U.S recession 2008 and its effect on Indian economy

9. 1 Sub-prime is a financial term that denotes financial institutions providing credit to borrowers
deemed sub-prime (sometimes referred as under-banked). Sub-prime borrowers have a
heightened perceived risk of default, those with a recorded bankruptcy or those with limited
debt experience. Sub-prime lending means extending credit to people who would otherwise
not have access to the credit market
Robert J. Shiller, The Subprime Solution, Princeton: Princeton University Press, 2008,
2 Securitisation is a structured finance process, which involves pooling and repackaging of
cash flow producing financial assets into securities that are then sold to investors. Securitisation
means turning something into a security. For example, taking the debt from a number of
mortgages and combining them to make a financial product which can then be traded. Banks
who buy these securities receive income when the original home-buyers make their mortgage
payments.

10. (iii) Excessive Leverage1
The final problem came from excessive leverage. Investors bought
mortgage-backed securities by borrowing. Some Wall Street Banks had
borrowed 40 times more than they were worth.17 In 1975, the Securities
Exchange Commission (SEC) established a net capital rule that required the
investment banks who traded securities for customers as well as their own
account, to limit their leverage to 12 times. However, in 2004 the Securities
and Exchange Commission (SEC) allowed the five largest investment banks
– Merrill Lynch, Bear Stearns, Lehman Brothers, Goldman Sachs and Morgan
Stanley – to more than double the leverage they were allowed to keep on
their balance sheets, i.e. to lower their capital adequacy requirements.
The Basel-II framework evolved by the Bank of International Settlements
(BIS) in 2006 sets a CRAR of 9 per cent for adoption by banking regulators
globally. However, at the end of the year 2007, the Federal National Mortgage
Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation
(Freddie Mac) had an effective leverage of an astounding 65 times and
79 times, respectively. And the leverage ratio for the big five investment
banks at 2007 year end was 27.8 times for Merrill Lynch, 30.7 times for Lehman
Bros., 32.8 times for Bear Stearns, 32.6 times for Morgan Stanley and
26.2 times for Goldman Sachs. These investment banks had become the
reference point of excessive leverage.

11. This was far too risky. The system went into reverse gear after the
middle of 2007. US housing prices fell at their fastest rate in 75 years.
Sub-prime borrowers started missing their payment schedules. The banks
and investment firms that had bought billion of dollars worth of securities
based on mortgages were in trouble. They were caught in a vicious circle of
credit derivative losses, accounting losses, rating downgrades, leverage
contraction, asset illiquidity and super distress sale of assets at below
fundamental prices causing another cascading and mounting cycle of losses,
further downgrades and acute credit contraction. Initially started as a liquidity
problem, it soon precipitated into a solvency problem, making them search for
capital that was not readily available. Bear Stearns was sold to the commercial
bank J.P. Morgan Chase in mid-March 2008; Lehman Bros filed for bankruptcy
in mid-September 2008; Merrill Lynch was sold to another commercial bank,
Bank of America and finally Morgan Stanley and Goldman Sachs signed a letter
of intent with US Federal Reserve on September 22, 2008 to convert themselves
into bank holding companies. The year 2008 will go as the worst year in the history
of modern finance wherein the sun of powerful and iconic Wall Street
investment banks set in.

12. 1Leverage means borrowing money to supplement
existing funds for investment in such a way
that the potential positive or negative outcome is
magnified and/or enhanced. It generally
refers to using borrowed funds, or debt, so as to
attempt to increase the returns to equity.

13. (iv) Misleading judgements of the Credit-
Rating Organisations-
The role of the Credit-Rating Organisations (CROs) in creating an
artificial sense of security through complex procedure of grading had
contributed to the financial mess. The giants of credit rating agencies like
Standard and Poor (S&P), Moody’s, Fitch had dominated the global ratings
market for a long time. They were the agencies which had been deemed by
the US capital markets regulator Securities and Exchange Commission (SEC)
as Nationally Recognized Statistical Rating Organisations (NRSRO). As
NRSROs, these CROs had a quasi regulatory role and were required to
disclose their methodologies. But, these credit rating agencies used poorly
tested statistical models and issued positive judgments about the underlying
loans. No safeguards were put in place for assembling an appropriate
information system to deal with the delinquencies and defaults that might
eventually arise.

14. (v) Mismatch between Financial
Innovation and Regulation
It is not surprising that governments everywhere seek to regulate financial
institutions to avoid crisis and to make sure a country’s financial system
efficiently promotes economic growth and opportunity. Striking a balance
between freedom and restraint is imperative. Financial innovation inevitably
exacerbates risks, while a tightly regulated financial system hampers growth.
When regulation is either too aggressive or too lax, it damages the very
institutions it is meant to protect.

15. (vi) Failure of Global Corporate Governance
One of the reasons for current crisis in the advanced industrial countries
related to the failures in corporate governance that led to non-transparent
incentive schemes that encouraged bad accounting practices. There is
inadequate representation and in some cases no representation of emerging
markets and less developed countries in the governance of the international
economic institutions and standard setting bodies, like the Basle Committee
on Banking Regulation. The international economic organization such as
IMF has been wedded to particular economic perspectives that paid little attention to the
inherent risks in the policies pursued by the developed
countries.

