A STUDY ON SUBPRIME CRISIS AND

ITS EFFECTS ON INDIA

Project submitted in partial fulfillment of the requirement for the award of the degree of
MASTER O !"S#$ESS A%M#$#STRAT#O$&
DECLARATION
I hereby declare that this project report titled A STUDY ON SUBPRIME CRISIS
AND ITS EFFECTS ON INDIA submitted by me to the department of Business
Management of XXXX is a bonafide work undertaken by me and it is not
submitted to any other University or Institute for the Award of any degree
diploma/certificate or published any time before
!ame"
#ate" $%ignature&
1
ABSTRACT

'he sub prime lending crisis in the real estate sector In the U%A where in
borrowers with a low or sub prime credit rating were given loans to invest in the
booming real estate sector in ())*+), has led not only to a dig slow down of the
U% economy but its effect was also felt over the major nations of the world.

In this project it has been tried in the best way possible to analy-e the various
ways in which the sub prime lending muddle actually started
It has also been tried to analy-e the way the U% banking and lending agencies
camouflaged their sub prime loans In to attractive ones and how backed by some
credit rating agencies. were able to sell them off to other banks and investors by
dividing them into collaterali-ed debt obligations $/#0s&
'his project also tries to give a comprehensive picture of the losses that the U%
banking sector incurred and not just that but how the whole sub prime muddle
effected and 1uestioned the banking practices in the world
In the end it has been tired to take an Indian view of the whole sub prime fiasco
and how India. though effected by this. thankfully not in a big way. can actually
2
avoid such a scenario from occurring in the country and all the measures and
practices that can been taken into consideration to avoid such a scenario
ACKNOWLEDGEMENT
I take this opportunity to thank all those who have been of help to me in the
completion of this project
I would like to appreciate the guidance and co+operation provided to me by our
project guide XXXX $faculty of Business Management& in the completion of this
project
I am also grateful to XXXX. #irector XXXX and all the faculty members who have
directly or indirectly helped me in preparing this project report
3
TABLE OF CONTENTS:
1. CHAPTER I pag !"
I!'20#U/'I0! + 3
0bjective of the %tudy + (4
%cope of the %tudy + (*
5imitations of the %tudy + (*
#. CHAPTER $ II
%ubprime 5ending /risis + (6
7ffect of %ubprime /risis on U%A + (3
Actions taken to manage the + *3
crisis in U%A
Implications on different countries + ,8

4 CHAPTER $ III
Impact on India + 63
4
Measures that can be taken + 69
* CHAPTER I%
%UMMA2: A!# /0!/5U%I0! + 3(
Bibliography + 36
/;A<'72 I
INTRODUCTION
5
THE ECONOMY OF THE UNITED STATES OF AMERICA:
'he economy of the United %tates has been 7arth=s largest since the early >93)s
?>@ Its gross domestic product $A#<& was estimated as B>49 trillion in ())3
?(@ It is a miCed economy and private firms make the majority of microeconomic
decisions. while being regulated by the government
'he U% economy maintains a high level of productivity $A#< per capita.
B*,.8)) in ())3 with the U% population hitting 4)( million&. although it is not the
world=s highest 'he U% economy has maintained a high overall A#< growth
rate. a low unemployment rate. and high levels of research and capital
investment Major economic concerns in the U% include national debt. eCternal
debt. entitlement liabilities for retiring baby boomers that have already begun
entering the %ocial %ecurity system. corporate debt. mortgage debt a low savings
rate. and a large current account deficit

Dundamental 7lements of the U% 7conomy"

'he United %tates is rich in mineral resources and fertile farm soil. and it is
fortunate to have a moderate climate It also has eCtensive coastlines on both the
Atlantic and <acific 0ceans. as well as on the Aulf of MeCico 2ivers flow from
far within the continent. and the Areat 5akesEfive large. inland lakes along the
6
U% border with /anadaEprovide additional shipping access 'hese eCtensive
waterways have helped shape the country=s economic growth over the years and
helped bind America=s ,) individual states together in a single economic unit
'he number of available workers and. more importantly. their productivity help
determine the health of the U% economy 'hroughout its history. the United
%tates has eCperienced steady growth in the labor force. a phenomenon both
cause and effect of almost constant economic eCpansion 'he promise of high
wages brings many highly skilled workers from around the world to the United
%tates
In the United %tates. the corporation has emerged as an association of owners.
known as stockholders. who form a business enterprise governed by a compleC
set of rules and customs Brought on by the process of mass production.
corporations such as Aeneral 7lectric have been instrumental in shaping the
United %tates 'hrough the stock market. American banks and investors have
grown their economy by investing and withdrawing capital from profitable
corporations 'oday in the era of globali-ation American investors and
corporations have influence all over the world 'he American government has
also been instrumental in investing in the economy. in areas such as providing
cheap electricity $such as from the ;oover #am&. and military contracts in times
of war
Fhile consumers and producers make most decisions that mold the economy.
government activities have a powerful effect on the U% economy in at least four
areas %trong government regulation in the U% economy started in the early
>8))s with the rise of the <rogressive MovementG prior to this the government
promoted economic growth through protective tariffs and subsidies to industry.
7
built infrastructure. and established banking policies. including the gold standard.
to encourage savings and investment in productive enterprises
STABILI&ATION AND GROWTH:
'he federal government attempts to use both monetary policy $control of the
money supply through mechanisms such as changes in interest rates& and fiscal
policy $taCes and spending& to maintain low inflation. high economic growth. and
low unemployment
Dor many years following the Areat #epression of the >84)s. recessionsE
periods of slow economic growth and high unemploymentEwere viewed as the
greatest of economic threats Fhen the danger of recession appeared most
serious. government sought to strengthen the economy by spending heavily itself
or cutting taCes so that consumers would spend more. and by fostering rapid
growth in the money supply. which also encouraged more spending In the
>83)s. major price increases. particularly for energy. created a strong fear of
inflation As a result. government leaders came to concentrate more on
controlling inflation than on combating recession by limiting spending. resisting
taC cuts. and reining in growth in the money supply
Ideas about the best tools for stabili-ing the economy changed substantially
between the >86)s and the >88)s In the >86)s. government had great faith in
fiscal policyEmanipulation of government revenues to influence the economy
%ince spending and taCes are controlled by the president and the U% /ongress.
these elected officials played a leading role in directing the economy A period of
high inflation. high unemployment. and huge government deficits weakened
confidence in fiscal policy as a tool for regulating the overall pace of economic
activity Instead. monetary policy assumed growing prominence a piece
8
%ince the stagflation of the >83)s. the U% economy has been characteri-ed by
somewhat slower inflation In >89,. the U% began its growing trade deficit with
/hina
In recent years. the primary economic concerns have centered on" high national
debt $B8 trillion&. high corporate debt $B8 trillion&. high mortgage debt $over B>)
trillion as of ()), year+end&. high unfunded Medicare liability $B4) trillion&. high
unfunded %ocial %ecurity liability $B>( trillion&. and high eCternal debt $amount
owed to foreign lenders&. high trade deficits In ())6. the U% economy had its
lowest saving rate since >844 'hese issues have raised concerns among
economists and unfunded liabilities and national politicians
'he U% economy maintains a relatively high A#<. a reasonably high A#<
growth rate. and a low unemployment rate. making it attractive to immigrants
worldwide
Na'("!a) D*':
'he national debt. also known as the U% public debt $part of which is the gross
federal debt&. is the overall collective sum of yearly budget deficit owed by all
branches of the United %tates government. plus interest 'he economic
significance of this debt and its potential ramifications for future generations of
Americans are controversial issues in the United %tates
As of Hanuary 4). ())9. the total U% federal debt was approCimately B8( trillion
or about B38.))) in average for each of the >>3 million American taCpayers 'he
borrowing cap debt ceiling as of ()), stood at B9>9 trillion In March ())6.
/ongress raised that ceiling an additional B)38 trillion to B983 trillion. which is
approCimately 69I of A#< /ongress has used this method to deal with an
9
encroaching debt ceiling in previous years. as the federal borrowing limit was
raised in ())( and ())4
Fhile the U% national debt is the world=s largest in absolute si-e. a more
convenient measure is that of its si-e relative to the nation=s A#< Fhen the
national debt is put into this perspective it appears considerably less today than
in past years. particularly during Forld Far II By this measure. it is also
considerably less than those of other industriali-ed nations such as Hapan and
roughly e1uivalent to those of several Festern 7uropean nations
E+',!a) D*': L(a*()('(- '" F",(g!,-:
Aross U% liabilities to foreigners are B>64 trillion as at end ())6 'he U% Net
International Investment Position (NIIP) deteriorated to a negative B(, trillion at
the end of ())6. or about minus >8I of A#<
'he eCternal debt is an accounting entry that largely represents U% domestic
assets purchased with trade dollars and owned overseas. largely by U% trading
partners

;owever. this is not the whole picture. as foreign holdings of
government debt currently amount to about (3I of the total. or some ( trillion
dollars
Dor countries like the United %tates. a large net eCternal debt is created when the
value of foreign assets $debt and e1uity& held by domestic residents is less than
the value of domestic assets held by foreigners In simple terms. as foreigners
buy property in the U%. this adds to the eCternal debt Fhen this occurs in
greater amounts than Americans buying property overseas. nations like the
United %tates are said to be debtor nations. but this is not conventional debt like
a loan obtained from a bank ;owever. foreigners also purchase U% debt
instruments. such as government bonds. which are forms of conventional debt
10
If the eCternal debt represents foreign ownership of domestic assets. the result is
that rental income. stock dividends. capital gains and other investment income is
received by foreign investors. rather than by U% residents 0n the other hand.
when U% debt is held by overseas investors. they receive interest and principal
repayments As the trade imbalance puts eCtra dollars in hands outside of the
U%. these dollars may be used to invest in new assets $foreign direct investment.
such as new plants& or be used to buy eCisting U% assets such as stocks. real
estate and bonds Fith a mounting trade deficit. the income from these assets
increasingly transfers overseas
0f major concern is the fact that the magnitude of the !II< $or net eCternal debt&
is 1uite a bit larger than most national economies Dueled by the si-able trade
deficit. the eCternal debt is so large that many wonder if the trade situation can be
sustained in the long term /omplicating the matter is that many of America=s
trading partners. such as /hina. depend for much of their entire economy on
eCports. and especially eCports to America Many controversies eCist about the
current trade and eCternal debt situation. and it is arguable whether anyone
understands how these dynamics will play out in an historically unprecedented
floating eCchange rate system Fhile various aspects of the U% economic
profile have precedents in the situations of other countries $notably government
debt as a percentage of A#<&. the sheer si-e of the U%. and the integral role of
the U% economy in the overall global economic environment. create considerable
uncertainty about the future
I!',!a'("!a) ',a.
