The Global Financial Crisis

What happened? How does it affect me?

Bharat Phatak
2008 The year of drastic change
How things have changed in the Year 2008! We started the year in euphoria. The
economy was booming. Real estate prices were sky rocketing. The stock market
was at a life time high of 21,000. Everything looked rosy. As we end the year, we
are at the other end of the spectrum. The economy is in a slow down. or
recession. There are no takers for real estate. Builders say, they are not seeing
any new bookings. Stock market has nosedived to 9,000. The spirits are down
due the dastardly terrorist attacks. There is talk about a possible war. The
economic situation appears to have turned 180 degrees. I am sure you are
wondering- What happened?

Where did it start?

It looks as if there are problems everywhere in the world today. Reputed
investment banks and insurance companies in the US have perished. Worlds
largest housing mortgage companies have been bailed out. The leading
automobile companies are close to bankruptcy. People are losing jobs. Houses
are being taken over by banks. The crisis broke out in July 2007. It reached
gigantic proportions in October 2008. But this is not when it started. To
understand the origin of the problem, we must go back to the Year 2000.
2000 saw the bursting of the Dotcom bubble in the US. The stock markets had
boomed, placing great hopes on the magic of the internet. Many dotcom
companies mushroomed. They were not earning money. Many of them, also
were not selling any goods or services. But innovation had caught the fancy of all
investors. Their prices were shooting through the roof, but there was very little to
support those values. Then the inevitable happened. The markets crash landed
with a thud.
The situation became worse after the WTC attacks in September 2001. The
economy was in a slow down after the dotcom crash. Consumer confidence was
shaken. To revive the growth in the economy, the US authorities started cutting
interest rates. This made cheap capital available. Investors had lost money,
because they invested in virtual companies. They were looking for some hard
assets to invest in. Something that was real. House properties seemed to fit
the bill.
You rarely come across anyone who has lost money in his house property.
Generally, the houses are bought and held for a long time say, 10 years, 20

years. Long term investments benefit from inflation and development. There is a
physical use of the asset, as one lives in it and saves on the rent. Most
importantly, it is easy to get a loan for buying a house. With easy liquidity and
lower interest rates, more Americans started buying houses. This started a self
feeding cycle. Because more people were buying houses, the prices went up.
Because of higher prices, the investment looked more profitable. This drove
more people to the housing market. Prices went up further!

Credit Expansion based on Market Price

Generally, the loan that you will get for buying a house depends on 2 factors:
your income and the value of the property. Your income shows how much you
can repay on a monthly basis. This is the equated monthly installment, popularly
known as EMI. Someone could buy a house worth 50,000 dollars by taking a
loan of 40,000 dollars, because his income supported an EMI of say, 1000
dollars. Now, the price of this house went up to, say, 90,000 dollars. Banks
started offering him further loan of 32,000 dollars. Without an increase in
repayment capacity, the loan went up. This was the beginning of the credit
bubble.
The extra 32,000 dollars loan increased the liquidity in the hands of the investor.
In some cases, this led to an impression that one had become wealthier. He
started spending that amount on consumption: Buying a fancy SUV, for example.
Some others used the 32,000 dollars to make a down payment on another house
worth 160,000 dollars. Now, the loan has gone up to 200,000 dollars, without any
increase in repayment capacity.
Banks started giving interest onlyloans. If you cannot repay the installment, pay
just the monthly interest. The repayment will be done from the appreciated sale
value of the house. If you cannot pay the interest in full, the banks came out with
schemes where the unpaid interest would be added back to the principle amount.
This increased the loan burden, but kept feeding the price bubble. With this
change, banks started giving housing loans to borrowers without the repayment
capacity. Even people without sufficient income were given loans. These
borrowers were below the qualifying conditions to become a prime borrower.
Hence, they came to be known as sub-prime loans. The upward spiral
continued, based on a belief House prices never come down!.

Global wave of Liquidity

The credit expansion in the US was fuelled by the housing boom. This money
started chasing other assets throughout the world. With globalization, money
could flow anywhere in the world. Hedge Funds are a type of funds, who have
no restriction in investing anywhere. They are also allowed to borrow to invest.
The number of such funds multiplied. They would borrow in the US when the
interest rates were lower. Then, they started borrowing in Japan because the
interest rates there were practically zero. The real estate price, stock prices,

metals & commodity prices, energy prices in developed as well as developing

countries went up many folds.

