US Financial Crisis: Causes and its impact on India

Introduction

The global Financial Crisis of 2008 is the most severe financial crisis that the world has ever faced since the Great Depression of the 1930s The !Financial Crisis of 2008" # also called the $% &eltdown# has its origin in the $nited %tates ho'sing sector bac( in 2001)02# b't grad'all* e+tended over a period of time and event'all* bro'ght the entire world 'nder its grip The financial crisis is characteri,ed b* contracted li-'idit* in the global credit and ho'sing mar(et# triggered b* the fail're of mortgage companies# investment ban(s# and government instit'tions which had heavil* invested in s'bprime loans Tho'gh the crisis started in 200.)0/# b't has become more visible d'ring 2000)08# when man* of the renowned 1all %treet firms collapsed 2ccording to 3&F officials# the losses d'e to real estate crisis is amo'nted to 495. billion in $%2 alone# b't ma* r'n into trillions of dollars# the losses of all the co'ntries considered together 3nitiall*# the crisis ca'sed mass foreclos're and defa'lt in s'bprime loans b't the crisis accelerated d'ring the month of %eptember 2008# and 'ltimatel* developed into a global financial crisis The impact of this crisis was so severe that it led to the collapse of top investment firm"s vi, 6ehman 7rothers# 7ears %terns &erill 6*nch and others s'ch as Citi Gro'p# 89 &organ were resc'ed b* the government and 23G :2merican 3nvestment Gro'p; The impact of this crisis was so severe that the $nited %tates Government had to intervene in the free mar(et econom* and had to come with 4000 billion bailo't pac(age to revive the investment ban(s<firms and reinstate the investor"s faith in the stoc( mar(et %ince 8an'ar* 1# 2008 owners of stoc(s in $ % stoc( mar(et have s'ffered abo't 412 trillion dollar in losses# as their val'e declined from 420 trillion to 412 trillion The s'bprime lending is the practice of providing loans to borrowers who do not -'alif* at the mar(et rate of interest owing to vario's ris( factors s'ch as low income level# si,e of down pa*ments made# credit histor*# emplo*ment stat's etc The s'bprime loans :also called =in>a or 6iar loans; are provided to those who do not -'alif* at the mar(et rate of interest The val'e of $ % s'bprime mortgages was estimated at 41 3 trillion till &arch 2000 2n agoni,ing fact of these s'bprime loans was that the delin-'ent rate was as high as 2. per cent till &arch 2008

Causes of the Subprime crisis 3t is diffic'lt to pin down the e+act ca'se of the financial crisis# b't ma>orit* of the e+perts and economists are of the view that s'bprime loans in the ho'sing sector was one of the most important ca'se of the financial crisis of 2008 The different ca'ses of the crisis are specified below? Boom and bust in the housing market: The c'rrent crisis act'all* started with the b'rsting of ho'sing @b'bbleA that began in 2001 and started growing at a rapid rate 'ntil it reached its pea( in 200. The ho'sing b'bble occ'rred d'e to rapid increase in the rate of the val'ation of real propert* 'ntil the prices of the propert* reached the 'ns'stainable level The factors that led to the rapid increase in the demand for ho'se price are)) low interest rate and the h'ge inflow of foreign capital from co'ntries s'ch as China# 8apan $ B 2lso# s'bprime loans added f'el to the fire# f'rther increasing the demand for ho'ses 2lso# the Federal Ceserve 7oard c't the short)term interest rate from / . percent in 2000)01 to 1 percent in 2003)05 2 Greenspan# the Governor of Federal Ceserve# accepted in 2000# the fact that ho'sing b'bble was @f'ndamentall* endangered b* the decline in real long)term interest rateA :7ianco# 2008; 7eca'se of above mentioned fact# the home ownership rate increased from /5 per cent in 1995 to an all time high pea( of /9 per cent in 2005 :1i(ipedia; This rise in demand p'shed the prices of ho'se b* leaps and bo'nds 7etween 1990 and 200/# 2merican home prices increased b* 125 per cent :1i(ipedia; F'rther# $ % cons'mers l'red b* the increasing val'e of their homes went on borrowing spree The* started borrowing mone* for cons'mption b* mortgaging their propert* 2lso# 2mericans spent 4800 billion per *ear more than the* earned Do'sehold debt grew from 4/80 billion in 1905 to 415 trillion in 2008 D'ring 2008# the average $ % ho'sehold owned 13 credit cards# and 50 percent of them carried a balance 'p from / percent in 1900 :1i(ipedia; 7't overb'ilding d'ring the boom period and rise in interest rate led to the b'rsting of the b'bble 7etween 2005 and 200/ the Federal Ceserve 7oard raised the interest rate b* 10 times# 'p from 1 percent to . 2. percent 2lso# overb'ilding d'ring the

