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SUB PRIME CRISIS
Transcript of SUB PRIME CRISIS
The Sub Prime Story
What goes up, comes down.
IMPACT ON THE INDIAN ECONOMY & THE ROLE OF SERVICES
PRIME MORTGAGE LOANS
Low interest rates by the feds
Borrowers have good credit history
Most secured loans
High interest rates
Poor quality collateral
Less favourable terms to compensate credit risk
Packaged by MBS
MORTGAGE BACKED SECURITIES- MBS
Asset backed by mortgage
Sale of security from financial institutions to investors
COLLATERAL DEBT OBLIGATION
A structured financial product that pools together cash flow, generating assets and repackages this asset pool into discreet tranches that can be sold to investors..
Involves security firms, CDO managers, rating agencies, financial guarantors and investors.
If A lends 10 prime loans of 1 lac each at 8% p.a. monthly reducing for tenure of 60 months(5 years), he can expect a return of 2,16,800/-
If A lends 10 sub prime loans of 1 lac each at 10% p.a. monthly reducing for tenure of 60 months(5 years), he can expect a return of 3,34,400/-
The blame for the sub prime crisis goes to many elements of the economic system
We have the Clinton administration , the banks ,the hedge funders, the SEC , the investment banks etc.
The solution to the crisis by which it could have been avoided lies within all these elements.
The regulations and policies
The regulatory bodies that allowed banks to issue mortgages could have kept a better criteria before allowing the bank to issue .
The regulation of mortgage brokers, who made the bad loans and hedge funds, who used too much leverage.
The government policies encouraging to issue more and more credit to every citizen.
Recognition early-on that it was a credibility problem, and that the government would have to buy the bad loans. If it had been done last year, the bill might have been less than $700 billion.
Control of financial instruments like MBS and Derivatives since its impact wasn’t understood even by the experts who created them.
The Subprime Story
The term "Subprime" reflects not the lending rate but the borrower's credit status. Potential sub-prime borrowers may comprise of financially troubled people, meaning thereby that the sub-prime lenders take a higher degree of risk.
Sub prime mortgages totalled $600 billion in 2006, accounting for about one-fifth of the US home loan market.
TYPES OF SUB PRIME MORTGAGES
Allow borrowers to pay only interest for a period of time, typically 5-10 years.
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).
Initial fixed rate mortgages
Can be converted to variable rates.
THE SUBPRIME FLOW
Investment banks help companies and governments raise money by issuing and selling securities in the capital markets
Asset Price Risk
This risk is borne by the lending institution and is the risk of prospective default by the mortgage seeker. However, with the introduction of MBS, this risk is covered to an extent.
Major banks and other financial institutions around the world reported losses of approximately US $435 billion as of 17 July 2008.
During the week of September 14, 2008 the crisis accelerated, developing into a global financial crisis, resulting in the bankruptcy of some of the world’s biggest financial institutes
America’s financial system failed in its two crucial responsibilities: managing risk and allocating capital
The economy collapsed which created a ripple effect and drastically affected other economies in the world
Between June 2007 and November 2008, Americans lost more than a quarter of their net worth
Savings and investment assets (apart from retirement savings) lost $1.2 trillion
IMPACT ON UNCLE SAM
Real gross domestic product (GDP) began contracting in the third quarter of 2008 and did not return to growth until Q1 2010.
The unemployment rate rose from 5% in 2008 pre-crisis to 10% by late 2009, then steadily declined to 7.6% by March 2013.
Residential private investment (mainly housing) fell from its 2006 pre-crisis peak of $800 billion, to $400 billion by mid-2009 and has remained depressed at that level.
Housing prices fell approximately 30% on average from their mid-2006 peak to mid-2009 and remained at approximately that level as of March 2013.
Stock market prices, as measured by the S&P 500 index, fell 57% from their October 2007 peak of 1,565 to a trough of 676 in March 2009. Stock prices began a steady climb thereafter and returned to record levels by April 2013.
U.S. total national debt rose from 66% GDP in 2008 pre-crisis to over 103% by the end of 2012.
The crisis generally progressed from banking system crises to sovereign debt crises.
Many countries elected to bailout their banking systems using taxpayer money.
Several countries received bailout packages from the "troika”
Many European countries embarked on austerity programs, reducing their budget deficits relative to GDP from 2010 to 2011
IMPACT ON EUROPE
The Indian economy looked relatively insulated from the global financial crisis that started in August 2007.
RBI was raising interest rates until August 2008 with the explicit objective of bringing down the GDP growth rate.
Collapse of Lehman Brothers on 23 September 2008 morphed the US financial meltdown into a global economic downturn, the impact on the Indian economy was almost immediate.
IMPACT OF THE GLOBAL CRISIS ON INDIA
The immediate or direct impact on its financial sector
The indirect impact on economic activities
Fortunately, India, could avoid the first round of adverse effects because the banks were not overly exposed to sub-prime lending.
Only one of the larger private sector banks, the ICICI, was partly exposed.
The banking sector as a whole remained financially sound. In fact, during the third quarter of FY2008–2009, was a nightmare for many large global financial institutions, banks in India announced encouraging results and witnessed an impressive jump in their profitability.
INDIRECT CONSEQUENCES HIT INDIA HARDER!
The liquidity squeeze in global markets following the collapse of Lehman Brothers had serious implications for India.
It led to: massive outflows of foreign institutional investment (FII).
It also compelled Indian banks and corporations to shift their credit demand from external sources to the domestic banking sector.
Year-on-Year Quarterly GDP Growth Rates (%)
Composition of GDP Growth (%)
ASPECTS OF FINANCIAL TURMOIL IN INDIA
IMPACT ON STOCK AND FOREX MARKET
IMPACT ON THE INDIAN BANKING SYSTEM
IMPACT ON INDUSTRIAL SECTOR AND EXPORT PROSPECT
INDIAN ECONOMIC OUTLOOK
(i) Drying up of overseas financing for Indian banks and Indian corporates;
(ii) Constraints in raising funds in a bearish domestic capital market; and
(iii) Decline in the internal accruals of the corporates.
Financial health of investment banks has taken a southward position, potentially increasing the risk to their counterparties and creating further uncertainty in the market.
This risk relates to the valuation of MBS, whether it will be able to overcome the credit risk or not.
Due to increasing mortgage delinquency rates, value of MBS has started declining
To run its operations, and generate cash, many companies rely on access to short-term funding markets such as commercial papers and repurchase market
However, because of concerns regarding the value of the MBS due to sub prime crisis, the ability of many companies to issue such paper has been significantly affected leading to liquidity risk.