Impact of US Subprime Crisis on Indian Fnancial Sector

A Study of The Impact of Us Subprime Crisis on Indian Financial Sector

CONTENTS

Chapter Particulars Page No.

1. Introduction

2. Research Methodology

3. Objectives of the study

4. Review of literature

5. An overview of subprime crisis in US

6. Subprime crisis and Indian financial sector

7. Conclusion and findings of the study

0


CHAPTER-1

INTRODUCTION

1


Today’s economy is the globalised economy. None of the economies, today, is entirely

and independent economy. Various day-today phenomena in one economy affect the

other directly or indirectly. What caused the Great Depression, the worst economic

depression in US history? It was not just one factor, but instead a combination of

domestic and worldwide conditions that led to the Great Depression. As such, there is no

agreed upon list of all its causes. Here instead is a list of the top reasons that historians

and economists have cited as causing the Great Depression. The effect of the Great

Depression was huge across the world. Not only did it lead to the New Deal in America

but more significantly, it was a direct cause of the rise of extremism in Germany leading

to World War II.

1. Stock Market Crash of 1929

Many believe erroneously that the stock market crash that occurred on Black Tuesday,

October 29, 1929 is one and the same with the Great Depression. In fact, it was one of the

major causes that led to the Great Depression. Two months after the original crash in

October, stockholders had lost more than $40 billion dollars. Even though the stock

market began to regain some of its losses, by the end of 1930, it just was not enough and

America truly entered what is called the Great Depression.

The Great Depression was a severe worldwide economic depression in the decade

preceding World War II. The timing of the Great Depression varied across nations, but in

most countries it started in about 1929 and lasted until the late 1930s or early 1940s. It

was the longest, most widespread, and deepest depression of the 20th century. In the 21st

century, the Great Depression is commonly used as an example of how far the world's

economy can decline. The depression originated in the U.S., starting with the fall in stock

prices that began around September 4, 1929 and became worldwide news with the stock

market crash of October 29, 1929 (known as Black Tuesday). From there, it quickly

spread to almost every country in the world. The Great Depression had devastating

effects in virtually every country, rich and poor. Personal income, tax revenue, profits

2

http://en.wikipedia.org/wiki/Personal_income

http://en.wikipedia.org/wiki/Wall_Street_Crash_of_1929



http://en.wikipedia.org/wiki/World_War_II

http://en.wikipedia.org/wiki/Depression_(economics)

http://americanhistory.about.com/od/worldwarii/a/wwiioverview.htm

http://americanhistory.about.com/od/greatdepression/tp/new_deal_programs.htm


and prices dropped while international trade plunged by ½ to ⅔. Unemployment in the

U.S. rose to 25% and in some countries rose as high as 33%. Cities all around the world

were hit hard, especially those dependent on heavy industry. Construction was virtually

halted in many countries. Farming and rural areas suffered as crop prices fell by

approximately 60%. Facing plummeting demand with few alternate sources of jobs, areas

dependent on primary sector industries such as cash cropping, mining and logging

suffered the most

2. Bank Failures

Throughout the 1930s over 9,000 banks failed. Bank deposits were uninsured and thus as

banks failed people simply lost their savings. Surviving banks, unsure of the economic

situation and concerned for their own survival, stopped being as willing to create new

loans. This exacerbated the situation leading to less and less expenditures.

3. Reduction in Purchasing Across the Board

With the stock market crash and the fears of further economic woes, individuals from all

classes stopped purchasing items. This then led to a reduction in the number of items

produced and thus a reduction in the workforce. As people lost their jobs, they were

unable to keep up with paying for items they had bought through installment plans and

their items were repossessed. More and more inventory began to accumulate. The

unemployment rate rose above 25% which meant, of course, even less spending to help

alleviate the economic situation.

4. American Economic Policy with Europe

As businesses began failing, the government created the Smoot-Hawley Tariff in 1930 to

help protect American companies. This charged a high tax for imports thereby leading to

less trade between America and foreign countries along with some economic retaliation.

5. Drought Conditions

3

http://americanhistory.about.com/od/greatdepression/f/smoot_hawley.htm

http://en.wikipedia.org/wiki/Logging

http://en.wikipedia.org/wiki/Mining

http://en.wikipedia.org/wiki/Cash_crop

http://en.wikipedia.org/wiki/Primary_sector_of_economic_activity

http://en.wikipedia.org/wiki/Farming

http://en.wikipedia.org/wiki/Heavy_industry

http://en.wikipedia.org/wiki/Cities_in_the_Great_Depression


While not a direct cause of the Great Depression, the drought that occurred in the

Mississippi Valley in 1930 was of such proportions that many could not even pay their

taxes or other debts and had to sell their farms for no profit to themselves.

British India

The Great Depression of 1929 had a very severe impact on India, which was then under

the British. The Government of British India adopted a protective trade policy which,

though beneficial to the United Kingdom, caused great damage to the Indian economy.

During the period 1929–1937, exports and imports fell drastically crippling seaborne

international trade. The railways and the agricultural sector were the most affected.

The international financial crisis combined with detrimental policies adopted by the

Government of India resulted in the soaring prices of commodities. High prices along

with the stringent taxes prevalent in British India had a dreadful impact on the common

man. The discontent of farmers manifested itself in rebellions and riots. The Salt

Satyagraha of 1930 was one of the measures undertaken as a response to heavy taxation

during the Great Depression.

The Great Depression and the economic policies of the Government of British India

worsened the already deteriorating Indo-British relations. When the first general elections

were held according to the Government of India Act 1935, anti-British feelings resulted

in the Indian National Congress winning in most provinces with a very high percentage

of the vote share.

4

http://en.wikipedia.org/wiki/Indian_National_Congress

http://en.wikipedia.org/wiki/Government_of_India_Act_1935

http://en.wikipedia.org/wiki/Salt_Satyagraha

http://en.wikipedia.org/wiki/Salt_Satyagraha

http://en.wikipedia.org/wiki/Agricultural

http://en.wikipedia.org/wiki/Railways

http://en.wikipedia.org/wiki/Imports

http://en.wikipedia.org/wiki/Exports

http://en.wikipedia.org/wiki/United_Kingdom

http://en.wikipedia.org/wiki/British_Raj

http://en.wikipedia.org/wiki/British_Raj

http://en.wikipedia.org/wiki/India


CHAPTER-2

RESEARCH METHODOLOGY

5


The Study:

The study “A Study of The Impact of US Subprime Crisis on Indian Financial Sector” is

descriptive in nature that provides insight into; and understanding, the subprime crisis in

US and its effects on India at macro level.

Area of Study:

Pan India is the area of study in which the following parameters are chosen to measure

the impact of subprime crisis on India.

Revenue in IT Sector

Exchange Rate

Foreign Exchange Outflow

Investment

Stock Market Indices

Growth Rate of Banking

Money Market

GDP

Balance of Payment

Unemployment Rate

Taxation

The Tools for Data Collection:

The study is primarily based on secondary data, reports published by Finance and

Commerce Ministry, UNCTAD, RBI and CSO etc. Websites are the major source for

exploring data.

A theoretical investigation of various journals, research papers written on subprime crisis

are read thoroughly. The population of the study is various financial institutions of India

like ICICI bank, Bank of Baroda and many more.

For Data Analysis:

For data analysis various time series of data are used to perform simple arithmetic

comparison with line, bar charts are used exclusively.

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CHAPTER-3

OBJECTIVES OF THE STUDY

7


To highlight various reasons behind subprime crisis in US

To study impact of subprime crisis in India

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CHAPTER-4

REVIEW OF LITERATURE

9


A. Prasad and C. Panduranga Reddy in their study “Global Financial Crisis and Its

Impact on India” evaluate that different views on the reasons of the crisis include boom

in the housing market, speculation, high-risk mortgage loans and lending practices,

securitization practices, inaccurate credit ratings and poor regulation of the financial

institutions. The financial crisis has not only affected United States of America, but also

European Union, U.K and Asia. The Indian Economy too has felt the impact of the crisis

to some extent. Though it is difficult to quantify the impact of the crisis on India, it is felt

that certain sectors of the economy would be affected by the spillover effects of the

financial crisis.

Nidhi Choudhari Manager RBI Kolkata in her research “global recession and its impact

on Indian financial markets” (2009) says that the global financial recession which started

off as a sub-prime crisis of USA has brought all nations including India into its fold. The

GDP growth rate which was around nine per cent over the last four years has slowed since

the last quarter of 2008 owing to deceleration in employment, export-import, tax-GDP ratio,

reduction in capital inflows and significant outflows due to economic slowdown. The

demand for bank credit is also slackening despite comfortable liquidity in the system. Higher

input costs and dampened demand have dented corporate margins while the uncertainty

surrounding the crisis has affected business confidence leading to the crash of Indian stock

market and volatility in FOREX market. Nevertheless, a sound and resilient banking sector,

well-functioning financial markets, robust liquidity management and payment and settlement

infrastructure, buoyancy of foreign exchange reserves have helped Indian economy to remain

largely immune from the contagious effect of global meltdown. Indian financial markets are

capable of withstanding the global shock, perhaps somewhat bruised but definitely not

battered. India, with its strong internal drivers for growth, may escape the worst

consequences of the global financial crisis. In other words, the fundamentals of our economy

continue to be strong and robust. The global economic environment continues to remain

uncertain, although the rate of contraction in economic activities and the extent of pressures

on financial systems eased in the first quarter of 2009-10. Yet, it is not possible to clearly see

the path of the crisis and its resolution over the coming months. In this sense, India is not

10


unique as almost every country, whether or not directly affected, has to manage the current

economic crisis under uncertainty.

