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Essay/Paragraph/Speech on “Global Economic Meltdown” Complete Essay, Speech for Class 10, Class 12 and Graduation and other classes.

Global Economic Meltdown

 

In mid-Sept. 2008, the world witnessed unprecedented financial crisis which shook the whole US economy and brought it virtually to the brink of collapse. The crisis sent the financial and capital markets the world over into jitters. Most of the stock markets lost nearly 10-15 per cent within a span of three days. The turmoil was so dangerous that the Russian authorities closed markets for a few days. In the recent developments, the US Congress has rejected the $700 billion bailout plan which was reflected in 780 points fall in the Dow Jones Index, the biggest one-day fall in history. Though the government is trying to put up another bailout package which will be acceptable to the Congress, it has done great damage to the reputation of the government. Meanwhile, two more banks, viz., Wachovia and Fortis have been rescued by Citibank and a consortium of European banks respectively.

The Crisis

The main reasons were the financial crisis faced by its premier financial institutions one after the other. Lehman Brothers, the fourth largest US securities house founded in 1850, filed for bankruptcy protection in New York after it failed to survive the global financial turmoil and lost nearly $639 billion. At the same time, its rival Morgan Stanley was purchased by Bank of America at half the prevailing market capitalisation to save the ailing company. The world’s biggest insurance company AIG asked for financial help to the tune of $85 billion to save it.

Genesis of the Problem

The heart of the crisis lies in the recklessness of the banking system of US that started giving loans to sub-prime borrowers (those borrowers who have no capacity or track record of payment of loans from their income) in the belief that the real estate boom that had doubled home prices in the US would allow people with even dodgy credit backgrounds to repay the loans that they were taking to buy or build homes.

When the US economy started facing the problem of inflation, the Federal Reserve reacted by raising the interest rates. The bank rates, which had gone to the level of 1 per cent, were raised to more than 5 per cent within a span of 18 months. This led to slowdown in the real estate prices and people stopped paying their loan installments. Since most of the loans were non-recourse loans (i.e., if the borrower hands over the collateral security, the bank cannot recover anything more from the borrower) and the loans were granted to the extent of 100 per cent of the cost of the property, borrowers started handing over the assets to the banks which led to further fall in the prices. This became a vicious circle and suddenly the real estate prices went down so drastically that the banks were left with lots of real estate for which there were no buyers.

Now, this situation would probably have caused the losses for the banks which had given loans on mass scales and they would have gone bankrupt. But, here came the real adverse impact of liberalisation and integration of world financial markets. The banks which had given loans had issued the bonds against their loans which were purchased by a number of investment banks and other banks world over. The correct figure of losses made on account of such sub-prime loans is yet not available as a large number of banks have not yet provided for losses in the balance sheet in the hope that they will be able to sell the properties with them. Still the losses which have been written off by various banks and other investors have crossed $600 billion. The table shows the losses declared by major banks in 2007 and early 2008.

Thereafter, the problem of sub-prime losses led to the bigger problem of credit crisis. Though Lehman Brothers and Morgan Stanley had enough of the capital with them but all of them were blocked in the assets for which there were no buyers. They required a lot of capital to run their regular business and pay off their debts. But, due to lack of confidence in the market, they could not get the support from other institutions. To manage things, they kept on taking loans from wherever possible. But when they reached at the peak of this, they just collapsed.

Timeline of Credit Crisis

A year ago, few people had heard of the term credit crunch, but the phrase has now entered dictionaries. Defined as “a severe shortage of money or credit”, the start of the phenomenon has been pinpointed as Aug. 9, 2007 when bad news from French bank BNP Paribas triggered sharp rise in the cost of credit, and made the financial world realise how serious the situation was. The following timeline of events explains how the losses of sub-prime market led to culmination of present credit crisis.

Oct. 1, 2007: Swiss bank UBS, the world’s first top-flight bank—announce losses—$3.4bn—from sub-prime related investments. The chairman and chief executive of the bank step down. Later, the banking giant Citigroup unveils a sub-prime related loss of $3.lbn. A fortnight on, Citigroup is forced to write down a further $5.9bn. Within six months, its stated losses amount to $40bn.

Oct. 30, 2007: Merrill Lynch’s chief resigns after the investment bank unveils a $7.9bn exposure to bad debt.

March 17, 2008: Wall Street’s fifth largest bank, Bear Stearns, is acquired by larger rival JP Morgan Chase for $240m in a deal backed by $30bn of central bank loans. A year earlier, Bear Stearns had been worth £18bn.

April 8, 2008: The International Monetary Fund (IMF), which oversees the global economy, warns that potential losses from the credit crunch could reach $1 trillion and may be even higher.

May 22, 2008: Swiss bank UBS, one of the worst affected by the credit crunch, launches a $15.5bn rights issue to cover some of the $37bn it lost on assets linked to US mortgage debt.

