Economic Crisis and Consumer Financing - Term Paper Example

Economic crisis and consumer financing Economic Crisis and Consumer Financing Introduction The world is currently passing through one of the worst periods of economic crisis since the great depression of the 1920s. The problem started with the subprime crisis in the USA during 2005-2006 and has quickly engulfed all sectors of economic activities in a domino effect by late 2007. It spread from the housing sector to the banking and financial sectors, leading to credit squeeze and as a result, to serious drop in sales of consumables and durables. This is a vicious cycle that leads to drop in production, further job losses and deepening crisis. The impact is not local or national but global in view of the current global interdependence. Recession in one part of the world is spreading to many other countries. Services sector (or the tertiary sector) is one of the three major pillars of any economy, the other two being primary (agriculture) and secondary (manufacturing) sectors. Service sector includes insurance, banking and financial institutions among other things – all of which had been expanding their businesses across the globe. Hypothesis As a result of the huge losses suffered in the housing loans business, many of the well-known banks and financial institutions have either gone bankrupt or had to be rescued by government support. Big names like Fannie May and Freddie Mac, Northern Rock and Lehman Bros. come to one’s mind in this context. In this bleak economic scenario, the genuine activities of banks on one hand, and needs of consumers on the other have suffered seriously. Consumer loans being one such activity, this paper examines the Economic crisis and consumer financing 2 impact of the current global economic crisis on consumer loan segment of banking industry. Purpose This study is a process of conducting research into an important business activity with a view to find evidence or the lack of it, to validate the hypothesis given above, and further to enhance the body of literature on this subject. The subject has relevance in the current economic situation. Methodology It is recognised that it is too early to gather data and make a statistical analysis of the impact of the current crisis on various sectors of the economy and more so in an area like the consumer financing. The events are just over a year old and are still unfolding. Hence this report relied upon literary sources on the subject of consumer finance in general and the published information / data / articles on the current situation in particular, to gather descriptive opinions from among a cross section of sources. Important financial and other newspapers like the Financial Express, Guardian, The Economic Times etc. have been accessed on the Internet to read through relevant articles. Based on such literature review work, the gathered information is analysed and appropriate conclusions drawn. Consumer finance Consumer loans, personal loans, home loans, car loans, student loans or by whatever name they are called, all come under consumer finance (Reliance Finance). These are loans issued generally by banks to enable consumers to access finance as per agreed terms and conditions and to use the finance for the specified purpose – to buy Economic crisis and consumer financing 3 consumable durables, build / buy homes, automobiles or to pay for education etc. Purchases through credit cards are also a form of consumer finance although they are essentially short term transactions to be settled within a month. The importance of consumer financing industry can not be underestimated. By availing loan facility, the consumers become active participants in the economy of a nation and keeping the wheels of industry and commerce moving. The obligation to repay the loans together with interest makes them responsible individuals to work and earn sufficient money. In a way, while sanctioning loans, bankers are confidently investing in the future earning capacity of consumers. In order to secure their own interests, the banks exercise sufficient care and due diligence in assessing a consumer’s eligibility and obtain sufficient collateral to guarantee recovery of dues. Thus in an ideal situation, the interests of the banks and consumers are perfectly balanced. This equilibrium is disturbed if there is large scale default on the part of consumers due to economic conditions as is happening now. As mentioned earlier, home loans, auto loans and student loans are some of the most important consumer loans in the consumer finance business. The collapse of the home and auto loan sector has dented the ability of banks to sanction student loans, as will be seen in the later part of this paper. Such loans are also likely to become more expensive if they are accessed from private sector banks. Auto