Us crisis 2008


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U.S recession 2008 and its effect on Indian economy

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Us crisis 2008

  1. 1. 1 Sub-prime is a financial term that denotes financial institutions providing credit to borrowers deemed sub-prime (sometimes referred as under-banked). Sub-prime borrowers have a heightened perceived risk of default, those with a recorded bankruptcy or those with limited debt experience. Sub-prime lending means extending credit to people who would otherwise not have access to the credit market Robert J. Shiller, The Subprime Solution, Princeton: Princeton University Press, 2008, 2 Securitisation is a structured finance process, which involves pooling and repackaging of cash flow producing financial assets into securities that are then sold to investors. Securitisation means turning something into a security. For example, taking the debt from a number of mortgages and combining them to make a financial product which can then be traded. Banks who buy these securities receive income when the original home-buyers make their mortgage payments.
  2. 2. (iii) Excessive Leverage1 The final problem came from excessive leverage. Investors bought mortgage-backed securities by borrowing. Some Wall Street Banks had borrowed 40 times more than they were worth.17 In 1975, the Securities Exchange Commission (SEC) established a net capital rule that required the investment banks who traded securities for customers as well as their own account, to limit their leverage to 12 times. However, in 2004 the Securities and Exchange Commission (SEC) allowed the five largest investment banks – Merrill Lynch, Bear Stearns, Lehman Brothers, Goldman Sachs and Morgan Stanley – to more than double the leverage they were allowed to keep on their balance sheets, i.e. to lower their capital adequacy requirements. The Basel-II framework evolved by the Bank of International Settlements (BIS) in 2006 sets a CRAR of 9 per cent for adoption by banking regulators globally. However, at the end of the year 2007, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) had an effective leverage of an astounding 65 times and 79 times, respectively. And the leverage ratio for the big five investment banks at 2007 year end was 27.8 times for Merrill Lynch, 30.7 times for Lehman Bros., 32.8 times for Bear Stearns, 32.6 times for Morgan Stanley and 26.2 times for Goldman Sachs. These investment banks had become the reference point of excessive leverage.
  3. 3. This was far too risky. The system went into reverse gear after the middle of 2007. US housing prices fell at their fastest rate in 75 years. Sub-prime borrowers started missing their payment schedules. The banks and investment firms that had bought billion of dollars worth of securities based on mortgages were in trouble. They were caught in a vicious circle of credit derivative losses, accounting losses, rating downgrades, leverage contraction, asset illiquidity and super distress sale of assets at below fundamental prices causing another cascading and mounting cycle of losses, further downgrades and acute credit contraction. Initially started as a liquidity problem, it soon precipitated into a solvency problem, making them search for capital that was not readily available. Bear Stearns was sold to the commercial bank J.P. Morgan Chase in mid-March 2008; Lehman Bros filed for bankruptcy in mid-September 2008; Merrill Lynch was sold to another commercial bank, Bank of America and finally Morgan Stanley and Goldman Sachs signed a letter of intent with US Federal Reserve on September 22, 2008 to convert themselves into bank holding companies. The year 2008 will go as the worst year in the history of modern finance wherein the sun of powerful and iconic Wall Street investment banks set in.
  4. 4. 1Leverage means borrowing money to supplement existing funds for investment in such a way that the potential positive or negative outcome is magnified and/or enhanced. It generally refers to using borrowed funds, or debt, so as to attempt to increase the returns to equity.
  5. 5. (iv) Misleading judgements of the Credit- Rating Organisations- The role of the Credit-Rating Organisations (CROs) in creating an artificial sense of security through complex procedure of grading had contributed to the financial mess. The giants of credit rating agencies like Standard and Poor (S&P), Moody’s, Fitch had dominated the global ratings market for a long time. They were the agencies which had been deemed by the US capital markets regulator Securities and Exchange Commission (SEC) as Nationally Recognized Statistical Rating Organisations (NRSRO). As NRSROs, these CROs had a quasi regulatory role and were required to disclose their methodologies. But, these credit rating agencies used poorly tested statistical models and issued positive judgments about the underlying loans. No safeguards were put in place for assembling an appropriate information system to deal with the delinquencies and defaults that might eventually arise.
  6. 6. (v) Mismatch between Financial Innovation and Regulation It is not surprising that governments everywhere seek to regulate financial institutions to avoid crisis and to make sure a country’s financial system efficiently promotes economic growth and opportunity. Striking a balance between freedom and restraint is imperative. Financial innovation inevitably exacerbates risks, while a tightly regulated financial system hampers growth. When regulation is either too aggressive or too lax, it damages the very institutions it is meant to protect.
