The traumatic turbulence on Wall Street triggered by the collapse of Lehman Brothers and the sell-out of Merrill Lynch has spread panic across the global financial system. Even the $85-billion bail out for distressed insurance giant AIG has failed to curb the panic.

Central banks from Moscow to Sydney are pumping billions of dollars into the system to ease the cash crunch for banks. The world stock, bonds and currencies markets are in turmoil as investors scurry for safe havens. Fear of the unknown has gripped the markets as each day exposes ever more entities. This is a poor commentary on a country never tired of preaching accounting (and other) standards to the world.

In the highly interlocked world of global finance, a rapidly globalising India can no longer remain immune to these upheavals. The BSE Sensex has lost 739 points (5.27%) to 13,261 in the last three days. More unnerving than the decline is the volatility, with intra-day movements being larger than the overnight change. The rupee has tumbled below 46 to a dollar as greenbacks are leaving India. The yield on 10-year government bond has hardened to 8.19 percent. India would have been in greater trouble if it had capital account convertibility, strongly advocated by many “reformers.”    

At the root of this unnerving scenario is the US sub-prime mortgage debacle. The trouble erupted last year, and all hopes that it would be temporary and limited have been belied by the recent developments.

If some people in the US cannot repay their housing loans, why should Indian equities take a hit? Here is why.

To begin at the beginning, a 10-year housing boom in the US lulled mortgage lenders into complacency. They started lending 100% of the value of a house to sub-prime borrowers i.e. people with poor credit histories, who were earlier regarded as non-creditworthy. Often the loans were sweetened with low interest rates. Since house prices were rising, lenders were confident that if the borrower defaulted they would be able to recover their dues by reclaiming and selling the property.

Today, house prices have fallen and are still falling, effective interest rates have gone up, and sub-prime borrowers are defaulting. Lenders can repossess the houses, but these are now worth much less than the outstanding loans. Moreover, a spate of repossession and resale could depress house prices even further and thus aggravate the problem.

If these loans had remained only on the books of original lenders, the impact of the default would have been confined to them. But, and here lies the true beginning of the scam, in order to create a large portfolio of loans from the limited amount of owned capital, the companies resorted to what is called securitization. Low, medium and high-quality loans were clubbed together, sliced into small pieces, and sold to investors as high-interest bonds known as asset-backed securities or collaterised debt obligations (CDOs).

Obliging rating agencies in turn assigned these debts a high rating, making them investment grade securities even for institutions with a cautious and conservative approach to asset selection. These bonds were bought and traded by hedge funds, pension funds, insurance companies, private equity funds, and many other specialist funds operating all over the world. Banks would give fresh loans against these bonds. As a result, no one knows who is exposed and how much!

Once the housing prices started falling and interest rates firmed up, the original borrowers started defaulting. Bonds based on their loans became exposed as worthless paper (which is what they logically amounted to anyway), their artificially-created market value disappeared and their holders incurred huge losses. In every asset market, investors rushed to reduce risk. As the funds started liquidating their investments - good, bad and ugly - and exited emerging markets in search of safe havens, the stock markets across the globe felt the tremors.

The crisis erupted in August 2007. Since then, world financial markets have been living on the edge. Several venerable banks, investment banks, mortgage houses, specialised funds and finance houses have gone bust. Since no one knows who is exposed and how much, even banks are unwilling to lend one another, creating a crisis of confidence and cash - the so-called liquidity crunch.

In order to improve liquidity and restore confidence in the market, central banks of US, Europe, England, Russia, Japan and Australia among others, have poured billions of dollars into the system. But that has not helped. The latest shake up on Wall Street shows that we have not yet seen the end of the tunnel.

The direct losses from sub-prime are estimated to be around $400 billion. Besides, there are a lot of derivative losses down the line, taking the total to $1000 billion.

The Federal Reserve is under pressure to rescue institutions in trouble so as to contain and minimize damage. The Fed pledged $29 billion to swing the Bear Stearns sale to J P Morgan in March, $100 billion to rescue mortgage finance firms Fannie Mae and Freddie Mac, up to $300 billion for the Federal Housing Authority. But there are also voices of dissent, cautioning against using taxpayers’ money to bail out private adventurers. It will encourage other banks to behave recklessly, say critics. It will send a signal that profits are privatized but losses are socialised, they say.