Securitization
The banks started selling their loan assets by bundling them together. A bank will
take, say, 1,000 housing loans and create a bond containing these loans. The
future instalments on these loans would be paid to the bond holders. This is
called securitization. Such securities were give credit ratings. The banks could
also add guarantees and insurance to the bonds, and upgrade the credit ratings.
These bonds were bought by other banks, hedge funds, high net worth
individuals and overseas investors. Thus, a problem which could have remained
localized in the US housing market was broken into pieces and sent all over the
world.

Sub Prime Default

The sub-prime borrowers lacked the capacity to repay. A time came when their
homes had to be forfeited by the bank. When the banks started to resell these
repossessed houses, there were no takers. The prices started coming down.
When one house was sold at a lower price, all the houses in the same locality
lost their value. More loans became unsecured. The banks started to repossess
these, and the prices went down further. This triggered of a downward spiral,
which we know today as the global financial crisis.
When the sub-prime loans defaulted, the banks had to bear the loss on the
uncovered portion of the loans. The bonds created out of housing loans also
suffered a loss. The amount of loans that a bank can give is proportional to their
capital in the business. This is called the capital adequacy. Many of the banks
were lending 30 times their capital. When they suffered a loss of 1 dollar, their
capital was less by 1 dollar. They were forced to call back loans worth 30 dollars.
When banks started calling back their loans, the borrowers (such as hedge
funds) were forced to sell off their assets at whatever price they could fetch. This
de-leveraging process resulted in the distress sale of assets across the globe.
Stock markets crashed. Real estate plummeted. Metals tanked. Crude oil
tumbled.

End of Easy Liquidity

The credit bubble was creating easy liquidity conditions all over the world. Deleveraging meant exactly the opposite. Liquidity vanished. Lenders became wary
to lend their money to others. Level of trust between lenders and borrowers
dropped. This lack of liquidity means that raising loans has become more difficult
for a number of companies. Due to the stock market crash, raising Equity capital
is also nearly impossible. This exposed companies who were running their
business on borrowed capital. Many companies were borrowing in the short term
money market, but using that money to buy long term assets. They found
themselves high & dry. Many companies had undertaken ambitious expansion.
They had acquired other companies in the good times. These assets have now

become liabilities. Companies find themselves in a cash crunch. The demand for
what they produce has also come down dramatically.

Impact on India
India is not directly affected by the global financial crisis. However, we cannot
escape collateral damage. Visible growth has happened in the last decade in
Indian software industry. The software industry and other IT enabled services
such as BPO are largely dependent on foreign customers, especially from the
banking & financial services industry. Due to the turmoil abroad, the growth of
this sector will have a setback. There will be cost pressures. We will see job
losses. One job in the software industry gives rise to at least 5 related jobs. The
automobile industry and the building construction industry were booming
because of the demand from highly paid professionals. They will feel the pinch.
Indian companies had benefited from money flow from abroad. The capacities
have been expanded. The lack of demand will make these capacities unviable.

How it affects me?

The down turn will mean that we have to think differently from the boom period.
The demand for all types of goods and services will go down. Certain types of
goods and services are necessities. It is not in the hands of the user to cut
down on the consumption. Somebody who is not well will still consult a doctor
and will still buy medicines. However, he will become more cost conscious. He
may avoid or postpone cosmetic treatments. He will try to bargain about the
charges. He may ask for credit. Some of the amounts due may have to be written
off.

How to gear up
Downturns are an opportunity to rationalize and reform. The economic reforms in
India started because of the foreign exchange crisis the country faced in 1991. In
the personal context, we can use this phase to re-work our strategy, and come
out stronger. Simple tips which will help are:
? Keep fixed cost under control
? Avoid the use of excessive borrowing
? Double check your expansion programs for their viability
? If you are planning to change an asset ( say, a car or a machine), see if
the useful life of the earlier asset is still there, and is the change really
necessary
? Avoid buying unproductive assets, and get rid of those already owned
? Avoid unrelated diversification
? Use the lean period to build a portfolio of outstanding equity shares at
reasonable prices!