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GLOBAL PERSPECTIVE The CredIT CrIsIs of 2008: CAuses, ConsequenCes And ImplICATIons for IndIA The ripple effects of global credit crisis has hit world economy hard, triggering global recession. India is no exception to the woes of this financial meltdown as it has led to some credit squeeze and erosion of huge amounts of investor wealth. It, however, is in far more comfortable position than many other nations. This scenario offers an opportunity to India to learn from America’s mistakes and take corrective, preventive measures. This article discusses the causes and consequences of the crisis, its impact on India and the lessons that need to be learnt by the country. To understand the genesis of the current financial meltdown we need to start with the US housing market, a $22.5 trillion major economic driver larger in size than the US stock market. The US housing market witnessed an unprecedented run-up in prices from the mid 1990s until it peaked in mid 2006. 1 Between 1997 and 2006, home prices increased by nearly 85% overall 2 with a per year compound rate of 12% between 2000 – Professor V.G. Narayanan* and Lisa Brem** (*The author is faculty of Harvard Business School. **The author is Research Associate at Harvard Business School. They can be reached at vnarayanan@ hbs.edu) and 2005. 3 Ratios of home prices to household incomes were at an all time high and appeared unsustainable. Low interest rates made borrowing money cheap and fueled the rise in home prices. Low inflation, in turn, kept interest rates down during this period, and low unemployment allowed people to feel comfortable taking on more debt. Easy access to cheap credit during a period of very high appreciation in real estate prices meant that builders and real estate speculators made healthy profits. As a re- 1 Standard Standard & Poors, Case Shiller Index Website, http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_csmahp/0,0,0,0,0,0,0,0,0,2,1,0,0,0, 0,0.html, excel file dated August 2008, accessed November 12, 2008. 2 Report and Recommendations by the Majority Staff of the Joint Economic Committee, “The Subprime Lending Crisis,” October 2007, pp. 2 and 3. 3 Ken Leon, “Industry Surveys Home Building,” Standard & Poors. July 3, 2008, p. 9. THE CHARTERED ACCOUNTANT 1007 DECEMBER 2008
DECEMBER 2008 1008 THE CHARTERED ACCOUNTANT GLOBAL PERSPECTIVE It took nearly a year of falling home prices and subsequent mortgage defaults to leak into the larger economy. Lenders with a significant sub-prime loan portfolio were affected first. $56 billion New Century Financial Corporation, one of the largest subprime lenders in the United States, was one of the first banks to fail. Over 150 prime and subprime lenders also failed in 2007. sult, they continued to build, leading to an oversupply of homes. Building of single family homes peaked in 2005, with 1.7 million single family housing starts that year. 4 Renters saw the amazing appreciation on their neighbor’s houses and decided to take the plunge. Home owners, buoyed by the profit they made on their primary homes, bought second homes and vacation homes in large numbers; 12% of all homes purchased in 2007 were vacation homes and 21% were purchased for investment. 5 Rather than opting for the traditional fixed-rate mortgage, home buyers took on risky adjustable rate mortgages, where the interest rate they paid fell or rose with the interest rate in the economy. Homeowners refinanced their mortgages within a few months of purchase at lower interest rates, and continued to refinance, cashing in the equity that had appreciated on their homes to pay the mortgage or for discretionary spending. The spiral of rising home prices led to increased borrowings that then allowed home owners to spend and consume more than was sustainable, but this underlying weakness was masked as long as home prices appreciated and interest rates stayed low. Refinancing accounted for 66% of the $3.8 trillion in mortgage originations in 2003, and continued to remain high through 2007, at 52% of the $2.4 trillion originations that year. 6 Looking back at that period and the number of refinance and easy credit advertisements that proliferated at the time, it is obvious that the United States was in a massive housing bubble. Unfortunately, it is the hallmark of all epic bubbles that few realize they are in one until it is too late. The rise of subprime The idea that housing prices would only appreciate caused US banks and mortgage companies to loosen their credit standards and start lending to families with no credit history and only tenuous ability to service their mortgages. Subprime lending, which in the US context meant lending to homeowners with less than stellar credit histories, grew rapidly during the housing bubble and more than tripled from $190 billion in 2001 to $625 billion in 2005. 7 The US Government actively encouraged banks to lend to low income families with the belief that home investment in poor and urban neighborhoods would strengthen weak economies in those areas. Mortgage brokers, many of whom were paid on volume of loans originated rather than on the quality of those loans, sold adjustable rate mortgages to people who did not have the ability to sustain them. The first death knell for subprime mortgage holders was the increase in oil and commodity prices, which pushed up inflation and the all-important interest rates. In 2006, when the housing bubble burst and home prices stopped their steep ascent and interest rates rose simultaneously, the game was up for many subprime borrowers. Unable to meet higher payments (in some cases a 30% increase in their monthly payment) when their mortgages reset to the higher interest rates, subprime borrowers began defaulting on their mortgages in large numbers. In cases where the home prices dropped, some owed more money than they could obtain from the sale of the house. In these cases, home owners walked away from their debt, leaving the deed to the house with the bank or mortgage company. The US government estimated that starting in March 2007, three million subprime and nonprime mortgages worth $600 billion would reset their interest rates higher by 2010. It conservatively estimated that 2.2 million loans (worth $164 billion) would foreclose. 8 By October 2007 home builders’ expectations for the housing market had reached historic lows. 9 By some estimates, the total loss in real estate values since 2006 have exceeded $5 trillion. Housing bubbles and aggressive lending by financial institutions, followed by increasing interest rates and defaults by borrowers has happened before in the United States, most recently during the Savings and Loan crisis in the mid 1980s. What makes the current crisis unique is its severity and global reach. The 4 Ibid., p. 4. 5 Reuters, “Second-Home Sales Accounted for One Third of Transactions in 2007,” March 28, 2008, http://www.reuters.com/article/pressRelease/idUS145670+28-Mar- 2008+PRN20080328, accessed November 12, 2008. 6 Kevin Cole, “Industry Surveys, Savings & Loans,” Standard & Poors, July 24, 2008, p.2. 7 “The Subprime Lending Crisis,” p. 10. 8 Ibid., p. 7. 9 Ibid., p. 5.
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