Origin of the Financial Crisis

Today I got up a little early and thought of browsing through some of the websites that have been lashed with the alien attack nowadays. Well, don’t be frightened – I am referring to the window for the common man to the vast and enormously expanded financial world websites (some of which that suddenly strike me are http://www.bloomberg.com/, http://www.finance.yahoo.com/, http://www.cnn.com/, http://www.efinancialnews.com/ and a lot more of such famed sites). Even if we open the print edition of our local newspaper(s), we generally have a feeling as to some negative news is already around the corner... Bear Stearns, Lehman Brothers, Merill Lynch, AIG... What next??? Perhaps, no one has the answer...but everyone has this small intuition that somewhere or the other some big firm has either trod the path to bankruptcy filing or is looking for a saviour.

Let us try to follow a sequential manner and delve more into it to try and discover the entire series of events which has led to the present situation and its fall out on our country, India, in particular.

On this slight thought of delving into the past, the first significant event that strikes the mind, which we can suppose to be the prime driver for this crisis – the devil - is the US sub-prime crisis.

What Happened:
After emerging out of the recession of 2001, the US economy was in a desperate need of an alternative to survive and maintain its supremacy. In order to come out of the downturn in its economy, it asked the consumers to spend, spend as much as they could and even above their abilities. It bolstered the consumption activities by various ways and means. Credit was made available at cheaper rates. The philosophy of ‘Borrow and spend’ was popularised. The US Fed even reduced the interest rate by 1%. With such lower interest rates, consumers started to increase their consumption levels and began improving their standard of living. As part of these activities, purchasing their own land and houses became a sudden need for the US citizens. This bubbled demand for real-estate and the given sudden rush of cheap money resulted in the domestic land and house prices in the country to shoot up by astounding rates of more than 6 % in 2003, 8 % in 2004, 14 % in 2005, and 13 % in 2006. As the asset value of the consumers went up, they were tempted to borrow more for the increased valuation of the properties. They spent their money on consumption with the unlimited borrowing available at their disposal.

On the other hand, a number of financial institutions also wanted to take advantage of this situation. They sought to sell their initial credits to special vehicles. In doing so, they perceived two advantages: one, they made high fees on securitisation transactions and second, they got out of their balance sheets costly (capital adequacy wise) and risky credits. The financial institutions became less vigilant on the quality of their loans and more interested in the quantity of credits to be packaged at remunerative conditions. They stressed too much on the volumes of customers and were tempted to give too much weight to the growth of their business. However, these loans were offered with a catch that they found an arranger to bundle and sell the assets as well as properly bridge refinancing. The same pattern was true for the arrangers: they only took the transitional warehousing risk and the distribution risk. Even though they knew that the underlying risk of the assets was increasing but still, they didn’t always care for it, more because, they were not supposed to hold these assets for long-term. This resulted in the sub-prime lending to come into existence. Borrowers with poor credit history were given loans and further these loans were securitised.

Effect:
The resultant indebtedness in American households reached an extraordinarily high level: 140% (in other words household debts amount to almost one and a half times their annual income). Mortgage debts of households represented 95% of their income in 2005 (compared to 63% in 1995).

Impact:
Since the loan-takers already had a dearth of funds, default of interest and loan re-payment started. A wave of re-possessions started and the real estate prices started to decline. This property crash in turn affected the broader economy. With the building industry expected to cut its output by half, the result was a loss of approximately one to two million jobs. Many smaller builders went out of business, and the larger firms suffered huge losses.

Even though the building industry made up 15% of the US economy, a slowdown in the property market hit many other related industries, for instance, makers of durable goods industry started to face the pressures of bad economy. The financial institutions started to lose majorly as the collateral value had declined and suffered huge losses. This was the start of the downward movement of the growth index for the country and it started showing its impact on all related foreign markets as well.

In our next post, we shall continue from this note as to how the loss to these financial institutions had an impact on the US as well as the global economy and the role played by the Fed.