boom event'all* led to a s'rpl's inventor* of ho'ses# ca'sing home prices to decline# beginning in s'mmer# 200/ :7ianco# 2008; 2s a res'lt foreclos're and defa'lt rate increased 2bo't 8 8 million homeowners :10 8 per cent of total homeowners; had ,ero or negative e-'it* as of &arch# 2008# :1i(ipedia; meaning their ho'ses are worth less than their mortgage %ales of ho'ses decreased b* 2/ 5 per cent in 2000 compared with the previo's *ear SSpeculation: 2nother important ca'se of ho'sing crisis is spec'lation in real estate 3t was observed that investment in ho'sing sector *ield high ret'rn compared to other traditional investment aven'es 2s a res'lt investment in ho'sing sector increased D'ring 200/# 22 per cent of homes p'rchased :1 /. million 'nits; were for investment p'rposes# with an additional 15 per cent :1 00 million 'nits; p'rchased as vacation homes =earl* 50 per cent of home p'rchases were not for primar* residences 2 hoping 8. percent of the ho'ses p'rchased in &iami were for investment p'rposes :1i(ipedia; HHigh risk loans and lending practices: The s'bprime loans were highl* ris(*# as these loans were offered to the high ris( borrowers)) illegal immigrants# person witho't an* >ob# an* assets and an* income The repa*ment from these borrowers was hardl* e+pected The share of s'bprime mortgages to total originations increased from . per cent :43. billions; in 1995 to 20 per cent :4/00 billions; in 200/ 2gain the difference between the prime loan and s'bprime loan declined from 2 8 per cent in 2001 to 1 3 per cent in 2000 This res'lted in the increase in demand for s'bprime loans :1i(ipedia; 2nother e+ample of high ris( loans is the 2d>'stable Cate &ortgages :2C&; $nder 2C&s borrowers had to pa* the onl* the interest :not principal; d'ring the initial period 2n estimated one)third of 2C&s originated between 2005 and 200/ had !teaser" rates below 5 percent :1i(ipedia; SSecuritization: %ec'riti,ation is a str'ct'red finance process in which assets# receivables or financial instr'ments are ac-'ired# pooled together as collateral for the third part* investments :3nvestment ban(s; D'e to sec'riti,ation# &ortgage 7ac(ed %ec'rities :&7%; is created< originated and distrib'ted b* the investment firms<ban(s 3nitiall* Freddie &ae and Fannie &ac :-'asi government agenc*; 'se to iss'e &7% b't later private agencies also started iss'ing &7% on s'bprime loans D'ring 2003 to 200/#

the agencies share of &7% fell from 0/ per cent to 53 per cent while 1all %treet"s share climbed 'p from 25 per cent to .0 per cent d'ring the same period The sec'riti,ed share of s'bprime mortgages :&7s on s'bprime; increased from .5 per cent in 2001 to 0. per cent in 200/ :7ianco# 2008; IInaccurate credit rating: $nder new s*stem of sec'riti,ation# investment firms<ban(s repac(aged mortgages sec'rities :&7%; into innovative financial prod'cts called CDEs :Collateral Debt Ebligation;# that promised to boost the ret'rn for investors These CDEs were f'rther divided into small financial 'nits called !tranches" These tranches were rated on the basis of ris( involved The safest portion of the tranches received the highest rating of 222<aaa# while ris(ier tranches received the medi'm -'alit* 777<bbb rating# >'st above the >'n( bonds 3t has been observed that &7% and CDEs originated from s'bprime mortgages were distrib'ted b* the investment firms Credit rating agencies are 'nder scanner for giving investment)grade rating to sec'riti,ation transactions based on s'bprime loans GGovernment olicies: To provide ho'se at affordable price to all the people was the priorit* of both the Clinton and 7'sh administration 3n 1905# 9resident Carter passed the Comm'nit* Ceinvestment 2ct This 2ct made mandator* for all the ban(s and saving instit'tion to provide home loans to the lower income people in broad o'tl*ing areas where the* had branch

The $ % Department of Do'sing and $rban Development"s &ortgage policies f'eled the trend towards iss'ing ris(* loans Do'sing and $rban Development directed Freddie and Fannie to provide at least 52 per cent of their mortgage financing to borrowers with income below the median in their area This target was increased to .2 per cent in 200. The onl* wa* to achieve income loan target while dramaticall* increasing lending was to erode 'nderwriting lending standards Fannie &ae aggressivel* bo'ght 2lt)2 loans# where these loans ma* re-'ire little or no doc'mentation of a borrower"s finances Till =ovember 2000 Fannie &ae held a total of 4.. 9 billion of s'bprime sec'rities and 4325 0 billion of 2lt)2 sec'rities in their portfolios

