Global Crisis and Its Implications 1MBA 10 Global Crisis

Global Crisis and Its Implications

1MBA 10 Global Crisis

Some Terms & Phrases Used• Sub-Prime Borrowers: Those with poor credit history/worthiness

• Hedge Funds: An aggressively managed portfolio of investments (shares, debts, commodities, derivatives, etc) using advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets, often speculative in nature. Primary goal is generating high returns. Usually private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments are illiquid requiring investors keep to their money in the fund for long. Are unregulated for the most part– Misnomer! “Hedging” should mean “reducing” risk!


Some Terms & Phrases Used (Contd)• Structured Finance: Entails aggregating multiple

underlying risks (such as market and credit risks) by pooling instruments subject to those risks (for example, bonds, loans, or mortgage-backed securities) and then dividing the resulting cash flows into "tranches," or slices, paid to different holders. Payouts from the pool are paid to the holders of these tranches in a specific order, starting with the "senior" tranches (least risky) and working down through various levels to the "equity" tranche (most risky). If some of expected cash flows into the pool are not forthcoming (loans default), the equity tranche holders absorb payment shortfalls.

MBA 10 Global Crisis 3

The Sub-Prime Boom• Originated with a global imbalance between the

supply (more) & demand (less) for credit – Pre-2007

• At that time, corporate, the traditional mainstays for borrowing funds, moved to a defensive stance, having grown conservative after Enron & WorldCom fiascos

• Central banks (USA primarily) let monetary policy move to a nearly unprecedented accommodative stance, pumping money into the system• Which opened big windows to sub-prime borrowers


Sub-Prime Boom (Contd)• There had to be someone who could take the money from

investors and give to the borrowers; Banks did. • Banks gave money to sub-prime borrowers, then bundled

the loans to a package, and sold securities by linking values to the performance of the package.

• These instruments were called Collaterized Debt Obligations (CDOs); form of Asset Backed Securities (ABS).

• Investors bought these securities and thus indirectly provided the money required for sub-prime lending.

• The investors came extensively beyond the USA• Hedge Funds held majority of these sub-prime related

securities, due to inherent nature of their business, making them extremely vulnerable to sub-prime related issues.


And, then the Sub-Prime Crisis• So, what triggered the Sub-prime crisis?• It occurred when sub-prime borrowers defaulted in

their loans, affecting the returns of CDOs. • Another catalyst was the rising segment of credits like

“Home Equity Loans” through which the borrowers could take a second credit on the same mortgage. This reduced value of the security

• As a result, some started force selling their houses, due to which property prices came down, reducing the value of security still further


Sub-Prime Crisis (Contd)• The result, more and more defaults!• The highly leveraged hedge funds, found

themselves in distress due to the rising defaults by sub-prime borrowers, and low security levels

• Most Investors in these funds wanted their money back which forced these funds to liquidate their assets.

• And thus started a vicious spiral of forced selling of sub-prime securities!


Sub-Prime Crisis (Contd)

• This reduced the price of these securities in the market and thus the crisis grew new bounds.

• Since hedge funds are highly leveraged, a small decrease in their asset values is enough to make them bankrupt.

• As a result several funds filed for bankruptcy. Thus the sub-prime crisis showed its red face!

• Peak was felt during July-September 2007• It was spread all over the advanced markets


How the Governments Acted!• Bear Stearns had was taken over by JPMorgan with the

support of the Federal Reserve• Bank of New York, and financial institutions in both the

US (e.g. Citibank, Merrill Lynch) and in Europe (UBS, Credit Suisse, RBS, HBOS, Barclays, Fortis, Société Générale) raised a significant volume of additional capital to finance, inter alia, major realised losses on assets, diluting in a number of cases existing shareholders.

• Freddie Mac and Fanny Mae, two government sponsored important intermediaries in the US secondary mortgage market, had to be taken into govnmnt conservatorship


- - Governments Acted!(contd)

• Similar measures were resorted all over Europe (taking over, nationalizing, etc).

