Financial Crisis Affect on Automobile Industry
Financial Crisis Affect on Automobile Industry document sample
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The Global Financial Crisis What happened? How does it affect me? Bharat Phatak 2008 – The year of drastic change How things have changed in the Year 2008! We started the year in euphoria. The economy was booming. Real estate prices were sky rocketing. The stock market was at a life time high of 21,000. Everything looked rosy. As we end the year, we are at the other end of the spectrum. The economy is in a slow down. – or recession. There are no takers for real estate. Builders say, they are not seeing any new bookings. Stock market has nosedived to 9,000. The spirits are down due the dastardly terrorist attacks. There is talk about a possible war. The economic situation appears to have turned 180 degrees. I am sure you are wondering- What happened? Where did it start? It looks as if there are problems everywhere in the world today. Reputed investment banks and insurance companies in the US have perished. World’ s largest housing mortgage companies have been bailed out. The leading automobile companies are close to bankruptcy. People are losing jobs. Houses are being taken over by banks. The crisis broke out in July 2007. It reached gigantic proportions in October 2008. But this is not when it started. To understand the origin of the problem, we must go back to the Year 2000. 2000 saw the bursting of the “ Dotcom” bubble in the US. The stock markets had boomed, placing great hopes on the magic of the internet. Many dotcom companies mushroomed. They were not earning money. Many of them, also were not selling any goods or services. But innovation had caught the fancy of all investors. Their prices were shooting through the roof, but there was very little to support those values. Then the inevitable happened. The markets crash landed with a thud. The situation became worse after the WTC attacks in September 2001. The economy was in a slow down after the dotcom crash. Consumer confidence was shaken. To revive the growth in the economy, the US authorities started cutting interest rates. This made cheap capital available. Investors had lost money, because they invested in “virtual” companies. They were looking for some “hard assets” to invest in. Something that was “ . real” House properties seemed to fit the bill. You rarely come across anyone who has lost money in his house property. Generally, the houses are bought and held for a long time – say, 10 years, 20 years. Long term investments benefit from inflation and development. There is a physical use of the asset, as one lives in it and saves on the rent. Most importantly, it is easy to get a loan for buying a house. With easy liquidity and lower interest rates, more Americans started buying houses. This started a self feeding cycle. Because more people were buying houses, the prices went up. Because of higher prices, the investment looked more profitable. This drove more people to the housing market. Prices went up further! Credit Expansion based on Market Price Generally, the loan that you will get for buying a house depends on 2 factors: your income and the value of the property. Your income shows how much you can repay on a monthly basis. This is the equated monthly installment, popularly known as “ . EMI” Someone could buy a house worth 50,000 dollars by taking a loan of 40,000 dollars, because his income supported an EMI of say, 1000 dollars. Now, the price of this house went up to, say, 90,000 dollars. Banks started offering him further loan of 32,000 dollars. Without an increase in repayment capacity, the loan went up. This was the beginning of the “ credit bubble” . The extra 32,000 dollars loan increased the liquidity in the hands of the investor. In some cases, this led to an impression that one had become wealthier. He started spending that amount on consumption: Buying a fancy SUV, for example. Some others used the 32,000 dollars to make a down payment on another house worth 160,000 dollars. Now, the loan has gone up to 200,000 dollars, without any increase in repayment capacity. Banks started giving “ interest only”loans. If you cannot repay the installment, pay just the monthly interest. The repayment will be done from the appreciated sale value of the house. If you cannot pay the interest in full, the banks came out with schemes where the unpaid interest would be added back to the principle amount. This increased the loan burden, but kept feeding the price bubble. With this change, banks started giving housing loans to borrowers without the repayment capacity. Even people without sufficient income were given loans. These borrowers were below the qualifying conditions to become a “ prime” borrower. Hence, they came to be known as “ sub-prime” loans. The upward spiral continued, based on a belief “ House prices never come down!” . Global wave of Liquidity The credit expansion in the US was fuelled by the housing boom. This money started chasing other assets throughout the world. With globalization, money could flow anywhere in the world. “Hedge Funds” are a type of funds, who have no restriction in investing anywhere. They are also allowed to borrow to invest. The number of such funds multiplied. They would borrow in the US when the interest rates were