Roll No.13 2008 Crisis Secondary Market

8/4/2019 Roll No.13 2008 Crisis Secondary Market

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What is sub prime lending?

The term subprime refers to the credit status of the borrower (being less than ideal), notthe interest rate on the loan itself. sub prime is any loan that does not meet primeguidelines. If your mid fico score is below 620 and you have any mortgage rates within12 months or recent BK/foreclosure, you are considered sub prime .

Subprime lending, also called B-paper, near-prime, or second chance lending, is thepractice of making loans to borrowers who do not qualify for the best market interestrates because of their deficient credit history. The phrase also refers to paper taken onproperty that cannot be sold on the primary market, including loans on certain types of investment properties and certain types of self-employed individuals. Subprime lendingrisky for both lenders and borrowers due to the combination of high interest rates, poorcredit 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 theincreased risk.

Subprime Crisis

How it all started - low interest rates period:-

Remember the dot-com boom and bust? In late 1990s and early 2000s, stock markets in USAreached their historic highs making an overwhelming impact on almost every stock exchange.This was aided by unrealistic valuations of Internet companies. It was essentially a bubble, whultimately burst during the spring of 2001. The market crashed all around declaring numerouscompanies bankrupt; this sponsored an extensive loss of jobs and a very real fear of economicrecession in the US, which was further compounded by 9/11.

The Lower Interest Rate Saga :-

In order to prevent an economic downturn, the Fed Reserve (Fed) started to reduce itslending rates. A reduction in Central Banks money lending rates to other banks causes adiminishment in value of funds as well. The lower cost of funds helps banks in a lower-rate lending to businesses and consumers. This leads to a greater economic activity as

businesses increase banks investments and consumers increase expenditure of thefinancial organization. This approach to boost economic activity is called MonetaristApproach (essentially increasing the supply of money).

Hence, the Federal Reserve reduced its lending rate from an average of 6.4% in Dec 20to 1% in Dec 2003. It had the desired effect, as commercial and consumer lending pickeup and US economy avoided recession. Though, the low interest rates regime also


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indicates that banks are lacking borrowers. To cope with the pressure of more businessgeneration, a new section of borrowers was endowed with loans; this new group wasintroduced as the sub-prime category.

Reckless Lending

Sub- prime means less -than- prime or in a more practical way it stands for riskylending. In normal circumstances, the sub -prime borrowers would not be able to receiveloans from banks. Yet, with the interest rates at historic lows (basically, cheap money),many banks come forward to offer loan to these borrowers for buying homes (mortgagein US parlance). Most of these borrowers had poor credit histories, many were recentimmigrants to the US, and indeed, there was a category of buyers called NINJA (NoIncome, No Job Also). These buyers were lured into borrowing by extremely favorableinitial payment terms. This was followed by an idea of a great boom in real-estate pricelater, which could propel them to avail further loans. Shortly it became a self-fulfillingprophesy, as low interest rates resulted in more home purchases that caused anunexpected hike in its price. The strategy was continued, as they kept lending on lowerrates followed by appreciation of property prices.

Reckless Lending- The Next Picture

In a bid to regulate this irresponsible lending procedure, Fed started increasing its intererates from July 2004, which provoked mortgage organizations to increase their rate tooConsequently, the rate kept increasing till it hit a high of 5.25% in July 2007.

Now the situation of a mortgage borrower became terrible The higher interest ratesettled background for an increased EMI. (First two years were a payment holiday inmost of the cases.) This hike in interest rate dropped off the demand of mortgage too,which tended to a great reduction in property prices. At this instant, borrowers were noeven in the condition to sell their property to pay the loan amount. Hit by this doublewhammy, these borrowers were left with no option but to default on their payments andforeclose the loan, which brought down property prices even more (supply of homesbecame greater than its demand).

Now it comes to lenders, what happened with them? Well, many of them were saddledwith bad debts in their books, and had to declare bankruptcy. They had violated basic rimanagement principle by lending money to borrowers, who have no ability andwillingness to pay back. Therefore, it was an expected outcome.

Though, mortgage banks were highly affected by large number of home-loan defaultersit caused almost same impact on non-mortgage banking organizations. Read on to get adetailed information- .

Impact on Non-Mortgage Banks


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Bank A can be taken as an example; this bank is primarily into mortgage business itprovides home loans. To provide loan, bank needs money which can be generatedthrough accepting deposits from public/investors (capital) and operations (say profitsfrom treasury operations).

Evidently, if it can increase cash generation, it can also increase the amount it lends, andhence its a profit making deal.

In order to increase its cash generation, bank A started selling (issuing) securities whoscash flows were supported by its underlying portfolio of mortgages. These were calledmortgage-backed securities, and they worked as follows bank A had several borrowers,who would repay a certain amount every month/quarter. These would form the projectecash inflows. Bank A would then sell securities to other banks/financialinstitutions/corporate (Bank B) whose repayment would be tied to these inflows. A

holder of these securities, Bank B, would be assured of getting his money back becausebank A would be getting money from its mortgage buyers.

Clearly, if the mortgage buyers are unable to repay, bank A does not get anything. And bank A does not get anything, it cannot repay bank B. And suddenly, Bank B is left wita bad loan in its records, thanks to the sub-prime lending in mortgage sector, even if ithas not directly financed a single mortgage.

