Table of Contents

Sr. no. Particulars Pg. no.1 Executive Summary 5

2 Introduction 6

3 What is Mortgage? 7

4 Types of Mortgages 8

5 Prime v/s Sub-Prime Mortgage 12

6 Characteristics of a Sub-Prime Loan 14

7 Why did Banks / FI’s lend to Sub-Prime Borrowers? 15

8 Why Crisis? 16

9 How did Subprime Crisis Spread? 18

Mortgage Backed Securities (MBS)

Collateral Debt Obligation (CDO)

Credit Default Swap (CDS)

10 Domino – effect 22

11 Spill – Over effect of sub-prime crisis 24

12 The Participants of the Crisis 25

13 Great Depression 30

14 Great Depression v/s Sub-Prime Crisis 35

15 Impact on World Economy 39

16 Effect on US Economy 41

17 Impact on Indian Economy 45

18 Learning’s from the crisis 48

19 Conclusion 51

20Write-downs on the value of loans, MBS and CDOs due to the subprime mortgage crisis 53

21 Bibliography 56

1

Executive Summary

It is important to understand how the sub-prime problem is causing a great concern to the

global financial markets. The effect of this sub-prime crisis has a spill-over effect not only on

different sectors of US economy but also on other economies round the globe. A Domino Effect

is clearly visible, i.e. happening of a linear sequence of events which is in turn affecting almost

all the sectors. In other words, a change is affecting another change which further affects the

change and this process goes on. For example, the effect of loan default has an effect on

mortgage finance companies, which would lead to erosion in value of their products like CDOs

which would have an impact on Investment companies and underwriters. Likewise, dwindling

property value would affect retailers and consumer companies, increased mortgage insurance

claims will affect Insurance companies. Also slack in home construction would affect

construction companies, furniture, pipes, electricity equipment manufacturers etc.

Thus we see a domino effect happening above. Also as said before that the crisis has not only

spilled to various sectors but also to other economies.

Of late, there is an optimistic belief that the world has weaned from the affect of crisis on US

i.e. there is a global decoupling from the US economy. But it is too optimistic a belief in this era

of globalization that any economy can be decoupled from an economy like US, which boasts of

a considerable consumption growth. Although, we can say that the Asian economies like India

would not be affected to that extent, but it would be incorrect to say that there is outright

decoupling.

This subprime crisis has taught some lessons to the world. The need for sound banking

practices, controlled derivative markets, issues regarding securitization by investment finance

companies, etc. The failure of regulatory entities to anticipate the impact of the crisis is also a

major learning for the world and specially India.

2

Introduction

Uncertainty enveloped the capital markets around the globe due to the sub-prime problems

affecting America’s banking industry. There was a gloomy forecast that the US sub-prime

mortgage crisis might convert into recession that could be as great as the Great Depression of

1930's that lasted over a decade. The sub-prime crisis that started in 2004 - 2005 is extended to

the current economic cycle the world over.

In US, homeowners select a mortgage lender who gives the loan after inquiring the borrower's

creditworthiness and the property that serves as collateral. The lenders resell these loans to

Special Purpose Vehicles (SPV’s) or Wall Street firms, who in turn bundle thousands of

mortgage loans from different lenders into mortgage backed securities. These securities are

often sliced and diced into different structures like Collateralized Debt Obligations (CDO), rated

by rating agencies like Moody's, S&P, Fitch etc. and are finally sold to institutional investors

worldwide- mutual funds, banks, hedge funds, central banks and pension funds.

These mortgages do not create any problem for lenders until the mortgagers fulfill their

commitments in time. But with rising payment obligations, sub-prime mortgagers ran for

foreclosures.

3

What is Mortgage?

A mortgage is a transfer of an interest in land (or the equivalent) from the owner to the

mortgage lender, on the condition that this interest will be returned to the owner when the

terms of the mortgage have been satisfied or performed.

In other words, the mortgage is a security for the loan that the lender makes to the borrower.

