You are on page 1of 60

SUBPRIME MORTGAGE CRISIS

Submitted to: Submitted by:

Prof. Chandan Sharma Chitra Yadav (91076)

Neha Mittal (91095)

Shweta Kathuria (91108)

Sowmya Deepthi KVN


(91111)

1
ACKNOWLEDGEMENT

We would like to thank Prof. Chandan Sharma, Fore School of Management, New Delhi
for his support and guidance and also for imparting us with the knowledge and skills
required to study the subject.

2
Contents

Contents...............................................................................................................................3
1. OBJECTIVE....................................................................................................................5
2. INDICATIVE METHODOLGY.....................................................................................5
3. SOURCES TO COLLECT DATA..................................................................................5
4. SUBPRIME CRISIS AND ITS CAUSES – SHWETA KATHURIA (91108)...............6
4.1. Introduction...................................................................................................................6
4.2. Timeline of events.........................................................................................................6
4.3. The main causes of the crisis........................................................................................8
4.3.1 Formation and bursting of U.S. Housing bubble........................................................8
4.3.2 Speculation................................................................................................................10
4.3.3 High Risk Borrowing and Lending Practices...........................................................10
4.3.4 Securitization............................................................................................................12
4.3.5 Inaccurate credit ratings............................................................................................12
4.3.6 Government Policies.................................................................................................13
4.3.7 Policies of Federal Reserve.......................................................................................14
4.3.8 Debt levels of financial institutions..........................................................................15
4.3.9 Shadow Banking System..........................................................................................15
4.4. Vicious Cycle of Foreclosure and Bank Instability....................................................16
5. EFFECT ON USA – NEHA MITTAL (91095)............................................................17
5.1 Introduction – Impact on USA.....................................................................................17
5.2 TED Spread..................................................................................................................17
5.3 Stock market................................................................................................................19
5.4 Effect on Jobs in the financial sector...........................................................................19
5.5 Effects on Housing Prices............................................................................................20
5.6 Effect on Consumer Confidence..................................................................................21
5.7 USA Bank Earnings.....................................................................................................22
5.8 USA Money Supply ....................................................................................................23
5.9 USA Trade Deficit and % GDP...................................................................................25
5.10 Effect on IS-LM curve...............................................................................................25
5.11 Gross Domestic Product............................................................................................26
5.12 Inflation rates.............................................................................................................27
5.13 Manufacturing Index..................................................................................................28
5.14 Impacts worldwide.....................................................................................................29
6. EFFECT ON INDIA – CHITRA YADAV (91076)......................................................32
6.1. Introduction.................................................................................................................32
6.2. Impact of Global Crisis on India.................................................................................33
6.2.1 Visible Impacts.........................................................................................................34
6.2.2 Hidden Impacts.........................................................................................................36
3
6.3. RBI’s Response to Subprime Crisis............................................................................37
6.4. Analysis of RBI Policies.............................................................................................39
6.5. Recommendations.......................................................................................................41
7. REGULATIONS AND MEASURES UNDERTAKEN – SOWMYA DEEPTHI KVN
(91111)...............................................................................................................................42
7. 1. Introduction................................................................................................................42
7.2. US Bailout Acts..........................................................................................................42
7.2.1 Major Acts................................................................................................................42
7.2.2 Term Auction Facility (TAF)....................................................................................44
7.2.3 Term Asset-Backed Securities Loan Facility (TALF)..............................................44
7.2.4 Troubled Asset Relief Program (TARP)...................................................................45
7.2.5 Total US Bailouts Till Date......................................................................................47
7.3. Policies in G-20 countries...........................................................................................48
7.4. Policy recommendations.............................................................................................49
7.4.1 Interest rates..............................................................................................................49
7.4.2 Easy Credit ..............................................................................................................49
7.4.3 Nationalization of Financial Institutions...................................................................49
7.4.4 Bailouts by the Government.....................................................................................50
7.4.5 Purchasing of Bad Assets..........................................................................................50
7.4.6 Bondholder Haircuts.................................................................................................50
7.4.7 Government Expenditure..........................................................................................50
7.4.8 Tax Rebates...............................................................................................................51
7.4.9 Homeowner Assistance.............................................................................................51
7.4.10 Establish a System Risk Regulator.........................................................................51
7.4.11 Capital Ratio Requirements....................................................................................52
7.4.12 Break up institutions that are Too Big to Fail.........................................................52
7.4.13 Regulating the Shadow Banking System................................................................52
7.4.14 Strict Mortgage Regulations...................................................................................52
7.4.15 A Financial Products Safety Commission..............................................................53
7.5. The exit strategy..........................................................................................................53
7.5.1 FED’s Exit Strategy..................................................................................................53
7.5.2 G-20’s Exit Strategy.................................................................................................54
7.6. IS-LM curves..............................................................................................................54
8. REFERENCES..............................................................................................................58

4
1. OBJECTIVE

To understand and analyze the causes and impacts of the subprime mortgage crisis. To analyze
the measures taken by the governments against the crisis.

2. INDICATIVE METHODOLGY
• Analyzing the causes of the subprime crisis
• Analyzing the impacts of the crisis largely on USA and India
• Analyzing the policies undertaken by the US government to counter the crisis

3. SOURCES TO COLLECT DATA


1. Research papers
2. IMF publications
3. Online journals
4. Newspapers and magazines
5. RBI website
6. US Bureau of Labor website and other US government websites

5
4. SUBPRIME CRISIS AND ITS CAUSES – SHWETA
KATHURIA (91108)

4.1. Introduction
The subprime mortgage crisis is the current real estate crisis and financial crisis which
started as a result of dramatic rise in defaults in mortgage loan repayments and
foreclosures in the United States. The crisis put many banks into bankruptcy and came as
a big jolt for financial markets in the whole world. The crisis which exposed the
underlying weakness in financial industry regulation started in the last decade of 20th
century but it became more pronounced in 2007.

The crisis is named so because it started as a result of defaults in loan repayment of


subprime mortgage loans. The subprime loan is a type of loan that banks offer at an
interest rate above the interest rate for prime loan to those individuals who do not qualify
for the latter. Quite often, subprime borrowers are not able to get a loan from traditional
lenders because of their low credit ratings that suggest that it is quite probable that they
will default on their loan repayment. A mortgage represents a loan on a property/house
that has to be paid over a specified period of time.

4.2. Timeline of events

Following is the timeline of events showing the United States enactment of government
laws and regulations, as well as public and private actions which affected the housing
industry and related banking and investment activity.
1913: A National banking system created by Federal Reserve Act
1914: Unfair or deceptive business practices prohibited by Federal Trade Commission
Act
1933: Formulation of Glass Steagall Act which separated commercial banks from
investment banks.
1968: It becomes mandatory for banks to disclose loan terms and fees.
1970: Weakening of Glass Steagall Act due to introduction of amendments in Bank
Holding Company Act; allowing commercial banks to do both - accept deposits and
make commercial loans via holding companies.
1978: Supreme Court allows banks to give loans in states other than where they are
located. This led to lenders rushing to places with easy lending conditions.

6
1980: Demolition of usury caps for mortgages and rise in bar for prosecuting lenders.
1982: Deregulation of savings and loan industry under Depository Institutions Act
1984: Savings and Loans Industry starts crashing.
1986: Tax Reform Act provides taxpayers to pay off consumer debt form their home
equity loans.
1987: Creation of Collateralized Debt Obligations Securities
1989 – 1995: Establishment of Resolution Trust Corporation (RTC) under the Financial
Institutions Reforms, Recovery and Enforcement Act that led to closing of several
insolvent loans and savings and shifting of regulatory authority to the Office of Thrift
Supervision.
1992: Creation of Federal Housing Enterprises Financial Safety and Soundness Act to
encourage Freddie Mac and Fannie Mae to lend to support affordable housing thus
increasing their pooling and selling of such loans as securities.
1995: Congress enacts measures that make it difficult to sue companies for securities
fraud.
1995 – 2001: Formation and collapse of Dot-com bubble.
1997: For conventional home purchasers Mortgage-denial rate increases to 29%.
Purchase of more than $60 billion worth of mortgage backed securities by investors.
1998: Formation of housing bubble with appreciation in house prices.
1999: Easing of credit requirements by Fannie Mae thus encouraging banks to lend to
high risk individuals. Deregulation of banking, insurance and securities into a financial
services industry.
2000: Interest rates, currency prices and stock indexes defined as excluded commodities
under Commodity Futures Modernization Act thus encouraging trade of credit-default
swaps.
2000 – 2001: Lowering of interest rates from 6.5% to 1.75% leading to creation of easy
credit conditions and growth of subprime mortgages.
2002 – 2003: Reduction in mortgage denial rate to 14% for conventional home
purchasers.
2003: Federal Reserve’s key interest rate lowers to just 1%.
2003 – 2007: U.S. subprime mortgages increase to 292% due to private sector entering
the mortgage bond market. Federal Reserve fails to exercise control over financial
institutions foregoing loan standards.
2004 – 2007: A belief that housing prices would continue to go up lead to issuing of large
amounts of debt and investment in mortgage backed securities by financial institutions.
2004: U.S. home ownership rate increases to 69.2% Lenders adopt automated loan
approvals. SEC foregoes Net Capital Rule for Merrill Lynch, Lehman Brothers, Bear
Stearns, Goldman Sachs and Morgan Stanley; thus allowing them to increase their

7
leverage tremendously by buying mortgage backed securities and other risky
investments.
2005: Abrupt halt in booming housing market; housing prices drop 3.3% nationwide.
2006: U.S. Home Construction Index dips tremendously. Many financial institutions go
bankrupt.
2007: Home sales continue to fall. The subprime mortgage industry collapses.
Foreclosure activity increases tremendously. Rising interest rates worsen the situation.
2008: Financial crisis escalates with collapse of major lenders and investors and the
situation gets worsened by stock market collapse and severe job cuts; which is followed
by steps to revive the economy.

4.3. The main causes of the crisis


The crisis was a result of a number of factors that emerged over a number of years,
prevalent in both real estate and credit markets

4.3.1 Formation and bursting of U.S. Housing


bubble

Prevalence of easy credit conditions for a continued time period due to low interest rates
and large inflows of foreign funds led to formation of housing bubble and encouraged
debt-financed consumption.
The USA home ownership rate increased to 69.2% in 2004. This increase in home
ownership rates and rise in demand for housing that led to house prices to rise was caused
mainly due to Subprime lending. There was a price rise of 124% between 1997 and 2006
in the price of a typical American house.

8
Increase in housing prices resulted in more and more people to refinance their homes at
lower interest rate or financing their spending by taking out second mortgages fuelled by
increase in home prices. This constant increase in house prices and easy credit conditions
led to a construction boom and led to a surplus of unsold houses which eventually caused
to decline of U.S. Housing prices. People believed that housing prices would continue to
go up, and prevalence of easy credit conditions encouraged borrowers to obtain
adjustable rate mortgages. These mortgages charged a below market interest rate for a
predetermined period of time followed by market interest rate for the rest of the loan’s
term. Many borrowers could not make the higher payments after ending of the period of
low interest rate; they would then go for refinancing their homes.

As housing prices began to decline; refinancing homes became more difficult. And those
borrowers who could neither pay loan amount back nor refinance their homes began
defaulting.

As more and more people started defaulting on their loan repayments, foreclosures as
well as supply of homes for sales increased, which further led to decrease in housing
prices. This decline in mortgage payments also lead to decrease in value of mortgage
backed securities, which deteriorated the net worth and financial health of banks. This
resulted in a vicious cycle which worsened the situation.

9
By mid 2008, the U.S. housing prices declined considerably. This severe and sudden
decline in house prices lead to a zero or negative equity of homes that translated to homes
being worth less than the mortgages for the borrowers. Borrowers in this situation had an
incentive to default on their mortgages. By 7 there was a great decline in the number of
new homes sold. Further increasing rate of foreclosures increased the surplus of unsold
homes which further led to decline in house prices. This worsened the situation as more
people were now at the risk of foreclosure or default since refinancing became more
difficult.

4.3.2 Speculation
Subprime mortgage crisis has been said to have also caused by a phenomenon called as
speculative borrowing. During 2005, 28% of homes purchased (1.65 million units) were
for investment purposes, with an additional 12% (1.07 million units) purchased as
vacation homes. During 2006, these figures rose to 22% and 14%, respectively. In other
words, a record level of nearly 40% of homes purchases were not intended as primary
residences. Earlier homes had not been seen as investments but it happened during the
housing boom. Homes under construction were being purchased and sold at profit
without the seller even having lived in them. Speculators suddenly left the market in
2006, which caused investment sales to fall very fast bringing down the demand for
homes.

4.3.3 High Risk Borrowing and Lending


Practices
In the early 21st century, lenders became more risk-taking as they started offering loans to
high risk borrowers including illegal immigrants. Subprime mortgages increased from
5% in 1994 to 20% in 2006. Also the difference between subprime and prime interest
rates reduced significantly from 2001 to 2007.

10
In addition to considering higher-risk borrowers, lenders started offering highly risky
loan options and borrowing incentives. In 2005, the average down payment for first-time
home buyers was just 2%. In fact, 43% of those buyers made no down payment at all.

The mortgage qualification guidelines also began to change. First SIVA (Stated Income
Verified Assets) loans were created. These loans did not require the borrowers to show
proof of income. They were just required to state their proof of income and show that
they had money in the bank. Then No Income Verified Assets (NIVA) loans were created
which did not even require the borrowers to state their proof of income. They just had to
show they had money in the bank. Strictness in loan approval process declined even
further with the introduction of NINA (No Income No Assets). These loans did not even
require the borrowers to show or state any money in the banks. Only credit score was
required to get a mortgage.

The interest-only adjustable-rate mortgage, which allows the homeowner to pay just the
interest during an initial period, also enticed more borrowers. In 2007, 40% of all
subprime loans resulted from automated underwriting. To sell more and more mortgages
the lending standards kept declining.

But the real problem was that in spite of the fact that housing prices were rising
tremendously people were not earning proportionately more. The average household
income did not change from 2000 to 2007. So, it was becoming difficult for people to
repay their loan installments. That was the time when this housing bubble actually burst.

11
4.3.4 Securitization
Earlier when a bank used to give loan to a borrower, the risk was retained by the bank
itself. But, then the technique of securitization was created. It was based on originate to
distribute model, in which several mortgage loans are pooled together into Mortgage
backed securities and sold to investors. By selling the mortgages before maturity banks
were able to get more money to lend even more. Thus, aim of the banks remained lending
as much as possible with no regard to the credit quality of mortgages.

Securitization became more prevalent in late 20th century. But it became thrice of its 1997
value by 2007.This practice declined considerably in 2007 and ended completely in
2008.This led to a sudden and steep decline in source of funds for banks.

A major reason why securitizations lead to subprime mortgage crisis was because of the
way rating agencies modeled the correlation of risks involved with various loans that
form a part of the many loans pooled together in form of mortgage backed security. But,
the problem with this rating technique was realized only after billions of dollars of
subprime loans had already been sold in form of securities. When finally investors
stopped buying mortgage backed securities which decreased the ability of banks to give
out more mortgage loans – it was too late. The effects of crisis had already started
showing.

4.3.5 Inaccurate credit ratings


Credit rating agencies then gave high rating (investment grade) to mortgage backed
securities which was obviously faulty. These high ratings fuelled the sale of mortgage
backed securities to investors and thus enabled banks to lend more. Due to the alleged
advantages like credit default insurance and equity investors willing to bear first losses,
these ratings were considered just.

12
When credit rating agencies realized the fault with ratings they had previously awarded;
they lowered the credit ratings on these securities. The credit ratings on mortgage backed
securities declined by trillions of dollars from 2007 to 2008. In order to maintain their
capital ratios several financial institutions had to reduce their mortgage backed securities
value and get additional capital. To do this, banks had to sell the new shares of their stock
thus bringing down the value of their existing shares.

4.3.6 Government Policies


American presidents have been keen in increasing the home ownership rates. The
congress passed AMTPA (Alternative Mortgage Transactions Parity Act) which
encouraged the lenders to give out adjustable rate mortgages. Many new loan types were
created in the 80s like balloon-payment, adjustable-rate, option-adjustable rate and
interest-only mortgages. Also, the government was unable to regulate and prevent the
exploitation of these loans. Approximately, 80% of subprime mortgages are adjustable-
rate mortgages.

In 1995, the GSEs like Fannie Mae began receiving government tax incentives for
purchasing mortgage backed securities which included loans to low income borrowers.
Combined purchases of these two GSEs increased significantly from 2002 to 2006. In
late 2008 when it became evident that Freddie Mac and Fannie Mae will not be able to
withstand the crisis, the government was forced to nationalize them.

The Glass-Steagall Act was enacted after the Great Depression. It aimed at separating
the commercial banks from investment banks. This was done because of conflicting

13
interests of the two. The act contributed to the crisis because conservative nature of
commercial banking was dominated by risk taking culture of investment banking. This
led to increased level of risk taking and high leverage during the high growth period
before crisis.

4.3.7 Policies of Federal Reserve


Significant decrease of interest rates by Federal Reserve in early 21st century was a major
contributor to real estate boom. From 2000 to 2003, the Federal Reserve lowered the
interest rate target from as high as 6.5% to as low as 1.0%. This was done to soften the
effects of the collapse of the dot-com bubble and of the September 2001 terrorist attacks,
and to combat the perceived risk of deflation. Fed believed that since the rate of inflation
was low, interest rates could be safely lowered. But, Fed ignored other important factors.
Fed’s assumption was obviously faulty because calculated inflation in the years before
crisis was below the real inflation. And thus the monetary policy by government lead to
housing bubble.

When Fed realized that it had lowered the interest rates much below required and for a
time period much above required, it started decreasing its interest rates. This made loan
repayments for those borrowers more difficult who had taken adjustable rate mortgages.

14
This also led to bursting of housing bubble because houses as investment were not that
lucrative and speculation became riskier.

4.3.8 Debt levels of financial institutions


According to a SEC decision concerned with net capital rule, U.S. banks could issue
more debt, use it and increase their leverage. This made them more vulnerable to
declining value of Mortgage backed securities.

During 2008, the three biggest U.S. investment banks went bankrupt or were taken over
by other banks. These included Lehman Brothers, Bear Stearns and Merrill Lynch. These
failures further increased the instability of economy worldwide. The rest of the
investment banks like Morgan Stanley and Goldman Sachs became commercial banks,
thereby subjecting themselves to more stringent regulation.

4.3.9 Shadow Banking System


The shadow banking system consists of non-bank financial institutions that play an
increasingly critical role in lending businesses the money necessary to operate. Shadow
banking institutions are typically intermediaries between investors and borrowers. They
channel funds from the investors to the corporation, profiting either from fees or from the
difference in interest rates between what it pays the investors and what it receives from
the borrowers.

In the years leading up to the crisis, the top four U.S. depository banks moved an
estimated $5.2 trillion in assets and liabilities off-balance sheet into special purpose
vehicles or other entities in the shadow banking system. This enabled shadow institutions
like Bear Stearns and Lehman Brothers to essentially bypass existing regulations
regarding minimum capital ratios, thereby increasing leverage and profits during the
boom but increasing losses during the crisis.

15
4.4. Vicious Cycle of Foreclosure and Bank
Instability

Housing prices
decline

Negative equity Mortgage Value of Banks


(Home worth less than payments MBS incur
mortgage) decline declines losses

Economic
Bank capital
Home owners walk activity Banks
slows and (Loanable
away or involuntary restrict funds)
foreclosures increase unemploy lending
ment decline
increases

Increased
supply of homes

The severity of the subprime mortgage crisis was exaggerated because of the fact that a
cycle of events started occurring that led to further deterioration of the situation.

Two cycles were taking place simultaneously. The first one involved lowering of housing
prices. This led to a decline in equity of the home and thus refinancing of homes became
difficult. Thus, more and more people started defaulting on their loan repayments.
Foreclosures of homes increased substantially, both voluntary and involuntary. These
foreclosed homes were put on auction by banks. But, there were not many buyers of these
homes, so, supply was more than the demand. This further led to a decrease in the prices
of homes, which was the starting point of this cycle.

The second cycle starts from increased foreclosures. This led to a decreased collection of
loan repayments by banks. So, the value of mortgage backed securities declined because
they were sold by banks to investors as a combination of many mortgage loans. Thus,
banks started to incur losses and this declined the capital with banks. Thus, fewer funds
were now available to give away as loans. Thus, the lending practices of banks reduced
significantly which led to economic slowdown and increased unemployment. Since,

16
people did not have much money to pay their loans and refinancing also became difficult,
so, it further intensified the rate of foreclosures, which was the starting point of this cycle.
This also links the two cycles together.

5. EFFECT ON USA – NEHA MITTAL (91095)

5.1 Introduction – Impact on USA

The impact of the subprime crisis was felt on the financial sector when in February 2007
HSBC bank wrote down of subprime-related MBS by $10.5 billion. This was just the first
subprime related loss reported. During 2007, more than 100 mortgage companies had to
shut down their operations. As the crisis deepened more firms suspended or merged.

The mortgage defaults and the provisions for future expected defaults had a drastic
impact on the US profits. The decline was $646 million in 4th quarter of 2007 for profits
of the USA depository institutions insured by the FDIC. This was a decline of 98% from
Q4-2006 to Q4-2007. In 2008 also the trend continued and the decline was 46% from Q1-
2007 to Q1-2008. By August 2008 the financial firms all over the world had written
down holdings of $501 billion. These holdings were of the subprime related securities.

The crisis reached its peak when Lehman Brothers failed in September 2008. $150 billion
were withdrawn from the US monetary funds. US lost 25% of their net worth between
June 2007 and November 2008. The impacts in the stock index, housing prices, savings,
jobs etc has been discussed in the further topics. The retirement assets of US also dropped
by 22% in 2008 as compared to 2006. The total losses are estimated to be around $8.3
trillion by 2008. There have also been large numbers of foreclosures.

5.2 TED Spread

The measure used for the risk for interbank lending is the TED Spread. The higher the
TED Spread, it indicates that the banks perceive it riskier to lend money to the banks. It is
the difference between the 3 month US T-bill and the 3 month LIBOR rate. LIBOR rate
is the rate at which the banks usually lend to each other. The US T-bill is considered as
the risk free investment. As can be seen from the graph below, the TED Spread was
highest during October 2008 and reached a peak of 450 basis points.

17
500

450
400
Difference (basis points)

350
300

250

200
150

100
50

0
02-Jan-03

13-May-03

18-Sep-03

28-Jan-04

09-Jun-04

18-Oct-04

24-Feb-05

08-Jul-05

14-Nov-05

24-Mar-06

08-Aug-06

14-Dec-06

27-Apr-07

06-Sep-07

16-Jan-08

27-May-08

03-Oct-08
The diagram below shows that the 3 month Treasury bill yield movement was close to
zero. This indicates that people were willing to forego interest only to keep their money
safe for three months. This shows that there was a very high perception of risk and there
was almost lending in those times. Also, it can be observed that LIBOR rate was at a
peak during those times. This means that the instruments which had variable interest
terms were becoming expensive. The instruments include car loans, mortgages, credit
card interest rates etc.

Source: Wikipedia

18
5.3 Stock market
There was a decline in the stock market.

5.4 Effect on Jobs in the financial sector

More than 34000 employees had been laid off by the financial institutions from July 2007
to March 2008 as per Bloomberg.

Some of the statistics to show the amount of lay-offs are:


• Citigroup announced 9000 layoffs for the rest of 2008 after already terminating
4200 jobs in January 2008
• Merrill Lynch announced layoff of 2900 jobs by 2008 end
• Washington Manual cut the payroll of 3000 workers
• RBS planned to cut 7000 jobs as per a report by Financial Times

According to the Department of Labor, more than 65,400 jobs had been terminated from
August 2007 to August 2008 by the financial institutions in the United States.

The graph below shows that the peak employment level was at its lowest as compared to
the last five recessions:

19
Source: Bureau of Labor Statistics

The below graph indicates that the unemployment rate increased to 8.9% in April 2009,
which was the highest level recorded since 1983:

Source: Bureau of Labor Statistics

If the part time and discouraged workers are also considered, the unemployment rate
would increase to 15.8% in April 2009. The average work week in April was 33.2 hours
which was also the lowest in records. The U.S. unemployment rate had increased to
10.2% by October 2009.

5.5 Effects on Housing Prices

20
As per the S&P/Case-Shiller housing price index, the average housing price had fallen
8% approximately by November 2007 from their mid 2006 peak. By June 2008, the
decrease was 20%. The sales of new houses dropped by 26.4% in 2007.

US CASE-SHILLER HOUSE PRICE INDEX

100

90

80

70

60

50
2000Q1 2000Q4 2001Q3 2002Q2 2003Q1 2003Q4 2004Q3 2005Q2 2006Q1 2006Q4 2007Q3 2008Q2

Nominal Real

5.6 Effect on Consumer Confidence

The consumer confidence index also decreased with the subprime crisis. The U.S.
Consumer Confidence Index (CCI) is an indicator designed to measure consumer
confidence, which is defined as the degree of optimism on the state of the economy that
consumers are expressing through their activities of savings and spending.

21
Source: The Conference Board

5.7 USA Bank Earnings

This above graph is based on the data from a quarterly report from the U.S. Federal
Depository Insurance Corporation (FDIC), which is about the bank financial health and

22
profitability. The graph clearly shows that the bank earnings in USA in the 3rd and 4th
quarters of 2007 saw a negative value.

Q4 -- US Banking Industry

2007 2006 2005 2004 2003 2002 2001

Return on assets 0.86 1.28 1.28 1.28 1.38 1.3 1.14


(%)
Return on equity 8.17 12.30 12.43 13.20 15.05 14.08 13.02
(%)
Core capital 7.98 8.22 8.25 8.11 7.88 7.86 7.79
(leverage) ratio
(%)
Noncurrent 0.94 0.54 0.50 0.53 0.75 0.90 0.87
assets plus
OREO (%)
Net charge-offs 0.59 0.39 0.49 0.56 0.78 0.97 0.83
to loans (%)
Net operating -23.72 8.50 11.39 4.02 16.39 17.58 -0.48
income growth
(%)
Source: FDIC – Quarterly Banking Profile

This shows that the US banking industry saw lowest returns on assets and equity in the
year 2007 compared to the last 6 years. The quarter to quarter report also indicates
negative net operating income growth in the 4th quarter of 2007.

5.8 USA Money Supply

• M0: This is the total physical currency with people and the central bank accounts
which can be exchanged for the physical currency
• M1: This is the total physical currency plus the demand deposits
• M2: This is M1 plus the savings accounts, money market accounts, retail money
market mutual funds, and small denomination time deposits (certificates of deposit
of under $100,000)

23
• M3: This is M2 plus all the other CDs (large time deposits, institutional money
market mutual fund balances), deposits of Eurodollars and repurchases agreements.

As can be observed from the above graph, there was a steep decline in M1 which is
basically the money with the people in the form of currency and demand deposits. This
can be attributed to the subprime crisis as people did not have money in hand and thus
also defaulted in the payment of the mortgages.

24
5.9 USA Trade Deficit and % GDP

The USA current deficit had increased from 1.5% to 5.8% of GDP between 1996 and
2004. This was an increase by $650 billion. Now, to finance these deficits, USA had to
borrow large sums of money from abroad, mostly from Asia and oil exporting nations
which were running on trade surpluses. As per the Balance of Payments identity, the
BoP=0, i.e. capital account surplus should match the current account deficit. Thus there
were large capital funds (foreign) into USA to finance its imports. These foreign
governments supplied funds by purchasing the USA Treasury bonds and thus they were
not very directly impacted by the subprime crisis. USA households on the other side used
funds from the foreigners.

5.10 Effect on IS-LM curve

US GDP saw a decline of -0.3% in the 3rd quarter of 2008 and this was mostly due to the
fall in consumption which was -2.25% was a decline in fixed investment which was
-0.83%. This decline in the consumption and investment has been due to the increase in
the cost of credit and the availability of credit reduced. Also there was a fall in the
confidence among consumers and the businesses about the future because of which the
investment declined.

25
Analysing this effect with the help of IS-LM curve, the fall in the consumer confidence of
future leads to a leftward shift of IS curve. Moreover due to a decrease in stock price and
disposable income led to decreased demand and thus the IS curve shifted leftwards.

5.11 Gross Domestic Product

Real gross domestic product is the output of goods and services produced by the labor
and property. There was a decrease in the Real GDP of US following the subprime crisis,
the largest decrease found in the ending quarters of 2008 and the beginning quarters of
2009.

26
Quarter
2008: 2008: 2009: 2009: 2009:
3 4 1 2 3
Gross Domestic
Product
( Billions of US 13324 13141 12925 12901 12990
Dollars) .6 .9 .4 .5 .3
Percent Change
(Annual Rate) -2.7 -5.4 -6.4 -0.7 2.8

5.12 Inflation rates

27
Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Average
- - - - - - - -
2009 0.03% 0.24% 0.38% 0.74% 1.28% 1.43% 2.10% 1.48% 1.29% 0.18% NA NA NA
2008 4.28% 4.03% 3.98% 3.94% 4.18% 5.02% 5.60% 5.37% 4.94% 3.66% 1.07% 0.09% 3.85%
2007 2.08% 2.42% 2.78% 2.57% 2.69% 2.69% 2.36% 1.97% 2.76% 3.54% 4.31% 4.08% 2.85%
2006 3.99% 3.60% 3.36% 3.55% 4.17% 4.32% 4.15% 3.82% 2.06% 1.31% 1.97% 2.54% 3.24%
2005 2.97% 3.01% 3.15% 3.51% 2.80% 2.53% 3.17% 3.64% 4.69% 4.35% 3.46% 3.42% 3.39%
2004 1.93% 1.69% 1.74% 2.29% 3.05% 3.27% 2.99% 2.65% 2.54% 3.19% 3.52% 3.26% 2.68%
2003 2.60% 2.98% 3.02% 2.22% 2.06% 2.11% 2.11% 2.16% 2.32% 2.04% 1.77% 1.88% 2.27%
2002 1.14% 1.14% 1.48% 1.64% 1.18% 1.07% 1.46% 1.80% 1.51% 2.03% 2.20% 2.38% 1.59%
2001 3.73% 3.53% 2.92% 3.27% 3.62% 3.25% 2.72% 2.72% 2.65% 2.13% 1.90% 1.55% 2.83%
2000 2.74% 3.22% 3.76% 3.07% 3.19% 3.73% 3.66% 3.41% 3.45% 3.45% 3.45% 3.39% 3.38%
Note: Red indicates Deflation, NA indicates data not yet released.

Source: InflationData.com

There has been a decline in the inflation rates and 2009 saw a deflationary period.

5.13 Manufacturing Index

The US business sector is measured using the ISM manufacturing index, which was
earlier termed as the PMI – Purchasing Manager’s Index. This index is released by the
Institute of Supply Management in Arizona in the monthly report on the first working
day. The five main indicators are production levels, new orders placed, inventory levels,
supplier deliveries and employment environment.

An ISM value of 50 is considered neutral, above 50 points as an expansion of the


manufacturing sector and below 50 points as a decline in industrial production.

MA AP MA JU AU SE OC NO DE
JAN FEB R R Y N JUL G P T V C
200 36. 40. 44. 48. 52. 52. 55.
9 35.6 35.8 3 1 42.8 8 9 9 6 7
200 48. 49. 49. 49. 43. 38. 32.
8 50.8 48.8 49 6 49.3 5 5 3 4 7 36.6 9
200 51. 52. 52. 51. 50. 50. 50. 49.
7 49.4 51.9 1 8 52.5 9 9 6 5 2 50.4 1
200 54. 52. 51. 52.
6 54.8 55.4 5 56 53.6 3 53 53 8 51 50 2

28
200 54. 52. 51. 56. 57. 54.
5 56.6 54.8 9 5 51 52 54 6 5 2 56.5 9
200 60. 60. 60. 59. 58. 57. 56. 57.
4 60.8 59.9 6 6 61.4 5 9 5 4 3 56.2 2

Source: ISM Manufacturing Report on Business® PMI History

There was a decline in the manufacturing in USA in the year 2008. But now in the year
2009, there has been an increase in the manufacturing index.

5.14 Impacts worldwide

The financial crisis had its impacts in many advanced economies and led to a fall in
household wealth and asset prices. As per an IMF research, the fall in asset prices led to a
downfall in the financial and household assets and the net worth of households.
In the first 3 quarters of 2008, the value of household financial assets decreased and the
value of housing assets deteriorated with falling house prices. The decrease in household
financial assets in United States was 8%, in United Kingdom by 8%, 6% in Europe and
5% in Japan.

29
Source:World Economic and Financial Surveys;World Economic Outlook;April 2009

Net worth is the total assets (i.e. housing and financial assets) minus the financial
liabilities. The household wealth losses in United States in 2008 amounted to $11 trillion
which included $8.5 trillion in financial assets and $2.5 trillion in housing assets. In UK,
the losses were $1.5 trillion.

World share price indices:

30
225

200

175

150

125

100

75 16-May-05

14-May-07
29-Nov-04

21-Mar-05

19-Mar-07
27-Nov-06
24-Jan-05

12-Jun-06

09-Jun-08
14-Jun-04

22-Jan-07
23-Feb-04

09-Aug-04

06-Sep-05

27-Dec-05

21-Feb-06

07-Aug-06

04-Sep-07

24-Dec-07

19-Feb-08

04-Aug-08

29-Sep-08
19-Apr-04

11-Jul-05

31-Oct-05

09-Jul-07
04-Oct-04

17-Apr-06

02-Oct-06

29-Oct-07

14-Apr-08
US S&P500 JPN Nikkei225 DJ Euro Stoxx
UK FTSE100 HK Hang Seng AUS ASX S&P200

As can be seen from the above indices, there was a sudden fall in the price indices all
over the world.

WORLD MARKET CAPITALIZATION:


The effect of subprime crisis has also been on the world market capitalization. Since
March 2007 it had dropped by 20% and by 31% since December 2007. The worst
performers have been the Indian, Russian and Chinese markets as observed by the
indices.
Mar
2007 to
Dec-2007 Sept Dec-2007
to Sept 2008 to Sept Mar 2007
2008 (% 2008 to Sept
Sep- (%chang change Sep- (%chang 2008 (%
Country 08 e) ) Country 08 e) change)
139
United States 31 -21% -21% India 894 -51% 10%
347
Japan 9 -23% -30% Spain 734 -33% -285
United 271
Kingdom 3 -33% -295 Italy 703 -36% -36%
217 South
China 0 -51% 31% Korea 660 -40% -20%
184
France 4 -33% -30% Taiwan 496 -29% -23%
161
Hong Kong 6 -39% -7% Russia 479 -52% -53%
Canada 147 -16% -3% Argentina 418 -26% 5%

31
5
144
Germany 1 -35% -23% Sweden 359 -38% -42%
Switzerland 969 -20% -22% Mexico 340 -15% -7%
Australia 935 -34% -8% Singapore 327 -34% -21%
418
Brazil 934 -33% 23% Total World 06 -31% -20%
Source: Bloomberg

6. EFFECT ON INDIA – CHITRA YADAV (91076)

6.1. Introduction

Subprime Crisis is the major cause of the economic downturn that had engulfed a lot of
big economies including US since the past one year. The major cause of this crisis was
Subprime Lending, which refers to the process in which loans are given to people who
have belongs to highest-risk categories and whose chances of default are very high.
During 2008 the default rate on loans especially home loans was at its highest and people
were losing their homes at an alarming rate. Along with that many lenders like Financial
Banks were also losing their money and filed for bankruptcy. All this created a vicious
circle in US economy and people started pulling their money out of stocks and banks
which further escalated the problem.
In this era of liberalization and globalization the impact of Subprime Crisis was not
limited to US only. Instead a lot of other economies are bearing the brunt and trying hard
to come out of so called recession. And India is one of those.

Now most of our economists and analysts believe that this crisis did not affected India in
a big way and it is much safer as compared to other economies. The reasons given by
them for such estimations are:

• Indian Banking System had no direct exposure to the mortgage assets and the
financial institutions, like Lehman Brothers and had very limited securitized
assets.

• The second reason given is that Indian consumer is very aspirational and its recent
growth is driven primarily by domestic consumption and investment and exports
account for less than 15 percent of our GDP.

32
• Also there was a little or almost negligible presence of foreign banks in our
country which minimized the impact of recession on domestic economy.

According to some of the analysts the real picture of economy in 2009 was as shown:

INR
Indian
Capital Market FII’s Pooling In
Market
Availability of
Debt

Overseas
Lender has
Appetite Manageable
Liquidity Issue

Picture of Indian Economy as Projected by some analysts in 2009

However, the picture is not so good as it is projected by the analysts. Because if in reality
Subprime had not affected our economy then it won’t have been the most talked about
topic for all the newspapers, editorial sections, news channels, etc. Also we all have read
a lot of news telling the suicides committed by a lot of people due to job losses as an
impact of recession. Pune itself lost about 2,00,000 jobs and about 41 diamond workers
committed suicide in a small time span of three months from November-08 to January-
09.

6.2. Impact of Global Crisis on India

The impacts of crisis can be divided into two parts, Visible Impacts and Hidden Impacts.

33
6.2.1 Visible Impacts
• The average GDP of India was about 9.4 percent during three successive years
from 2005-06 to 2007-08, but it came down to 6.7 percent for 2008-09 which
means our economy was back to what it was about five years ago.

• Industrial production was also hit hard. It grew by just 2.6 percent as compared to
7.4 percent in the previous year.

• Merchandise Sector was among the most affected sectors. Imports of India fell by
around 12 percent and Exports by more than 20 percent. This put a lot of stress on
other sectors too. Trade deficit also widened to around $120 billion in 2008-09
from $88.5 billion 2007-08.


Trends in Exports of India and World from Jan-08 to Jan-09
FII’s i.e. Foreign Institutional Investors also withdraw from the stock market which
led to a steep decline in the Sensex. Sensex fall by 1400 point in one single day in
January, 09. The reduction in FII’s greatly impacted our forex and capital market
because of lack of funds.

The following graph shows the fluctuations in Sensex closing prices from May-08
to May -09:

34
Trends in BSE Sensex Prices from May-08 to May-09

The graphs show a steep fall in prices from a high of 16,000 to a very low of
about 8,000 in the months of November and December-08.

• The amount of liquidity available in the market reduce to about one-third in FY


2008-09 from 2007-08.

• Net capital inflows from US were much lower in 2008-09 as compared to 2007-
08. The following table shows the amount of FII’s, External Commercial
Borrowings and Short term credit flow. As can be seen FII’s were negative in
2008-09 depicting an alarming situation. This was mainly because of the drop in
confidence of investors in the stock market in US.

TRENDS IN CAPITAL FLOW


(US $ MILLION)
COMPONENT PERIOD 2007- 2008-
08 09
FIIs (net) April – Sept 26 15,508 -6,421
External Commercial April- June 6,990 1,559
Borrowings (net)

Short-term Trade Credits April- June 1,804 2,173


(net)

35
Trends in FII’s in 2007-08 to 2008-09

All these factors led to a pressure on liquidity and credit position of due to fall in global
trade and industrial output. These factors in cumulation had some implications on other
sectors too.

6.2.2 Hidden Impacts


The above mentioned effects were those which can be quantified, but there are some
other impacts which can’t be but they have a direct impact on us. Some of these are:

• Rising Unemployment and Underemployment- Unemployment grew at a very


high rate during recession. Companies mainly in Information Technology and
Financial Sector saw large number of job cuts. All this had a direct impact on the
consumer consumption and investment levels.

• Fall in demand for Labor- Due to decrease in income level of expenditure also
decreased and people started saving money. Hence labor demand dropped to an
all time low.

• Expansions in informal economy- Financial banks were not ready to lend


money which expanded the base of informal economy.

36
• SME’s were hit hard- SME’s i.e. Small and Medium Term Enterprises were
among the worst hit sectors. They did not had enough money to support their
functions and no one was ready to lend them money too.

• Downward Pressure on Wages- Since the liquidity position was not good,
companies were into cost-cutting for which they cut down the wages and salaries
of their employees.

• More Expensive Capital- Interest rates were increased to a high level as banks
were lending to each other at higher rates.

6.3. RBI’s Response to Subprime Crisis


Following policies and steps were taken by RBI in order to protect the Indian Economy
from recession. The source of the following information is http://www.rbi.org.in

RBI’s response as monetary authority


• Till August 2008, the RBI followed a tight monetary stance in view of the
inflationary pressures arising from crude, commodity and food prices. In mid-
September 2008, severe disruptions of international money markets, sharp
declines in stock markets across the globe and extreme investor aversion brought
pressures on the domestic money and forex markets.
• The RBI responded by selling dollars consistent with its policy objective of
maintaining orderly conditions in the foreign exchange market. Simultaneously, it
started addressing the liquidity pressures through a variety of measures.
• A second repo auction in the day under the Liquidity Adjustment Facility (LAF)
was also re-introduced in September 2008. The repo rate was cut in stages from 9
per cent in October 2008 to the current rate of 4.75 per cent.
• The reverse repo rate was brought down from 6 per cent to 3.25 per cent. The
cash reserve ratio which was 9 per cent in October 2008 has been brought down
to 5 per cent.
• To overcome the problem of availability of collateral of government securities for
availing of LAF, a special refinance facility was introduced in October 2008 to
enable banks to get refinance from the RBI against a declaration of having
extended bona fide commercial loans, under a pre-existing provision of the RBI
Act for a maximum period of 90 days.
• The statutory liquidity ratio requiring banks to keep 25 per cent of their liabilities
in government securities was reduced to 24 per cent. These actions of the RBI
since mid-September 2008 resulted in augmentation of actual/potential liquidity
of nearly $50 billion.

37
RBI’s response as forex manager
• The RBI assured the markets that it would continue to sell foreign exchange (US
dollar) through agent banks to augment supply in the domestic foreign exchange
market or intervene directly to meet any demand-supply gaps, and did so,
especially in October 2008. It also provided forex swap facility with a three
month tenor, to Indian public and private sector banks having overseas branches
or subsidiaries – this acted as a strong comfort to such banks in the context of the
drying up of the overseas money markets. Further, for funding the swap facility,
banks were allowed to borrow under the LAF for the corresponding tenor at the
prevailing repo rate. The forex swap facility of tenor up to three months was
extended up to March 31, 2010. The prudential limit on overseas borrowing by
banks has been doubled.
• Taking into account the difficulties faced by exporters, as orders got cancelled
and receivables mounted, the RBI extended the period of concessional pre-
shipment and post-shipment export credit. The export credit refinance available to
banks from the RBI was also increased.
• Interest rates on dollar and rupee deposits kept in Indian banks by non resident
Indians are capped by the RBI in order to prevent hot money flows. In order to
address the impact of slow down in capital flows, the ceiling rates on these
deposits were raised.
• The ceiling on the interest rates at which companies could raise funds from
abroad were increased and the end use restrictions that were placed on the
deployment of such funds, to deal with the huge inflows in 2007-08, were
restored to the status quo position.

RBI’s response for Employment intensive sectors –


• Following the announcement in the Union Budget 2008 in February 2008, the
commercial banks, cooperative banks and regional rural banks implemented in the
period till June 2008, the debt waiver (100 per cent waiver) program for small and
marginal farmers and debt relief (25 per cent relief) program for other farmers,
covering an estimated 40 million farmers to the extent of nearly Rs. 71,000 crore
or $14.5 billion. The RBI took sector-specific measures to alleviate the stress
faced by employment intensive sectors such as SME, export and housing.
• The RBI extended special refinance of $1.4 billion to Small Industries
Development Bank of India (SIDBI) to enable it to on-lend to banks and financial
institutions towards incremental SME loans. Banks were advised to carve out and
monitor separate sub-limits of large companies to meet payment obligations to
micro and small enterprises.

38
• MSME (Refinance) Fund of Rs. 2000 crore ($400 million) was instituted and
banks were asked to contribute towards this fund against their shortfall in their
lending to the weaker sections as low interest deposits with SIDBI to be used by
the latter for providing assistance to the MSME sector.

RBI’s response as debt manager


• To contain the knock on effects of the global slowdown, the Government of India
announced three fiscal stimulus packages during December 2008-February 2009.
• These stimulus packages were in addition to the already announced post-budget
expenditure towards farm loan waiver, rural employment guarantee and other
social security programs , enhanced pay structure arising from the sixth pay
commission, etc.
• As a result, the net borrowing requirement for 2008-09 increased by nearly 2.5
times the original projection in 2008-09 from 2.08 per cent of GDP to 5.89 per
cent of GDP.
The inherent synergies in its multiple roles enabled the RBI to ensure orderly functioning
of money, forex and government securities markets while dealing with capital flows,
managing additional government market borrowing and ensuring adequate credit to
restore growth momentum.

6.4. Analysis of RBI Policies


RBI has taken a lot of fiscal and monetary policies as mentioned above which brought the
economy under control. Government of India also stepped in at right time to increase
spending in the economy. The various policies released about a potential liquidity of Rs.
4, 90,000 crores.

39
But as it is said nothing comes free of cost. Government pressures increased due to
increase in expenditure. The revenue deficit widened to about 4 percent in 2008-09 from
2 percent in 2007-08 as shown:

40
Trend in Revenue Deficit of Indian Government

But overall the timely steps taken by RBI and Government of India restricted the negative
impacts which the global downturn could have on the Indian economy.

6.5. Recommendations

Other than taking fiscal and monetary policies the government can try to achieve the
following goals to:
• Rapid and Intrusive Growth

• Greater integration with rest of the world.

• Strengthen the democratic policies and safeguard its border .

• Invest in carbon-imperative projects,

• Carry on with its strengths of being a Multiethnic, Diversified and at the same
time Integrated economy.

• Should try to bring harmony with its neighboring countries for a proper flow of
goods and services.

41
7. REGULATIONS AND MEASURES UNDERTAKEN
– SOWMYA DEEPTHI KVN (91111)

7. 1. Introduction

The crisis became apparent in August 2007. With more than 6 Million job cuts and over 100
financial institutions becoming insolvent within the US, the extent of damage caused by the
crisis is unimaginable. The Federal Reserve and other central banks took steps which can be
broadly classified as follows:
o Increased open market operations
o Term Auction Facility (TAF) and Term Asset-Backed Securities Loan Facility (TALF) to
provide lending facilities against a plethora of collaterals
o Drastically reduced Federal Funds rate and discount rate

7.2. US Bailout Acts

7.2.1 Major Acts

o The Economic Stimulus Act of 2008 was signed on 13 February 2008. Under this act, 168
Billion Dollars were sanctioned as tax rebates. However, a preliminary investigation revealed
that, though the families who received the benefit spent 3.5% more than others, this cannot be
attributed to be a good sign of recovery. The primary cause for such an increase in spending
would have been the inflation, which occurred around the same time, leading to very high
increases in prices of all food items and petroleum products.
o The Student loan guarantees program of 2008, with an allocated amount of 195 Billion
Dollars, was announced to assist financial institutions providing student loans. Out of the 195
Billions, 32.6 Billions have been spent under this program.
o The Emergency Economic Stabilization Act of 2008 was signed in October 2008. Under
this act, 700 Billion Dollars were to be used for purchase of distressed assets, also called
Mortgage Backed Securities (MBS). This Act also announced facilitation of financial assistance
to banks.
o The American Recovery and Reinvestment Act (ARRA) of 2009 was signed in February
2009. Under this act, 787 Billion Dollars were to be spent in the form of extended unemployment
benefits, tax rebates to common man, provisions for social welfare, spending in sectors like
education, medical facilities, and infrastructure, including the energy sector and also various
non-economic items as a part of future outlook. Out of the 787 Billions, 358 Billions have been
spent under this Act.

42
o The Unemployment benefits extension Act was signed in February 2009. Under this act, a
sum of 8 Billion Dollars was sanctioned to be provided in the form of assistance to the
unemployed.
o The Public-Private Investment Program was signed in June 2009. Under this program, a
sum of 100 Billion Dollars was sanctioned to be used to buy up financial institutions bad assets
worth 500 Billions Dollars. This 100Billions, as suggested by the name of the program are
government funds which will be combined with private funds to achieve the purpose. Out of the
100 Billions, 23.3 Billions have been spent under this program.

The table below lists the various programs formulated in the US to provide financial assistance.
A sum of 1.2 Trillion Dollars has been allocated out of which 577.8 Billion Dollars have been
spent till date.
Committed Invested
Program

Economic Stimulus Act of


2008 $168 billion $168 billion

• Rebates for • $117 billion • $117 billion


individuals
• $51 billion • $51 billion
• Tax breaks for
businesses

Unemployment benefit
$8 billion $8 billion
extension

Student loan guarantees $195 billion $32.6 billion

American Recovery and $787.2 billion $358.2 billion


Reinvestment Act
• $288 billion • $62.5 billion
• Tax relief
• $499.2 billion • $295.6 billion
• Stimulus

$25 billion $8 billion


Advanced Technology
Vehicles Manufacturing

43
Committed Invested
Program

program

Car Allowance Rebate


$3 billion $3 billion
System

7.2.2 Term Auction Facility (TAF)

The TAF is a Federal credit facility. In TAF, every participating depositary institution places a
bid with a specified interest rate and amount of credit. An auction is conducted afterwhich the
bids are opened and the winners of the auction are declared. The auctioned funds typically vary
from 28 day to 84 day maturity periods. Since, the funds are of short term and decided by an
auction, the name of the facility was coined as TAF.
The main purpose of TAF is to allow for a wider range of collaterals against the funds auctioned.
Also, any institution can participate in the bidding process until its financial condition is sound,
as determined by its local central bank. Not only the present financial condition, but also the
extent to which the institution can maintain the same in the near future also is taken into
consideration before deciding on the participation permissions. Hence, a wider range of
depositary institutions than possible for normal credit facilities, can take advantage of TAF.
Using TAF, the Fed fulfils the function of providing financial assistance to institutions even
when the interbank markets are under pressure.
The amount of advances to be put under auction, the duration of the auction, the minimum
interest rate and auction amount per institution, maximum auction amount in a bid by a
depositary institution and other details are all specified well before the start of the bidding
process. The participating institutions take part in the bidding process by placing their bids on the
local central bank’s toll-free number. For this, the bid process start date and time, end date and
time for each auction are also specified before hand.

7.2.3 Term Asset-Backed Securities Loan


Facility (TALF)

Fresh issues of Asset Backed Securities (ABS) stopped in US around October 2008. During the
same time period, the interest rates on AAA rated Securities (ABS) increased dramatically to
reach highest levels. If this was to continue, then, the US economic activity would have further
deteriorated as a direct consequence of low credit available to individuals and minor business

44
houses. Hence, the TALF came into picture. Under TALF, these sectors were facilitated with
credit against ABS at an affordable interest rate instead of the abnormally high interest rates.
A total of 200 Billion Dollars were announced under this program, when it was initialized in
November 2008. But, the amount was later increased to 1 Trillion Dollars. The Fed would utilize
this amount to extend credit to parties holding ABS which are AAA rated in the form of student
loans, auto loans, credit card loans, loans guaranteed by the Small Business
Administration (SBA), newly and recently originated consumer and small business loans. The
main advantage of TALF is that it does not require approval of the Congress because it is not a
part of US Treasury programs.

7.2.4 Troubled Asset Relief Program (TARP)

The troubled asset relief program 2008 is also called as Mortgage Bailout Bill. Unlike the
TALF, this program is under the supervision and in the hands of the Treasury Secretary. TARP
was initiated to buy out the bad assets of the financial institutions of US and transfer them to the
Federal government. It was first rejected in the senate and then accepted in October 2008. TARP
was planned in such a way as to not affect the financial markets and also prevent the use of
taxpayer’s money. A total of 700 Billion Dollars has been allocated. An initial report was
submitted to the congress after the first three months. Then, an additional report needs to be
submitted for every additional 50 Billion Dollars spent under this program.
Signs of recovery were detected under this program, when in June 2009, ten of the banks under
this program decided to exit it. This decision was taken by the banks to save huge amounts of
interests being paid on the amount borrowed under this program and also to break free of the
terms and conditions inherent in case of borrowings under TARP. These banks were given
permission to pay back 68 Billion Dollars of the amount borrowed. But, the Government still
holds the right to buy shares of these banks even though the amount was repaid prior to the
maturity date. There are controversies involved in this context, as the warrants are convertible
only at fair market value and the fair market value is not that easy to predict.

Below is the summary of the proceedings under TARP till date:


Program Committed Invested

American International Group $70 billion $69.8 billion

45
Program Committed Invested

Asset Guarantee Program $12.5 billion $5 billion

• • •

Auto Supplier Support Program $5 billion $3.5 billion

• • •

Automotive Industry Financing $80 billion


Program $80.1 billion

Capital Purchase Program $218 billion $204.7 billion


($70.9 billion) ($70.9 billion)

Consumer and Business Lending $70 billion


Initiative $20 billion

Making Home Affordable


$50 billion $27.3 billion

Public-Private Investment
$100 billion $23.3 billion
Program

Targeted Investment Program $40 billion $40 billion

Funds paid back ($73 billion) ($73 billion)

46
Program Committed Invested

TARP total $700 billion $403.6 billion

7.2.5 Total US Bailouts Till Date

Type of Bailout Estimated Amount Invested Amount


TARP 700 403.6
Fed Reserve 6400 1500
Fed Stimulus 1200 577.8
AIG Bailout 182 127.4
FDIC Fund 45.4 45.4
Other Financial 1700 366.4
Other Housing 745 130.6

Estimated vs Invested

7000

6000

5000
In Billion Dollars

4000
Estimated
Invested
3000

2000

1000

0
TARP Fed Fed AIG FDIC Other Other
Reserve Stimulus Bailout Fund Financial Housing

As seen from the figure above, the Invested amount, except for AIG Bailout and FDIC funds, is
much lesser than the Estimated Investment. So, there is still chance for the Government to pump

47
in more money with cautionary measures in place to reduce the inflationary trend that will arise
as a result.

7.3. Policies in G-20 countries

According to IMF report, till date, the fiscal stimulus policies adopted by the G-20 countries total
up to one-and-a-half percent of their GDP in 2008, one-and-a-half percent of their GDP in 2009
and are expected to be around one-one by fourth percent of their GDP in 2010. These figures are
on an average basis. However, the actual figures of the stimulus packages vary both in amount
and composition across the G-20 countries. The common policies across the countries were in
the form of tax rebates especially in the personal taxes and some others like VAT. The
Government stimulus directly has been in the form of expenditure in the infrastructure sector,
financial assistance to state governments, housing aids and supporting small businesses.
o About half of these countries gave personal income tax rebates, one-third of them
gave indirect tax rebates and about another half announced corporate tax rebates.
o About seventy—five percent of countries have increased expenditure in infrastructure
sector, specifically in the transportation sector. These vary in the form from direct spending by
the central government to transfer to local governments
o Many of these countries have also protected sectors vulnerable to becoming
insolvent. They have also extended benefits to the unemployed, direct funds
transfer to the down-trodden, retired and minors, credit facilities to the not so well
to do section of their communities.
o About one-fourth of these countries have also extended credit to small business
houses and other sectors like construction, defense, agriculture etc which are
directly threatened by the bad economic position.
o A few of these countries are also laying the road ahead for future, by directing
their spending appropriately. Some of the ways are expenditures in health care
and education sectors or investing for development of environmental-friendly
devices and mechanisms.
Automatic stabilizers working in the economy are helping to strengthen demand by
further lowering tax rates and at the same time increasing government expenditure. But,
the negative side is the worsening Balance of Payments for the countries.G-20 countries,
most of them being developing economies, are in deeper trouble in this regard, than the
developed economies. The higher levels of stimulus packages is being offered by
increased government borrowing and thereby taking a serious hit in the Balance of
Payments for the government. This effect is not to be neutralized in the short run in any

48
way. Long term outlook is what is forcing the Governments to think twice while
implementing the stimulus packages. The repercussions will be felt in the near future. As
estimated by the IMF, the Balance of Payment for the G-20 countries as a whole is
expected to deteriorate by three-and-a-half percent of GDP in 2009 on an average rate.

7.4. Policy recommendations

Now, let us have a look at a plethora of solutions which have been proposed by various
statesmen, economists, businessmen and journalists to the present crisis and also to
prevent it from happening again. Some of these have been implemented and most of them
have not made it to this day.

7.4.1 Interest rates


Lowering the interest rates is the first thing that comes to mind. This will stimulate the economy
because the credit becomes cheaper. Banks will be the most benefitted by this policy, as they will
borrow at a lower interest rate from depositors and then lend at a higher interest rate to the
borrowers. But, the repercussions are that the capital outflows from the country may be high to
countries offering higher interest rates, which in turn weakens the domestic currency. Also, it
discourages saving and encourages spending. Once, the economy starts growing, there are high
chances of demand driven inflation occurring.

7.4.2 Easy Credit


Credit easing is increasing the money supply in the economy. For example, Fed has done it
through increasing open market operations and other tools like TAF and TALF. Even this
method leads to weakening of the domestic currency and inflation.

7.4.3 Nationalization of Financial Institutions


Nationalization is the Government assuming partial or full control of financial institutions as part
of bailout. Incase of full control, the suppliers, depositors and long-term debt holders are paid as
per the money available and the equity share holders and entirely wiped out. The US and other
countries have injected huge amounts of money into insolvent financial institutions, however, not
through nationalization. The injected amount till date has been in the form of preferred stock or
asset purchases. Economists Paul Krugman and Nouriel Roubini support Nationalization. The
drawbacks are that the Government may not be able to run the institution better. Also, a threat of
nationalization will lead to institutions not getting private funds. It is also a threat to the current
shareholders, bond holders as well as the tax payers.

49
7.4.4 Bailouts by the Government
Governments bailout big institutions because their bankruptcy would mean huge stock
market crashes or unavailability of credit to borrowers who are worthy. AIG was one of
the big financial institutions to be bailed out during the crisis. But, one of the most
pointed out drawback is that this creates a safety net for these institutions and proves to
be a moral hazard. Journalist Nicole Gelinas harshly criticizes saying that in bailing out
failing companies, we are confiscating money from productive members of the economy
and giving it to failing ones. Hence, the government indirectly makes their resources
being unavailable to other companies that can put them to better, more productive use.
World Bank reported that country bailouts cost an average of fourteen percent of GDP.

7.4.5 Purchasing of Bad Assets


It is to purchase those assets of financial institutions which are significantly reduced in
value due to payment delinquency which will lead to a winning situation if the
institutions can get appropriate price for the assets sold. Added to it, transparency of
financial institutions comes into picture in the economy, further improving investor
confidence as these institutions can be valued for a fair market price. The Public-Private
Partnership Investment Program by the US is an example. Economist Joseph Stilglitz
criticized this measure stating that this is generally a loss for the tax payers because the
assets are bought at a higher price than the market and sometimes even at the book value
which is much higher.

7.4.6 Bondholder Haircuts


Bondholders of the financial institutions that received a bailout have been forced to
accept a reduction in the principal amount and the interest rates. This creates a reduction
of debt and on the balance sheet thereby improving the solvency situation of the
institution. Economists Joseph Stilglitz and Jeffrey Sachs argue that this is the right way
to deal with the situation as this method does not need infusion of extra tax payer’s
money. Some Economists argue that if this step would have been implemented way back
in 2008, the situation would have been much brighter. But, this would act as a repellant
for investors. Insurance companies and other investors who hold bonds of these
institutions will suffer huge losses. This fear of losing one’s investment would only
worsen the recession.

7.4.7 Government Expenditure


Keynesian economics suggests that if spending by government is increased in the same
proportion as the consumer expenditure and investment in business have declined, then
the economic situation can be improved. US has approximately spent 968 Billion Dollars

50
under this measure. Economist Joseph Stiglitz says that stimulus can be seen as an
investment and not just as spending, if used properly. Economists Alan Blinder and Alan
Auerbach also support short term Government spending. But, Harvard professor Niall
Ferguson and Economists Peter Schiff and John B. Taylor say that US is already facing
long term funding and debt challenges and increasing stimulus would only lead to further
debts. Conservatives have gone a step further by saying that government expenditure
should be reduced. The reason being that, this would result in reduction of cost of inputs
for the businesses and hence, they will be able to invest further, thereby providing more
employment.

7.4.8 Tax Rebates


Having rejected the idea of increased government spending, instead the Conservatives
and supply-side economists propose tax rebates. The tax rebates in the form of indirect or
corporate tax cuts will lead to businesses investing further, which will prove to be truly
productive and help in reviving the economy. But, the government needs the tax revenue
if it has to keep up its regular expenditure levels or risk losing confidence of people.
Also, spending on infrastructure such as roads and bridges has a higher impact on GDP
and jobs than tax cuts.

7.4.9 Homeowner Assistance


Assistance was provided to the homeowners with case-by-case mortgage assistance, to
lessen the impact of the foreclosures which were increasing rapidly. Up to nine million
homes are expected to come forward for foreclosure in the next two years, compared to
one million in a normal year. Economists Nouriel Roubini and Mark Zandi
recommendation was to lower the mortgage balance, which would help lower monthly
payments. This would prove to be an incentive to an estimated twenty million
homeowners to enter voluntary foreclosure. But, such assistance may also further damage
the financial condition of banks.

7.4.10 Establish a System Risk Regulator


The purpose of a systemic risk regulator would be to address the failure of any entity of
sufficient scale which would threaten the financial system. Economists Nouriel
Roubini and Lasse Pederson made some recommendations in January 2009. Firstly, the
capital requirements for financial institutions should be proportional to the systematic
risk they pose, which would be assessed by the established body. Secondly, each
financial institution would pay an insurance premium to the government based on its
systemic risk. Libertarians and conservatives argue for minimal intervention. The markets

51
should be allowed to self-regulate. Extensive regulation of financial institutions will
render then ineffective.

7.4.11 Capital Ratio Requirements


The solution is to have regulatory capital requirements to discourage financial institutions
from becoming too big and to offset their competitive advantage. This must be combined
with pre-planned levels of reserves as a safety against losses of loans and borrowers most
likely to default on their borrowings. This will also ensure liquidity, as the credit facilities
available in the market can freeze up. Both Joseph Stiglitz and Alan Greenspan
recommend this. Economists Raghuram Rajan and Paul McCulley have gone a step
ahead and suggested “counter-cyclical regulatory policy to help modulate human nature”.
On the other hand, higher capital ratios or requirements mean, banks cannot lend as much
of their capital base, which increases interest rates and theoretically places downward
pressure on economic growth relative to freer lending regulations.

7.4.12 Break up institutions that are Too Big to


Fail
Economists Joseph Stiglitz and Simon Johnson have argued that institutions that are "too
big to fail" should be broken up, perhaps by splitting them into smaller regional
institutions because they are more prone to taking excessive risks due to the availability
of support by the central bank should their bets go bad. This has been further supported
by Wall Street journalists Martin Wolf and Niall Ferguson. So, when such a “biggie”
fails, the creditors should take the hit, not the task payers.

7.4.13 Regulating the Shadow Banking System


Unregulated financial institutions called the shadow banking system, play a critical role
in the credit markets. They can have a very high level of financial leverage i.e. they can
have a higher level of lending in comparison to the amount of current assets they hold to
pay up day-to-day claims. Market pressures to enhance profits by unimaginable levels of
risk taking were prevalent everywhere in the economy before the recession. So, many
state that the shadow banks need a regulation system in place. But, Economists Nouriel
Roubini and Paul Krugman argue that this would impair innovation and anticompetitive
economies of scale. Larger the size of financial institutions, the lesser it will be effected
by the costs of regulation. The smaller institutions will definitely take a hit.

7.4.14 Strict Mortgage Regulations


At the height of the bubble in 2005, the median down payment for first-time home buyers
was two-percent, with more than forty-three percent of those buyers making no down

52
payment. Economist Stan Leibowitz states that there should be a down payment of at
least ten percent and monthly payments that can be easily afforded, keeping in view the
income levels of the borrower. But, such a change in regulations will shatter the hopes of
the people belonging to low-income groups and will also reduce the levels of economic
growth.

7.4.15 A Financial Products Safety Commission


Economist Joseph Stiglitz proposed this and was accepted by the Obama administration
and put on the to-do list. Such a commission, under the government supervision or as an
independent body will review the risk levels of every new financial product. The results
would then be periodically conveyed to investors as to which ones are risky and which
are safe. The downside being that the rate of financial innovation will take a hit.
Moreover, risk-free instruments already exist in the market. People can put their money
in a bank account or open market instruments and government securities.

7.5. The exit strategy

7.5.1 FED’s Exit Strategy


The Fed has been reassuring financial markets about the long-term inflationary risks that might
arise from pumping large amounts of liquidity into the economy and that, it has the necessary
tools to soak up any excess liquidity once the economy starts to recover.
o Gradual response to demand :
As the financial market picks up and the economy starts recovering, the Fed can gradually
remove its stimulus as the demand for its credit facilities in the short-term goes down. Indeed,
this process has already begun. By mid-July, short-term credit extended by the Fed to financial
institutions and other market participants had fallen to less than 600 Billion Dollars from a peak
of 1.5 Trillion Dollars at the end of 2008.
o Reserve rates :
The Fed can increase the interest rates on the reserves of banks kept with Fed which will help
regulate the interest rates in the market to reach federal funds rate target. Banks lend funds at a
rate higher than the risk-free rate (the interest rate they earn at Fed) to borrowers. Hence, this
would regulate by placing a minimum level on the interest rates charged in the short run.
o Traditional tools :
The Fed also has a wide range of open market monetary policy instruments at its disposal. These
will be used to soak up excess liquidity. These instruments primarily consist of large-scale
reverse repurchase agreements with market participants, Treasury bills/ Treasury bond sales and
the offering of term deposits to banks.

53
7.5.2 G-20’s Exit Strategy

According to the International Monetary Fund (IMF), the G-20 countries should follow an exit
policy keeping in mind the following points:
1. The timing of exits should depend on the position of the economy and the health of the
financial system. Also, future growth in demand and supply and further revival of the economy
should be kept in mind.
2. The primary goal should be the consolidation of Fiscal stimulus and policies in place.
This is due to the fact that Monetary policy can be more easily normalized than the Fiscal policy.
3. The Fiscal policy exit strategies should be transparent, throughout the economy, and
communicated clearly. The aim should be to lower the debt levels and restore Balance of
Payments in the economy with well-planned time frame in which to achieve it.
4. First, the crisis related stimulus packages must be the target of exit strategies. Then, the
debt levels and Balance of Payments management will automatically improve.
5. It is not necessary that unconventional monetary policy instruments be removed before
the conventional monetary policy is restored to the original state.
6. Prevailing economic situation, the stability of financial markets should be the primary
decision criteria for the time frame in which Fiscal policy is to be restored.
7. If the exit strategies of all the G-20 countries are consistent, they will be more effective.
This however, does not mean that they have to be synchronized, but lack of coordination can
cause adverse spillovers

7.6. IS-LM curves

The following figure shows the movement of IS-LM curves

54
After the regulations were applied, the LM curve moved to the right and the interest rate fell. In
principle, the income should have risen as shown below

55
Since, initially, there was no increase in money supply, the shift in the LM curve to the
rightwards caused inflation because in the M/P, the M remained constant, so for a rightwards
shift, the P (Price levels) had to increase. The IS curve was expected to shift to right with the tax
cuts and increase in Government Stimulus which would in turn increase the consumer
expenditure and investment. But, the IS curve moved to left in reality, due to fall in the consumer
confidence and the protectionist psychology that had started to prevail in the consumers and
investors. Moreover, the decrease in stock price and disposable income as an effect of inflation
further led to its shift leftwards.

56
Hence, the interest rates fell further and the Income effect that would have been realized was
infact not. With the economies now on the path of recovery, the IS curve will shift rightwards
and the interest rates will rise as the expansionary monetary policy is repealed till the interest
rates reach the normal levels.

57
8. REFERENCES

1. http://en.wikipedia.org/wiki/Subprime_mortgage_crisis
2. http://en.wikipedia.org/wiki/File:Effects_of_Crisis_on_U.S._Household_Wealth_v1.png
3. http://en.wikipedia.org/wiki/File:FDIC_Bank_Profits_-_Q1_Profile.png
4. http://en.wikipedia.org/wiki/File:TED_Spread_Chart_-_Data_to_9_26_08.png
5. http://en.wikipedia.org/wiki/Indirect_economic_effects_of_the_subprime_mortgage_crisis
6. http://en.wikipedia.org/wiki/Financial_crisis_of_2007-2009
7. http://en.wikipedia.org/wiki/File:U.S._Trade_Deficit_Dollars_and_%25_GDP.png
8. http://www.globalissues.org/article/768/global-financial-crisis
9. http://www.imf.org/external/pubs/ft/survey/so/2009/NUM062409A.htm
10. http://news.bbc.co.uk/2/hi/business/7073131.stm
11. WORLD ECONOMIC OUTLOOK, April 2009, Crisis and Recovery, IMF report
12. The Subprime Crisis -- Cause, Effect and Consequences, March 2008, R. Christopher
Whalen
13. http://www.bloomberg.com
14. http://www.bls.gov
15. http://www.bsu.edu/ibb/US/qtable.htm
16. http://www.inflationdata.com/inflation/Inflation_Rate/CurrentInflation.asp
17. http://www.wikinvest.com/index/ISM_Manufacturing_Index
18. http://www.imf.org/external/cap/2008/101308.pdf
19. http://www.ism.ws/ISMReport/content.cfm?ItemNumber=10752&navItemNumber=12961
20. http://en.wikipedia.org/wiki/Money_supply
21. http://en.wikipedia.org/wiki/Consumer_Confidence_Index
22. http://upload.wikimedia.org/wikipedia/en/a/a4/Changes_in_US_money_supply_1960-
2007.gif
23. http://www.shadowstats.com/alternate_data/money-supply
24. Impact of global financial crisis on Reserve Bank of India (RBI) as a national regulator -
Presentation by Ms Usha Thorat, Deputy Governor of the Reserve Bank of India, at the 56th
EXCOM Meeting and FinPower CEO Forum.
25. Impact of the global financial crisis on India – collateral damage and response - Speech by
Dr Duvvuri Subbarao, Governor of the Reserve Bank of India
26. The Sub-prime Crisis – Likely Consequences for the Indian Economy - By (S. Narayan1)
27. Global Financial Crisis and Key Risks: Impact on India and Asia - By Rakesh Mohan,
Deputy Governor, Reserve Bank of India.
28. http://en.wikipedia.org/wiki/Subprime_crisis_impact_timeline
29. http://www.investopedia.com/terms/s/subprimeloan.asp
30. http://en.wikipedia.org/wiki/Mortgage

58
31. http://www.accountingforinvestments.com/meaning-of-sub-prime-mortgage-crisis
32. http://www.federalreserve.gov/newsevents/press/monetary/20081125a.htm
33. http://www.federalreserve.gov/monetarypolicy/bst_reports.htm#frsreports
34. http://www.federalreserve.gov/monetarypolicy/taf.htm
35. http://www.federalreserve.gov/monetarypolicy/tslf.htm
36. http://www.federalreserve.gov/monetarypolicy/talf.htm
37. http://www.federalreserve.gov/bankinforeg/tarpinfo.htm
38. http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm
39. http://money.cnn.com/news/storysupplement/economy/bailouttracker/index.html
40. http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm
41. http://www.forbes.com/2009/03/04/global-recession-insolvent-opinions-columnists-
roubini-economy.html
42. http://www.ft.com/cms/s/0/9c158a92-1a3c-11de-9f91-0000779fd2ac.html?
nclick_check=1
43. http://www.nytimes.com/2009/01/19/opinion/19krugman.html?
_r=3&partner=rssnyt&emc=rss
44. http://www.charlierose.com/view/interview/9310
45. http://www.nytimes.com/2009/04/01/opinion/01stiglitz.html?_r=1
46. http://www.hussmanfunds.com/wmc/wmc090330.htm
47. http://cop.senate.gov/documents/testimony-011409-stiglitz.pdf
48. http://www.ft.com/cms/s/0/85106daa-f140-11dd-8790-0000779fd2ac.html
49. http://roomfordebate.blogs.nytimes.com/2009/04/01/the-art-of-persuasion-at-the-g-20-
summit/
50. http://www.city-journal.org/2009/eon0323ng.html
51. http://www.forbes.com/2009/02/18/depression-financial-crisis-capitalism-opinions-
columnists_recession_stimulus.html
52. http://www.reuters.com/article/newsOne/idUSTRE51R16220090228?
pageNumber=3&virtualBrandChannel=0
53. http://online.wsj.com/article/SB124657539489189043.html
54. http://edition.cnn.com/2008/POLITICS/09/17/stiglitz.crisis/
55. http://www.washingtonpost.com/wp-
dyn/content/article/2009/06/14/AR2009061402443_pf.html
56. http://www.foxnews.com/story/0,2933,329565,00.html
57. http://www.govtrack.us/congress/billtext.xpd?bill=h110-5140
58. http://www.irs.gov/newsroom/article/0,,id=179181,00.html
59. http://en.wikipedia.org/wiki/subrpime crisis
60. http://stimulus.org/
61. http://www.ft.com/cms/s/4d0add58-ee27-11dd-b791-
0000779fd2ac,Authorised=false.html?_i_location=http://www.ft.com/cms/s/0/4d0add58-ee27-

59
11dd-b791-
0000779fd2ac.html&_i_referer=http://en.wikipedia.org/wiki/Subprime_mortgage_crisis_solutio
ns_debate
62. http://www.economist.com/finance/displaystory.cfm?story_id=13446173
63. http://media.pimco-global.com/pdfs/pdf/GCB%20Focus%20May%2009.pdf?
WT.cg_n=PIMCO-US&WT.ti=GCB%20Focus%20May%2009.pdf
64. http://www.imf.org/external/np/g20/110709.htm
65. http://www.imf.org/external/np/g20/pdf/090309b.pdf
66. http://www.imf.org/external/np/g20/pdf/102909.pdf
67. http://www.imf.org/external/np/g20/pdf/100109a.pdf

60