Here, the question arises, why would Bank B buy mortgage -backed securities if the cashflows were at risk ? It would not, but due to a complex financial engineering, these

securities were fixed in accordance with rating provided by famous credit rating agencisuch as Moodys and Standard & Poor (S&P). These agencies perform financial researchand analysis of commercial entities. These agencies were lured by mortgageorganizations and a good portfolio of Bank A was presented to Bank B. Perceptibly, thiresulted in commonly referred terminology of risk management terminology as MoralHazard, which reduced rigor in decision-making (greater risk-taking) since the decisionmaker had no idea of the final outcome.

At its peak, the US mortgage-backed securities market was worth $6 Trillion; this wasthe largest part of entire $27 trillion US bonds markets. The value of US mortgage-backed security market is considered bigger than the Treasury bonds issued by the

American government. This was the mortgage saga of USA and few European countries; these nations arecrammed with financial organizations which have bad loans in their records and lookinforward for massive capital injection to continue operations. Nevertheless, manyinstitutions have received financial aid from multiple sources but those who couldntavail it, are collapsed.


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Subprime Crisis: Impact on Overall Economy

Broken down by serious mortgage collapse, US economy was experiencing a greatslowdown in its real-estate market too. Holding 15% of entire national economy, propemarket deceleration made its impacts on other industries also. Few industries such ashome appliance market, DIY stores are directly linked with property market; hence, areal-estate slowdown influenced all of its associated industries.

Taking lesson from previous records, banks have become much more cautious in lendinmoney (return to the basics of risk management); consequently, credit card or a personaloan availing procedure became more difficult. This made clear impacts on thepurchasing power of an average US consumer, which further affected the sinking USeconomy.

IMPACT OF SUBPRIME CRISIS ON ALL OVER THE WORLD

Many of us might be wondering as Sub prime crisis has occurred in the US, then why itimpacts are being seen on all over the world. To describe it in brief, it can be said that thinvestors who have bought these MBS (Mortgage Backed security) are spread all across

the world. Therefore, the huge amount of money they had invested in buying these MBhoping for a very good return didnt happen and they were unable to realize even smallmarginal return on these MBS. Incurring huge amount of losses the initial steps taken bfew banks and financial institution during beginning of the crisis (Aug, 07), clearlyindicates the impact of the same.


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The downturn in facts and figures

The US sub-prime mortgage crisis has led to plunging property prices, a slowdownin the US economy, and billions in losses by banks. It stems from a fundamentalchange in the way mortgages are funded.

THE NEW MODEL OF MORTGAGE LENDING


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How it went wrong:-

Traditionally, banks have financed their mortgage lending through the deposits theyreceive from their customers. This has limited the amount of mortgage lending they coudo.

In recent years, banks have moved to a new model where they sell on the mortgages tothe bond markets. This has made it much easier to fund additional borrowing,

But it has also led to abuses as banks no longer have the incentive to check carefully themortgages they issue.


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THE RISE OF THE MORTGAGE BOND MARKET

THE RISE OF THE MORTGAGE BOND MARKET

.

In the past five years, the private sector has dramaticallyexpanded its role in the mortgage bond market, whichhad previously been dominated by government-sponsored agencies like Freddie Mac.

They specialised in new types of mortgages, such as sub-prime lending to borrowers with poor credit histories andweak documentation of income, who were shunned bythe "prime" lenders like Freddie Mac.

They also included "jumbo" mortgages for propertiesover Freddie Mac's $417,000 (202,000) mortgage limit.

The business proved extremely profitable for the banks,which earned a fee for each mortgage they sold on. Theyurged mortgage brokers to sell more and more of thesemortgages.

Now the mortgage bond market is worth $6 trillion, andis the largest single part of the whole $27 trillion USbond market, bigger even than Treasury bonds.


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HOW SUB-PRIME LENDING AFFECTED ONE CITY:-

THE SUB-PRIME CRISIS IN CLEVELAND

For many years, Cleveland was the sub-prime capital of America.

It was a poor, working class city, hit hard by the decline of manufacturing and sharplydivided along racial lines.

Mortgage brokers focused their efforts by selling sub-prime mortgages in working classblack areas where many people had achieved home ownership.

They told them that they could get cash by refinancing their homes, but often neglectedproperly explain that the new sub-prime mortgages would "reset" after 2 years at doublthe interest rate.

The result was a wave of repossessions that blighted neighbourhoods across the city andthe inner suburbs.

By late 2007, one in ten homes in Cleveland had been repossessed and Deutsche BankTrust, acting on behalf of bondholders, was the largest property owner in the city.


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THE CRISIS GOES NATIONWIDE

Sub-prime lending had spread from inner-city areas rightacross America by 2005.

By then, one in five mortgages were sub-prime, and theywere particularly popular among recent immigrantstrying to buy a home for the first time in the "hot"housing markets of Southern California, Arizona,Nevada, and the suburbs of Washington, DC and NewYork City.

House prices were high, and it was difficult to becomean owner-occupier without moving to the very edge of the metropolitan area.

But these mortgages had a much higher rate of repossession than conventional mortgages because theywere adjustable rate mortgages (ARMs).

The payments were fixed for two years, and then becameboth higher and dependent on the level of Fed interesetrates, which also rose substantially.

Consequently, a wave of repossessions is sweepingAmerica as many of these mortgages reset to higher ratesin the next two years.

And it is likely that as many as two million families willbe evicted from their homes as their cases make theirway through the courts.

The Bush administration is pushing the industry to renegotiate rather than repossesswhere possible, but mortgage companies are being overwhelmed by a tidal wave of cas


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THE HOUSING PRICE CRASH

The wave of repossessions is having a dramatic effect on house prices, reversing the

housing boom of the last few years and causing the first national decline in house pricessince the 1930s.