'he United %tates is the most significant nation in the world when it comes to
international trade Dor decades. it has led the world in imports while
simultaneously remaining as one of the top three eCporters of the world
11
As the major epicenter of world trade. the United %tates enjoys leverage that
many other nations do not Dor one. since it is the world=s leading
consumer. it is the number one customer of companies all around the world
Many businesses compete for a share of the United %tates market In
addition. the United %tates occasionally uses its economic leverage to
impose economic sanctions in different regions of the world U%A is the top
eCport market for almost 6) trading nations worldwide
'he U% is a member of several international trade organi-ations 'he purpose
of joining these organi-ations is to come to agreement with other nations on
trade issues. although there is some disagreement among U% citi-ens as
to whether or not the U% government should be making these trade
agreements in the first place
%ince it is the world=s leading importer. there are many U% dollars in circulation
all around the planet 'he stable U% economy and fairly sound monetary
policy has led to faith in the U% dollar as the world=s most stable currency.
although that may be changing in recent times
In order to fund the national debt $also known as public debt&. the United %tates
relies on selling U% treasury bonds to people both inside and outside the
country. and in recent times the latter have become increasingly important
Much of the money generated for the treasury bonds came from U%
dollars which were used to purchase imports in the United %tates
12
13
;aving taken a comprehensive view of the economy of ';7 U!I'7# %'A'7%
0D AM72I/A. it is only pertinent to get into the topic of this project+ 'he %ub
<rime 5ending Mortgage /risis 5et us first ac1uaint ourselves with the
terminology of this concept before venturing into the shock and awe that this
terminology has created in the form of recession in the United %tates and how it
rather than being limited to only the United %tates has effected almost all the
major economies of the world
S/*p,(0 L!.(!g:
%ubprime lending $also known as B+paper. near+prime. or second chance
lending& is the practice of making loans to borrowers who do not 1ualify for the
best market interest rates because of their deficient credit history 'he phrase
also refers to banknotes taken on property that cannot be sold on the primary
market. including loans on certain types of investment properties and certain
types of self+employed persons
%ubprime lending is risky for both lenders and borrowers due to the combination
of high interest rates. poor credit history. and adverse financial situations usually
associated with subprime applicants A subprime loan is offered at a rate higher
than A+paper loans due to the increased risk %ubprime lending encompasses a
variety of credit instruments. including subprime mortgages. subprime car loans.
and subprime credit cards. among others 'he term JsubprimeJ refers to the
credit status of the borrower $being less than ideal&. not the interest rate on the
loan itself
%ubprime lending is highly controversial 0pponents have alleged that subprime
lenders have engaged in predatory lending practices such as deliberately lending
to borrowers who could never meet the terms of their loans. thus leading to
default. sei-ure of collateral. and foreclosure 'here have also been charges of
14
mortgage discrimination on the basis of race <roponents of subprime lending
maintain that the practice eCtends credit to people who would otherwise not have
access to the credit market
'he controversy surrounding subprime lending has eCpanded as the result of an
ongoing lending and credit crisis both in the subprime industry. and in the greater
financial markets which began in the United %tates 'his phenomenon has been
described as a financial contagion which has led to a restriction on the availability
of credit in world financial markets ;undreds of thousands of borrowers have
been forced to default and several major American subprime lenders have filed
for bankruptcy
Ba12g,"/!.
%ubprime lending evolved with the reali-ation of a demand in the marketplace
and businesses providing a supply to meet it Fith bankruptcies and
consumer proposals being widely accessible. a constantly fluctuating
economic environment. and consumer debt loan on the rise. traditional
lenders are more cautious and have been turning away a record number of
potential customers %tatistically. approCimately (,I of the population of
the United %tates falls into this category
In the third 1uarter of ())3. %ubprime adjustable rate mortgages $A2Ms& only
represent 69I of the mortgages outstanding in the U%. yet they represent
*4)I of the foreclosures started %ubprime fiCed mortgages represent
64I of outstanding loans and >()I of the foreclosures started in the
same period
D3(!('("!
15
Fhile there is no official credit profile that describes a subprime borrower. most in
the United %tates have a credit score below 3(4 Dederal !ational Mortgage
Association commonly known as Dannie Mae has lending guidelines for what it
considers to be JprimeJ borrowers on conforming loans 'heir standard provides
a good comparison between those who are Jprime borrowersJ and those who are
Jsubprime borrowersJ <rime borrowers have a credit score above 6() $credit
scores are between 4,) and 9,) with a median in the U% of 639 and a mean of
3(4&. a debt+to+income ratio $#'I& no greater than 3,I $meaning that no more
than 3,I of net income pays for housing and other debt&. and a combined loan
to value ratio of 8)I. meaning that the borrower is paying a >)I down payment
Any borrower seeking a loan with less than those criteria is a subprime borrower
by Dannie Mae standards
S/*p,(0 )!.,-
'o access this increasing market. lenders often take on risks associated with
lending to people with poor credit ratings %ubprime loans are considered to carry
a far greater risk for the lender due to the aforementioned credit risk
characteristics of the typical subprime borrower 5enders use a variety of
methods to offset these risks In the case of many subprime loans. this risk is
offset with a higher interest rate In the case of subprime credit cards. a subprime
customer may be charged higher late fees. higher over limit fees. yearly fees. or
up front fees for the card %ubprime credit card customers. unlike prime credit
card customers. are generally not given a Jgrace periodJ to pay late 'hese late
fees are then charged to the account. which may drive the customer over their
credit limit. resulting in over limit fees 'hus the fees compound. resulting in
higher returns for the lenders 'hese increased fees compound the difficulty of
the mortgage for the subprime borrower. who is defined as such by their
unsuitability for credit
16
S/*p,(0 *",,"4,-
%ubprime offers an opportunity for borrowers with a less than ideal credit record
to gain access to credit Borrowers may use this credit to purchase homes. or in
the case of a cash out refinance. finance other forms of spending such as
purchasing a car. paying for living eCpenses. remodeling a home. or even paying
down on a high interest credit card ;owever. due to the risk profile of the
subprime borrower. this access to credit comes at the price of higher interest
rates 0n a more positive note. subprime lending $and mortgages in particular&.
provide a method of Jcredit repairJG if borrowers maintain a good payment record.
they should be able to refinance back onto mainstream rates after a period of
time /redit repair usually takes twelve months to achieveG however. in the UK.
most subprime mortgages have a two or three+year tie+in and borrowers may
face additional charges for replacing their mortgages before the tie+in has
eCpired
Aenerally. subprime borrowers will display a range of credit risk characteristics
that may include one or more of the following"
'wo or more loan payments paid past 4) days due in the last >( months.
or one or more loan payments paid past 8) days due the last 46 monthsG
Hudgment. foreclosure. repossession. or non+payment of a loan in the
prior *9 monthsG
Bankruptcy in the last 3 yearsG
2elatively high default probability as evidenced by. for eCample. a credit
bureau risk score $DI/0& of less than 6() $depending on the
product/collateral&. or other bureau or proprietary scores with an
e1uivalent default probability likelihood
17
TYPES:
S/*p,(0 0",'gag-
As with subprime lending in general. subprime mortgages are usually defined by
the type of consumer to which they are made available According to the U%
#epartment of 'reasury guidelines issued in ())>. J%ubprime borrowers typically
have weakened credit histories that include payment delin1uencies and possibly
more severe problems such as charge+offs. judgments. and bankruptcies 'hey
may also display reduced repayment capacity as measured by credit scores.
debt+to+income ratios. or other criteria that may encompass borrowers with
incomplete credit historiesJ
In addition. many subprime mortgages have been made to borrowers who lack
legal immigration status in the United %tates
%ubprime mortgage loans are riskier loans in that they are made to borrowers
unable to 1ualify under traditional. more stringent criteria due to a limited or
blemished credit history %ubprime borrowers are generally defined as individuals
with limited income or having DI/0 credit scores below 6() on a scale that
ranges from 4)) to 9,) %ubprime mortgage loans have a much higher rate of
default than prime mortgage loans and are priced based on the risk assumed by
the lender
Although most home loans do not fall into this category. subprime mortgages
proliferated in the early part of the (>st /entury About (> percent of all mort gage
originations from ())* through ())6 were subprime. up from 8 percent from
>886 through ())*. says Hohn 5onski. chief economist for Moody=s Investors
%ervice %ubprime mortgages totaled B6)) billion in ())6. accounting for about
one+fifth of the U% home loan market
'here are many different kinds of subprime mortgages. including"
18
Interest+only mortgages. which allow borrowers to pay only interest for a
period of time $typically ,L>) years&G
J<ick a paymentJ loans. for which borrowers choose their monthly
payment $full payment. interest only. or a minimum payment which may be
lower than the payment re1uired to reduce the balance of the loan&G
And initial fiCed rate mortgages that 1uickly convert to variable rates
'his last class of mortgages has grown particularly popular among subprime
lenders since the >88)s /ommon lending vehicles within this group include the
J(+(9 loanJ. which offers a low initial interest rate that stays fiCed for two years
after which the loan resets to a higher adjustable rate for the remaining life of the
loan. in this case (9 years 'he new interest rate is typically set at some margin
over an indeC. for eCample. ,I over a >(+month 5IB02 Mariations on the J(+(9J
include the J4+(3J and the J,+(,J
S/*p,(0 C,.(' Ca,.-
/redit card companies in the United %tates began offering subprime credit cards
to borrowers with low credit scores and a history of defaults or bankruptcy in the
>88)s 'hese cards usually begin with low credit limits and usually carry
eCtremely high fees and interest rates as high as 4)I or more In ())(. as
economic growth in the United %tates slowed. the default rates for subprime
credit card holders increased dramatically. and many subprime credit card
issuers were forced to scale back or cease operations
In ())3. many new subprime credit cards began to sprout forth in the market As
more vendors emerged. the market became more competitive. forcing issuers to
make the cards more attractive to consumers Interest rates on subprime cards
now start at 88I but in some cases still range up to (*I annual percentage rate
$A<2&
19
%ubprime credit cards however can help a consumer improve poor credit scores
Most subprime cards report to major credit reporting agencies such as
'ransUnion and 71uifaC /onsumers that pay their bills on time should see
positive reporting to these agencies within 8) days
P,"p"!!'-
Individuals who have eCperienced severe financial problems are usually labeled
as higher risk and therefore have greater difficulty obtaining credit. especially for
large purchases such as automobiles or real estate 'hese individuals may have
had job loss. previous debt or marital problems. or uneCpected medical issues.
