The financial crisis was caused by loose lending standards in the US housing market and excessive risk taking by investment banks. Alan Greenspan lowered interest rates after the dot-com bubble burst and 9/11, fueling a housing boom. Banks aggressively lent to subprime borrowers and for amounts above property values. Meanwhile, investment banks like Goldman Sachs took on huge debt loads compared to equity, leaving them vulnerable to losses. The housing bubble then burst, loans defaulted, and the high leverage caused major banks like Lehman Brothers to collapse, spreading the crisis globally. Prudent regulations in India protected its banks from similar troubles.

1. October Saturday 11 2008 (14h07) :
Inside the Financial Tsunami: What Brought It On?
The financial tsunami now inundating global economies and markets was brought on by imprudent easing
of US lending norms and extreme over-leveraging by giant US investment banks, analysts say.
The dotcom bubble burst in 2000 and the collapse of the World Trade Centre, a mighty symbol of US
economic and financial prowess in 2001, made Alan Greenspan, the then chief of the US banking
regulator, the Federal Reserve, believe that a US recession was a certainty and it had to be staved off.
His solution: Increase liquidity in the system. The mechanism: Ease lending norms, especially for the real
estate sector.
The result was aggressive lending by banks to home loan borrowers, defying time-tested, conservative
and prudent norms of ensuring that the loan amount did not exceed the value of the asset being
purchased.
Thus was born the concept of home equity, when if you asked for a $1 million loan to buy a house, US
banks lent $1.2 million in the belief that real estate prices will only go up and never come down.
In contrast, in India or in all other countries in the world, banks lend only about 80-85 percent of the
value of the asset, and the borrower has to pay the balance.
Greenspan’s thinking was that lenders would use the extra funds to spend on other items of consumption
and recession would be beaten.
Not only that, in their bid to capture market share, banks lent even to people with doubtful
creditworthiness.
In the US there are three classes of borrowers - prime rate borrowers who have the highest
creditworthiness, followed by what are called Alt A Mortgage borrowers and finally subprime borrowers
who have the least creditworthiness.
As banks can charge a higher interest rate from borrowers with less than best creditworthiness,
aggressive marketing saw a more than prudent share of loans going to the least creditworthy borrowers.
quot;Whether we like it or not, the laws of gravity work in financial markets as well and what goes up
ultimately comes down,quot; Jagannadham Thunuguntla, head of the capital markets arm of India’s fourth
largest share brokerage firm, the Delhi-based SMC Group, told IANS.
Despite a bull run in the US real estate market due to the big rush in home purchases during 2002-06, the
party had to end some time and prices began to come down.
Real estate prices have fallen 16 percent till July 2008 since the corresponding month last year and had
fallen by a similar amount the previous year.
Suddenly, from early this year, banks found their so-called home equity had completely vanished and
their loans were not protected by the value of the assets bought with the loans.
Alongside, there was another development.

2. In normal manufacturing and other businesses, the debt to equity ratio is usually in the range of 1.33-2 to
1.
This means, out of the total capital invested by a business, if $1 is the promoter’s equity, borrowed funds
invested in the business is $1.33 to $2.
But in the banking industry, the debt-equity ratio is always much higher because the deposits of banks are
considered as debts of the bank.
Commercial banks, however, despite their high loan-deposit ratio (conceptually similar to debt-equity
ratio) are highly regulated as they take deposits from the public and have to follow strict lending,
provisioning and capital norms.
Investment banks, such as Goldman Sachs, for example, are, however, very lightly regulated and do not
have to follow these prudential lending and capital norms.
Just before Goldman Sachs got into trouble two weeks ago, it had debts of about $1.08 trillion against its
own equity capital of only $40 billion. This means it had a debt to equity ratio of 24.7:1.
To simplify the explanation, let us say its debt-equity ratio was 24:1. That means of every $25 it was
investing or lending, $1 was its own money and balance $24 was borrowed money.
In this situation, even if it incurs a loss of four percent on its loans or investments, the bank runs up a loss
of $1, which is four percent of $25 originally invested.
This in turn means the entire equity capital of the bank is wiped out and it has to file for bankruptcy
because losses have to be borne by the owner of equity capital. Borrowed funds have to be returned to
borrowers.
It is very usual for any bank to make a mistake in lending or investment decisions to the extent of four
percent.
In the real estate boom of 2002-06, banks had lent an imprudent share to Alt A mortgages and subprime
borrowers. Running up a four percent or more non-performing assets was just waiting to happen.
When it happened, Goldman Sachs as also all the other investment banks which had equally high debt to
equity leveraging found their capital eroding too fast for their comfort.
Lehman went down first, followed by the others and Goldman and Merrill Lynch are surviving by infusing
more capital through sale of some of their assets.
For example, after the crisis broke, US investor and one of world’s richest men Warren Buffet and others
stepped in and pumped in about $7.5 billion equity into Goldman Sachs and brought down its leveraging
to 20.8:1.
In good times, however, even a four percent return on their capital, that means a return of $1 on the $25
invested would translate into a 100 percent return on these banks’ own equity capital of $1, Thunuguntla
explained.
The problem with the European banks was they too had big exposures in the US market during the real
estate bull phase and they too did not follow prudent loan to deposit ratios.
A prudent loan-deposit norm for commercial banks is around 80 percent. That means they lend 80 percent
of their deposits and keep the balance 20 percent to service depositors.
Northern Rock, the first British or European bank to be hit by the subprime crisis and nationalised in 2007
had a loan-deposit ratio of 215 percent.

3. Most of the other banks hit also have excessive loan-deposit ratios of around 160 percent so that when
faced with troubled assets they are no more able to service depositors.
quot;Indian banks are safe and sound mainly because of our extremely prudent banking regulations,quot;
Thunuguntla said.
Here are the key developments that led to the US financial crisis:
The dotcom bubble bursts in 2000, many US companies go bankrupt.
The World Trade Centre, mighty symbol of the US’ economic and financial prowess collapses Sep 11,
2001... triggers fears of adverse economic impact.
Alan Greenspan, then chairman of the US central bank, the Federal
Reserve Bank, fears recession in the US economy is a certainty.
Eases bank lending norms especially to the real estate sector in early 2002.
Banks told to lend more than asset value on the belief asset values will keep going up so loans will stay
protected.
Banks begin to lend aggressively even to borrowers with doubtful credit worthiness.
Real estate prices keep going up between 2002 and 2006.
The real estate bubble bursts following oversupply and increasing defaulters (subprime borrowers);
property prices start coming down.
By middle of 2008, banks suddenly find value of assets does not protect loans advanced to buy them.
Investment banks not under strict banking regulations over-leverage themselves and use excessive
borrowed funds to invest.
Most run up debt-equity ratios of around 24:1.
Now even a four percent loss means their own equity capital is wiped out.
With too many borrowers having doubtful creditworthiness, a four percent or more loss was just waiting to
happen.
By middle of September 2008, first Lehman Bros, then others find their equity capital almost completely
wiped out.
Lehman files for bankruptcy, Merrill Lynch is bought out, Goldman Sachs,
Morgan Stanley sell off some assets, raise some equity capital and survive but decide to become holding
companies of commercial banks.
Other commercial banks in the US and Europe with high loan to deposit ratios also in trouble.
Liquidity crunch spreads to all over the world.
By : Arjun Sen
October Saturday 11 2008