There is a glut of four million unsold homes that is depressing prices, as builders havealso been forced to lower prices to get rid of unsold properties.

And house prices, which are currently declining at an annual rate of 4.5%, are expectedfall by at least 10% by next year - and more in areas like California and Florida whichhad the biggest boom.


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HOUSING AND THE ECONOMY

The property crash is also affecting the broadereconomy, with the building industry expected to cut itsoutput by half, with the loss of between one and twomillion jobs.

Many smaller builders will go out of business, and thelarger firms are all suffering huge losses.

The building industry makes up 15% of the USeconomy, but a slowdown in the property market alsohits many other industries, for instance makers of durable goods, such as washing machines, and DIYstores, such as Home Depot.

Economists expect the US economy to slow in the lastthree months of 2007 to an annual rate of 1% to 1.5%,compared with growth of 3.9% now.

But no one is sure how long the slowdown will last.Many US consumers have spent beyond their currentincome by borrowing on credit, and the fall in the valueof their homes may make them reluctant to continue thispattern in the future.


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CREDIT CRUNCH

One reason the economic slowdown could get worse isthat banks and other lenders are cutting back on howmuch credit they will make available.

They are rejecting more people who apply for creditcards, insisting on bigger deposits for house purchase,and looking more closely at applications for personal

loans.

The mortgage market has been particularly badlyaffected, with individuals finding it very difficult to getnon-traditional mortgages, both sub-prime and "jumbo"(over the limit guaranteed by government-sponsoredagencies).

The banks have been forced to do this by the drying up of the wholesale bond marketsand by the effect of the crisis on their own balance sheets


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BANK LOSSES

The banking industry is facing huge losses as a result of the sub-prime crisis.

Already banks have announced $60bn worth of losses asmany of the mortgage bonds backed by sub-primemortgages have fallen in value.

The losses could be much greater, as many banks haveconcealed their holdings of sub-prime mortgages inexotic, off-balance sheet instruments such as "structuredinvestment vehicles" or SIVs.

Although the banks say they do not own these SIVs, andtherefore are not liable for their losses, they may beforced to cover any bad debts that they accrue.


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BOND MARKET COLLAPSE

Also suffering huge losses are the bondholders, such aspension funds, who bought sub-prime mortgage bonds.

These have fallen sharply in value in the last fewmonths, and are now worth between 20% and 40% of their original value for most asset classes, even thoseconsidered safe by the ratings agencies.

If the banks are forced to reveal their losses based oncurrent prices, they will be even bigger.

It is estimated that ultimately losses suffered by financialinstitutions could be between $220bn and $450bn, as the$1 trillion in sub-prime mortgage bonds is revalued.


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Global Recession due to US Subprime Crisis

Abstract: The US Subprime Crisis has not only resulted in US economy recession but its ripple effects has

touched the countries like UK, Spain, Japan and Singapore as well. Emerging economies likeChina and India are also affected by the negative influence of the US Subprime Market Crisis. Atpresent it seems that this subprime crisis of US is going to generate a global recession byaffecting the major countries of the world.

The US Subprime Market Crisis has already resulted in US Economy Recession. Thecountries like Britain, Spain, Japan, Singapore are going to bear the negative effects of US economy recession. Emerging economies like China and India are also suffering frothe ill effects of the US Subprime Crisis. All these countries together form a major part the global economy. So, it can be said that the US Subprime Market Crisis is going toaffect the global economy as a whole. As all the countries mentioned above are being

influenced in a negative way by the US economy recession, it is expected that the growrate of the world economy would experience a significant fall. According to AlanGreenspan, the Former Federal Reserve Chairman, Global Recession is surely going totake place in some form or other.

As the US Federal Reserve is opting interest rate cuts in order to fight with the problemof subprime crisis, countries like UK and Japan are also introducing interest rate cuts intheir country. India is also thinking over introducing a cut in interest rate in its nextmonetary policy. This is because all these countries are speculating that cut in US intere

rate will result in capital inflow in their economies which will in turn result in high leveof inflation. This problem of US Subprime Market is generating Credit Crunch in some economies

and accelerating Global Recession in a way. The Economy of Singapore has alreadyentered into recession. The total factory output of the country has got reduced and expoof electronics goods has declined significantly. The real estate sector of the country isalso experiencing a slow down.

The UK economy is also suffering from the problem of credit crunch as the rate of loantaking for home purchase has been recorded at a two year low.

Other than Japan, China, Singapore, UK, Spain there are other countries like Germanywhich are showing signs of slow downs , thereby accelerating the pace of global

recession.


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Reflections on the International Dimensions and Policy Lessons of the USSubprime Crisis

15 March 2008

We may just have started to feel the pain. Asset price drops including housing arecommon markers in all the big banking crises over the past 30 years. GDP declines after such crises were both large (-2% on average) and protracted (2 years to return to trend);in the 5 biggest crises, the numbers were -5% and 3 years. This column, based on the

authors testimony to the Congress, picks through the causes and consequences. It arguesthat when it comes to cures, it would be far better to get the job done right than get the job done quickly.

There is nothing new except what is forgotten. - Mlle. Rose Bertin.

The financial press has often characterised the 2007-2008 United States subprime mess

a new breed of crisis. Indeed, this view often points to the international repercussions othe US-based crisis as evidence that the globalization of financial portfolios hasintroduced brand-new channels for spillovers. At present, there is also considerableconfusion in academic and policy circles as to whether the shaky predicament of theglobal economy owes to contagion or to shared (common) economic fundamentals. Iaddress these issues, in turn, and discuss some of the questions, as regards regulation offinancial institutions, that the current crisis has raised.


