LIQUIDITY CRISIS AND LOOMING BOOM: MEASURES TAKEN BY

GOVERNMENT OF INDIA AND REGULATORS

Minaketan Dash
Student, MBA 1st Year
DRIEMS Business School, Tangi, Cuttack- 754022
Mob: +919777122126
Email: [email protected]

Mr. Sasikanta Tripathy

Lecturer- Finance & Accounting
DRIEMS B-School, Tangi, Cuttack- 754022
Mob: +919337026846, Email: [email protected]
 LIQUIDITY CRISIS AND LOOMING BOOM: MEASURES TAKEN BY
GOVERNMENT OF INDIA AND REGULATORS

Abstract

As the term sub-prime refers to not prime or secondary, the meaning of the phrase is the crisis
which is caused due to the sub prime causes. Due to the adoption of sub prime policy this crisis
is happening. Sub prime lending evolved with the realization of a demand in the marketplace for
loans to high-risk borrowers with imperfect credit. In this present study the author has
demystified about the impact on global financial market as well as India’s financial market
and it’ measures taken by Indian government and by other country.This is a burning
economic management problem and the author tried to offer a bird’s eye view of the
same in this present problem. Even India has been affected by this crisis ,however it is
just the tip of the ice comparison to other country.

Key Words: Sub Prime Crisis, Mortgage Crisis, Credit Risk, Asset risk, Liquidity risk, etc.

INTRODUCTION

The word sub prime crisis refers to a broad concept. Here it is treated as the global financial
crisis which has started from US. If we will treat the crisis as the effect which is occurring at
present than there are so many causes. It is no the effect of a short term decision. It is the effect
of yester causes, which may be high inflation rate which bailed out in a galloping manner. Here
the author is concentrating towards business cycle. At the second stage inflation which is the
main cause, because in this stage the economy of a country will rise rapidly. But if the inflation
rate will rise more than comparison to the level of nations GDP growth, than un-doubtly there
must be depression.

The sub prime mortgage crisis is an ongoing financial crisis triggered by a dramatic rise in
mortgage delinquencies and foreclosures in the United States, with major adverse
consequences for banks and financial markets around the globe. The crisis, which has its roots
in the closing years of the 20th century, became apparent in 2007 and has exposed
pervasive weaknesses in financial industry regulation and the global financial system.
Approximately 80% of U.S. mortgages issued in recent years to sub prime borrowers were
adjustable-rate mortgages. When U.S. house price began to decline in 2006-07, refinancing
became more difficult and as adjustable-rate mortgages began to reset at higher rates,
mortgage delinquencies soared. Securities backed with sub prime mortgages, widely held
by financial firms, lost most of their value. The result has been a large decline in the capital
of many banks and USA government sponsored enterprises, tightening credit around the
world. The crisis began with the bursting of the United States housing bubble which peaked in
approximately 2005–2006. High default rates on "sub prime" and adjustable rate mortgages
(ARM) began to increase quickly thereafter. Lax regulation, deregulation of government
policies and investment from the private sector had greatly increased Wall Street's
involvement In higher-risk lending. Sub prime mortgages increased 292%, from 2003 to 2007.
Domestic money lending business is the genesis of modern banking and institutional financing
what we experience today. Idle money does not generate any financial benefit and it is thus
necessary to put it for useful purpose through changing hands i.e. circulation. Financing
transaction takes place on the basis of creditworthiness of the borrower(s) in particular and
necessary security for recovery of loan extended in case of failure on the part of the borrower to
honour the financial obligation as per the stipulations mutually agreed upon. The financer
assumes risk while it extends credit and the risk is hedged against the rate of interest. Interest rate
is higher when risk is also higher. In simplicity, interest rate and degree of risk are positively
correlated. There is low degree of risk when the borrower is attributed with high degree of
creditworthiness. Banks and financial institutions are the prime sources of financing the projects
for realty and other tangible assets.The contagion of the crisis have spread to India through all
the channels – the financial channel, the real channel, and importantly, as happens in all financial
crises, the confidence channel.

MEANING AND CONCEPT

As the term sub-prime refers to not prime or secondary, the meaning of the phrase is the crisis
which is caused due to the sub prime causes. Due to the adoption of sub prime policy this crisis
is happening. This CRISIS can be defined by dividing it in to three stages.
In stage 1 the time period is from late 2006 to spring 2007.In this period a number of mortgage
specialist collapsed.
In stage 2 the time period is from spring 2007 to summer 2008. In this time brokers triggered a
fail out of ABCP (ASSET BACKED COMMERCIAL PAPER) market and liquidity crisis in the
short term lending market.
In stage 3 it covers the time period of autumn of 2008 to onwards. In this time period sub-prime
related losses have emerged in European banks and in US.

