With a common view “Financial Crisis” means, when there is a disturbance in the financial market because of constrained of flow of households and businesses and there has been an adverse effect to the goods and services of the economy. One thing is common in all crises: that “All Crisis are Crisis of Success”.
During the recession years, the mortgage brokers earned a huge profit in form of commission. They encouraged poor credit buyers to take-up housing mortgages with little or no advance money and without credit checks. This combination of low interest costs with large inflow of foreign funds helped the banks to create easy credit conditions for long time. On the assumption that there would be a rise in housing prices banks kept on lending money. Also, the real estate bubble encouraged the demand for houses as financial assets. Later on, Banks and financial institutions, sold these high-risk debts to world- wide investors creating financial instruments called Collateralized Debt Obligations[i]. In this manner the risk was passed on multifold derivatives trade.
There has been a decline in the interest rate of housing prices during 2006-07 because of surplus house inventory and increment in interest rate which ultimately led to increased defaults and many activities relating to housing collapsed. Therefore, an enormous number of properties were available to be purchased affecting mortgage companies, speculation firms and government supported enterprises which had put intensely in subprime mortgages. Since the distribution of collateral debt instruments worldwide, numerous banks and other monetary establishments all throughout the globe were affected. As on 17th July 2008, many banks and other monetary organizations all throughout the globe have reported losses of roughly US $ 435 billion. Hence, with the fall or failure of a few leading institutions in United States, the whole monetary system in the world has been affected.[ii]
Reasons for Financial Crisis
The reasons for the crisis are varied and complex. Some of them include boom in the housing market, speculation, high-risk mortgage loans and lending practices, securitization practices, inaccurate credit ratings and poor regulation.
1- Boom in the Housing Market: The main reason of this recession was subprime borrowing which led to an increase in house ownership rates and demand for housing. This made the public to spend more on housing price. With the increase in housing rate prices, there was a boom in surplus inventory of houses, which led to decline in housing prices. Many subprime borrowers were encouraged with the formula of easy credit and assuming that housing prices would continue to increase, obtained adjustable-rate mortgages which they couldn’t manage after the initial incentive period. Once there was a decline in housing prices, re-financing was troublesome as many owners were not able to re-finance their loans back[iii]. Excess supply of houses placed significant downward pressure on prices.
2- Speculation: During 2006, 22 per cent of houses purchased were for investment purposes with an addition to 14 per cent purchased as vacation homes. Speculators left the market in 2006, which caused investment sales to fall much faster than the primary market. Therefore, we can say that, speculation in real estate was a contributing factor.
3- High- Risk Mortgage Loans and Lending Practices: There were many factors which led lenders from offer higher-risk loans to higher-risk borrowers. High-risk borrowers, lenders have offered increasingly high-risk loan options and incentives. It is criticized that mortgage underwriting practices including automated loan approvals were not subjected to appropriate review and documentation.
4- Poor Regulation- This issue happened when the market segment was poorly regulated primarily in the U.S. This directly affected internal controls and the ineffectiveness of regulatory oversight in the context of a large volume of non-transparent assets.
Impact on India
The Indian economy too has felt the impact of the crisis though not to the same extent. It is premature to try to quantify the consequences of the crisis on the Indian economy. However, there were many sectors that were impacted badly.
1- Investment: The fall down in the U.S economy caused decrease in investment flow and as expected the capital inflows into the country will dry up. More funds were bought by infrastructure and other projects which were under implementation. There was no cheer-up in the Indian Economy. All sectors were in buoyancy. During that time investments in sectors such as tourism, hospitality and healthcare were slowed down.
2- Real Estate: The sector which got most affected was the real estate. The crisis hitted the Indian real estate sector much harder. The realty sector witnessed a sudden droop in demand because of the global economic slowdown. The global recession forced the real estate organisations to curtail their extension plans. Many on-going real estate projects in 2007-08 were suffered due to lack of capital, both from buyers and bankers. Few real estate agents had effectively defaulted in delivery dates and commitments[iv].
3- Increase in Unemployment: One danger is of a dip in the employment market. The global financial crisis increased the unemployment. Layoffs and wage cuts took place in many companies. As people lost their jobs, the gap between the rich and the poor widened.
4- Exports: The crisis contracted the demand for exports adversely affecting the country’s growth prospects. It had an impact on merchandise exports and service exports. The decline in export growth sharply affected some segments of the Indian Economy that are export oriented. The slowdown in the world economy had affected the garment industry[v]. The orders for factories which are dependent on exports, mainly to the U.S have come down following deferred buying by big apparel brands.
Great investment funds propensity among individuals, strong fundamentals, strong conservative and administrative system have saved Indian economy from going out of gear, though certain parts of the economy were affected and have slowed down. The most important lesson that we must learn from the crisis is that we must be self-reliant. Though World Trade Organization (WTO) propagates free trade, we must adopt protectionist measures in certain sectors of the economy so that recession in any part of the globe does not affect our country.
[i] Venkitaramanan S 2008. Global financial crisis: reflections on its impact on India. The Hindu, Daily, October10, 2008, P. 11.
[ii] A. Prasad and C. Panduranga Reddy, Global Financial Crisis and Its Impact on India, J Soc Sci, 21(1): 1-5 (2009)
[iii] Sadhu Naveen 2008. Global financial crisis: The Story so far. (September 21, 2008)
[iv] Chandrasekhar CP, Ghosh Jayanthi 2008. India and the Global Financial Crisis. (October 8, 2008).
[v] Atreya Manohar M 2008. The U.S Financial Crisis: Impact on the Indian IT Sector. (December 29, 2008).
Authored by: Vrinda Mittal
Vrinda is currently pursuing BBA LLB from Symbiosis International University. She is a diligent and thorough Legal Researcher.