usually unforeseen and causing major financial setbacks As a result. late
payments. charge+offs. repossessions and even foreclosures may result
#ue to these previous credit problems. these individuals may also be precluded
from obtaining any type of conventional loan for a large purchase. such as an
automobile 'o meet this demand. lenders have seen that a tiered pricing
arrangement. one which allows these individuals to receive loans but pay a
higher interest rate. may allow loans which otherwise would not occur
Drom a servicing standpoint. these loans have higher collection defaults and are
more likely to eCperience repossessions and charge offs 5enders use the higher
interest rate to offset these anticipated higher costs
<rovided that a consumer enters into this arrangement with the understanding
that they are higher risk. and must make diligent efforts to pay. these loans do
indeed serve those who would otherwise be underserved /ontinuing the
eCample of an auto loan. the consumer must purchase an automobile which is
well within their means. and carries a payment well within their budget
C,('(1(-0
20
/apital markets operate on the basic premise of risk versus reward Investors
taking a risk on stocks eCpect a higher rate of return than do investors in risk+free
'reasury bills. which are backed by the full faith and credit of the United %tates
'he same goes for loans 5ess creditworthy subprime borrowers represent a
riskier investment. so lenders will charge them a higher interest rate than they
would charge a prime borrower for the same loan
'o avoid the initial hit of higher mortgage payments. most subprime borrowers
take out adjustable+rate mortgages $or A2Ms& that give them a lower initial
interest rate But with potential annual adjustments of (I or more per year. these
loans can end up charging much more %o a B,)).))) loan at a *I interest rate
for 4) years e1uates to a payment of about B(.*)) a month But the same loan
at >)I for (3 years $after the adjustable period ends& e1uates to a payment of
B*.(() A 6+percentage+point increase in the rate caused slightly more than a
3,I increase in the payment
0n the other hand. interest rates on A2Ms can also go down + in the U%. the
interest rate is tied to federal government+controlled interest rates. so when the
Ded cuts rates. A2M rates go down. too A2M interest rates usually adjust once a
year. and the rate is based on an average of the federal rates over the last >(
months Also. most A2Ms limit the amount of change in a rate
'he cycle of increased fees due to default+prone borrowers defaulting is a vicious
cycle 'hough some subprime borrowers may be able to repair their credit rating.
much default and enter the vicious cycle Fhile this enhances the profits of the
subprime lender. it also leads to further vicious cycling as the subprime lenders
are unable to recover what has been lent to subprime borrowers ;ence the
current subprime mortgage crisis
M",'gag .(-1,(0(!a'("!
%ome subprime lending practices have raised concerns about mortgage
discrimination on the basis of race Black and other minorities disproportionately
21
fall into the category of Jsubprime borrowersJ because of lower credit scores.
higher debt+to+income ratios. and higher combined loan to value ratios Because
they are higher risk borrowers. they are more likely to seek subprime mortgages
with higher interest rates than their white counterparts 7ven when median
income levels were comparable. home buyers in minority neighborhoods were
more likely to get a loan from a subprime lender Interest rates and the availability
of credit are often tied to credit scores. and the results of a ())* 'eCas
#epartment of Insurance study found that of the ( million 'eCans surveyed.
Jblack policyholders had average credit scores that were >)I to 4,I worse than
those of white policyholders ;ispanics= average scores were ,I to (,I worse.
while Asians= scores were roughly the same as whites African+Americans are in
the aggregate less likely to have a higher than average credit score and so take
on higher levels of debt with smaller down+payments than whites and Asians of
similar incomes
O*51'(6- "3 '7 S'/.8:
'o understand the meaning of N%ubprime /risisO
'o analy-e the effects of %ubprime /risis on the world
'o analy-e the impact of %ubprime crisis on India
'o understand the risks and causes of %ubprime crisis
22
S1"p "3 '7 S'/.8"
'he study is to cover the impact of the subprime crisis that started in United
%tates of America which led to huge loss in its economy 'he study also
concentrates on impact of subprime crisis on Alobal economics in general and
Indian economy in particular.
L(0('a'("!-:
23
'he study is very much limited to understand the reasons behind the crisis
at origin and its impact on Indian economy
#ue to the short period of time it was not possible to gather all the data
%ince the crisis is 1uite recent there is no published manual available
/;A<'72 II
%ubprime /risis
24
SUBPRIME MORTGAGE CRISIS
7veryone has been constantly reading in almost all newspapers about the U%
subprime mortgage crisis which has been said to have the potential to bring the
U% economy to a brink of a recession It has led to the ouster of top eCecutives of
Merrill 5ynch. /itibank etc to name a few because of eCposure to the subprime
mortgage turmoil Ironically. the same crisis has led to an Indian born banker+
Mikram % <undit being put at the helm of the worldPs largest bank L /itigroup %o
what is eCactly the subprime crisis all aboutQ
'he following eCtract seeks to eCplain what we mean by the term Nsubprime
lendingO 'hen we decipher what is the subprime mortgage lending crisis all
about and what led to its happening 5astly. we seek to find its potential impact
on the U% and Indian economy
25
%ub prime lending refers to the category of borrowers with weak credit history
'hese borrowers usually find it tough to land mortgage+backed loans %ub prime
lending is a general term that refers to the practice of making loans to borrowers
who do not 1ualify for loans at market
Interest rates because of problems with their credit history or the lacking of their
ability to prove that they have enough income to support the monthly payment on
the loan for which they are applying 'hus. a sub prime loan is one that is offered
at an interest rate higher than A+paper $<rime& loans due to the increased risk
E331' "3 S/*p,(0 C,(-(- "! U.S.A
Ba12g,"/!. '" '7 1,(-(-
'he -/*p,(0 0",'gag 1,(-(- was a sharp rise in home foreclosures which
started in the United %tates in late ())6 and became a global financial crisis
during ())3 and ())9
'he crisis began with the bursting of the housing bubble in the U% and high
default rates on JsubprimeJ and other adjustable rate mortgages $A2M& made to
higher+risk borrowers with lower income or lesser credit history than JprimeJ
borrowers 5oan incentives and a long+term trend of rising housing prices
encouraged borrowers to assume mortgages. believing they would be able to
refinance at more favorable terms later ;owever. once housing prices started to
drop moderately in ())6+())3 in many parts of the U%. refinancing became
more difficult #efaults and foreclosure activity increased dramatically as A2M
26
interest rates reset higher #uring ())3. nearly >4 million U% housing
properties were subject to foreclosure activity. up 38I versus ())6 As of
#ecember ((. ())3. a leading business periodical estimated subprime defaults
would reach a level between U% B())+4)) billion
'he mortgage lenders that retained credit risk $the risk of payment default& were
the first to be affected. as borrowers became unable or unwilling to make
payments Major Banks and other financial institutions around the world have
reported losses of approCimately U% B>,) billion as of Debruary ())9. as cited
below #ue to a form of financial engineering called securiti-ation. many
mortgage lenders had passed the rights to the mortgage payments and related
credit/default risk to third+party investors via mortgage+backed securities $MB%&
and collaterali-ed debt obligations $/#0& /orporate. individual and institutional
investors holding MB% or /#0 faced significant losses. as the value of the
underlying mortgage assets declined %tock markets in many countries declined
significantly
'he widespread dispersion of credit risk and the unclear impact on financial
institutions caused lenders to reduce lending activity or to make loans at higher
interest rates %imilarly. the ability of corporations to obtain funds through the
issuance of commercial paper was impacted 'his aspect of the crisis is
consistent with a credit crunch 'he li1uidity concerns drove central banks
around the world to take action to provide funds to member banks to encourage
the lending of funds to worthy borrowers and to re+invigorate the commercial
paper markets.
'he subprime crisis also places downward pressure on economic growth.
because fewer or more eCpensive loans decrease investment by businesses and
consumer spending. which drive the economy A separate but related dynamic is
27
the downturn in the housing market. where a surplus inventory of homes has
resulted in a significant decline in new home construction and housing prices in
many areas 'his also places downward pressure on growth Fith interest rates
on a large number of subprime and other A2M due to adjust upward during the
())9 period. U% legislators and the U% 'reasury #epartment are taking action
A systematic program to limit or defer interest rate adjustments was implemented
to reduce the impact In addition. lenders and borrowers facing defaults have
been encouraged to cooperate to enable borrowers to stay in their homes 'he
risks to the broader economy created by the financial market crisis and housing
market downturn were primary factors in the Hanuary ((. ())9 decision by the
U% Dederal reserve to cut interest rates and the economic stimulus package
signed by <resident Bush on Debruary >4. ())9 Both actions are designed to
stimulate economic growth and inspire confidence in the financial markets
Ba12g,"/!. (!3",0a'("!:
A subprime loan is one that is offered at an interest rate higher than A+paper
loans due to the increased risk %ubprime. therefore. is not the same as JAlt+AJ.
because Alt+A loans 1ualify for the JA+ratingJ by Moody=s or other rating firms.
albeit for an JalternativeJ means
'he value of U% subprime mortgages was estimated at B>4 trillion as of March
())3. with over 3, million first+lien subprime mortgages outstanding
ApproCimately >6I of subprime loans with adjustable rate mortgages $A2M&
were 8)+days delin1uent or in foreclosure proceedings as of 0ctober ())3.
roughly triple the rate of ()), By Hanuary of ())9. the delin1uency rate had
risen to (>I

%ubprime A2Ms only represent 69I of the loans outstanding in the U%. yet they
represent *4)I of the foreclosures started during the third 1uarter of ())3
?
