the credit crunch-second issue

8/8/2019 The Credit Crunch-Second Issue

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The credit crunch - second issue

Analysis of what really happened in the US and its

impact on business owners in India

Foreword

The credit crunch is rapidly making its way from WallStreet to Main Street and squeezing businesses across a wide swath of industries. Slowing growth, weakening demand and reduced lending by banks compound analready difficult environment in which key commodity prices had risen rapidly. While some geographies andindustries are proving more resilient than others, ourgeneral advice is to take proactive steps to prepare for potentially challenging days ahead.

The current upheaval in the credit markets is analogous

to riding a roller coaster, for the first time on its way down a steep hill. It has everyone holding on tight,hunkering down, with a sick feeling in their stomach and wondering if the worst is yet to come. No doubt, 2008has been a rough ride for the global economy and thefinancial sector. It seems that each week another majorbank failure, economic crisis or government bailout orother related events grab the headlines. Keeping track of all of the events and understanding the impact they willhave, are daunting tasks.

With careful planning and foresight, we believe that

you should be able to turn conditions to youradvantage. Businesses that are well capitalized, wellpositioned, and well managed should see opportunities.

Management teams often ignore the fundamentals whenthe focus is on revenue growth, as it has been for severalyears now. That growth was fueled by relatively easy credit and global demand, but the emphasis will need tochange for now.

The coming months should be about instilling rigorand discipline throughout your business. A few weeks back, Grant Thornton had prepared and circulateda “10 - Point” checklist (which can be downloadedfrom www.wcgt.in), of aspects for you to consider as youmanage your business in this difficult time. Building onthis initiative, we have undertaken an analysis of thesignificant events that have resulted in the currentsituation and provided an explanation of some of therecent major financial events and a brief assessmentof how they may affect business owners in this special

issue. In addition, we have commented on steps being undertaken to combat the challenge in India.

Even as the road ahead may look uncertain, successfulbusiness owners would be able to chart out an effectivestrategy, by carefully monitoring the situation andseeking timely and good “value for money ” professionaladvice as required by their business.

The credit crunch ▪ 1



2008: A tumul tuous r ide, thus far

Most people are generally aware of the major events of the past year, beginning with the sub-prime crisis andcontinuing through the failure and overnight sales of major Wall Street banks; and on to the more recent

breakdown in the credit markets that has necessitatedmajor government intervention. Years of easy credit,covenant-light loans, record consumer spending, housing speculation, and exotic mortgages set the stage forunprecedented home ownership levels andsecuritizations of assets, with financial institutionsfeeding the voracious return objectives of hungry investors.

The system worked until the economy softened and fearstarted to creep in, as doubts were raised about the ability of borrowers to pay their debts, initially in the United

States of America (“US”). Investors then started balking at paying higher prices for assets in the secondary market. With liquidity evaporating, a sudden flight tosafety caused a rush to hoard cash, as buyers stoppedbuying, lenders stopped lending; and accounting rulesgoverning certain balance sheet assets resulted in therecognition of mounting losses at banks and furtherreduction in the availability of credit.

The following is a brief overview of some of thesesignificant events, including an explanation of whatoccurred and what it means to the economy.

Sub-prime cr is is

As the economy continued its strong performancethrough 2007, mortgage lenders became more and moreaggressive in lending on what is called the “margin.” Thisterm refers to those types of loans that edge ever closerto the line between aggressive and reckless. Sub-primerefers specifically to loans to individuals that have creditscores and credit profiles below a certain industry-setcriteria. Loans of this type typically carry higher interestrates and this had created an incentive for mortgagelenders to extend credit to these individuals.

As fuel and other commodity prices began to rise,marginal loans were the first to be affected as theseborrowers had difficulty making monthly payments ontime.

Further, many of these loans were structured asadjustable rate mortgages (“ARMs”), meaning that after aset period of time, introductory interest rates could bereset.

As lending tightened, interest rates and the consequentmonthly payments increased. Compounding theseproblems, housing prices have been falling throughout2008, resulting in situations where the value of the home

may be less than the total debt (loan-to-value ratio inexcess of 100 percent).

Certain sub-prime (and now even prime) borrowers inthe US simply handed the keys over to the bank,defaulting on their mortgages. All of these issuesconverged to significantly increase mortgage defaults andgive rise to the sub-prime mortgage crisis.

Bear Stearns

Wall Street conducts hundreds of thousands of tradesper day, buying and selling securities to rebalanceportfolios, lending to others doing the same thing; andmaking markets for securities to reduce counterparty risk while enabling efficient execution of trades. In order todo this, banks extend credit to one another, providing the liquidity and the necessary collateral to conducttrades without the need to sell other assets. In normaltimes, lending between banks is the engine oil of thefinancial world, allowing these firms to conduct theirbusiness and generate profits for investors. However, aseries of complex events ultimately led to Bear Stearns’sinability to borrow money from other banks, essentially cutting off the liquidity it needed to continue to conduct

its business.

