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PREFACE

IN THE FORMATION OF THIS REPORT EFFORTS


HAD BEEN MADE TO COVER EVERY ASPECT OF
THE RECESSION BUT DUE TO THE TIME
CONSTRAINT SOME OF THE TOPICS HAD NOT
BEEN COVERED IN ITS FULL EXTENT SUCH AS
HOW RECESSION SPREAD FROM U.S. TO
ACROSS THE WORLD, AND WHAT ARE THE
IMMEDIATE MEASURES TAKEN BY THE INDIAN
GOVT TO PROTECT INDIAN MARKET, AND
WHAT ARE THE CAUSES OF GREAT
DEPRESSION OF 1926 AND HOW U.S. CAME
OUT OF IT. HOWEVER EVERY EFFORT HAS
BEEN MADE TO EXPLAIN THE PRESENT
ECONOMIC CRISIS AND FAILURE OF LEADING
BANKS OF THE WORLD AND THE BAILOUT
PLAN ADOPTED BY THE WEST TO KEEP
RECESSION UNDER ARREST SO AS TO
PREVENT IT FROM BECOMING A DEPRESSION
AND AT LAST BUT NOT THE LEAST THE
IMPACT OF RECESSION ON INDIA.
INDEX
1.Why banks prefer low rates.
2.How low rates lead to recession.
3.Spread of Crisis
4.Measures taken by U.S.
5.Measures taken by other economies.
6.Impact on India
7.Conclusion

ABSTRACT -
Prior to crisis the financial market in U.S. and
other major economies of the world had been
growing at a rapid rate. Investors of all types
that is both the small savings of household and
large corporate savings have been able to
mobilize their savings and earned a lot
investing through capital market. Various type
of sectoral funding agencies had been
operating to facilitate those movements and
help the borrowers in getting their
requirement financed.
However, with the advent of subprime
crisis that generally refers to situation that
resulted from the borrowing defaults on
subprime lenders. This type of lending was
advanced mostly by the mortgage funding
agencies. However as long as situation in both
the market i.e. capital market and property
market remained tacit the things were okay.
With time the house prices initially rising and
than falling these agencies started making
huge losses on account of defaulting loans and
decreasing prices and decreasing prices of
mortgaged houses. This led to credit crunch for
other sector thus the whole financial market
came under this grip. Also recently some of the
America’s top investment banks like Lehman
Brothers, Merill Lynch, Wachovia also started
falling as the assets valuation began to
decrease and liabilities rose for these
institutions.
This economic imbalance first hit the
financial sector, then the credit sector, then the
whole of capital sector.

1.Why prefer low rate


1.1 “Lend and hold
model”
Before 1970s U.S. financial sector was an example
of a highly regulated and stable financial system in
which bank dominated deposits rate were
controlled, small and medium deposits were
guaranteed, bank profits were determined by the
difference between deposits and lending rates, and
banks were restrained from staying into areas such
as securities, trading and insurance. To quote one
apt description, that was a time when banks that
lent to a business or provide a mortgage would
take the asset and put it on their books much the
way a museum “would place a piece of art on the
wall or under glass to be admired and valued for
its security and constant return”. This was the
“lend and hold model”.
` 1.2 “Originate and sell model”
1.Banks extended their activity beyond
conventional commercial banking into
merchant banking and insurance.
2.Within banking there was a gradual shift in
focus from generating income from net
interest margins to obtaining them in the form
of fees and commissions charged for various
financial services.
3. Banks adopted changes in the focus of banking
activity. While banks did provide credit and
create assets that provide a stream of income
in the future, they did not hold these assets
any more. Rather, they structured them into
pools securitised those pools, and sold these
securities for a fee to institutional investors
and portfolio management.
Banks transferred
the risk for a fee, and those who bought into
the risk looked to the returns, they would earn
in the long run. This was the “Originate and
sell” model. This “Originate and sell” model of
banking meant, in the words of Secretariat of
the Organization for Economic Cooperation and
Development, the banks were no longer
museum, but parking lots that served as
temporary holding spaces to bundle up assets
and sell them to investor looking for long term
investments.

