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Bankruptcy of
lehman Brothers
A Pointer of Subprime Crisis
Pankaj Madhani
not qualify for normal market interest rate loans due to various risk factors, such as income
Thelevel,
termsize
subprime
refers to the
practice
making and
loansemployment
available to borrowers
who do
of the lending
down payment
made,
creditof history
status. Subprime
mortgages are defined as housing loans which do not conform to the criteria for prime mortgages,
and also have a lower probability of the full repayment of mortgages. Subprime mortgage .loans
are made to home loan borrowers who have higher credit risks compared to prime mortgages,
because of irregular payment in the past, higher amount of debt compared to income level and
such other factors. According to Federal banking and thrift regulatory agencies, sub prime
mortgages are those made to borrowers who display among other characteristics, (i) a previous
record of delinquency, foreclosure or bankruptcy, (ii) a low credit score, and/or (iii) a ratio of debt
service to an income of 50% or greater (Office of the Comptroller of the Currency, et aI, 2007).1
Subprime mortgages were mainly responsible for an increased demand in housing and home
ownership rates in the US. The overall US home ownership rate increased from 64% to 70%
. between 1994 and 2004. This surging demand helped fuel housing price hike and consumer
spending. Between 1997 and 2006, American home prices increased by 124%. This is, partly, due
to the encouragement from the Federal government for the consumption economy after the
September 2001 disaster to boost domestic economy based on consumer spending.
During the period of the housing property bubble in the US, when property price was having a
continuous northward journey, many homeowners used the increased property value to refinance their
houses with lower interest rates available in the market. Such second mortgages against the increased
value of home ownership were used for personal consumer spending. In 2007, the US household debt
was 130% (as a percentage of income), which was considerably higher compared to 100% recorded _
www.federalreserve.gov/boarddocs/press!bcreg/2006/20060929/defalilt.htm
World
BUSINESS
ENVIRONMENT
securitization, act as collateral for new financial assets issued by financial institutions or those
owning such underlying assets. In this way, mortgages with a high risk of default could be
derived effectively through MBS and COOs, by shifting inherent risks from the mortgage issuer to
the investors.
Lehman Brothers Debacle
One of the major causes of the Lehman Brothers' (the fourth largest securities company in the US)
default was its exposure to the subprime market. In recent years, many home mortgages issued in
US were made to subprime borrowers. Compared to prime borrowers, subprime borrowers are
having lesser ability to repay the loan, based on various criteria. During 2006-07, housing prices
began to drop in the US, causing mortgage delinquencies to soar and huge losses to financial firms
as they hold financial securities backed with subprime mortgages. This resulted in a large decline
in the capital of many banks and government-backed enterprises of the US.
Lehman Brothers was a key player in the MBS market. A single MBS might consist of a number
of mortgage loans clustered together and enclosed in a set of mortgage securities, which can be
bought and sold in the secondary market for securities. Although, the subprime MBS market was
having a high proportion of inherent risks, it looked much more attractive as the MBS market was
growing at an exponential rate with a market size in trillions, having doubled between 2001 and
2003. Many banks and financial institutes turned to such riskier investments as they promised
greater returns during the period of relatively slow economic growth. The massive size of the
MBS market also tempted many finance and securities firms to it. As residential property prices
soared, home owners and mortgage borrowers used their homes as collateral for increasing
indebtedness and that enhanced debt also provided the starting point for a stockmarket bubble.
Lehman Brothers had a huge exposure to property derivatives, such as MBS and COOs. These
mortgage derivatives were attached to underlying assets, such as value of homes and mortgages.
However, with the beginning of property price crash, the value of Lehman Brothers' investment
started to decline sharply. Lehman Brothers also had a large chunk of leveraged assets and was
exposed to a significant portion of subprime MBS. As Lehman Brothers was exposed to huge
amounts of bad debt, it suffered a severe credit crunch. Lehman Brothers collapsed, as it failed to
raise enough capital to secure its debts and filed Chapter 11 of the United States Bankruptcy Code
on September 15, 2008, causing panic in the entire global financial market.
Lehman Brothers' working model of securitization involved obtaining loans from other banks
and then selling them off as MBS in the secondary market. In this process, the bank would pay the
monthly interest it earned out of that loan to Lehman Brothers. Finally, Lehman Brothers would
pay the investors who bought the MBS. Here, the main risk was that, if the loans were unpaid and
defaulted, the bank was not obliged to pay Lehman Brothers, even though Lehman Brothers was
required to pay the customers who bought the MBS. Hence, when the mortgage loan customers
started defaulting on loan payment! banks stopped paying Lehman Brothers. These were the
reasons behind the downfall of Lehman Brothers. After the bankruptcy of the Lehman Brothers,
the liquidity crisis deepened further, having an immediate impact on the American International
Group (AIG), the biggest US life insurer. To ease the liquidity crisis, AIG received emergency loans
from the US Federal Reserve on September 17, 2008 , and was effectively bailed out and placed
under government supervision.
