FINANCIAL MELTDOWN AND ITS RECOVERIES: A CASE STUDY OF INDIA
Dr. Neeru Chadha (Associate Professor),
PG Department of Commerce and Business Management,
BBK DAV College for Women, Amritsar-143001 (PUNJAB).
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ABSTRACT
This study traces out the genesis of Global recession and evaluates its impact on Indian Economy. The root cause of crisis is the building up of global imbalances. The origin of this crisis can be attributed to large subprime lending in USA due to several factors like uncontrolled lending, securitization and promotion of housing finance by government. Most of the countries witnessed this crisis in the form of recession but India experienced least. Global crisis has led to stock market crashes, panic in Indian banking system, currency collapse and decline in export market. The slow pace of financial reforms taking place in India, careful approach towards foreign investments in Indian business sectors, frequent technical obstacles and regulatory control have turned out to be beneficial for India and helped it to escape from adverse affects. Numerous steps have been taken by RBI to stabilize the economy, as a result of which the economy has started gaining ground.
INTRODUCTION
In the era of Globalization, no country can be isolated from the fluctuations of world economy. Heavy losses suffered by international banks were affected all countries of world. The collapse of the Bear Stearns[1] was a lead up to the meltdown in September 2008, and then followed by Global financial crisis and recession. Bear Stearns pioneered the securitization and asset-backed securities markets, especially the mortgage-backed assets that were pivotal to the subprime mortgage crisis. The condition became more worsen with the failure of Lehman Brothers on 15 September 2008. Problems in mortgage and credit markets spilled over into interbank money markets from mid-September to late October, there was collapse of the financial system and guided many countries to face a severe meltdown in economy. This crisis led to drastic change in the world economy, the global financial system and for the central banks.
GENESIS OF GLOBAL CRISIS
Global Recession is not a new phenomenon for whole world. The cause of the crisis was the bursting of the United States housing bubble which highlighted in approximately 2005–2006. There was collapse in housing market. There are three categories of mortgages: Prime mortgage, Subprime mortgage, Alt-A mortgage. Prime mortgages are normal mortgages given to normal borrowers who have strong income and decent creditworthiness. These borrowers also known as Prime Borrowers and they provide full documentation of income, assets and liabilities. Subprime mortgages are more risky than earlier one. Subprime lending is a kind of lending to borrowers who might not qualify for a loan because of unstable incomes or low creditworthiness. These borrowers are also known as Ninjas. Ninjas mean no income, no job and assets. Alt-A mortgages fall between Prime and subprime mortgages. They are borrowers with good credit history, but who provide lower documentation to support the loan or who make payment less than 20% of down payment.[2] The origin of this crisis can mostly be attributed to large subprime mortgage lending. The banks were eager to earn more profits and moreover banks know that in case if borrowers were not able to make payment, they could sell the houses at higher price due to appreciation. Hence, they had increased the mortgaged interest rate and call it as a Subprime mortgage. They also knew that they did not have to carry these bad loans in their books as to offshore the balance sheet, they could transfer the default risk to financial institutions all over the world. On the other hand, borrowers thought once they purchased the house, then in future, value of house would went up and they could sell it, thus all debts could be easily paid off. Eventually when the economic cycle got reversed and asset prices decreased, the value of mortgages also went down. The interest rates on mortgaged loans were increased by banks to cover losses. But borrowers failed to pay their monthly loan payment due to increased interest rate as there was also situation of credit squeeze which led to more poor condition, as a result of this, borrowers could not take fresh credit, so they might have to surrender their homes.[3] Asset backed securities did not worked in this situation because the underlying assets behind the securities were now worthless. Liquidity dried up and led to credit crunch. So, banks stopped the subprime lending and also interbank lending as they were afraid of losing money because they lend money to banks which were also exposed to subprime loans.[4]
Quick Review of Timeline
The current recession which affected the whole of world, is not a new phenomenon. World earlier also faced this phenomenon. (See Appendix: Table 1)
THE GLOBAL CRISIS
An economic recession is primarily attributed to the actions taken to control the money supply in economy. Usually, central bank of every country is responsible for maintaining the balance between money supply, interest rates and inflation. So, to curb inflation, proper balance has to be striked out to restrict bank rates, so that it will not lead to credit crunch. When delicate balance is tipped, the economy is forced to correct itself. Some times, central bank smoothen the money supply in money market. This helps to keep interest rates low, even if inflation rises. Inflation is the rise in prices of goods and services over a period of time. Higher level of inflation leads to fall in purchasing power of consumers. Hence, people are restricting themselves from spending money on luxury items. In simple, people now want to save more and spend less. People and business are looking forward to different ways to cut costs and spend less on expenditures. Companies will start retrenching workers in order to cut down cost. Hence GDP begins to decline. All these factors combine to drive economy into state of recession.[5]
The causes of current Global Recession are:
Housing finance and securitization of mortgages: Federal Housing Administration (FHA), Veterans Administration (VA), Fannie Mae, Freddie Mac were those entities created by US Government for promotion of home ownership making mortgages available. Securitization eliminates uncertainty and allows the risk to be price through higher interest rates. Firms who were engaged with mortgage business know that they could reduce the overall risk because of pooling system. So, this was the way how Fannie Mae, Freddie Mac expand the mortgage market. By the end of 2008, the US mortgage market had $14.6 trillion outstanding of which $7.6 trillion was mortgage-backed securities, including $5 trillion held or guaranteed by Fannie May and Freddie Mac, and $2.6 trillion in held by private entities. An additional $5 trillion was held as individual mortgages by commercial banks, thrifts and life insurance companies. The remainder of the $14.6 trillion in mortgages was held by various government agencies and individuals as individual mortgages[6].
