Table of Contents

Sr. no.
1 2 3 4 5 6 7 8 9 Executive Summary Introduction What is Mortgage? Types of Mortgages Prime v/s Sub-Prime Mortgage Characteristics of a Sub-Prime Loan Why did Banks / FI’s lend to Sub-Prime Borrowers? Why Crisis? How did Subprime Crisis Spread?
Mortgage Backed Securities (MBS) Collateral Debt Obligation (CDO) Credit Default Swap (CDS)


Pg. no.
5 6 7 8 12 14 15 16 18

10 11 12 13 14 15 16 17 18 19 20 21

Domino – effect Spill – Over effect of sub-prime crisis The Participants of the Crisis Great Depression Great Depression v/s Sub-Prime Crisis Impact on World Economy Effect on US Economy Impact on Indian Economy Learning’s from the crisis Conclusion Write-downs on the value of loans, MBS and CDOs due to the subprime mortgage crisis Bibliography

22 24 25 30 35 39 41 45 48 51 53 56


Executive Summary
It is important to understand how the sub-prime problem is causing a great concern to the global financial markets. The effect of this sub-prime crisis has a spill-over effect not only on different sectors of US economy but also on other economies round the globe. A Domino Effect is clearly visible, i.e. happening of a linear sequence of events which is in turn affecting almost all the sectors. In other words, a change is affecting another change which further affects the change and this process goes on. For example, the effect of loan default has an effect on mortgage finance companies, which would lead to erosion in value of their products like CDOs which would have an impact on Investment companies and underwriters. Likewise, dwindling property value would affect retailers and consumer companies, increased mortgage insurance claims will affect Insurance companies. Also slack in home construction would affect construction companies, furniture, pipes, electricity equipment manufacturers etc. Thus we see a domino effect happening above. Also as said before that the crisis has not only spilled to various sectors but also to other economies. Of late, there is an optimistic belief that the world has weaned from the affect of crisis on US i.e. there is a global decoupling from the US economy. But it is too optimistic a belief in this era of globalization that any economy can be decoupled from an economy like US, which boasts of a considerable consumption growth. Although, we can say that the Asian economies like India would not be affected to that extent, but it would be incorrect to say that there is outright decoupling. This subprime crisis has taught some lessons to the world. The need for sound banking practices, controlled derivative markets, issues regarding securitization by investment finance companies, etc. The failure of regulatory


entities to anticipate the impact of the crisis is also a major learning for the world and specially India.

Uncertainty enveloped the capital markets around the globe due to the subprime problems affecting America’s banking industry. There was a gloomy forecast that the US sub-prime mortgage crisis might convert into recession that could be as great as the Great Depression of 1930's that lasted over a decade. The sub-prime crisis that started in 2004 - 2005 is extended to the current economic cycle the world over. In US, homeowners select a mortgage lender who gives the loan after inquiring the borrower's creditworthiness and the property that serves as collateral. The lenders resell these loans to Special Purpose Vehicles (SPV’s) or Wall Street firms, who in turn bundle thousands of mortgage loans from different lenders into mortgage backed securities. These securities are often sliced and diced into different structures like Collateralized Debt Obligations (CDO), rated by rating agencies like Moody's, S&P, Fitch etc. and are finally sold to institutional investors worldwide- mutual funds, banks, hedge funds, central banks and pension funds. These mortgages do not create any problem for lenders until the mortgagers fulfill their commitments in time. But with rising payment obligations, subprime mortgagers ran for foreclosures.


In other words.What is Mortgage? A mortgage is a transfer of an interest in land (or the equivalent) from the owner to the mortgage lender. 4 . the mortgage is a security for the loan that the lender makes to the borrower. on the condition that this interest will be returned to the owner when the terms of the mortgage have been satisfied or performed.

Types of Mortgages 1) Fixed Rate Mortgage 2) The Adjustable Rate Mortgage (ARM) 3) Interest Only Mortgage 4) Biweekly Mortgage 5) Two Step Mortgage 6) Federal Housing Authority (FHA) Mortgage 7) Veterans Affairs Loan Fixed Rate Mortgage This is the most common type of residential home loan. the lender has the right to realize the loan proceeds by selling the house in the market. 15. Now. The way fixed mortgage loans are structured. In the first years of the residential loan. 20 or the popular 30 year fixed rate mortgage term. the Financial Institutions (FI’s) / Banks lends loan proceeds to the home borrower by accepting Realty papers as collateral [protection against default in payment of principal + interest (EMI) by the borrower]. if the borrower defaults on the payment. The term of the home mortgage can be 10.In the above figure. the bulk of the monthly payments go to paying mortgage 5 . The mortgage loan is repaid through fixed monthly payments of principal and interest over a set term.This process is termed as a mortgage loan. the mortgage interest is front loaded. The borrowing rate stays the same over the life of the residential mortgage loan.

These periods could be for 2. it features no payments of principal at the beginning of the home loan. The Prime Rate. An arm adjustable rate mortgage is a combination of a fixed rate mortgage and a floating rate mortgage. At the beginning of the mortgage term. you qualify for a bigger residential loan. Libor etc. The Adjustable Rate Mortgage (ARM) The adjustable rate mortgage is usually referred to as an ARM. the mortgage rate is fixed for certain periods. X is a mortgage borrower and has taken a Adjustable Rate Mortgage (2/28) loan of $100000 at an interest rate of 5% p. 3.interest. 6 . The rates are generally determined by Treasury Bill Rates. Interest Only Mortgage In interest only home mortgage the monthly payments consist of mortgage interest only. It’s only later that you will start significantly building equity in your home as more of your mortgage payments go towards paying down the mortgage loan principal. Due to the lower monthly mortgage payments.a for the 1st 2 years and then the interest rate begins to float for the remaining 28 years. 5. 7 or 10 years. After this period expires. the mortgage interest rate becomes adjustable. A fixed rate mortgage is ideal for those who intend to stay in their properties for a long time. Let understand it with the help of an illustration: Illustration: Mr.