In the case of Bear Stearns, it is their exposure to sub-prime mortgage securities that caused rumors about itsliquidity, and this caused other banks to stop renewing itsloans. Once that happened, a failure was imminent, andthe Treasury Department, along with the FederalReserve, acted. Their underlying purpose was to preventthe collapse of other banks because the global banking system is highly interconnected. The ultimate wisdom of the bailout in the US and its effect on the economy willbe debated for years to come.




Amer ican Insurance Group (“AIG”)

Among its many insurance products, AIG sold a productcalled a credit default swap (“CDS”). Essentially, a CDSis an insurance policy that an investor purchases toguarantee a certain amount of value from a debt

instrument, if the borrower cannot continue paying itsdebts. Like any other insurance product, this policy isbased on actuarial analysis of the security. AIG sold thesepolicies to all sorts of investors and it collected hefty fees. In fact, AIG also sold such policies to investors thathad no exposure to the underlying security.

Think of it as your neighbor buying insurance on yourcar: He’s confident your driving habits will result in anaccident. This had resulted in the nominal value of CDSs, far exceeding the face value of the debt they weresupposed to be insuring.

The problem arose when certain securities - in particular,securities tied to mortgages (including sub-prime), beganto significantly decline in value, with declines muchgreater than any reasonable risk analysis assumed. Thisforced AIG to pay out billions on insurance policies,numbers that were far in excess of what it’s forecasts hadpredicted.

As AIG began to need more and more cash to makegood on these insurance policies, the major credit rating agencies (functioning as they are supposed to function)reassessed the risk profile of AIG and signaled they

would reduce their credit rating on AIG.

A reduction in credit ratings results in a host of consequences, including increasing the cost of borrowing and limiting the type of credit that a company can obtain.It became obvious that AIG would be unable to raiseenough capital to meet its commitments, and failureappeared imminent.

The failure of an insurance company like AIG wasconsidered too big a risk to the economy. Its widespreadbusiness activities reached every corner of the global

financial system.

As a result, the federal government in the US stepped inand agreed to guarantee the obligations, in a transactionthat effectively transferred ownership of AIG to thegovernment in the US.

Fannie Mae and Freddie Mac

Fannie and Freddie, as they have been known, were setup as government sponsored enterprises (“GSEs”) thatmade loans and provided loan guarantees. GSEsprovided liquidity to the mortgage industry by purchasing

loans from banks and other mortgage originators. Fannieand Freddie would then package these loans into largerpools and sell them off as mortgage-backed securities(discussed below). As mortgage lending becameincreasingly aggressive, targeting prospectivehomeowners with riskier credit profiles, Fannie andFreddie became laden with increasingly risky mortgages. As interest rates rose and adjustable rate mortgages werereset, a large number of mortgages began to default.

As the mortgage crisis continued and investors becameincreasingly concerned with the risk profiles of thesesecurities, the GSEs’ ability to support their own liquidity by using the mortgage-backed security market began tofail. Ultimately, the federal government in the USstepped in and became the effective owner of bothFannie and Freddie, in a bid to guarantee that neither would fail. As of early 2008, Fannie and Freddie ownedapproximately half of the mortgage market in the US.




Lehman Brot hers , Washington Mutua l ,

Wachovia , e tc .

Though it might seem odd to include Lehman Brothers with the names of two major commercial banks, at a highlevel, the same thing happened to all three institutions.

Banks engage in a few basic transactions, taking deposits,lending money and investing in securities. In the case of these institutions, a somewhat circular series of eventsled to situations in which the banks were, or wouldquickly become, insolvent. The companies had to writedown the value of their assets, thus depleting the capitalsupporting all their loans. Depositors, increasingly risk averse, started pulling cash out of these institutions. Inorder to protect the banks themselves as well asdepositors and investors, these institutions were sold toother larger entities that had sufficient capital to ensuresolvency.

As a result of these sales, the combined banks wererequired to meet their obligations, execute trades, makeloans, and most importantly, return deposits toindividuals and corporations on demand. Lehman filedfor bankruptcy court protection when it was unable tofind a buyer or investor to shore up its capital. It is now,in the process of selling itself bit by bit.

Mortgage-back ed secur i t ies and the cred i t

c runch

Years ago, lenders would make loans to individuals and

businesses; and assume all of the risk associated withthose loans. Further, once a specified amount of loans were made, the bank would need to raise additionalcapital to make additional loans to meet regulatory capitalrequirements. The securitization market provided a way to resolve both challenges.

