, Israeli exports depend on world markets, high-tech may be affected again."

But all in all, Prof. Galai shows cautious optimism: "The money withdrawn from the provident funds eventually returns to the banks and the flow of dollars from abroad also continues. Foreign residents transfer dollars to banks in Israel - the banks have a huge amount of credit and in the end they will lower the interest rate."

While the macroeconomic crisis will be severe in the United States and may continue throughout 2009, the crisis in Israel is expected to be less severe, and this is because we have already gone through a corrective and acute crisis in Israel from October 2000 to 2004. It must be remembered that the capital market precedes and anticipates the real economy, and its proper functioning is a condition necessary for economic growth. Therefore, we can expect that the prices of corporate bonds and shares will start to rise a few months before we decide on a change in the real economy.