World Financial crisis : Major reasons and way forward

1.2 This article briefly analyses, in simple language, the
main causes of this crisis, its possible impact on India and the way forward.

1.3 The major causes of the financial turmoil can be
attributed to the following factors :

Let us briefly discuss each of these factors.

2. Faulty Business Model : Subprime Lending :

The primary cause of the present financial crisis is the
Faulty Business Model of the US lenders in the housing and other markets. To
grow their business, many lenders started lending to subprime borrowers,
i.e., borrowers who were not credit- worthy or were less creditworthy. In
2007, the size of the subprime mortgages was approximately US $ 1.3 trillion.
Such a large-scale subprime lending was possible because of easy availability of
money at an affordable rate which led to excessive leveraging (i.e.,
borrowings) by the mortgage lenders. Even though the borrowers did not have
adequate income or adequate borrowing capacity, money was lent to them for
purchase of homes in the hope that they will be able to meet their financial
commitments out of the appreciation in the real estate prices. The expectation
was that in future the real estate prices would increase significantly, and then
the borrower would be able to refinance his loan at a lesser interest rate. As
long as the real estate prices were rising, this model worked. In 9 years up to
2006, the real estate prices increased by 124%. This model started showing its
weaknesses as the housing prices started declining. From the last quarter of
2006 onwards, a large number of subprime mortgage lenders in the US started
failing.

The ironic situation is that to overcome the recession of
1990s in the US, ample liquidity at a lower rate was injected in the system.
This made subprime lending business very attractive. This led to the housing
boom and eventual housing price bubble. Now, the subprime failure has caused
unprecedented financial tsunami including big liquidity crisis. To solve this
problem, most of the Central Banks are injecting large amount of liquidity in
the system. If the bail-out packages are not carefully administered, it may lead
to further problems.

The fundamental problem is the price bubble in the real
estate market and the valuation bubble in the mortgage financing market. Once
the price bubble burst, the valuation bubble also burst.

3. Financial Derivative Instruments :

Once the original subprime mortgage lenders ran out of funds
for lending (even after excessive leveraging), the investment bankers and others
started creating financial derivative instruments, such as Mortgage-Backed
Securities (MBS) and Collateralised Debt Obligations (CDO). Further, these
instruments were made attractive by providing insurance through Credit Default
Swaps (CDS) instrument. These instruments were sold to various investors. Thus,
the original lenders got a seemingly unending supply of money for the purpose of
subprime lending. Through the creation of financial instruments in the home
mortgage market, the participants in the US home mortgage market were not only
home mortgage lenders but also investors who invested in the financial
instruments based on the underlying home mortgages. These investors are spread
all over the world and consist of banks, financial institutions, mutual funds,
corporates and HNIs. The private wealth management advisors and mortgage brokers
recommended this new asset class for investment purposes. This had a duel
effect : on the one hand, it supplied unusually large amount of money for
subprime lending and on the other hand, the risks associated with it were widely
distributed across the globe. Therefore, the adverse impact also is felt
instantly across the globe. If these financial derivative instruments were not
created, the amount of subprime lending and the consequential losses would have
been substantially lower.

4. Credit Rating System & Agencies :

The financial derivative instruments gained popularity,
because various credit rating agencies assigned investment-grade ratings to
these financial derivative instruments, on the ground that they are backed by
the underlying housing mortgages. They did not consider the housing price bubble
which was being built over a period of about nine years.

5. Fault of Borrowers :

Even though the subprimc borrowers had no known resources for paying the interest and repaying the housing loans, they borrowed recklessly, partly to capture the boom in the real estate market. Secondly, since they were high-risk borrowers, the interest rate for them was higher. To make it affordable, most of them opted for Adjustable-Rate Mortgages (or ARMs) with an initial lower rate of interest which was adjusted every two years. The borrowers borrowed money on ARMs in the hope that they would be able to refinance the loans at a lower rate of interest in future with the increase in the property prices. Since this did not happen, they were stuck with high interest-bearing loans. As the borrowers started defaulting on repayment of the subprime mortgages, foreclo-sures started. As the subprime lenders were not able to recover their money, a large number of subprime mortgage lenders went bankrupt.

6.    Oversupply of Housing Inventory Fuelled by Speculation:

Because of the nine-year long boom in the real estate market in the US, the builders started building real estate in the expectation that the boom would continue. To a great extent, the demand was pushed by investors and speculators who invested in the real estate in the hope that they will be able to make money by reselling them. The over supply reduced the home prices which further aggravated the problem.

7.    Poor Corporate Governance: Lack of Promoters & Conflict of Interest:

In the US, most of the financial institutions have no promoters. The salaries and bonuses of the senior management executives depend upon the performance of their companies. To get higher compensation from their companies, they need to show better current performance, without regard to the impact in the future. Thus, there is a conflict of interest situation in these institutions. How else can one explain that the CEO of now bank-rupt Lehman Brothers got bonus of US $ 22 million in March 2008 based on the performance of 2007 and after just a few months Lehman went bankrupt? Further, to acquire more funds for lending, the mortgage lenders required higher ratings for their financial derivative instruments. Rating agencies obliged because they would earn more fees. Relying upon the ratings given by the rating agencies, investors invested huge amount of money in the financial derivative instruments. Thus, one can say that there was a well-orchestred conspiracy for each party’s personal gain. This clearly shows that there was a poor corporate governance in these financial institutions.