At the highest level, securitization involves transferring risk and profit from one entity to multiple investors.Essentially, a bank packages a pool of mortgages intoone fund, and then sells the fund in pieces as securities.Each piece is entitled to interest and principal that are

supported by the entire fund, thus reducing the exposureto any single mortgage and appeasing different appetitesof various investors.

The bank benefits by removing the loans from its ownbalance sheet, thus enabling the issuance of new loans.Origination fees are more profitable than the spread abank earns between the cost of money (interest paid on

deposits) and interest income (interest charged on loansit makes).

Through the securitization market, banks also transferdefault risk to third parties and the investors thatpurchase the securities backed by these pools of loans.In a normal market, securitization works as intended. The percentage of nonperforming mortgages has beenfairly constant for decades; and given the size of the U.S.mortgage market, a significant increase in defaults wasconsidered unlikely at best. However, a host of factorscombined to create an environment where mortgagedefaults increased, home prices declined and the resulting risk of mortgage-backed securities skyrocketed - reducing the value of those securities and the desire of investors to

own them.

Since mortgage-backed securities are widely held among banks and other investors and thus widely affected by thecrisis, the market for buying and selling them haseffectively disappeared. As a result, banks are now unableto sell off loans to make room for new lending. Thisissue is further magnified by the requirement to mark theassets to market, an accounting requirement thatmandates the bank to estimate the value of such assetsbased on what they can be currently sold for in the openmarket.

The inability to sell the loans caused write-downs of the value of the assets, thus resulting in reduced capitalaccounts (banks are required to maintain minimumcapital-to-loan ratios). The worst-case scenario is that allforms of lending could be affected, including auto loans,business loans, student loans, etc. If that suddencontraction were to become more permanent, thefinancial system would effectively freeze.




Borrowing is a primary way in which companies invest inthe growth of their enterprises. Funding is necessary tofinance day-to-day working capital, growth, capitalexpenditures and strategic acquisitions. The health of aneconomic system is reliant on the ability of banks to lendto consumers, businesses, investors and foreign

governments. When fear and uncertainty take over thenormal functioning of the system, people begin to ask what will happen to their money held by financialinstitutions. Widespread uncertainty causes financialinstitutions to conserve cash, and lenders require betterand more collateral in order to make a loan or a trade. Torestore confidence, the federal government in the UnitedStates passed a US$700 billion bailout plan (known as the Troubled Asset Relief Program, or TARP).

The intent of the plan is to accomplish two main goals:

•

enable banks to have the necessary capital to beginlending again by purchasing illiquid securities fromtheir balance sheets, and

• restore the confidence in the financial system forbanks, individuals, businesses and governmententities to conduct business in the ordinary course.

All that being said, restoring order is a process and thistakes time.

What can be expec ted i n t he c red i t marke t s ,

go ing forw ard?

Despite the government intervention, credit markets areanticipated to remain tight in the intermediate term.Banks continue to hoard cash while trying to eliminate or write down from their balance sheets risky mortgage-related loans that are clogging up lendable capital anddeteriorating capital adequacy. Meanwhile, inter-bank lending has dramatically declined, resulting in lowerliquidity for banks in the US and also elsewhere in the world.

What does th is mean for the typ ica l bus iness

owner?

Securing new debt or refinancing/extending currentcredit facilities has become increasingly difficult. Today,debt is still available, but banks and investors are looking for higher-credit-quality issuers with greater protectionagainst loan defaults. In addition, debt providers arelooking for increasingly larger premiums to compensatethem for the risks related to extending credit. Accordingly, borrowers can expect increased borrowing

costs. Additional fuel for higher borrowing costs resultsfrom wider credit spreads coupled with a dramatic rise inshort-term variable rates such as LIBOR. Consolidation within the banking industry in the US, as institutionscontinue to merge or fail, will decrease competition,thereby supporting the increased borrowing costs as well

as higher anticipated bank fees.

Additionally, lenders are increasingly requiring addedcredit enhancements such as personal guarantees frombusiness owners, LIBOR floors (for variable-pricedloans), and most importantly, stronger covenantpackages with greater restrictions on total leverage levelsand increased cash flow coverage of interest, fixedcharges and debt service. Meanwhile, uses of borrowedfunds are also being closely monitored, with substantialrestrictions on dividend distributions and owner salaries.

Lenders have also tightened advance rates on collateralto provide additional cushion, in case pledged assetsdecline in value in today’s volatile market environment. Along with these reduced advance rates, borrowers areexperiencing increased financial reporting requirementsin the form of more frequent submission of borrowing bases or financial statements to lenders.