Seemingly listening to them, the Federal Reserve allowed Lehman Brothers to go under, refusing to guarantee its liabilities. However, just two days later, it provided a massive loan of $85 billion to American Insurance Group, wiping out what credibility it won by resisting Lehman Brothers' rescue plea and inviting tough questions on how exactly it determined whether a company was too big to fail. It also opened its doors to countless other companies to come calling for cash. Already there are talks of a huge money market in need of a bailout.

The recent developments on Wall Street will have a serious impact on Europe and Asia. Mr. David Wyss, chief economist at Standard and Poor’s, said in an interview that conditions in UK and Japan could be as bad as in USA. Indeed, UK may actually be in worse shape than the US as the housing bubble was bigger there and their banking system is not so well capitalised. Japan too seems to be in as bad a shape as the US. Clearly, the industrial world is in a recession and it should stay this way till early next year. This fear of a deepening of the global downturn has driven oil prices to $92 a barrel.

For India, the Wall Street crash has come a most inopportune time. The last few weeks had seen some good news on the macro-economic front. Inflation, though still high, has been declining for three weeks in succession. Industrial production growth in July was better than general expectations. Equity markets were moving in a range-bound manner, suggesting that a floor had been found.

The Wall Street bombshell sent financial markets in a tailspin. Although equities find support at low levels, the overall trend is downwards and may continue that way till the global scene is stabilized. The Foreign Institutional Investors (FIIs), which had poured $17.2 billion into Indian bourses last year, pushing stock valuation to dizzy heights, are now pulling out their capital and returning to safe havens at home. In 2008 so far, they have been net sellers to the extent of Rs. 34,176 crore ($8.472 billion). Given their leadership in determining market sentiment, stocks seem to be headed southwards.

It is too early to assess the precise impact of these developments on India’s real economy. But some trends are visible. First, Indian companies will find it difficult to raise cheap funds abroad. In addition to portfolio investment, FDI also will be affected.

Second, the Indian IT sector is in for rough times since about 60 percent of the revenue of India’s software firms comes from the global financial sector. Software majors such as TCS, Infosys, Wipro and Satyam that earn a significant portion of their revenues from the banking, financial services and insurance (BFSI) sectors need to be prepared for loss of business. So far, all are claiming that they will not be seriously affected. But how serious is “serious”?

Already, hundreds of jobs have been lost following the downsizing of operations and closing down of back offices in India - the toll of the collapse of Lehman alone is reportedly about 2,200 jobs. Several other global financial services companies too have been forced to cut the strength of back office operations in India, laying off people across various functions as their incomes were hurt by the crash of the stock markets.

Third, the loss of several well-paying jobs would dampen demand in some product-segments as well as real estate, which is already suffering due to sluggish sales. Real estate companies which have partnered these institutions for business collaborations or funds would have to be prepared for a change in partners and even stake sale by the distressed institutions.

Many leading realtors, already facing a paucity of funds due to a slowdown or correction in prices, may find it more difficult to raise resources even at the project level. Many of them had raised money from hedge funds or private equity firms through structured deals and also pledged promoters’ holding as collateral. The investors have the option to sell these shares in the secondary market in case their prices go below a certain level. Following the turmoil on Wall Street, realty stocks may continue to face selling pressure in the domestic market.

Finally, the rupee has been depreciating against the dollar, hitting a two-year low of Rs. 46.99 before RBI intervention propped it up. Dollar is strengthening against other currencies as the outlook for European countries and Japan is believed to be even worse than that for the US. With oil prices coming down, India’s oil companies have rushed in to buy before they go up again and exporters are delaying repatriation of export proceeds in the hope of getting an even better rate.

Understandably, there is gloom all around, though, as previously noted, there have been a few positive developments over the past couple of weeks. On the flip side, even if markets in developed countries stabilize at some level, FIIs - the main drivers of Indian markets - may take their own sweet time to return. That, coupled with the recent slowdown in corporate earnings, could keep stock prices down for a substantial period. The present valuations may seem attractive, but could fall further.

It is too early - and risky - to say how things will shape in coming weeks. We may hope for the best; but we must also prepare for the worst.

The author is Executive Editor, Corporate India, and lives in Mumbai