loans Consumer loans for purchase of automobiles have virtually dried up in many countries and as a result, auto sales have suffered significant drop, leading to build up of high inventories and cash crunch for manufacturers. Banks which have themselves suffered Economic crisis and consumer financing 4 huge cash losses (bad assets valued downwards) on their balance sheets due to bad loans to housing sector are unwilling to take even normal business risks to extend credit to industries (Zuckerman, 2007). For example, the three giants of the US automobile industry namely GM, Chrysler and Ford, have been asking for billions of dollars in financial support but have not yet been granted the same in full measure (Moore, WSJ). Other major car makers like Toyota, Jaguar & Land Rover, Daimler Benz etc. are also hit by the current economic crisis. Toyota reported its first loss in 70 years following a 21.8 percent fall in sales in November 2008 compared to the corresponding month of 2007; Nissan reported a 19.8% drop in sales in November 2008, with its global production contracting by as much as 33.7%; and, Honda reported similar massive production and sales losses (Washington Post). The high spurt in crude oil prices up to US$147 per barrel by July 2008, and its precipitous fall to less than US$40 per barrel now can be partly explained by the crisis that hit the auto industry. There is a demand recession for petroleum products and the reasons for this are not far to seek. Banks and financial institutions have virtually stopped lending and hence consumers are not spending on new automobiles as per their usual habit. This case is not an exceptional feature of the US auto industry since firms like Toyota, Honda and Nissan have also reported huge drop in their global sales (Washington Post). Home loans Coming to home loans, the genesis of the present global crisis, the problem is on two major counts – existing homes and new homes. In the era of euphoric rise in sanction of Economic crisis and consumer financing 5 home loans, credit worthiness of consumers was deliberately bypassed by subprime lenders while commercially unviable and customer-friendly initial terms but with high interest rates were signed upon on a very large scale (Wikipedia, 2007). In the absence of regulations, the home loan mortgages were bundled and resold to financial institutions and banks around the world. The adjustable rate mortgages (ARM), increasing oil prices and the general economic down turn due to the continuing wars in Iraq and Afghanistan led to job losses and increasing defaults on mortgage repayments. This has in turn led to the housing bubble to burst, prices of properties fell sharply and the banks and financial institutions that held the mortgages in the hope of earning high interest rates coupled with the security of ever increasing property prices, were caught on the wrong foot. They had no option but to seek foreclosure of the loans and sale of the underlying assets. It is reported that, “During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006 (Realtytrac.com, quoted in Wikipedia). With so many foreclosures and non-availability of credit, there were hardly any buyers in the market. Zuckerman gives us a figure of US$2.1 trillions as the loss suffered by the home loan consumers as a result of the fall in home prices in the USA alone (Zuckerman, 2007). The story of existing home loans as seen above is having its impact on new home starts as well. According to the Financial Express, “…financing is also becoming scarce, a quarterly survey of banks by the Federal Reserve showed. Three- fourths of the loan officers polled reported they tightened standards on prime mortgage loans, up from the April survey” (Financial Express, Aug. 18, 2008).The Economic Times also reported that Economic crisis and consumer financing 6 new housing starts in the US fell to a 17-year low during August 2008 and it represents a 33% drop compared to a year ago (Economic Times, Sept.17, 2008). Banks and financial institutions outside of the USA but which have global business profile got involved in this crisis as for example Northern Rock of UK, Icesave of Finland and many more. According to Thomas L. Friedman, the attractive rate of interest on savings account offered by banks such as ‘Icesave’ coupled with online globalized banking services enabled them to gather huge deposits from government departments, hospitals, universities etc., and individuals (Friedman T.L, 2008). When the global credit crisis occurred it was impossible for these Icelandic banks to finance their foreign denominated debt, leading to default on repayment of deposits or failure to honor withdrawals. Thus, the current economic crisis has hit the credit market including home loan market significantly. Student loans – UK Government policy In UK the public policy