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The role of the real estate market

This sorry spectacle repeats itself in the various types of crises, but the most relevant tothe present situation is the aftermath of banking crises. In recent work with KennethRogoff, I documented eighteen such episodes in industrial economies over the past thirtyears. Declines in assets, including those of both houses and equities that the US hasexperienced over the past year, are common markers of the onset of banking crises. In tworst five banking crises (The Big Five) in industrial countries over the past thirty yearthe value of houses fell about 25 percent on average from their peak (Figure 1)


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The fallout of banking crises

The cautionary lesson for todays situation in the United States is that the decline inoutput after a banking crisis is both large and protracted (Figure 2). The average drop in(real per capita) output growth is over 2 percent, and it typically takes two years to returto trend. For the five most catastrophic cases, the drop in annual output growth from peto trough is over 5 percent, and growth remained well below pre-crisis trend even afterthree years.

Sources: Reinhart and Rogoff (2008) and sources cited therein.


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The international repercussions of the US crisis: contagion or confusion?

Swift international spillovers are not a new phenomenon. In this regard, the panic of 1907, which began in the US and quickly spread to other advanced economies(particularly, Denmark, France, Italy, Japan, and Sweden), serves as an illustrativehistorical benchmark for modern-day financial contagion. Like in the present episode,emerging markets were mostly spared in 1907; the only casualty in that episode wasMexico.

There is little doubt that the US crisis has spilled over into other markets. Two majoradvanced economies, Japan and Germany, have been singled out by the financial press being particularly hard-hit. There is no denying that German and Japanese financialinstitutions sought more attractive returns in the US subprime market, perhaps owing tothe fact that profit opportunities in domestic real estate were limited at best and dismal worst (Figure 3). Indeed, after the fact, it has become evident that financial institutions these countries had nontrivial exposure to the US subprime market. This is a classicchannel of transmission or contagion, through which a crisis in one country spreadsacross international borders. In the present context, however, contagion or spillovers areonly a part of the story

If other countries are experiencing economic difficulties at the same time as the US, it idue to the fact that many of the features that characterised the run-up to the subprimecrisis in the US were also present in many other advanced economies. Specifically, mancountries in Europe and elsewhere (New Zealand, for example) were having their ownhome-grown real estate bubbles (Figure 3). This, in and of itself makes, these countriesvulnerable to the usual nasty consequences of asset market crashes irrespective of what

may be happening in the United States. This cannot be pinned on the US subprime fiascor on contagion. The odds of a correction were already present.


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Sources: Shiller, and Bank of International Settlements.


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Policy Lessons: the banana republic approach to banking supervision

As Venezuelas worst banking crisis unfolded in 1994 -1995 (conservative estimates of

the bailout costs of that crisis are at around 18 percent of GDP), no one in that countryseemed to know whose responsibility it was to supervise the financial institutions. As iusual in most banking crises, lending standards had become lax, there was interconnectlending, and there was plenty of plain old-fashioned graft. The central bank blamed themain regulatory agency (SUDEBAN), the regulatory agency blamed the depositinsurance agency (FOGADE), and everyone else blamed the central bank.

At the time of that crisis, the received wisdom was that such supervisory disarray couldonly happen in an emerging market; advanced economies had outgrown such chaos. Wenow know better.

For starters, part of the supervisory responsibilities in the US is delegated to the states,

which is to say that 50 emerging markets agencies were partially responsible for theoversight of real estate lending. Supervisors failed to caution depositories as they offerepotential borrowers unsuitable mortgages. They also acquiesced as complicatedstructures were booked off the balance sheet, even though, in the event, they were nottreated as such by corporate headquarters at the first sign of stress. And after the fact,they have pointed to the other guy as responsible for the problem.

In the private sector, mortgage brokers often sought no more assurance of futurerepayment than a signature. That act of faith was made easier because their owncompensation came from originating loans rather than how the loans played themselvesout. And underwriters took that raw material of mortgages and somehow convincedthemselves that the law of large numbers would make the whole better than the sum of parts, even though many of those pieces needed double-digit house price growth to makeconomic sense. Credit rating agencies, encouraged by their own fee structure, listenedattentively to underwriters assurances of the power of pooling and their ability to predictdespite a limited track record. And final investors substituted the judgment of the ratingagencies for their own due diligence, perhaps abetted by regulation and accounting rulethat imparted special significance to those judgments.

No doubt, change is needed in both the private and public sectors. My immediate fear isthat, as in most prior episodes, the initial reaction will be overdone andinefficient. Financial institutions are already tightening the terms and standards for newlending at a ferocious clip. Rating agencies, following their pro-cyclical tendencies, wiloverreact as well in the effort to distract the investing public from their laxness of the pafew years by strict standards going forward. Similarly, bank examiners will interpret theregulations narrowly, reinforcing the natural tendencies of depositories to tighten creditavailability.


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Stock Market Crash of 2008

Only time will tell the full story of thestock market crash of 2008 , but on Monday October 6,the stock market would start a weeklong decline in which the Dow Jones Industrial Averagewould fall 1,874 points or 18.1%. While the exact cause of this crash may differ from those o

1929 and 1987, they share one common element - they all began in October.In this article, we're going to provide a brief summary of the market movements betweenOctober 1, 2008 and October 10, 2008. We'll also discuss some of the events leading up to thimarket collapse. Finally, we're going to talk about human nature, and how investor reaction coften provide the fuel necessary for a volatile market.

