The world is going through its worst economic meltdown since the Great depression of 1930s. Though the crisis can be attributed to several causes, the subprime mortgage failure is unarguably the major among these. Subprime lending is mainly in the form of mortgages for the purchase of residences to borrowers who do not meet the usual criteria for borrowing at the lowest prevailing market interest rate.
These criteria pertain inter alia to the borrower’s credit score and credit history. If a borrower is delinquent in making timely repayment to a loan servicer-usually a bank or financial institution-the lender can take possession of the residence acquired using the proceeds of the mortgage, though a process known as foreclosure. The crisis began with the bursting of housing bubble in the United States marked by high default rates on subprime and adjustable rate mortgages (ARM) beginning approximately in 2006.
According to New York Times, “Government policies and competitive pressures for some years prior to the crisis encouraged high risk lending practices.” An increase in loan incentives such as easy initial terms and a long-term trend to escalating housing prices encouraged borrowers to assume difficult mortgages in the belief that they would be able to quickly refinance at more favorable terms.
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However, once the interest rates began to rise, and housing prices started to drop- moderately in the beginning, but significantly later on-in many parts of US, refinancing became more difficult. Defaults and consequent foreclosure activity started rising dramatically as easy initial terms expired, the home prices did not go up as anticipated, and ARM interest rates were reset higher. Foreclosures went up 79 per cent in 2007 from those in the preceding year.
It is also believed that the credit rating agencies, which are now under scrutiny for having given investment-grade ratings to mortgage-based securities (MBSs), were instrumental in effecting a large scale sale of such risky securities.
Some people believe that these ratings were justified because of risk reducing practices, such as credit default insurance and equity investors willing to bear the first losses however, there are clear indications that some agencies knew that the rating process was faulty.
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Critics have alleged that the rating agencies suffered from conflicts of interest as they were paid handsomely by investment banks and other firms that organize and sell structured securities to investors.
The crisis which originated from widespread subprime mortgage failures quickly engulfed the entire financial system as well as industry, resulting in widespread layoffs, for example, 70,000 job losses in a single day in six companies ranging from manufacturing to telecom across the United States and Europe as a measure of cost-cutting to grapple with slump in consumer spending.
Construction machinery manufacturer Caterpillar, pharmacy major Pfizer, telecom firm Spring Nextel Corporation and home improvement retailer Home Depot were among the top companies adversely affected.
When the financial crisis erupted in a comprehensive manner on Wall Street, there was some premature triumphs among the Indian policymakers who argued that India would be relatively immune to this crisis because of the strong fundamentals of its economy and a well-regulated banking system even while the other developing countries in Asia clearly showed signs of significant negative impact through domestic credit stringency. However, the crash in the Indian stock market, triggered by a pull-out of Foreign Institutional Investors (FIIs) funds, October 2008 onwards is not only an indicator of the impact of international contagion but also a sign of the integration of Indian economy with the world economy despite claims of decoupling.
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Global response to the financial crisis has been prompt, and by and large adequate, though it will take some time to have the desired impact. There have been relief plans, bailout packages, etc. in many countries of Europe, Asia and America. China has announced a $556 billion domestic stimulus package. Federal Reserve reduced its fund rates six times in 2008-from 3.5 per cent to 1.5 per cent.
The European Central Bank and the Bank of England have pumped in billions of dollars in the money-market auction. President Barrack Osama has brought another relief package to revive the economy, apart from sector- specific measures like housing rescue plan, and buyback plan of banks’ toxic assets.
The unprecedented economic stimulus packages announced by governments will take time to have an effect on economic growth and employment. The recent turmoil has presented a new set of challenges to most, if not all, regions of the world by rendering the achievement of a path, toward sustainable and socially equitable growth, and decent work for all, increasingly more difficult.
In the current uncertain environment, banks and financial institutions, concerned about their balance sheets, have been cutting back on credit-leading to liquidity crunch and its resultant effects of shelving or delaying of some projects by some large companies, and ,consequent downsizing of staff.
There is a strong consensus among observers that the crisis will get worse before it gets better. While the risk of a total systemic financial meltdown has been somewhat reduced by the actions of the G7 and other economies to backstop their financial systems and provide economic stimulus, severe vulnerabilities remain. It is likely that the credit crunch will get worse as de- leveraging by major institutions and the household sector continues.
The Indian government has also taken a slew of monetary measures like reducing interest rates, earmarking funds for infrastructure growth and giving tax sops to revive the economy. Positive signs of revival are already visible.