Financial Hurricane brewing in US market……Lets understand how does it work

Ten years ago, the Asian financial crisis smashed markets and economies globally. Today, another financial crisis is brewing in the US mortgage market.

History repeats itself. An economic boom for several years creates the illusion that business risks have been lowered permanently, that big loans on easy terms can be made to people earlier viewed as non-credit worthy. Imprudent lending booms to Thailand and Korea sparked the Asian financial crisis. Another imprudent boom is now roiling sub-prime mortgages in the US.

A 10-year housing boom in the US lulled mortgage lenders into satisfaction. They started lending 100% of the value of a house to people with poor credit histories, often inducing them with teaser low interest rates, which later rose sharply. Today, house prices are falling, effective interest rates are rising, and sub-prime borrowers are defaulting. Lenders can repossess the houses, but these are now worth less than the outstanding loans. A modest rise in defaults can break a lender. Housing loans no longer stay on the books of the mortgage lender. They are sliced into small pieces, clubbed together with medium and high quality loans, and sold to investors as high-interest packages. These have been bought by hedge funds, private equity funds, and many other specialist funds. This spreads default risks among more financiers, and lowers the danger to the original lender.

In theory, all financial products are supposed to be valued at market price, and so a falling market price is supposed to give advance warning of troubles ahead. But many new financial products are hardly traded at all, and so are valued at face value. When a fund in distress tries to sell, it suddenly finds it can get only half the face value. So, huge losses can arise without warning, and can kill a fund.

The problem is worse in the case of derivatives and other complex financial instruments that are now traded in trillions. In similar situation, panic sets in and everybody tries to sell at the same time. So asset prices crash, causing the serial bankruptcy of many huge funds. Millions lose their savings, investment and consumption shrink, and this causes a global recession.

Similar situation has created the SE Asian crisis in nineties. India has saved itself with low FII exposure. Now India has huge Foreign Investment in all its sectors. At the same time, RBI has safeguarded Indian interest against a sudden fund pull by FII.

An Indian shield in a globalized economy.