16. RESULTS

18. Layoffs & Job Cuts

20. Financial institution loss
Banks Loss Banks Loss
America Out of America
UBS AG $37.7 bln Deutsche Bank $11.2 bln
Citigroup $39.1 bln Mizuho Financial Group $5.5 bln
Merrill Lynch $29.1 bln Crédit Agricole $4.8 bln
Morgan Stanley $11.5 bln HSBC $17.2 bln
Freddie Mac $4.3 bln Royal Bank of Scotland $15.2 bln
Bank of America $7.95 bln Credit Suisse $9.0 bln
JP Morgan Chase $5.5 bln Swiss Re $2.04 bln
Lehman Brothers $3.93 bln LBBW $1.1 bln
CIBC $3.2 bln Société Générale $3.0 bln
Bear Stearns $2.6 bln BNP Paribas $0.870 bln
Washington Mutual $2.4 bln Barclays Capital $3.1 bln
Goldman Sachs $1.5 bln BayernLB $6.7 bln
American
International Group
$11.1 bln Commerzbank $1.1 bln

24.  Reducing dividend payouts to increase liquidity and further
 Selling record amounts of bonds and preferred stock to obtain cash in the
short-run
 Banks harden loans policy.
 Restrict loans conditions.
 Stopping subprime loans
 Improve supervision
What did Bank do?

27. Slowing GDP
In the past 5 years, the economy has grown at an average rate of 8-9 percent.
Services which contribute more than half of GDP have grown fastest along with
manufacturing which has also done well. But this impressive run of GDP ended in the first
quarter of 2008 and is gradually reduced as the economy was slowing.

28. The most immediate effect of that crisis on
India has been
an outflow of foreign institutional investment
from the equity
market. Foreign Institutional Investment
(FIIs), which need
to retrench assets in order to cover losses in
their home
countries and were seeking havens of
safety in an uncertain
environment, have become major sellers in
Indian markets.
As FIIs pull out their money from the stock
market, the large
corporate no doubt have affected, the worst
affected was
likely to be the exports and small and
marginal enterprises
that contribute significantly to employment
generation

29. Reduction in Import Export
Global recession affects the import export business severely. In New Delhi
area,
nearly 125 companies survey report shows that in Aug 08 to Oct 08 1792 cr.
Export
orders lost which resulting 65000 people lost their employment. This can be
elaborated
by the following table.

30. INDIAN STOCK MARKET

32. . Reduction in Employment
Employment is worst affected during any fiscal crisis, so is true with the current
global meltdown. This recession has adversely affected the service industry of India
mainly the BPO,KPO,IT companies etc. According to a sample survey by the commerce
ministry, 109,513 people lost their jobs between Aug 08 and Oct 08 in export related
companies in several sectors primarily textiles, leather, engineering, gems and jewellery,
handicraft and food processing.

33. Taxation
The economic slowdown has severely dented the Center's tax collection with
indirect taxes bearing the brunt. The tax-GDP rate registered a steady increase from
8.97 percent to 12.56 percent between 2000-01 and 2007-08. But this trend has been
reversed as the tax-GDP ratio has fallen to 10.95 percent during current fiscal year
mainly on account of reduction in customs and excise tax due to effect of economic
slowdown.
In comparison to the advanced market economies which are on the verge of
recession, the rapidly globalizing emerging economies have been far more resilient and
dynamic - India being one among them. In the post-reform period, India stands as an
economy that is rapidly - modernizing, globalizing and growing. India is poised as a fast
growing emerging market economy in the face of the current turmoil and pessimism. The
resilience shown by India comes from the strong macroeconomic fundamentals. India
has weathered the storms of the recent financial market crisis with great strength and
stability. India flouts a robust GDP growth rate of almost 9.0 percent in the midst of all
international economic mayhem. The household sector is coming to prominence with
impressive contribution in the national pool of savings. Rising investment levels and improved
productivity are the engines driving growth. Indians have witnessed a doubling of average
real per capita income growth during the tenth plan period.

34. HOW TO TACKLE RECESSION?

35. The following measures can be adopted to tackle
the recession:
1. Tax cuts are generally the first step any government takes during
slump.
2. Government should hike its spending to create more jobs and
boost the manufacturing sectors in the country.
3. Government should try to increase the export against the initial
export.
4. The way out for builders is to reduce the unrealistic prices of
property to bring back the buyers into the market. And thus
raise finances for the incomplete projects that they are
developing.
5. The falling rupees against the dollar will bring a boost in the
export industry. Though the buyers in the west might become
scarce.

36. 6. The oil prices decline will also have a positive impact on the
importers.
India has adopted certain measures to combat recession. Since
October, 2008 The Reserve Bank of India has cut the repo rate and
the CRR by 350 and 400 basis points respectively. The reverse repo
rate has been cut by 200 basis points over the same period. This in
turn has made credit cheaper and has increased the overall liquidity in
the system. Further, the PSU banks of the country have decreased
the home loan rates. This is expected to induce more buyers and
boost the real estate sector. In addition to this government has
proposed to cut service tax and excise duty on most goods.