October 2008 Stock Market Crash

Although history may state the actual market crash occurred on Monday, October 6,2008, the market experienced eight consecutive trading days of negative movementstarting on October 1, 2008. The table below shows the decline of the Dow JonesIndustrial Average from October 1st through October 10th.

Date DJIA Close Point Change % Change

October 1, 2008 10,831.07 -19.59 -0.18%

October 2, 2008 10,482.85 -348.22 -3.22%

October 3, 2008 10,325.38 -157.47 -1.50%

October 6, 2008 9,955.50 -369.88 -3.58%

October 7, 2008 9,447.11 -508.39 -5.11%

October 8, 2008 9,258.10 -189.01 -2.00%

October 9, 2008 8,579.19 -678.91 -7.33%

October 10, 2008 8,451.19 -128.00 -1.49%

During these eight trading days, the DJIA would drop a total of 2,399.47 points or22.11%. The market would rebound sharply on Monday October 13, and rise 936.42points, only to drop 733.08 points on Wednesday of that same week.
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October was shaping up to be a volatile month, as investors began reacting to the worrisomecredit market news that started back in March 2008.

The Credit Market Collapse

During the years preceding the credit market collapse, the sub-prime mortgage industrythrived. Individuals with poor credit were given access to loans they really couldn'tafford. But as long as home prices were on the rise, these poor lending practices weresimply ignored.

Lenders could afford to write bad loans as long as the homeowner's equity in their houseoutpaced their desire for new debt. If borrowers were to fail to pay back their loans, lenders could always foreclose on the home, since it was an asset with ever-increasingvalue.

The credit market's problems began when housing prices started to fall in 2007. Homeownersfrequently found themselves with underwater loans. They owed lenders more than the homewas worth. When faced with these facts, homeowners no longer feared the threat of foreclosure. Even more disturbing was the fact that some families abandoned their homes;choosing to start their lives anew elsewhere rather than worry about paying off their debts .

Bear Stearns' Collapse

As mortgage defaults started to rise, the national economy started to falter, and fear creptinto the credit markets. Despite the efforts of the Federal Reserve, the destabilization othe credit market quickly spread to the national financial system. Lenders began to fearborrowers could no longer repay their loans.

Bear Stearns was the first investment bank to fall victim to this fear. Investors, as well other financial institutions, began to worry that money borrowed by Bear Stearns would

not be repaid, and they began pulling money back from Bear Stearns.

On March 13, 2008, Bear Stearns advised the Federal Reserve that its liquidity positionhad deteriorated, and that it would file for bankruptcy unless alternative sources of fundswere made available. Two days later, Bear Stearns agreed to merge with JP MorganChase in a deal that wiped out 90% of Bear Stearns' market value.
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Fannie Mae and Freddie Mac Fall

By the year 2008, the Federal National Mortgage Association (FNMA or Fannie Mae)and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) eitherowned or guaranteed nearly $6 trillion in mortgage loans. With a mortgage crisis in theUnited States, these two corporations quickly began showing signs of financial distress

On September 7, 2008, the governing authority over these two agencies, the FederalHousing Finance Agency, or FHFA, placed both Fannie Mae and Freddie Mac undertheir conservatorship. In addition, the U.S. Treasury department began supplying fundsto help stabilize these companies, raising the national debt ceiling by $800 billion in theprocess.

Financial Instability Grows

On September 14, 2008, Bank of America agreed to acquire Merrill Lynch for $50billion, as a second wave of volatility began in the financial community. On Septembe15, 2008, concerns over the ability of financial institutions to cover their exposure in bothe sub-prime loan market as well as credit default swaps led to further marketinstability. That same day, Lehman Brothers would be forced to file for Chapter 11bankruptcy protection.

On September 16, 2008, American International Group would fall victim to a liquiditycrisis, as AIG's shares lost 95% of their value and the company reported a $13.2 billionloss in just the first six months of the year. By September 22, 2008, AIG was removedfrom the DJIA, replaced by Kraft Foods.
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The Crash of 2008 Begins

Although the market arguably started its crash back on October 1, 2008, the Black Weekbegan on October 6th and lasted five trading sessions. During that week, the Dow JoneIndustrial Average would fall 1,874 points or 18.1%. In that same week, the S&P 500would fall more than 20%.

After a brief uptick in mid-October, the market would begin a second decline later in thsame month. On October 24th, the Dow would fall 312.30 points to 8,378.95. This waits lowest level since April 25, 2003. The S&P 500 would fall 31.24 to 876.77, its lowelevel since April 11, 2003. Finally, the Nasdaq Composite would fall 51.88 points to1,552.03, its lowest level since May 23, 2003.

Stock Market Sell-Offs

Many market theorists believe that stock market crashes feed on themselves. Oncedestabilization of the stock market occurs, this incident may be followed by a series of events that trigger an even larger decline in the market. One of these events has to dowith investor fear, and the other has to do with stop losses.

Investor Fear and Market Losses

Investors may reach a "loss threshold" where they are unwilling to continue to riskadditional losses. Unfortunately, selling stocks well into a bear market is a good way tolock in losses, and this type of panic selling often backfires as an effective strategy tocombat such losses in a down market.

Stop Loss Orders

Investors can place stop loss orders in advance with brokers. These orders

programmatically sell a security when it reaches a certain price. The intention of a stoploss order is to limit the potential decline of a security's value. During the onset of amarket crash, stop loss orders can lead to a sell-off of stocks, and an even further declinin stock prices. As the market gets flooded with sell orders (from stop loss orders), theprices of the underlying stocks begin to drop rapidly as the supply of stocks overwhelmtheir demand.
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The impact of US sub prime crisis on Indian stock market

The impact of the US Subprime economic crisis has been significant and has been on thnegative side.

