The Sub-Prime Crisis

Over the past several weeks everybody has been hit by this global economic crisis. If not financially then definitely mentally (like us). This tectonic financial crisis has captured the attention of people all over the world. Well if your 160 year old company is about to go bust (read Lehman Brothers) then you better panic!

Investors across the world are in total panic. People are losing their hard earned money, established banks and companies are becoming bankrupt, stock markets and currencies are plummeting. Scary situation! Definitely scarier than Ram Gopal Verma Movies at least! So what exactly is this whole thing? And how does it affect us in India? I attempt to address this here, in my new post.

The origins of today’s crisis lie in the progressively digressing US Government policies. Over the last 5 to 6 years, the US administration has successfully rescinded well-placed restrictions and safeguards in the banking and market sector. Regulations regarding granting of loans or restrictions on banks becoming share market speculators have been removed. Any Tom, Dick or Harry can obtain a loan in the US which he otherwise would not have been eligible for. Also there is little control on hedge fund investment companies and this kind of investment can become multi-fold.

Thus as a result, low income (i.e. sub-prime) US households borrowed heavily from banks to buy homes, etc. and then started defaulting on their payments. Then the house prices dropped. So the value of the purchased property decreased and any hopes of positive returns were squashed. This coupled with the inherent tendency or attribute of eating more than they can chew, living beyond their means resulted in compounding defaults on their debt obligations.

Here are few statistics to make it crystal clear. The ratio of outstanding loan to GDP in India is about 60%. Kindly indulge your mind in working some of those Grey cells and make a wild guess about the corresponding figure in the US!

75%, 90%, 95% or 99.999% ? Guys and Gals you hit way below the target! This figure is a staggering and mind boggling 330% in the US and about 240% in the UK! This means their respective GDPs are virtually non existent and feed almost completely on these loans. Thus the sub-prime housing loan market in the US is huge at about 1.4 Trillion $.

Now Wall Street’s Geeks (shrewd and cunning geeks however) repackaged these loans into a very complicated entity called CDO (Collateralized Debt Obligation) and sold these entities to various European and American Banks and financial corporations. This feature is known as the Hedging. It's simple: Suppose I lend you Rs. 100. Now I will sell this loan to a third-party hedge fund for Rs. 90. They in turn will sell it to some one else for Rs.85 and so on. The complexity lies in the calculations of profit and other percentages on these assets. These hedge Fund companies expect huge profit on these instruments in the future. But there is a glitch, a serious and glaring pitfall. What if these housing loans turn bad? The instruments based on them would then lose value. That is what has exactly happened. The defaults on US house loans started increasing and as result CDO prices stated tumbling. Falling prices made the portfolios of the banks ugly and eroded the banks' capital to a large extent thus affecting liquidity.

Also it is interesting to note that banks do not have all the ready cash that they distribute as credit. The inter-bank lending serves the purpose of getting cash-surplus and cash-deficit banks together and fuels the process of giving loans, lending money, etc. to individual consumers (to buy cars, white goods) and also to corporations (working capital,etc.) With increasing market uncertainty banks become suspicious and the inter-bank loan rates are affected. In the past few weeks the inter-bank loan rates have risen from around 3% to about 7%! With no one willing to buy anything the whole situation has become frightening. All over the world inter-bank markets have become frozen and liquidity in the market has taken a toll.

To address this problem the US Government is putting in about $700 billion as a bailout plan. They will buy these bad loans from the banks and improve the cash-flow in the market. Interest rate will be reduced. But remember that it has no Money Tree or a treasure hove, but the money ultimately comes from the tax-payers pocket! In India the apex bank, RBI is trying to address this problem by reducing the CRR (Cash Reserve Ratio) and thus increase the liquidity in the Inter-Bank market.

We in India are slightly cushioned against a very catastrophic financial adversity because our domestic markets are pretty large and secondly because our banks are not exposed to these CDO business to a large extent. According to ICICI and other Indian Banks their institutions are cash-rich and can wade through these troubled times. (I hope it is true!!!) But ultimately Indian Companies have become more global than before and therefore the global economic meltdown in bound to affect our sanctimonious markets. Tatas acquired a host of companies in recent years. This meltdown is surely going to burn a hole in their pockets! Corus would be laughing hysterically right now. They got out with their money and it is the Tatas who now face the acid test!

A large number of Indian sectors might face problems, market pundits believe. This includes hotels, software, some outsourcing services, real estate, infrastructure, construction, banking, stock broking, mutual funds, and to some extent air travel. Hotels, mainly those in big cities that cater to business travelers, are largely dependent upon foreign tourists. In India, most foreign tourists are from the UK, followed by the US. Moreover, the October-December period is peak travel time and the impact could be higher on hotels because the pace of blow-ups in the US has recently peaked.

The software industry, one of India's largest export-earners, is almost certain to be affected. The industry earns more than 60% of its revenue from the US and the recent spate of closures and mergers will mean the trimming of various software-related services, analysts believe. It could be a mixed bag for the BPO sector. While some BPOs, which were heavily dependent on the BFSI sector, could see their fortunes dwindling, some high-end BPOs with substantial cost advantage could see more business coming their way.

The real estate sector, which was booming just a few months ago, could be affected in a major way. Industry players predict that real estate companies could suffer because of high property prices, high interest rates, and lower demand from IT-BPO companies and reduced availability of speculative funds because of bad stock market conditions. A slowing real estate sector could also lead to a slowdown in the construction industry. This in turn is likely to affect the cement and steel sectors. The construction industry could also suffer from a slowdown when it comes to new projects.

The US crisis and the resulting slowdown in India are also expected to weaken the Indian Rupee. It touched 49 Rs. to a Dollar yesterday! This in turn would mean a higher oil-import bill. With almost no scope to adjust prices, companies selling petroproducts are likely to be hit. Stockbrokers too are expected to suffer as the market slides, volume of trade dwindles and speculators vanish from Dalal Street. Big players and brokers with deep pockets could survive the tough times, but the smaller ones may be forced either to fold up or sell out, market veterans say. Also because the Rupee gets weaker, the software companies and other firms which earn in dollars will benefit from the stronger dollar as there net earning might increase and this might balance the reduction in business. Also petroleum prices are falling so the weakening of Rupee would not have a drastic impact. The assurances of our PM to achieve a GDP growth of 7% are hence pragmatic and not illusionary.

So this, my friends is the whole thing. I sincerely hope that you find this post informative. And as far ass the economic problem is concerned let our Dads worry, we better worry about our submissions and exams!