July 14, 2008: Financial authorities step in to assist America’s two largest lenders, Fannie Mae and Freddie Mac. As owners or guarantors of $2 trillion worth of home loans, they are crucial to the US housing market and authorities agree they could not be allowed to fail.

July 31. 2008: UK house prices show their biggest annual fall since the nation began its housing survey in 1991, a decline of 8.1 per cent. Meanwhile, HBOS reveals that profits for the first half of the year sank 72 per cent to £848m, while bad debts rose 36 per cent to £1.31bn as customers failed to repay loans.

Sept. 10, 2008: Wall Street bank Lehman Brothers posts a loss of $3.9bn (£2.2bn) for the three months to August.

Sept. 15, 2008: After days of searching frantically for a buyer, Lehman Brothers files for Chapter 11 bankruptcy protection, becoming the first major bank to collapse since the start of the credit crisis. Former Federal Reserve chief Alan Greenspan dubs failure as “probably a once in a century type of event” and warns that other major firms will also go bust. Meanwhile fellow US bank Merrill Lynch, also stung by the credit crunch, agreed to be taken over by Bank of America for $50bn, the latest twist in a dramatic turn of events on Wall Street.

Sept. 16, 2008: The US Congress decides to salvage AIG by lending nearly $85 billion

Oct. 2, 2008: US Senate approves a bailout of $ 700 billion.

Impact on India

When a giant tree falls, the impact is felt all around. The financial crisis on Wall Street will have its repercussions for Indian corporates and the subsidiaries of failed blue chip in-vestment banks such as Lehman and Merrill Lynch in India. The impact will be in the following ways:

(1) Direct exposure of Indian banks in derivatives of failed US entities

(2) The Domino Effect

(3) General credit crunch and slow down of capital projects

(4) Loss of jobs.

Direct Exposure: MTM losses of the banking sector including private sector, due to direct exposure stood at Rs. 410 crore of which, ICICI Bank alone has MTM loss of about Rs. 309 crore. Besides, some state-owned banks had exposure in the instruments of these troubled US financial institutions to the tune of Rs 234 crore. Exposure of a few public sector banks to credit-linked and floating rate notes of Lehman Brothers and other troubled institutions is about USD 52 million. ICICI Bank, which has the largest exposure, has invested euro 57 million, (around $80 million) in senior bonds of Lehman Brothers, through its UK subsidiary, ICICI Bank UK PLC, and the bank has already made a provision of about $12 million against investments in these bonds. The investment in Lehman bonds forms less than 1 per cent of the bank’s UK subsidiary’s assets and less than 0.1 per cent of ICICI group’s total assets. Among the public sector banks, State Bank of India has an exposure of $5 million to Lehman through one of its foreign offices. Thus exposure of Indian banks and consequent losses are not very high.

The Domino Effect: This is the major problem for India. Domino Effect explains how the losses made in bad assets affect the good assets. Suppose Lehman faces 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. This is when the crisis spreads from sub-prime to prime. This led to heavy offloading of Indian stocks by these foreign investors and consequent fall of Indian capital markets.

General Credit Crunch: Indian banks too have started tightening the noose on credit. Consequently, financing costs have risen sharply and some of the banks, even Indian banks, have gone back on financing deals. There have been cases where corporates which had gone to these banks, lured by cheap financing, suddenly found themselves caught on the wrong foot. Banks which had originally promised them cheap financing options, reneged on the deals. By the time they went to other banks, financing costs had risen by 20-30 per cent. These corporates had already given firm order for plants on the back of the earlier commitment from banks. Most bankers feel that multi-billion dollar overseas takeovers could be few and far in between. Indian corporates are getting ready for either shelving projects or delaying implementation.

Job Losses: Investment bankers who could until a year ago choose their jobs are now being rendered unemployed. Bonuses which were paid in stock are now worth nearly 70 per cent less than what they were. This will affect the overall job market in financial sector in India.

Lessons for India

The current crisis in the global markets should, however, force us to introspect into the limitations of the free market economy model. A glance at the current global financial crisis will tell us that some fundamentals which, free markets take for granted, just do not always work, even in the most sophisticated financial markets such as the US. It is very important for financial institutions that they continue to work in the core area of business. Excessive leverage and greed to make money may create havoc for such institutions. In India, there is an ever-growing demand for greater deregulation, and rightly so. While this is required, we need to exercise restraint and build a regulatory framework for the economy at a much faster rate. Further, we need to pause to ensure that we do not get carried away with blind faith in the doctrine that there is a direct relationship between economic growth and economic freedom.

A key lesson is that India needs to continue to develop its own economic model. Definitely far away from the socialistic model, but equally distant from the “free for all market”, India needs a modified free market economy model.

Future Safeguards

To stop banks from going overboard, capital requirement may have to be raised for derivatives position. Moreover, the accounting treatment in case of derivatives needs to be revised so that the balance sheets reflect true position of the exposure of a company in such derivatives. But all this may be easier said than done. This is going to be difficult as finance is the brain of the economy. For all its excesses, it allocates resources to where they are productive better than any central planner ever could.

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