Foreign Institutional Investors or FII's in short had been heavy buyers in the Indian stocmarkets in the past few years. They too believed in the Great Indian Growth Story. Theyinvested in millions of dollars and bought out stocks of India's famous companies.

Once the subprime crisis started looming large on the US financial players and othercompanies they were stuck with bad debt. They were running short of cash which theyneeded badly to keep themselves alive. Companies like Lehmann which were unable to

raise enough capital had to declare bankruptcy.

When we need cash we usually sell out our assets in order to save ourselves. The USbased companies that had invested in the Indian stock markets did exactly the same. Thstarted selling off all their share holdings to make money out of it.

As you may already know, the stock markets work using a simple principle. More peopbuy -> The index goes up and the share prices go up. More people sell -> The index godown and the share prices go down.

Since almost all FII's opted to sell out their holdings simultaneously the prices of sharesof companies that were once considered invincible came down like a rocket that ran outof gas.

Almost all companies were being sold out in a frenzy. Seeing the FII's sell in thousandsthe Indian investors also joined the party and started selling their holdings.

Net Result: A Magnificent Disaster which has eroded the portfolio's of everyone whoinvested in the Indian Stock Markets...


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Lehman Brothers

Lehman Brothers Holdings Inc. (former NYSE ticker symbolLEH ) was a globalfinancial services firm. Before declaring bankruptcy in 2008, Lehman was the fourthlargest investment bank in the USA (behind Goldman Sachs, Morgan Stanley, andMerrill Lynch), doing business in investment banking, equity and fixed-income sales andtrading (especially U.S. Treasury securities), research, investment management, privateequity, and private banking.

On September 15, 2008, the firm filed for Chapter 11 bankruptcy protection followingthe massive exodus of most of its clients, drastic losses in its stock, and devaluation of assets by credit rating agencies. The filing marked the largest bankruptcy in U.S.history,[4] and is thought to have played a major role in the unfolding of the late-2000sglobal financial crisis. The following day, Barclays announced its agreement to purchase,subject to regulatory approval, Lehman's North American investment-banking andtrading divisions along with its New York headquarters building.[5][6] On September 20,2008, a revised version of that agreement was approved by US Bankruptcy Court JudgeJames M. Peck.[7] The next week, Nomura Holdings announced that it would acquireLehman Brothers' franchise in the Asia-Pacific region, including Japan, Hong Kong andAustralia,[8] as well as Lehman Brothers' investment banking and equities businesses inEurope and the Middle East. The deal became effective on October 13, 2008.[9]
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ghttp://en.wikipedia.org/wiki/Bond_%28finance%29http://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Merrill_Lynchhttp://en.wikipedia.org/wiki/Morgan_Stanleyhttp://en.wikipedia.org/wiki/Goldman_Sachshttp://en.wikipedia.org/wiki/Investment_bankhttp://en.wikipedia.org/wiki/Bankruptcy_of_Lehman_Brothershttp://en.wikipedia.org/wiki/Financial_serviceshttp://en.wikipedia.org/wiki/NYSE


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Bankruptcy of Lehman Brothers

Lehman Brothers filed for Chapter 11 bankruptcy protection on September 15, 2008. Thebankruptcy of Lehman Brothers remains the largest bankruptcy filing in U.S. history withLehman holding over $600 billion in assets

BackgroundMain article: Subprime mortgage crisis

Exposure to the mortgage market

Lehman borrowed significant amounts to fund its investing in the years leading to itsbankruptcy in 2008, a process known as leveraging or gearing. A significant portion of this investing was in housing-related assets, making it vulnerable to a downturn in thatmarket. One measure of this risk-taking was its leverage ratio, a measure of the ratio ofassets to owners equity, which increased from approximately 24:1 in 2003 to 31:1 by2007.[2] While generating tremendous profits during the boom, this vulnerable positionmeant that just a 3-4% decline in the value of its assets would entirely eliminate its boovalue or equity.[3] Investment banks such as Lehman were not subject to the sameregulations applied to depository banks to restrict their risk-taking.[4]

In August 2007, Lehman closed its subprime lender, BNC Mortgage, eliminating 1,200positions in 23 locations, and took a $25-million after-tax charge and a $27-millionreduction in goodwill. The firm said that poor market conditions in the mortgage space"necessitated a substantial reduction in its resources and capacity in the subprimespace".[5]

Lehman's final months

In 2008, Lehman faced an unprecedented loss due to the continuing subprime mortgagecrisis. Lehman's loss was apparently a result of having held on to large positions insubprime and other lower-rated mortgage tranches when securitizing the underlying

mortgages. Whether Lehman did this because it was simply unable to sell the lower-ratbonds, or made a conscious decision to hold them, is unclear. In any event, huge lossesaccrued in lower-rated mortgage-backed securities throughout 2008. In the second fiscaquarter, Lehman reported losses of $2.8 billion and was forced to sell off $6 billion inassets.[6] In the first half of 2008 alone, Lehman stock lost 73% of its value as the creditmarket continued to tighten.[6] In August 2008, Lehman reported that it intended torelease 6% of its work force, 1,500 people, just ahead of its third-quarter-reportingdeadline in September.[6]
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On August 22, 2008, shares in Lehman closed up 5% (16% for the week) on reports thathe state-controlled Korea Development Bank was considering buying Lehman.[7] Mostof those gains were quickly eroded as news emerged that Korea Development Bank wa"facing difficulties pleasing regulators and attracting partners for the deal."[8] Itculminated on September 9, 2008, when Lehman's shares plunged 45% to $7.79, after i

was reported that the state-run South Korean firm had put talks on hold.[9]

