The world economies are passing through very difficult time. It is a worst economic crisis as compared with the great depression of 1930’s., The developed world is going to an inevitable recession, the global economy is going to experience a slow down,the credit market is in a big crisis and there will be a massive credit contraction in developed countries of the world and sub emerging world. Stock market all over the world crashed without exception from developed countries to emerging markets. Currency market has been experiencing a turbulent time. Though it started to show its effect only the middle of 2008, it is expected that the intensity and effect to the grass root level of economy can be experienced during march 2009.We had a difficult time and in this global financial turmoil, the government even in the wealthiest nation had to come up with rescue packages to bailout their financial system. What will be the reason for al these?. This paper is trying to have a quick look into it
What is a sub-prime loan?
In the US, borrowers are rated either as 'prime' - indicating that they have a good credit rating based on their track record - or as 'sub-prime', meaning their track record in repaying loans has been below par. Loans given to sub-prime borrowers, something banks would normally be reluctant to do, are categorized as sub-prime loans. Typically, it is the poor and the young who form the bulk of sub-prime borrowers.
Why loans were given?
In roughly five years leading up to 2007, many banks started giving loans to sub-prime borrowers. They did so because they believed that the real estate boom, which had more than doubled home prices in the US since 1997, would allow even people with dodgy credit backgrounds to repay on the loans they were taking to buy or build homes. Government also encouraged lenders to lend to sub-prime borrowers, arguing that this would help even the poor and young to buy houses. .
What was the interest rate on sub-prime loans?
Since the risk of default on such loans was higher, the interest rate charged on sub-prime loans was typically about two percentage points higher than the interest on prime loans. This, of course, only added to the risk of sub-prime borrowers defaulting. Being flush with funds they were willing to compromise on prudential norms. In one of the instruments they devised, they asked the borrowers to pay only the interest portion to begin with. The repayment of the principal portion was to start after two years.
How did this turn into a crisis?
The housing boom in the US started petering out in 2007. One major reason was that the boom had led to a massive increase in the supply of housing. Thus house prices started falling. This increased the default rate among subprime borrowers Estimates are that US housing prices have dropped by almost 50% from their peak in 2006 in some cases. The declining value of the collateral means that lenders are left with less than the value of their loans and hence have to book losses. Traditionally, banks lent money to home owners for their mortgage and regained the risk of default, called credit risk. However, due the financial innovations, banks can now sell rights to the mortgage payments and related credit risk to investors through a process called securitization. Such home loans purchase by the investors are called Mortgage Backed Securities(MBS) and Collateralized Debt Obligations(CDO).the complex derivatives developed based on the loan portfolios, which were also sold to other players, some of how then sold it on further and so on. As a result, nobody is absolutely sure what the size of the losses will be when the dust ultimately settles down. Nobody is also very sure exactly who will take how much of a hit. It is also important to realise that the crisis has not affected only reckless lenders.
What has been the impact of the crisis?
Global banks and brokerages have had to write off an estimated $512 billion in sub-prime losses so far, with the largest hits taken by Citigroup ($55.1 bn) The crisis has also seen Lehman Brothers - the fourth largest investment bank in the US - file for bankruptcy. Merrill Lynch has been bought out by Bank of America. Freddie Mac and Fannie Mae have effectively been nationalized to prevent them from going under.
How is the rest of the world affected?
Apart from the fact that banks based in other parts of the world also suffered losses from the subprime market, there are two major ways in which the effect is felt across the globe. First, the US is the biggest borrower in the world since most countries hold their foreign exchange reserves in dollars and invest them in US securities. Thus, any crisis in the US has a direct bearing on other countries, particularly those with large reserves like Japan, China and - to a lesser extent - India. Also, since global equity markets are closely interlinked through institutional investors, any crisis affecting these investors sees a contagion effect throughout the world.
WHAT paves the way?
The very first thing occurred with the withdrawal of the Glass- Stegall Act was passed after the Great depression in 1930’s. The above said Act separated the investment activities and commercial banking activities in to two. Economist Robert Kuttner has criticized the repeal of this Act but Gramm-Leach Act 1999 as possibility contributing to the sub prime melt down. The US department of Housing and Urban Developments, mortgage polices fueled the trend towards issuing risky loans.
Above all, normally the global investors from pension funds in Japan to Life insurance companies in Finland were typically interested in US government bonds which were considered to be the safest in the world. But unfortunately the Federal Reserve Bank has reduced the interest rate to nearly1 percent to perk up the economy after the September 11 attacks. This has left many funds looking for alternative investments that can give them higher returns and turns to home loans because the offer 4-6 percent interest. This inflow of cash pressurized bank to issue more loans, so that they can be sold to the investment banks in return for a commission. Slowly banks started lowering the credit quality for availing a home loan and aggressively used agents to source new loans. This leads to provision of loans without income proof, without other assets without credit history, sometimes even without proper job
EFFECTS IN India
India benefited from large inflows(FIIs/FDI) arising out of easy international liquidity leading to lower interest rates land extremely high credit growth since 2004. Some of the sectors like real estate and the capital market got overheated. The bubble burst and the worst- occurring and expected are :-
Already occurring
Capital out flows from beleaguered FIIs
Adverse exchange rate movements
Global slowdown and recession could effect new jobs, retrengment of employees
Effects expected
Asset price deflation (particularly in real estate could distress banks.
Global recession reduce our exports and thus slowdown our growth.
Corporate will find it difficult to roll over their $ borrowings adding ti liquidity pressure.