A
total of nearly **6.3(6 U% household properties were subject to some sort of
28
foreclosure action from Huly to %eptember ())3. including those with prime. alt+A
and subprime loans 'his is nearly double the ((4.))) properties in the year+ago
period and 4*I higher than the 444.6(3 in the prior 1uarter 'his increased to
,(3.3*) during the fourth 1uarter of ())3. an >9I increase versus the prior
1uarter Dor all of ())3. nearly >4 million properties were subject to (( million
foreclosure filings. up 38I and 3,I respectively versus ())6 Doreclosure filings
including default notices. auction sale notices and bank repossessions can
include multiple notices on the same property
'he estimated value of subprime adjustable+rate mortgages $A2M& resetting at
higher interest rates is U% B*)) billion for ())3 and B,)) billion for ())9 2eset
activity is eCpected to increase to a monthly peak in March ())9 of nearly B>))
billion. before declining An average of *,).))) subprime A2M are scheduled to
undergo their first rate increase each 1uarter in ())9
U!.,-'a!.(!g '7 1a/-- a!. ,(-2- "3 '7 -/*p,(0 1,(-(-
'he reasons for this crisis are varied and compleC Understanding and managing
the ripple effect through the world+wide economy poses a critical challenge for
governments. businesses. and investors #ue to innovations in securi-ation the
risks related to the inability of homeowners to meet mortgage payments have
been distributed broadly. with a series of conse1uential impacts 'he crisis can
be attributed to a number of factors. such as the inability of homeowners to make
their mortgage paymentsG poor judgment by either the borrower or the lenderG
inappropriate mortgage incentives. and rising adjustable mortgage rates Durther.
declining home prices have made re+financing more difficult 'here are three
primary risk categories involved"
29
C,.(' R(-2: 'raditionally. the risk of default $called credit risk& would be
assumed by the bank originating the loan ;owever. due to innovations in
securiti-ation. credit risk is now shared more broadly with investors.
because the rights to these mortgage payments have been repackaged
into a variety of compleC investment vehicles. generally categori-ed as
mortgage+backed securities $MB%& or collaterali-ed debt obligations
$/#0& A /#0. essentially. is a repacking of eCisting debt. and in recent
years MB% collateral has made up a large proportion of issuance In
eCchange for purchasing the MB%. third+party investors receive a claim on
the mortgage assets. which become collateral in the event of default
Durther. the MB% investor has the right to cash flows related to the
mortgage payments 'o manage their risk. mortgage originators $eg.
banks or mortgage lenders& may also create separate legal entities. called
special+purpose entities $%<7&. to both assume the risk of default and
issue the MB% 'he banks effectively sell the mortgage assets $ie.
banking accounts receivable. which are the rights to receive the mortgage
payments& to these %<7 In turn. the %<7 then sells the MB% to the
investors 'he mortgage assets in the %<7 become the collateral
A--' P,(1 R(-2: /#0 valuation is compleC and related Jfair valueJ
accounting for such J5evel 4J assets is subject to wide interpretation 'his
valuation fundamentally derives from the collectibles of subprime
mortgage payments. which is difficult to predict due to lack of precedent
and rising delin1uency rates Banks and institutional investors have
recogni-ed substantial losses as they revalue their /#0 assets
downward Most /#0s re1uire that a number of tests be satisfied on a
periodic basis. such as tests of interest cash flows. collateral ratings. or
market values Dor deals with market value tests. if the valuation falls
below certain levels. the /#0 may be re1uired by its terms to sell
collateral in a short period of time. often at a steep loss. much like a stock
brokerage account margin call If the risk is not legally contained within an
30
%<7 or otherwise. the entity owning the mortgage collateral may be forced
to sell other types of assets. as well. to satisfy the terms of the deal In
addition. credit rating agencies have downgraded over U% B,) billion in
highly+rated /#0 and more such downgrades are possible %ince certain
types of institutional investors are allowed to only carry higher+1uality
$eg. JAAAJ& assets. there is an increased risk of forced asset sales.
which could cause further devaluation
L(9/(.('8 R(-2: A related risk involves the commercial paper market. a key
source of funds $ie. li1uidity& for many companies /ompanies and %<7
called structured investment vehicles $%IM& often obtain short+term loans
by issuing commercial paper. pledging mortgage assets or /#0 as
collateral Investors provide cash in eCchange for the commercial paper.
receiving money+market interest rates ;owever. because of concerns
regarding the value of the mortgage asset collateral linked to subprime
and Alt+A loans. the ability of many companies to issue such paper has
been significantly affected 'he amount of commercial paper issued as of
0ctober >9. ())3 dropped by (,I. to B999 billion. from the August 9
level In addition. the interest rate charged by investors to provide loans
for commercial paper has increased substantially above historical levels
U!.,-'a!.(!g '7 (0pa1' "! 1",p",a'("!- a!. (!6-'",-
Average investors and corporations face a variety of risks due to the inability of
mortgage holders to pay 'hese vary by legal entity %ome general eCposures by
entity type include"
Bank corporations" 'he earnings reported by major banks are adversely
affected by defaults on mortgages they issue and retain /ompanies value
31
their mortgage assets $receivables& based on estimates of collections from
homeowners /ompanies record eCpenses in the current period to adjust
this valuation. increasing their bad debt reserves and reducing earnings
2apid or uneCpected changes in mortgage asset valuation can lead to
volatility in earnings and stock prices 'he ability of lenders to predict
future collections is a compleC task subject to a multitude of variables
Mortgage lenders and 2eal 7state Investment 'rusts" 'hese entities face
similar risks to banks In addition. they have business models with
significant reliance on the ability to regularly secure new financing through
/#0 or commercial paper issuance secured by mortgages Investors
have become reluctant to fund such investments and are demanding
higher interest rates %uch lenders are at increased risk of significant
reductions in book value due to asset sales at unfavorable prices and
several have filed bankruptcy
%pecial purpose entities $%<7&" 5ike corporations. %<7 are re1uired to
revalue their mortgage assets based on estimates of collection of
mortgage payments If this valuation falls below a certain level. or if cash
flow falls below contractual levels. investors may have immediate rights to
the mortgage asset collateral 'his can also cause the rapid sale of assets
at unfavorable prices 0ther %<7 called structured investment vehicles
$%IM& issue commercial paper and use the proceeds to purchase
securiti-ed assets such as /#0 'hese entities have been affected by
mortgage asset devaluation %everal major %IM are associated with large
banks
Investors" %tocks or bonds of the entities above are affected by the lower
earnings and uncertainty regarding the valuation of mortgage assets and
related payment collection Many investors and corporations purchased
MB% or /#0 as investments and incurred related losses
32
Ca/-- "3 '7 1,(-(-
T7 7"/-(!g ."4!'/,!
%ubprime borrowing was a major contributor to an increase in home ownership
rates and the demand for housing 'he overall U% homeownership rate
increased from 6* percent in >88* $about where it was since >89)& to a peak in
())* with an all time high of 68( percent
'his demand helped fuel housing price increases and consumer spending
Between >883 and ())6. American home prices increased by >(*I %ome
homeowners used the increased property value eCperienced in the housing
bubble to refinance their homes with lower interest rates and take out second
33
mortgages against the added value to use the funds for consumer spending U%
household debt as a percentage of income rose to >4)I during ())3. versus
>))I earlier in the decade A culture of consumerism is a factor In the early
()))s recession that began in early ())> and which was eCacerbated by the
%eptember >>. ())> terrorist attacks. Americans were asked to spend their way
out of economic decline with Jconsumerism cast as the new patriotismJ 'his
call linking patriotism to shopping echoed the urging of former <resident Bill
/linton to Jget out and shopJ and corporations like Aeneral Motors produced
commercials with the same theme
0verbuilding during the boom period. increasing foreclosure rates and
unwillingness of many homeowners to sell their homes at reduced market prices
have significantly increased the supply of housing inventory available %ales
volume $units& of new homes dropped by (6*I in ())3 versus the prior year By
Hanuary ())9. the inventory of unsold new homes stood at 89 months based on
#ecember ())3 sales volume. the highest level since >89> Durther. a record of
nearly four million unsold eCisting homes was available
'his eCcess supply of home inventory places significant downward pressure on
prices As prices decline. more homeowners are at risk of default and
foreclosure According to the %R<//ase+%hiller housing price indeC. by
!ovember ())3. average U% housing prices had fallen approCimately 9I from
their ())6 peak ;owever. there was significant variation in price changes across
U% markets. with many appreciating and others depreciating 'he price decline
in #ecember ())3 versus the year+ago period was >)*I As of Debruary ())9.
housing prices are eCpected to continue declining until this inventory of surplus
homes $eCcess supply& is reduced to more typical levels
R") "3 *",,"4,-
34
A variety of factors have contributed to an increase in the payment delin1uency
rate for subprime A2M borrowers. which recently reached (>I. roughly four
times its historical level
7asy credit. combined with the assumption that housing prices would continue to
appreciate. also encouraged many subprime borrowers to obtain A2Ms they
could not afford after the initial incentive period 0nce housing prices started
depreciating moderately in many parts of the U%. refinancing became more
difficult %ome homeowners were unable to re+finance and began to default on
loans as their loans reset to higher interest rates and payment amounts 0ther
homeowners. facing declines in home market value or with limited accumulated
e1uity. are choosing to stop paying their mortgage 'hey are essentially Jwalking
awayJ from the property and allowing foreclosure. despite the impact to their
credit rating
Misrepresentation of loan application data is another contributing factor In a
Hanuary >4. ())9 column in the !ew :ork 'imes. Aeorge Mason University
economics professor 'yler /owen wrote. J'here has been plenty of talk about
=predatory lending.= but =predatory borrowing= may have been the bigger problem
As much as 3) percent of recent early payment defaults had fraudulent
misrepresentations on their original loan applications. according to one recent
study 'he research was done by Base<oint Analytics. which helps banks and
lenders identify fraudulent transactionsG the study looked at more than three
million loans from >883 to ())6. with a majority from ()), to ())6 Applications
with misrepresentations were also five times as likely to go into default Many of
the frauds were simple rather than ingenious In some cases. borrowers who
were asked to state their incomes just lied. sometimes reporting five times actual
incomeG other borrowers falsified income documents by using computersJ
U% #epartment of the 'reasury suspicious activity report of mortgage fraud
increased by >.*>> percent between >883 and ()),
35
R") "3 3(!a!1(a) (!-'('/'("!-
A variety of factors have caused lenders to offer an increasing array of higher+risk
loans to higher+risk borrowers 'he share of subprime mortgages to total
originations was ,I $B4, billion& in >88*. 8I in >886. >4I $B>6) billion& in >888.
and ()I in ())6 A study by the Dederal 2eserve indicated that the average
difference in mortgage interest rates between subprime and prime mortgages
$the Jsubprime markupJ or Jrisk premiumJ& declined from (9 percentage points
$(9) basis points& in ())>. to >4 percentage points in ())3 In other words. the
risk premium re1uired by lenders to offer a subprime loan declined 'his occurred
even though subprime borrower and loan characteristics declined overall during
the ())>+())6 period. which should have had the opposite effect 'he
combination is common to classic boom and bust credit cycles
36
In addition to considering higher+risk borrowers. lenders have offered
increasingly high+risk loan options and incentives 0ne eCample is the interest+
only adjustable+rate mortgage $A2M&. which allows the homeowner to pay just
the interest $not principal& during an initial period Another eCample is a Jpayment
optionJ loan. in which the homeowner can pay a variable amount. but any interest
not paid is added to the principal Durther. an estimated one+third of A2M
originated between ())*+())6 had JteaserJ rates below *I. which then
increased significantly after some initial period. as much as doubling the monthly
payment
%ome believe that mortgage standards became laC because of a moral ha-ard.
where each link in the mortgage chain collected profits while believing it was
passing on risk
R") "3 -1/,('(:a'("!
