The global credit crisis that started in the US in 2008 and spiraled to each and every corner of the world also had its share of impact on India. The impact on India was not great at that time because India opened its doors to the global economy pretty late and hence was cushioned from major impact.
You may ask why I am raking up an eight-year old history today. It is because in the last decade India has taken several steps to be one among the more active players in the global economy. In view of this, it is feared that if there is a repeat India may not be that lucky the second time.
It is therefore necessary to understand well what exactly happened in the US back in 2008.
What exactly is the credit crisis?
Credit crisis can be defines as a global crisis or rather a worldwide fiasco involving aspects like:
- Sub-prime mortgages
- Collateralized Debt obligations
- Frozen Credit Markets
- Credit Default Swaps
The above terms might look confusing right now, but the important question is, who was affected in it? Bankers? Common people? The answer unfortunately is – Everyone!
How did the Credit Crisis happen?
If we take two groups of people, home owners and their investors, the first group represents their mortgages, while the latter group represents their money. Again, the mortgages represent houses, while the money represents large intuitions such as insurance companies, mutual funds, and the like. So what makes these two groups come together? The financial system. And this financial system, i.e. the banks and the brokers, are commonly known as ‘Wall Street’.
Earlier, the investors sat on a pile of money and looked out for a good investment. Traditionally they went to the US Federal Reserve and bought treasury bills, believed then to be the safest investments. But in the wake of the dot com bust and the 11th September attacks, the then Federal Reserve Chairman lowered interest rates to only 1% to keep the economy strong. Since 1% was extremely low, investors backed out from buying treasury bills. On the other side, banks could now borrow from the Federal Reserve for just 1%. This basically made borrowing easier for banks as there was abundance of cheap credit. As a result banks went crazy with Leverage.
What exactly is Leverage?
Leverage refers to borrowing money to amplify the outcome of a deal. This is one of the major ways in which banks make money. Leverage can be easily understood from this basic example:
Case A: Mr. A has Rs. 10,000 and with it he buys a box. He then sells the box at Rs. 11,000. He makes Rs. 1000 profit. A good deal!
Case B: Mr A has the same Rs. 10,000. With that he goes and gets Rs. 9, 90,000 more. So now he has Rs. 10, 00,000 in his hand. With this he buys 100 boxes and sells them at Rs. 11, 00,000. From this money, he pays back Rs. 9, 90,000 + Rs. 10,000 interest. So leaving his initial Rs. 10,000, he makes Rs. 90,000 profit. A great deal!
So leverage turns good deals to great deals. Wall Street took out a ton of credit, made great deals and grew tremendously rich. The investors saw this and also wanted to be part of the action. So Wall Street came up with the idea to connect the investors to the home owners through mortgages.
How did this work?
A family who wanted a house, saved for the down payment, contacted a mortgage broker, who in turn connected to a Mortgage Lender who gave them a mortgage. So the family bought a house, the broker earned a good commission. Win-win situation for all.
Gradually Investment bankers also started buying mortgages from the lenders at a good price. So the investment bankers bought millions of such mortgages which paid them millions of mortgage amounts every month. These accumulated mortgages were called Collaterized Debt obligation (CDO). A CDO basically had three parts to it- the safe, okay and risky parts to put it simply. When money came in, it filled the safe part first, cascaded to the okay portion and lastly into the risky portion.
This basically meant that if a homeowner was to default, less money would flow in and the risky portion might not get filled. To compensate this, the risky portion was offered at a higher return and the safe portion, at a lower return. To make the safe portion all the more safer, banks insured it with a small fee which was called the credit default swap. The banks did all this so that the credit rating agencies ranked the safe portion as safe AAA investments, the okay portion as BBB and didn’t rate the risky portion of it. Now, due to the AAA rating, the investment bankers could sell this to the investors who were only looking for safe investments to begin with. The okay portion was sold to other bankers and the risky portion to hedge funds and other risk takers. So the investment banker made millions, repaid his loans and the investors found a good mode of investment much better than the 1% treasury bills. Again, a win-win situation for all.
Since investors were so pleased, gradually they started wanting more CDO slices. So there was a pressure on the entire chain to find more home owners. But they were no more to be found. Everyone who qualified for a mortgage, already had a house by then. So now they had another idea. They made the rule that incase homeowners default, the lender would be the owner of the house. This would work since property prices were forever going up, so there was nothing to lose for the lenders. So lenders started adding risk to new mortgages, such as – no down payment, no proof of income and no documents at all. So instead of lending to responsible home owners, or the Prime mortgages, they started lending to the not-so-responsible home owners, or the sub-prime mortgages. And this was the turning point!
When the defaults started happening first, it was foreclosure for the lender which essentially meant that one of his avenues of money suddenly turned into a house. At first there was no problem. When this happened, the lender just put it up for sale. But when more and more defaults started happening, the money generating avenues all started turning into physical houses. In no time, there were suddenly too many houses, more supply than demand, causing the cost of houses to fall. This created a problem with the home owners still paying their mortgages. As all the houses in his/her neighborhood went up for sale, value of his house fell and they start wondering why they were paying such high mortgages and they simply walk out of their houses. In this way housing prices plummeted throughout the country and for the investment bankers there was a huge accumulation of worthless houses. They could not sell their CDOs to investors anymore, neither could they sell the houses to anyone. Investors had also bought thousand of these seemingly time bombs. Lenders could not sell their mortgages anymore since the banker could not buy and brokers were anyways out of work. The entire financial system got frozen. And then the system collapsed. Everyone started going bankrupt. Lastly, the investors called up these very home owners and informed them that their investments have become worthless. And in this way, the crisis flew in a circle – the global credit crisis.
Impact on India
With the entire world getting affected with the global financial crisis, India’s growth rate declined too, especially because its export market took a hit.
With the outflow of FIIs, India’s rupee depreciated by approximately 20 percent. However, India survived the crash. It did not affect India as it affected other parts of the world. The three main reasons were:
- Disconnect with the Global Economy: It was not too much connected to it to bear the major blunt.
- Less dependency on housing sector: Unlike US, Japan and Europe, private has never been a main part of the domestic economy of India.
- Strong Financial System: A highly regulated and conservative financial system did not allow banks to take deposits to enter into speculative activities and buy mortgaged back securities like other banks throughout the word.