Sub Prime Crisis

Subprime Crisis (Subprime loans)

Sub-prime mortgage loans are loans

given to people with unstable
incomes or low creditworthiness.
These individuals are not financially
sound enough to be given a loan
when judged under the strict
standards that should normally be
followed by a bank or lending
institution.
 Mechanism of Sub Prime Lending
Three parties involved in sub prime mortgage loans
are:
 Banks (First American)
 Financial Institution (Second American)
 Borrower (Sub prime borrowers)
 Securitization
 Securitization means converting the home loans into financial securities,
which promising to pay a certain rate of interest.
These financial securities are then sold to big institutional investors through
an issuer (A bankruptcy-remote special purpose entity (SPE) formed to
facilitate a securitization and to issue securities to investors).
Investors provide funding for the loans and assume varying degrees of credit
risk, based on the terms of the securities they purchase.
 The interest and the principal that is repaid by the sub-prime borrowers
through equated monthly installments (EMIs) is passed onto these institutional
investors.
 A Servicer is appointed who collects these installments from the sub prime
borrower, passes on to the issuer which is eventually distributed to the investor.
 Advantages
Pros & cons of dealing in secuitization
 The risk is passed onto the investors who buy the financial securities
issued for securitising the home loan.
 Proper due diligence to give out the home loan was not done and
loans were extended to individuals who are more likely to default.
 By giving out greater amounts of home loan, the institutions were
able to securitise more, issue more financial securities and thereby earn
more money.
 Credit / Default risk
 Interest rate fluctuations
 Domino Effect
 The immediate cause or trigger of the crisis was the bursting
of the United States Housing bubble.
 High default rates on "subprime" and adjustable rate
mortgages (ARM), began to increase quickly.
 Falling prices resulted in homes worth less than the mortgage
loan, providing a financial incentive for borrowers to enter
foreclosure.

Excess Housing Inability to Mortgage Negative

housing price decline refinance foreclosure effect on
inventory mortgage economy
• Poor lending
• Housing
& borrowing
bubble burst decisions
• ARM
adjustments
Subprime mortgage crisis
 Facts & Figures
 The USA home ownership rate increased from 64% in 1994 (about
where it had been since 1980) to an all-time high of 69.2% in 2004.
 Between 1997 and 2006, the price of the typical American house
increased by 124 %.
 Household debt grew from $705 billion at year end 1974 (60% of
disposal personal income) to $7.4 trillion at year end 2000, and finally to
$14.5 trillion in midyear 2008, 134% of disposable personal income.
 U.S. home mortgage debt relative to its GDP increased from an average
of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion.
 As of March 2008, an estimated 8.8 million borrowers — 10.8% of all
homeowners — had negative equity in their homes, a number that is
believed to have risen to 12 million by November 2008.
 By January 2008, the inventory of unsold new homes was 9.8 times the
December 2007 sales volume, the highest value of this ratio since 1981. [60]
Furthermore, nearly four million existing homes were for sale.
Foreclosure graph
 Federal Reserve & Govt Packages
 Lowered the target for the Federal funds rate from 5.25% to 2%, and the
discount rate from 5.75% to 2.25%.
 Undertaken, along with other central banks, open market operations to ensure
member banks remain liquid. These are effectively short-term loans to member
banks collateralized by government securities
 Created a variety of lending facilities to enable the Fed to lend directly to
banks and non-bank institutions, against specific types of collateral of varying
credit quality.
 On 17 February 2009, U.S. President Barack Obama signed the American
Recovery and Reinvestment Act of 2009, an $787 billion stimulus package with a
broad spectrum of spending and tax cuts.
 The U.S. government passed the Emergency Economic Stabilization Act of
2008 (EESA or TARP) during October 2008. This law included $700 billion in
funding for the "Troubled Assets Relief Program" (TARP), which was used to
lend funds to banks in exchange for dividend-paying preferred stock.
 On 18 February 2009, U.S. President Barack Obama announced a $73 billion
program to help up to nine million homeowners avoid foreclosure.
IMPACT OF SUBPRIME
CRISIS

ON US ECONOMY

 ON WORLD ECONOMY

ON INDIAN ECONOMY

 ON US ECONOMY
• Americans lost more than a quarter of their net worth.

• Housing prices had dropped 20% from their 2006 peak, with futures markets
signaling a 30-35% potential drop.