The Indian Securitization
Market
Though the securitization market in India is of recent origin, it looks promising. The Indian
structured finance market registered a growth rate of 44%, Rs. 370 bn in the year 2007. Out of this,
65% of the securitized assets were originated by banks and the remaining 35% by non-banking
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2009
financial companies. The following table provides the growth path of the Indian securitization
market:
'"
Table: Growth of 36.8
the Indian Securitization
Market
04.0
12.9
0.8
FY02
19.1
29.6
77.7
369.5
139.2
33.4
256.5
308.2
36.4
24.3
234.2
016
0.5
00.4
28.3
FY04
FY03
FY07
119.2
80.9
16.1
14.8
021.0
6.8
222.9
10
25.8
50.1
178.5
1.9
FY06
FY05
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BUSINESS
ENVIRONMENT
It is imperative that banks and financial institutions share the credit history of home loan
borrowers to better assess their creditworthiness. One such step in this direction could be to
encourage and support usage of the services of the Credit Informatipn Bureau (CIB). For all banks
and financial institutions, institutional membership as well as the sharing of credit information
with CIB, should be made obligatory. This will help in sharing all the relevant information
pertaining to individual borrowers among all the lending banks and financial institutions.
A major drawback in the credit rating mechanism has been that the credit rating processes
largely rely on past performance records. For MBS, such historical records has been very
impressive. However, such credit rating processes or models do not take into account, newer or
imminent macro risks. Even the risks arising from newer mortgage structures, such as negative
amortization mortgage or ARM, which is more prone to loan repayment default, are not
considered.
Credit rating models used by the originators of the mortgage loans and rating agencies must
be able to comprehend potential risks in such financial innovations and should make sure that
such impending risks are adequately accounted in their rating processes, so far as new risk is
concerned. It must also ensure constant credit monitoring, so
that the fast changing environment of the global economy is
reflected and accounted in the credit rating processes. Credit
rating agencies should learn lessons from subprime related
For all banks and financial
crisis, to modify their rating methodologies and models, to
institutions, institutional
incorporate certain predictive elements, and to build greater
membership as well as the
rigor in their rating mechanism. Immediate action by credit
rating agencies in identifying toxic MBS will help in boosting
sharing of credit information
investors' confidence in the efficiency and effectiveness of the
with CIB, should be made
entire credit rating system.
Implications
obligatory
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II
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corporate and an increase in the outflow of foreign funds from the capital market. These adverse
global developments will drastically slowdown capital inflows into India. For the year 2008-09,
it is estimated to be between $40 and $50 bn. The recent downward trend in the Indian and global
capital markets, also a reflection of increased global risk aversion and reduction in market liquidity,
will have a negative impact on global investment and consumption patterns.
Indian firms were active in the foreign debt markets for financing overseas expenditures
denominated in foreign currency, mergers and acquisitions. Hence, the Indian corporate houses
are facing mounting difficulty in raising foreign loans as liquidity crisis faced by the foreign
banks and their loss of risk appetite are the key hindrances in any such moves. Pricing for foreign
borrowing by even blue chip Indian borrowers (e.g., Tata Motors, Reliance, etc.), has increased
significantly since the beginning of January 2008.
Central banks, across various countries including India, made a quick decision to cut interest
rates along with the declaration of economic stimulus packages by respective governments. All
these collective steps were taken to control risks to broader economy, created by subprime crisis
and subsequent financial meltdown. It is envisaged that these measures will stimulate economic
growth and rebuild confidence in the financial and capital markets. The effects of subprime crisis
and subsequent financial turmoil on the global stock markets have been severe. Between January
1, 2008 and October 11, 2008, the market capitalization of the US stock market had suffered $8 tn
in losses, as their value declined from $20 tn to $12 tn. Losses in other nine countries have averaged
about 40%4.
The major turbulence in the global capital and financial markets and subsequent lower risk
appetite of financial institutions and FII, will impact India's ability to finance its capital intensive
infrastructure projects. As credit growth has not responded positively to liquidity strengthening
measures by central banks across the globe, it is envisaged that the supply of long-term funds for
financing infrastructure projects worldwide will remain restricted for the next 12 to 24 months.
There is a pressing need for the development of long-term debt market, locally.
A sub prime-like crisis in India seems unlikely, given the current state of regulatory affairs. In
recent years, the home loan mortgage market has grown rapidly in India. However, the Indian
credit growth is far behind the levels of credit growth seen in Western countries. Mortgage loans,
as a percentage of GDP in India, are still at a smaller percentage as compared to the US and the UK.
The approach of the Indian regulators regarding financial markets has been cautious, balanced
and forward-looking. The RBI's policy of strict watch on market liquidity, in order to ensure that
the money supply (and hence inflation) is kept within manageable limits, is helping to avoid any
such full blown financial crisis like subprime crisis.
Conclusion
The aftershocks from subprime crisis caused widespread panic in the global financial and capital
markets and encouraged investors to abandon risky mortgage bonds and volatile equities. The
subprirne crisis is likely to have long-lasting economic impacts on the world market. Continuously
declining home prices in the US have adversely affected household wealth and consumption
patterns. The immediate impact of subprime crisis on global banking industry, involves
fundamental changes in banking business models, eliminating volume and income, with net
effect of large percentage reduction in the available credit. The subprime crisis has altered investor
and lender risk preferences in a big way. Structured financial products are being avoided by
investors and financial institutions, as they prefer holding in favor of cash or cash equivalent
securities.l4\
Reference # 09M-2009-06-06-01
2009