As a result. The amount paid is half of what your monthly mortgage payment would be. you’ll save significant amounts in mortgage interest and pay off your home mortgage years earlier. The starting home loan rate is lower than a 30-year fixed rate but is higher than ARM mortgage. you will begin making payments on your mortgage principal. The 5/25s has a fixed interest rate for the first five years and then switches to either a 25 year fixed mortgage rate or adjustable mortgage rate. The 7/23 has a fixed interest rate for the first seven years and then converts to a 23 year fixed or adjustable. Your monthly mortgage payment will go up considerably during the 2nd half of your loan duration. After the interest only payment is over. Interest only mortgage payments periods range from 1 year up to half the term of the mortgage loan. These mortgage loans are also known as 5/25s and 7/23s. 7 . You will be making 26 biweekly mortgage payments instead of 24 payments. there are two extra payments in a year. On an annualized basis. Biweekly Mortgage Mortgage payments are made every two weeks. Two Step Mortgages A two step mortgage is essentially a 30 year mortgage with special features: Convertible or non-convertible.The interest only payments do not go on for the whole term of the home loan mortgage. These are available in adjustable rate mortgage format and fixed mortgage format. A bi weekly mortgage program has you paying down your principal mortgage earlier.

The down payment mortgage can be as low as 2% but you will be required to pay private mortgage insurance (PMI). Department of Housing and Urban Development (HUD).S. Department of Veterans Affairs guarantees mortgage loans for veterans and service persons. usually with little or no down payment. To be eligible for the VA loan. You do need to get a certificate of eligibility from the Department of Veterans affairs as proof of service. Veterans Affairs Loan The U.Federal Housing Authority (FHA) Mortgage A FHA mortgage is a residential loan insured by the FHA that is part of the U. The best feature of an FHA loan is the low down payment. It does not underwrite the residential loans. 1980 you need to have two years of service. If you enlisted after September 7. 8 . The guaranty allows veterans to get home mortgage loans with good borrowing terms.S. The goal of the FHA is to make housing affordable and stimulate demand. you must have served 180 active days service since September 1940. FHA loans have lower mortgage down payment requirements and were easier to qualify for than conventional loans (mentioned above).

Prime v/s Sub-Prime Mortgage In simple terms. near-prime. Sub-prime mortgage (also known as B-paper. 9 . it is termed as Prime Mortgage and on the other hand if it is granted to an individual with not so sound Credit Rating it is termed as Sub-Prime Mortgage. or second chance lending) refers to the lending by the banks and other financial institutions to borrowers with poor or no credit history or variable income flows. Borrowers with the higher-than-average risk profile because of low creditworthiness are charged a higher interest rate for loans. These loans are considered subprime. when a loan is granted to an individual with High Credit Rating.

In short.Let us also understand another aspect of Sub-Prime Loan: When a Financial Institution/Bank lends loan to a money lender with high credit rating who in turn lends the same amount to an individual with low credit rating but at a higher rate of interest. such loans are also know as SubPrime Loan. the money lender in this case acts as an intermediate between the FI’s / Banks and the individuals with Low Credit Rating (who do not have easy access to loans) with a view to earn on the difference in the interest rate that he pays to the FI/Bank and the rate that he charges to sub-prime borrower. 10 .

 Having FICO Credit Scores below 640 on a scale that ranges from 300 to 850.Characteristics of a Sub-Prime Loan Sub-Prime borrower usually is an individual with:  Limited Income. 11 .

 Minimum documents and at times No Documents. due to special features and Long term speculation of realty rates increasing the home ownership rate appreciably increased in 2005 12 . they would realize the realty in the market and recover much more than what was lent. Weak Credit History and therefore higher probability of defaulting on the payment (principal or interest or both). Now. Why did Banks / FI’s lend to SubPrime Borrowers? The Banks/FI’s speculated that the Realty Rates would go up and then even if the borrowers default on the payment (principal + interest).

and aren't docked if those loans fail. with the borrowing and lending rates extremely low the demand for and supply of new and existing houses boosted. Why Crisis? Housing prices began spiraling upwards in the US since 2000-01 and continued through mid-2006. Mortgage Brokers are paid for writing loans. 13 .Moreover.

Approximately 80% of U. when the Federal Reserve (the central bank in the US) began a cycle of interest rate hikes that raised the cost of borrowing from the lowest levels registered since the 1950s. 2004. refinancing became more difficult and as Adjustable Rate Mortgages began to reset at higher rates which lead to several sub-prime mortgage holders defaulting on their loans. The US housing market began sliding in August 2005 and that continued through 2006 resulting into tumbled Building rates and housing prices (against the speculation of the Banks/FI’s). It increased the interest rates seventeen times and paused only in June 2006 when the borrowing cost touched 5.S.S. mortgages issued to Subprime borrowers were Adjustable Rate Mortgages (ARM).25 per cent.Many institutions offered home loans to borrowers with poor or no credit histories by requiring higher than normal repayment levels — creating what is referred to as “sub-prime mortgages” —attracting investment banks and hedge fund owners to bet big on this emerging aspect of the US economy. When U. The countdown began on June 30. house prices began to decline in 2006-07. The below chart displays the same: 14 .

15 .

How did Subprime Crisis Spread?  Mortgage Backed Securities (MBS)  Collateral Debt Obligation (CDO)  Credit Default Swap (CDS) 16 .

