We read it in the papers, see it in the news, hear about it everyday - ABC bank has gone bust; they are waiting for XYZ bank to be taken over etc.

What is happening with these companies and how did it all start?

Let us look at the basics of how this started.

For banks (lenders): About four years ago, banks came up with a new financial product and found that they could package the loans or other assets on their balance sheet and sell them in return for immediate liquidity. This would give them liquid funds which could be lent further to increase business.

Hence, with more funds at their disposal, they started lending more money, even to people who would not have been eligible borrowers otherwise. Loans were made to to people who did not have perfect or good credit history or a steady income stream; these were called sub-prime loans. Slowly various others such products related to loans were created and gained popularity; these products had higher risk but also higher returns for banks.
Meanwhile property prices were soaring. A look at the statistics shows property prices in the US (where this problem is the biggest) rose 53% in the five years ended December 2007. People, on the other hand, had started buying more homes with mortgage loans, now easily available from banks. The rise in property prices was not entirely due to healthy demand and supply factors, but more due to this easily available money. This fueled the construction industry, property markets, etc.

For investing companies (which included banks): The loans that were packaged (securitized) and sold by banks were held as collateral against which securities were issued to investors (which are generally financial companies). These securities, called asset backed securities (ABS), could be traded in the secondary market. The repayments on the loans that were held as the collateral would provide for returns and principal repayment to these investors.

Start of the crisis: As interest rates kept increasing, the monthly installments payable by mortgage loan borrowers started rising. Slowly, borrowers started defaulting on their loan repayments. This raised the level of non-performing assets or problem loans for banks.
These defaults also led to disturbance in the cash flow to ABS investors. The risks related to this type of securities increased and their market value consequently decreased. The investors started incurring losses which decreased the viability of these securities. Soon the market for these securities slackened and losses (both realized and marked to market) started eating into investors’ profits and affected capital negatively.
Besides, banks could no longer easily securitize their assets. This led to lower availability of funds and hence low business volumes. Since loan disbursement was now selective, investment in property was lower and property prices started declining due to lack of demand. This in turn decreased the value of collateral for mortgage loans given by banks and increased the risk attached.

Securitization of loans led to more funds with banks, higher and riskier lending, defaults on repayments, losses for banks and ABS investors which made a large hit on profits and capital. All these things were hence interlinked and one after the other led to weakening of the entire system.

Thanks to the more-than-adequate regulation by the RBI this has not happened in India. However, let’s see how much this affects Indian Banks and the economy indirectly.

Like a drunkard who is wandering alone on the street trying to find a foot hold for his slippery feet, the Indian markets are no less choppy since the first month of the New Year ended the 3 year bull run party. When the 100 year old BSE Sensex hit 21113.13 on January 9th 2008 India was been viewed from Dalal Street to Wall Street as someone who has just driven at 100mph from 17000 to 21000 ,and with 25000 in touching distance. Anticipation seldom turns into reality, come 16th July 2008 BSE Sensex was 12514 a yearly low and 40% down from the top. With IPOs claiming to be multi-billion dollar projects in next five, ten and fifteen years and garnering over Rs 700000 crores, peons, school children, taxi drivers, the what nots, and the who’s who of the Indian economy wanted to apply. The only companies who would have made money would have been paper manufacturers, while Mother Nature was at receiving end for all the paper required to make 200-page red herring prospectuses (RHP).

With equity as an asset class going for a long random walk into oblivion, foreign institutional investors (FIIs), the usual market makers, who had put in close to $17 billion for the FY07, now, in the first six months of the CY08, have pulled out close to $7 billion. Usually bad follows bad but evil follows worse; the American housing bubble woes relentlessly made lives of economists, governors of central banks and heads of states lose sleep over deepening credit crises. The U.S. of A, which prides itself as John Rambo in the Middle East and central banker to the world, has already lost $500 billion in asset write-downs. Simply put, the things that were not affordable were made affordable to people who could not afford them; in other words, the houses for which the loans were taken turned bad value as borrowers defaulted and the subsequent MBSs (mortgage-backed securities) and ABSs (asset-back securities) markets who leverage themselves over these loans also defaulted. Then, with home loan default rising, interest rates rising, and slowing consumer demand, the unfaultable investment banks of Wall Street were getting jittery over their exposure to complex derivates products. Ultimately $500 billion in assets were written down on Wall Street with repercussions felt across the globe.

The regular oil and inflation shock has started to generate fewer tremors as their pace of growth has come off recently. Oil in last couple of weeks has been hovering at sub $110 levels and domestic WPI inflation at sub 13% levels. The booming GDP growth made India hit the $1 trillion economy club, with fiscal year 2007-2008 hitting 9.1% growth. Certainly now with the equity markets off hugely, capital expenditure for India Inc has become a huge question - rising interest costs will make longer-term capital intensive projects in the infrastructure space unviable. The IPO market, also the primary market to raise equity, has also dried up as investors have lost confidence to invest in new unlisted companies.

Estimates of $350-$400 billion have been made for lessening India’s infrastructure woes, and the bill is to be footed via the PPP (public private partnership) route. What remains to be seen is whether the big boys of India Inc ready to participate and does the FDI still hold India in high regard. The nuclear deal has been signed, which comes as a good sign for an energy-hungry country which according to government estimates will require an installed capacity of over 200,000 MW by 2012 to meet its electricity demand, 60 percent more than what the country currently has. India envisages providing electricity to all households including 234 million families living below the poverty line and electrifying around 115,000 villages by 2009.

Certainly all this looks a daunting task to accomplish and only strong jolt of foreign capital flows, relaxed government policies, and wish to take India global with domestic companies a lot of dope is required to put India back on track.

Anurag Sharma is a Research Associate at Padmakshi Financials Services Limited.