In the above figure, the Financial Institutions (FI’s) / Banks lends loan proceeds to the home

borrower by accepting Realty papers as collateral [protection against default in payment of

principal + interest (EMI) by the borrower].This process is termed as a mortgage loan.

Now, if the borrower defaults on the payment, the lender has the right to realize the loan

proceeds by selling the house in the market.

4

Types of Mortgages

1) Fixed Rate Mortgage

2) The Adjustable Rate Mortgage (ARM)

3) Interest Only Mortgage

4) Biweekly Mortgage

5) Two Step Mortgage

6) Federal Housing Authority (FHA) Mortgage

7) Veterans Affairs Loan

Fixed Rate Mortgage

This is the most common type of residential home loan. The mortgage loan is repaid through

fixed monthly payments of principal and interest over a set term. The borrowing rate stays the

same over the life of the residential mortgage loan. The term of the home mortgage can be 10,

15, 20 or the popular 30 year fixed rate mortgage term. The way fixed mortgage loans are

structured, the mortgage interest is front loaded. In the first years of the residential loan, the

bulk of the monthly payments go to paying mortgage interest. It’s only later that you will start

significantly building equity in your home as more of your mortgage payments go towards

paying down the mortgage loan principal. A fixed rate mortgage is ideal for those who intend to

stay in their properties for a long time.

The Adjustable Rate Mortgage (ARM)The adjustable rate mortgage is usually referred to as an ARM. An arm adjustable rate

mortgage is a combination of a fixed rate mortgage and a floating rate mortgage. At the

beginning of the mortgage term, the mortgage rate is fixed for certain periods. These periods

5

could be for 2, 3, 5, 7 or 10 years. After this period expires, the mortgage interest rate becomes

adjustable.

Let understand it with the help of an illustration:

Illustration:

Mr. X is a mortgage borrower and has taken a Adjustable Rate Mortgage (2/28) loan of $100000

at an interest rate of 5% p.a for the 1st 2 years and then the interest rate begins to float for the

remaining 28 years.

The rates are generally determined by Treasury Bill Rates, The Prime Rate, Libor etc.

Interest Only MortgageIn interest only home mortgage the monthly payments consist of mortgage interest only, it

features no payments of principal at the beginning of the home loan. Due to the lower monthly

mortgage payments, you qualify for a bigger residential loan.

The interest only payments do not go on for the whole term of the home loan mortgage.

Interest only mortgage payments periods range from 1 year up to half the term of the

mortgage loan. These are available in adjustable rate mortgage format and fixed mortgage

format.

After the interest only payment is over, you will begin making payments on your mortgage

principal. Your monthly mortgage payment will go up considerably during the 2nd half of your

loan duration.

6

Biweekly MortgageMortgage payments are made every two weeks. The amount paid is half of what your monthly

mortgage payment would be. On an annualized basis, there are two extra payments in a year.

You will be making 26 biweekly mortgage payments instead of 24 payments.

A bi weekly mortgage program has you paying down your principal mortgage earlier. As a

result, you’ll save significant amounts in mortgage interest and pay off your home mortgage

years earlier.

Two Step MortgagesA two step mortgage is essentially a 30 year mortgage with special features: Convertible or non-

convertible. These mortgage loans are also known as 5/25s and 7/23s. The 5/25s has a fixed

interest rate for the first five years and then switches to either a 25 year fixed mortgage rate or

adjustable mortgage rate. The 7/23 has a fixed interest rate for the first seven years and then

converts to a 23 year fixed or adjustable. The starting home loan rate is lower than a 30-year

fixed rate but is higher than ARM mortgage.

Federal Housing Authority (FHA) MortgageA FHA mortgage is a residential loan insured by the FHA that is part of the U.S. Department of

Housing and Urban Development (HUD). FHA loans have lower mortgage down payment

requirements and were easier to qualify for than conventional loans (mentioned above). The

goal of the FHA is to make housing affordable and stimulate demand.

The best feature of an FHA loan is the low down payment. The down payment mortgage can be

as low as 2% but you will be required to pay private mortgage insurance (PMI).

