Global Financial Crisis

By Jitendra Garg MS (Finance), CFA

2nd March 2009

Global Financial Crisis

Table of Contents
Overview ............................................................................................................................ 3

The Origin of the Subprime Mortgage Crisis ................................................................ 3

Transformation of Subprime Mortgage Crisis into Global Financial Crisis .............. 4

Bursting the Subprime-CDO-CDS Bubble ..................................................................... 5

Contagion Effects on world Economy ............................................................................. 5

Deeper problems and Dramatic Measures ..................................................................... 6

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Global Financial Crisis

Overview
In the fall of 2008, the credit crunch, which had emerged a little more than a year before, began as a bursting of the U.S. housing market bubble and a rise in foreclosures has ballooned into Wall Street’s biggest crisis since the Great Depression. As hundreds of billion dollars in mortgagerelated investments went bad, some of the largest and most venerable banks, investment houses, and insurance companies have either declared bankruptcy or have had to take enormous financial hit. In 2008, credit flows froze, lender confidence dropped, and one after another the economies of countries around the world dipped into recession. The crisis exposed fundamental weaknesses in financial systems worldwide, and it continues despite coordinated easing of monetary policy, trillions of dollars in intervention by central banks of different countries, and several stimulus packages by various governments. The crisis started in the US soon spread to Europe, and then to Japan and emerging markets. Governments of most of countries have scrambled to prop up banks, broadened guarantees for deposits and agreed on a coordinated response.

The Origin of the Subprime Mortgage Crisis
The origin of this crisis can primarily be attributed to large subprime lending due to plummeting housing prices. Subprime lending is a kind of lending against mortgages to borrowers who might not normally qualify for a loan because of their poor credit worthiness or credit records.

Price went up suddenly to unrealistic levels
The genesis of the housing market slowdown lies in the loose credit regime that was unleashed by the Fed in the aftermath of the dotcom bust in 2000-01. At that time, economy was in the grip of recession, so series of rate cut (between Mar 2001 and June 2003, the interest rate was reduced from 5 percent to 1 percent) to alleviate the investment slowdown and to encourage economic activity took real interest rates into negative territory, creating what negative real interest rates do-asset price bubbles. Since stocks were heading down from stratospheric levels at that time, the asset that increased in price was housing. Price went up suddenly to unrealistic levels. Between 1997 and 2006, the price of the typical American house increased by 124%. During the two decades ending in 2001, the national median home price ranged from 2.9 to 3.1 times median household income. This ratio rose to 4.0 in 2004 and 4.6 in 2006. Rising housing prices spurred speculation out of fear & greed. Fear of being priced out forever from owning a house motivated people into buying houses, they could ill-afford. Greed motivated speculators into buying houses as they were perceived as safe investments. The temporary secular rising trend provided both groups a false sense of security that they can’t loose in ‘housing investments’. This housing bubble was also fuelled by the loose credit policy of the Fed, return/profit focused hedge & investment funds and investment banks sitting in Wall Street – all far removed from the final borrowers – completed the equation by providing more than ample liquidity to take house prices to astronomical levels, further feeding the bubble & creating a sense of euphoria.

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Global Financial Crisis

Aggressive lending to sub-prime
By 2005, more than US$635 billion of sub prime loans were issued. In 2006 the amount was another US$600 billion. The total cumulative amount of subprime rate mortgages has been estimated to be upwards of US$1.3 trillion by 2007. That was, about 10% of the total value of the US housing market value & reached a peak of 22% of total lending in 2006. Consequently, USA household debt as a percentage of annual disposable personal income has increased to 127% at the end of 2007, versus 77% in 1990. All these demand & supply factors led to a construction boom and contributed to a substantial part of US growth up until 2006. Beginning in mid-2004; when the market conditions eased, there was a slow rising of interest rates by 475 basis points by Fed, in tranches until mid-2006 which slowed down the demand for new houses, house building (supply), though, reacted with a lag to the demand slowdown. The above two (supply increase & demand slowdown) put together created a rising inventory of houses for sale. As a result, house price rises flattened & then began to decline.

Transformation of Subprime Mortgage Crisis into Global Financial Crisis
The question now arises how did bad loans to subprime people in US become a global financial crisis? The answer lies in what is called financial engineering. One of the outcomes of financial engineering is securitisation based instruments named as Collateralized debt obligations (CDOs). These are the type of structured Asset-Backed Security (ABS) whose value and payments are derived from a portfolio of fixed-income underlying assets. For example, a mortgage lender would make a house loan and then use the investment bank, hedge funds and other funds to sell bonds to fund debt. The money from the sale of bonds can be used to make new loans. The lender accepts loan payments and passes the payments on to the bondholders. Later; these funds can also sell the paper to somebody else. The paper originally bought by these funds now becomes somebody else’s asset. Interestingly, investment banks themselves started lending in subprime market and securitising such loans. Banks and other financial institutions which are far off from the US started owning these assets having no real way of assessing the likelihood of these original loans ever being repaid. According to best estimates, outstanding size of CDOs based on mortgaged assets was approximately US$2trillion by end of 2006. But the banks and other institutions that eventually sell the CDOs were, at least until the recent crisis began to appear in late summer 2007, not all that concerned about the quality of such derivative-CDOs. Their ability to take risk had gone up by buying insurance for the CDO in the form of yet another derivative called a Credit Debt Swap or (CDS). A CDS is a credit derivative contract between two counter parties. The buyer makes periodic payments (premium leg) to the seller, and in return receives a payoff (protection or default leg) if an underlying financial instrument defaults. Yet another means by which banks attempted to insulate themselves from the shaky quality of speculative investment has been their creation of Secured Investment Vehicles (SIVs). These are in essence
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electronic shadow banks set up by investment and commercial banks to offload potentially risky CDOs from the banks' balance sheets. And indeed, the volume of CDS has exploded with nuclear force, nearly doubling every year since 2001 to reach a recent peak of $62 trillion at the end of 2007, before receding to $54.6 trillion as of June 30, 2008 according to ISDA. But why did banks and other financial institutions buy these dirty assets? Part of the reason lies in rating agencies. These agencies are paid to rate the complex products of financial institutions for their riskiness, nothing more than that. If they rate some securities favourably vis-a-vis the other, that means there is little chance of losing money if someone invests in that particular security. Apart from it, the bank’s SIVs make money from marking up and selling the CDOs as well as from insuring them at an additional charge with credit debt swaps. It is therefore not surprising that mainline investment and commercial banks experienced compound profit growth of more than 20 percent per year collectively for each year from 2004 through 2006—i.e., roughly the period of the most explosive growth of subprime mortgages bundled with CDOs.

Bursting the Subprime-CDO-CDS Bubble
The rate resets on the subprime & adjustable rate mortgages have increased the monthly mortgages payments typically by 25% & upwards. Declining housing prices coupled with increased rates meant that they could not reset their mortgage terms. As a result, defaults increased & houses went into repossessions & foreclosures. By mid-2006 it had become clear that the subprime mortgage market was in freefall. By late summer 2007 it was estimated that there would be two to three million potential foreclosures over the next few years. The value of subprime mortgages quickly plummeted and with them many of those CDOs in which they were imbedded. Consequently, all synthetic CDOs created in form of CDS came under high pressure of default & spread of CDS had increased drastically.

The Crisis Takes Hold
All entities having exposure in these instruments have faced redemption pressure & due to settlement of all these liabilities; many of biggest financial institutions like Lehman Brothers, Merrill Lynch, AIG, Fortis Group, Wachovia Bear Stearns, Freddie Mac, Citigroup Washington Mutual, Fannie Mae and so on have gone bankrupt or sold or bail out by Fed or cried for help. The Lehman brothers have outstanding exposure of US$597 bn at the time of filing bankruptcy and the same figure was US$441bn for A.I.G. Bear Stearns had sold to J.P. Morgan and the Fed could not let Bear Stearns enter bankruptcy because and only because the billions of dollars of credit default swaps on its books would be wiped out. All the banks and institutions that had insurance written by Bear would not be able to say that they were insured or hedged anymore and they would have to write-down billions and billions of dollars in losses that they've been carrying at higher values because they could say that they were insured for those losses. The counterparty risk that all Bear's trading partners were exposed to was so far and wide, and so deep, that if Bear was to enter bankruptcy it would take years to sort out the risk and losses. The severity of the problem is evident by the fact that major banks and financial institutions which borrowed and invested heavily in MBS & related derivatives based on these MBS, have reported losses of more than US$500 billion till now & this is expected to touch US$1 trillion due to spiral effect.

Contagion Effects on world Economy
All these events have created a cascading effect and crores of people have lost their jobs or faced decline in their salaries. Due to fall in creditability & liquidity, banks have discontinued their previous policy of proving credit with free hands. Consequently, demand in the U.S. which mainly depends on credit has come down & private consumption which constitutes over two-third of GDP went for a tail spin. Further, those economies like China & Japan and so on, which mainly depend on exports to the U.S. has also come into trouble. All this have decreased the demand for goods & services in different parts of the world. Accordingly, due to reduction in
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industrial production & demand; oil prices after touching a height of US$147/b have come down to US$42.95/b (as on 26 Feb. 09) and world trade has also decreased. Thus some of big economies have registered negative growth & whole world including emerging nations are facing slowdown in their GDP growth rate. Simultaneously, world stock markets have lost approximately 40% of their value as on Jan. 2008 and in all, the slide from the height of the stock markets had wiped out more than US$8 trillion in wealth.

Deeper problems and Dramatic Measures
The bleeding in the stock market stopped only after a huge bailout plan of US$700bn being announced by the federal govt. on Sept. 18, 2008. Other countries have also taken measures in response to this crisis & more than one trillion dollars have injected in world markets by respective govts. to restore the confidence in financial system. Apart from it, U.S. has also announced a stimulus package of US$789bn after Baraq Obama has taken over and key interest rates in world market have decreased dramatically to boost the world economy. Others measures have also taken in forms of tax cut & subsidies. -----------------------------------------------------------------------------------------------------------------

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