Barry Nielsen, CFA says a simple and important principle of finance is mean reversion.

While housing markets are not as subject to bubbles as some markets, housing bubbles do

exist. Long-term averages provide a good indication of where housing prices will

eventually end up during periods of rapid appreciation followed by stagnant or falling

prices. The same is true for periods of below average price appreciation.

Eric Petroff, the director of research of Wurts & Associates states that it was a mix of

factors and participants that precipitated the current subprime mess. Ultimately, though,

human behavior and greed drove the demand, supply and the investor appetite for these

types of loans. Hindsight is always 20/20, and it is now obvious that there was a lack of

wisdom on the part of many. However, there are countless examples of markets lacking

wisdom, most recently the dotcom bubble and ensuing "irrational exuberance" on the part

of investors. It seems to be a fact of life that investors will always extrapolate current

conditions too far into the future - good, bad or ugly.

Shreyansh Mardia and Karthik Mudaliar in their research point out 3 main factors which

are mainly responsible for the recession in the US. They are-

Decrease in Consumer Expenditure.

Sub-prime mortgage fiasco.

Increase in energy prices.

The depreciation in the value of dollar is a natural consequence of recession. Such a

recession will adversely affect the exporters and favor the importers. However as has

been analyzed, the quantum of Indian exports to the US far exceeds the imports. The

Indian economy is shielded in part from an impending recession as India has a well

established and growing domestic market and a booming economy to offset any direct

impact of recession. 11


Anup Shah Analyses that the global financial crisis, really started to show its effects in

the middle of 2007 and into 2008. Around the world stock markets have fallen, large

financial institutions have collapsed or been bought out, and governments in even the

wealthiest nations have had to come up with rescue packages to bail out their financial

systems. On the one hand many people are concerned that those responsible for the

financial problems are the ones being bailed out, while on the other hand, a global

financial meltdown will affect the livelihoods of almost everyone in an increasingly inter-

connected world. The problem could have been avoided, if ideologues supporting the

current economics models weren’t so vocal, influential and inconsiderate of others’

viewpoints and concerns.

Abhishikta Chadda, Associate Chartered Accountant finds that a situation that rose in

world market cannot make India stand out without being impacted by it. However, the

impact is not too big to create a crisis. Economists feel that even if the subprime crisis

leads to a global credit crunch, it still may not have a big effect because there is quite a

lot of liquidity in domestic markets in countries like India. Lack of exposure to U.S.

mortgage securities; availability of liquidity in domestic markets; and the possibility of

lower capital inflows could help countries such as India with macroeconomic

management to face the crisis. The first Indian Organization to be affected by this Crisis

is ICICI Bank Ltd. ICICI Bank's profit took a hit of more than Rs 1,050 crores ($264

million) in the year 2007-08. This is an indirect effect. ICICI lost money due to

depreciation in the value of securities it bought in the international markets. Due to a rise

in global interest rates after the subprime loan crisis, the value of these securities fell,

forcing the bank to provide for the difference from its profits. The loss, however, is

notional since the bank has not actually sold these securities. Public Sector Banks, viz

State Bank of India, Bank Of India, Bank Of Baroda, Canara Bank, Punjab National

Bank etc do not have major exposure to credit derivatives market due to their limited

overseas operations. However, the impact of the global crisis on Indian Stock Market is

12


on a negative side. Once investments in the US turned bad, more money had to be

invested in the US to maintain the fixed proportion of the investments by institutional

investors. In order to invest more money in the US, money came in from emerging

markets like India, where their investments have been doing well. These big institutional

investors, to make good of their losses on the subprime market, have been selling their

investments in India and other emerging markets. Since the amount of selling in the

market far overweighs the amount of buying, Indian stock prices have been falling.

Taking it forward to the job market, Multinational Corporates have adopted a wait and

watch policy and had softened their hiring plans both in India and abroad.

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CHAPTER-5

AN OVERVIEW OF SUBPRIME

CRISIS

14


For going in depth of the topic, it is essential to understand the term Sub-prime.

Sub Prime: Sub Prime as the word defines, means subordinate to primary. The word is

used in the lending industry to define a borrower who does not have a good credit history

and hence is not able to qualify for best market rates vis-a-vis the prime category

borrower. The term "subprime" reflects not the lending rate but the borrower's credit

status. Potential sub-prime borrowers may comprise of financially troubled people,

meaning thereby that the sub-prime lenders take a higher degree of risk. Hence to offset

the risk to an extent the lenders increase the interest rates.

Sub-prime lending may be utilized for sub-prime mortgages, sub-prime car loans, sub-

prime credit cards etc. Subprime mortgages totaled $600 billion in 2006, accounting for

about one-fifth of the US home loan market. Federal National Mortgage Association, a

government sponsored enterprise of the US government has standards to differentiate

between prime and subprime loans. Eligible borrowers for prime loans have a credit score

above 620 (credit scores are between 350 and 850 with a median in the U.S. of 678 and a

mean of 723), a debt-to-income ratio (DTI) no greater than 75% (meaning that no more

than 55% of net income pays for housing and other debt), and a combined loan to value

ratio of 90%, meaning that the borrower is paying a 10% down payment.

Subprime lending is also called B-Paper, near-prime, or second chance lending.

Types of Sub Prime Mortgages: Sub Prime Mortgages can be classified in 3

categories:

Interest-only mortgages, which allow borrowers to pay only interest for a period of

time, typically 5-10 years.

“Pick a payment loans”, for which borrowers choose their monthly payment (full

payment, interest only, or a minimum payment which may be lower than the payment

required to reduce the balance of the loan).

Initial fixed rate mortgages that can be converted to variable rates.

15


Sub Prime Crisis:

It all started in 2006 with US Market tumbling down due to defaults by the subprime

borrowers. The doubled edged sword, increase in interest rates and simultaneously fall in

property prices, hit the market leading to subprime mortgage crisis. Between the years

2000 and 2005, along with very low interest rates, property prices were also on a rising

trend and the subprime borrowers were able to meet their obligations as they were

building equity by selling the properties or getting the properties refinanced. However, in

2005, the property prices started falling, interest rates started touching the roof top,

leaving no room for the subprime borrowers to meet their liabilities leading to meltdown

of the US subprime mortgage industry.

The term “subprime” refers to the credit status of the borrower (being less than ideal), not

the interest rate on the loan itself. “Subprime” is any loan that does not meet “prime”

guidelines. If your mid fico score is below 620 and you have any mortgage rates within

12 months or recent foreclosure, you are considered “subprime”.

The word subprime refers to a type of borrower. A person who has been categorized as

subprime is someone who has an imperfect credit history. For example, the person may

have had a problem with missed payments, or a prior foreclosure or bankruptcy. This

leads to a low credit score, generally below 640. In other words, this type of borrower is

considered to be at a higher risk for defaulting on a loan.

What are Subprime loans?

The subprime loans are loans given to borrowers with low credit scores. These are the

loans, which are granted at interest rates above the prime lending rate. The general idea in

a subprime loan is that, because the person is a higher risk, the person will be charged a

higher interest rate. For example, the person might be given an Adjustable Rate Mortgage

that has a low rate initially and then adjusts much higher. These borrowers are subject to

16


sub-prime lending on their defaults in credit card payments or any other type of credit

default or delays.

What is Subprime Lending?

Subprime lending, also called B-paper, near-prime, or second chance lending, is the

practice of making loans to borrowers who do not qualify for the best market interest

rates because of their deficient credit history. The phrase also refers to paper taken on

property that cannot be sold on the primary market, including loans on certain types of

investment properties and certain types of self-employed individuals. Subprime lending is

risky for both lenders and borrowers due to the combination of high interest rates, poor

credit history, and adverse financial situations usually associated with subprime

applicants. A subprime loan is offered at a rate higher than A-paper loans due to the

increased risk.

Subprime lending (near-prime, non-prime, or second-chance lending) in finance means

making loans that are in the riskiest category of consumer loans and are typically sold in

a separate market from prime loans. The standards for determining risk categories refer to

the size of the loan, "traditional" or "nontraditional" structure of the loan, borrower credit

rating, ratio of borrower debt to income or assets, ratio of loan to value or collateral, and

documentation provided on those loans which do not meet Fannie Mae or Freddie Mac

underwriting guidelines for prime mortgages (are "non-conforming"). Although there is

no single, standard definition, in the United States subprime loans are usually classified

as those where the borrower has a FICO score (Fair Issac and Company) below 640.

Subprime lending encompasses a variety of credit types, including mortgages, auto loans,

and credit cards. The term was popularized by the media during the "credit crunch" of

2007.

17

http://en.wikipedia.org/wiki/Subprime_mortgage_crisis

http://en.wikipedia.org/wiki/Subprime_mortgage_crisis

http://en.wikipedia.org/wiki/Credit_card

http://en.wikipedia.org/wiki/Auto_loan

http://en.wikipedia.org/wiki/Mortgage_loan

http://en.wikipedia.org/wiki/FICO_score

http://en.wikipedia.org/wiki/United_States

http://en.wikipedia.org/wiki/Underwriting

http://en.wikipedia.org/wiki/Freddie_Mac

http://en.wikipedia.org/wiki/Fannie_Mae


Subprime could also refer to a security for which a return above the "prime" rate is

adhered, also known as C-paper.

