8/14/2019 YahooNews_Oct 3, 2008_financial Tsunami What Brought
It On
2/3
In the US there are three classes of borrowers - prime rate
borrowers who have the highestcreditworthiness, followed by what
are called Alt A Mortgage borrowers and finally subprimeborrowers
who have the least creditworthiness.
As banks can charge a higher interest rate from borrowers with
less than best creditworthiness,
aggressive marketing saw a more than prudent share of loans
going to the least creditworthyborrowers.
Whether we like it or not, the laws of gravity work in financial
markets as well and what goesup ultimately comes down, Jagannadham
Thunuguntla, head of the capital markets arm ofIndias fourth
largest share brokerage firm, the Delhi-based SMC Group, told
IANS.
Despite a bull run in the US real estate market due to the big
rush in home purchases during2002-06, the party had to end some
time and prices began to come down.
Real estate prices have fallen 16 percent till July 2008 since
the corresponding month last year
and had fallen by a similar amount the previous year.
Suddenly, from early this year, banks found their so-called home
equity had completely vanishedand their loans were not protected by
the value of the assets bought with the loans.
Alongside, there was another development.
In normal manufacturing and other businesses, the debt to equity
ratio is usually in the range of1.33-2 to 1.
This means, out of the total capital invested by a business, if
$1 is the promoters equity,
borrowed funds invested in the business is $1.33 to $2.
But in the banking industry, the debt-equity ratio is always
much higher because the deposits ofbanks are considered as debts of
the bank.
Commercial banks, however, despite their high loan-deposit ratio
(conceptually similar to debt-equity ratio) are highly regulated as
they take deposits from the public and have to follow
strictlending, provisioning and capital norms.
Investment banks, such as Goldman Sachs, for example, are,
however, very lightly regulated anddo not have to follow these
prudential lending and capital norms.
Just before Goldman Sachs got into trouble two weeks ago, it had
debts of about $1.08 trillionagainst its own equity capital of only
$40 billion. This means it had a debt to equity ratio of24.7:1.
To simplify the explanation, let us say its debt-equity ratio
was 24:1. That means of every $25 itwas investing or lending, $1
was its own money and balance $24 was borrowed money.
8/14/2019 YahooNews_Oct 3, 2008_financial Tsunami What Brought
It On
3/3
In this situation, even if it incurs a loss of four percent on
its loans or investments, the bank runsup a loss of $1, which is
four percent of $25 originally invested.
This in turn means the entire equity capital of the bank is
wiped out and it has to file forbankruptcy because losses have to
be borne by the owner of equity capital. Borrowed funds have
to be returned to borrowers.
It is very usual for any bank to make a mistake in lending or
investment decisions to the extent offour percent.
In the real estate boom of 2002-06, banks had lent an imprudent
share to Alt A mortgages andsubprime borrowers. Running up a four
percent or more non-performing assets was just waitingto
happen.
When it happened, Goldman Sachs as also all the other investment
banks which had equally highdebt to equity leveraging found their
capital eroding too fast for their comfort.
Lehman went down first, followed by the others and Goldman and
Merrill Lynch are survivingby infusing more capital through sale of
some of their assets.
For example, after the crisis broke, US investor and one of
worlds richest men Warren Buffetand others stepped in and pumped in
about $7.5 billion equity into Goldman Sachs and broughtdown its
leveraging to 20.8:1.
In good times, however, even a four percent return on their
capital, that means a return of $1 onthe $25 invested would
translate into a 100 percent return on these banks own equity
capital of$1, Thunuguntla explained.
The problem with the European banks was they too had big
exposures in the US market duringthe real estate bull phase and
they too did not follow prudent loan to deposit ratios.
A prudent loan-deposit norm for commercial banks is around 80
percent. That means they lend80 percent of their deposits and keep
the balance 20 percent to service depositors.
Northern Rock, the first British or European bank to be hit by
the subprime crisis andnationalised in 2007 had a loan-deposit
ratio of 215 percent.
Most of the other banks hit also have excessive loan-deposit
ratios of around 160 percent so that
when faced with troubled assets they are no more able to service
depositors.
Indian banks are safe and sound mainly because of our extremely
prudent banking regulations,Thunuguntla said.