supports a wide variety of student finance schemes to enable both local and foreign student to access credit from financial institutions at reasonable rates. Extensive information is given by the government concerning various schemes for student finance in their website ‘direct.gov.uk’. These schemes cover full time or part time students, students from Northern Ireland, Scotland and Wales, from the EU Zone, and international students. Finance may be in the form of loans, grants or bursaries from the educational institutions. A full time student executing higher studies can avail loans up to £9,650 (direct.gov.uk., Dec. 25, 2008). Out right grants from the government or bursaries from the universities and colleges are also available that need not be paid back Economic crisis and consumer financing 7 at all, as per policy. Such finances cover both tuition fee costs and costs of accommodation and other living costs. Interest charges are linked to inflation. Part time students get similar financing schemes but the amounts of loan or grants / bursaries depend upon individual situations (direct.gov.uk., Dec. 25, 2008). The UK government supported student finance schemes are available currently at 3.8% rate of interest per annum and repayment starts only when the student starts to earn £15,000 or more per annum. Since the cost of government supported loans is directly related to inflation, it is important to note changes in inflation rates over the past few years. UK government statistics give the following data. Consumer Price Index (CPI) for all items, % change over 12 months: Year Ave. J F M A M J J A S O N D Int. Rate% 2004 1.3 1.4 1.3 1.1 1.1 1.5 1.6 1.4 1.3 1.1 1.2 1.5 1.7 2.6 2005 2.1 1.6 1.7 1.9 1.9 1.9 2.0 2.3 2.4 2.5 2.3 2.1 1.9 3.2 2006 2.3 1.9 2.0 1.8 2.0 2.2 2.5 2.4 2.5 2.4 2.4 2.7 3.0 2.4 2007 2.3 2.7 2.8 3.1 2.8 2.5 2.4 1.9 1.8 1.8 2.1 2.1 2.1 4.8 2008 2.2 2.5 2.5 3.0 3.3 3.8 4.4 4.7 5.2 4.5 4.1 3.8 (Sources: Office for national statistics, Government of UK; Student Loans Co. Ltd.) It is inferred from the above statistics that inflation is on the rise (between February & October ’08) and hence student finance is becoming more expensive in general although the rates were kept relatively low in 2006 and 2008. Coming to the quantum of loans being sanctioned by the government, statistics are as given below: Economic crisis and consumer financing 8 Student support in the form of loans: Estimated eligibility and take-up of maintenance loans in England Academic Year Eligible Population (000s) Estimated Number of loans taken out (000s) Estimated Take up of loans by eligible population (%) Total sum borrowed (£m) Average value of loan (£) 2001/02 768.0 629.0 82 2,007.0 3,190 2002/03 816.0 666.0 82 2,161.0 3,250 2003/04 840.0 682.0 81 2,258.0 3,310 2004/05 874.3 693.1 79 2,348.6 3,390 2005/06 897.0 719.1 80 2,495.5 3,470 2006/07 905.0 728.1 80 2,613.4 3,590 2007/08 (provisional) … 746.2 … 2,630.7 3,530 2008/09 (provisional) … 714.3 … 2,541.2 3,560 (Source: Student Loans Company Limited) The above statistics show steady rise in the number of maintenance loans taken out (generally in line with the rise in the number of eligible persons) till 2007/08 and shows a dip in the year 2008/09. This may be attributed at least partially to the economic crisis in UK. If we consider the inflation, the reduction in total loan sanctioned becomes more significant. Student loans – banks and institutions In UK, corporate banks also support students by providing loans for executing professional courses like medicine, law, engineering or MBA etc. Currently banks like the National Westminster (NatWest) or HSBC charge interest rates on such loans from 6.5% to 10% in addition to the applicable processing fees. These rates are substantially higher compared to the rates on student loans issued by the government. Barclays Bank does not offer student loans at all. Economic crisis and consumer financing 9 The situation in the USA is perhaps worse. Jagger reporting in the Timesonline brings out the squeeze applied by bankers on student loan sanctions in the US (Jagger S., Timesonline, March 31, 2008). According to her report, during the second fortnight of February 2008, banks including HSBC have withdrawn from the student loan market, estimated at £42 billions in the USA, confirming the spread of the credit crisis. These loans amounted to about £8.5 billions during 2005-06 and provided by banks such as JP Morgan Chase, Citigroup and Bank of America, she points out. Further she stated that Iowa Student Loan which sanctioned 29,000 loans during 2007 proposed to stop offering private loans altogether stating that, “This is really a reaction to the economy’s recent situation, the sub-prime market in particular” (ibid). Ironically enough, a Fitch Research report comparing the UK and US student loan market holds out that, “The potential