Subprime borrowers show data on their credit reports associated with higher default rates,

including limited debt experience, excessive debt, a history of missed payments, failures

to pay debts, and recorded bankruptcies. Proponents of subprime lending maintain that

the practice extends credit to people who would otherwise not have access to the credit

market

What about Lending Rates?

To avoid the initial hit of higher mortgage payments, most subprime borrowers take out

Adjustable-Rate Mortgages (or ARMs) that give them a lower initial interest rate. But

with potential annual adjustments of 2% or more per year, these loans can end up

charging much more. So a $500,000 loan at a 4% interest rate for 30 years equates to a

payment of about $2,400 a month. But the same loan at 10% for 27 years (after the

adjustable period ends) equates to a payment of $4,470. A 6-percentage-point increase in

the rate caused slightly more than an 85% increase in the payment.

Subprime 2/28 and 3/27 ARMs

A subprime 2/28 ARM is an adjustable-rate mortgage with an initial two-year, fixed-

interest rate period. A subprime 3/27 ARM is an adjustable-rate mortgage with an initial

three-year, fixed-interest rate period. They are the equivalent in the subprime mortgage

market to what is commonly known as a hybrid or fixed-period ARM in the prime

mortgage market.

After the fixed interest rate period, the interest rate starts to adjust according to an index

plus a margin. The index value plus the margin is known as the fully indexed interest

rate. For example, 2/28 ARMs are frequently tied to the six-month LIBOR index. If the

six-month LIBOR index is 6% and the margin on the loan is 5%, the fully indexed

18

http://www.investopedia.com/terms/l/libor.asp

http://www.investopedia.com/terms/f/fullyindexedinterestrate.asp

http://www.investopedia.com/terms/f/fullyindexedinterestrate.asp

http://www.investopedia.com/terms/f/fixedperiodarm.asp

http://www.investopedia.com/terms/h/hybridarm.asp


interest rate will be 11%. Subprime 2/28 and 3/27 ARMs carry a higher fixed period

interest rate and a larger margin than prime fixed period ARMs.

The 2/28 ARM

A very common mortgage in the subprime market, which we have never seen outside of

that market, is the 2/28 ARM. This is an adjustable rate mortgage on which the rate is

fixed for 2 years, and then reset to equal the value of a rate index at that time, plus a

margin. Because the margins are high, the rate on most 2/28s will often rise sharply at the

2-year mark, even if market rates do not change during the period.

For example, the rate is 8% for 2 years but the index is currently 4% and the margin is

6%. If the index remains at 4% after 2 years, the loan rate will jump to 10%.

Some borrowers with poor credit scores take a 2/28 at a high rate and plan to rebuild their

credit during the 2-year period. Their plan is to refinance at a better rate at that time. The

major threat to such a plan is a prepayment penalty that runs past two years, which some

do; and a lender who fails to report their payment history to the credit reporting agencies.

Borrowers should be on their guard against both.

Who opt Subprime Lending?

Individuals who have experienced severe financial problems are usually labeled as higher

risk and therefore have greater difficulty obtaining credit, especially for large purchases

such as automobiles or real estate. These individuals may have had job loss, previous

debt or marital problems, or unexpected medical issues; usually these events were

unforeseen and cause a major setback in finances. As a result, late payments, charge-offs,

repossessions and even foreclosures may result. Due to these previous credit problems,

these individuals may also be precluded from obtaining any type of loan for an

automobile. To meet this demand, lenders have seen that a tiered pricing arrangement,

one which allows these individuals to pay a higher interest rate, may allow loans which

otherwise may not occur. From a servicing standpoint, these loans have higher collection

19


defaults and experience higher repossessions and charge offs. Lenders use the higher

interest rate to offset these anticipated higher costs. Provided a consumer will enter into

this arrangement with the understanding that they are higher risk, and must make diligent

efforts to pay, these loans do indeed serve those who would otherwise be undeserved.

The consumer must purchase an automobile which is well within their means, and carries

a payment well within their budget.

The subprime mortgage crisis is a real estate crisis and financial crisis triggered by a

dramatic rise in mortgage delinquencies and foreclosures in the United States, with major

adverse consequences for banks and financial markets around the globe. The crisis, which

has its roots in the closing years of the 20th century, became apparent in 2007 and has

exposed pervasive weaknesses in financial industry regulation and the global financial

system.

Approximately 80% of U.S. mortgages issued in recent years to subprime borrowers were

adjustable-rate mortgages. After U.S. house prices peaked in mid-2006 and began their

steep decline thereafter, refinancing became more difficult. As adjustable-rate mortgages

began to reset at higher rates, mortgage delinquencies soared. Securities backed with

subprime mortgages, widely held by financial firms, lost most of their value. The result

has been a large decline in the capital of many banks and U.S. government sponsored

enterprises, tightening credit around the world.

During 2008, three of the largest U.S. investment banks either went bankrupt (Lehman

Brothers) or were sold at fire sale prices to other banks (Bear Stearns and Merrill Lynch).

These failures augmented the instability in the global financial system. The remaining

two investment banks, Morgan Stanley and Goldman Sachs, opted to become commercial

banks, thereby subjecting themselves to more stringent regulation. Apart from this, total

of 54 banks in US have crashed. However, in 2005, the rates of interest began to increase.

Therefore, demand for home came down which also brought down the property prices

leading to start of subprime crisis.

20

http://en.wikipedia.org/wiki/Goldman_Sachs

http://en.wikipedia.org/wiki/Morgan_Stanley

http://en.wikipedia.org/wiki/Merrill_Lynch

http://en.wikipedia.org/wiki/Bear_Stearns

http://en.wikipedia.org/wiki/Lehman_Brothers

http://en.wikipedia.org/wiki/Lehman_Brothers

http://en.wikipedia.org/wiki/Adjustable-rate_mortgage

http://en.wikipedia.org/wiki/Financial_crisis

http://en.wikipedia.org/wiki/Crisis

http://en.wikipedia.org/wiki/Real_estate


A borrower “X” with poor credit history approaches a lender/financial institution “B” for

loan. Seeing his poor records, the financial institution declines the mortgage to him at

prime lending rates. However, “B” has an appetite to take risk by charging higher interest

rate from “X”. This is called sub prime rate and subprime mortgage market. “X” agrees

to avail loan at sub prime rate. “B” further securitizes these loans i.e. it converts these

home loans into financial securities, which promise to pay a certain interest. This is called

investment in Mortgage Backed Securities (MBS).

Banks began lending to people with BAD CREDIT

Banks promised that housing prices will continue to rise.

The current Subprime crisis was not really a crisis due to over lending of banks, but

situation created due to subprime lending.

How the Subprime Crisis Started?

The subprime lending was 9% in 1996 but in 2004 it was 21%. Due to securitization,

investor appetite for mortgage-backed securities (MBS), and the tendency of rating

agencies to assign investment-grade ratings to MBS, loans with a high risk of default

could be originated, packaged and the risk readily transferred to others. In addition to

considering higher-risk borrowers, lenders have offered increasingly high risk loan

options and incentives to them.

Homeowners had been using the increased property value experienced in the housing

bubble to refinance their homes with lower interest rates and take out second mortgages

against the added value to use the funds for consumer spending. Between 1997 and 2006,

American home prices increased by 124%. Easy credit combined with the assumption

that housing prices would continue to appreciate also encouraged many subprime

borrowers to obtain ARM they could not afford after the initial incentive period. With

housing prices now depreciating moderately in many parts of the U.S., refinancing has

become difficult, leaving homeowners with higher payments than anticipated.

21


Beginning in late 2006, the U.S. subprime mortgage industry entered what many

observers have begun to refer to as a meltdown. A steep rise in the rate of subprime

mortgage foreclosures has caused more than 100 subprime mortgage lenders to fail or file

for bankruptcy, most prominently New Century Financial Corporation, previously the

USA’s second biggest subprime lender. The failure of these companies has caused prices

in the $6.5 trillion mortgage backed securities market to collapse, threatening broader

impacts on the U.S. housing market and economy as a whole.

However, the crisis has had far-reaching consequences across the world. Sub-prime debts

were repackaged by banks and trading houses into attractive-looking investment vehicles

and securities that were snapped up by banks, traders and hedge funds on the US,

European and Asian markets. Thus when the crisis hit the subprime mortgage industry,

those who bought into the market suddenly found their investments near-valueless. With

market paranoia setting in, banks reined in their lending to each other and to business,

leading to rising interest rates and difficulty in maintaining credit lines. As a result,

ordinary, run-of-the-mill and healthy businesses across the world with no direct

connection whatsoever to US sub-prime suddenly started facing difficulties or even

folding due to the banks’ unwillingness to budge on credit lines.

Reasons for The Crisis

The first hint of the trouble came from the collapse of two Bear Stearns hedge funds early

2007. Subsequently a number of other banks and financial institutions also began to show

signs of distress. Matters really came to the fore with the bankruptcy of Lehman Brothers,

a big investment bank, in September 2008. The reasons for the crisis are varied and

complex. Some of them include boom in the housing market, speculation, high-risk

mortgage loans and lending practices, securitization practices, inaccurate credit ratings

and poor regulation.