1.3 Loop Holes


Financial liberalization increased the number of
layers in an increasingly universalized financial
system, with the extent of regulation varying
across the layers. In areas where regulation was
light ( investment banks, hedge funds and private
equity firms, for instance), financial companies
could borrow a huge amounts based on a small
amount of their own capital and undertake
leveraged investment to create complex products
that were often traded over the counter rather
than through exchanges. Finally, while the many
layers of the financial structure were seen as
independent and were differentially regulated
depending upon how and from whom they obtained
their capital ( such as small depositors, pension
funds or high net worth individual ), they were in
the final analysis integrated in ways that were not
always transparent.

1.4 Only way to survive


The household debt crisis erupted in the 1990s,
largely because of the stagnation in real wages
(more than a quarter of U.S. workers labour
for wages below the poverty line). As ordinary
people struggled to hold on to jobs, they turns to
the generous credit markets to pay off their
overpriced homes, their cars, their college tuitions
and their everyday expenses.
The Federal govt. kept interest rates very
low to enable the expansion of the debt, which was
one easy way to maintain the illusion of the
American dream as U.S. manufacturing
disappeared and pay packets in service jobs
shrank. The total consumer debt in the U.S. is now
about $2.6 trillion (22 % more than in 2000).
Mortgage debt is around $10.5 trillion (in 2000 it
was $4.8 trillion)
1.5. Steps that gradually lead to
failure
Banks that sold credit assets to investment banks,
and claimed to have transferred the risk, lent to or
invested in these investment banks in order to
earn higher returns from the less regulated
activities. Investment banks that sold derivative to
hedge fund served as prime brokers for these
funds and therefore provided them credit . Credit
risk transfer neither meant that the risk
disappeared nor that some segments were
absolved of exposure to such risk.
T
his complex structure, which delivered extremely
high profit to the financial sector, was prone to
failure and has been proved by the number of bank
failure in the U.S. after the 1980s.
The Saving and Loan (S & L) crisis
was precipitated by the financial behavior induced
by liberalization; and the collapse of long term
capital management pointed to the dangers of
leveraged speculation.
Each time a mini-crisis occurs, there are calls for a
reversal of liberalization and return to regulation.
But financial interest that had become extremely
powerful and had come to control the U.S. treasury
managed to stave, off criticism, stall any reversal
and even ensure further liberalization. The
financial sector had become to complex to be
regulated from outside; what was needed was self
regulation.
In the event, a less regulated more complex
financial structure then existed at the time of S & L
crisis was in place by the late 1990s.

2.How low banking rates leads to


economic collapse.
From late 2002 to mid 2005, the U.S. Federal
Reserves federal funds rate stood at levels, which
implied that, when adjusted for inflation, the
“real” interest rate was negative. Further, by the
middle of 2003, the federal fund ate has been
reduced to 1%, where it remained for more than a
year. Easy access to credit at low interest rates
triggered a housing boom, which in turn triggered
inflation in housing prices that encouraged more
housing investment. From 2001 to end 2007, the
real estate value of household and the corporate
sector is estimated to have increased by $14.5
trillion. Many believe that thw process would go
on.
Sensing an opportunity based on that
belief & the interest rate environment, the
financial system worked to expand the circle of
borrowers by including sub prime ones, or
borrowing with low credit ratings and high
probability of default. Mortgage brokers attracted
these clients by relaxing these income
documentation requirements or offering
sweeteners like lower interest rates for an initial
period. The share of such sub-prime loans in all
mortgage rose sharply, from 5% in 2001 to more
than 20% by 2007.
In the process,
demand rose stressing the prices, as a result
house prices began to rise. The interest cost in
general started rising making the borrowing costly.
As a result many borrowers started defaulting.

