Credit Crisis
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ANATOMY OF GLOBAL CREDIT CRISIS
Team Members: Chandan Gundala Ramana Reddy Shair Mohamed Khan Afridi Midhat Zahra
WHAT IS CREDIT CRUNCH? A
credit crunch is a sudden reduction in the general availability of loans (or credit), or a sudden increase in the cost of obtaining loans from banks.
REASONS FOR CREDIT CRUNCH
Due to decline in value of the collateral used by the banks when issuing loans, or even an increased perception of risk regarding the solvency of other banks within the banking system. Due to a change in monetary conditions (for example, where the central bank suddenly and unexpectedly raises interest rates or reserve requirements). Due to the central government imposing direct credit controls.
EFFECT OF CREDIT CRISIS ON INDIA
The bull run in India was backed by excess FII liquidity. Considering the worsening situation in US/Europe, this liquidity will dry up.
Indian banks with exposure to US/Europe markets with derivative positions will be forced to book MTM losses. ICICI Bank is one such example. It will definitely impact them.
FDI will slow down. India is dependent on FDI to grow faster.
The falling out of global majors affect Indian IT and ITES industry as definitely 40-50 per cent of India's revenues for IT sector comes in from Foreign sector and Banking and eventually it will trigger slow down of Indian economy too. Due to the worsening situation in the West, FIIs are selling across the world to balance their positions and pay for redemptions. India doesn’t want to allow money to move out. Depreciating the rupee would give lesser dollars as and when they want to exit.
QUESTIONS THAT NEED TO BE ADDRESSED
But don’t investment banks play advisory role?
They do, but slowly over the years, their prop books have multiplied. Investment banks also organize big loans for their clients for funding acquisitions. At times, investment banks take positions, only to palm off the securities to other clients and banks. In a crisis, they may not get the opportunity to down-sell such positions. This adds to the panic.
Can’t central banks step in to stem the crisis?
It’s precisely to discourage banks and bond houses from selling securities to generate liquidity, Fed has relaxed the rules under which it lends to institutions against securities. Moreover, if there’s a financial chaos of this magnitude, banks refrain from lending each other, fearing that the money would get stuck. A liquidity window from the central bank thus comes handy.
How does the domino effect play out?
Suppose Lehman faces a redemption and has to repay another bank it has borrowed from. If it sells the mortgage-backed bonds, whose prices have fallen, it will not raise as much as was earlier expected. So, it sells some of the other good assets or bonds which may have nothing to do with mortgages. But since the bank starts dumping these assets, prices of these bonds also dip.
How does it impact the balance-sheet?
Herein lies the strange accounting of bonds and derivatives like mortgage-backed securities. All banks are required to mark-to-market (MTM) their investments. So, if the price of an instrument falls, the difference between the price at which it was bought and the current market price has to be provided — meaning, it has to be deducted from the earnings. So, a drop in price leads to the MTM loss. But there’s a bigger problem which really has deepened the crisis. An MTM loss can be provided only if there’s a ‘market’. How do you provide when there is no market?
LEHMAN BROTHERS
America's fourth-largest investment bank Lehman Brothers Holdings Inc filed the biggest bankruptcy petition known to mankind. Lehman Bros, which till June 2008 had not reported a quarterly loss even once. The collapse of the giant investment bank came as a major shock for the entire world markets that plunged after Lehman filed a Chapter 11 petition with US Bankruptcy Court in Manhattan.
Why did Lehman Brothers go bankrupt?
The giant investment bank succumbed to the subprime mortgage crisis that has rocked the United States and the global economy. Lehman was strangled by a massive credit crisis and fast plummeting real estate prices.
The gargantuan $60 billion loss in bad real estate loans forced the bank to file for bankruptcy.
Refusal of other banks to do business with it because of its complex and, at times, opaque ways of trading.
Housing loans made by the bank to people with little support made these loans very risky, and when interest rates rose, these borrowers could no more repay Lehman. Thus other banks stopped trading with Lehman. This led to it losing almost all business and triggered its fall.
The final straw for Lehman was the fact that both Barclays Plc of the United Kingdom and Bank of America Corp pulled out of takeover talks.
CONCLUSIONS
The ongoing financial sector crisis in the United States and its repercussions on developed markets worldwide will result in lower capital inflows into emerging markets like India, economists and government officials. IT firms to sign any significant contracts in the banking, financial services and insurance (BFSI) space in the months to come. Huge layoffs in IT and ITES sector both in USA and INDIA.