1. Boom in the Housing Market:

Subprime borrowing was a major contributor to an increase in house ownership rates and

the demand for housing. This demand helped fuel housing price increase and consumer

22


spending. Some house owners used the increased property value experienced in housing

bubble to re-finance their homes with lower interest rates and take second mortgages

against the added value to use the funds for consumer spending. Increase in house

purchases during the boom period eventually led to surplus inventory of houses, causing

house prices to decline, beginning in the summer of 2006. Easy credit, combined with the

assumption that housing prices would continue to appreciate, had encouraged many

subprime borrowers to obtain adjustable-rate mortgages which they could not afford after

the initial incentive period. Once housing prices started depreciating moderately in many

parts of the U.S, re-financing became more difficult. Some house owners were unable to

re-finance their loans reset to higher interest rates and payment amounts. Excess supply

of houses placed significant downward pressure on prices. As prices declined, more

house owners were at risk of default and foreclosure.

The Causes of a Housing Market Bubble

The price of housing, like the price of any good or service in a free market, is driven by

supply and demand. When demand increases and/or supply decreases, prices go up. In the

absence of a natural disaster that might decrease the supply of housing, prices rise

because demand trends outpace current supply trends. Just as important is that the supply

of housing is slow to react to increases in demand because it takes a long time to build a

house, and in highly developed areas there simply isn't any more land to build on. So, if

there is a sudden or prolonged increase in demand, prices are sure to rise.

Once you've established that an above-average rise in housing prices is primarily driven

by an increase in demand, you might ask what the causes of that increase in demand are.

There are several:

An upturn in general economic activity and prosperity that puts more disposable income

in consumers' pockets and encourages home ownership.

1. An increase in the population or the demographic segment of the population

entering the housing market.

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2. A low general level of interest rates, particularly short-term interest rates, which

make homes more affordable.

3. Innovative mortgage products with low initial monthly payments that make

homes more affordable.

4. Easy access to credit (a lowering of underwriting standards) that brings more

buyers to market.

5. High-yielding structured mortgage bonds, as demanded by investors that make

more mortgage credit available to borrowers.

6. A potential mispricing of risk by mortgage lenders and mortgage bond investors

that expands the availability of credit to borrowers.

7. The short-term relationship between a mortgage broker and a borrower under

which borrowers are sometimes encouraged to take excessive risks.

8. A lack of financial literacy and excessive risk-taking by mortgage borrowers.

9. Speculative and risky behavior by home buyers and property investors fueled by

unrealistic and unsustainable home price appreciation estimates.

All of these variables can combine to cause a housing market bubble. They tend to feed

off of each other. A detailed discussion of each is out of the scope of this article. We

simply point out that in general, like all bubbles, an uptick in activity and prices precedes

excessive risk-taking and speculative behavior by all market participants: buyers,

borrowers, lenders, builders and investors.

The Forces that Cause the Bubble to Burst

The bubble bursts when excessive risk-taking becomes pervasive throughout the housing

system. This happens while the supply of housing is still increasing. In other words,

demand decreases while supply increases, resulting in a fall in prices. This pervasiveness

of risk throughout the system is triggered by losses suffered by homeowners, mortgage

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lenders, mortgage investors and property investors. Those losses could be triggered by a

number of things, including:

1. An increase in interest rates that puts homeownership out of reach for some

buyers and, in some instances, makes the home a person currently owns

unaffordable, leading to default and foreclosure, which eventually adds to supply.

2. A downturn in general economic activity that leads to less disposable income, job

loss and/or fewer available jobs, which decreases the demand for housing.

3. Demand is exhausted, bringing supply and demand into equilibrium and slowing

the rapid pace of home price appreciation that some homeowners, particularly

speculators, count on to make their purchases affordable or profitable. When rapid

price appreciation stagnates, those who count on it to afford their homes long term

might lose their homes, bringing more supply to the market.

The bottom line is that when loses mount, credit standards are tightened, easy mortgage

borrowing is no longer available, demand decreases, supply increases, speculators leave

the market and prices fall.

2. Speculation:

Speculation in real estate was a contributing factor. During 2006, 22 per cent of houses

purchased (1.65 million units) were for investment purposes with an additional 14

percent (1.07 million units) purchased as vacation homes. In other words, nearly 40 per

cent of house purchases were not primary residences. Speculators left the market in 2006,

which caused investment sales to fall much faster than the primary market.

3. High- Risk Mortgage Loans and Lending Practices:

A variety of factors caused lenders to offer higher-risk loans to higher-risk borrowers.

The risk premium required by lenders to offer a subprime loan declined. In addition to

considering high-risk borrowers, lenders have offered increasingly high-risk loan options

and incentives. These high-risk loans included “No Income, No Job and No Assets

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loans.” It is criticized that mortgage underwriting practices including automated loan

approvals were not subjected to appropriate review and documentation.

4. Securitization Practices:

Securitization of housing loans for people with poor credit- not the loans themselves-is

also a reason behind the current global credit crisis. Securitization is a structured finance

process in which assets, receivables or financial instruments are acquired, pooled together

as collateral for the third party investments (Investment Banks). Due to securitization,

investor appetite for Mortgage Backed Securities (MBS), and the tendency of rating

agencies to assign investment-grade ratings to MBS, loans with a high risk of default

could be originated, packaged and the risk readily transferred to others.

5. Inaccurate Credit Ratings:

Credit rating process was faulty. High ratings given by credit rating agencies encouraged

the flow of investor funds into mortgage-backed securities helping finance the housing

boom. Risk rating agencies were unable to give proper ratings to complex instruments.

Several products and financial institutions, including hedge funds, and rating agencies are

largely if not completely unregulated.

6. Poor Regulation:

The problem has occurred during an extremely accelerated process of financial

innovation in market segments that were poorly or ambiguously regulated – mainly in the

U.S. The fall of the financial institutions is a reflection of the lax internal controls and the

ineffectiveness of regulatory oversight in the context of a large volume of non-transparent

assets. It is indeed amazing that there were simply no checks and balances in the financial

system to prevent such a crisis and “not one of the so-called pundits” in the field has

sounded a word of caution. There are doubts whether the operations of derivatives

markets have been as transparent as they should have been or if they have been

manipulated. The headline grabbing collapse of two Bear Stearns hedge funds in July

2007 offers fascinating insight into the world of hedge fund strategies and their

associated risks.

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Investment Structure

The strategy employed by the Bear Stearns funds was actually quite simple and would be

best classified as being a leveraged credit investment. In fact, it is formulaic in nature and

is a common strategy in the hedge fund universe:

Step 1: Purchase collateralized debt obligations (CDOs) that pay an interest rate

over and above the cost of borrowing. In this instance 'AAA' rated tranches of

subprime, mortgage-backed securities were used.

Step 2: Use leverage to buy more CDOs than you can pay for with capital alone.

Because these CDOs pay an interest rate over and above the cost of borrowing,

every incremental unit of leverage adds to the total expected return. So, the more

leverage you employ, the greater the expected return from the trade.

Step 3: Use credit default swaps as insurance against movements in the credit

market. Because the use of leverage increases the portfolio's overall risk exposure,

the next step is to purchase insurance on movements in credit markets. These

"insurance" instruments are called credit default swaps, and are designed to profit

during times when credit concerns cause the bonds to fall in value, effectively

hedging away some of the risk.

Step 4: Watch the money roll in. When you net out the cost of the leverage (or

debt) to purchase the 'AAA' rated subprime debt, as well as the cost of the credit

insurance, you are left with a positive rate of return, which is often referred to as

"positive carry" in hedge fund lingo.

In instances when credit markets (or the underling bonds' prices) remain relatively stable,

or even when they behave in line with historically based expectations, this strategy

generates consistent, positive returns with very little deviation. This is why hedge funds

are often referred to as "absolute return" strategies.

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Can't Hedge All Risk

However, the caveat is that it is impossible to hedge away all risk because it would drive

returns too low. Therefore, the trick with this strategy is for markets to behave as

expected and, ideally, to remain stable or improve. Unfortunately, as the problems with

subprime debt began to unravel the market became anything but stable. To oversimplify

the Bear Stearns situation, the subprime mortgage-backed securities market behaved well

outside of what the portfolio managers expected, which started a chain of events that

imploded the fund.

First Inkling of a Crisis to begin with, the subprime mortgage market had recently begun

to see substantial increases in delinquencies from homeowners, which caused sharp

decreases in the market values of these types of bonds. Unfortunately, the Bear Stearns

portfolio managers failed to expect these sorts of price movements and, therefore, had

insufficient credit insurance to protect against these losses. Because they had leveraged

their positions substantially, the funds began to experience large losses. Problems

Snowball. The large losses made the creditors who were financing this leveraged

investment strategy uneasy, as they had taken subprime, mortgage-backed bonds as

collateral on the loans. The lenders required Bear Stearns to provide additional cash on

their loans because the collateral (subprime bonds) was rapidly falling in value. This is

the equivalent of a margin call for an individual investor with a brokerage account.

Unfortunately, because the funds had no cash on the sidelines, they needed to sell bonds

in order to generate cash, which was essentially the beginning of the end.

Demise of the Funds Ultimately, it became public knowledge in the hedge fund

community that Bear Stearns was in trouble, and competing funds moved to drive the

prices of subprime bonds lower to force Bear Stearns' hand. Simply put, as prices on

bonds fell, the fund experienced losses, which cause it to sell more bonds, which lowered

the prices of the bonds, which caused them to sell more bonds - it didn't take long

before the funds had experienced a complete loss of capital.

