Presented By:

Kaushambi Ghosh
Manish Madhukar
Mohit Almal
Pankaj Agarwal
 Agenda

Subprime
•Traditional Model Vs Subprime Model
•Players in the Game

Bubble
•Housing Bubble
Why it burst?

Global Crisis

Impact

Events

Indian story

Bailouts

What Next?
Subprime
Traditional Model Vs Subprime
Model
Players in the GAME
 Players
Player 1: Fed
-- Fed kept the interest rate low during much of 1990s
and particularly 2001-2005 (low oil prices, and low
inflation prompted the policy), fueling the market
-- During the 2001-2005, FFR was in the 1% to 3%
range, and mostly in the 1% range
-- Fed encouraged more risky ARM lending
(Greenspan)
Player 2: Mortgage Salespersons
-- Worked on commission based on the number of
arms successfully twisted
 Contd..
Player 3: Primary Lenders
-- No incentives for judicious lending
Banks no longer needed to hold on to the mortgage,
as use of mortgage-backed securities made risk
taking more appealing

-- Use of ARMs with low teaser rates (below market

rates for a while, followed by much higher rates
tied to index, LIBOR + some %). Teaser rates are
popular when long-term interest rates are at
historical lows (like much of this period), as they
help lenders benefit from ARMs as rates rise

-- Net Effect: Many loans were made to NINJA’s

(people with No Income, No Jobs or Assets).
 Contd..
Player 4: Other Financial Institutions
-- Freddie Mac and Fannie Mae issued many
Mortgage Backed Securities

-- Other financial institutions that traded in

these as well as derivatives based on real
estate assets. Many of these were global
institutions
 Contd..
Player 5: Credit rating Agencies and Analysts
-- Lack of market for many of these securities, so
models were used to price them
-- Inflated ratings, mostly in A range (similar to T-Bills)
-- Conflict of Interest: Investment bankers’ analysts
were rating investment bankers’ clients (scandal)
-- For example, 3 months prior to its demise, AIG was
rated strong buy (8 analysts), buy(3), hold (10))!!!
Player 6: Home Buyers (Taking Excessive Risk)
-- Home buyers were enjoying the ride
-- New ones were joining the ride, even if unqualified
-- Home ownership up from 60% in 1990s to 70%
Bubble
 Historic Bubbles

Dutch Tulip Mania (1630s)

South Sea Bubble (1710s)

British Railway Bubble (1840s)

US Railway Bubble (1880s)

Roaring Twenties (1920s)

Multi Bubble (1960s)

Internet Bubble (1990s)

Housing Bubble (2000s)
 Structure of a Bubble

Displacement (diffusion of new technology starts)

Take off (stock prices show abnormal increase)

Exuberance (stock prices grow at very high rate)

Critical Stage (stock price growth slows down)

Crash (stock prices start tumbling)

Population Dynamics in the Course of
a Bubble
Housing Bubble
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Why housing bubble
burst????
Process of Securitization
 Recap: Causes

Boom and bust in the housing market

High-risk mortgage loans and lending practices

Securitization practices

Speculation
 Contd..

Inaccurate credit ratings

Government policies

Policies of central banks

Financial institution debt levels and incentives

Credit default swaps

How bubble burst led to
crisis???
 How did this turn into a crisis ?
Step 1 - The housing boom in the US started fading out in 2007

Step 2 - Boom had led to massive increase in supply of housing

Step 3 - Thus House prices started falling

Step 4 - This increased the default rate among sub-prime borrowers

Step 5 - These borrowers were no longer able/willing to pay high price for a house
that was declining in value

Step 6 – Security/Guarantee being the house being bought , this increased the
supply of houses for sale while lowering the demand, thereby lowering prices
even further and setting off a vicious cycle
 Ripple Effect-Suck Everything
The housing bubble

Defaults & write

A hole in the bubble

Banks go belly-up

Banks get sucked in

How it Unfolded???
Impact
 Banks Writedown($ billion) Actions
Citigroup 55.1 Bailout by Fed Reserve($326 billion)

Merrill Lynch 51.8 Taken over by Bank of America

UBS 44.2 $5.3 billion Swiss government bailout

HSBC 27.4

Wachovia 22.5 Wells Fargo

Bank of America 21.2

Royal Bank of Scotland 14.9

Morgan Stanley 14.4 bank holding companies

JP Morgan chase 14.3

Lehman Brothers 8.2 Files for Bankruptcy

AIG 18.5 bailed out by Federal reserve

 Crashing Stock Indices
30000
25000
20000
Value

15000
10000
5000 17th Jan' 2008
25th Nov' 2008
0

Indices
List of events
Date Events

8th September Fannie Mae/Freddie Mac placed into conservatorship by U.S.

