Tuesday, October 28, 2008

The global financial crisis explained.

'Global Credit Crunch', 'Global Economic Turmoil', 'Global Meltdown' are some of the most widely used terms now-a-days to reflect the current economic situation worldwide. So how did this crisis evolve? Who is responsible for this mess? Why has it effected the entire world and finally Who is going to ultimately pay for this? are some of the questions that I am hoping to answer in this post.

Before getting there, let me explain how any 'traditional' bank in India works. Banks like companies strive towards earning profit. Home loans sector is one of key contributors to its profits. An aspiring home owner goes to a bank for a home loan. The bank verifies his credit history and on being satisfied that the customer would be able to repay the loan, issues the home loan. The borrower(home owner) starts paying monthly interest on the principal he owes to the bank. To ensure that the borrower pays interest on a regular basis, the banks take the house as mortgage i.e., if the borrower is unable to pay the interest on a regular basis, the bank has the right to auction the house and retrieve the principal. In India, this is where the story stops. However in countries like the USA, the banks go a step further and sell all these mortgages to third party institutions such as the now infamous Lehman Brothers. There third party institutions, then convert these mortgages into financial products and sell them to investors on the Wall Street. This process is called securitization. Thus, a link is established between home loan and the Wall Street. Now what happens if a lot of home owners default on their home loans? This is precisely what happened in the USA. The banks lent money to a lot of people whose credit history was not good at higher interest rates(aka sub-prime lending). They banked on the rising real estate prices to secure their loans via mortgage. But when a lot of customers began defaulting, the bubble burst. Real estate prices plummeted and everyone from banks to the financial markets got effected.

The banks ran out of the cash as they were unable to retrieve their loans, either from the customer or from auctioning the mortgages(houses). There was a liquidity crunch. Banks also stopped lending to other banks over fears that the other banks might fail. So, a vicious cycle started. Now, we should remind ourselves that availability of credit is the key for the growth of any economy. For example, entrepreneurs need credit to start/run companies. When there is a credit crunch, the whole economy is effected and if that economy is US, then the whole world is effected as most countries rely on exports to the US. For example, the software, BPO service sectors in India are heavily dependent on the US for their survival or profits. If these are effected then the jobs of many young Indians are effected. As Indians begin to spend less and less owing to such fears, the Indian economy is effected. So is the case with China which exports most of the manufactured goods to US and EU.

Why did banks resort to sub-prime lending? As explained, one of the reasons was that they assumed that even if some customers default on the loans, they will be able to retrieve the principal by selling their mortgages. This assumption was fine as long as the real estate market was up. But as the market slowed down, it started hurting the balance sheets of the bank. One should also blame the Fed for not installing proper regulatory measures to arrest this whole process. All in all, it was a collective miscalculation on the part of banks, investment banks (those third party ones) and the US Fed (regulatory authority) that led to this crisis which is threatening the world in many ways.

So, what is the way out? Last month, most of the governments in Europe and the US have decided to directly pump money into the banks to ease the crunch. Will it work? Only time will tell because at present, there is a complete lack of confidence in the financial world. No one is sure if the money they lend is ever going to come back to them, let alone the profits. Even if the governments provide them cash, they may not be ready to lend. This crisis is also a crisis of confidence. In my opinion, it will take at least 18 months to gain back the confidence and for everything to fall in place. Until then, the markets will be volatile and people will spend nights in fear of losing their jobs and dreams.