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