7

Veterans Affairs LoanThe U.S. Department of Veterans Affairs guarantees mortgage loans for veterans and service

persons. It does not underwrite the residential loans. The guaranty allows veterans to get home

mortgage loans with good borrowing terms, usually with little or no down payment.

To be eligible for the VA loan, you must have served 180 active days service since September

1940. If you enlisted after September 7, 1980 you need to have two years of service. You do

need to get a certificate of eligibility from the Department of Veterans affairs as proof of

service.

8

Prime v/s Sub-Prime Mortgage

In simple terms, when a loan is granted to an individual with High Credit Rating, it is termed as

Prime Mortgage and on the other hand if it is granted to an individual with not so sound Credit

Rating it is termed as Sub-Prime Mortgage.

Sub-prime mortgage (also known as B-paper, near-prime, or second chance lending) refers to

the lending by the banks and other financial institutions to borrowers with poor or no credit

history or variable income flows. Borrowers with the higher-than-average risk profile because

of low creditworthiness are charged a higher interest rate for loans. These loans are considered

sub-prime.

9

Let us also understand another aspect of Sub-Prime Loan:

When a Financial Institution/Bank lends loan to a money lender with high credit rating who in

turn lends the same amount to an individual with low credit rating but at a higher rate of

interest, such loans are also know as Sub-Prime Loan.

In short, the money lender in this case acts as an intermediate between the FI’s / Banks and the

individuals with Low Credit Rating (who do not have easy access to loans) with a view to earn

on the difference in the interest rate that he pays to the FI/Bank and the rate that he charges to

sub-prime borrower.

10

Characteristics of a Sub-Prime Loan

Sub-Prime borrower usually is an individual with:

Limited Income.

Having FICO Credit Scores below 640 on a scale that ranges from 300 to 850.

Weak Credit History and therefore higher probability of defaulting on the payment (principal or interest or both).

Minimum documents and at times No Documents.

11

Why did Banks / FI’s lend to Sub-Prime Borrowers?

The Banks/FI’s speculated that the Realty Rates would go up and then even if the borrowers

default on the payment (principal + interest), they would realize the realty in the market and

recover much more than what was lent.

Now, due to special features and Long term speculation of realty rates increasing the home

ownership rate appreciably increased in 2005

Moreover, Mortgage Brokers are paid for writing loans, and aren't docked if those loans fail.

12

Why Crisis?

Housing prices began spiraling upwards in the US since 2000-01 and continued through mid-

2006, with the borrowing and lending rates extremely low the demand for and supply of new

and existing houses boosted.

Many institutions offered home loans to borrowers with poor or no credit histories by requiring

higher than normal repayment levels — creating what is referred to as “sub-prime mortgages”

—attracting investment banks and hedge fund owners to bet big on this emerging aspect of the

US economy.

The countdown began on June 30, 2004, when the Federal Reserve (the central bank in the US)

began a cycle of interest rate hikes that raised the cost of borrowing from the lowest levels

registered since the 1950s.

It increased the interest rates seventeen times and paused only in June 2006 when the

borrowing cost touched 5.25 per cent.

The US housing market began sliding in August 2005 and that continued through 2006 resulting

into tumbled Building rates and housing prices (against the speculation of the Banks/FI’s).

Approximately 80% of U.S. mortgages issued to

Subprime borrowers were Adjustable Rate Mortgages

(ARM). When U.S. house prices began to decline in

2006-07, refinancing became more difficult and as

Adjustable Rate Mortgages began to reset at higher rates which lead to several sub-prime

mortgage holders defaulting on their loans. The below chart displays the same:

13

14

How did Subprime Crisis Spread?

Mortgage Backed Securities (MBS)

Collateral Debt Obligation (CDO)

Credit Default Swap (CDS)

It is important to note that the crisis not only hit the lenders but also spread far and wide.