Team Members: Chandan Gundala Ramana Reddy Shair Mohamed Khan Afridi Midhat Zahra
WHAT IS CREDIT CRUNCH? A
credit crunch is a sudden reduction in the general availability of loans (or credit), or a sudden increase in the cost of obtaining loans from banks.
REASONS FOR CREDIT CRUNCH
Due to decline in value of the collateral used by the banks when issuing loans, or even an increased perception of risk regarding the solvency of other banks within the banking system. Due to a change in monetary conditions (for example, where the central bank suddenly and unexpectedly raises interest rates or reserve requirements). Due to the central government imposing direct credit controls.
EFFECT OF CREDIT CRISIS ON INDIA
The bull run in India was backed by excess FII liquidity. Considering the worsening situation in US/Europe, this liquidity will dry up.
Indian banks with exposure to US/Europe markets with derivative positions will be forced to book MTM losses. ICICI Bank is one such example. It will definitely impact them.
FDI will slow down. India is dependent on FDI to grow faster.
The falling out of global majors affect Indian IT and ITES industry as definitely 40-50 per cent of India's revenues for IT sector comes in from Foreign sector and Banking and eventually it will trigger slow down of Indian economy too. Due to the worsening situation in the West, FIIs are selling across the world to balance their positions and pay for redemptions. India doesn’t want to allow money to move out. Depreciating the rupee would give lesser dollars as and when they want to exit.
QUESTIONS THAT NEED TO BE ADDRESSED
But don’t investment banks play advisory role?
They do, but slowly over the years, their prop books have multiplied. Investment banks also organize big loans for their clients for funding acquisitions. At times, investment banks take positions, only to palm off the securities to other clients and banks. In a crisis, they may not get the opportunity to down-sell such positions. This adds to the panic.
Can’t central banks step in to stem the crisis?
It’s precisely to discourage banks and bond houses from selling securities to generate liquidity, Fed has relaxed the rules under which it lends to institutions against securities. Moreover, if there’s a financial chaos of this magnitude, banks refrain from lending each other, fearing that the money would get stuck. A liquidity window from the central bank thus comes handy.
How does the domino effect play out?
Suppose Lehman faces a redemption and has to repay another bank it has borrowed from. If it sells the mortgage-backed bonds, whose prices have fallen, it will not raise as much as was earlier expected. So, it sells some of the other good assets or bonds which may have nothing to do with mortgages. But since the bank starts dumping these assets, prices of these bonds also dip.
How does it impact the balance-sheet?
Herein lies the strange accounting of bonds and derivatives like mortgage-backed securities. All banks are required to mark-to-market (MTM) their investments. So, if the price of an instrument falls, the difference between the price at which it was bought and the current market price has to be provided — meaning, it has to be deducted from the earnings. So, a drop in price leads to the MTM loss. But there’s a bigger problem which really has deepened the crisis. An MTM loss can be provided only if there’s a ‘market’. How do you provide when there is no market?
LEHMAN BROTHERS
America's fourth-largest investment bank Lehman Brothers Holdings Inc filed the biggest bankruptcy petition known to mankind. Lehman Bros, which till June 2008 had not reported a quarterly loss even once. The collapse of the giant investment bank came as a major shock for the entire world markets that plunged after Lehman filed a Chapter 11 petition with US Bankruptcy Court in Manhattan.
Why did Lehman Brothers go bankrupt?
The giant investment bank succumbed to the subprime mortgage crisis that has rocked the United States and the global economy. Lehman was strangled by a massive credit crisis and fast plummeting real estate prices.
The gargantuan $60 billion loss in bad real estate loans forced the bank to file for bankruptcy.
Refusal of other banks to do business with it because of its complex and, at times, opaque ways of trading.
Housing loans made by the bank to people with little support made these loans very risky, and when interest rates rose, these borrowers could no more repay Lehman. Thus other banks stopped trading with Lehman. This led to it losing almost all business and triggered its fall.
The final straw for Lehman was the fact that both Barclays Plc of the United Kingdom and Bank of America Corp pulled out of takeover talks.
CONCLUSIONS
The ongoing financial sector crisis in the United States and its repercussions on developed markets worldwide will result in lower capital inflows into emerging markets like India, economists and government officials. IT firms to sign any significant contracts in the banking, financial services and insurance (BFSI) space in the months to come. Huge layoffs in IT and ITES sector both in USA and INDIA.
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