  7. 7. (vi) Failure of Global Corporate Governance One of the reasons for current crisis in the advanced industrial countries related to the failures in corporate governance that led to non-transparent incentive schemes that encouraged bad accounting practices. There is inadequate representation and in some cases no representation of emerging markets and less developed countries in the governance of the international economic institutions and standard setting bodies, like the Basle Committee on Banking Regulation. The international economic organization such as IMF has been wedded to particular economic perspectives that paid little attention to the inherent risks in the policies pursued by the developed countries.
  8. 8. RESULTS
  9. 9. Layoffs & Job Cuts
  10. 10. Financial institution loss Banks Loss Banks Loss America Out of America UBS AG $37.7 bln Deutsche Bank $11.2 bln Citigroup $39.1 bln Mizuho Financial Group $5.5 bln Merrill Lynch $29.1 bln Crédit Agricole $4.8 bln Morgan Stanley $11.5 bln HSBC $17.2 bln Freddie Mac $4.3 bln Royal Bank of Scotland $15.2 bln Bank of America $7.95 bln Credit Suisse $9.0 bln JP Morgan Chase $5.5 bln Swiss Re $2.04 bln Lehman Brothers $3.93 bln LBBW $1.1 bln CIBC $3.2 bln Société Générale $3.0 bln Bear Stearns $2.6 bln BNP Paribas $0.870 bln Washington Mutual $2.4 bln Barclays Capital $3.1 bln Goldman Sachs $1.5 bln BayernLB $6.7 bln American International Group $11.1 bln Commerzbank $1.1 bln
  11. 11.  Reducing dividend payouts to increase liquidity and further  Selling record amounts of bonds and preferred stock to obtain cash in the short-run  Banks harden loans policy.  Restrict loans conditions.  Stopping subprime loans  Improve supervision What did Bank do?
  12. 12. Slowing GDP In the past 5 years, the economy has grown at an average rate of 8-9 percent. Services which contribute more than half of GDP have grown fastest along with manufacturing which has also done well. But this impressive run of GDP ended in the first quarter of 2008 and is gradually reduced as the economy was slowing.
  13. 13. The most immediate effect of that crisis on India has been an outflow of foreign institutional investment from the equity market. Foreign Institutional Investment (FIIs), which need to retrench assets in order to cover losses in their home countries and were seeking havens of safety in an uncertain environment, have become major sellers in Indian markets. As FIIs pull out their money from the stock market, the large corporate no doubt have affected, the worst affected was likely to be the exports and small and marginal enterprises that contribute significantly to employment generation
  14. 14. Reduction in Import Export Global recession affects the import export business severely. In New Delhi area, nearly 125 companies survey report shows that in Aug 08 to Oct 08 1792 cr. Export orders lost which resulting 65000 people lost their employment. This can be elaborated by the following table.
  16. 16. . Reduction in Employment Employment is worst affected during any fiscal crisis, so is true with the current global meltdown. This recession has adversely affected the service industry of India mainly the BPO,KPO,IT companies etc. According to a sample survey by the commerce ministry, 109,513 people lost their jobs between Aug 08 and Oct 08 in export related companies in several sectors primarily textiles, leather, engineering, gems and jewellery, handicraft and food processing.
  17. 17. Taxation The economic slowdown has severely dented the Center's tax collection with indirect taxes bearing the brunt. The tax-GDP rate registered a steady increase from 8.97 percent to 12.56 percent between 2000-01 and 2007-08. But this trend has been reversed as the tax-GDP ratio has fallen to 10.95 percent during current fiscal year mainly on account of reduction in customs and excise tax due to effect of economic slowdown. In comparison to the advanced market economies which are on the verge of recession, the rapidly globalizing emerging economies have been far more resilient and dynamic - India being one among them. In the post-reform period, India stands as an economy that is rapidly - modernizing, globalizing and growing. India is poised as a fast growing emerging market economy in the face of the current turmoil and pessimism. The resilience shown by India comes from the strong macroeconomic fundamentals. India has weathered the storms of the recent financial market crisis with great strength and stability. India flouts a robust GDP growth rate of almost 9.0 percent in the midst of all international economic mayhem. The household sector is coming to prominence with impressive contribution in the national pool of savings. Rising investment levels and improved productivity are the engines driving growth. Indians have witnessed a doubling of average real per capita income growth during the tenth plan period.
  19. 19. The following measures can be adopted to tackle the recession: 1. Tax cuts are generally the first step any government takes during slump. 2. Government should hike its spending to create more jobs and boost the manufacturing sectors in the country. 3. Government should try to increase the export against the initial export. 4. The way out for builders is to reduce the unrealistic prices of property to bring back the buyers into the market. And thus raise finances for the incomplete projects that they are developing. 5. The falling rupees against the dollar will bring a boost in the export industry. Though the buyers in the west might become scarce.
  20. 20. 6. The oil prices decline will also have a positive impact on the importers. India has adopted certain measures to combat recession. Since October, 2008 The Reserve Bank of India has cut the repo rate and the CRR by 350 and 400 basis points respectively. The reverse repo rate has been cut by 200 basis points over the same period. This in turn has made credit cheaper and has increased the overall liquidity in the system. Further, the PSU banks of the country have decreased the home loan rates. This is expected to induce more buyers and boost the real estate sector. In addition to this government has proposed to cut service tax and excise duty on most goods.