Powerful financial institutions going down one after another in the world's most powerful and economically strong country ?The United States of America?. How did all this happen? Did it all come down without any warning? Can this happen to India's financial institutions ever? What will be the effect of the ongoing financial crisis in India? These are some of the questions that need to be answered for the common man.



This crisis was started with what is called the ?sub-prime? crisis. This happens when the sub-prime borrowers that are the borrowers with a poor credit history start defaulting. The sub-prime borrowers have a poor track record of repaying loans. In many cases it is the poor and young those form the sub-prime borrowers. There was a real estate boom in the

USA from the year 1997. This encouraged banks to give loans to almost everybody, the prime and sub-prime borrowers. Also the government encouraged banks to give loans to the

poor and the young in a bid to help them. Because of the real estate boom the prices of houses more than doubled during

this period. Hence banks also found it safe to give loans against these houses (mortgaged loans). The boom subsequently led to a massive increase in the supply of houses which led to a fall in the real estate prices. This led to defaulting by the sub-prime borrowers who were not willing to pay for houses that began to decline in value. Since the risk of default on sub-prime loans was higher, the interest rate charged on sub-prime loans was about two percentage points higher than the interest on prime loans. The higher interest rate additionally meant substantially higher EMIs than for prime borrowers, further raising the risk of default.

The two reasons stated above, the declining value of the house and the higher interest rate charged led to massive defaulting by the borrowers.

Defaults and foreclosure activity increased dramatically, as easy initial terms expired, home prices failed to go up as

anticipated, and ARM (adjustable rate mortgage) interest rates reset higher. Foreclosures accelerated in the United States in late 2006 and triggered a global financial crisis through 2007 and 2008. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006. The mortgage lenders that retained credit

risk (the risk of payment default) were the first to be affected, as borrowers became unable or unwilling to make payments. Major banks and other financial institutions around the world have reported losses of approximately US$435 billion as of 17 July 2008.

Global banks and brokerages have had to write off an estimated $512 billion in sub-prime losses so far, with the largest hits taken by Citigroup ($55.1 bn) and Merrill Lynch ($52.2 bn). A little more than half of these losses, or $260 bn, have been suffered by US-based firms, $227 billion by European firms and a relatively modest $24 bn by Asian ones.

This crisis saw the major financial institutions in the US in the red. Some of them either filed for bankruptcy or were bought over by other institutions. Below are a few of the shockers that were witnessed:

Bear Sterns, one of the world's largest investment banks and securities trading firm was bought out by JP Morgan Chase with some help from the Fed. The crisis has also seen Lehman Brothers - the fourth largest investment bank in the US - file

for bankruptcy. Merrill Lynch has been bought out by Bank of America. Freddie Mac and Fannie Mae have effectively been nationalised to prevent them from going under. Reports suggest that insurance major AIG (American Insurance Group) is also under severe pressure and has asked for a $40 bn bridge loan to tide over the crisis. If AIG also collapses, that would really test the entire financial sector.

The rippling effects in India

The crisis could impact the availability of credit for the common man thus making loans more expensive, some suggest that it could be even heading towards the 16% mark.

Those intending to raise capital from the stock market will find it difficult in the wake of the FII pull out as capital will become more expensive. Also it will become difficult for domestic companies to garner overseas funds in adequate amounts.

This will see a dip in the employment market. Many IT companies and financial institutions are already downsizing to cut costs.

Private sector banks have invested in Lehman's security bonds for example ICICI Bank has invested to the tune of

$80 mn, SBI $55 mn, PNB $5mn to a few. These banks will feel the impact and profitability will take a hit.

Effect may also be seen in the real estate and infrastructure projects. Lehman Brothers and Meryill Lynch have invested through FDI in many such projects in India. Hence those projects that have received payments for this year are safe but those that are yet to receive the promised amount have their future hanging.

The positive side

Some Indian professionals may loose jobs but this phenomenon is shortlived as talent becomes available to go to places where it is scarce.

Global recession may not affect the Outsourcing business in india as foreign clients will be looking for more cheaper alternatives.

In conclusion:

India is a country with a population of over 1-2 billion hence it is consumer driven leading to huge domestic consumption base never letting demand die. Also now lakhs of central government employees will be have a surplus of cash in hand due the arrears they would receive owing to the sixth pay commission recommendations. They will look for investment opportunities in order to save tax. That will see a rise in demand for real estate besides other areas of investment including the stock markets. With the GDP hovering around 7-8 % it is a golden opportunity for India to show the world our economy is strong and we have the potential and the backup to stand up despite hiccups.