%ecuriti-ation is a structured finance process in which assets. receivables or
financial instruments are ac1uired. classified into pools. and offered as collateral
for third+party investment 'here are many parties involved #ue to securiti-ation.
investor appetite for mortgage+backed securities $MB%&. and the tendency of
rating agencies to assign investment+grade ratings to MB%. loans with a high risk
of default could be originated. packaged and the risk readily transferred to others
Asset securiti-ation began with the structured financing of mortgage pools in the
>83)s 'he securiti-ed share of subprime mortgages $ie. those passed to third+
party investors& increased from ,*I in ())>. to 3,I in ())6 Alan Areenspan
stated that the securiti-ation of home loans for people with poor credit E not the
loans themselves E were to blame for the current global credit crisis
R") "3 0",'gag *,"2,-
Mortgage brokers don=t lend their own money 'here is not a direct correlation
between loan performance and compensation 'hey have big financial incentives
37
for selling compleC. adjustable rate mortgages $A2M=s&. since they earn higher
commissions
According to a study by Fholesale Access Mortgage 2esearch R /onsulting Inc.
in ())* Mortgage brokers originated 69I of all residential loans in the U%. with
subprime and Alt+A loans accounting for *(3I of brokerages= total production
volume
'he chairman of the Mortgage Bankers Association claimed brokers profited from
a home loan boom but didn=t do enough to eCamine whether borrowers could
repay
R") "3 0",'gag /!.,4,(',-
Underwriters determine if the risk of lending to a particular borrower under certain
parameters is acceptable Most of the risks and terms that underwriters consider
fall under the three /Ps of underwriting" credit. capacity and collateral %ee
mortgage underwriting
In ())3. *) percent of all subprime loans were generated by automated
underwriting An 7Cecutive vice president of /ountrywide ;ome 5oans Inc
stated in ())* J<rior to automating the process. getting an answer from an
underwriter took up to a week JFe are able to produce a decision inside of 4)
seconds today And previously. every mortgage re1uired a standard set of full
documentationJ %ome think that users whose laC controls and willingness to rely
on shortcuts led them to approve borrowers that under a less+automated system
would never have made the cut are at fault for the subprime meltdown
38
R") "3 g"6,!0!' a!. ,g/)a'",-
%ome economists claim that government policy actually encouraged the
development of the subprime debacle through legislation like the /ommunity
2einvestment Act. which they say forces banks to lend to otherwise un+
creditworthy consumers 7conomist 2obert Kuttner has critici-ed the repeal of
the Alass+%teagall Act as contributing to the subprime meltdown A taCpayer+
funded government bailout related to mortgages during the %avings and 5oan
crisis may have created a moral ha-ard and acted as encouragement to lenders
to make similar higher risk loans
%ome have argued that. despite attempts by various U% states to prevent the
growth of a secondary market in repackaged predatory loans. the 'reasury
#epartment=s 0ffice of the /omptroller of the /urrency. at the insistence of
national banks. struck down such attempts as violations of Dederal banking laws
In response to a concern that lending was not properly regulated. the ;ouse and
%enate are both considering bills to regulate lending practices
R") "3 1,.(' ,a'(!g ag!1(-
/redit rating agencies are now under scrutiny for giving investment+grade ratings
to securiti-ation transactions holding subprime mortgages ;igher ratings are
theoretically due to the multiple. independent mortgages held in the MB% per the
agencies. but critics claim that conflicts of interest were in play
R") "3 1!',a) *a!2-
/entral banks are primarily concerned with managing the rate of inflation and
avoiding recessions 'hey are also the Nlenders of last resortO to ensure li1uidity
'hey are less concerned with avoiding asset bubbles. such as the housing
39
bubble and dotcom bubble /entral banks have generally chosen to react after
such bubbles burst to minimi-e collateral impact on the economy. rather than
trying to avoid the bubble itself 'his is because identifying an asset bubble and
determining the proper monetary policy to properly deflate it are not proven
concepts 'here is significant debate among economists regarding whether this
is the optimal strategy
Dederal 2eserve actions raised concerns among some market observers that it
could create a moral ha-ard %ome industry officials said that Dederal 2eserve
Bank of !ew :ork involvement in the rescue of 5ong+'erm /apital Management
in >889 would encourage large financial institutions to assume more risk. in the
belief that the Dederal 2eserve would intervene on their behalf
A potential contributing factor to the rise in home prices was the lowering of
interest rates earlier in the decade by the Dederal 2eserve. to diminish the blow
of the collapse of the dot+com bubble and combat the risk of deflation
IMPACT
I0pa1' "! -'"12 0a,2'-
0n Huly >8. ())3. the #ow Hones Industrial Average hit a record high. closing
above >*.))) for the first time By August >,. the #ow had dropped below
>4.))) and the %R< ,))$S;P <== is an indeC containing the stocks of ,))
5arge+/ap corporations. most of which are American. this indeC is developed by
standard and poor& had crossed into negative territory year+to+date %imilar drops
occurred in virtually every market in the world. with Bra-il and Korea being hard+
hit 5arge daily drops became common. with. for eCample. the K",a C"0p"-('
S'"12 P,(1 I!.+ $K0%<I& dropping about 3I in one day. although ())3=s
largest daily drop by the %R< ,)) in the U% was in Debruary. a result of the
subprime crisis
40
Mortgage lenders and home builders fared terribly. but losses cut across sectors.
with some of the worst+hit industries. such as metals R mining companies. having
only the vaguest connection with lending or mortgages
I0pa1' "! 3(!a!1(a) (!-'('/'("!-
Many banks. mortgage lenders. real estate investment trusts $27I'&. and hedge
funds suffered significant losses as a result of mortgage payment defaults or
mortgage asset devaluation As of Debruary >8. ())9 financial institutions had
recogni-ed subprime+related losses or write+downs eCceeding U% B>,) billion
<rofits at the 9.,44 U% banks insured by the Dederal #eposit Insurance
/orporation $D#I/& declined from B4,( billion to B,9 billion $94, percent&
during the fourth 1uarter of ())3 versus the prior year. due to soaring loan
defaults and provisions for loan losses It was the worst bank and thrift
performance since the fourth 1uarter of >88> Dor all of ())3. these banks
earned B>),, billion. down (3* percent from a record profit of B>*,( billion in
())6
0ther companies from around the world. such as IKB #eutsche Industriebank.
have also suffered significant losses and scores of mortgage lenders have filed
for bankruptcy 'op management has not escaped unscathed. as the /70s of
Merrill 5ynch and /itigroup were forced to resign within a week of each other
Marious institutions followed+up with merger deals
I0pa1' "! (!-/,a!1 1"0pa!(-
'here is concern that some homeowners are turning to arson as a way to escape
from mortgages they can=t or refuse to pay 'he DBI reports that arson grew *I
41
in suburbs and ((I in cities from ()), to ())6 As of Han ())9. the ())3
numbers were not yet available
I0pa1' "! 0/!(1(pa) *"!. >0"!")(!> (!-/,,-
A secondary cause and effect of the crisis relates to the role of municipal bond
JmonolineJ insurance corporations By insuring municipal bond issues. those
bonds achieve higher debt ratings ;owever. these insurers used premiums to
purchase /#0 investments and have suffered a significant loss. which brings
their ability to insure bonds into 1uestion Unless these insurers obtain additional
capital. rating agencies may downgrade the bonds they insured or guaranteed In
turn. this may re1uire financial institutions holding the bonds to lower their
valuation or to sell them. as some entities $such as pension funds& are only
allowed to hold the highest+grade bonds 'he impact of such devaluation on
institutional investors and corporations holding the bonds $including major banks&
has been estimated as high as B()) billion 2egulators are taking action to
encourage banks to lend the re1uired capital to certain monoline insurers. to
avoid such an impact
I0pa1' "! 7"0 "4!,-
According to the %R<//ase+%hiller housing price indeC. by !ovember ())3.
average U% housing prices had fallen approCimately 9I from their ())6 peak
;owever. there was significant variation in price changes across U% markets.
with many appreciating and others depreciating 'he price decline in #ecember
())3 versus the year+ago period was >)*I %ales volume $units& of new homes
dropped by (6*I in ())3 versus the prior year By Hanuary ())9. the inventory
of unsold new homes stood at 89 months based on #ecember ())3 sales
volume. the highest level since >89>
42
;ousing prices are eCpected to continue declining until this inventory of surplus
homes $eCcess supply& is reduced to more typical levels As MB% and /#0
valuation is related to the value of the underlying housing collateral. MB% and
/#0 losses will continue until housing prices stabili-e As home prices have
declined following the rise of home prices caused by speculation and as re+
financing standards have tightened. a number of homes have been foreclosed
and sit vacant 'hese vacant homes are often poorly maintained and sometimes
attract s1uatters and/or criminal activity with the result that increasing
foreclosures in a neighborhood often serve to further accelerate home price
declines in the area 2ents have not fallen as much as home prices with the
result that in some affluent neighborhoods homes that were formerly owner
occupied are now occupied by renters In select areas falling home prices along
with a decline in the U% dollar have encouraged foreigners to buy homes for
either occasional use and/or long term investments Additional problems are
anticipated in the future from the impending retirement of the baby boomer
generation It is believed that a significant proportion of baby boomers are not
saving ade1uately for retirement and were planning on using their increased
property value as a Jpiggy bankJ or replacement for a retirement+savings
account 'his is a departure from the traditional American approach to homes
where Jpeople worked toward paying off the family house so they could hand it
down to their childrenJ
I0pa1' "! 0(!",('(-
'here is a disproportionate level of foreclosures in some minority neighborhoods
About *6I of ;ispanics and ,,I of blacks who obtained mortgages in ()), got
higher+cost loans compared with about >3I of whites and Asians. according to
Dederal 2eserve data 0ther studies indicate they would have 1ualified for lower+
rate loans
Businesses filing for bankruptcy
43
B/-(!-- T8p Da'
!ew /entury
Dinancial
subprime lender April (. ())3
American ;ome
Mortgage
mortgage lender August 6. ())3
%entinel
Management Aroup
investment fund August >3. ())3
Ameri1uest subprime lender August 4>. ())3
!etBank on+line bank %eptember 4). ())3
'erra %ecurities securities !ovember (9. ())3
American
Dreedom Mortgage.
