World Financial Crisis II

In first part of the captioned report we discussed the current financial chaos and the
aftermath actions of various governments like bailout programs and buying stakes in
Sensex 11,337 institutions by governments in order to rescue them. Now in this report, we will
discuss the whole scenario at length.

What went wrong?

The question that must be intriguing even a layman is what went wrong with the US
institutions and the economy. This mess indeed happened not overnight. It was the
result of a combination of factors like crony capitalism, connivances, lack of
disclosures, reporting requirement policies and fragile financial systems.

Background

Nifty 3,491 It started in 2003 when there was a great demand for American home loans.
Investment banks like Lehman Brothers would buy from the US banks and convert
them into what was called as CDOs (Collateralized Debt Obligations). Simply
speaking, this refers to buying home loans that banks has already issued to
borrowers, cutting them into smaller pieces, packaging the pieces based on return
(i.e. interest rate), value, tenure and selling them to investors like pension funds and
insurance companies among others across the world with a fancy name, such as
"High Grade Structured Credit Enhanced Leverage Fund". It is something like debt
securitization. Such innovative products meant good business for both the banks
who lent home loans and Investment banks who bought CDOs because the latter
would allow banks to keep a significant part of the interest rate charged on the home
loans besides paying upfront cash, which banks could use to issue more home
loans. As home loans could go on for 20-30 years and it would have taken a long
time for the banks to recover their money, such arrangement helped them maintain
more liquidity.

On the other hand, investment banks would sell CDOs to investors at the higher rate
than the US treasury and in return such investors would receive a share of the
monthly EMI paid by the person who took underlying home loans. Since US home
prices were always going up, there were chances of defaults. So investment banks
roped in insurance biggies like AIG by convincing them that it was a risk free income
for them as even in case of defaulting EMIs, the home could be seized and sold for
Deepak Tiwari
Research Analyst
much higher prices.

deepakt@arthamoney.com
T: + 91 22 4063 3032
This whole premise was built on the assumption that home prices would keep rising.
As demand for the CDOs started growing across the global investment community,
the investment bankers who were meant to sell these instruments also started
investing a significant part of their own capital in these. Gradually the markets for
CDOs and Credit Default Swaps (CDS) started expanding with traders and investors
buying and selling these as if they were hot stocks of a blue-chip company shunning
the facts like the capacity of underlying people to repay.

The problem begun when such investment banks started churning more and more
home loans into CDOs and selling them or investing their own money, there was a
pressure on the banks to issue more loans so that they could be sold to investment
banks in return for a commission. Then the problem aggravated when banks started
lowering the credit quality for availing a home loan and aggressively used agents to
source new loans.