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Time line - Bear Stearns Hedge Funds Collapse

In early 2007, the effects of subprime loans started to become apparent as subprime

lenders and homebuilders were suffering under defaults and a severely weakening

housing market.

June 2007 – Amid losses in its portfolio, the Bear Stearns High-Grade Structured

Credit Fund receives$1.6 billion bait out from Bear Stearns, which would help it

to meet margin calls while it liquidated its positions.

July 17, 2007 – In a letter sent to investors, Bear Stearns Asset Management

reported that its Bear Stearns High-Grade Structured Credit Fund had lost more

than 90% of its value, while the Bear Stearns High-Grade Structured Credit

Enhanced Leveraged Fund had lost virtually all of its investor capital. The larger

Structured Credit Fund had around $1 billion, while the Enhanced Leveraged

Fund, which was less than a year old, had nearly $600 million in investor capital.

July 31, 2007 – The two funds filed for Chapter 15 bankruptcy. Bear Stearns

effectively wound down the funds and liquidated all of its holdings.

Aftermath – Several shareholder lawsuits have been filed on the basis of Bear Stearns

misleading investors on the extent of its risky holdings.

The Mistakes Made

The Bear Stearns fund managers' first mistake was failing to accurately predict how the

subprime bond market would behave under extreme circumstances. In effect, the funds

did not accurately protect themselves from event risk. Moreover, they failed to have

ample liquidity to cover their debt obligations. If they'd had the liquidity, they wouldn't

have had to unravel their positions in a down market. While this may have led to lower

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returns due to less leverage, it may have prevented the overall collapse. In hindsight,

giving up a modest portion of potential returns could have saved millions of investor

dollars. Furthermore, it is arguable that the fund managers should have done a better job

in their macroeconomic research and realized that subprime mortgage markets could be

in for tough times. They then could have made appropriate adjustments to their risk

models. Global liquidity growth over recent years has been tremendous, resulting not

only in low interest rates and credit spreads, but also an unprecedented level of risk

taking on the part of lenders to low-credit-quality borrowers. Since 2005,

the U.S. economy has been slowing as a result of the peak in the housing markets, and

subprime borrowers are particularly susceptible to economic slowdowns. Therefore, it

would have been reasonable to assume that the economy was due for a correction.

Finally, the overriding flaw for Bear Stearns was the level of leverage employed in the

strategy, which was directly driven by the need to justify the utterly enormous fees they

charged for their services and to attain the potential payoff of getting 20% of profits. In

other words, they got greedy and leveraged the portfolio to much.

Consequences:

Five economic trends heralded a dramatic decline of the U.S. economy:

1. Stock prices plummeted. The Dow dropped 40%, from a high of 14,043 in October

2007 to 6,594.44 on March 5, 2009. Between its peak and its bottom, the Dow

dropped over 50% in just 17 months. It dropped 800 points during intra-day trading

on October 6, its largest one-day drop ever. European stocks, as measured by the

Stoxx 600, fell 7.6%, the U.K.'s FTSE 100 dropped 7.9% and France's CAC 40 slid

9%. These were the largest declines since 1987, and erased $2.5 trillion from global

equities.

2. Business credit has dried up. To restore financial stability, Congress passed an $800

billion bailout to buy back troubled mortgages. Central banks in the U.S. and Europe

dropped rates .5%. The Federal Reserve doubled its currency swaps with foreign

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central banks in Europe, England and Japan to $620 billion, and has agreed to lend

directly to businesses that can't find credit. The governments of the world are being

forced to provide all the liquidity for frozen credit markets.

3. Housing prices have dropped 28% overall. The median single family home price has

dropped from $229,000 in June 2007 to $164,800 in January 2009. (Source: National

Association of Realtors)

4. Bank near-failures have taken some of the most prestigous financial services

companies, including Lehman Brothers, AIG, Wachovia, Bear Stearns, Washington

Mutual and IndyMac Bank as well as many foreign banks.

5. Oil prices set new records, rising to $144 per barrel in July 2008 before settling at

$30 per barrel in December 2008. (Source: EIA, Spot Oil Prices)

Background

Stock market losses were due to a rush to safe haven Treasury Bonds and gold as panic

gripped investors concerned about the impact of the credit crisis on the global economy.

Housing price declines and foreclosures were a result of mortgage financing reliant

upon mortgage-backed securities, which contributed to lax lending standards (See A

Primer on the Subprime Mortgage Mess) Banks literally stopped purchasing them on the

secondary market, which meant that few mortgages were being issued that weren't

guaranteed by the Federal Government. This further depressed the housing market.

Business credit has frozen. Demand for any type of asset-backed commercial paper has

virtually disappeared. This panic over the value of these commercialized debt obligations

led to the financial sector's crisis, causing the intervention of the Federal Reserve and the

Treasury.

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Bank near-failures were a result of their inability to raise funds, either through debt

offerings or sale of stock. This led to a cash flow problem which caused their demise. In

some cases, such as WaMu and IndyMac, depositors rushed to withdraw their savings,

reminiscent of the Great Depression.

Oil prices were high due to a seasonal surge in demand and an investment bubble by

traders. However, concerns about a global slowdown in economic growth since returned

prices to more normal levels.

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CHAPTER-6

SUBPRIME CRISIS AND INDIAN

FINANCIAL SECTOR

33


There was also no direct impact of the Lehman failure on the domestic financial sector in

view of the limited exposure of the Indian banks. However, following the Lehman

failure, there was a sudden change in the external environment. As in the case of other

major EMEs, there was a sell-off in domestic equity markets by portfolio investors

reflecting deleveraging.

Consequently, there were large capital outflows by portfolio investors during September-

October 2008, with concomitant pressures in the foreign exchange market. While foreign

direct investment flows exhibited resilience, access to external commercial borrowings

and trade credits was rendered somewhat difficult. On the whole, net capital inflows

during 2008-09 were substantially lower than in 2007-08 and there was a depletion of

reserves. However, a large part of the reserve loss (US $ 33 billion out of US $ 54 billion)

during April-December 2008 reflected valuation losses.

The contraction of capital flows and the sell-off in the domestic market adversely

affected both external and domestic financing for the corporate sector. The sharp

slowdown in demand in the major advanced economies is also having an adverse impact

on our exports and industrial performance. On the positive side, the significant correction

in international oil and other commodity prices has alleviated inflationary pressures as

measured by wholesale price index. However, various measures of consumer prices

remain at elevated levels on the back of continuing high inflation in food prices.

Reflecting the slowdown in external demand, and the consequences of reversal of capital

flows, growth in industrial production decelerated to 2.8 per cent in 2008-09 (April-

February) from 8.8 per cent in the corresponding period of 2007-08. On the other hand,

services sector activity has held up relatively well in 2008-09 so far (April-December)

with growth of 9.7 per cent (10.5 per cent in the corresponding period of 2007-08).

Services sector activity was buoyed up by acceleration in “community, social and

personal services” on the back of higher government expenditure. Overall, real GDP

growth has slowed to 6.9 per cent in the first three quarters of 2008-09 from 9.0 per cent

in the corresponding period of 2007-08. On the expenditure side, growth of private final

34


consumption expenditure decelerated to 6.6 per cent from 8.3 per cent. On the other hand,

reflecting the fiscal stimuli and other expenditure measures, growth in government final

consumption expenditure accelerated to 13.3 per cent from 2.7 per cent.

Impact on India

Due to globalization, the Indian economy cannot be insulated from the present financial

crisis in the developed economies. The development in the U.S financial sector has

affected not only America but also European Union, U.K and Asia. The Indian economy

too has felt the impact of the crisis though not to the same extent. It is premature to try to

quantify the consequences of the crisis on the Indian economy. However the impact will

be multi-fold.

1. Declining in Revenue of Information Technology:

With the global financial system getting trapped in the quicksand, there is uncertainty

across the Indian Software industry. The U.S. banks have huge running relations with

Indian Software Companies. A rough estimate suggests that at least a minimum of 30,000

Indian jobs could be impacted immediately in the wake of happenings in the U.S.

financial system. Approximately 61 per cent of the Indian IT Sector revenues are from

U.S financial corporations like Goldman Sachs, Washington Mutual, Citigroup, Bank of

America, Morgan Stanley and Lehman Brothers. The top five Indian players account for

46 per cent of the IT industry revenues. The revenue contribution from U.S clients is

approximately 58 per cent. About 30 percent of the industry revenues are estimated to be

from financial services (Atreya 2008). The software companies may face hard days

ahead.

2. Exchange Rate:

Exchange rate volatility in India has increased in the year 2008-09 compared to previous

years. Massive selling by Foreign Institutional Investors and conversion of their holdings

from rupees to dollars for repatriation has resulted in the rupee depreciating sharply

35


against the dollar. Between January 1 and October 16, 2008, the Reserve Bank of India

(RBI) reference rate for the rupee fell by nearly 25 per cent, from Rs.39.20 per dollar to

Rs.48.86 (Chandrasekhar and Gosh 2008). This depreciation may be good for India’s

exports that are adversely affected by the slowdown in global markets but it is not so

good for those who have accumulated foreign exchange payment commitments.

3. Foreign Exchange Outflow:

After the macro-economic reforms in 1991, the Indian economy has been increasingly

integrated with the global economy. The financial institutions in India are exposed to the

world financial market. Foreign institutional investment (FII) is largely open to India’s

equity, debt markets and market for mutual funds. The most immediate effect of the crisis

has been an outflow of foreign institutional investment from the equity market. There is a

serious concern about the likely impact on the economy because of the heavy foreign

exchange outflows in the wake of sustained selling by Foreign Institutional Investors in

the stock markets and withdrawal of funds by others. The crisis resulted in net outflow of

$ 10.1billion from the equity and debt markets in India till 22nd Oct, 2008 (Kundu 2008).