Inc
subprime lender Hanuary 4). ())3
W,('$."4!- "! '7 6a)/ "3 )"a!-? MBS a!. CDO-
C"0pa!8 B/-(!-- T8p L"-- @B())("! AB
/itigroup I!6-'0!' *a!2 A#C.1 *)!
M,,()) L8!17 I!6-'0!' *a!2 A##.< *)!
UBS AG I!6-'0!' *a!2 A1D.E *)!
M",ga! S'a!)8 I!6-'0!' *a!2 A1=.F *)!
C,.(' Ag,(1") I!6-'0!' *a!2 AC.D *)!
HSBC Ba!2 AF.C *)!
44
Ba!2 "3 A0,(1a Ba!2 A<.#D *)!
CIBC Ba!2 AF.# *)!
D/'-17 Ba!2 Ba!2 AF.1 *)!
Ba,1)a8- Cap('a) I!6-'0!' *a!2 AF.1 *)!
Ba, S'a,!- I!6-'0!' *a!2 A#.G *)!
RBS I!6-'0!' *a!2 AF.< *)!
Wa-7(!g'"! M/'/a) Ba!2 A#.C *)!
S4(-- R Sa6(!g- a!. )"a! A1.=E *)!
L70a! B,"'7,- R$(!-/,a!1 A#.1 *)!
LBBW I!6-'0!' *a!2 A1.1 *)!
HP M",ga! C7a- Ba!2 A#.I *)!
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45
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B/-7 A.0(!(-',a'("! p)a!
<resident Aeorge F Bush announced a plan to voluntarily and temporarily
free-e the mortgages of a limited number of mortgage debtors holding A2Ms.
declaring JI have a message for every homeowner worried about rising mortgage
payments" 'he best you can do for your family is to call >+9))+88,+;0<7 $sic&J
'he correct number is >+999+88,+;0<7 A refinancing facility called Dederal
;ousing Administration+ D;A+%ecure was also created 'his is part of an ongoing
collaborative effort between the U% Aovernment and private industry to help
some sub+prime borrowers called the ;ope !ow Alliance
'he ;ope !ow Alliance released a report in Debruary. ())9 indicating it helped
,*,.))) subprime borrowers with shaky credit in the second half of ())3. or 33
percent of 3> million subprime loans outstanding in %eptember ())3 A
spokesperson acknowledged that much more must be done
46
#uring Debruary ())9. a program called J<roject 5ifelineJ was announced %iC of
the largest U% lenders. in partnership with the ;ope !ow Alliance. agreed to
defer foreclosure actions for 4) days for homeowners 8) or more days
delin1uent on payments 'he intent of the program was to encourage more loan
adjustments. to avoid foreclosures
'he U% 'reasury #epartment is working directly with major banks to develop a
systematic means of modifying loans for a significant portion of borrowers facing
A2M increases. rather than working through loans on a case+by+case basis
<resident Bush also signed into law on Debruary >4. ())9 an economic stimulus
package of B>69 billion. mainly in the form of income taC rebates. to help
stimulate economic growth
O'7, a1'("!-
5enders and homeowners both may benefit from avoiding foreclosure.
which is a costly and lengthy process %ome lenders have taken action to
reach out to homeowners to provide more favorable mortgage terms $ie.
loan modification or refinancing& ;omeowners have also been
encouraged to contact their lenders to discuss alternatives /orporations.
trade groups. and consumer advocates have begun to cite statistics on the
numbers and types of homeowners assisted by loan modification
programs 'here is some dispute regarding the appropriate measures.
sources of data. and ade1uacy of progress A report issued in Hanuary
())9 showed that mortgage lenders modified ,*.))) loans and
established >94.))) repayment plans in the third 1uarter of ())3. a period
in which there were 49*.))) new foreclosures /onsumer groups claimed
the modifications affected less than > percent of the 4 million subprime
loans with adjustable rates that were outstanding in the third 1uarter
/redit rating agencies help evaluate and report on the risk involved with
various investment alternatives 'he rating processes can be re+eCamined
47
and improved to encourage greater transparency to the risks involved with
compleC mortgage+backed securities and the entities that provide them
2ating agencies have recently begun to aggressively downgrade large
amounts of mortgage+backed debt
2egulators and legislators can take action regarding lending practices.
bankruptcy protection. taC policies. affordable housing. credit counseling.
education. and the licensing and 1ualifications of lenders 2egulations or
guidelines can also influence the nature. transparency and regulatory
reporting re1uired for the compleC legal entities and securities involved in
these transactions /ongress also is conducting hearings help identify
solutions and apply pressure to the various parties involved
'he media can help educate the public and parties involved It can also
ensure the top subject material eCperts are engaged and have a voice to
ensure a reasoned debate about the pros and cons of various solutions
Banks have sought and received additional capital $ie. cash investments&
from sovereign wealth funds. which are entities that control the surplus
savings of developing countries An estimated U% B68 billion has been
invested by these entities in large financial institutions over the past year
0n Hanuary >,. ())9. sovereign wealth funds provided a total of B(>
billion to two major U% financial institutions %uch capital is used to help
banks maintain re1uired capital ratios $an important measure of financial
health&. which have declined significantly due to subprime loan or /#0
losses %overeign wealth funds are estimated to control nearly B(8 trillion
Much of this wealth is oil and gas related As they represent the surplus
funds of governments. these entities carry at least the perception that their
investments have underlying political motives
5itigation related to the subprime crisis is underway A study released in
Debruary ())9 indicated that (39 civil lawsuits were filed in federal courts
48
during ())3 related to the subprime crisis 'he number of filings in state
courts were not 1uantified by are also believed to be significant 'he study
found that *4 percent of the cases were class actions brought by
borrowers. such as those that contended they were victims of
discriminatory lending practices 0ther cases include securities lawsuits
filed by investors. commercial contract disputes. employment class
actions. and bankruptcy+related cases #efendants included mortgage
bankers. brokers. lenders. appraisers. title companies. home builders.
servicers. issuers. underwriters. bond insurers. money managers. public
accounting firms. and company boards and officers
T7 F.,a) R-,6
Fithin the Dederal 2eserve. /hairman Ben Bernanke signals towards making
interest rate cuts In early ())9. Ben Bernanke said" JBroadly. the Dederal
2eservePs response has followed two tracks" efforts to support market li1uidity
and functioning and the pursuit of our macroeconomic objectives through
monetary policyJ 'ougher regulatory standards are proposed Additionally. a
free-e of interest payments on certain sub+prime loans is announced 0n
Hanuary ((. ())9. the Ded also slashed a key interest rate $the federal funds
rate& by 3, basis points to 4,I. the biggest cut since >89*. followed by another
cut of ,) basis points on Hanuary 4)th
/entral banks have conducted open market operations to ensure member banks
have access to funds $ie. li1uidity& 'hese are effectively short+term loans to
member banks collaterali-ed by government securities /entral banks have also
lowered the interest rates charged to member banks $called the discount rate in
the U%& for short+term loans Both measures effectively lubricate the financial
system. in two key ways Dirst. they help provide access to funds for those
49
entities with illi1uid mortgage+backed assets 'his helps lenders. %<7. and %IM
avoid selling mortgage+backed assets at a steep loss %econd. the available
funds stimulate the commercial paper market and general economic activity
E+p1'a'("!- a!. 3",1a-'-
As early as the ())4 Annual 2eport issued by DairfaC Dinancial ;oldings 5imited.
<rem Fatsa was raising concerns about securiti-ed products"
JFe have been concerned for some time about the risks in asset+backed
bonds. particularly bonds that are backed by home e1uity loans.
automobile loans or credit card debt $we own no asset+backed bonds& It
seems to us that securiti-ation $or the creation of these asset+backed
bonds& eliminates the incentive for the originator of the loan to be credit
sensitive 'ake the case of an automobile dealer <rior to securiti-ation.
the dealer would be very concerned about who was given credit to buy an
automobile Fith securiti-ation. the dealer $almost& does not care as these
loans can be laid off through securiti-ation 'hus. the loss eCperienced on
these loans after securiti-ation will no longer be comparable to that
eCperienced prior to securiti-ation $called a SSmoralPP ha-ard& 'his is not a
small problem 'here is B>) trillion in asset+backed bonds outstanding as
of #ecember 4>. ())4 in the U% Fho is buying these bondsQ
Insurance companies. money managers and banks L in the main L all
reaching for yield given the eCcellent ratings for these bonds Fhat
happens if we hit an air pocketQ UnlikeJ
'he legacy of Alan Areenspan has been cast into doubt with %enator /hris #odd
claiming he created the Jperfect stormJ Alan Areenspan has remarked that there
is a one+in+three chance of recession from the fallout !ouriel 2oubini. a
professor at !ew :ork University and head of 2oubini Alobal 7conomics. has
said that if the economy slips into recession Jthen you have a systemic banking
crisis like we haven=t had since the >84)sJ
50
0n %eptember 3. ())3. the Fall %treet Hournal reported that Alan Areenspan
has said that the current turmoil in the financial markets is in many ways
JidenticalJ to the problems in >893 and >889
'he Associated <ress described the current climate of the market on August >4.
())3. as one where investors were waiting for Jthe neCt shoe to dropJ as
problems from Jan overheated housing market and an overeCtended consumerJ
are Jjust beginning to emerge J Market Fatch has cited several economic
analysts with %tifel !icolaus claiming that the problem mortgages are not limited
to the subprime niche saying Jthe rapidly increasing scope and depth of the
problems in the mortgage market suggest that the entire sector has plunged into
a downward spiral similar to the subprime woes whereby each negative
development feeds further deteriorationJ. calling it a Jvicious cycleJ and adding
that they Jcontinue to believe conditions will get worseJ
As of !ovember ((. ())3. analysts at a leading investment bank estimated
losses on subprime /#0 would be approCimately U% B>*9 billion As of
#ecember ((. ())3. a leading business periodical estimated subprime defaults
between U% B())+4)) billion As of March >. ())9 analysts from three large
financial institutions estimated the impact would be between U% B4,)+6))
billion
Alan Greenspan, the former Chairman of the Federal Resere, stated! "#he $%rrent $redit
$risis &ill $ome to an end &hen the oerhan' of inentories of ne&l( )%ilt homes is
lar'el( li*%idated, and home pri$e deflation $omes to an end+ #hat &ill sta)ili,e the no&-
%n$ertain al%e of the home e*%it( that a$ts as a )%ffer for all home mort'a'es, )%t most
importantl( for those held as $ollateral for residential mort'a'e-)a$.ed se$%rities+ /er(
lar'e losses &ill, no do%)t, )e ta.en as a $onse*%en$e of the $risis+ 0%t after a period of
protra$ted ad1%stment, the 2+3+ e$onom(, and the &orld e$onom( more 'enerall(, &ill )e
a)le to 'et )a$. to )%siness+"
51
The "nited States subprime crisis in 'raphics
52
53
54
B",,"4(!g U!., a S1/,('(:a'("! S',/1'/,
55
56
57
I0p)(1a'("!- "3 -/*p,(0 1,(-(- "! 6a,("/- 1"/!',(-:
'hough the subprime crisis has had its effects on the economies of various
countries across the world. for us it is of significance to know the amount of
impact it has had on the major economies that share strong political.
geographical and economic ties with the United %tates
I0pa1' "! Ca!a.a:
'he subprime crisis was supposed to be locali-ed to the U% As we see the write
downs in /anadian banks one wonders when the problem will tip over to
/anada 'he U% sub+prime mortgage fiasco is already s1uee-ing borrowers in
/anada as bankers struggle to determine which lenders are eCposed to the
greatest risk. says /raig Fright 2B/ chief economist
'he U% is moving into a recession 'he impact on the /anadian economy will
be significant as the U% economy slows down <ropelled by the dramatic
slowdown in the U% housing market is being offset by strong growth in
American trade as a result of the weakening greenback 'he level of foreclosures
has not hit the market yet 0nce the impact is felt both financial and from the
perspective of consumer confidence the economy in the U% will deepen the
move into recession 'he economies of /anada and B/ are being helped by a
long period of strong global growth but could be hit by Nfriendly fireO if the U%
resorts to protectionist measures as a result of a weak dollar and a weak
economy in an election year 0ne only needs to review the recent forestry sector
difficulties last year
'he recent rise in the /anadian dollar has driven profitability out of the industry
If the AmericanPs choose to reignite the softwood lumber dispute it will cripple one
of the chief resource sectors in western /anada 'he impact of the loss of eCport
58
volumes due to the strong /anadian dollar as well as U% protectionistPs
measures could stimulate a recession in /anada 'he impact of both will
certainly pop the real estate bubble in western /anada Fe are already seeing
corrections in the /algary markets It is only a matter of time before we see a
correction in the Mancouver real estate markets 'he impact of high ratio
financing and higher debt loads on consumers will see an impact on the level of
bankruptcies and debt consolidations
I0pa1' "! E/,"p:
'he impact of U% subprime crisis on 7urope is gaining prominence with every
passing day. 7arlier real estate agents could 1uote the prices of their choice
while selling properties ;owever. things have changed a lot down the line
/urrently. the prices of homes are dropping and there is a probable fear that the
recession may be reigning supreme in 5ondon neCt year It is also being feared
that the U% %ubprime crisis may be falling upon as a grind 0wing to this state of
affairs. lenders around the globe are a bit apprehensive in eCtending new loans
to debtors
Impact of U% %ubprime crisis on 7urope cannot be ignored 'hat this part of the
world will be impacted as well. can be concluded from the fact that signs of the
same have already started showing $like falling prices of homes& in 5ondon
!orthern 2ock. which was an eminent mortgage lender. took refuge in the
Bank of 7ngland for purposes of emergency financing in the month of
%eptember. ())3 <rospective purchasers for the mortgage lender are still being
looked for
Another instance in Aermany. which implies the impact of U% subprime crisis
on 7urope. is when AermanyPs IKB #eutsche Industriebank accepted U%#B>>>
billion from the Aovernment as a bailout pertaining to its various United %tates
mortgage investments
59
B!< <aribas. the Drench Bank was compelled to take some drastic steps It
stopped all withdrawals from a fund of U%#B(( billion pertaining to investment
funds as the true value of the investment portfolios could not be ascertained
I0pa1' "! A3,(1a:
Africa was the least affected with %outh Africa and 7gypt being the only countries
to record some minor disturbances
Fhy has Africa remained so detached from the sub prime crisisQ
'he main reason why Africa has not felt the full effect of the sub+prime crisis
which has since culminated in the slowdown of the U% economy is that most
African financial markets still lag behind in terms of financial market
sophistication in terms of products on offer as well as information asymmetry
'his is evident in the fact that most of the capital markets in Africa are still being
developed with the eCception of the two advanced ones which are %outh Africa
and 7gypt
%ome African countries still have eCchange controls which restrict the flow of
international capital thus limiting the contagion effect from foreign financial
markets
%ome African countries have just established %tock 7Cchanges which by and
large lack li1uidity and market depth with a case in point being %wa-iland which
has siC listed counters and an inactive bond market
0ther established eCchanges are illi1uid and in a way limit Africa=s eCposure to
the global village
60
According to the African #evelopment Bank. the African economy is eCpected to
grow by 6.,I in ())9 driven by increased demand for resources from the
booming /hinese and Indian 7conomies which will offset the decline in demand
from the U% and 7urope
'he /hinese economy is eCpected to grow by 8. 6I in ())9 which is still high
enough to benefit African economies despite the threat of a U% recession 'he
indirect effect on African economies of a global slowdown emanating from the
sub+prime crisis will be felt nevertheless through reduced demand for African
goods and services
'he /hinese economy which is eCpected to grow by 8.6I down from the initial
forecast >>.3I will insulate Africa and ensure some growth going forward despite
a slowdown in the U%
I0pa1' "! -"/'7 A0,(1a
%o far. the sub+prime crisis has had a limited direct impact on 5atin AmericaPs
mortgage markets In MeCico. the market for new low+and middle+income
housing has grown rapidly. thanks to the creation of a market for residential
mortgage securities in ())4 In the last 1uarter of ())3 alone. MeCican issuers
sold B>, billion in new mortgage+backed securitiesG a significant portion of B**
billion outstanding. with only a slight drop in prices to reflect globally induced risk.
according to the publication Asset %ecuriti-ation 2eport /hilean markets also
have stayed relatively calm
'hese markets have been insulated in part because most investment in real
estate+backed securities has come from local investors who often need to invest
in local+currency markets Most important. 5atin AmericaPs mortgage markets and
homeowners are very different from those in the U% NItPs natural that the state of
global markets will have some kind of ripple effect.O says Areg Kabance.
61
managing director for 5atin American structured finance at Ditch 2atings. the
international credit ratings agency NBut 5atin American countries. from a credit
standpoint. are a lot better off than they have ever been to withstand turbulence
and weather global market problemsO
'o their benefit. 5atin American governments have applied the lessons of the
past MeCicoPs Nte1uila crisisO of >88*+>88, forced many homeowners into default
when the peso fell by 3) percent and interest rates soared In MeCico. all
mortgages carry fiCed interest rates. unlike the infamous NeCploding A2MsO that
left U% homeowners ruing their choice of adjustable+rate mortgages when
interest rates rose MeCican mortgages are indeCed to inflation. but the state
mortgage agency links that indeC to the minimum wage and makes up the
difference if mortgage interest adjustments for inflation outpace wage growth
'his protects both borrowers and lenders
'he silver lining of past financial crises in 5atin America is that most individuals
carry far less debt than do Americans In MeCico. for eCample. mortgage debt
represents less than >) percent of A#<. compared to about ,) percent of A#< in
7urope and 9( percent of A#< in the U% L a ratio that has increased more than
fourfold in the last two decades
I0pa1' "! S"/'7 A-(a
J'he current subprime mortgage crisis in the United %tates will not seriously
impact %outh Asian countriesJ. said %hanta #evarajan. Forld Bank /hief
7conomist for the %outh Asia 2egion N'he impact will be mild because of the
structure of the regionPs trade and financial flows. and partly because of
compensating effectsO
#evarajan attributed three factors that work well for the %outh Asian countries" >&
5ack of eCposure to U% mortgage securitiesG (& availability of li1uidity in
62
domestic marketsG and 4& the possibility that lower capital inflows could help
countries such as India with macroeconomic management
;ighlighting that Indian companies do not have big eCposure to U% mortgage
securities. #evarajan said. N7ven if the subprime crisis leads to a global credit
crunch. it still may not have a big effect because there is 1uite a lot of li1uidity in
domestic markets in countries like IndiaO
;e believes that if a global credit crunch leads to a decline in capital flows. it may
still not be a bad thing for India ;e pointed out that Indian policymakers recently
were having difficulties in managing the sudden surge in capital inflows while
trying to manage India=s eCchange and inflation rates
%peaking on a possible slowing down of the United %tates economy. #evarajan
said. N'he impact on %outh Asian countries will still be relatively mildO ;e drew
attention to the fact that the share of %outh AsiaPs trade with the United %tates
has been declining and that the U% is no longer India=s leading supplier %ri
5anka. which used to rely on the United %tates for its garment eCports. has now
increased them to 7urope and other regions substantially
0n the other hand. #evarajan eCpects that Na slowdown of the United States
economic growth will moderate the increase in prices of oil and other commodity
prices which will have a favorable impact on So!th "siaO %ince all %outh Asian
countries are net importers of these commodities. such a slowdown will provide
some relief in their balance+of+payments
N'he declining value of U% dollar will certainly affect IndiaPs I' companies that sell
services to the United %tates. and already many I' companies are feeling the
effect.O #evarajan said 'he Indian companies engaged in business processes
such as mortgage documentation have seen a decline in work orders and loss of
revenues as U% lenders have tightened their eCposure to credit market 'he
63
Indian I' industry. which derives about 6,I of its revenues from the U% market.
will also be adversely affected if the subprime crisis leads to a recession in the
United %tates
;owever. #evarajan allayed the fears of a significant negative impact on IndiaPs
overall economy and said. N'he share of I' services eCports in total eCports of
India is not growing very fast because India has started eCporting more
manufactured goods and other servicesO Also. he said that eCports are not the
only determinant of economic growth in India ;e eCpects that domestic demand
in India will continue to fuel economic growth even when there is a dampening of
I' eCports to the United %tates
64
65
/;A<'72 III
Impact on India
66
I0p)(1a'("!- "! I!.(a:
7ven though the Indian markets are eCperiencing the echo. the Indian banking
system has remained fairly insulated from any direct impact of the subprime
crisis in the U% 'his is because the Indian banks did not have significant
eCposure to subprime loans in the U% ;owever. there was a major impact on the
e1uity Markets as many foreign institutional investors $DIIs& sold off their
investments into Indian /ompanies to cover their huge losses 'he DIIs have
and. as of date. are continuing to withdrawn from the e1uity Markets Aoing
forward. any subprime related tremors in the global Markets are likely to cause
further chaos in the Indian e1uity Markets as well
Also. a subprime like scenario in India seems unlikely given the current state of
affairs Dirst and foremost. despite rapid growth in recent years. the mortgage
market in India is nowhere near the levels of developed countries. such as the
U% or the UK Mortgages as a percentage of A#< in India are still at a small
percentage as compared with the U% and the UK %econdly. the approach of the
Indian regulators has been balanced and forward+looking Its continuous doses
of monetary tightening aims to ensure that the money supply $and hence
inflation& is kept within manageable limits Admittedly housing prices in India are
affected but this has got more to do with the demand+supply factors

67
Ma-/,- '7a' 1a! * 'a2!:
!evertheless. the events which have unfolded in the recent months offer
valuable learning for an emerging country like India 0n the fundamental level.
there is an utmost need to strengthen the system for assessment of the
borrowerPs credit worthiness 'he root cause of the sub prime mortgage crisis is
the unsound credit practices that emerged in the U% market Dake certification.
which helps an ineligible person to raise a home loan. cannot be ruled out in
India ;ousing loan frauds are not uncommon in the cities of India and the
aggressiveness with which housing loans are being sold by banks and financial
companies in violation of sound credit practices cannot be ignored <ersonal
loans and overdue credit cards are the other sectors which the regulators and
bankers should handle carefully because they have the potential to plunge the
Indian banking sector into a crisis 0versight at this stage is bound to cause
repercussions in future. no matter how robust the subse1uent processes are
'he regulator will have to ensure that banks do not follow imprudent and
predatory lending practices by offering far too lenient lending terms than are
warranted for 0n the other hand. banks need to make sure that they share the
credit history of borrowers to better assess the credit worthiness of borrowers
0ne such initiative could be to encourage wider use of the services of the credit
information bureau $/IB& Membership as well as sharing of credit information
with /IB may be made mandatory for all financial institutions so that the
comprehensive credit information pertaining to individual borrowers can be made
available to all the financial institutions
A fundamental limitation has been that the rating models largely rely on the
historical performance record. which has been eCcellent in case of mortgage
backed securities But these models do not take into account newer risk
implications arising from newer mortgage structures. such as the option
68
adjustable rate mortgage. which is prone to payment shocks /redit models at
the originators and rating agencies must tailored to address the potential risks in
such innovations and ensure that they are ade1uately factored in their rating
mechanisms !ot only that. they must also ensure continuous monitoring so that
the changing conditions of the 7conomy are reflected in their processes /redit
rating agencies should use learning from this episode to modify their rating
methodologies + incorporate certain predictive elements. and add greater rigor in
their timely surveillance of rating securities A swift move by credit rating
agencies in identifying sticky mortgage backed securities will only help instill
confidence in the efficiency of the entire rating system
Dinancial institutions will also play a larger role in avoiding any shocks by
carrying out proper due diligence of securities and borrowers. besides relying on
credit ratings 'hey need to strengthen their risk management framework in view
of increasing compleCities in products/services. and customersP re1uirements
Although it would be compelling in such situations. one of the foremost things to
note is that the regulator should not get carried away by the events in the global
Markets to impose far too many stringent regulations to restrict credit growth
'his may lead to stifling of economic growth in the process 2ather. the approach
should be to put in place right kind of enablers to identify the potent risks and
deal with them appropriately in the Indian conteCt
69
CHAPTER I%
SUMMARY
70
SUMMARY AND CONCLUSION
N#erivatives are financial weapons of mass destruction. carrying dangers that.
while now latent. are potentially lethal.O so said Farren Buffett. reportedly the
third richest person in the world. in ())( ;is prophetic words are becoming true
with the unraveling of the financial mess created by the sub+prime lending spree
in the U% 'he developments will also affect emerging market countries such as
India 'he developments that led to the eCplosive situation are traced here
%ub+prime loans are those given to borrowers whose creditworthiness is below
prime and hence are of low 1uality In India. sub+prime lending refers to loans
carrying rates below the prime lending rate normally offered to high 1uality
borrowers
%ub+prime or low 1uality loans are mainly of three kinds" car loans. credit card
loans and house mortgage loans 0f these. the biggest and the ones that can
endanger the entire financial system are the house mortgage loans 'hese
formed nearly one fifth of all U% mortgage loans in ())6. going up from 8 per
cent till ())*
'he sub+prime loans were given to borrowers who did not have the capacity to
service them $pay interest and repay principal& At the height of such lending. it
was said. the borrowers were in the !I!HA $no income. no jobs also& category 'o
lure such borrowers. some lenders adopted SpredatoryP practices 'hey lent
deliberately knowing that there will be default and. when it occurred. sei-ed the
houses mortgaged and sold them off to make a profit
'he basic 1uestion is why any lender $apart from the predatory ones& would give
loans that carried the highest risk 0ne reason is that these carried higher
interest rates But. the main reasons seem to be two" large surplus funds with
71
banks and the introduction of esoteric financial instruments that passed on the
risk to unsuspecting investors
%oon after the dotcom bubble burst in ())(. the Dederal 2eserve $central bank&
of the U% pumped in money into the system 'oo much money in the system led
inevitably to lower 1uality of lending 'he availability of credit derivative
instruments. which basically transferred the risk to another party. accelerated the
pace of sub+prime lending
'ypically. a bank or mortgage finance company $many of them owned by banks&
lent to a sub+prime borrower to finance purchase of a house %ince the borrower
did not have the means to even pay interest in the beginning. the lender sugar+
coated the loan through an adjusted rate mortgage $A2M& 0ne type of such a
loan was called (+(9 #uring the first two years of a 4)+year mortgage loan.
interest was pegged at a low fiCed rate of * per cent In the subse1uent (9 years.
the rate was floating $variable& at around , per cent over a benchmark rate such
as 5IB02 $5ondon Inter+Bank 0ffered 2ate&
'he lender hoped that even if the borrower could not service the loan after two
years. he/she could always take refinance $raise a fresh loan against the same
house& for a larger amount Implicit in this was the assumption that house prices
will go on increasing 'his premise got a jolt when house prices started climbing
down after peaking in ()),+)6 Fhen the first two years eCpired. the interest rate
also moved up to very high levels Fith 5IB02 ruling at over , per cent. the
mortgage rate shot up to >) per cent %uddenly. the 7MI $e1uated monthly
installment& of such a loan nearly doubled" for a 2s , lakh loan. it is 2s *.*3) a
month for a (9+year. >) per cent loan. against 2s (.*)) for a 4)+ year * per cent
loan
'he primary lenders $originators& of the sub + prime loans wanted to sell the loans
to investors 'o make them attractive. they pooled such loans into baskets and
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created what are known as /#0s $collaterali-ed debt obligations& 'he baskets
were sliced and spliced to make layers of /#0s $derivatives& carrying different
risks 'he underlying assumption was that all borrowers would not default at the
same time and a percentage of them would be prompt in payment 'he SsafeP
portion was sold to investors averse to high risk and the balance to others 'he
credit rating agencies put in their might behind the maneuver by giving the best
rating to the portion deemed low risk %ome even alleged that the agencies
helped in the splicing game
'hese /#0s were bought by some big investment banks and hedge funds in
which the super rich invested for high returns 'hey. in turn. financed these
investments by borrowing from banks against the security of /#0s 'he banksP
action in passing on the risk to others boomeranged. with the same sub + prime
loans coming back to them as security for loans
'he whole arrangement crumbled when things turned adverse with falling home
prices and rising interest rates In early ())3. when !ew /entury Dinancial. a
large sub+prime lender. collapsed. it resulted in Barclays Bank taking over sub+
prime loans of about B8)) million In Debruary. ;%B/. another big British bank.
reported steep losses in sub+prime lending in the U% Many /anadian. Aerman
and Drench banks followed suit Many of the big investment banks in the U%
also reported large losses
As a result. confidence in the banking system was rudely shaken And. no bank
could be sure of the solvency of another bank and the inter bank money market.
where short term lending was common. almost dried up
Authorities in 7urope and the U% had to pump in money to prevent the whole
system from collapsing 'hese developments had their impact on Indian stock
markets in which many hedge funds and investment banks had invested Fhen
they faced li1uidity problems in the U%. they sold part of their Indian holdings.
sending the share indices down
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Fith the sub + prime loans taking different avatars and changing hands
fre1uently. no one knows for sure which institution holds how much of the low
1uality loans Assessing the impact of this worldwide financial contagion will take
months. if not years <erhaps. it could bring about a prolonged recession or very
slow growth in the U%. as it happened in Hapan in the>88)s <art of the blame
perhaps attaches to the U% Dederal 2eserve which detected the problem too
late to take corrective action
Ultimately. bankers will have to return to the time tested practice of prudence in
lending if problems witnessed in sub + prime loans are not to recur
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BIBLIOGRAPHY
N4-pap,-:
'he ;indu
7enadu
Business 5ine
Business %tandard
NET
wwwgooglecom
wwwwikipediaorg
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