• The crisis intensified in the third quarter of 2008 with a number of collapses (especially Lehman Brothers) and a generalized loss of confidence that hit all financial institutions. As a result, several banks failed in Europe and the US while others received government recapitalisation towards the end of 2008.


Rephrasing the Sub-Prime Crisis1. Assets were created, sold, and bought, which

appeared much less risky than they truly were.

2. Securitization (selling loan portfolio of banks to investors) led to complex and hard to value assets on financial institutions balance sheets.

3. Securitization & globalization led to increasing connectedness between financial institutions, both within and across countries.

4. Leverage had increased, to get higher return on equity, and hence absorption capacity was very low


Then Snowballed into a Economic Crisis• To make matters worse, Economic Downturn

also surfaced in many countries– which impacted consumer sentiment, investment

sentiment, business profits, resultant stock prices – Also surfaced was galloping prices of crude– And, additionally, food prices galloped due to

shortages in production on a world-wide scale

• Global Economy thus turned into a Severe Recession, in addition to mere “financial crisis”


It was “Global Economic Crisis” - - beyond “financial”

• The pullback by consumers has reverberated in export-dependent economies, while the sharp correction in commodity prices caused many new markets exports to contract as well.

• Consumers in the U.S. and other advanced economies became dramatically less willing and able to purchase consumer durables. This led, for example, to Japanese auto exports dropping by nearly 70 percent


Global Economic Crisis (Contd)• The shock got propagated rapidly through integrated

supply chain with impact on intra-regional trade.

• This trade shock spilled over to domestic demand in many countries, as consumption and private investment weakened in many countries, as well.

• Overall, Global GDP fell by unprecedented 6% in 4th quarter of 2008. Global FDI inflows fell by whopping 50% in 2009 compared to 2007.

• World Merchandise Exports fell to US $ 12461000 Mn in 2009 from US $ 16097000 Mn in 2008


When Fighting the Global Crises• Strategy for economic recovery in most

countries was stimulus packages of Government spending to boost demand

• That created mounting government debts and, hence, spiraling inflationary pressures - - - all over the world - - - and the previously noted parameters of global crisis worsened

• Emerging markets and developing economies faced double blow of drop in international capital flows and in external demand (exports).


Implications to Globalization • Even before this crisis began in 2007, globalization

was already being challenged. Not everyone bought into its benefits free trade and movement of factors.

• The crisis started a shift in the balance between the political and economic forces at play in the process of globalization.

• The drivers of the globalization wave—open markets, the global supply chain, globally integrated companies, and private ownership—started getting undermined, and spirit of protectionism reemerged.

• And once-footloose global companies commenced returning to their national roots.


- - - Globalization (Contd)• But, a recent Mckinsey study observes: “Globalization

consists of trade, investment, and migration. One of the most important (yet neglected) insights of economics is that trade, investment, and migration can all substitute for each other. So if trade is cut off, investment can flow or labor can move from one country to another. If Toyota cannot ship more cars to the American market, the company will open up a plant in Kentucky. Globalization will halt only when all the three are halted - - - - but that would take a truly major negative event, far worse than the ongoing financial crisis. “


On Globalization (contd)

THE global system “needs a fundamental reboot” - - - That was the clearest conclusion from the 700 or so Davos Men and Women gathered in Dubai between November 7th and 9th, 2008 by the World Economic Forum (WEF) to discuss how to lead the world out of its crisis. This computing analogy immediately inspired a series of pointed jokes: “Before you reboot, make sure the operating system works”; “First, make sure the power is switched on”, and (to the loudest laughter) “Let’s hope we don’t end up with another version of Windows.” Indeed.


A Comment by World Economic Forum

• “This is a “leadership moment”. Global co-ordinated action is needed. The unthinkable must be thought. Business as usual is no longer an option. What is needed is “restorative innovation.” Solutions should be the result of multi-stakeholder engagement, with everyone having a seat at the table. Risks must be better measured, and better managed. Solutions should be transformational, and sustainable. Thinking holistically, connectedly, is essential.”


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Global Crisis and Its Implications 1MBA 10 Global Crisis