Keep anticipating this space for more.

Au Revoir

Idea behind Finominic

After such a fine intro by our anonymous (well...he is yet to decide on his name) financial expert, it is apt to get into the picture and tell you more about myself and how the idea of the blog came up...Well as has already been revealed that I have some engineering background and got an opportunity in consulting perchance.. hello... it was not perchance but was a conceived mistake that made me more tempted to pursue my MBA and voila - I met some beautiful brains of the country.

An ideal MBA is forced to think jara 'hat-ke' - the so called buzz word for it is to be innovative...and even we were pushed on the same line of thought invaders to think differently, but to be frank,neither of us could gather so much support (both mental and physical) to call themselves an innovator. So, we have tried to get something new in the existing scenario and started working on this concept. This brought into picture the three novel minds of their times - the creative collaborators in this concept. Well - to know about each of them, you can either ask direct questions or keep waiting for them to find an opportune moment to reveal about themselves completely.

There was actually another reason for this concept - the discussions that we used to have for solving our case assignments and the way we used to feel for a ready repository of all glossary terms and their explanations that could have made our lives easier. Even though our discussions were very healthy and fruitful, we missed them when we required to refer to the same things again and again (after all its human memory and to forget is but natural ;)). This concept is thus more of an answer to that problem that we and all others like us face during the discussions and will be a ready guide to more prevalent problems in the financial world.

In addition to the theoretical concepts, we would also be discussing about the pertinent financial issues that are causing the waves now or have done so in the past. We would try to bring in the layman's perspective as much as possible in our posts ..or as our financial expert puts it..."keep it simple yaar !".. so that it becomes easier for the people who are going through the posts to understand and pitch in with their comments and queries...

So ending this post with this note, keep anticipating this space for the financial cornerstones and trivia.

Au Revoir

Introduction to the Blog and writers

Just close your eyes and think of the first thing that comes in your mind when you read the name of this blog.. hey wait don’t close the window this was just for starting this blog entry, I agree there is nothing much that comes in the mind except stock market and inflation..when you read the name but believe me there would be lot more when you will read the columns in this blog. You must be wondering columnssss.. Yeah, columns as the blog will deal with the effect of finance on your life from point of view of the writers. As you know finance affects us more than anything and it’s like omnipresent. So you must be wondering who all are there to give tell us how it would impact our life and same thing came to my mind also so I thought to just give some introduction about the writers.

Firstly all the current writers are pursuing MBA from same alma mater in India and have decided to start this blog as they all are gripped with the effects that finance has on life.

So here we go the concept developer first, He is an engineer and than some how got into consultancy and now is trying hard to come into terms with this dinosaur called Finance. He would give you a layman’s view of financial events(FE). So this will help you understand that what you thought was and why was it wrong or right. His name in the blog would be-----------------(left blank as at lest this much liberty is allowed ;-). Really you would enjoy his writing.. Reason? you will yourself comment..

Next one is a girl..yeah this blog also has a girl writer and this is not to spice up the blog but to give the blog the real meaning. A bachelor in economics & management, and after working at a reputed broking house she will help you in visualizing the effects of FE’s. She will tell you inside stories that she is able to link and also explaining how exactly a decision or announcement is going to effect economy and in turn you and in short would be boring you ;-) but better be bored than ignorant J. Her name on the blog --------is again left to her discretion.

Now next one is a genius in finance.. he has it on his tips and would provide the effect of finance on your lifestyle in a way that you will appreciate .. off course you must have guessed by now that this one is writer of this entry itself :D. Now humor apart writer is just trying to come to the grip with niceties this beautiful subject throw him at daily basis and would like to throw those at you as questions and try and get your thought process rolling.. he had run his small business for three years before joining MBA. wait.. his name on the blog would be ---------( he is thinking)

The Blog has lot of story behind it and that would be told later and also there might be changes in profiles of the writers when they write about themselves.