3.Spread of Crisis

However, the crisis began in June 2007 with the


advent of subprime market crisis hitting the US
market. This crisis became prominent in June
2007 when the two subprime mortgage hedge
funds managed by Bear Stearns collapsed
followed by three other funds managed by BNP
Paribas.
The financial dam burst on Sep 13,
2008. A flood of capital swept out of the stock
markets and went into govt backed bank
accounts, where they remain pooled up and
inert. For the month after Sep 13, the
topography of the wall street changed
radically.
Bear Stearns (founded in 1923) had
already collapsed in March and was acquired
by J.P.Morgan (Which later bought the ailing
bank Washington Mutual).Lehman Brothers
(founded in 1850) declared bankruptcy, and
was swepy up for a song by Babclay’s Bank .
Merlill Lynch (founded in 1914) folded
alongside Lehman, to be picked up by the Bank
ofAmerica. American International Group (AIG)
(founded in 1919), the world’s largest
insurance company went down the slope
towards bankruptcy but was saved at the
eleventh hour by an emergency infusion of $85
billion by the U.S.Govt, few weeks later, the
Federal Reserves provided an additional loans
of almost $38 billion just as reports emerged
that executives of the firm went off on a
corporate retreat that included golf and spa
treatment and cost $440,000.
Again later in july and august, govt
sponsored mortgage agencies Freddie Mac and
Fannie Mae (created in 1970 and 1968
respectively) faltered. Federal reserves
pumped in $200 billion to ease the credit
situation. Finally, in mid October, Wells Fargo
Bank absorbed Wachovia Bank (founded in
1879). Meanwhile, J.P.Morgan (founded in
1824) and Goldman Sachs (founded in 1869)
went from being investment bank holding
companies (with Mitsubhi taking a stake in
J.P.Morgan)
Turbulence on the stock market now
resulted in a downward slide for the Dow Jones
and, as a consequence, for the world’s stock
market. By Sep 18, sellers flocked to the pits,
asking for their money back, and put whatever
could be made liquid into the cash backed by
the governmental assurance. Credit markets
seized up, which threatened economic activity
outside stock exchanges, investment firms and
their computer networks. The pulse of
electricity now began to make inroads into the
confidence of those who hire and fire, who
makes and break.

4.Measures taken by U.S.

Treasury Secretary = Henry Paulson


Federal Reserve Chairman = Ben Bernanke
Chairperson of the Federal deposit insurance
carp = Sheila Bair

 J.P.Morgan chase was paid off to take over


Bear Stearns at a cheap price.
 Lehman was allowed to go.
 Fannie Mae and Freddie Mac were
nationalized.
 AIG was rescued with a huge infusion of
public funds, triggering allegation of
conflict of interest on the grounds that
this was an effort at protecting Goldman
Sachs that was substantially exposed to
the insurer (AIG)

But as a number of cases multiplied and


lack of a clear strategy become obvious,
the danger of the financial crisis
intensified. This was when the the first
signs recognition that there was a
problem of potential generalized
insolvency emerged. The first response
was TARP (Troubled asset relief
programme). Declaring that the system
was faced with financial collapse of a kind
that could drive the economy to recession,
the Treasury Secretary, backed by the
Chairman of the Federal Reserves,
badgered congress into authorizing a $700
billion bailout package, which was
primarily geared to buying into out the
near worthless or “impaired” mortgage
related assets rom financial institution, as
also any other assets from any other party
so as to “unclog” their balance sheets and
get credit moving. However, no one knew
the exact size of this toxic pool, and even
Paulson admitted that the figure he
choose was largely a guess. Asked what
he might do if this plan did not work,
Paulson responded “We have nothing
else”.
Paulson assumed as the credit
entered the system, normal economic
vibrancy would pick up. In other words,
the Bush team saw this as a solvency
crisis created by the bad loans made by
irresponsible bankers and not as a wider
problem of debt in American society.
This plan, too, did not clearly
recognize that generalized insolvency was
a potential problem. This was clear from
the fact that the bailout plan sought to
use market based methods to buy up
troubled assets. Since, the prevailing
market price of those assets was also
close to zero, this would imply that the
institutions selling those assets would
have to take large write downs onto their
balance sheets and reflect these losses.
This would undermine their viability and
result in failure unless they were
recapitalized with an infusion of new
funds.
No one knows the exact size of the
fictitious sector , but some estimate that
the credit default swap market alone is
about $62 trillion. The danger this poses
to the financial architecture is
considerable. This is particularly the case
as the major banks and investment houses
now consolidate into four companies
(J.P.Morgan, Citigroup, Bank of America,
and Wachovia Wells Fargo). The toxic
fictitious sector and equally unstable
consumer debt bubble are within the
balance sheet of these four entities.