Investor confidence continued to erode as Lehman's stock lost roughly half its value andpushed the S&P 500 down 3.4% on September 9, 2008. The Dow Jones lost nearly 300points the same day on investors' concerns about the security of the bank.[10] The U.S.government did not announce any plans to assist with any possible financial crisis thatemerged at Lehman.[11]

On September 10, 2008, Lehman announced a loss of $3.9 billion and their intent to seloff a majority stake in their investment-management business, which includes NeubergerBerman.[12][13] The stock slid 7% that day.[13][14]

On September 13, 2008, Timothy F. Geithner, then president of the Federal ReserveBank of New York called a meeting on the future of Lehman, which included thepossibility of an emergency liquidation of its assets.

[15] Lehman reported that it had beenin talks with Bank of America and Barclays for the company's possible sale.[15] The New

York Times reported on September 14, 2008, that Barclays had ended its bid to purchaseall or part of Lehman and a deal to rescue the bank from liquidation collapsed.[16] Itemerged subsequently that a deal had been vetoed by the Bank of England and the UK'sFinancial Services Authority.[17] Leaders of major Wall Street banks continued to meetlate that day to prevent the bank's rapid failure.[16] Bank of America's rumoredinvolvement also appeared to end as federal regulators resisted its request for governmeinvolvement in Lehman's sale.[16]
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Bankruptcy filing

Lehman Brothers headquarters in New York City

Lehman Brothers filed for Chapter 11 bankruptcy protection on September 15, 2008.According to Bloomberg, reports filed with the U.S. Bankruptcy Court, Southern Districtof New York (Manhattan) on September 16 indicated that J.P. Morgan provided LehmanBrothers with a total of $138 billion in "Federal Reserve-backed advances." The cash-advances by JPMorgan Chase were repaid by the Federal Reserve Bank of New York for$87 billion on September 15 and $51 billion on September 16.[18

Breakup process

On September 22, 2008, a revised proposal to sell the brokerage part of Lehman Brotheholdings of the deal, was put before the bankruptcy court, with a $1.3666 billion (700million) plan for Barclays to acquire the core business of Lehman Brothers (mainlyLehman's $960 million Midtown Manhattan office skyscraper), was approved. Manhattan court bankruptcy Judge James Peck, after a 7 hour hearing, ruled: "I have to approve this
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transaction because it is the only available transaction. Lehman Brothers became avictim, in effect the only true icon to fall in a tsunami that has befallen the credit marke

This is the most momentous bankruptcy hearing I've ever sat through. It can never bedeemed precedent for future cases. It's hard for me to imagine a similar emergency."[19]

Barclays acquired the investment banking business of Lehman Brothers in September 2008

Luc Despins, the creditors committee counsel, said: "The reason we're not objecting isreally based on the lack of a viable alternative. We did not support the transactionbecause there had not been enough time to properly review it."[citation needed ] In theamended agreement, Barclays would absorb $ 47.4 billion in securities and assume $ 4

billion in trading liabilities. Lehman's attorney Harvey R. Miller of Weil, Gotshal &Manges, said "the purchase price for the real estate components of the deal would be $1.29 billion, including $960 million for Lehman's New York headquarters and $ 330million for two New Jersey data centers. Lehman's original estimate valued itsheadquarters at $ 1.02 billion but an appraisal from CB Richard Ellis this week valued iat $900 million."[citation needed ] Further, Barclays will not acquire Lehman's Eagle Energyunit, but will have entities known as Lehman Brothers Canada Inc, Lehman BrothersSudamerica, Lehman Brothers Uruguay and its Private Investment Management businefor high net-worth individuals. Finally, Lehman will retain $20 billion of securities assein Lehman Brothers Inc that are not being transferred to Barclays.[20] Barclays had apotential liability of $ 2.5 billion to be paid as severance, if it chooses not to retain some

Lehman employees beyond the guaranteed 90 days.[21][22]

On September 22, 2008, Nomura Holdings, Inc. announced it agreed to acquire LehmanBrothers' franchise in the Asia Pacific region including Japan, Hong Kong andAustralia.[23] The following day, Nomura announced its intentions to acquire LehmanBrothers' investment banking and equities businesses in Europe and the Middle East. Afew weeks later it was announced that conditions to the deal had been met, and the dealbecame legally effective on Monday, 13 October.[24] In 2007, non-US subsidiaries of Lehman Brothers were responsible for over 50% of global revenue produced.[25]
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Impact of bankruptcy filing

The Dow Jones closeddown just over 500 points (4.4%) on September 15, 2008, at thetime the largest drop by points in a single day since the days following the attacks onSeptember 11, 2001.[26] (This drop was subsequently exceeded by an even larger 7.0%plunge on September 29, 2008.)