This is due to the fact that the lenders further bundled and sold these mortgages to other

institutions (Special Purpose Vehicles). Now these institutions sliced these mortgages into the

securities that are backed by collateral and the collateral here being these mortgages held by

sub-prime borrowers. These Mortgage Backed Securities (MBS) were rated by rating

institutions such as Standard & Poor and Moody’s. That’s where these agencies came into

15

picture. Now further after getting the ratings these securities were further divided and sold as

Collateral Debt Obligations (CDOs) to various investors.

An example of this effect surfaced when Bear Stearns hedge fund borrowed money from Merrill

Lynch and gave their Collateral Debt Obligations (CDOs) as collateral. Now when Merrill Lynch

wanted to sell the collateral, it couldn’t, because price started to fell, owing to fall in demand.

The market for the CDOs collapsed and because of this the banks holding these CDOs suffered

badly and this is the reason for the volatility which was seen in the global stock markets.

Various Investment houses suffered heavy losses due to the sub-prime mortgage crisis.

The below diagram securatisation* process :

16

The sequence of events is:

1. The originator lends money on mortgages.

2. Mortgages are selected to go into a pool whose cash flows (EMI’s)are to be securitised

and are sold to the Special Purpose Vehicles (SPV’s). These are termed as Mortgage

Backed Securities (MBS)

3. The Credit Rating Agencies gives ratings to these pool.

4. The pool thus framed is sold in the form of CDO to various investors (Banks, Hedge

Funds, Insurance Companies, Pension Funds etc).

5. The amount thus realized is then transferred to the originator by the SPV’s after

deducting a fee.

6. The cash flows (EMI’s) realised from the borrowers then go to the holders of the

securities (in the form of Coupons)

17

Credit Default Swap

The Banks then further issued Credit Default Swap (CDS) ** to other Banks, which further

added to the spread of crisis.

In the above figure, ABC Banks Sells its risk on the Bond/Loan issued by the SPV’s to the Big

Bank on payment of the premium, Big Bank hedges its risk by entering into a CDS Contract

(opposite direction i.e. sells risk) with XYZ Bank on payment of a premium.

18

Domino – effect

Due to increase in Interest rates the sub-prime borrowers defaulted on the payment of EMI’s

which further obstructed the payment of the coupons to the investors (Banks, Hedge Funds,

Insurance Companies, Pension Funds etc). Due to this the Seller of Risk of the CDS Contract was

liable to pay the nominal to its counterparty; many Banks like Citigroup, Merill Lynch etc who

hadn’t hedged their position were exposed to the risk as were liable to a lot of counterparties

which further lead to write-offs.

Moreover, since these were Over the Counter (OTC) products, there was a lack of direct

regulation.

This was a domino effect of subprime lending on investors. Which lead to tremendous write

downs as follows:

19

* Securitization is a structured finance process that involves pooling and repackaging of cash-

flow-producing financial assets into securities, which are then sold to investors.

Source: www.wikipedia.org

** Credit Default Swap (CDS): A swap designed to transfer the credit exposure of fixed income

products between parties. The buyer of a credit swap receives credit protection, whereas the

seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of

default is transferred from the holder of the fixed income security to the seller of the swap.

For example, the buyer of a credit swap will be entitled to the par value of the bond by the

seller of the swap, should the bond default in its coupon payments.

Source: www.investopedia.org

Buyer of Risk: Obliged to pay premium; Right to receive the nominal in case of credit event.

Seller of Risk: Obliged to pay the nominal in case of a credit event; Right to receive premium.

20

Spill – Over effect of sub-prime crisis

A chain reaction of adverse events, in the financial markets has put a squeeze on lenders and

made it harder for businesses and consumers to get loans thereafter. The residential

foreclosure crisis has ultimately caused what is known as a credit crunch.

In the credit crunch, Banks/FI’s became risk averse and stopped lending and started hoarding

cash because they are afraid of rising bankruptcies and mortgage defaults. It leads them to

charge higher interest rates or reject all but the safest loans.

For an economy that has been fueled by easy access to borrowed money, tighten credit could

spell trouble for companies that need loans to pursue their business plans and for consumers

who want to buy big-ticket items.

