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Subprime

Subprime

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Published by: mohit.almal on Sep 17, 2009
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10/20/2011

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Presented By: Kaushambi Ghosh Manish Madhukar Mohit Almal Pankaj Agarwal

Agenda
Subprime
•Traditional Model Vs Subprime Model •Players in the Game

Bubble
•Housing Bubble
Why it burst?

Global Crisis Impact
Events Indian story

Bailouts What Next?

Subprime

Traditional Model Vs Subprime Model

Players in the GAME

Players
Player 1: Fed -- Fed kept the interest rate low during much of 1990s and particularly 2001-2005 (low oil prices, and low inflation prompted the policy), fueling the market -- During the 2001-2005, FFR was in the 1% to 3% range, and mostly in the 1% range -- Fed encouraged more risky ARM lending (Greenspan) Player 2: Mortgage Salespersons -- Worked on commission based on the number of arms successfully twisted

Contd..
Player 3: Primary Lenders -- No incentives for judicious lending Banks no longer needed to hold on to the mortgage, as use of mortgage-backed securities made risk taking more appealing -- Use of ARMs with low teaser rates (below market rates for a while, followed by much higher rates tied to index, LIBOR + some %). Teaser rates are popular when long-term interest rates are at historical lows (like much of this period), as they help lenders benefit from ARMs as rates rise -- Net Effect: Many loans were made to NINJA’s (people with No Income, No Jobs or Assets).

Contd..
Player 4: Other Financial Institutions -- Freddie Mac and Fannie Mae issued many Mortgage Backed Securities -- Other financial institutions that traded in these as well as derivatives based on real estate assets. Many of these were global institutions

Contd..
Player 5: Credit rating Agencies and Analysts -- Lack of market for many of these securities, so models were used to price them -- Inflated ratings, mostly in A range (similar to T-Bills) -- Conflict of Interest: Investment bankers’ analysts were rating investment bankers’ clients (scandal) -- For example, 3 months prior to its demise, AIG was rated strong buy (8 analysts), buy(3), hold (10))!!! Player 6: Home Buyers (Taking Excessive Risk) -- Home buyers were enjoying the ride -- New ones were joining the ride, even if unqualified -- Home ownership up from 60% in 1990s to 70%

Bubble

Historic Bubbles
Dutch Tulip Mania South Sea Bubble British Railway Bubble US Railway Bubble Roaring Twenties Multi Bubble Internet Bubble Housing Bubble (1630s) (1710s) (1840s) (1880s) (1920s) (1960s) (1990s) (2000s)

Structure of a Bubble
Displacement Take off Exuberance Critical Stage Crash (diffusion of new technology starts) (stock prices show abnormal increase) (stock prices grow at very high rate) (stock price growth slows down) (stock prices start tumbling)

Population Dynamics in the Course of a Bubble

Housing Bubble

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Why housing bubble burst????

Process of Securitization

Recap: Causes
Boom and bust in the housing market High-risk mortgage loans and lending practices Securitization practices Speculation

Contd..
Inaccurate credit ratings Government policies Policies of central banks Financial institution debt levels and incentives Credit default swaps

How bubble burst led to crisis???

How did this turn into a crisis ?
Step 1 - The housing boom in the US started fading out in 2007 Step 2 - Boom had led to massive increase in supply of housing Step 3 - Thus House prices started falling Step 4 - This increased the default rate among sub-prime borrowers Step 5 - These borrowers were no longer able/willing to pay high price for a house that was declining in value Step 6 – Security/Guarantee being the house being bought , this increased the supply of houses for sale while lowering the demand, thereby lowering prices even further and setting off a vicious cycle

Ripple Effect-Suck Everything
The housing bubble Defaults & write A hole in the bubble Banks go belly-up Banks get sucked in

How it Unfolded???

Impact

Banks
Citigroup Merrill Lynch UBS HSBC Wachovia Bank of America Royal Bank of Scotland Morgan Stanley JP Morgan chase Lehman Brothers AIG

Writedown($ billion)
55.1 51.8 44.2 27.4 22.5 21.2 14.9 14.4 14.3 8.2 18.5

Actions
Bailout by Fed Reserve($326 billion) Taken over by Bank of America $5.3 billion Swiss government bailout

Wells Fargo

bank holding companies

Files for Bankruptcy bailed out by Federal reserve

Crashing Stock Indices
30000 25000 20000 Value 15000 10000 5000 0 17th Jan' 2008 25th Nov' 2008

Indices

List of events

Date 8th September 14th September 15th September 16th September 18th September 19th September

Events Fannie Mae/Freddie Mac placed into conservatorship by U.S. Government Bank of America agrees to purchase Merrill Lynch for $35B Lehman Brothers declares bankruptcy Reserve Primary Fund “breaks the buck” U.S. government seizes control of AIG in $85B bailout Treasury Secretary Paulson announces bailout plan Governments worldwide announce short selling restrictions Treasury establishes Temporary Guarantee Program for money market funds

21st September

Fed allows investment banks Goldman Sachs and Morgan Stanley to become bank holding companies Warren Buffett announces $5B investment in Goldman Sachs

23rd September

Date 25th September

Events Washington Mutual is seized by FDIC; assets sold to JPMorgan for $1.9B Citigroup agrees to acquire Wachovia with FDIC guarantee; a private transaction with Wells Fargo is later announced First bailout bill is rejected by U.S. House of Representatives - Congress passes TARP legislation FDIC temporarily increases deposit insurance to $250,000 Fed announces Commercial Paper Funding Facility (CPFF) Coordinated rate cut by central banks around the globe Mitsubishi UFJ finalizes $9B equity investment in Morgan Stanley Mitsubishi UFJ finalizes $9B equity investment in Morgan Stanley Treasury announces TARP Capital Purchase Program

29th September

3rd October 7th October 8th October 13th October 14th October

21st October

Fed announces Money Market Investor Funding Facility (MMIFF)

Loss in crisis
1000 900 800 700 600 500 Expon. (Series1) 400 300 200 100 0 savings and loan crisis(198695) Banking crisis(1990-99) Banking Crisis(98-99) Subprime crisis(2007-present)

IMF raises the estimated loss amount to 1.4 trillion dollars

Country wise Action
United kingdom
Has lined up a $850-billion rescue plan, May nationalise Royal Bank of Scotland Will recapitalise banks by up to $88 billion. Abbey, Barclays, HSBC, Llyods, Standard Chartered, HBOS and Nationwide Building Society can draw from an aggregate of $44 billion to boost their Tier 1 capital Bank of England will infuse liquidity of $351 billion through loans The government will guarantee $439 billion worth of short-and-medium term debt Britain has seized control of mortgage lender Bradford & Bingley Earlier this year nationalised Northern Rock Alarm: The total liabilities of Barclays of £1,300 billion (leverage ratio of over 60), surpass Britain's GDP

Contd..
Belgium
The government took partial control of the struggling Fortis Bank

France, Belgium and Luxembourg stumped up $93 billion to recapitalise Dexia, a French-Belgian lender that ran up huge losses in its US operations Alarm: Fortis Bank's liabilities are several times larger than the GDP of Belgium (leverage ratio of 33)

Iceland
The government has nationalised three of Iceland's biggest banks

Accounts in these banks stand frozen

Contd..
United states
May pick up ownership in failing US banks (Morgan Stanley is reported to be one) Fed ready to lend directly to stressed companies

Germany
Has guaranteed all bank deposits Has organised a credit lifeline of euros 35 billion for blue-chip commercial real estate lender Hypo Real Estate Holding Alarm: The total liabilities of Deutsche Bank (leveraging ratio of over 50) amount to 2,000-billion euro, which is more than 80 per cent of the GDP of Germany

Contd..
Singapore
Eased monetary policy for the first time since 2003 after sinking into its first recession in six years, hit by the meltdown in financial markets The government revised its 2008 growth forecast to around 3 per cent from an earlier estimate of 4 to 5

Italy
UniCredit Bank has announced plans to raise its capital ratio by spinning of property assets

Ireland
Has guaranteed all bank deposits

Contd..
Spain
Will spend 50 billion Euros ($68 billion) to buy bank assets, almost a third of the proposed 2009 central government budget

Japan
Yamato Life Insurance failed with $2.7 billion in debt The government may revive a bank-rescue law of the 1990s banking crisis Tokyo may set up a $100-billion fund to prop up smaller lenders Alarm: Real estate companies are folding up, forcing regional banks to raise reserves against bad loans

Indian Story

Impact of Subprime Crisis in India
No direct impact: Structured finance undeveloped No deleveraging On the contrary India and China were seen as saviors of a ‘decoupling’ global economy Result: Capital influx, currency appreciation, stock market boom

Impact on India-Second Round
The second round effect of Sub Prime + spike in oil prices was devastating for Asian countries, including India

But for the macroeconomic cushion of low external debt Ratio and fiscal deficits and comfortable reserves this had the ingredients of a classic currency crisis

The Devastation
Oil shock – worsening current account balance
India’s merchandise trade deficit in April-July 2008 increased by 50% BRIC may split – prospects of Brazil/Russia brightened& that of India/China darkened

Sharp increase in inflation – food & oil the culprits
Governments could no longer fully insulate consumers from increase in retail oil prices Spike in food prices through biofuels link Higher weightage of food and oil in the consumption basket of developing world July 2008- CPI at 9.41% and WPI at 12%+

Increase in fiscal deficit
Government absorbed part of the increase in oil and food prices – lower savings EAC’s estimate of off balance sheet deficit on account of rising food and oil prices – 4.5% of GDP Threat of credit downgrade

Decline in Capital flows
Sharp decline in stock market capitalization and bearish markets Rupee under pressure – feeds inflation

Decline in Growth [EAC’s estimate for 2007-08 : 7.7%]
Rising interest rates hurt consumption and investment Rise in fiscal deficit and decline in corporate profits result in fall in savings

U.S

Soudi Arabia

The Devastating effect

Consumer price inflation

Russia

Brazil

U.K.

Germany

South Korea

China

India

Thailand

16

14

12

10

8

6

4

2

0

M…

21000 20000 19000 18000 17000 16000 15000 14000 13000 12000 11000 10000

January 2007 February 2007

BSE Sensex and FII Equity

March 2007 April 2007 May 2007 June 2007 July 2007 August 2007 September 2007 October 2007 November 2007 December 2007
FII Equity $M Sensex Close

Contd..

January 2008 February 2008 March 2008 April 2008 May 2008 June 2008 July 2008 August 2008
7000.00 6000.00 5000.00 4000.00 3000.00 2000.00 1000.00 0.00 -1000.00 -2000.00 -3000.00 -4000.00

46 45 44 43 42 41 40 39
January 2007 February 2007 March 2007 April 2007 May 2007

US Dollar - Indian Rupee Exchange Rate (RBI)

June 2007 July 2007 August 2007 September 2007 October 2007 November 2007 December 2007 January 2008 February 2008 March 2008 April 2008 May 2008 June 2008 July 1 2008 August 1 2008 September 10 2008

Contd..

Emerging economies adversely impacted by demand destruction in ‘global consumer of the last resort’: US major trading partner for India (15% of exports), Brazil and China (20% of exports)

Can India and China rescue the world?

Emerging markets have borne the brunt of the second round impact and are themselves bearish

Lessons of the sub prime crisis for India
You cannot decouple from the world’s biggest economy in a fast integrating world Sophisticated structured finance products can become ‘weapons of mass destruction’ Moral hazard and financial sector liberalization RBI must rethink the concept of Universal Banking Focus on ‘Credit Discipline’ as a corrective to financial inclusion Reconsider basing monetary policy entirely on movements in consumer prices alone

Bailout Ben

Rationale for the Bailout
Stabilise the Economy Improve Liquidity Comprehensive Strategy Immediate and Significant Broad Impact Investor Confidence Impact on Economy and GDP

Second Bailout of $800 billion announced yesterday by FED

When the music stops in terms of liquidity, things will get complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing. Chuck Prince, Citigroup

Now What???

Liquidity Crunch
The reduced availability of liquidity Interest rate premiums U.S.: Banks not lending to each other ROW: London Interbank Offered Rate (Libor) Libor is used to set rates on the $360 trillion of financial products worldwide. Three month Libor set an all time high last week at 5.34%.

Overview of Credit Exposures and Estimated Losses
(September 2008; billions of US dollars) Amount Outstanding Residential Credit: Depository Institution Loans Non-Agency Securities GSE Exposures Subtotal Non Residential Credit: Loans Non-Agency Securities Subtotal $2,889 $2,531 $4,807 $10,227 Estimated Losses $308 $523 $76 $907

$7,670 $5,440 $13,110

$195 $475 $670

Total

$23,337

$1,577

Estimated Costs of Banking Crisis
Country Period Estimated Cost as % of GDP 2.5 % 20.0 % est. 4.0 % 60.0 % p 80.0 % p
$700 billion = 5.0 % $1600 billion = 11.4 % $3200 billion = 22.8 %

United States Japan Norway Korea Indonesia
U.S.A.

1980 1990 1987-89 1997 1997
2007-2010

Is Depression Imminent:
During the Great Depression
Combined GDP of 7 largest economies dropped by 20% during 1929-1932 There were no deposit insurance, so people withdrew money from banks and many banks failed Fed increased interest rate (!!) and reduced liquidity U.S. imposed heavy tariffs and other countries reciprocated lowering world trade by 70% The situation is much different as a lot is learned from experiences of the Great Depression

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