Oil/fertilizer subsidies and debt waiver will increase real fiscal deficit with no room for further fiscal maneuvering.
Rise in inflation and interest rate(could be moderated due to slow down in growth)
Pressure on profitability of corporate/banks
Threat of higher NPAs due to recession, delays in infrastructure project and delinquency in retail loans
What is a sub-prime loan?
In the US, borrowers are rated either as 'prime' - indicating that they have a good credit rating based on their track record - or as 'sub-prime', meaning their track record in repaying loans has been below par. Loans given to sub-prime borrowers, something banks would normally be reluctant to do, are categorized as sub-prime loans. Typically, it is the poor and the young who form the bulk of sub-prime borrowers.
Why loans were given?
In roughly five years leading up to 2007, many banks started giving loans to sub-prime borrowers. They did so because they believed that the real estate boom, which had more than doubled home prices in the US since 1997, would allow even people with dodgy credit backgrounds to repay on the loans they were taking to buy or build homes. Government also encouraged lenders to lend to sub-prime borrowers, arguing that this would help even the poor and young to buy houses. .
What was the interest rate on sub-prime loans?
Since the risk of default on such loans was higher, the interest rate charged on sub-prime loans was typically about two percentage points higher than the interest on prime loans. This, of course, only added to the risk of sub-prime borrowers defaulting. Being flush with funds they were willing to compromise on prudential norms. In one of the instruments they devised, they asked the borrowers to pay only the interest portion to begin with. The repayment of the principal portion was to start after two years.
How did this turn into a crisis?
The housing boom in the US started petering out in 2007. One major reason was that the boom had led to a massive increase in the supply of housing. Thus house prices started falling. This increased the default rate among subprime borrowers Estimates are that US housing prices have dropped by almost 50% from their peak in 2006 in some cases. The declining value of the collateral means that lenders are left with less than the value of their loans and hence have to book losses. Traditionally, banks lent money to home owners for their mortgage and regained the risk of default, called credit risk. However, due the financial innovations, banks can now sell rights to the mortgage payments and related credit risk to investors through a process called securitization. Such home loans purchase by the investors are called Mortgage Backed Securities(MBS) and Collateralized Debt Obligations(CDO).the complex derivatives developed based on the loan portfolios, which were also sold to other players, some of how then sold it on further and so on. As a result, nobody is absolutely sure what the size of the losses will be when the dust ultimately settles down. Nobody is also very sure exactly who will take how much of a hit. It is also important to realise that the crisis has not affected only reckless lenders.
What has been the impact of the crisis?
Global banks and brokerages have had to write off an estimated $512 billion in sub-prime losses so far, with the largest hits taken by Citigroup ($55.1 bn) The crisis has also seen Lehman Brothers - the fourth largest investment bank in the US - file for bankruptcy. Merrill Lynch has been bought out by Bank of America. Freddie Mac and Fannie Mae have effectively been nationalized to prevent them from going under.
How is the rest of the world affected?
Apart from the fact that banks based in other parts of the world also suffered losses from the subprime market, there are two major ways in which the effect is felt across the globe. First, the US is the biggest borrower in the world since most countries hold their foreign exchange reserves in dollars and invest them in US securities. Thus, any crisis in the US has a direct bearing on other countries, particularly those with large reserves like Japan, China and - to a lesser extent - India. Also, since global equity markets are closely interlinked through institutional investors, any crisis affecting these investors sees a contagion effect throughout the world.
WHAT paves the way?
The very first thing occurred with the withdrawal of the Glass- Stegall Act was passed after the Great depression in 1930’s. The above said Act separated the investment activities and commercial banking activities in to two. Economist Robert Kuttner has criticized the repeal of this Act but Gramm-Leach Act 1999 as possibility contributing to the sub prime melt down. The US department of Housing and Urban Developments, mortgage polices fueled the trend towards issuing risky loans.
Above all, normally the global investors from pension funds in Japan to Life insurance companies in Finland were typically interested in US government bonds which were considered to be the safest in the world. But unfortunately the Federal Reserve Bank has reduced the interest rate to nearly1 percent to perk up the economy after the September 11 attacks. This has left many funds looking for alternative investments that can give them higher returns and turns to home loans because the offer 4-6 percent interest. This inflow of cash pressurized bank to issue more loans, so that they can be sold to the investment banks in return for a commission. Slowly banks started lowering the credit quality for availing a home loan and aggressively used agents to source new loans. This leads to provision of loans without income proof, without other assets without credit history, sometimes even without proper job
EFFECTS IN India
India benefited from large inflows(FIIs/FDI) arising out of easy international liquidity leading to lower interest rates land extremely high credit growth since 2004. Some of the sectors like real estate and the capital market got overheated. The bubble burst and the worst- occurring and expected are :-
Already occurring
Capital out flows from beleaguered FIIs
Adverse exchange rate movements
Global slowdown and recession could effect new jobs, retrengment of employees
Effects expected
Asset price deflation (particularly in real estate could distress banks.
Global recession reduce our exports and thus slowdown our growth.
Corporate will find it difficult to roll over their $ borrowings adding ti liquidity pressure.
Oil/fertilizer subsidies and debt waiver will increase real fiscal deficit with no room for further fiscal maneuvering.
Rise in inflation and interest rate(could be moderated due to slow down in growth)
Pressure on profitability of corporate/banks
Threat of higher NPAs due to recession, delays in infrastructure project and delinquency in retail loans
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