Normally, banks fear that individuals and business borrowers won't be able to repay them on

time. Now, banks are even afraid to loan to each other because no single bank knows what the

other's exposure to the credit crunch really is.

21

The Participants of the Crisis

Lenders: The Biggest Culprits

The main culprits responsible for the crisis were the lenders or the originators who lent funds to

people with poor creditworthiness and high risk of default.

In a period of excess capital liquidity supplied by the central bank, which not only lowered

interest rates, but also broadly depressed risk premiums as investors sought riskier

opportunities to bolster their investment returns lenders found themselves with ample capital

to lend and, like investors, an increased willingness to undertake additional risk to increase

their investment returns.

In that period Lenders saw subprime mortgages as a lesser risk then it actually was, this can be

attributed to the fact that the economy was healthy, interest rates low, and people were

making their payments. Also, there was an increased demand for mortgages and cost of houses

was increasing.

The figure below shows the growth in subprime mortgage orientations on a 13 year horizon.

Post the September 11, 2001 attacks subprime mortgage originations grew from $213 billion in

2002 to a record level of $640 billion in 2006, which represented an increase of nearly 200%.

22

Homeowners

Consumer (borrowers) have been criticised for overstating their incomes on loan applications,

which did not require verification and entering into loan agreements they could not meet or did

not understand, or were motivated by greed. The unrealistic growth in the US home prices in

the early 2000’s made homeowners believe that the prices will continue to grow and make

future refinance and second mortgages quite profitable and eased lending standards allowed

them to buy more expensive homes than they could afford. Besides, they entered into riskier

loan agreements like the ARM – Adjustable Rate Mortgage without understanding them clearly

and even provided untrue information about their stated income in the loan applications.

Investment Banks

The increased use of the secondary mortgage market by lenders added to the number of sub-

prime loans lenders could originate. Instead of holding the originated mortgages on their

books, lenders were able to simply sell off the mortgages in the secondary market and collect

23

the originating fees. This freed up more capital for even more lending, which increased liquidity

even more.

A lot of the demand for these mortgages came from the creation of assets that pooled

mortgages together into a security, such as a collateralized debt obligation (CDO). In this

process, investment banks would buy the mortgages from lenders and securitize these

mortgages into bonds, which were sold to investors through CDOs.

The chart below demonstrates the incredible increase in global CDOs issues in 2006.

Government and Regulators

Some observers claim that government policy actually encouraged the development of the

subprime disaster through legislation like the Community Reinvestment Act* **, which they

say forces banks to lend to otherwise non-creditworthy consumers. In response to a concern

that lending was not properly regulated, the House and Senate are now considering bills to

regulate lending practices.

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***The Community Reinvestment Act - is intended to encourage depository institutions to

help meet the credit needs of the communities in which they operate, including low- and

moderate-income neighborhoods, consistent with safe and sound banking operations.

Credit Rating Agencies

Rating agencies gave higher grades to Mortgage Backed Securities (MBS) without foreseeing

the possibility of high default by the borrowers. The bonds were rated AAA which are normally

given to high quality tranches.

Also there was a lot of competition between the rating agencies which further fueled the issue.

Moreover, underwriting was done through automation which clearly showed lack of

underwriting standards in the US.

Investor Behavior

Just as the homeowners are to blame for their purchases gone wrong, much of the blame also

must be placed on those who invested in CDOs. Investors were the ones willing to purchase

these CDOs at ridiculously low premiums over Treasury bonds. These enticingly low rates are

what ultimately led to such huge demand for subprime loans.

Much of the blame here lies with investors because, finally it is up to individuals to perform due

diligence on their investments and make appropriate expectations. Investors failed in this by

taking the 'AAA' CDO ratings at face value, thereby adding fuel to the fire.

25

Hedge Funds

The Hedge Fund Industry aggravated the problem not only by pushing rates lower, but also by

fueling the market volatility that caused investor losses. To illustrate, there is a type of hedge

fund strategy that can be best described as "credit arbitrage".