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Post this financial crisis and bail out
measures, we should expect more tight
and transparent policies. We may see
increased intervention from
governments. Further, it will take some
time to return to normalcy.
Current global liquidity crunch has
forced Reserve Bank to cut CRR by 150
bps. Some more such cuts are
expected. FIIs exodus will continue in
short term till normalcy returns to the
markets. Further, the sectors that will
be impacted hard by this mess are
BFSI, real estate, infrastructure and IT.
October 13, 2008
And as a result a time came in 2005 when almost anyone in the US could buy a
home without income proof, other assets, credit history or sometimes even without a
proper job. Such loans were called NINA which stands for "No Income No Assets".
To make things even worse, interest rates began to rise during 2004-2006. Many
people had taken variable rate home loans that started getting reset to higher rates,
which in turn meant higher EMIs that borrowers had not planned for. This led up to a
chain of defaults making home prices going further down. Then in 2007 it came to
the fore what we now know it as sub-prime crisis.
What is in store?
This hydra headed monster called sub-prime crisis has engulfed many financial
giants that ruled the financial world for many decades and are a thing of past now.
Only time will tell how the US bailouts plan of $700 billion to buy a pile of bad
mortgage debt in an attempt to rescue the nation's credit markets will be effective. In
subprime crisis, several firms have lost over $501 billion and there is speculation that
worst is yet to come to the fore. (A list of such write downs is enclosed somewhere in
the report). Banks and financial institutions are facing liquidity crunch across the
globe particularly in the US and Europe. Respective governments are fighting tooth
and nail and are pumping billions of cash into the banking system to stave off any
liquidity crisis.
We expect that the dust will settle in two three quarters. But this mortgage mess will
certainly teach us many lessons. First and foremost, it must result into tighter and
transparent regulations. No doubt, government interventions will increase but
sometimes it’s good for the markets if it is aimed at bringing stability and normalcy to
the equities and safety of the interests of hapless investors. Right now equities are
reacting sharply while panic and fear ruling the game. There are wild rumours and
speculations. Foreign investors have turned risk averse now and are trying to cash
out to make up for their losses incurred in developed markets resulting in exodus of
monies out of the emerging markets.
How it will impact us?
Emerging economies including India cannot remain insulated from sinking US
economies is now a fact difficult to swallow. Rising unemployment, declining factory
orders and economic slowdown which are the pre cursor of the impending US
recession is a matter of great concerns for India. Though India’s growth engines are
set to ignite and we are still the second fastest growing economies at 7.5-8%. But we
need foreign funds to sustain such growth. As of now FIIs are in panic mode and
trying to take out their monies from the emerging markets. But we are of the view
that the sense will prevail and they will return to us. It’s a just a matter of time.
The nefarious subprime crisis is going to further impact sectors like BFSI, real estate,
infrastructure and IT. Sectors that are likely to be impacted mildly are Power
equipment & services, auto, retail, logistics, hospitality & tourism. The least impacted
sectors however would be pharma, fertilizers energy, FMCG and media. And there
are positive developments too such as receding crude price, levelling off inflation etc.
RBI has cut CRR by 150 bps to release Rs 80,000 crore in the banking system.
There may be more such rate cuts in the offing. Sebi has eased PN rules to attract
FIIs while it has allowed foreign companies to buy Indian stocks. There will be more
such congenial measures to rev up the markets sentiments in time to come.
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Once upon a time: It happened only in America

Home Loan Seeker In 2003 there was great demand for house loan in
the US. Like debt securitization, investment banks
would buy home loans from the US banks while
allowing them to keep a significant part of interest
income besides paying upfront cash.

Bank (The lender) In turn such investment bank would convert loans
into CDOs and then sell them to investors across
the globe giving them higher returns than the US
treasury.

The buyers who would buy CDOs would be

Investment bank entitled for a share of the monthly EMI.

Since home prices were consistently rising,

Investors (Pension funds insurance companies were easily convinced that
or insurance companies) even in case of default, house can be seized and
sold at much higher prices, giving them risk free
premiums.

This mounted pressure on banks to dole out more

loans to create CDOs and in this process they
Insurance started ignoring borrowers credentials like
capacity to repay.
Companies

In 2004 interest rate began to rise which led up to

a series of default. Since it was very lucrative
business investment banks went overboard and
leveraged their equities 30-40 times.

October 13, 2008 For Private Circulation only 3

Write downs/ losses and capital raised by respective worst hit companies

Companies Write down/ Losses Capital Raised

Citigroup 55.1 49.1
Merrill Lynch 51.8 29.9
UBS 44.2 28.3
HSBC 27.4 3.9
Wachovia 22.5 11
Bank Of America 21.2 20.7
IKB Deusches 15.3 12.6
RBS 14.9 24.3
Wasgington Mutual 14.8 12.1
Morgan Stanley 14.4 5.6
JP Morgan Chase 14.3 7.9
Deusches Bank 10.8 3.2
Credit Suisse 10.5 2.7
Wells Forgo 10 4.1
Barclays 9.1 18.6
Lehman Brothers 8.2 13.9
Societe Generale 6.8 9.8
ING Group 5.8 4.8
BNP Paribas 4 0
Goldman Sachs 3.8 0.6
Bear Stearns 3.2 0
ABN Amro 2.3 0
Others 130.7 89.8
Total 501.1 352.9
Figures in $ billion

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