OBJECTIVES

The objective of the present study is to find out:

1. A brief history of sub prime crisis
2. The impact of this crisis.
3. The measures taken by Fedral Reserve Bank & US Government in general and by Govt.
of India, SEBI & RBI in particular.

METHODOLOGY

This paper enlightens the pre-history, objectives of the crisis started at US which affected our
country (India). The data colleted mainly from the secondary sources like: Journals, Magazines,
Newspaper and Websites.

CRISIS IN USA

Over the last five years USA economy has continuously increasing, in case of mortgage market
in the whole global credit market. Whatever problem America is facing today is the result of
yester years. The serious sub prime mortgage crisis was started from June 2007, when leading
global investment bank of US has collapsed. Gradual fall financial institution in US begin
from 2007.According to the market estimates(IMF estimates)ABCP reached at $1.5 trillion in
march 2007,o0ut of which$300 billion was based on mortgage backed assets. So far the total
credit down from different banks and brokerages is approximately $200 billion. IF we will open
the passage of time in 1996&2004 the USA current account deficit increased by $650
billion from 1.5% to5.8% GDP. To finance this deficit the USA govt borrowed a large
sums from abroad .Here the author is describing something about the causes of the
crisis.

1. Sub prime lending.

2. Mortgage system.
3. Debt obligation.
4. Inability of people to repay loan.

In this paragraph the author is concentrating towards the main two causes in USA which
leads the crisis.

SUBPRIME LENDING

First of all what is this sub prime lending? In the general language we can say the inappropriate
policy which is adopted by the lender for lending, where the degree of risk is more. Banks and
financial institutions are the prime sources of financing the projects for reality and other tangible
assets. At the time of 2006-07 banks of America were found to be quite liberal in granting loan
just a voluntary declaration of income statement or stated income banks used the policy like “no
assets no income verification” for granting loan. Problems arise when the price of reality crashed
in early 2007 and interest rate were soaring high.

The situation further aggravated when NEW CENTURY financial which happened to be the
second largest sub-prime lending agency crashed down with the burden of bad debt to the
tune of $ 23 billion. The stock crashed from $66 to almost zero within a week or so. The
groups of prime lending financial institutions are WELLS FARGO, CITI BANK, GE CRIDIT,
HOUSEHOLD FINANCE and many more.

Risk involved in sub-prime lending

1. Credit risk
2. Asset price risk.

MORTGAGE SYSTEM

Also the inappropriate mortgage system is one type of cause of this crisis. The first is the
housing boom. The overall us home ownership rate increased from 64% in1994 to a peak in
2004 that is 69.2%.Between 1997 and 2006 , us home prices increased by 124%.After
which it becomes more difficult for refinancing US govt. Also a study by the federal
Reserve indicated that the average difference in mortgage interest rates declined from
2.8% in 2001 to 1.3% in 2007. The shares of subprime mortgages to total organization are given
in the diagram.

600

500

400

300
$(billion)
200

100

0
1994 1996 1999 2006

In this data the share is increasing in a rapid manner. According to the FDCI (Federal Deposited
Insurance Corporation) two thirds of home mortgage originators in 2005 were securitized. The
securitized share of sub-prime mortgage in US increased from 54% in 2001 to 75% in 2006.

Apart from these causes there are also so many other risk which are associated with this cause.
1. Credit risk
2. Asset price risk
3. Liquidity risk

IT’S IMPACT ON FINANCIAL MARKET

Many banks, mortgage a lender, real estate investment trust (REIT) suffered a significant loses as
a result of mortgage payment defaults. As of March 16,2008 financial institution had recognized
sub prime related loses exceeds $175billion related to mortgage leveraged lending and
CDO position (collateralized debt obligation). US banks by assets posted it’s second losses at
least $15billion.

With regard to equity market it may go downward and the cost of capital may rise by 2000
basis points as compared to base line. From half of the previous year 2008 it started a
affecting the both financial market and capital market. Like

1. Tightening of lending criteria.

2. Turmoil on the credit market.
3. Contraction of ABCP (Asset Back Commercial Paper) and shortage of liquidity on the short
term lending.