Government
14th September Bank of America agrees to purchase Merrill Lynch for $35B

15th September Lehman Brothers declares bankruptcy

16th September Reserve Primary Fund “breaks the buck” U.S. government seizes
control of AIG in $85B bailout
18th September Treasury Secretary Paulson announces bailout plan

19th September Governments worldwide announce short selling restrictions

Treasury establishes Temporary Guarantee Program for money

market funds
21st September Fed allows investment banks Goldman Sachs and Morgan Stanley to
become bank holding companies

23rd September Warren Buffett announces $5B investment in Goldman Sachs

Date Events
25th September Washington Mutual is seized by FDIC; assets sold to JPMorgan for
$1.9B

29th September Citigroup agrees to acquire Wachovia with FDIC guarantee; a

private transaction with Wells Fargo is later announced
First bailout bill is rejected by U.S. House of Representatives
3rd October - Congress passes TARP legislation
FDIC temporarily increases deposit insurance to $250,000
7th October Fed announces Commercial Paper Funding Facility (CPFF)
8th October Coordinated rate cut by central banks around the globe

13th October Mitsubishi UFJ finalizes $9B equity investment in Morgan

Stanley
14th October Mitsubishi UFJ finalizes $9B equity investment in Morgan
Stanley
Treasury announces TARP Capital Purchase Program

21st October Fed announces Money Market Investor Funding Facility

(MMIFF)
 Loss in crisis
1000

900

800

700

600

500
Expon. (Series1)
400

300

200

100

0
savings and loan crisis(1986- Banking crisis(1990-99) Banking Crisis(98-99) Subprime crisis(2007-present)
95)
IMF raises the estimated loss
amount to 1.4 trillion dollars
 Country wise Action
United kingdom

Has lined up a $850-billion rescue plan, May nationalise Royal Bank of Scotland

Will recapitalise banks by up to $88 billion. Abbey, Barclays, HSBC, Llyods, Standard
Chartered, HBOS and Nationwide Building Society can draw from an aggregate of $44
billion to boost their Tier 1 capital

Bank of England will infuse liquidity of $351 billion through loans

The government will guarantee $439 billion worth of short-and-medium term debt

Britain has seized control of mortgage lender Bradford & Bingley

Earlier this year nationalised Northern Rock

Alarm: The total liabilities of Barclays of £1,300 billion (leverage ratio of over 60),
surpass Britain's GDP
 Contd..
Belgium

The government took partial control of the struggling Fortis Bank

France, Belgium and Luxembourg stumped up $93 billion to recapitalise Dexia, a

French-Belgian lender that ran up huge losses in its US operations

Alarm: Fortis Bank's liabilities are several times larger than the GDP of Belgium
(leverage ratio of 33)

Iceland

The government has nationalised three of Iceland's biggest banks

Accounts in these banks stand frozen

 Contd..
United states

May pick up ownership in failing US banks (Morgan Stanley is reported to be one)

Fed ready to lend directly to stressed companies

Germany

Has guaranteed all bank deposits

Has organised a credit lifeline of euros 35 billion for blue-chip commercial real estate
lender Hypo Real Estate Holding

Alarm: The total liabilities of Deutsche Bank (leveraging ratio of over 50) amount to
2,000-billion euro, which is more than 80 per cent of the GDP of Germany
 Contd..
Singapore

Eased monetary policy for the first time since 2003 after sinking into its first
recession in six years, hit by the meltdown in financial markets

The government revised its 2008 growth forecast to around 3 per cent from an
earlier estimate of 4 to 5
Italy

UniCredit Bank has announced plans to raise its capital ratio by spinning of
property assets
Ireland

Has guaranteed all bank deposits
 Contd..
Spain

Will spend 50 billion Euros ($68 billion) to buy bank assets, almost a third of the
proposed 2009 central government budget

Japan

Yamato Life Insurance failed with $2.7 billion in debt

The government may revive a bank-rescue law of the 1990s banking

crisis

Tokyo may set up a $100-billion fund to prop up smaller lenders

Alarm: Real estate companies are folding up, forcing regional banks to
raise reserves against bad loans
Indian Story
 Impact of Subprime Crisis in India
No direct impact:
Structured finance undeveloped
No deleveraging

On the contrary India and China were seen as

saviors of a ‘decoupling’ global economy

Result:
Capital influx, currency appreciation, stock market
boom
 Impact on India-Second Round
The second round effect of Sub Prime + spike in oil prices
was devastating for Asian countries, including India

But for the macroeconomic cushion of low external debt

Ratio and fiscal deficits and comfortable reserves this had
the ingredients of a classic currency crisis
 The Devastation
Oil shock – worsening current account balance
India’s merchandise trade deficit in April-July 2008 increased by 50%
BRIC may split – prospects of Brazil/Russia brightened& that of India/China darkened