There is even the prospect of emergence of deficit in the balance of payments in the near

future.

In India, the economic crisis was largely insulated by the reversal of foreign institutional

investment (FII), external commercial borrowings (ECB) and trade credit. Its spillovers

became

visible in September-October 2008 with overseas investors pulling out a record USD 13.3

billion and fall in the nominal value of the rupee from Rs. 40.36 per USD in March 2008

to Rs. 51.23 per USD in March 2009, reflecting at 21.2 per cent depreciation during the

fiscal 2008-09. The annual average exchange rate during 2008-09 worked out to Rs.

45.99 per US dollar compared to Rs. 40.26 per USD in 2007-08 which is the biggest

annual loss for the rupee since 1991 crisis. Moreover, there is reduction in the capital

account receipts in 2008-09 with total net capital flows falling from USD 17.3 billion in

April-June 2007 to USD 13.2 billion in April-June 2008. Hence, sharp fluctuation in the

36


overnight forex rates and the depreciation of the rupee reflects the combined impact of

the global credit crunch and the deleveraging process underway in Indian forex market.

4. Investment:

The tumbling economy in the U.S is going to dampen the investment flow. It is expected

that the capital inflows into the country will dry up. Investments in mega projects, which

are under implementation and in the pipeline, are bound to buy more time before

injecting funds into infrastructure and other ventures. The buoyancy in the economy is

absent in all the sectors. Investment in tourism, hospitality and healthcare has slowed

down. Fresh investment flows into India is in doubt.

5. Stock Market:

The economy and the stock market are closely related as the buoyancy of the economy

gets reflected in the stock market. Due to the impact of global economic recession, Indian

stock market crashed from the high of 20000 to a low of around 8000 points. Corporate

performance of most of the companies remained subdued, and the impact of moderation

in demand was visible in the substantial deceleration during the current fiscal year.

Corporate profitability also exhibited negative growth in the last three successive quarters

of the year. Indian stock market has tumbled down mainly because of 'the substitution

effect' of:

• Drying up of overseas financing for Indian banks and Indian corporates;

• Constraints in raising funds in a bearish domestic capital market; and

• Decline in the internal accruals of the corporates.

Thus, the combined effect of the reversal of portfolio equity flows, the reduced

availability of international capital both debt and equity and the perceived increase in the

price of equity with lower equity valuations has led to the bearish influence on stock

market.

The financial turmoil affected the stock markets even in India. The combination of a

rapid sell off by financial institutions and the prospect of economic slowdown have

pulled down the stocks and commodities market. Foreign institutional investors pulled

37


out close to $ 11 billion from India, dragging the capital market down with it (Lakshman

2008). Stock prices have fallen by 60 per cent. India’s stock market index—Sensex—

touched above 21,000 mark in the month of January,2008 and has plunged below 10,000

during October 2008 ( Kundu 2008).The movement of Sensex shows a positive and

significant relation with Foreign Institutional Investment flows into the market. This also

has an effect on the Primary Market. In 2007-08, the net Foreign Institutional Investment

inflows into India amounted to $20.3 billion. As compared to this, they pulled out $11.1

billion during the first nine-and-a-half months of the calendar year 2008, of which $8.3

billion occurred over the first six-and-a-half months of the financial year 2008-09 (April

1 to October 16).

Stock Market

The Sensex has given a CAGR of 17.5% since inception in 1986 to the current level

of 17528 as on March 31,2010, with the base of 100 set for 1978/79

Last five years it has moved as below

2005……Up 42%

38

year open High low close2000 5209.54 6150.69 3491.55 3972.122001 3990.65 4462.11 2594.87 3262.332002 3262.01 3758.27 2828.48 3377.282003 3383.85 5920.76 2904.44 5838.962004 5872.48 6617.15 4227.5 6602.692005 6626.49 9442.98 6069.33 9397.932006 9422.49 14035.3 8799.01 13786.912007 13827.7 20498.11 12316.1 20286.992008 20325.2 21206.77 7697.39 9647.312009 9720.55 17530.94 8047.17 17464.812010 17473.45 17793.01 15651.99 17527.77


2006……Up 47%

2007……Up 47%

2008……Down 52%

2009……Up 81%

2010 till March 31, 2010….Flat at 0.36%

If we observe the 2000/1 Crash, we can see the Sensex dropped to a low of 2595 in

2001 from a High of 615I in 2000…that’s a 58% decline. From the Low of 2595 in

2001 to the current 16496 as on Feb 3,2010 the Sensex CAGR for the 9 years has

been a fabulous 23%….Message is clear…Never miss an Opportunity to Invest

More in Equity at Sensex Lows….You got opportunities in 2002 and 2003 too and

more recently in October 2008 and March 2009.

6. Exports:

The crisis will sharply contract the demand for exports adversely affecting the country’s

growth prospects. It will have an impact on merchandise exports and service exports. The

decline in export growth may sharply affect some segments of the Indian Economy that

are export oriented. The slowdown in the world economy has affected the garment

industry. The orders for factories which are dependent on exports, mainly to the U.S have

come down following deferred buying by big apparel brands. Rising unemployment and

reduced spending by the Americans have forced some of the leading brands in the U.S to

close down their outlets, which in turn has affected the apparel industry here in India. The

U.S accounts for 55 per cent of all global apparel imports (Bageshree and Srivatsa 2008).

The global recession will undermine other major export sectors of the Indian economy

like sea foods, gems and jewellery.

39


7. Banks:

The ongoing crisis will have an adverse impact on some of the Indian banks. Some of the

Indian banks have invested in derivatives which might have exposure to investment

bankers in U.S.A. However, Indian banks in general, have very little exposure to the asset

markets of the developed world. Effectively speaking, the Indian banks and financial

institutions have not experienced the kind of losses and write-downs that banks and

financial institutions in the Western world have faced. Indian banks have very few

branches abroad. Our Indian banks are slightly better protected from the financial

meltdown, largely because of the greater role of the nationalized banks even today and

other controls on domestic finance. Strict regulation and conservative policies adopted by

the Reserve Bank of India have ensured that banks in India are relatively insulated from

the travails of their western counterparts.

According to one estimate, global majors like Citibank, Merrill Lynch and Deutsche

Bank, have lost over US$180 billion due to the subprime crisis.

ICICI bank’s loss: India's largest private bank is faced with a loss of Rs10.56 billion till

January 2008. ICICI did not have exposure to the US sub-prime market. Its profits were

hurt by depreciation in the value of securities it bought in the international markets. The

sub-prime crisis led to a rise in global interest rates, which in turn caused a decline in the

value of securities, leaving ICICI with the task of making up the difference from its

profits. The investment losses resulting from the sub-prime crisis could eliminate

approximately 9% of its profits this year.

AOL India News quoted analysts as saying that other Indian banks with exposure to

credit derivatives include the country’s largest bank, the State Bank of India (SBI) Rs 40

billion, Bank of India - Rs12 billion and Bank of Baroda Rs 6 billion. Applying the same

rate as ICICI’s 7.6% to the exposure of these government-run banks, we have a loss of Rs

7.04 billion for SBI, Rs 2.11 billion for Bank of India and Rs1.08 billion for Bank of

Baroda.

40


8. Fiscal Impact

Government finances, which had exhibited a noteworthy correction starting 2002-03,

came under renewed pressure in 2008-09 on account of higher expenditure outgoes due

to (i) higher international crude oil prices (up to September 2008) and the incomplete

pass-through to domestic prices (ii) higher fertilizer prices and associated increase in

fertilizer prices (iii) the Sixth Pay Commission award and (iv) debt waiver scheme. The

fiscal stimulus packages involving additional expenditures and tax cuts have put further

stress on the fisc. Reflecting these factors, the Central Government’s fiscal deficit more

than doubled from 2.7 per cent of GDP in 2007-08 to 6.0 per cent in 2008-09, reaching

again the levels seen around the end of the 1990s. The revenue deficit at 4.4 per cent of

GDP will be at its previous peak touched during 2001-02 and 2002-03. Primary balance

again turned into deficit in 2008-09, after recording surpluses during the preceding two

years. Net market borrowings during 2008-09 almost trebled from the budgeted

Rs.1,13,000 crore to Rs.3,29,649 in the revised estimates (actual borrowings were

Rs.2,98,536 crore as per Reserve Bank records) and are budgeted at Rs.3,08,647 crore

(gross borrowings at Rs. 3,98,552 crore) in 2009-10.

In view of the renewed fiscal deterioration, the credit rating agency Standard and Poor’s

has changed its outlook on long-term sovereign credit rating from stable to negative,

while reaffirming the “BBB-” rating. If bonds issued to oil and fertilizer companies are

taken into account, the various deficit indicators will be even higher. Moreover, in order

to boost domestic demand, the Government has announced additional tax sops

subsequent to the interim vote-on-account budget putting further pressure on fiscal

position. Thus, while the slowdown in the domestic economy may call for fiscal stimulus,

fiscal maneuverability is limited.