Lehman's bankruptcy is expected to cause some depreciation in the price of commerciareal estate. The prospect for Lehman's $4.3 billion in mortgage securities gettingliquidated sparked a selloff in the commercial mortgage-backed securities (CMBS)market. Additional pressure to sell securities in commercial real estate is feared asLehman gets closer to liquidating its assets. Apartment-building investors are alsoexpected to feel pressure to sell as Lehman unloads its debt and equity pieces of the $22billion purchase of Archstone, the third-largest United States Real Estate InvestmentTrust (REIT). Archstone's core business is the ownership and management of residentiaapartment buildings in major metropolitan areas of the United States. Jeffrey Spector, areal-estate analyst at UBS said that in markets with apartment buildings that competewith Archstone, "there is no question that if you need to sell assets, you will try to getahead" of the Lehman selloff, adding "Every day that goes by there will be more pressuon pricing."[27]

Several money funds and institutional cash funds had significant exposure to Lehmanwith the institutional cash fund run by The Bank of New York Mellon and the PrimaryReserve Fund, a money-market fund, both falling below $1 per share, called"breakingthe buck", following losses on their holdings of Lehman assets. In a statement The Bankof New York Mellon said its fund had isolated the Lehman assets in a separate structureIt said the assets accounted for 1.13% of its fund. The drop in the Primary Reserve Fundwas the first time since 1994 that a money-market fund had dropped below the $1-per-share level.

Putnam Investments, a unit of Canada's Great-West Lifeco, shut a $12.3 billion money-market fund as it faced "significant redemption pressure" on September 17, 2008.Evergreen Investments said its parent Wachovia Corporation would "support" threeEvergreen money-market funds to prevent their shares from falling.[28] This move tocover $494 million of Lehman assets in the funds also raised fears about Wachovia'sability to raise capital.[29]
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Close to 100 hedge funds used Lehman as their prime broker and relied largely on thefirm for financing. In an attempt to meet their own credit needs, Lehman BrothersInternational routinely re-hypothecated[30] the assets of their hedge funds clients thatutilized their prime brokerage services. Lehman Brothers International held close to 40billion dollars of clients assets when it filed for Chapter 11 Bankruptcy. Of this, 22

billion had been re-hypothecated.[31]

As administrators took charge of the London business and the U.S. holding company filed for bankruptcy, positions held by thosehedge funds at Lehman were frozen. As a result the hedge funds are being forced to de-lever and sit on large cash balances inhibiting chances at further growth.[32] This in turncreated further market dislocation and over all systemic risk, resulting in a 737 billiondollar decline in collateral outstanding in the securities lending market.[33]

In Japan, banks and insurers announced a combined 249 billion yen ($2.4 billion) inpotential losses tied to the collapse of Lehman. Mizuho Trust & Banking Co. cut its profit

forecast by more than half, citing 11.8 billion yen in losses on bonds and loans linked toLehman. The Bank of Japan Governor Masaaki Shirakawa said "Most lending to LehmanBrothers was made by major Japanese banks, and their possible losses seem to be withithe levels that can be covered by their profits," adding "There is no concern that the lateevents will threaten the stability of Japan's financial system."[34] During bankruptcyproceedings a lawyer from The Royal Bank of Scotland Group said the company isfacing between $1.5 billion and $1.8 billion in claims against Lehman partially based oan unsecured guarantee from Lehman and connected to trading losses with Lehmansubsidiaries, Martin Bienenstock.[35]

Lehman was a counterparty to mortgage financier Freddie Mac in unsecured lendingtransactions that matured on September 15, 2008. Freddie said it had not receivedprincipal payments of $1.2 billion plus accrued interest. Freddie said it had furtherpotential exposure to Lehman of about $400 million related to the servicing of single-family home loans, including repurchasing obligations. Freddie also said it "does notknow whether and to what extent it will sustain a loss relating to the transactions" andwarned that "actual losses could materially exceed current estimates." Freddie was still the process of evaluating its exposure to Lehman and its affiliates under other businessrelationships.[36]

After Constellation Energy was reported to have exposure to Lehman, its stock wentdown 56% in the first day of trading having started at $67.87. The massive drop in stocled to the New York Stock Exchange halting trade of Constellation. The next day, as thestock plummeted as low as $13 per share, Constellation announced it was hiring Morgan
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Stanley and UBS to advise it on "strategic alternatives" suggesting a buyout. Whilerumors suggested French power company lectricit de France would buy the companyor increase its stake, Constellation ultimately agreed to a buyout by MidAmericanEnergy, part of Berkshire Hathaway (headed by billionaire Warren Buffett).[37][38][39]

The Federal Agricultural Mortgage Corporation or Farmer Mac said it would have towrite off $48 million in Lehman debt it owned as a result of the bankruptcy. Farmer Masaid it may not be in compliance with its minimum capital requirements at the end of September.[40]

In Hong Kong more than 43,700 individuals in the city have invested in HK$15.7 billionof "guaranteed mini-bonds" ( ) from Lehman.[41][42][43] Many claim that banks

and brokers mis-sold them as low-risk. Conversely, bankers note that minibonds areindeed low-risk instruments since they were backed by Lehman Brothers, which until jumonths before its collapse was a venerable member of Wall Street with high credit andinvestment ratings. The default of Lehman Brothers was a low probability event, whichwas totally unexpected. Indeed, many banks accepted minibonds as collateral for loansand credit facilities. Another HK$3 billion has been invested in similar like derivatives.The Hong Kong government proposed a plan to buy back the investments at their currentestimated value, which will allow investors to partially recover some of their loss by thend of the year.[44] HK chief executive Donald Tsang insisted the local banks respondswiftly to the government buy-back proposal as the Monetary Authority received morethan 16,000 complaints.[41][43][44] On October 17 He Guangbe, chairman of the Hong

Kong Association of Banks, agreed to buy back the bonds, which will be priced using anagreed upon methodology based on its estimated current value.[45] This episode has deeprepercussions on the banking industry, where misguided investor sentiments havebecome hostile to both wealth management products as well as the banking industry as whole. Under intense pressure from the public, all political parties have come out insupport of the investors, further fanning distrust towards the banking industry.
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Roll No.13 2008 Crisis Secondary Market