We have discussed in detail about the right kind of love we should have for the Money.
Today I thought it is time to look back at one of the worst Financial Crises of our era. And also understand why we in India were safer and less hit when compared to America.
As always, a statutory warning. This financial post is not about making money. As usual this post is also to provide you the understanding and manage finance better.
Before we get into the details, the first thing we should understand here is the housing market and how it is different between India and Western countries like America.
How does the Property Market work?
In India, it is taken for granted that the housing prices will only go in one direction – North. So, every time the house or property changed hand, it was always higher than the price at which it was bought years ago.
This is the predominant reason that we Indians park our funds in real estate rather than investing shares or starting some business.
One of the main reasons for this high demand in the property market or the real estate is the higher population we have, and many of the younger generation queueing to buy new houses.
People move from villages to bigger cities for the job, and this contributes to the main reason for the younger generation to continuously invest in properties. Due to the high rental prices, they decide to pay the same amount as EMI and one fine day owning the house.
Moreover, most of the governments also provide incentives for people taking home loans – in a way encourage their citizens to buy home and live a dignified life.
All these reasons kept spinning the wheel of the property market faster & faster, and the prices were always on the rise. Banks started to look at this as a good opportunity to invest the money we people put in it.
Is Competition Healthy or Bad?
So many banks started to pour lots of money into this market. When there is competition, it is healthy for consumers. The interest rates were falling, offers & discounts were pouring in for buyers.
But at the same time, the so-called predators pricing strategy made banks to shell out more than what the house was really worth.
For example, to attract buyers, they started to overvalue the houses, including the home improvement loans to the base loan and clubbed even the furnishing of houses in home loans.
Not just that, banks started to fund projects for houses directly, and this pushed the supply so much that in a few years the demand far exceeded the supply by the constant increase of the inventory.
Basics of economics say that a market price is determined by the demand vs supply. So, when the supply surpassed the demand, the fall of price starts. Houses are not selling at same rate as it used to be. So, the builders and companies default on their payment with an excuse of no sales.
Add to this, people see this fall of price and hold on to their prices in a fear that it could fall further. When this property sale falls, builders fail to pay back banks. Once the non-payment increases, banks started to feel the pain.
Till here, it’s the same story in India and America. What happened next was the one that shows the clear difference between a saving economy and spending economy.
How Saving Economy is Good
Most banks in US insure the loan they distribute to reduce their share of risk. In other words, they just move their risk to insurance companies. And insurance companies run on the strategy that not all who insure will claim.
To give an example, when was the last time you claimed money from insurance for your vehicle? Or even health insurance? You will be surprised by the number of people really claim to the one who insures.
But, if everyone starts to claim what will happen to the insurance companies? It will go bankrupt too, right?
And this is exactly what happened in the US. The banks went back to such insurance companies, (Remember the name Lehman Brothers?) and finally those insurance company has to file Chapter 11 (sorry guys, leave us alone because we are out of money!)
When such huge companies fall, all employees get affected. When employees get affected, unemployment rises. When unemployment rises buying power reduces. When buying power reduces, production is reduced. When production in a company is reduced, again employees get reduced.
And this is like a chain reaction. Finally, the bubble burst!
And this is what happened.
Do Indians Live Today?
So how different was our banks from American banks and why it did not run out of cash?
Because we Indians had a mentality of “Savings are the first expense“. And the majority of the Indians saved for the future. Some even saved all their income for the future of their kids that they lived less. I do not want to debate on if this is right or wrong. But this is the reality.
Do not miss to read more on this in my post “What will make you Rich?“
And all these savings were safe in the Bank.
So, our Banks had enough buffer to manage the liquidity crunch.
And this is where there was a huge difference between India and America.
America is more of a consumer economy which is run predominantly by plastic. Yes, the famous credit cards.
Americans kept using cards, paid back the card with their income. And when there is one issue with the income due to job loss, or anything, the cycle is broken. This has a chain of reaction and slowly it affects the economy itself.
So, when people had issues in repaying the debt, mortgages etc Banks went to the insurance companies to save their back. Unfortunately, the insurance companies could not arrange for the huge cash in such a short time and went bankrupt.
You may ask, why do banks give so many loans? But that is why banks are there in the first place.
Remember, no bank keeps all the investor’s money. Idle money is dead money. So, it is always lent out as loans to companies, individuals etc. This means if all the investors went to the bank on a given day requesting money, the bank cannot give back all the money at once.
And in this case, the bank was not able to source money from the loans it distributed. Why? Because most people and companies cannot repay the loan.
Oh, the house or the property is still there, why can’t bank sell it and take its share? You may ask.
That is where the real problem arises. The house is just a non-performing asset. The banks can neither enjoy it, not sell it easily. Because, first many houses were over-valued. Moreover, there is already more supply than demand which caused this fall.
So, who will buy it? So this will further make the prices fall and this chain reaction will just make the economy collapse.
You see, that is exactly how one small issue can lead to others and finally result in a disaster.
From this disaster, the world have learned a new lesson. Banks and financial institutions are no more generous in lending money. Even governments have amended the laws and regulations to make sure such a bubble does not happen in the future.
How long will this hold true? Will these steps be fool-proofs?
In my opinion, NEVER. Unless people follow ethics and live a contented life, it will never happen.
A search of wealth in this materialistic world will lead few to the richness, and rest to – I do not want to say it!