Many business owners are being forced to considernontraditional financing sources such as sale leaseback arrangements, greater reliance on leased equipment, just-in-time inventory management and sales of assets such asfactoring of accounts receivable to supplement their

liquidity or financing needs.

From a personal wealth perspective, business owners andmanagers are increasingly working with their bankers,accountants and consultants to figure out a rational andappropriate investment strategy. As the questionable viability of many banking institutions continues to makeheadline news, many owners are concerned about thedeposits in their operating accounts, to the extent thesedeposits exceed the FDIC insurance limit. Because of this, there continues to be a “silent run” on many banking institutions, further restricting lendable capital

and tightening available credit, as depositors havecontinued a flight to quality.

Many business owners are considering “safe” short-terminvestment vehicles such as US Treasury notes or T-bills. The significant rise in demand for these types of investments has, however, significantly depressed yields,resulting in lower earnings for investors.




Impac t on I nd ia

Although the Indian economy has been bolstered bystrong demand in the domestic markets, the rippleeffect of the crisis in world’s largest financial market hasinevitably, also, impacted its trade and economy.

Owing to the recessionary trends in the US, the exportoriented industries of India that count on their clientsand customers in the US are among the most-affected,from the current situation. The incidents of cutback inprojects have already been witnessed in sectors such asinformation technology, information technology enabledservices, software and hardware companies.

Amidst the current scenario, one question that loomslarge in the market is that how much of the Indianbanking industry will be affected from the crisis in theUS. The answer lies in the nature of American andIndian banking industry. For unlike the US, where theprivate investment banks led the banking industry, theIndian banking industry has public sector banks as majorconstituents. Notwithstanding this distinction, whetherthe Indian financial system will suffer a similar situationas in the US is hard to speculate on; however there is alot that can be learnt from the practices in the US which led to the current situation.

The credit crunch has a double side impact on the Indianreal estate industry that managed over 30 % growth ratesfrom 2003 to 2006. On one end, the cost of financing

has increased exponentially for both the developer andbuyer, while on the other hand, the cost of constructionand operations have also gone up due to rise in inputcosts.

Similarly, the infrastructure industry is also facing thecredit crunch wherein the availability of finance is limitedand suppliers have also reduced the period of credit.

Being capital intensive in nature, the companies in theauto sector are also significantly impacted due to theongoing credit crunch. Auto ancillaries, in particular, are

facing restricted availability of funds. In fact, theavailability of credit in the market has emerged as aconcern bigger than the cost of finance.

New employment generation is dampened and salary increases have been curtailed by several employers. Theairlines industry is bearing a severe brunt, with highlosses, salary cuts and job losses in this turbulent phase.

Cement, fertilisers, metals and media too have been hithard, with rising inputs costs which have could not beoffset with price increases.

FDI and FII inflows are relatively subdued and with thisthe US dollar is trading at an all time high, leading toIndia importing inflation, even as it tries to combatdomestic cost push inflation through Repo and CashReserve Ratio and Statutory Liquidity ratio cuts.

While several companies are trying to develop suitablestrategies to face and beat the global meltdown, for alarge segment, the current situation also presents aunique opportunity - an opportunity to eitherintrospect or consolidate or integrate, or even grow. Forthe others, the opportunity may well be on its way. Forsuccessful businesses, the time to prepare does not comeafter they have been given the opportunity. It comes long before the opportunity arises. History tells us that mostcompanies that fail do so in times when the economy iscoming out of a turbulent period, not during theturbulent period. These are generally the companies thatcut back and did not prepare themselves for the eventualeconomic upturn; and hence could not compete.

India has shown its resilience in the past, particularly inthe late 1990’s when the Far East countries were reeling under the depressed economic environment. It is hopedthat India’s strong economic fundamentals, relatively

robust domestic demand, large pool of talent andpositive outlook, propelled by infrastructuredevelopment and a responsive government will be ableto steer India out of the current situation.

India was expected to overtake the US economy by 2050;and given the current situation this may happen wellbefore then! Behind the cloudy skies across the globe,there is a strong ray of hope in India.




About Grant Thornton IndiaGrant Thornton India is a member firm within Grant Thornton International. The Firm in India was established in 1935 & it is one of the oldestand most reputed accountancy firms in India. Grant Thornton India is also the leading firm in India advising business owners and entrepreneurswith international ambitions.

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Disclaimer:This summary has been prepared from various public sources and is not a substitute for either conclusive or comprehensive advice. Theinformation in this document is not focused on specific industries and is relatively generic in nature. Grant Thornton is not responsible for anyerror or any decision by the reader based on this information and does not accept responsibility for any loss as a result of relying on materialcontained herein.

Published by Grant Thornton. © 2008 Walker Chandiok Grant Thornton. All rights reserved.www.wcgt.in


the credit crunch-second issue

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