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World Financial Crisis II

World Financial Crisis II

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Published by ca.deepaktiwari

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Published by: ca.deepaktiwari on Dec 16, 2008
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06/10/2010

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 October 13, 2008 For Private Circulation only 1
Sensex 11,337Nifty 3,491
Deepak TiwariResearch Analystdeepakt@arthamoney.com T: + 91 22 4063 3032
 
World Financial Crisis II
In first part of the captioned report we discussed the current financial chaos and theaftermath actions of various governments like bailout programs and buying stakes ininstitutions by governments in order to rescue them. Now in this report, we willdiscuss the whole scenario at length.
What went wrong?
The question that must be intriguing even a layman is what went wrong with the USinstitutions and the economy. This mess indeed happened not overnight. It was theresult of a combination of factors like crony capitalism, connivances, lack ofdisclosures, reporting requirement policies and fragile financial systems.
Background
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 convertthem into what was called as CDOs (Collateralized Debt Obligations). Simplyspeaking, this refers to buying home loans that banks has already issued toborrowers, 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 andinsurance companies among others across the world with a fancy name, such as"High Grade Structured Credit Enhanced Leverage Fund". It is something like debtsecuritization. Such innovative products meant good business for both the bankswho lent home loans and Investment banks who bought CDOs because the latterwould allow banks to keep a significant part of the interest rate charged on the homeloans besides paying upfront cash, which banks could use to issue more homeloans. As home loans could go on for 20-30 years and it would have taken a longtime for the banks to recover their money, such arrangement helped them maintainmore liquidity.On the other hand, investment banks would sell CDOs to investors at the higher ratethan the US treasury and in return such investors would receive a share of themonthly EMI paid by the person who took underlying home loans. Since US homeprices were always going up, there were chances of defaults. So investment banksroped in insurance biggies like AIG by convincing them that it was a risk free incomefor them as even in case of defaulting EMIs, the home could be seized and sold formuch higher prices.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 startedinvesting a significant part of their own capital in these. Gradually the markets forCDOs and Credit Default Swaps (CDS) started expanding with traders and investorsbuying and selling these as if they were hot stocks of a blue-chip company shunningthe facts like the capacity of underlying people to repay.The problem begun when such investment banks started churning more and morehome loans into CDOs and selling them or investing their own money, there was apressure on the banks to issue more loans so that they could be sold to investmentbanks in return for a commission. Then the problem aggravated when banks startedlowering the credit quality for availing a home loan and aggressively used agents tosource new loans.
 
 October 13, 2008 For Private Circulation only 2
And as a result a time came in 2005 when almost anyone in the US could buy ahome without income proof, other assets, credit history or sometimes even without aproper 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. Manypeople 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 achain of defaults making home prices going further down. Then in 2007 it came tothe 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 financialgiants 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 badmortgage debt in an attempt to rescue the nation's credit markets will be effective. Insubprime crisis, several firms have lost over $501 billion and there is speculation thatworst 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 theglobe particularly in the US and Europe. Respective governments are fighting toothand nail and are pumping billions of cash into the banking system to stave off anyliquidity crisis.We expect that the dust will settle in two three quarters. But this mortgage mess willcertainly teach us many lessons. First and foremost, it must result into tighter andtransparent regulations. No doubt, government interventions will increase butsometimes it’s good for the markets if it is aimed at bringing stability and normalcy tothe equities and safety of the interests of hapless investors. Right now equities arereacting sharply while panic and fear ruling the game. There are wild rumours andspeculations. Foreign investors have turned risk averse now and are trying to cashout to make up for their losses incurred in developed markets resulting in exodus ofmonies out of the emerging markets.
How it will impact us?
Emerging economies including India cannot remain insulated from sinking USeconomies is now a fact difficult to swallow. Rising unemployment, declining factoryorders and economic slowdown which are the pre cursor of the impending USrecession is a matter of great concerns for India. Though India’s growth engines areset to ignite and we are still the second fastest growing economies at 7.5-8%. But weneed foreign funds to sustain such growth. As of now FIIs are in panic mode andtrying to take out their monies from the emerging markets. But we are of the viewthat 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 Powerequipment & services, auto, retail, logistics, hospitality & tourism. The least impactedsectors however would be pharma, fertilizers energy, FMCG and media. And thereare 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 attractFIIs while it has allowed foreign companies to buy Indian stocks. There will be moresuch congenial measures to rev up the markets sentiments in time to come.
Post this financial crisis and bail outmeasures, we should expect more tightand transparent policies. We may seeincreased intervention fromgovernments. Further, it will take sometime to return to normalcy.
 
Current global liquidity crunch hasforced Reserve Bank to cut CRR by 150bps. Some more such cuts areexpected. FIIs exodus will continue inshort term till normalcy returns to themarkets. Further, the sectors that willbe impacted hard by this mess areBFSI, real estate, infrastructure and IT.
 
 October 13, 2008 For Private Circulation only 3
Once upon a time: It happened only in America
Home Loan SeekerBank (The lender)Investment bankInsuranceCompaniesInvestors
 
(Pension fundsor insurance companies)
In 2003 there was great demand for house loan inthe US. Like debt securitization, investment bankswould buy home loans from the US banks whileallowing them to keep a significant part of interestincome besides paying upfront cash.In turn such investment bank would convert loansinto CDOs and then sell them to investors acrossthe globe giving them higher returns than the UStreasury.The buyers who would buy CDOs would beentitled for a share of the monthly EMI.Since home prices were consistently rising,insurance companies were easily convinced thateven in case of default, house can be seized andsold at much higher prices, giving them risk freepremiums.This mounted pressure on banks to dole out moreloans to create CDOs and in this process theystarted ignoring borrowers credentials likecapacity to repay.In 2004 interest rate began to rise which led up toa series of default. Since it was very lucrativebusiness investment banks went overboard andleveraged their equities 30-40 times.

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