When the world collapsed around Lehman Brothers
Headline : When the world collapsed around Lehman Brothers
What triggered the crisis?
- From 2005 to 2007, at the height of the real estate bubble, mortgages were given to many homebuyers who could not afford them, and then packaged into securities and sold off.
- Lehman Brothers bought several mortgage brokerages and posted record profits.
- But in mid-2007, defaults on sub-prime mortgages rose exponentially.
- A credit crisis erupted in August 2007 with the failure of two Bear Stearns hedge funds while payment defaults triggered massive declines in banks and real estate incomes.
- In 2008, Lehman Brothers declared bankruptcy.
Was there any ‘rescue act’ by banks?
- In 2008, when America’s two biggest banks Merrill Lynch and Lehman Brothers reported high losses due to huge exposure to risk assets, all triggered by sub-prime lending by banking institutions, Bank of America came to the rescue of Merrill Lynch while Lehman Brothers had to file for bankruptcy.
What is a sub-prime loan?
- Sub-prime refers to a loan given to a borrower who does not qualify for a regular home loan because of a poor credit record, low income and lack of job security.
If the customer has a poor credit record, why did banks offer a loan?
- The main reason was banks expected the value of the underlying security or the property to go up.
- So, they increased the mortgage interest rate (higher than the conventional loan) and called it a sub-prime mortgage.
- They could earn more with the higher mortgage interest rate and if the borrowers discontinued repayment, they could sell the property for a higher consideration due to appreciation in property prices.
Impacts of the US Financial Crisis on India
- The impact on the Indian economy was less severe due to lower dependence on exports and the fact that a sizeable contribution to the GDP came from domestic sources.
- Indian banks had limited exposure to the U.S. mortgage market, directly or through derivatives, and also to the failed and financially-stressed global financial institutions.
- Unlike in US where capitalism rules, in India, market is closely regulated by the government.
Fiscal Cliff- A sudden condition of high taxes and reduced public expenditure after a long period of tax cuts and liberal public expenditure is known as Fiscal Cliff.