• Total home equity in the United States, which was valued at $13 trillion at its
peak in 2006, had dropped to $8.8 trillion by mid-2008 .

• Total retirement assets, Americans' second-largest household asset, dropped

by 22 percent, from $10.3 trillion in 2006 to $8 trillion in mid-2008.

• Savings and investment assets (apart from retirement savings) lost $1.2 trillion
and pension assets lost $1.3 trillion .

• Taken together, these losses total a staggering $8.3 trillion.

 ON WORLD ECONOMY
• HSBC, the world's largest (2008) bank, wrote down its holdings of subprime-related
MBS by $10.5 billion.

• 100 mortgage companies either shut down, suspended operations or were sold.

• The CEOs of Merrill Lynch and Citigroup resigned within a week of each other in late
2007.

• Financial speculation in commodity futures following the collapse of the financial

derivatives markets has contributed to the world food price crisis and oil price increases .

• Lehman Brothers and other important financial institutions failed in September 2008.

• Third-World economies, such as the Brazilian and Chinese ones, will not suffer as much
as those from more developed countries.
 Cont.
 Third-World economies, such as the Brazilian and Chinese ones, will
not suffer as much as those from more developed countries.

 The International Monetary Fund estimated that large U.S. and

European banks lost more than $1 trillion on toxic assets and from bad
loans.

 The credit freeze brought the global financial system to the brink of
collapse.

 The securitization markets started to close down in the spring of 2007

and nearly shut-down in the fall of 2008 .
 ON INDIAN ECONOMY
 DECLINE IN INDO-US TRADE.

 FALL IN DOLLAR RATE TO RS 43.

 CRR INCREASED TO 8.25% FROM 5%.

 INFLATION IS AT ALL TIME HIGH AT 11.63% AS ON JULY

2008

 CRUDE OIL PRICES & OIL PRICES IS ABOUT 100% RISE IN AN

YEAR.
 EFFECTS ON INDIAN EXPORTERS
 LESS BUSINESS CONTRACTS FOR INDIA.

 HIGH INFLATION LED TO HIGH OPERATING COSTS.

 FALL IN DOLLAR PRICE LED TO LOWER REVENUES FOR

EXPORTERS.
 EXPECTED TREND
 The current credit crisis will come to an end when the overhang of
inventories of newly built homes is largely liquidated.

 Home price deflation comes to an end.

 Very large losses will, no doubt, be taken as a consequence of the

crisis.

 After a period of protracted adjustment, the U.S. economy, and the

world economy more generally, will be able to get back to business.
 Summary
The subprime crisis was rooted from the credit boom. Therefore, when the
Federal Reserve started raising rates in June 2004, the Americans felt the ever
increasing pressure from its heavy financial burden. However, as the Americans
did not have savings to counter economic downturn, the loan delinquency
problem began to grow. The credit boom was then burst amid the sharp property
market correction. The financial institutions then tighten their lending standards
and do not have confidence in the creditworthiness of both the corporations and
individuals because of the huge losses suffered. The risk bearing ability is also
lowered aggressively. This led to the spread of the problems in subprime assets to
a wider range of financial products. Globalization of the financial markets spread
the subprime problems to the whole world.
 Conclusion
The effect of the subprime and credit crisis will continue to surface. The world
economic growth will slow from the 30-year high of around 5% - 8% between 2004
and 2008 to its trend growth or even lower level. The future outlook remains highly
uncertain.
The subprime crisis marked the end of the relaxed lending environment. The US
employment market also weakens and would, no doubt, restrain the consumption
power of the Americans. The real private consumption growth is expected to lag the
growth of real disposable income. The private consumption dominated economic
structure should be adjusted. Private consumption growth would remain weak in the
future.
The US economy will continue to face the risk of recession and might have multi-year
economic difficulties, like Japan which suffered multi-year economic weakness after
the credit and housing bubble burst. Additionally, the subprime and credit crisis
clearly exposed the problems of the financial system and regulatory regime in the US.
Contd……..
All in all, both the developed economies, like the US, and the developing
countries, the global financial system and regulatory regime, should face a long
period of profound adjustments and rebalancing, in order to ensure a balanced,
healthy and sustainable growth in the future.
However, it is difficult to return to a new equilibrium in the near term. The world
economy would face the problem of unemployment, stagflation and economic
hardship. The Government from different countries needs to be prepared for the
long-term adjustments and implement the policies that can correct the imbalance