In India, most of the companies have promoters with significant stake and therefore, they would not allow this type of conflict of interest situation to arise.

8.    Inadequate Risk Management Systems:

Several knowledgeable persons have asked: “How did such a financial tsunami arise despite the existence of the so-called sophisticated risk management systems in the US 7”. Firstly, the risk management systems are built around the business model. If the business model is faulty, no risk management system would help. Secondly, the risk management systems concentrated more on processes than on the business risks. Otherwise, the business risks would have been highlighted. Thirdly, conflict of interest also contributed to the inadequacy of the risk management systems.

9.    Inadequate Regulatory  Oversight:

Several mind-boggling questions arise in respect of the failure on the part of various regulatory agencies in the US in preventing or manaqinq the crisis. Various regulatory agencies, such as the Federal Reserve Bank, the Securities & Exchange Commission, Federal Deposit Insurance Corporation, etc., could not identify the crisis even after several bank-ruptcies took place among the housing mortgage lenders. Though the housing meltdown started from the last quarter of 2006, and a number of home mortgage lenders started facing crisis, the response of the government and the regulatory agencies was not only reactive but also delayed.

10.    Accounting Standards:

The accounting standards, particularly the mark-to-market requirement initially accounted for ‘unrealised profits’ resulting in rosy picture being presented of the financial health of the subprime lenders. Subsequently, as the borrowers started defaulting, the mark-to-market requirement had double adverse impact, because the provisioning or write-offs required increased significantly. Only a few months prior to the failure of several large finance companies in the US, their accounts were certified, both by their management and auditors, to represent a true and fair view of the state of their financial health! Does this situation not raise an eyebrow?

11.    Automation of Credit Approval Process:

The entire credit approval process for lending to the subprime borrowers was made objective and therefore, it was automated. For example, a few BPO companies located in India were authorised to approve subprime mortgage loans to US borrowers. It is obvious that subjective judgment was almost absent. Similarly, approval for the financial derivative instruments was also automated to a great extent, resulting in sky-rocketing of subprime lending.

12.    Macro Balance  Sheet:

To gain better understanding of the overall scenario of the financial crisis, let us assume that following is the consolidated balance sheet of all the players in the home mortgage financing market:

Let us say that the value of the mortgage houses has dropped by US $ 2 trillion. The houses have not disappeared; just their values have dropped. This loss is divided over the three categories of the providers of finance. The major loss will be borne by the holders of the financial instruments because its size is large. Since those investors are very large in number and spread across the globe, the financial turmoil in the US market has an adverse impact across the globe and is spread very widely among thousands of investors. The problem is compounded, because many investors in the financial derivative instruments have leveraged their investments. Further, even investors who have not leveraged are affected because of the substantial value erosion. Moreover, shareholders of finance companies and of companies holding the financial instruments have suffered because of the steep fall in the values of shares of those companies (e.g., the market caps of Freddie Mac, Fannie Mae, AIG, and Wachovia have fallen by more than 90%).

13.    Cascading  effect:

The liquidity crisis in the financial market has affected even companies which had no direct or indirect role in the mortgage financing market, because they are not able to easily get finance required for their businesses. In turn, their employees, suppliers and shareholders are affected. This reduces the purchasing power of the people all around because they are affected directly or indirectly. This, in turn, has an adverse impact on businesses because sales decline.

Even prime borrowers  may become subprime borrrowers or may default on their loan obligations if they lose their jobs or wealth because of the adverse economic scenario. It has also engulfed good mortgage-backed securities and therefore, the entire mortgage-backed securitised market has collapsed.

Thus, there is a multiplier negative cascading effect on the economy.

14.    Impact on Indian Economy:

Because of several unknown factors and unpredictable events which may happen abroad, it is very difficult to predict accurately what would happen in India. But the most-likely scenario is that in the short run, the Indian economy will be impacted to some extent, because of the withdrawal of investments by FIIs in the stock market, liquidity crunch, demand recession abroad, fear psychosis, etc. Some of the major adverse impacts would be difficulty”in raising funds through IPOs, FDls and borrowings; value erosion; slackness in the real estate market; fall in real estate prices; slowdown in industrial production, etc. The Indian financial systems are sound, the fundamentals of the Indian economy are strong and India has a large domestic market, and therefore, in the mid term and long term, India should not be materially affected by this turmoil. In fact, it can benefit from it, because after things settled down, more inflow of foreign funds will come to India as there are better opportunities for investments in India. However, the pre-requisite for this is that the RBI, SEBI, the Finance Ministry and the Government in general, should take appropriate measures to ensure adequate liquidity at an affordable rate and to sustain confidence among businesses and investors. Impact on the individual companies would depend upon the sector in which they are and their strategies. In the short run, cash-flow management and assets protection are more important than profitability and growth.

15.    Way forward : Expected major changes:

As a result of the financial crisis and the subsequent steps taken to tackle the same, the following major changes are likely to take place in the world: