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The Financial Digest (LQ)
The Financial Digest (LQ)
The institution giving out loans in the sub-prime market does not stop here. It does not wait for the principal and the interest on
the sub-prime home loans to be repaid, so that it can repay its loan to the bank (the prime lender), which has given it the loan.
Securitization means converting these home loans into financial securities, which promise to pay a certain rate of interest. These
financial securities are then sold to big institutional investors. And how are these investors repaid? The interest and the principal
that is repaid by the sub-prime borrowers through equated monthly installments (EMIs) are passed onto these institutional inves-
tors. The institution giving out the sub-prime loans takes the money that it gets by selling the financial securities and passes it on
to the bank he had taken the loan from, thereby repaying the loan. The sub-prime home loans were given out as floating rate
home loans. With an increases in home loan rate They, , defaulted( being credit unworthy in the first place). Once more and more
sub-prime borrowers started defaulting payments to the institutional investors who had bought the financial securities stopped,
leading to huge losses. The crisis began with the bursting of the United States housing bubble. Slowing US economy, high interest
rates, unrealistic real estate prices, high inflation and rising oil tags together led to a fall in stock markets, growth stagnation, job
losses, lack of consumer spending, a virtual halt to new jobs, and foreclosures and defaults. Sub-prime homeowners began to
default as they could no longer afford to pay their EMIs. A deluge of such defaults inundated these institutions and banks, wiping
out their net worth. Their mortgage-backed securities were almost worthless as real estate prices crashed. Now burdened with
tons of debt and no money to pay it back, the back of these financial entities such as Lehman broke, leading to the current melt-
down.
But how does this great American fall affect us here in India? The effect here is manifold, The development has already lead to a
loss of nearly Rs 2,000 crores for Indian companies in which Lehman had made equity investments. Even some reality developers
feel the heat. ICICI Bank will lose around Rs.375 Crores as ICICI Bank UK Plc holds 57 million euro of senior bonds of Lehman Broth-
ers Inc. The Indian markets experienced the ripple effects of the Lehman collapse; the mood is so bad that there are simply no
genuine buyers in the markets. On 15th Sept The Bombay Stock Exchange (BSE) benchmark Sensex fell by 772.62 points and the
Nifty of the National Stock Exchange also dipped below 4,000-mark by falling 242.40 points. Moreover, the stunning fall of Wall
Street icon Lehman Brothers could have major consequences for India’s outsourcing industry as global banking and financial
majors realign costs to turn the corner and stop themselves from going bust.
Volume 1, Issue 1 Page 3
Analysts and industry leaders say the specter of lower revenue, job loss and poor salary hikes loom large over India’s IT compa-
nies, many of which thrive on lucrative contracts from western financial giants. The immediate impact is being felt in human
resource management. Many of the troubled finance companies also operate captive BPO units in India. Chances are that these
would be shut down, as is already happening with Lehman Brothers that employs some 2,500 people in Mumbai for handling
back-office work. Time alone shall tell what is the overall impact of this landmark event on the Indian economy and the econo-
mies world over. For now we know that a company that assumed iconic proportions after starting as a simple cotton trading firm
in 1850, now no longer exists. “I want to be very clear. I take full responsibility for the decisions that I made and for the actions
that I took based on the information that we had at the time," Fuld, head of Lehman brothers told a congressional panel. "I feel
horrible about what has happened to the company and its effects on so many."
The Bailout
And it was then when after AIG shares were violently whipsawed in the market, representatives from the Fed and U.S. Treasury
Department met to discuss the fate of the insurer deemed by many "too large to fail". Subsequently the Fed outlined the emer-
gency bailout of AIG. "The Board determined that, in current circumstances, a disorderly failure of AIG could add to already signifi- "AIG is a solid company with over
cant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materi-
ally weaker economic performance," the Fed’s statement read. The U.S. government took control of American International $1 trillion in assets
Group Inc in an $85 billion bailout to prevent the bankruptcy of the nation's biggest insurer and the worst financial collapse in
and substantial equity, but it has
history. The Federal Reserve provided a two-year loan, took 79.9 percent of the New York-based company's stock and replaced
its management central bank. The global effect of a potential AIG collapse could have been far-reaching (costing the financial been recently experiencing
industry $180 billion) and could affect scores of businesses as well as many consumers. "AIG is a solid company with over $1 trillion
in assets and substantial equity, but it has been recently experiencing serious liquidity issues," the AIG board said in a statement serious liquidity issues”
released after the Fed’s announcement. "We believe the loan, which is backed by profitable, well-capitalized operating subsidiar-
ies with substantial value, will protect all AIG policyholders, address rating agency concerns and give AIG the time necessary to
conduct asset sales on an orderly basis."
What exactly was wrong with the core insurance business units of AIG? What triggered the downfall and the bailout? Nothing at
all. What imploded the venerable insurance giant was an accumulation of misplaced bets on credit default swaps. Now comes the
question of what exactly a credit default swap is and how did it lead to the scenario at AIG?? A credit default swap (CDS) is akin to
an insurance policy. It’s a financial derivative that a debt holder can use to hedge against the default by a debtor corporation of
sovereign. But a CDS can also be used to speculate. A subsidiary of AIG wrote insurance in the form of credit default swaps, mean-
ing it offered buyers insurance protection against losses on debts and loans of borrowers, to the tune of $447 billion. But the mix
was toxic. They also sold insurance on esoteric asset-backed security pools – securities like collateralized debt obligations (CDOs),
pools of subprime mortgages, pools of Alt-A mortgages, prime mortgage pools and collateralized loan obligations. The subsidiary
collected a lot of premium income and its earnings were robust. When the housing market collapsed, imploding home prices
resulted in precipitously rising foreclosures. The mortgage pools AIG insured began to fall in value. Additionally, the credit crisis
began to take its toll on leveraged loans and it saw mounting losses on the loan pools it had insured. In 2007, the company was
starting to feel serious heat. From its humble beginnings in China in 1919 – through the 40-year tenure of CEO Maurice R. “Hank”
Greenberg, which ended ignominiously for Greenberg in 2006 – AIG grew aggressively. Greenberg grew and diversified the insur-
ance giant, ultimately amassing a trillion-dollar balance sheet. In an effort to assuage analysts and maintain leverage, the firm
entered into sham transactions to affect the appearance on its balance sheet of $500 million of loan-loss reserves, which analysts
had been questioning as formerly declining. The result was a 2006 Securities and Exchange Commission enforcement action, a The current condition of the
$1.6 billion settlement and the removal of Greenberg. Greenberg is still fighting civil charges related to his actions at the firm. As US economy is very similar to
2007 progressed, so did the losses on AIG’s books and credit default swaps Last February, for instance, AIG said that “its auditor a sinking ship. Only time will
had found a material weakness in its accounting.” It had not been properly valuing its CDO liabilities and swap-related write tell the number of survivors!
downs. The losses were revealed to be in excess of $20 billion through this year’s first quarter. In February, AIG posted $5.3 billion
in collateral against credit default swap contracts it had written. In April, AIG had to post an additional $4.4 billion in collateral.
When rating agencies Standard & Poor’s, Moody’s Investors Service (MCO) and Fitch Ratings Inc., lowered the firm’s ratings and,
it triggered an additional $14 billion collateral call as margin against AIG’s credit default swaps.
Page 4 The Financial Digest
The company didn’t have the cash. Indeed, the dire need for cash collateral on top of mounting losses on warehoused CDO
“assets” on the company’s balance sheet necessitated a massive infusion of capital. That’s what happened to AIG.
Impact on India
Now the question arises that how would this trouble at AIG in US have a bearing on its business in India, particularly its insurance
business, which it is running in collaboration with Tata i.e. TATA AIG INSURANCE? However, sources in the industry say that the
policy holders need not worry as the financial condition of insurance subsidiaries of AIG in India is stable, and they can meet all the
liabilities arising out of the claims from the policy holders. Insurance watchdog, the Insurance Regulatory and Development Au-
thority, has also expressed concern over the matter Sources said that policy holders should wait for clarification and dust to settle
down before taking any decision. “AIG in US has a liquidity issue, but in India there is no solvency issue due to IRDA regulations. So
there may not be a crisis in the Indian insurance market,” a company official of a leading insurance player said. Though across
many countries, policy holders are rushing to redeem their policies, it does not make sense to take any such step in India, industry
experts said, adding that there is no need to panic and policy holders should keep invested. However, Tata group may exercise its
option to buy out AIG’s 26% stake in the life and non-life insurance ventures if the US government sells AIG’s business to other
insurance companies. Insiders admit that there is indeed a clause in the JV agreement which says the Tatas can buy AIG’s stake in
case of a change in management control in the foreign company. Industry officials feel that there is every possibility of the Tatas
buying their partner’s stake if AIG’s business is taken over by another insurer. There is a strong likelihood that the US government
will sell AIG’s international business entirely or in parts to rival insurance companies. “The right to buyout the foreign partner in
the event of a takeover is a standard condition in all joint venture contracts,” said an insurance official. He added that given the
surge in valuation of life insurance companies operating in India, It made sense to exercise the option in the first instance and
subsequently sell a stake to a new partner if required. Another reason why a buyout by the Tata Group is possible is that almost all
the companies being talked about as suitors for AIG’s Asian business are present in India. But for now only time alone can tell the
exact impact of this historical bailout on the Indian economy.
Conforming Loans: Fannie Mae and Freddie Mac have a limit on the maximum sized loan they will guarantee. This is known as the
"conforming loan limit". The conforming loan limit for Fannie Mae (along with Freddie Mac) is set by Office of Federal Housing
Enterprise Oversight (OFHEO), the regulator of both GSEs. OFHEO annually sets the limit of the size of a conforming loan based on
the October to October changes in mean home price. The GSEs only buy loans that are conforming, to repackage into the secon-
dary market, lowering the demand for non-conforming loans.
Guarantees and Subsidies: Speculation that the U.S. government would bail out an insolvent Fannie Mae is a hypothesis that had
never been tested until recently, when the sub prime mortgage crisis hit the U.S. Fannie Mae and smaller Freddie Mac own or
guarantee almost half of all home loans in the United States. They face billions of dollars in potential losses, and may need to raise
additional, potentially substantial, amounts of new capital as the current downturn in the U.S. housing market continues. Markets
assume that the taxpayer will if necessary take on the burden of all their mortgages because they underpin the whole U.S. mort-
gage market. If they were to collapse, mortgages would be harder to obtain and much more expensive.
No Actual Guarantees: Fannie Mae receives no direct government funding or backing; Fannie Mae securities carry no government
guarantee of being repaid. This is explicitly stated in the law that authorizes GSEs, on the securities themselves, and in many public
communications issued by Fannie Mae.
Conservatorship: Conservatorship is a legal concept to be found in the law of many states of the United States of America,
Fannie and Freddie-the story of insol-
vency continues!
whereby an entity is established by court order, or in the case of regulated business enterprises, via statutory or regulatory au-
thority, that some property, person or entity be subject to the legal control of another person or entity, known as a conservator.
In case of Freddie Mac and Fannie Mae , it is called nationalization. The combined GSE losses of $14.9 billion and market concerns
about their ability to raise capital and debt threatened to disrupt the U.S. housing financial market. The Treasury committed to
invest as much as $200 billion in preferred stock and extend credit through 2009 to keep the GSEs solvent and operating. The two
GSEs have outstanding more than US$ 5 trillion in mortgage backed securities (MBS) and debt; the debt portion alone is $1.6
trillion. United States Treasury Secretary Henry Paulson, at the same press conference stated that placing the two GSEs into
Volume 1, Issue 1 Page 5
conservatorship was a decision he fully supported, and said that he advised "that conservatorship was the only form in which I
would commit taxpayer money to the GSEs." He further said that "I attribute the need for today's action primarily to the inher-
ent conflict and flawed business model embedded in the GSE structure, and to the ongoing housing correction."
Reasons for the bailout: Fannie Mae and Freddie Mac don’t write mortgages themselves, but they own or guarantee almost half
of America’s $12 trillion mortgage debt. With the housing market in freefall, that’s inevitably lead to a crisis of confidence in the
companies’ balance sheets. Their shares have been hammered – and after this latest move, shareholders seem likely to be wiped
out altogether. But it’s not the shareholders who were the problem – it was bond holders. Fannie and Freddie are still responsible
for almost 70% of new mortgage loans in the States. They raised cheap money by issuing bonds, and were thus able to fund
cheap mortgages for US home buyers. Now Fannie and Freddie have always inhabited a kind of “nudge, nudge, wink, wink”
financial hinterland. The US government didn’t exactly say it was responsible for the two mortgage providers. But everyone
knew it was. So that meant that the two companies were able to borrow money at the same rate as the US government. That’s
ended recently as fears for Fannie and Freddie’s future grew. All those foreign governments buying up Fannie and Freddie debt
suddenly started to worry – wait a minute, maybe these guys aren’t bluffing. Maybe they really won’t pay back any of the loans
that we’ve got here. And that sent them rushing for the hills. That increased the cost of borrowing for Fannie and Freddie, which
in turn made US mortgages more expensive.
The deal is being handled as a major step in ensuring that India’s increasing energy demands are met in the most sustainable
manner. Some of its key features are as follows: -
1. The agreement not to hinder or interfere with India's nuclear programme for military purposes.
2. US will help India negotiate with the IAEA and NSG for an India-specific fuel supply agreement. “The NSG clearance has now
3. Washington will support New Delhi develop strategic reserves of nuclear fuel to guard against future disruption of supply. directly opened up business
4. In case of disruption, US and India will jointly convene a group of friendly supplier countries to include nations like Russia, opportunities worth Rs 1,20,000
France and the UK to pursue such measures to restore fuel supply.
crores in the next 15 years, The
5. Both the countries agree to facilitate nuclear trade between themselves in the interest of respective industries and consum-
ers. nuclear deal will also enable
6. India and the US agree to transfer nuclear material, non-nuclear material, equipment and components. addition of new capacity and help
7. Any special fissionable material transferred under the agreement shall be low enriched uranium. fulfill the target of adding 63,000
8. Low enriched uranium can be transferred for use as fuel in reactor experiments and in reactors for conversion or fabrication.
MW by 2030,’’
9. The ambit of the deal includes research, development, design, construction, operation, maintenance and use of nuclear
reactors, reactor experiments and decommissioning.
10. The US will have the right to seek return of nuclear fuel and technology but it will compensate for the costs incurred as a
consequence of such removal.
11. The US will have the right to seek return of nuclear fuel and technology. In case of return, Washington will compensate
New Delhi promptly for the "fair market value thereof" and the costs incurred as a consequence of such removal.
12. Both the countries to set up a Joint Committee for implementation of the civil nuclear agreement and development of
further cooperation in this field.
14. Sensitive nuclear technology, nuclear facilities and major critical components can be transferred after amendment to the
agreement.
15. India will establish a new national facility dedicated to reprocessing safeguarded nuclear material under IAEA safeguards.
Apart from the above mentioned features the deal is very important because with the NSG waiver that accompanied this deal,
the three decades of nuclear apartheid against India have ended giving India a very good opportunity to project itself as formida-
The Indo-US Nuclear Deal has
ble power with nuclear capabilities and also it has been recognized as a country with proven non-proliferation past. There are been one of the most talked
many who have criticized this deal because of the following reasons: - about issues in the Indo-US
relations.
1. Restrictions that the deal puts on India’s military nuclear programme.
3. Many call it surrender to the US because of fears of India losing its right to test a Nuclear weapon and ICBM’s.
In response to these concerns it has already been stated by the
concerned authorities that the deal is purely related to the civil
nuclear programme and has no reference the weapons
programme. Also the thorium programme will go on and every
country has the sovereign right to test and so India will always
continue to posses that right.
Economic Impact: The deal will also have a major economic impact.
Our Prime Minister Mr. Manmohan Singh has even said that the
deal will propel India’s energy sector to new highs which were FinX launches the first issue of its Quarterly e-newsletter,
earlier not imaginable. The Indian industry is optimistic that the THE FINANCIAL DIGEST. The newsletter will aim to bridge the gap
NSG waiver and India’s entry into the elite nuclear club will have
significant economic spin-offs. It is hopeful that this development
between theory and practical at CBS. It is an Endeavour to keep
will put the country’s high-technology trade and business in the Cbsites abreast of the latest happenings from around the world.
high-growth trajectory. While the benefits are expected to reach
beyond the power sector to the IT and pharmaceutical sector, Articles written by: Mehak Kharbanda, Nitima Malhotra, Raghvendra
another advantage of the deal is that it will provide an opportunity Singh Gaur, Skiti Lakhmani
for Indian manufacturers to gain technological expertise in the
supply of spares and components for the nuclear power plants. Newsletter Designed by: Vaibhav Arora
According to industry body CII, in the mid- and long-term, India has
an opportunity to become an export hub of these spares and FOR FURTHER INFORMATION
components. The bleeding automobile parts industry would be the LOG ON TO:
main beneficiary of this. “The NSG clearance has now directly
WWW.FINXKNOWLEDGEATCBSDU
opened up business opportunities worth Rs 1,20,000 crores in the .WORDPRESS.COM
next 15 years, The nuclear deal will also enable addition of new
capacity and help fulfill the target of adding 63,000 MW by 2030,’’
says CII.
These developments should benefit infrastructure and power companies such as NTPC, Jindal, Larsen & Toubro, Tata Power
and Reliance Power. Other companies that have traditionally not been in this field may also make a foray in this sector given
the magnitude of the business potential. Recently, L&T chairman A.M. Naik said that that his company is ready for its foray
into building nuclear reactors by investing about 1800 crores for a forging unit through a joint venture with Nuclear Power
Corporation. Also, Tata Power recently said it was planning a minimum $3 billion investment in nuclear energy, either on its
own or through joint ventures. The agreement with the US is likely to generate orders worth more than $10 billion for com-
panies such as L&T and BHEL.
Benefits to Sectors other than the Energy: In addition to power, other high technology sectors such as semi conductors,
advanced manufacturing, precision engineering, defense equipment, advanced and specialty chemicals, electronics, sensors,
environmental technology, space, automation and robotics, and pharma. While some sectors will be helped by removal of
restrictions on import of dual technology items and technology, others will get an opportunity to tap the potential created Team FinX
by nuclear trade. According to a senior official from Larsen & Toubro, the spurt of activities would be experienced in the
pharmaceutical and IT space. Overall, the mood is again upbeat among engineering companies. From having to fret about Advisory Team:
losing top talent to overseas companies, this core sector feels it is all set to see a sharp increase in business contracts, thanks 1. Satyam Arora
to the Nuclear Suppliers Group’s decision that has overturned a three-decade-long ban on India buying materials related to 2. Varun Madan
nuclear energy. In how much time will these benefits actually be realized? However, actual contracts could take more than
three to four years as varied issues, such as financial assistance and legal, regulatory and safety issues are spelt out clearly Core Team:
and local capability is developed. It is expected that the nuclear agreement with the US may allow India to generate 40,000
1. Bharat Wadhwa
megawatts of nuclear power by 2020. The waiver and the Indo-US nuclear deal has led global nuclear power majors, such as
2. Nikhil Tamta
General Electric, Westinghouse, Areva and Rosatom, have re-launched talks for manufacturing and supply of nuclear power
3. Vaibhav Arora
equipment while also initiating parallel negotiations with the state-owned Nuclear Power Corporation(NPCIL), the monopoly
nuclear power generator of India for supply of nuclear fuel and technology for existing power plants and upcoming projects
Organising Team:
and NPCIL has given a positive response by identifying the already mentioned four foreign reactor manufacturers — West-
1. Mehak Kharbanda
inghouse Electric Company (AP1000 series of reactors), GE-Hitachi (ABWR reactor series), Areva (1,000 mw European pres-
2. Nitima Malhotra
surized reactors) and Russia’s atomic energy agency Rosatom (VVER 1,000 reactors) — as among the frontrunners for new
3. Raghvendra Singh Gaur
projects based on “suitability” of technical parameters for placement of orders. Already, Russian firms are helping India build
two 1,000-MWe (megawatt electric) light water reactors at Koodankulam in Tamil Nadu and plans for an additional six units 4. Skiti Lakhmani
could be speeded up.
Interested in writing articles for
the e-newsletter?
Advantage for the United States: A deal always signifies a give and take relationship and same is the case in the Indo-US Contact us at
Nuclear deal. Out of the total number reactors being manufactured even if one of the reactors are imported from the US finx.cbs@gmail.com
then it would lead to the creation of 10000 jobs and increase if $1 billion in the exports, that is why GE is quickly acting upon
its joint venture with Hitachi for the Indian market and has recently been reported to be open to local partnerships.