Central bank policies: The Federal Ceserve"s primaril* concern was to manage the monetar* polic* and was least bothered abo't the ho'sing b'bble and dot)com b'bble Ence the b'bble b'rst# the Central 7an( tried to control the spread of the crisis on other sectors 2 contrib'ting factor to the rise in home prices was the lowering of the interest rate earlier in the decade b* the Federal Ceserve lowered b* the f'nds rate target from / . per cent to 1 per cent F'rther Greenspan has been critici,ed for flo'rishing s'bprime loans :7ianco# 2008; Impacts of the US Financial Crisis on India Tho'gh in the beginning 3ndian official denied the impact of $% meltdown affecting the 3ndian econom* b't later the government had to ac(nowledge the fact that $% financial crisis will have some impact on the 3ndian econom* The $% meltdown which shoo( the world had little impact on 3ndia# beca'se of 3ndia"s strong f'ndamental and less e+pos're of 3ndian financial sector with the global financial mar(et 9erhaps this has saved 3ndian econom* from being swa*ed over instantl* $nli(e in $% where capitalism r'les# in 3ndia# mar(et is closel* reg'lated b* the government !" Impact on stock market The immediate impact of the $% financial crisis has been felt when 3ndia"s stoc( mar(et started falling En 10 Ectober# Cs 2.0#000 crores was wiped o't on a single da* bo'rses of the 3ndia"s share mar(et The %ense+ lost 1000 points on that da* before regaining 200 points# an intrada* loss of 200 points This h'ge withdrawal from the 3ndia"s stoc( mar(et was mainl* b* Foreign 3nstit'tional 3nvestors :F33s;# and participator*)notes

#" Impact on India$s trade The trade deficit is reaching at alarming proportions 7eca'se of wor(er"s remittances# =C3 deposits# F33 investment and so on# the c'rrent deficit is at aro'nd 410 billion 7't if the remittances dr* 'p and F33 ta(es flight# then we ma* head for another 1991 crisis li(e sit'ation# if o'r foreign e+change reserves depletes and trade deficit (eeps increasing at

the present rate F'rther# the foreign e+change reserves of the co'ntr* has depleted b* aro'nd 4.0 billion to 42.3 billion for the wee( ended Ectober 31 :%ivaraman# 2008;

%" Impact on India$s e&port 1ith the $% and several F'ropean co'ntries slipping 'nder the f'll blown recession# 3ndian e+ports have r'n into diffic'lt times# since Ectober &an'fact'ring sectors li(e leather# te+tile# gems and >eweller* have been hit hard beca'se of the sl'mp in the demand in the $% and F'rope" F'rther 3ndia en>o*s trade s'rpl's with $%2 and abo't 1. per cent of its total e+port in 200/)00 was directed toward $%2 3ndian e+ports fell b* 9 9 per cent in =ovember 2008# when the impact of declining cons'mer demand in the $% and other ma>or global mar(et# with negative growth for the second month# r'nning and widening monthl* trade deficit over 410 billions Efficial statistics released on the first da* of the =ew Gear# showed that e+ports had dropped to 41 . billion in =ovember this fiscal *ear# :%ivaraman# 2008; from 412 0 billion a *ear ago# while imports grew b* 4/ 1billion to 421 . billion

Impact on India$s handloom sector' (e)elr* e&port and tourism 2gain red'ction in demand in the EFCD co'ntries affected the 3ndian gems and >eweller* ind'str*# handloom and to'rism sectors 2ro'nd .0#000 artisans emplo*ed in >eweller* ind'str* have lost their >obs as a res'lt of the global economic meltdown F'rther# the crisis had affected the Cs 3000 crores handloom ind'str* and vol'me of handloom e+ports dropped b* 5 / per cent in 2000)08# creating widespread 'nemplo*ment in this sector :Chandran# 2008; 1ith the global econom* still e+periencing the meltdown# 3ndian to'rism sector is badl* affected as the n'mber of to'rist flowing from F'rope and $%2 has decreased sharpl*

+" ,&change rate depreciation

1ith the o'tflow of F33s# 3ndia"s r'pee depreciated appro+imatel* b* 20 per cent against $% dollar and stood at Cs 59 per dollar at some point# creating panic among the importers

-" I./B 0 sector

The overall 3ndian 3T)79E reven'e aggregate is e+pected to grow b* over 33 per cent and reach 4/5 billion b* the end of c'rrent fiscal *ear :FG200; Ever the same period# direct emplo*ment to reach nearl* 2 million# an increase of abo't 30.000 professionals over the previo's *ear 3T sectors derives abo't 0. per cent of their reven'es from $% and 3T)3TF% :3nformation Technolog* Fnabled %ervices; contrib'tes abo't . . per cent towards 3ndia"s total e+port %o the meltdown in the $% will definitel* impact 3T sector F'rther# if Fort'ne .00 h'ndred companies slash their 3T b'dgets# 3ndian firms co'ld adversel* be affected

1" FII and F2I The contagio's financial meltdown eroded a large ch'n( of mone* from the 3ndian stoc( mar(et# which will definitel* impact the 3ndian corporate sector Dowever# the mone* eroded will hardl* infl'ence the performance real sector in 3ndia D'e to global recession# F33s made withdrawal of 4. . billion# whereas the inflow of foreign direct investment :FD3; do'bled from 40 .biilion in 2000)08 to 419 3 billion in 2008 :2pril)%eptember; Conclusion From the above arg'ment it can be noted down that the !Financial or %'bprime Crisis" was the shear conse-'ences of !greed" and to ma(e !too m'ch profit" on the part of 1all %treet Firms and 3nvestment 7an(s This crisis also shows the fail're of capitalist mar(et econom* Tho'gh the 3ndian econom* wo'ld be able to withstand the crisis witho't an* ma>or diffic'lt*# b't the crisis is still ca'sing ma*hem all over the world