Sharp increase in inflation – food & oil the culprits

Governments could no longer fully insulate consumers from increase in retail oil prices
Spike in food prices through biofuels link
Higher weightage of food and oil in the consumption basket of developing world
July 2008- CPI at 9.41% and WPI at 12%+

Increase in fiscal deficit

Government absorbed part of the increase in oil and food prices – lower savings
EAC’s estimate of off balance sheet deficit on account of rising food and oil prices – 4.5% of GDP
Threat of credit downgrade

Decline in Capital flows

Sharp decline in stock market capitalization and bearish markets
Rupee under pressure – feeds inflation

Decline in Growth [EAC’s estimate for 2007-08 : 7.7%]

Rising interest rates hurt consumption and investment
Rise in fiscal deficit and decline in corporate profits result in fall in savings
 U.S

Soudi Arabia
The Devastating effect

Consumer price inflation Russia

Brazil

M…
U.K.

Germany

South Korea

China

India

Thailand
16
14
12
10
8
6
4
2
0
 10000
11000
12000
13000
14000
15000
16000
17000
18000
19000
20000
21000
January 2007
February 2007

BSE Sensex and FII Equity

March 2007
April 2007
May 2007
June 2007
July 2007

Sensex Close
August 2007

Contd..
September 2007
October 2007
November 2007
December 2007
FII Equity $M

January 2008
February 2008
March 2008
April 2008
May 2008
June 2008
July 2008
August 2008
0.00
1000.00
2000.00
3000.00
4000.00
5000.00
6000.00
7000.00
-4000.00
-3000.00
-2000.00
-1000.00
 39
40
41
42
43
44
45
46
January 2007
February 2007
March 2007
April 2007
May 2007

US Dollar - Indian Rupee Exchange Rate

June 2007
July 2007

Contd..
August 2007
September 2007
October 2007
November 2007
December 2007
(RBI)

January 2008
February 2008
March 2008
April 2008
May 2008
June 2008
July 1 2008
August 1 2008
September 10 2008
 Emerging economies adversely
impacted by demand destruction in
‘global consumer of the last resort’:
US major trading partner for India
(15% of exports), Brazil and China
(20% of exports)
Can India and China rescue the world?

Emerging markets have

borne the brunt of the
second round impact
and are themselves
bearish
Lessons of the sub prime crisis for India

You cannot decouple from the world’s biggest economy in a
fast integrating world

Sophisticated structured finance products can

become ‘weapons of mass destruction’

Moral hazard and financial sector liberalization

RBI must rethink the concept of Universal Banking

Focus on ‘Credit Discipline’ as a corrective to financial

inclusion

Reconsider basing monetary policy entirely on movements in

consumer prices alone
Bailout Ben
 Rationale for the Bailout
Stabilise the Economy

Improve Liquidity Second

Bailout of
Comprehensive Strategy $800 billion
Immediate and Significant announced
yesterday
Broad Impact by FED
Investor Confidence

Impact on Economy and GDP

When the music stops in terms of liquidity, things will
get complicated. But as long as the music is playing,
you've got to get up and dance. We're still dancing. -
Chuck Prince, Citigroup
Now What???
 Liquidity Crunch
The reduced availability of liquidity
Interest rate premiums
U.S.: Banks not lending to each other
ROW: London Interbank Offered Rate (Libor)
Libor is used to set rates on the $360
trillion of financial products worldwide.
Three month Libor set an all time high last
week at 5.34%.
 Overview of Credit Exposures and Estimated Losses
(September 2008; billions of US dollars)

Amount Outstanding Estimated Losses

Residential Credit:
Depository Institution Loans $2,889 $308
Non-Agency Securities $2,531 $523
GSE Exposures $4,807 $76
Subtotal $10,227 $907

Non Residential Credit:

Loans $7,670 $195
Non-Agency Securities $5,440 $475
Subtotal $13,110 $670

Total $23,337 $1,577

Estimated Costs of Banking Crisis
Country Period Estimated Cost as % of
GDP

United States 1980 2.5 %

Japan 1990 20.0 % est.

Norway 1987-89 4.0 %

Korea 1997 60.0 % p

Indonesia 1997 80.0 % p

U.S.A. 2007-2010 $700 billion = 5.0 %

$1600 billion = 11.4 %
$3200 billion = 22.8 %
 Is Depression Imminent:

During the Great Depression

Combined GDP of 7 largest economies dropped by
20%
during 1929-1932

There were no deposit insurance, so people withdrew
money from banks and many banks failed

Fed increased interest rate (!!) and reduced liquidity

U.S. imposed heavy tariffs and other countries
reciprocated lowering world trade by 70%

The situation is much different as a lot is learned from

experiences of the Great Depression