lower. Then, they started borrowing in Japan because the interest rates there were practically zero. The real estate price, stock prices, metals & commodity prices, energy prices in developed as well as developing countries went up many folds. Securitization The banks started selling their loan assets by bundling them together. A bank will take, say, 1,000 housing loans and create a bond containing these loans. The future instalments on these loans would be paid to the bond holders. This is called securitization. Such securities were give credit ratings. The banks could also add guarantees and insurance to the bonds, and upgrade the credit ratings. These bonds were bought by other banks, hedge funds, high net worth individuals and overseas investors. Thus, a problem which could have remained localized in the US housing market was broken into pieces and sent all over the world. Sub Prime Default The sub-prime borrowers lacked the capacity to repay. A time came when their homes had to be forfeited by the bank. When the banks started to resell these repossessed houses, there were no takers. The prices started coming down. When one house was sold at a lower price, all the houses in the same locality lost their value. More loans became unsecured. The banks started to repossess these, and the prices went down further. This triggered of a downward spiral, which we know today as the global financial crisis. When the sub-prime loans defaulted, the banks had to bear the loss on the uncovered portion of the loans. The bonds created out of housing loans also suffered a loss. The amount of loans that a bank can give is proportional to their capital in the business. This is called the capital adequacy. Many of the banks were lending 30 times their capital. When they suffered a loss of 1 dollar, their capital was less by 1 dollar. They were forced to call back loans worth 30 dollars. When banks started calling back their loans, the borrowers (such as hedge funds) were forced to sell off their assets at whatever price they could fetch. This de-leveraging process resulted in the distress sale of assets across the globe. Stock markets crashed. Real estate plummeted. Metals tanked. Crude oil tumbled. End of Easy Liquidity The credit bubble was creating easy liquidity conditions all over the world. De- leveraging meant exactly the opposite. Liquidity vanished. Lenders became wary to lend their money to others. Level of trust between lenders and borrowers dropped. This lack of liquidity means that raising loans has become more difficult for a number of companies. Due to the stock market crash, raising Equity capital is also nearly impossible. This exposed companies who were running their business on borrowed capital. Many companies were borrowing in the short term money market, but using that money to buy long term assets. They found themselves high & dry. Many companies had undertaken ambitious expansion. They had acquired other companies in the good times. These assets have now become liabilities. Companies find themselves in a cash crunch. The demand for what they produce has also come down dramatically. Impact on India India is not directly affected by the global financial crisis. However, we cannot escape collateral damage. Visible growth has happened in the last decade in Indian software industry. The software industry and other IT enabled services such as BPO are largely dependent on foreign customers, especially from the banking & financial services industry. Due to the turmoil abroad, the growth of this sector will have a setback. There will be cost pressures. We will see job losses. One job in the software industry gives rise to at least 5 related jobs. The automobile industry and the building construction industry were booming because of the demand from highly paid professionals. They will feel the pinch. Indian companies had benefited from money flow from abroad. The capacities have been expanded. The lack of demand will make these capacities unviable. How it affects me? The down turn will mean that we have to think differently from the boom period. The demand for all types of goods and services will go down. Certain types of goods and services are “ . necessities” It is not in the hands of the user to cut down on the consumption. Somebody who is not well will still consult a doctor and will still buy medicines. However, he will become more cost conscious. He may avoid or postpone cosmetic treatments. He will try to bargain about the charges. He may ask for credit. Some of the amounts due may have to be written off. How to gear up Downturns are an opportunity to rationalize and reform. The economic reforms in India started because of the foreign exchange crisis the country faced in 1991. In the personal context, we can use this phase to re-work our strategy, and come out stronger. Simple tips which will help are: ? Keep fixed cost under control ? Avoid the use of excessive borrowing ? Double check your expansion programs for their viability ? If you are planning to change an asset ( say, a car or a machine), see if the useful life of the earlier asset is still there, and is the change really necessary ? Avoid buying unproductive assets, and get rid of those already owned ? Avoid unrelated diversification ? Use the lean period to build a portfolio of outstanding equity shares at reasonable prices!