The roots of the current crisis could be traced back to the slowdown experienced by the US economy in the earlier part of the decade. The US central bank decreased the interest rates to historically low levels to stimulate the slowing economy. Banks flush with excess funds, encouraged people with weaker credit histories to avail mortgage loans to purchase houses. These loans were often with a very low or no initial down-payment, low initial interest rates and higher rates or floating interest rates in the later years. Some of them were even negatively amortizing loans with higher payments scheduled in later years. This led to a rapid growth in the demand for new houses and sharp appreciation in the values of the houses. Taking advantage of these low interest rates and rising property values, US consumers borrowed heavily against their houses, and led a private consumption boom based economic revival.
The banks disbursing the housing loans lowered their due-diligence standards for the loan seekers, as they were not keeping these loans on their own books, and were securitizing them into independent investment vehicles or buying credit default swaps. These helped them in lowering their regulatory capital requirements, and still earn fee based incomes for loan origination, becoming brokers than custodians for these loans. The investment bankers were setting up investment pools, and issuing multiple types of securities against them. These securities were provided with a cushion of investment grade rating by the rating agencies to enable a wider clientele for these securities. These securities were purchased by various pension plans and insurance companies for long term investments. Thus in the process the riskiest assets became the safest assets to own in the market.
In order to earn higher returns, the investment banks themselves became highly leveraged with debt equity ratios reaching 30:1 and capital adequacy dipping to 3%. Any sudden adverse movement in the market could wipe out their entire capital and force them into receivership. Another key factor was the creation and issuance of newer types of derivative products like credit default swaps. These products were priced based on the mathematical models created, than the market forces, leading to imperfect pricing of these products.
With the rise in the interest rates in the US markets in 2006, the weaker home loan borrowers began to delay and default on the monthly payments. Also the borrowing against rising home values became expensive. This put a brake on further appreciation of the home values. This led to home owners reaching their maximum credit limits on their existing homes. The private consumption led boom could no longer sustained by economy due to sharp drop in available credit to consumers and decline in disposable incomes. The housing markets began to decline, leading to increased demand for additional payments and collateral. The weaker borrowers began to default on their payments leading to bargain sales of their homes, further depressing the prices of houses, going into a vicious circle of lowered house prices and further defaults in payments. This rapid default in home loan payments resulted in wiping out of the banks asset base and heavy losses for the mortgage backed securities investors. Further the markets were unable to value the complex derivative products leading to a complete drying up of liquidity for these products. This led to a liquidity crisis for the market players. But it is more a crisis of confidence in counter party that is leading to a crisis of liquidity.
Several iconic financial industry players have been wiped out (Lehman), nationalized (Freddie Mac, AIG), merged (Merrill Lynch), change business model (Goldman Sachs), recapitalized (Citigroup), and restructured (UBS). The sovereign wealth funds and Asian financial institutions which are relatively insulated from credit crisis are likely to cherry pick the assets of the failed and stressed US and European financial institutions, leading to emergence of Asian financial giants. The US economy is likely to enter into low growth or no growth phase with decline in private consumption and restricted availability of credit.
In Indian context the bull market in stocks which started in 2003, reaching its peak valuation in January in 2008 (PE of 28) has come to more modest levels now. The Indian real estate is also expected to decline in next 12 to 18 months, becoming more affordable. The prices of food commodities, metal commodities, energy (crude oil) has declined from their peaks, and will result in lower inflation, in turn lower interest rates in future. This is expected to revival in the manufacturing sector. The Indian stand on tight regulation of the financial sector and gradual introduction of reforms has been vindicated again by the credit crisis.
October 23, 2008 at 6:54 am |
[...] Source:A short history of the recent financial crisis [...]