In the first additional losses including both losses on securitization product and losses
arising on non-securitized mortgages come to an estimate of total $142bn. Also the global
losses as estimated by IMF from all aspect is $463.6bn. In US the top largest bank ICBC and
other like CITI bank, HSBC, and Bank of America are suffering also. In Australia BOA
(Australia Central Bank) has also cut it’s interest rate lowest in 50 years 3%. BOJ (Japan
Central Bank) also facing a lot like fix interest rate for this crises. “THE TIMES” reported on
it’s website, IMF suggest US-originated assets reached at $2.2tn by the next year is going
to be toxic asset.

The crisis began to affect the financial sector in February 2007, when HSBC, the world's largest
(2008) bank, wrote down its holdings of sub prime-related MBS by $10.5 billion, the first major
sub prime related loss to be reported.] During 2007, at least 100 mortgage companies either shut
down, suspended operations or were sold. Top management has not escaped unscathed, as the
CEOs of Merrill Lynch and Citigroup resigned within a week of each other in late 2007. As the
crisis deepened, more and more financial firms either merged, or announced that they were
negotiating seeking merger partners.

During 2007, the crisis caused panic in financial markets and encouraged investors to take their
money out of risky mortgage bonds and shaky equities and put it into commodities as "stores of
value".[] Financial speculation in commodity futures following the collapse of the financial
derivatives markets has contributed to the world food price crisis and oil price increases due to a
"commodities super-cycle." Financial speculators seeking quick returns have removed trillions of
dollars from equities and mortgage bonds, some of which has been invested into food and raw
materials.

Mortgage defaults and provisions for future defaults caused profits at the 8533 USA depository
institutions insured by the FDIC to decline from $35.2 billion in 2006 Q4 billion to $646 million
in the same quarter a year later, a decline of 98%. 2007 Q4 saw the worst bank and thrift
quarterly performance since 1990. In all of 2007, insured depository institutions earned
approximately $100 billion, down 31% from a record profit of $145 billion in 2006. Profits
declined from $35.6 billion in 2007 Q1 to $19.3 billion in 2008 Q1, a decline of 46%.

IMPACT ON INDIAN BANKS

Due to the globalization some Indian banks are also operating in US. So they are also suffering a
lot. The statement given by (Business Line) is Indian banks loosed estimated at $2bn on
account of this crisis. Also the data given by (Dr Parthasarathi Shome, Economic adviser ,
Union Finance Minister) due to this crisis in mortgage market, equity investment the loses
of four top banks operating in international trade was estimated as $2mn . Also India’s
second largest bank ICICI HAS reported mark to market loss of $263mn in it’s loan and
investment.

MEASURES (Globally)

Just like “a stick in time saves nine” government of each country has been taking so many
steps for the recovery. The US government has launched a new initiative at the Federal
Housing Administration (FHA) called as FHA secure to offer refinancing by giving it the
work to contact with the home owner.
FED RATE CUT

There was a series of FED rate cut starting from September 18,2007. In March 18, 2008 the
bench mark rate was at 2.25%.

TSLF (TERM SECURITIES LENDING FACILITY)

The FED has been working to pump billions of dollars into the banking system to add an
economy rocked by the sub prime mortgage crisis and severe tightening of credit. To
increase liquidity, US central bank announced the expansion of its lending facility.

SOVEREIGN WEALTH FUNDS

Banks have sought and received additional capital ( cash investment) from sovereign wealth
funds which are controlling the surplus fund. An estimated US $69bn has been invested by
these funds. On January 15, 2008 sovereign funds provided a total of $21bn to two major
financial institution.

CREDIT RATING AGENCIES

Rating agencies evaluate the report on the risk involved with various investment
alternatives. Now they are examining the process to encourage greater transparency to the
risk involved with complex MBS.

FORECLOSURE RELIEF ACT

Under this act the difference between mortgage price and selling rate will be extracted.
Those who have annual income of $100,000 or rented dispute property will liable for pay
tax under this act. This act helps the government to maintain proper liquidity ratio.

BAILOUT PACKAGES

To tackle the liquidity crunch, after the power coming to the hand of politics hero Mr
Barak Obama, the second bailout packages have been announced by US government on
February 10,2009 to cleanse the so called “Toxic assets” from bank books and support
new lending through an expanded federal reserve programme. The latest $500bn-$1tn bad
bank concept is supposed to be financed jointly by the government and private sector.

FREE TRADE AGREEMENT (FTA)

This agreement is also one type of trade opportunity for various countries for the recovery step.
Through this agreement different countries can make free trade which helps for inflow of foreign
currency. If all the negotiation India is having now completed nearly 80% of our trade will be
with FTA partner.