long-term privatisation of UK student loans may present investors with the opportunity to purchase UK student loan asset-backed securities, for which the student loans serve as primary collateral” (Fitch Research, 1997). It is seen that between 1997 and the current times, situation has dramatically changed for the worse and financial institutions are far from a positive frame of mind to buy securities, even when they are guaranteed by governments as in the case of student loans in the USA. Discussion The most important developments in the area of consumer finance in the past decade or so have been the significant rise in lending volumes, lending by a host of agencies other than banks, intermediation and resale of mortgages, particularly in the home loan market Economic crisis and consumer financing 10 and finally trading of such instruments as securities around the globe. This euphoric and practically unregulated financial engineering (as it has come to be known as) has created a bubble of economic boom quite unrelated to the real economy of goods and services. Unforeseen circumstances like the long drawn out wars, high oil prices and job losses led to demand recession as well as large scale failure on home loan repayments. This has in turn damaged the viability of big banks and financial institutions, culminating in the erosion of confidence – both for the financiers and the loan seekers. This phenomenon is not confined to one country or one region but practically to the entire global economy. The crisis of confidence has emanated from the collapse of such giant financial institutions like Fannie Mae, Freddie Mac, Lehman Brothers, Bank of America, JP Morgan Chase et al just to name a few. These institutions and a host of others had to be bailed out through infusion of capital or merger with others. In this era of globalised economies, their operations are interlinked with hundreds of other banks and financial institutions around the world. Thus the crisis in the US market had contagion impact around globe. Increased non-performing assets, reduced profitability and capital erosion are the consequences for the banking and finance industry, resulting in a credit crisis of global proportion. Consumers are naturally hit hard by these developments. A number of them have lost their homes, jobs and credit facility. In the absence of purchasing power, demand for goods and services has nose dived leading to recession or contraction of economic growth in many countries like the USA, UK, Japan and the European Zone to some extent. Economic crisis and consumer financing 11 Consumer finance in the three major areas of home loans, auto loans and student loans suffered in response to the market conditions described above. While government support for student loans appears to be only marginally impacted, private sector is keeping away from this segment of business, at least partially. To stimulate the beaten economies and to revive consumer confidence, many countries are reducing lending rates and this is having positive impact on consumer finance loans as well. UK has reduced its rate on student loans from 4.8% in the previous year to 3.8% in the current year. Private sector banks like NatWest are yet to follow this lead and their rates are still in the high range of 6.5 to 10%. Conclusion Consumer loans are the lubricants that keep the wheels of economy running smoothly. The current situation is not sustainable and many governments are taking aggressive actions to revive their economies. These measures include infusion of cash into the financial system, increase in public spending in areas like infrastructure, education & energy and reduction of interest rates. Thus these measures cover both monetary and fiscal policies. Home loans, auto loans and student loans are important areas of economic activity. Economic well-being of the citizens of a nation can be gauged by such facilities. In times of economic crisis, it is these facilities that get eroded leading to severe hardship for consumers on the one hand, and great loss of economic activity to the society on the other. The current economic crisis is having such impact on consumer finance, which has become scarce and dearer. Statistical data presented above gives a grim picture of the Economic crisis and consumer financing 12 present situation but it also provides an idea of the worse times to come unless the corrective steps being taken prove adequate. Since the problem has assumed global proportion, the solution also has to be a globally coordinated one. Economic crisis and consumer financing 13 References Direct.gov.uk., (2008), Student finance – UK. Available at: http://www.direct.gov.uk/en/educationandlearning/universityandhighereducation/studentfinance/index.htm. [accessed on December 26, 2008]. 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