According to the IMF, based on measures already taken and current plans, it is estimated

that government debt ratios and fiscal deficits, particularly in advanced economies, will

increase significantly. For the G-20 as a whole, the general government balance is

expected to deteriorate by 3½ percent of GDP, on average, in 2009. While the fiscal cost

for some countries will be large in the short-run, the alternative of providing no fiscal

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stimulus or financial sector support would be extremely costly in terms of the lost output

(IMF, 2009).

9. Money Market

The money market consists of credit market, debt market and government securities

market. All these markets are in some or other way related to the soundness of banking

system as they are regulated by the Reserve Bank of India. According to the Report

submitted by the Committee for Financial Sector Assessment (CFSA), set up jointly by

the Government and the RBI, our financial system is essentially sound and resilient, and

that systemic stability is by and large robust and there are no significant vulnerabilities in

the banking system. Yet, NPAs of banks may indeed rise due to slowdown as Reserve

Bank has pointed out. But given the strength of the banks’ balance sheets, that rise is not

likely to pose any systemic risks, as it might in many advanced countries. Nevertheless,

the call money rate went over 20 per cent immediately after the Lehman Brothers’

collapse and banks’ borrowing from the RBI under daily liquidity adjustment facility

overshot Rs. 50,000 crore on several occasions during September-October 2008 under

tight liquidity situation.

10. Slowing GDP

In the past 5 years, the economy has grown at an average rate of 8-9 per cent. 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. Even before the global confidence dived, the economy

was slowing. According to the revised estimates released by the CSO (May 29, 2009) for

the overall growth of GDP at factor cost at constant prices in 2008-09 was 6.7 per cent as

against the 7 per cent projection in the midyear review of the Economy presented in the

Parliament on December 23, 2008. The growth of GDP at factor cost (at constant 1999-

2000 prices) at 6.7 per cent in 2008-09 nevertheless represents a deceleration from high

growth of 9 per cent and 9.7 per cent in 2007-08 and 2006-07 respectively. (Table 1) The

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RBI annual policy statement 2009 presented on July 28, 2009 projects GDP growth at 6

per cent in 2009-10 in 2009-10.

Rate of Growth at Factor Cost at 1999-2000 Prices (per cent)

The slowdown in growth of GDP is more clearly visible from the growth rates over

successive quarters of 2008-09. In the first two quarters of 2008-09, the growth in GDP

was 7.8 and 7.7 respectively which fell to 5.8 per cent in the third and fourth quarters of

2008-09. The third quarter witnessed a sharp fall in the growth of manufacturing,

construction, trade, hotels and restaurants. The last quarter was an added deterioration in

manufacturing due to the deepening impact of the global crisis and a slowdown in

domestic demand.

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Source: Central Statistical Organisation

Hence, the slowdown in Indian economy is evident from the low GDP growth with

deceleration in the industrial activity, particularly in the manufacturing and infrastructure

sectors and moderation in the services sector mainly in the construction, transport and

communication, trade, hotels and restaurants. The capital account balance declined

significantly to US $ 16.09 billion in 2008-09 as compared to US $ 82.68 billion during

the corresponding period in 2007-08. As at end-March 2009 the foreign exchange

reserves stood at US $ 252 billion.

11. Strain on Balance of Payments

The overall balance of payments (BoP) situation remained resilient in 2008-09 despite

signs of strain in the capital and current accounts, due to the global crisis. During the first

three quarters of 2008-09 (April-December 2008), the current account deficit (CAD) was

US $ 36.5 billion as against US $ 15.5 billion for the corresponding period in 2007-08.

12. Reduction in Import-Export

During 2008-09, the growth in exports was robust till August 2008. However, in

September 2008, export growth evinced a sharp dip and turned negative in October 2008

and remained negative till the end of the financial year. For the first time in seven years,

exports have declined in absolute terms in October 2008.

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Export Growth Year Wise

Quarterly Export Growth in 2008-09

Source: Economic Survey 2009, Government of India

The above chart show that the exports have declined since October 2008 due to

contraction in global demand due to the synchronised global recession. Similarly, imports

growth also witnessed a deceleration during October-November 2008, before turning

negative thereafter. The merchandise trade deficit declined during 2009-10 (April-May) 45


over the corresponding period of the previous year, reflecting the sharper decline in the

imports in relation to exports.

13. Reduction in Employment

Employment is worst affected during any financial 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 August and October 2008, in export

related companies in several sectors, primarily textiles, leather, engineering, gems and

jewelry, handicraft and food processing. Economic Survey of India gives alarming bell

about the on-going effects of the global slowdown on employment and has pressed upon

the government the urgency of the major response, especially in the unorganized sector.

Growth in Employment Rate

Source: Economic Survey 2009, Government of India

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One danger is of a dip in the employment market. The global financial crisis could

increase unemployment. Layoffs and wage cuts are certain to take place in many

companies where young employees are working in Business Process Outsourcing and

Information Technology sectors. With job losses, the gap between the rich and the poor

will be widened. It is estimated that there would be downsizing in many other fields as

companies cut costs. The International Labor Organization predicted that millions of jobs

will be lost by the end of 2009 due to the crisis – mostly in “construction, real estate,

financial services, and the auto sector.” The Global Wage Report 2008-09 of

International Labor Organization warns that tensions are likely to intensify over the issue

of wages. There would also be a significant drop in new hiring (The Hindu 2008) All

these will change the complexion of the job market.

Jobs in Banking Sector-Indians feel how we are affected by Sub Prime. A situation that

rose in world market cannot make India stand out without being impacted by it. However,

the impact is not too big to create a crisis. Economists feel that even if the subprime crisis

leads to a global credit crunch, it still may not have a big effect because there is quite a

lot of liquidity in domestic markets in countries like India. Lack of exposure to U.S.

mortgage securities; availability of liquidity in domestic markets; and the possibility of

lower capital inflows could help countries such as India with macroeconomic

management to face the crisis. The first Indian Organization to be affected by this Crisis

is ICICI Bank Ltd. ICICI Bank's profit took a hit of more than Rs 1,050 crores ($264

million) in the year 2007-08. This is an indirect effect. ICICI lost money due to

depreciation in the value of securities it bought in the international markets. Due to a rise

in global interest rates after the subprime loan crisis, the value of these securities fell,

forcing the bank to provide for the difference from its profits. The loss, however, is

notional since the bank has not actually sold these securities. Public Sector Banks, viz

State Bank Of India, Bank Of India, Bank Of Baroda, Canara Bank, Punjab National

Bank etc do not have major exposure to credit derivatives market due to their limited

overseas operations. However, the impact of the global crisis on Indian Stock Market is

on a negative side. Once investments in the US turned bad, more money had to be

invested in the US to maintain the fixed proportion of the investments by institutional

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investors. In order to invest more money in the US, money came in from emerging

markets like India, where their investments have been doing well. These big institutional

investors, to make good of their losses on the subprime market, have been selling their

investments in India and other emerging markets. Since the amount of selling in the

market far overweighs the amount of buying, Indian stock prices have been falling.

Taking it forward to the job market, Multinational Corporates have adopted a wait and

watch policy and have softened their hiring plans both in India and abroad. However,

major hit is again on the existing employees of ICICI Bank Ltd. The bank has publicly

announced reduction in its bonus percentages with no increments and promotions.

Further it has decided to scale down its headcount by 4000-5000 employees. Similarly,

Citigroup across the globe, alone has plans to cut over 30,000 jobs over the next one and

half years because of subprime related debt write-downs.

14. Taxation

The economic slowdown has severely dented the Centre’s tax collections with indirect

taxes bearing the brunt. The tax-GDP ratio registered a steady increase from 8.97 per cent

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 per cent during current fiscal year mainly on account of

reduction in Customs and Excise Tax due to effect of economic slowdown.

Reduction in Tax-GDP ratio Source: Central Statistical Organisation

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Response to the Crisis

The future trajectory of the economic meltdown is not yet clear. However, the

Government and the Reserve Bank responded to the challenge strongly and promptly to

infuse liquidity and restore confidence in Indian financial markets. The Government

introduced stimulus package while the Reserve Bank shifted its policy stance from

monetary tightening in response to the elevated inflationary pressures in the first half of

2008-09 to monetary easing in response to easing inflationary pressures and moderation

of growth engendered by the crisis. The fiscal and monetary response to the crisis has

been discussed in the following points-

I. Fiscal Response

The Government launched three fiscal stimulus packages between December 2008 and

February 2009. These stimulus packages came on top of an already announced expanded

safety-net programme for the rural poor, the farm loan waiver package and payout

following the Sixth Pay Commission report, all of which added to stimulating demand.

The challenge for fiscal policy is to balance immediate support for the economy with the

need to get back on track on the medium term fiscal consolidation process. The fiscal

stimulus packages and other measures have led to sharp increase in the revenue and fiscal

deficits which, in the face of slowing private investment, have cushioned the pace of

economic activity. The borrowing programme of the government has already expanded

rapidly in an orderly manner by the Reserve Bank of India which would spur investment

demand in the domestic market. So while the government will continue to support

liquidity in the economy, it will have to ensure that as economic growth gathers

momentum, the excess liquidity is rolled back in an orderly manner. In India monetary

transmission has had a differential impact across different segments of the financial

market. While the transmission has been faster in the money and bond markets, it has

been relatively muted in the credit market on account of several structural rigidities. In

order to address these issues, the government has to effectively and carefully take up the

following steps -

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• Enhance coordination and harmonization of the regulatory apparatus internationally,

given the global scope of the recent crises with increased cross border financial

integration;

• Introduction of countercyclical prudential regulatory policy;

• Design regulation and supervision of financial companies for non-deposit taking

financial entities having the potential to cause systematic instability, as evident in the

current crisis;

• Supervision and management of liquidity risk and greater transparency in the financial

sector to improve better risk assessment by the customers and investors; Improvement in

transparency in the structured credit instruments. The rise in macroeconomic uncertainty

and the financial dislocation of the year 2008 have raised a problem of adjustment in

market interest rates in response to changes in policy rates gets reflected with some lag.

The Union Budget for 2009-10, presented against the backdrop of persistent global

economic slowdown and the associated dampened domestic demand, has placed the fiscal

deficit at 6.8 per cent of GDP in 2009-10 with a view to providing the necessary boost to

demand and thereby support a faster recovery.

II. Monetary Response

The RBI has taken several measures aimed at infusing rupee as well as foreign exchange

liquidity and to maintain credit flow to productive sectors of the economy such as

infusing liquidity through interest rate management, risk management and credit

management which is described in detail under the following heads:-

In order to deal with the liquidity crunch and the virtual freezing of international credit,

RBI took steps for monetary expansion which gave a cue to the banks to reduce their

deposit and lending rates. The major changes in the interest rate policy of RBI are given

below-

• Reduction in the cash reserve ratio (CRR) by 400 basis points from 9.0 per cent in

August 2008 to 5 per cent in January 2009 • Reduction in the repo rate (rate at which RBI

lends to the banks) by 425 basis points from 9.0 per cent as on October 19 to 4.75 per

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cent by July 2009 (the lowest in past 9 years) in order to improve the flow of credit to

productive sectors at viable costs so as to sustain the growth momentum.

• In order to make parking of funds with RBI unattractive for banks, the reverse repo rate

(RBI’s borrowing rate) was reduced by 275 points which currently stands at 3.25 per

cent.

1. Interest Rate Management

The above said policy changes since mid-September 2008, enabled Reserve Bank of

India to infuse Rs.5,61,700 crore (excluding Rs.40, 000 crore under SLR reduction) in

market in order to ensure ample liquidity in the banking system.

2. Risk Management

There has been a sustained demand from various quarters for exercising regulatory

forbearance in regard to extant prudential regulations applicable to the banking sector. As

a part of counter-cyclical package, RBI has already made several changes to the current

prudential norms for robust risk disclosures, transparency in restructured products and

standard assets such as-

• Implementation of Basel II w.e.f. March 2009 by all Scheduled Commercial Banks

except RRBs which would promote closer cooperation, information sharing and

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coordination of policies among sector wise regulators, especially in the context of

financial conglomerates.

• Further guidance to strengthen disclosure requirements under Pillar 3 of Basel II.

• Counter-cyclical adjustment of provisioning norms for all types of standard assets

(except in case of direct advances to agriculture and small and medium enterprises which

continue to be at 0.25 percent)

• Reduction in the risk weights for claims on unrated corporate and commercial real

estate to 100 per cent;

• Reduction in the provisioning requirement for all standard assets to 0.40 per cent;

• Improve and converge financial reporting standards for off balance sheet vehicles;

• Develop guidance on valuations when markets are no longer active, establishing an

expert advisory panel in 2008.

• Market participants and securities regulators will expand the information provided

about securitized products and their underlying assets.

• Permitting housing loans to be restructured even if the revised payment period exceeds

ten years;

• Making the restructured commercial real estate exposures eligible for special treatment

if restructured before June 30, 2009. Hence, RBI has ensured perseverance of prudential

policies which prevent institutions from excessive risk taking, and financial markets from

becoming extremely volatile and turbulent.

3. Credit Management

There was a noticeable decline in the credit demand during 2008-09 which is indicative

of slowing economic activity- a major challenge for the banks to ensure healthy flow of

credit to the productive sectors of the economy. The reduced funding demand on the

banks should enable them to reduce the interest rates on deposit and thereby reduce the

overall cost of funds. Although deposit rates are declining and effective lending rates are

falling, there is clearly more space to cut rates given declining inflation. In order to

facilitate demand for credit in the economy the Reserve Bank has taken certain steps such

as-

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• Opening a special repo window under the liquidity adjustment facility for banks for on-

lending to the non-banking financial companies, housing finance companies and mutual

funds.

• Extending a special refinance facility, which banks can access without any collateral

• Unwinding the Market Stabilization Scheme (MSS) securities, in order to manage

liquidity

• Accelerating Government’s borrowing programme

• Upward adjustment of the interest rate ceilings on the foreign currency non-resident

(banks) and non-resident (external) rupee account deposits

• Relaxing the external commercial borrowings (ECB) regime

• Allowing the NBFCs and HFCs access to foreign borrowing

• Allowing corporates to buy back foreign currency convertible bonds (FCCBs) to take

advantage of the discount in the prevailing depressed global markets

• Instituting a rupee-dollar swap facility for banks with overseas branches to give them

comfort in managing their short-term funding requirements

• Extending flow of credit to sectors which are coming under pressure include extending

the period of pre-shipment and post shipment credit for exports

• Expanding the refinance facility for exports

• Expanding the lendable resources available to the Small Industries Development Bank

of India, the National Housing Bank and the Export-Import Bank of India

Implementation of Basel II framework:

In keeping with the international best practices, the RBI decided to implement Basel II

framework. The foreign banks which are operating in India and Indian banks having

operational presence outside India have adopted the standardized approach (SA) for

credit risk and the basic Indicator Approach (BIA) for operational risk for computing

their capital requirements with effect form march 31, 2008. All other commercial banks

(excluding local area banks and regional rural banks) are expected to adopt Basel II

norms not later than March 31, 2009. The significant improvement in risk management

practices, asset-liability management and corporate governance in Indian banks could be

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observed. Implementing Basel II norms is not a one time measure. Banks have to

constantly monitor credit rating of the borrower and remain above the minimum

benchmark of Capital Adequacy Ratio (9 percent prescribed by the RBI) on an ongoing

basis.

Banks can leverage from sophisticated risk management practices needing lower capital

levels provided the data support is built. Developing a credible management information

system (MIS) to migrate to higher models of credit risk management is a big challenge

for Indian banks. According to the RBI, the total capital requirements in the five years

2007-08 to 2011-12 are projected to go up by about INR 5,70,000 crores assuming that

banks maintain capital to risk-weighted assets ratio (CRAR) at 12 percent. As a result,

the total capital requirements of PSBs are projected to go up by about INR 3,70,000

crores. Banks will have to plan for raising capital resources to support such potential

growth.

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CHAPTER-7

CONCLUSION AND FINDINGS

OF THE STUDY

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Owing to India’s traditional practices of banking and enough available liquidity, India

could keep itself a bit away from the endangered circle of US subprime. Since, today,

none of the economies is entirely isolated from this lethal consequence called as

subprime crisis, India too experienced many unfavorable effects of its.

Approximately 61 percent revenue in IT sector in India is from US financial system and

because of the crisis and layoffs these IT sectors got affected.

Investment in tourism, hospitality and healthcare has slowed down. Fresh investment

flows into India is in doubt. Due to the impact of global economic recession, Indian stock

market crashed from the high of 20000 to a low of around 8000 points.

Crisis had impact on merchandise exports and service exports. Crisis led to the layoffs in

banking sectors and the ICICI bank suffered a notional loss of Rs. 10.56 billion. However

there were no significant vulnerabilities in the banking system. The growth in GDP was

also affected and there was decline in the GDP. Also there was current account deficit in

balance of payment. Unemployment was increased in various sectors like private sector

and banking. Tax GDP ratio was also decreased due to this slow down. Various measures

were taken by the government and Reserve Bank of India. CRR and Repo rate was

decreased by RBI. Basel II norms were also applied to make the banking sector work

efficient.

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REFERENCES

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Morris Goldstein (2008). The Subprime and Credit Crisis. Peterson Institute for

International Economics.

Prasad A. and Reddy C. Panduranga Department Global Financial Crisis and Its Impact

on India of Humanities and Social Sciences, College of Engineering, Andhra University,

Visakhapatnam Andhra Pradesh.

Whitney Mike (July 1, 2007)– The Fed's Role in the Bear Stearns Hedge Funds

Meltdown.

Goodhart Charles and Persaud Avinash, (January 30, 2008) “How to Avoid the Next

Crash,” Financial Times.

Bajpai Nirupam (2010) Global Financial Crisis, its Impact on India and the Policy

Response

website: http://indiabudget.nic.in

Leonard Paul. Center for Responsible Lending California

Chandran Priyanka. (2008) Lessons from subprime melt down. Delhi

Mardia Shreyansh (June 20, 2008) Effects of Recession in US, on Indian Economy

Hemming Richard Roubini Nouriel A Balance Sheet Crisis in India? International

Business

Stern School of Business, New York University.

Chadda Abhishikta. sub prime

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http://indiabudget.nic.in/


Prof. Naidu p. Devasena (08-09 march 2010) economic meltdown and its impact on

Indian Economy Tirupati India

Narayan S. The Sub-prime Crisis – Likely Consequences for the Indian Economy

Singapore

Governor Williams Global Financial Turbulence and Financial Sector in India:

Choudhari Nidhi (2009) Manager, Reserve Bank of India, global recession and its impact

on

Indian Financial Markets. Kolkata

Shankar Anand The Subprime Crisis ‐ Implications for India

Asian Development Bank Institute (2008) research project Implications of the subprime

crisis

On Asia’s growth and Asia’s response

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