MEASURES BY INDIA GOVERNMENT AND RBI

Also the previous finance minister P.Chitamberm announced that RBI would provide temporary
liquidity support of 250 thousand crores to commercial bank and NABARD, against the first
debt. The government has decided that the limit of foreign investment (FII) in corporate bond
would be raised from $3billion to $6 billion. Also the govt has decided to provide certain
banks asses to finance ,to raise capital adequacy to 12% by a suitable date in future.
SEBI also played a celebrated role in managing the flow of money from abroad. The
promoters are now allowed to increase their holding in their company up to 75% through
creeping acquisition route Earlier restriction prohibited them from acquiring more then 55%
company’s equity.

Although, like other Asian country India is not so much affected still so many steps has been
taken as preventive package for the recovery, by government and SEBI as well as RBI. In the
first phase the cash reserve ratio (CRR) has cut down from 9 to 7.5 and again it fall into 5.5.The
total CRR reduction by 3.5 will release Rs1,40,000 cores into the liquidity starved economy.
Statutory liquidity ratio (SLR) has been reduced from 25% to 24%. Also RBI has allowed a
temporary relaxation in SLR to the extend of 1.5%.This facility was granted to enable banks to
borrow the RS 60,000 crores of additional liquidity to lending to mutual funds. RBI also cut repo
rate by the percentage to 8% and again by 0.5 to 7.5%. also RBI has increased the interest rate
ceiling on NRI and FCNR bank deposits. RBI also allowed banks to borrow funds from their
overseas branches and other sources up to 50% of their unimpaired tire1 capital as at the close of
the previous quarter or slom whichever is high. Both the private bank and public sector bank
has been reducing their lending rate according to the RBI. Like SBI has fixed it’s
BPLR(bench mark prime lending rate)at 12.25%,PNB at 12.5%,ICICI at 16.75%,HDFC at
16%.PNB has reduced it’s lending rate to the among all. SBI is also cutting it’s lending
housing rate to 8%.All these steps are taken to stave off the effect of crisis by providing a
huge amount of liquidity.

The policy response in India is likely to be to ensure that that the rupee does not appreciate ‘too
much’, a task that will entail active sterilisation operations by the RBI. These sterilisation
operations, through issue of market stabilisation bonds, entail an additional fiscal burden on the
government for the interest costs of these bonds. Energy costs have risen but adjustment of
consumer prices has not been possible due to political compulsions of the coalition. It is likely
that fiscal stresses on the government may increase. It is this total picture of rupee appreciation,
lower exports and fiscal stress that is causing worries in the Indian Finance Ministry and the
Planning Commission.

On the positive side, data reveals that the quarter ending December 2007 has been quite good for
Indian manufacturing as well as the services sector, asset prices in terms of equities and real
estate remain firm, and revenue collections have been extremely buoyant. The Indian industry
seems less than concerned about domestic demand growth. The measures by the RBI to curb
liquidity have yielded positive results and inflation appears to be a lesser worry than in China.

FINDINGS & CONCLUSION

After all discussion at the last part the author is deriving about all the steps taken by
the banking sector only for maintaining proper liquidity. Still it is not the time to say
about the effectiveness of these policy because there is also time for waiting and to see
what is going to happen. Not only the Indian government, SEBI & RBI also other bank
like BOA, BOJ,FEDRAL BANK all are now concentrating towards spending and
investment in current scenario. Specially America government Obama is now becoming more
active about this crisis for the recovery. Whatever excepted by other financial officers
with in two years there is chance of recovery i.e.2010 for US (stated by CEO,
chairman/New York life insurance). Indian government is taking this suggestion as warning
and trying to get the recovery in some extent in JUNE-JULY2009.

BIBLIOGRAPHY
Journal/Magazine/News Paper:

1. THE ANALYST, Volume XV, Issue- 03, March 2009, pp-19, 74-76.

2. FRONTLINE, Volume- 26, Issue- 05, 13 March 2009, pp-33-34.

3. BUSINESS LINE, Bhubaneswar, October 6 2008

4. THE ECONOMICS TIME, Kolkata, April 09 & 14, 2009

5. BUSINESS TODAY, February 2009.

Articles:

1. Mukopadhya D., (2008). “US SUBPRIME LENDING CRISIS & WARNING FOR

INDIA”, The Management Accountant, August, pp. 568-570.

2. Badami S., (2008), “SUB PRIME MORTGAGE CRISIS”, The Management Accountant,

August, pp.571-575.

3. Ckliu Hery, (2007). “’LIQUIDITY CRISIS LOOMING BOOM”, Asia Times, May 09,

2009.

Websites:

1. www.yahooanswer.com

2. www.wikipedia.com

3. www.rediffmail.com

4. www.abalert.com

5. www.google.com

6. www.jri.org