5.Measure taken by other


economies.

The U.K., having experimented with liquidity


infusion and limited nationalization, went
beyond the Bush Administration. P.M. Gordon
Brown announced that his govt would resort to
“equity injection” to buy ordinary and
preferences share worth £37 billion in three of
the biggest bank of the Country : Royal Bank of
Scotland (RBS), Lloyds TSB, and HBOS.

 Gordon Brown was the first Western


Leader to announce virtual stake takeovers
of major banks.
The Decision to nationalize banks was forced
on the British government because facing the
banking system was not just one of inadequate
liquidity resulting from fears generated from
subprime crisis. Rather, credit market had frozen
because the entities that needed liquidity most
were those faced with a solvency problem created
by the huge volumes of the bad assets they carried
on their balance sheet. To lend to or buy into these
entities with small doses of money was to risk
losses and rendered these banks viable. So money
was hard to come by, this is disastrous for a bank
because rumors of its vulnerability trigger a run
that devastate its already damaged images.
What needs to be noted, however is
that nationalization Is not the end of the matter. In
addition British govt had chosen to guarantee all
bank deposits, independent of their size to prevent
a run. It has also decided to guarantee inter bank
borrowing to keep credit flowing as and when
needed. Once the U.K. decide to take this radical
and comprehensive route, others were quick to
read the writing on the wall. What followed was a
deluge. Germany with an estimated bill of €470
billion, France with €340 billion, and others govt
with large amounts, pitched in with plans to
recapitalize banks with equity injection, besides
guaranteeing deposits and inter bank lending.
U.S. too has decided to use $250 billion
of the bailout money to acquire a stake in a large
number of banks. Half of that money is to go to the
nine largest banks, such as Bank of America,
Citigroup, Wachovia and Morgan Stanley. The
minimum investment will be the equivalent of 1.1%
of risk weighted assets or $25 billion whichever is
lower.

6.Impact on India
Since Indian market is still in its nascent stage of
growth with relatively less exposure to
international credit market. Thus, the trade
analysis and the policymakers believe that the
financial crisis in the U.S. will have limited impact
on Indian Market.
The recent turnmoil in the financial
markets weakened dollar in terms of major
currencies. However, after the spread of the crisis
in other major capital markets, the dollar value
strengthened again.
Some of the leading banks of India those
invested abroad in debt and security markets will
be hit by the crisis. ICICI, HDFC (Companies whose
shares are listed in NASDAQ and NEW YORK Stock
Exchange.)
Some of the Indian companies that are
listed in the New York Stock Exchange are
Dr.Reddy’s Laboratories Limited, GenPact Ltd,
HDFC, ICICI, MTNL, Satyam, Sterlite Industries Ltd,
Wipro, WNS, Tata Communication Ltd, Tata Motors
Ltd.

7. Conclusion
Even if the banks are safe (though there is no
definite guarantee) there are many other
institutions, varying from hedge and mutual funds
to pension funds, that have suffered huge loses,
both from the subprime fiasco and the stock
market crash, eroding the wealth of many. Housing
prices are still falling. The effect of that wealth
erosion on investment and consumption demand
are only now unraveling, indicating that there is
much to be hold in this story. What may be
necessary is one step more the refinancing of
mortgages to stop the foreclosures that underline
the financial crisis.

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