Subprime mortgage market: This market includes the business of subprime mortgages, subprime auto loans and subprime credit cards,as well as various securitization products that use subprime debt as collateral[7].
The Shadow Banking System: A major player in the Collateralized Mortgage Obligation (CMO) market wasShadow Banking System. It is a collection of financial institutions including investment banks, hedge funds, money-market funds, and finance companies, as well as newly invented entities called “asset-backed conduits” (ABCs) and “structured investment vehicles” (SIVs). As shadow banks are not part of the formal commercial banking system, so they are not entitled to same strict regulations as other banks. On April 28, 2004, the US Securities and Exchange Commission waived the net capital rule for the largest investment banks: Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley. Shadow banks were estimated to provide as much as 60% of total lending while commercial banks only 40%.The collateralized mortgage obligations sold by these shadow banks were similar to the mortgage-backed securities sold by Fannie Mae and Freddy Mac. The CMOs were sold in tranches (or slices) to investors based on the investors’ risk preference.These CMOs were sliced into three tranches: top, middle and bottom. The mortgage payments were accumulated each month would go to top tranche. When enough money collected, the top tranche’s interest payments were paid. The next mortgage payments were allocated to the middle tranche. When its interest payments were paid, the remaining mortgage payments went to the bottom tranche. If any mortgage holders failed to make their payments, the shortfall would apply to the bottom tranche. To compensate for this possibility, investors in the bottom tranche were paid a higher interest rate. The upper tranches were rated AAA by the bond rating agencies; thus, perceived to be safe investments.[8]
The Collapse: The financial crisis was the result of the collapse of a bubble in the US housing market which had formed in the early 2000s. There was the collapse of the housing bubble. Investment growth in residential housing measured to near zero in late 2005. The first quarter of 2006 saw a 3.6% decline, and another 16.6% dropped in the second quarter. Residential investment showed a 22.8% decline in the fourth quarter of 2008 and a 32.8% declined in the first quarter of 2009.[9]
The Credit Crisis: When businesses found difficulty in raising loans from market because of liquidity dried up, this led to credit crunch in market. A credit crunch is an economic condition in which investment capital is difficult to obtain. According to many economics experts, one of the reasons which lead to a credit crunch is a sustained period of careless and inappropriate lending which results in losses for lending institutions as well as investors in debt.[10] So, to make payment of earlier loan borrowers could not take the fresh loans from the market. Even by this condition interbank transactions were stopped because every bank had severe subprime loans.
IMPLICATIONS ON WORLD ECONOMY
This Financial crisis spread to whole of the economy in the form of recession. This recession was noticeable in late 2008 but it started very earlier. The broadest indicator of economy is GDP[11]. The aggregate demand consistently exceeded domestic output which led to current account deficit in US. Table 2 indicates current account balances of different countries. (See Appendix: Table 2). The large domestic demands of US were met by rest of the world especially China and other East Asian economies. These countries provided cheaper goods and services to US and also helped to maintain price stability in US (Taylor, John (2009)). Generally there was a misconception that US tighten the monetary policy which led to recession. But this was not the cause. It was collapse of housing bubble. The main implications of this recession are:
Rising in Unemployment: This decline in housing market spilled over into the labour market in late 2007. The unemployment rate was at 4.4% in October 2006 and began rise in December 2007. Over the next three months, the labour force dropped out.By May 2009, the unemployment rate had reached 9.4%, the highest it had been since 1983.
Personal Consumption Expenditures: Total Personal Consumption Expenditures began falling in the third quarter of 2008 with a -3.8% change which worsened to a -4.3% change in the fourth quarter. The majority of decline was occurred in the market of Durable goods which turned negative in first quarter of 2008 and snowballed to -22.1% in the fourth quarter of 2008. Non-durable Consumption had also declined beginning in the third quarter of 2008 with a -7.1% change and continuing into the fourth quarter at -9.4%. Non-durable consumption is largely a function of income. Services showed negative in the third quarter of 2008 at -0.1% turned positive again in the fourth quarter of 2008, clocking in at 1.5%. In the first quarter 2009, total consumer spending increased showed 9.6% growth in consumer durable spending.
Export and Import: During the period from the fourth quarter of 2005 to the second quarter of 2008, export growth averaged nearly 10% at an annualized rate. As recession became a global phenomenon, the world demand for American exports declined. In the third quarter of 2008, export growth slowed and dropped to 23.6% in the fourth quarter. This jump down accelerated in the first quarter of 2008 with 28.7% decrease. US import growth peaked in late 2005, turning negative in the fourth quarter of 2007, spreading the decrease in demand globally. Imports saw decline in the fourth quarter of 2008 at -17.5%. This decline had accelerated to nearly 40% in early 2009.
US Government spending: US government spending had not played a large role in the current recession. Substantial decline in federal defense spending in the first quarter of 2009 caused a noticeable 3.5% decline in total government spending.[12]
LINKAGE OF AMERICAN ECONOMY WITH INDIAN ECONOMY:
The current collapse of USA can be witnessed all over the world. It has been an extraordinary collapse of American economy. The effects of American crisis can be seen on European and Japanese economies. Indian economy is no exception to this rule but India is far more fortunate. The slow pace of financial reforms taking place in India, careful approach towards foreign investments in Indian business sectors, frequent technical obstacles and regulatory control have turned out to be beneficial for India and helped it to escape from adverse affects. [13]. Its impact on Indian economy is as follows: