SUB PRIME CRISIS

Group 8
Gunjan Shah Sreya Majumdar Siddarth Kamdar Dushyant Triwedi Sireesha Mallipudi Sangeet Kumar

Basic terms
Credit Ratings MBS - mortgage backed securities CDOs - collateralized debt obligations DTI Ratio FRMs - Fixed-rate mortgages ARMs - Adjustable-rate mortgages

Subprime lending
Sub Prime as the word defines, means subordinate to primary. Subprime lending (also called near-prime, non-prime, and second-chance lending) refers to giving loans to people who may find it difficult to adhere to the repayment schedule and have a weak credit history.

Why Subprime Lending?

These loans are accompanied by higher rates of interest and more stringent terms to compensate for increased credit risk.

Credit ratings
Subprime borrowers get credit ratings on the basis of: limited credit history (thus, the lender's assessor does not have the required knowledge and assumes the worst) no security or collateral (that may be sold by the lender in case of default) high debt to income ratio a history of late or missed payments default debt, and any court orders such as "orders to pay" or bankruptcy

Types of Sub Prime Mortgages

Sub Prime Mortgages can be classified in 3 categories:
1. Interest-only mortgages, which allow borrower to pay only interest for a period of time, typically 5-10 years. 2. Pick a payment loans , for which borrowers choose their monthly payment (full payment, interest only, or a minimum payment which may be lower than the payment required to reduce the balance of the loan). 3. Initial fixed rate mortgages that can be converted to variable rates.

 For trade finance and medium-term advances from foreign banks has virtually dried-up. This has had to be replaced with credit lines from domestic banks but at higher interest costs and has caused the Rupee to depreciate raising the cost of existing foreign loans The second transmission of the global downturn to the Indian economy has been through the steep decline in demand for India s exports in its major markets. (The first sector to be hit was the gems and jewellery which felt the impact in November itself and where more than 300,000 workers have lost their jobs.) The third transmission channel is the exchange rate as the Rupee has come under pressure with the outflow of portfolio investments, higher foreign exchange demand by Indian entrepreneurs seeking to replace external commercial borrowing by domestic financing, and the consequent decline in foreign exchange reserves

Factors that caused the crisis

1. Upswing and downswing in the housing market
Upswing due to
Low rates of interest along with large inflow of foreign funds encouraged debt-financed consumption During 1997 and 2006, the price of a usual American house rose by 124% Subprime lending led to the rise in house possession rates, which increased prices

Downswing due to
In 2006, short-term interest rates rose while the value of homes dropped High speculation in the real estate market This led to an excess of unsold houses Vicious cycle: An increased number of borrowers stopped paying their mortgage payments downward pressure on housing prices fall in the value of mortgage-backed securities--net worth and financial health of banks affected By January 2008, the stock of unsold new houses was 9.8 times the December 2007 sales volume

2. Subprime lending practices

Lenders began to offer increased number of loans to higher-risk borrowers Mortgage qualification guidelines changed
SIVA loans where proof of income was not needed NIVA loans where proof of employment was not needed NINA loans without the requirement to prove or even state any owned assets Interest-only adjustable-rate mortgage (ARM) allowing house owners to pay just the interest (not principal) during an initial period Payment option loan, in which the house owner could pay a variable amount, and any interest not paid was added to the principal Underwriting criteria were made less stringent

3. Mortgage fraud
The Financial Crisis Inquiry Commission reported in January 2011 that: "...mortgage fraud...flourished in an environment of collapsing lending standards and lax regulation. The number of suspicious activity reports reports of possible financial crimes filed by depository banks and their affiliates related to mortgage fraud grew 20-fold between 1996 and 2005 and then more than doubled again between 2005 and 2009. One study places the losses resulting from fraud on mortgage loans made between 2005 and 2007 at $112 billion. Lenders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities.

4. Erroneous credit ratings The Financial Crisis Inquiry Commission report in January 2011 blamed credit rating agencies for: flawed computer models Conflict of interest relentless drive for market share the absence of meaningful public oversight

5. Policies of the US Government

The Alternative Mortgage Transactions Parity Act (AMTPA), passed in 1982, permitted non-federally chartered housing creditors to write adjustable-rate mortgages 1996, United Stat es Department of Housing and Urban Development (HUD) set a goal for Fannie Mae and Freddie Mac that at least 42% of the mortgages they purchase should be issued to borrowers whose household income was below the median in their area. This target was increased to 50% in 2000 and 52% in 2005 Economist Joseph Stiglitz criticized the repeal of the GlassSteagall Act Amendments to the Community Reinvestment Act in the mid1990s, increased the sum of mortgages issued to otherwise unqualified low-income borrowers, and permitted the securitization of CRA-regulated mortgages, even though a fair number of them were subprime.

6. Policies of the Federal Reserve

The Federal Reserve's lessening of interest rates early in the decade The Fed then raised the Fed funds rate significantly between July 2004 and July 2006. This led to a rise in 1-year and 5-year ARM rates, making ARM interest rate resets more expensive for homeowners

7. Debt levels of financial institutions

Issued large amounts of debt during 2004 2007, and invested the proceeds in mortgage-backed securities (MBS), on the premise that house prices would go on rising, and that households would continue to make their mortgage payments

8. Credit Default Swaps (CDS)

Used to hedge risks As of 2008, there was no central clearing house to honour CDS in the event a party to a CDS proved unable to perform his obligations under the CDS contract American International Group (AIG) s having CDS insuring $440 billion of MBS resulted in its seeking and obtaining a Federal government bailout

9. Trade deficit
Between 1996 and 2004, the U.S. current account deficit increased by $650 billion, from 1.5% to 5.8% of GDP Had to maintain a surplus in the capital account Attracted a large amount of foreign investment, mainly from the emerging economies in Asia and oil-exporting nations Foreign investors had these funds to lend, either because
they had very high personal savings rates (as high as 40% in China), or due to high oil prices

According to Bernanke, this saving glut" pushed capital into the United States.

10. Boom and collapse of the shadow banking system

These entities were not subject to the same regulatory controls as depository banks They were vulnerable because they borrowed short-term in liquid markets to buy long-term, illiquid and risky assets Nobel laureate Paul Krugman described the run on the shadow banking system as the "core of what happened" to cause the crisis. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank." He referred to this lack of controls as "malign neglect."

IMPACT OF CRISIS
Indian economy was insulated from global financial crisis. The collapse of Lehman Brothers on 23 September 2008. IMF forecasted negative GDP growth world wide WTO declared world trade crash by nine percent US economy trapped as L shape economy in japan for recovery

IMPACT ON INDIA
The impact of the global crisis has been transmitted to the Indian economy through three distinct channels, 1.The financial sector, 2.Exports and 3.exchange rates. (The financial sector including the banking sector, equity markets) The Indian banking sector was not overly exposed to the subprime crisis. Only one of the larger banks, ICICI, was partly affected . The equity markets have seen a near 60 percent decline in the index and a wiping off of about USD1.3 trillion in market capitalization

Domino Effect in India

> FII investments increased in most of 2007 in a booming Indian economy, as the Sensex was on its way to a historic peak of over 20,000 points > Since the inflow of dollars in the Indian economy increased, the dollar exchange rate decreased > In 2008, however, due to the effect of the sub prime crisis, FIIs liquidated their equity investments in a big way leading to a crash in the stock markets > Simultaneously international commodity prices, including oil prices, were on a rise due increasing demand for these commodities > The combined effect resulted in an increase in the dollar exchange rate

 For trade finance and medium-term advances from foreign banks has virtually dried-up. This has had to be replaced with credit lines from domestic banks but at higher interest costs and has caused the Rupee to depreciate raising the cost of existing foreign loans The second transmission of the global downturn to the Indian economy has been through the steep decline in demand for India s exports in its major markets. (The first sector to be hit was the gems and jewellery which felt the impact in November itself and where more than 300,000 workers have lost their jobs.) The third transmission channel is the exchange rate as the Rupee has come under pressure with the outflow of portfolio investments, higher foreign exchange demand by Indian entrepreneurs seeking to replace external commercial borrowing by domestic financing, and the consequent decline in foreign exchange reserves

Measures taken
Measure were taken to contain inflation- Attempt to induce commercial banks to bring down their lending rates Model modified to incorporate the impact of the external shock and take the mitigating impact of the monetary and fiscal measures taken by the govt. Efforts at improving the investment climate both for domestic and foreign investors Bailout packages

 Measures were taken to improve liquidity

-Norms relaxed to allow companies in the mining, exploration and refineries sectors to bring in up to $500 million in external commercial borrowing (ECB) to the country for rupee expenditure. -Govt. released Agricultural Debt Waiver and Debt Relief Scheme -Limit for banks to borrow funds from their overseas branches was raised -Cutting of interest rates

Learning from the crisis

Assessment of the borrower s credit worthiness Banks should not follow imprudent and predatory lending practices Sharing the credit history of borrowers- Wider use of the services of the credit information bureau (CIB) Credit rating agencies should modify their rating methodologies as and when required. Risk management framework should be strengthened. FI should carry out proper due diligence of securities and borrowers. Avoid stringent regulations as it stifles economic growth in the process

 Housing, banks, hedge funds, insurance companies, commodities and currencies preferably should not be intertwined. Need for more transparency Consolidated bank supervision

References
http://www.financialexpress.com/news/the-subprime-crisisand-implications-for-india/271436/ http://www.iosco.org/library/pubdocs/pdf/IOSCOPD273.pdf http://www.economics.harvard.edu/files/faculty/51_Is_The_U S_Subprime_Crisis_So_Different.pdf http://www.oecd.org/dataoecd/36/27/40451721.pdf http://www.hbs.edu/units/am/pdf/Accounting%20in%20and% 20for%20the%20Subprime%20Crisis.pdf http://elsa.berkeley.edu/~eichengr/13%20questions.pdf http://data.undp.org.in/FinancialCrisis/RajivKumar_OP.pdf http://www.bis.org/publ/bppdf/bispap54m.pdf http://www.businessstandard.com/india/storypage.php?autono=335200 http://en.wikipedia.org/wiki/Subprime_crisis_impact_timeline

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