It is important to note that the crisis not only hit the lenders but also spread far and wide.

This is due to the fact that the lenders further bundled and sold these mortgages to other institutions (Special Purpose Vehicles). Now these institutions sliced these mortgages into the securities that are backed by collateral and the collateral here being these mortgages held by sub-prime borrowers. These Mortgage Backed Securities (MBS) were rated by

rating institutions such as Standard & Poor and Moody’s. That’s where these agencies came into picture. Now further after getting the ratings these securities were further divided and sold as Collateral Debt Obligations (CDOs) to various investors.

An example of this effect surfaced when Bear Stearns hedge fund borrowed money from Merrill Lynch and gave their Collateral Debt Obligations (CDOs) as collateral. Now when Merrill Lynch wanted to sell the collateral, it couldn’t, because price started to fell, owing to fall in demand. The market for the CDOs collapsed and because of this the banks holding these CDOs suffered badly and this is the reason for the volatility which was seen in the global stock markets. Various Investment houses suffered heavy losses due to the sub-prime mortgage crisis.


The below diagram securatisation* process :

The sequence of events is:
1. The originator lends money on mortgages.
2. Mortgages are selected to go into a pool whose cash flows (EMI’s)are to

be securitised and are sold to the Special Purpose Vehicles (SPV’s). These are termed as Mortgage Backed Securities (MBS)
3. The Credit Rating Agencies gives ratings to these pool. 4. The pool thus framed is sold in the form of CDO to various investors

(Banks, Hedge Funds, Insurance Companies, Pension Funds etc). 5. The amount thus realized is then transferred to the originator by the SPV’s after deducting a fee.


6. In the above figure.e. which further added to the spread of crisis. ABC Banks Sells its risk on the Bond/Loan issued by the SPV’s to the Big Bank on payment of the premium. 20 . sells risk) with XYZ Bank on payment of a premium. Big Bank hedges its risk by entering into a CDS Contract (opposite direction i. The cash flows (EMI’s) realised from the borrowers then go to the holders of the securities (in the form of Coupons) Credit Default Swap The Banks then further issued Credit Default Swap (CDS) ** to other Banks.

Due to this the Seller of Risk of the CDS Contract was liable to pay the nominal to its counterparty. since these were Over the Counter (OTC) products.Domino – effect Due to increase in Interest rates the sub-prime borrowers defaulted on the payment of EMI’s which further obstructed the payment of the coupons to the investors (Banks. Hedge Funds. This was a domino effect of subprime lending on investors. Moreover. there was a lack of direct regulation. Pension Funds etc). many Banks like Citigroup. Merill Lynch etc who hadn’t hedged their position were exposed to the risk as were liable to a lot of counterparties which further lead to write-offs. Insurance Companies. Which lead to tremendous write downs as follows: 21 .

the risk of default is transferred from the holder of the fixed income security to the seller of the swap. By doing this. the buyer of a credit swap will be entitled to the par value of the bond by the seller of the swap. Source: www. should the bond default in its coupon payments.* Securitization is a structured finance process that involves pooling and repackaging of cash-flow-producing financial assets into securities. which are then sold to ** Credit Default Swap (CDS): A swap designed to transfer the credit exposure of fixed income products between 22 . whereas the seller of the swap guarantees the credit worthiness of the product. Source: www. For example. The buyer of a credit swap receives credit protection.

Right to receive premium. Right to receive the nominal in case of credit event. Seller of Risk: Obliged to pay the nominal in case of a credit event. in the financial markets has put a squeeze on lenders and made it harder for businesses and consumers to get loans thereafter.Buyer of Risk: Obliged to pay premium. Spill – Over effect of sub-prime crisis A chain reaction of adverse events. 23 . The residential foreclosure crisis has ultimately caused what is known as a credit crunch.

The Participants of the Crisis Lenders: The Biggest Culprits 24 .In the credit crunch. Now. Normally. banks fear that individuals and business borrowers won't be able to repay them on time. Banks/FI’s became risk averse and stopped lending and started hoarding cash because they are afraid of rising bankruptcies and mortgage defaults. banks are even afraid to loan to each other because no single bank knows what the other's exposure to the credit crunch really is. For an economy that has been fueled by easy access to borrowed money. tighten credit could spell trouble for companies that need loans to pursue their business plans and for consumers who want to buy big-ticket items. It leads them to charge higher interest rates or reject all but the safest loans.

2001 attacks subprime mortgage originations grew from $213 billion in 2002 to a record level of $640 billion in 2006. which not only lowered interest rates. In a period of excess capital liquidity supplied by the central bank. like investors. Also. Post the September 11. an increased willingness to undertake additional risk to increase their investment returns. In that period Lenders saw subprime mortgages as a lesser risk then it actually was. 25 .The main culprits responsible for the crisis were the lenders or the originators who lent funds to people with poor creditworthiness and high risk of default. which represented an increase of nearly 200%. interest rates low. there was an increased demand for mortgages and cost of houses was increasing. and people were making their payments. but also broadly depressed risk premiums as investors sought riskier opportunities to bolster their investment returns lenders found themselves with ample capital to lend and. this can be attributed to the fact that the economy was healthy. The figure below shows the growth in subprime mortgage orientations on a 13 year horizon.

Investment Banks The increased use of the secondary mortgage market by lenders added to the number of sub-prime loans lenders could originate. Besides. The unrealistic growth in the US home prices in the early 2000’s made homeowners believe that the prices will continue to grow and make future refinance and second mortgages quite profitable and eased lending standards allowed them to buy more expensive homes than they could afford.Homeowners Consumer (borrowers) have been criticised for overstating their incomes on loan applications. Instead of holding the 26 . or were motivated by greed. they entered into riskier loan agreements like the ARM – Adjustable Rate Mortgage without understanding them clearly and even provided untrue information about their stated income in the loan applications. which did not require verification and entering into loan agreements they could not meet or did not understand.

Government and Regulators Some observers claim that government policy actually encouraged the development of the subprime disaster through legislation like the Community Reinvestment Act* **. such as a collateralized debt obligation (CDO). A lot of the demand for these mortgages came from the creation of assets that pooled mortgages together into a security.originated mortgages on their books. In response to a concern that lending 27 . The chart below demonstrates the incredible increase in global CDOs issues in 2006. which increased liquidity even more. In this process. which they say forces banks to lend to otherwise non-creditworthy consumers. lenders were able to simply sell off the mortgages in the secondary market and collect the originating fees. which were sold to investors through CDOs. This freed up more capital for even more lending. investment banks would buy the mortgages from lenders and securitize these mortgages into bonds.

much of the blame also must be placed on those who invested in CDOs. the House and Senate are now considering bills to regulate lending practices.was not properly regulated. Investors were the ones willing to purchase these CDOs at ridiculously low premiums over Treasury bonds. underwriting was done through automation which clearly showed lack of underwriting standards in the US. including low.and moderate-income neighborhoods. ***The Community Reinvestment Act . Credit Rating Agencies Rating agencies gave higher grades to Mortgage Backed Securities (MBS) without foreseeing the possibility of high default by the borrowers. Investor Behavior Just as the homeowners are to blame for their purchases gone wrong. finally it is up to individuals to perform due diligence on their investments and make 28 .is intended to encourage depository institutions to help meet the credit needs of the communities in which they operate. These enticingly low rates are what ultimately led to such huge demand for subprime loans. The bonds were rated AAA which are normally given to high quality tranches. Moreover. Much of the blame here lies with investors because. Also there was a lot of competition between the rating agencies which further fueled the issue. consistent with safe and sound banking operations.

but also by fueling the market volatility that caused investor losses. To illustrate. which is exactly what happened as soon as investors realized the true. Hedge Funds The Hedge Fund Industry aggravated the problem not only by pushing rates lower. by using leverage. lesser quality of subprime CDOs. thereby adding fuel to the fire. this set the stage for a spike in volatility. there is a type of hedge fund strategy that can be best described as "credit arbitrage". because leverage was involved. losses were amplified and many hedge funds shut down operations as they ran out of money in the face of margin calls. The credit arbitrage strategy is designed to create a long credit spread position while retaining neutrality to interest rate and equity risks. Investors failed in this by taking the 'AAA' CDO ratings at face value. a fund could purchase a lot more CDOs and bonds than it could with existing capital alone. This amplified demand for CDOs. pushing subprime interest rates lower and further fueling the problem. 29 . Moreover. Because hedge funds use a significant amount of leverage.appropriate expectations. It is designed to capture value from over/under priced credit risk inherent in the convertible bonds.

It was the longest and most severe depression ever experienced by the industrialized Western world. Europe. and other industrialized areas of the world that began in 1929 and lasted until about 1939. The major factors that lead to the great depression:  Stock Market crash  Bank Failure  Farmers Lost Crops  Dust Bowls (Dust Storms) on southern plains  Unequal distribution of wealth Stock Market Crash 30 .Great Depression The Great Depression was an economic slump in North America.

the bottom fell out.S. On October 29. until by late 1932 they had dropped to only about 20 percent of their value in 1929. stock prices rose steadily. Stock Prices/holding Rise through the 1920s: • • Through most of the 1920s. 16. 31 . 4 million Americans owned stocks. During the next three years stock prices in the United States continued to fall. • By 1929. • The 1929 Crash: In September. The Dow reached a high in 1929 of 381 points (300 points higher than 1924). 1929 the Stock Market had some unusual up & down movements.Though the U. this precipitous decline in the value of assets greatly strained banks and other financial institutions. People who had bought on margin (credit) were stuck with huge debts. Seeds of Trouble: • Speculation: Too many Americans were engaged in speculation – buying stocks & bonds hoping for a quick profit. the market took a plunge stating that the worst was yet to come. Besides ruining many thousands of individual investors. economy had gone into depression six months earlier. particularly those holding stocks in their portfolios. the Great Depression may be said to have begun with a catastrophic collapse of stock-market prices on the New York Stock Exchange in October 1929. On October 24. • Margin: Americans were buying “on margin” – paying a small percentage of a stock’s price as a down payment and borrowing the rest. which lead to huge debts. now known as Black Tuesday.4 million shares were sold that day which lead to plummeted prices.

• Banks had invested in the Stock Market and lost money. many Americans panicked and withdrew their money from banks.000 United States banks had failed.Bank Failure Many banks were consequently forced into insolvency. 32 . In 1929 – 600 Banks had failed. As: • After the stock market crash. by 1933 .11.000 out of 25.

Farmers Lost Crops As the 1920s advanced. and dirt storms. 33 . The decade of 1930s was full of extremes: blizzards.1930 "Dust Bowl" was a term born in the hard times from the people who lived in the drought-stricken region during the great depression. including: • • • • • • • • • Agriculture Railroads Textiles Steel Mining Lumber Automobiles Housing Consumer goods No industry suffered as much as agriculture. after the war demand plummeted and thus farmers increased production sending prices further downward. tornadoes. droughts. floods. Dust Bowls (Dust Storms) on southern plains . serious problems threatened the economy while Important industries struggled. during World War I European demand for American crops soared.

Moreover credit cards created false demand. In September 1930. In 1936. As a result there was no middle class. three record drought years were marked for the nation. The flooding in Cimarron County was accompanied by a dirt storm which damaged several small buildings and greeneries. it rained over five inches in a very short time in the Oklahoma Panhandle. a more severe storm spread out of the plains and across most of the nation. The drought years were accompanied with record breaking heavy rains. tornadoes and floods. Effects of Great Depression: • Real output (GDP) fell 29% from 1929 to 1933. 34 . Dust Bowl lead to: • Devastation of the cropland Respiratory health issues Unsanitary living Rampant crime Debt-ridden families • • • • Unequal distribution of wealth During the decade there was unequal distribution of wealth as supply wasn’t equal to demand. Later that year. the regions were whipped again by a strong dirt storm from the southwest until the winds gave way to a blizzard from the north.In 1934 to 1936. blizzards. This further triggered the great depression.

Three times as many people were admitted to state mental hospitals as in normal times. but outshined by certain differences. which led to ascension of big giants like Goldman Sachs. • • • Additionally. Morgan Stanley and more. many people developed habits of savings & thriftiness. Suicide rate rose more than 30% between 1928 -1932. Great Depression v/s Sub-Prime Crisis Though Sub-Prime Crisis holds similarities with Great Depression of 1929-39.• • • • Unemployment increased to 25% of labor force. homelessness and hunger to millions. However 35 . let us throw some lights on the same: • 1929-39 was a period when universal banks were bifurcated into separate commercial and investment banks. It brought hardship. wholesale prices by 32%. Alcoholism rose sharply in urban areas. Consumer prices fell by 25%.

to farmers and real estate. the policies of Federal Reserve differ in both the periods. • Apart from this. 1930’s policy was “downturn as a force for good”. Hawley Smoot act came along in decade of restrictive tariffs and international disharmony. decrease liquidity in labor. • In 1930. 36 .current global turmoil has taken a reverse gear where many of these investment banks are again turned into large commercial banks. However sub-prime crisis is characterized by prominent degree of free trade and global cooperation. However in today’s crisis Federal Reserve is making full efforts to increase liquidity in stocks. stocks. so that people will work harder and live more moral lives. the same is not the case during sub-prime bubble. • The era of 1929-39 was the one saw the absence of shock absorbers like such as social security and deposit insurance which could safeguard people from economic crisis. farmers.

But the data shows that the pre-crash bubble is much bigger now than it was prior to the Great Depression. Right X Axis . While the Dow increased about 2. Data .Closing price of the Dow on November 11 of each year.Dow's price during the early part of the 20th century.Dow's price in modern times.5X during 37 .• Dow Jones Crash Analysis Left X Axis . Inference: As you can see by looking at the blue and pink lines. before both crashes there was a sharp run-up in the value of the Dow.

9 1934 21.7 4.1 1936 16. In 1929.5 Depression 1929 3.1 8. the Dow was down almost 75% from its peak a few years earlier.7 1935 20. By that point.7 1931 15. with Black Friday. the Dow began to deflate and it hit a bottom in 1932.850. the Dow has fallen about 42% from its high of 13.the period 21 years before the crash of 1929-1930.2 1930 8.3 1938 19 It is easily noticeable from the above figures that the employment during the great depression was highly affected as compared to subprime period. 38 .9 1932 23. • US Unemployment Rate: Great Sub-Prime Crisis 2006 2007 2008 2009 4. it increased over 6X from 1988 to 2008. Today.4 5.6 1933 24.9 1937 14.

Therefore it can be said. roots of sub-prime crisis are similar to the great depression 1929-39 but the nature is totally different. 39 . Apart from this there have been bailout packages already becoming the breaking news. which is hard-hitting the nations worldwide. The methods which he plans to initiate are to follow policy of creation of jobs and more spending by American people. The another difference which can be drawn over these two crisis is that in present day there is president Barack Obama who promises to solve the crisis .It’s true that current sub-prime crisis are nowhere in comparison to great depression. but still there’s a need to put a full stop over these ongoing crisis.

7 HANG SENG 22953.29 1327.5 -718.31 -1169.879 11.27 15273.22 17TH AUGUST(AFTE R) 13079.55 -757.9 -192.129 7.182 % FALL 6.32 8090.96 NIKKIE 225 18217.639 .7 8105.98 2697.52 CHANG E -871.2 7387.862 40 14.458 8.Impact on World Economy 16TH GLOBAL MARKETS JULY(BEFOR E) DOW JONES NASDAQ BSE SENSEX 13950.515 9.8 1 KOSPI COMPOSITE 1949.38 -633.68 2943.57 6064.4 19.091 16.29 760.0 3 3896.5 9 TAIWAN WEIGHTED INDEX SHANGHAI INDEX FTSE 100 DAX(GERMANY) 9417.158 38.03 14141.51 1191.19 6697.94 20387.34 15311.13 2566.08 2505.249 7.69 4656.

The consumer (home loan borrower) spending has reduced to a great extent by the fear of defaults. economy only but also on world economy.The term commonly referred to as ‘housing bubble’ posing as a great threat. House prices have kept falling (backlog of unsold houses rose to 16 year high).2 4 15.52% on 28th august . 41 .CAC 40 (FRANCE) IBOVESPA(BRAZIL ) 6125.63 -761. Consumption growth has declined in US . Construction bust (of new houses) will surely bring down the US output growth.6 5363. stock markets fell sharply .97 - 12.S. Impact has been so strong that the yield on 10 year treasury bill fell to 4. that is because of less disposable income .76 8815. Housing market is in the worst shape.364 SOURCE-BUSINESS 2007(PAGE 104) TODAY 9YH SEPTEMBER The impact of sub-prime crisis is not limited to the U.439 57374 48558.

GDP Growth United States.Effect on US Economy With the country facing its worst crisis in recent years. Subprime crisis has already shown its effects on the US economy which is under the threat of going into recession.5 % for the 4th quarter. This reduction has largely been because of the credit concerns due to subprime crisis. top US bankers and officials are still unsure about the final outcome of the crisis which is still not in sight and this can very well continue in the next year as well.9 % in the 3rd quarter but since then its growth forecast has been reduced to 1. This will have an effect on 42 . the world’s largest economy grew at about 2. slump in housing prices due to more than expected foreclosures and reduction in consumer spending. The effect of the crisis has rippled through almost all the sectors/segments of the economy with housing and financial markets being the worst hit.

to reach upto the level of 5.5 % against Japanese Yen. which stopped the rise of Rupee. but since Aug Fed reserve has cut its rate 3 more times by 25 basis point each time to bring it to present level of 4. The result of falling US$ has resulted in steep rise in the oil .75% compared to the year 2006.the overall growth for the year 2007 which is likely to come down by 0. It has also fallen about 7. One of the major effect of the sub-prime crisis and subsequent slow down of US economy has been the continue weakening of US dollar vis a vis other major currencies of the world.25% . The oil nearly touched 100$/barrel mark. gold and other commodities as investors were trying to hedge their risks against weakening dollar buy buying into commodities. As is clearly visible from the table above US $ has fallen maximum against the Euro in last few months after the sub-prime woes. The worst rally was seen in Canadian dollar which rose at an exorbitant rate against the USD. Manufacturing Sector 43 . Its fall against INR has been about 2. US$ as fallen nearly 8% against the Euro.25%.2 % largely due to intervention by the RBI. By reducing the rates Fed reserve is trying to reduce the cost of borrowing for the banks which in turn would result in lowering of lending costs to the consumers and businesses. it’s all time high before cooling off in last few days. These rising prices. mainly that of oil has posed a risk of rise in inflation in the US as well as in the Global economy. These rate cuts are the result of credit shortage in the economy due to sub prime losses. Interest Rates The benchmark interest rates of Fed Reserve was raised 17 times.

Tighter credit as a result of subprime crisis seems likely to continue to restrain capital expenditure. which is worst hit by the Subprime crisis. generally indicates an expansion of the overall economy.7% on the Institute of Supply Management’s Purchasing Managers Index (PMI) in December. The index is closely watched because a slowdown in factory production can translate to job cuts. where operating earnings fell by as much as 25 percent. and it is the first month that the sector has failed to grow since January 2007The U. manufacturing sector dropped 3.1 points to 47. The main concern in the US markets this time is that much of last quarter's damage came in the financial sector. And it is this 44 .S. over a period of time.” according to US experts. which in turn means that their lending ability will be drastically reduced. The economy is starting to show signs of weakness outside of the depressed housing sector. Financial Sector & Stock Market The sector.9%. manufacturing sector dropped 3. ”A PMI in excess of 41. Banks exposure in risky mortgages could reduce the availability of credit to consumers and businesses by a whopping $2 trillion. is the Financial Sector. Therefore.S. which in turn reduce consumer spending — a major component of the economy.1 points to 47.7% on the Institute of Supply Management’s Purchasing Managers Index (PMI) in December.The U. Analysts' estimates compiled by Bloomberg indicate that the sector’s profits this quarter may decline by more than 25 percent. the PMI indicates that the overall economy is growing while the manufacturing sector is contracting. as banks and brokers were badly hurt by losses from subprime mortgages and related investments. The losses in financial sector have resulted in a huge reduction in the capital reserve’s of various banks. As a whole. other than housing.

5 trillion muni bond market has also suffered the credit crunch's damage. Furthermore. But worries about the companies that insure hundreds of billions of dollars in muni bonds are rippling through to muni bonds and rattling investors. The insurers. This could come as a biggest hit to the economy as banks are making it harder for businesses and consumers to borrow. The $2. Projects would be delayed. Cities and states would find it harder to raise money. could see their credit ratings reduced. Further to this. This will result in slowdown in consumer expenditure and investment in businesses. If that happened. highways and airports. the banks have tightened their lending standards. which have exposure to risky mortgages. Housing Sector The sector worst hit by the subprime was housing crunch which could result in the slowdown of other sectors of the economy resulting into an overall recession. The plunge in financial profits is a triple whammy for the economy as banks and other institutions pare payrolls. the muni bonds they guarantee would be downgraded. which shows its steepest decline since 1985.000) in considerably 45 . The Prices of residential property were at its lowest since 1999. Historically. too. the sub-prime crisis has not only shown its effect on government bonds but also on municipal (muni) bonds. Muni bonds are issued by cities and states to raise money for projects such as schools. The number of houses for sale (550. they've been relatively safe investments because it's rare that governments default on their debts. in the aftermath of the subprime. Taxpayers could face higher taxes. cut capital spending and become stringent with loans.

Apart from this about $31 billion will be indirectly destroyed due to the spillover effects of this on the value of neighboring properties. The housing prices have shown decline in 1/3 rd of the US cities with the rest showing the stagnating prices.000). Impact on Indian Economy The integration of the Indian economy into the world economy has brought about many disadvantages and complications. In addition to this state and local governments will lose more than $917 million in property tax revenue as a result of declining housing wealth due to the subprime crisis. if not recession.more than the demand (about 400. The fundamental issue is how to continue being an integral part of the globe and also remain unaffected by the crisis happening in other parts of the world? This question may not be related to a developed economy but for a developing economy like ours it holds true. According to the reports $71 billion will be destroyed directly because of the fore closures. less consumer spending and the fears of a slowdown. this will create further complications and make our position quite vulnerable 46 . shows that there is availability for the next 10 months. The excess liquidity is slowly evaporating and premium on risk is reappearing. in the month of November. The inventory situation. It has started causing problems for Americans in the form of job losses. If we are affected to a great extent by a crisis arising in some other part of the globe.

Some of the implications of the crisis are the following:- Liquidity crunch in the economy The US subprime crisis will reduce the flow of capital coming to the Indian stock market. India is considered as a robust emerging market albeit with certain political and economic risks. In the past these risks did not act as deterrent as excess liquidity was chasing investment avenues in emerging markets. Indian markets will see a correction on account of high oil prices. Correction of prices The market will correct for the price of risks. high interest rates. If that happens the increase in growth provided by easy credit would also be adversely affected. however after the subprime crisis this excess liquidity will vanish and this could have an effect on the amount of foreign capital coming into the Indian Stock Exchanges by way of Foreign Institutional Investment. slowing growth. Rupee appreciation and slump in the economy 47 . This will definitely have an impact on the GDP growth rate. adversely affecting credit availability in the Indian market and pushing up interest rates. in fact it is a favorite among foreign investors after the happenings of the outside world. The exit of foreign investors would result in absorbing much of the liquidity from the financial system. slowing down of exports on account of the slowing down of the US economy and rupee appreciation.

with exports coming down. the export growth in rupee terms was mere 3. The capital goods sector has registered 12. We are seeing a slowdown in the automobile sector. minerals and textile sector during April-July 2007 attributable to high interest rates and rupee appreciation. As rupee appreciated by 8.2 per cent in same month last year. The slowdown in manufacturing is prompted by slack in machinery.3 per cent in 2006 to 7. it would be difficult to maintain the growth momentum.1 per cent against 13.52 per cent in July 2007 compared to 40.2 per cent during April to July.3 per cent of the index of industrial production has taken the maximum hit with almost 50 per cent reduction in growth in July from 14. some slowing down is already being witnessed in the real-estate segment and.27 per cent growth in July 2006. jewellery and other areas as well.9 per cent growth in July this year as compared to 18. The manufacturing sector which accounts for 79. Losses to Banks 48 . Sharp slump in the growth of industrial production in July 2007 at 7. it will not be too long before we see the same in textiles.77 per cent in the month of July previous year. is seen as an early indication of deceleration in pace of economic expansion.The slowing down of the US economy along with the appreciation of rupee could lead to a reduction in exports from India thereby having a negative effect on India’s GDP. With the merchandise exports growth slowing down to 18. transport equipments.2 per cent this year. metals.10 per cent this year against the growth of 31.3 per cent same period last year.

both the companies lost big business and redeployed about 50 and 100 staff respectively. After the US-based GreenPoint winded up its business. still largely driven by local demand. 49 . Mumbai-based WNS Holdings is in the process of redeploying its 500 people after one of its top 10 clients. but there could be a short-term impact on the stock markets and on credit instruments with overseas investments. banks and mortgage companies. Moreover. big companies like Infosys Technologies and iGate Global Solutions are also subprime victims. Staff Cuts Going by the examples.S. could withstand the subprime situation affecting the U. Short-Term impact on the stock markets Indian industry.The Indian Banks are estimated to have lost US$ 2 billion as a result of the subprime crisis. First Magnus Financial Corporation filed for bankruptcy in the US. The said figure has been arrived at after a series of discussions between banks and rating agencies in India. This would primarily be a result of the low liquidity in the Indian economy led by a backtrack of foreign investments owing to the problem of subprime crisis.

It should also take care that the title deed of the property is original and is in place and proper valuation is done by a registered property valuation expert. cannot be ruled out in India. 50 . If any property is being mortgaged for obtaining the loan. Fake certification. the bank should ensure that the property actually exists and is not just on the papers. Once the background check is done the bank should check the credibility of the borrower and his financial records and prior loan history should be checked. which helps an ineligible person to raise a home loan. Housing loan frauds are not uncommon in the cities of India and the aggressiveness with which housing loans are being sold by banks and financial companies in violation of sound credit practices cannot be ignored. The bank should ensure that the person applying for the loan is not a regular defaulter. While approving the home loans the banks should conduct a thorough background check of the person applying for the loan and should ensure that the loan is not given to a fake person.Learning’s from the crisis Sound banking practices The main cause of the sub-prime crisis is the unsound credit practices that were being resorted to in the US market. Personal loans and overdue credit cards are the other sectors which the regulators and bankers should handle carefully because they have the potential to plunge the Indian banking sector into a crisis.

The fact that the sub-prime bust originated in securitized loans should not induce further restrictions on this. All the same. Derivatives lead to such a chain reaction that it will be nearly impossible to quantify the risk of exposure to bad loans and advances subsequently. indiscriminate use of such derivatives can lead to havoc as happened in US. 51 . releasing that proportionate share of capital for fresh lending. Securitization is a good tool to be carefully used. One of the wrong lessons that could be learnt from the sub-prime episode is about securitization Securitization of loans has developed over the last decade in India. These assets get off the balance sheet. The investor in the securitized assets gets hold of assets with good returns. It is a useful innovation and the RBI rules should take care not to scare it away totally. This is a device that enables the lender to create securities out of its loan assets and sell it to willing investors. RBI and GOI should prohibit indiscriminate use of such derivatives if they intend to introduce such products in India. which can spread the default risk attaching to loans. The securitization of loans in India is covered by a number of rigorous guidelines. Let not the RBI make the rules too strict. The risk is transferred from the lender to the investor. It is more important to ensure that the originator of the loan practices the appropriate procedures of lending — adequate security and monitoring of repayments in time.Controlled derivatives market Derivatives are financial instruments.

In the recent crisis. BNP Paribas of France and Macquarie Bank of Australia have been affected because of such overseas investments. Due to their stable nature. 52 . FDI can help in the growth of the country’s infrastructure. Quality inward investment FDI should be given priority over FIIs as history has shown that flight of capital in case of FDI is low compared to that in respect of FIIs. Reckless investment in the derivatives market abroad by banks and financial institutions has to be controlled. The exposure of Indian banks to the subprime crisis of US is minimal.Limited investment by Indian companies abroad Prudent investment abroad should be the order of the day.

Failure to anticipate impact All the entities charged with the supervision of the economy failed to anticipate the huge impact this housing crisis could have on the financial markets across the globe. The banks have now realized that the damage control would take years to complete and diligent efforts will have to be made in order to regain lost ground. they should have been farsighted and should have inculcated the same before the damage was done. burdensome reporting and negative attention that could keep customers away for years – or in the severest of cases. Financial institutions can’t afford to be shortsighted The saying “prevention is better than cure” will be an apt example to showcase the importance of compliance on part of the financial institutions. results in a total collapse of an institution. thus avoiding a system breakdown. Instead. The regulatory framework was not too effective in curbing the impact 53 . regulatory action against a financial institution which exhibits noncompliance with laws/regulations can result in costly fines. The innovation brought about by the financial institutions in terms of securitization of the mortgages had their pros and cons. the sound goodwill of the banks which has taken a hit due to the subprime crisis. The firms have started responding to this issue only after getting hit by the crisis. Similarly.Reputation risk is as real as credit risk The subprime crisis has led to huge losses for many banks and financial institutions which have forced staff cuts and reduction in the business capacities.

is that they may have already gone too far with the processes of financial restructuring that having increased fragility on all these counts 54 .  Second. whereas on the other hand the impact was underestimated which caused a lot of flutter in the financial markets. as the dotcom bust and the current crisis illustrates.  Firstly. The structure is prone to crisis. since these inevitably involve bringing risky borrowers into the lending and splurging net. however. India should refrain from over-investing in the doubtful securities that proliferate in the US. India should be cautious about resorting to financial liberalization that is reshaping its domestic financial structure.  Finally.  Third. India should be bewaring of international financial institutions and their domestic imitators. India should opt out of high growth trajectories driven by debtfinanced consumption and housing spending. who are importing unsavory financial practices into the domestic financial sector. The problem.on the one hand. Conclusion The Subprime crisis which occurred in the US in mid – 2007 has a lot of lessons to be learnt from it even for the countries like India.

55 . All consumer credit portfolios will likely see an increase in losses. i. better able to absorb shocks. have financial systems also become more resilient. Or is the continuing search for increased efficiency taking place at the price of weakening certain underlying mechanisms? It will be crucial for central banks and financial authorities to analyze financial developments in the coming months in order to provide an answer to this question. growth.S. But the impact will likely be broader than subprime. creating a drag on U.The losses are likely to occur over several years. the question remains as to whether in becoming more efficient. Finally. as the added supply and withdrawn demand for housing will lead to a widespread decline in housing values. as the benefits of borrowers’ growing wealth had kept their losses near-record lows.e.

4 Billion $15.1 Billion $20. MBS and CDOs due to the subprime mortgage crisis Company Citigroup UBS AG Merrill Lynch HSBC Royal Bank of Scotland Morgan Stanley Wachovia American International Group Credit Suisse Bank of America Business Type Bank Bank Investment Bank Bank Bank Investment Bank Bank Insurance Bank Bank Loss (Billion USD) $39.7 Billion $29.0 Billion $7.95 Billion 56 .1 Billion $9.2 Billion $11.5 Billion $11.1 Billion $37.Write-downs on the value of loans.1 Billion $11.

3 Billion $3.06 Billion $6.7 Billion $5.3 Billion 57 .Deutsche Bank HBOS BayernLB Mizuho Financial Group JP Morgan Chase Crédit Agricole Freddie Mac Countrywide Lehman Brothers Ambac Financial Group Dresdner Bank IKB Deutsche IndustrieBank MBIA CIBC Barclays Capital Société Générale Wells Fargo WestLB Bear Stearns Washington Mutual Fortis Bank Bank Bank Bank Bank Bank Mortgage GSE Mortgage Bank Investment Bank Bond Insurance Bank Bank Bond Insurance Bank Investment Bank Bank Bank Bank Investment Bank Savings and Loan Bank $7.7 Billion $7.2 Billion $3.45 Billion $3.93 Billion $3.74 Billion $2.0 Billion $2.49 Billion $3.6 Billion $2.5 Billion $4.1 Billion $3.9 Billion $2.8 Billion $4.3 Billion $4.0 Billion $3.4 Billion $2.5 Billion $5.5 Billion $3.

0 Billion $ www.264 Billion Bibliography 58 .5 Billion $1.1 Billion $1.896 Billion $0.580 Billion $0.75 Billion $1.DZ Bank Swiss Re Bank of China Natixis Goldman Sachs Lloyds TSB RBC LBBW CommerzBank Fannie Mae BNP Paribas Hypo Real Estate ICBC Aozora Bank ICICI Bank Bank Re-Insurance Bank Bank Investment Bank Bank Bank Bank Bank Mortgage GSE Bank Bank Bank Bank Bank $2.870 Billion $0.economywatch.1 Billion $0.32 Billion $1.2 Billion $1.448 Billion $0.1 Billion $2.04 Billion $2.397 Billion $0.

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