The credit arbitrage strategy is designed to create a long credit spread position while retaining

neutrality to interest rate and equity risks. It is designed to capture value from over/under

priced credit risk inherent in the convertible bonds.

This amplified demand for CDOs; by using leverage, a fund could purchase a lot more CDOs and

bonds than it could with existing capital alone, pushing subprime interest rates lower and

further fueling the problem. Moreover, because leverage was involved, this set the stage for a

spike in volatility, which is exactly what happened as soon as investors realized the true, lesser

quality of subprime CDOs. Because hedge funds use a significant amount of leverage, losses

were amplified and many hedge funds shut down operations as they ran out of money in the

face of margin calls.

26

Great Depression

The Great Depression was an economic slump in North America, Europe, and other

industrialized areas of the world that began in 1929 and lasted until about 1939. It was the

longest and most severe depression ever experienced by the industrialized Western world.

The major factors that lead to the great depression:

Stock Market crash

Bank Failure

Farmers Lost Crops

Dust Bowls (Dust Storms) on southern plains

Unequal distribution of wealth

Stock Market Crash

Though the U.S. economy had gone into depression six months earlier, the Great Depression

may be said to have begun with a catastrophic collapse of stock-market prices on the New York

Stock Exchange in October 1929. During the next three years stock prices in the United States

continued to fall, until by late 1932 they had dropped to only about 20 percent of their value in

1929. Besides ruining many thousands of individual investors, this precipitous decline in the

value of assets greatly strained banks and other financial institutions, particularly those holding

stocks in their portfolios.

Stock Prices/holding Rise through the 1920s:

• Through most of the 1920s, stock prices rose steadily.

• The Dow reached a high in 1929 of 381 points (300 points higher than 1924).

• By 1929, 4 million Americans owned stocks.

27

Seeds of Trouble:

• Speculation : Too many Americans were engaged in speculation – buying stocks & bonds

hoping for a quick profit.

• Margin : Americans were buying “on margin” – paying a small percentage of a stock’s

price as a down payment and borrowing the rest, which lead to huge debts.

• The 1929 Crash : In September, 1929 the Stock Market had some unusual up & down

movements. On October 24, the market took a plunge stating that the worst was yet to

come. On October 29, now known as Black Tuesday, the bottom fell out. 16.4 million

shares were sold that day which lead to plummeted prices. People who had bought on

margin (credit) were stuck with huge debts.

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Bank Failure

Many banks were consequently forced into insolvency; In 1929 – 600 Banks had failed; by

1933 - 11,000 out of 25,000 United States banks had failed. As:

• After the stock market crash, many Americans panicked and withdrew their money from

banks.

• Banks had invested in the Stock Market and lost money.

Farmers Lost Crops

As the 1920s advanced, serious problems threatened the economy while Important industries

struggled, including:

• Agriculture

• Railroads

• Textiles

• Steel

• Mining

• Lumber

• Automobiles

• Housing

• Consumer goods

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No industry suffered as much as agriculture, during World War I European demand for

American crops soared, after the war demand plummeted and thus farmers increased

production sending prices further downward.

Dust Bowls (Dust Storms) on southern plains - 1930

"Dust Bowl" was a term born in the hard times from the people who lived in the drought-

stricken region during the great depression.

The decade of 1930s was full of extremes: blizzards, tornadoes, floods, droughts, and dirt

storms.

In 1934 to 1936, three record drought years were marked for the nation. In 1936, a more

severe storm spread out of the plains and across most of the nation. The drought years were

accompanied with record breaking heavy rains, blizzards, tornadoes and floods. In September

1930, it rained over five inches in a very short time in the Oklahoma Panhandle. The flooding in

Cimarron County was accompanied by a dirt storm which damaged several small buildings and

greeneries. Later that year, the regions were whipped again by a strong dirt storm from the

southwest until the winds gave way to a blizzard from the north.

Dust Bowl lead to:

Devastation of the cropland

Respiratory health issues

Unsanitary living

Rampant crime

Debt-ridden families

Unequal distribution of wealth30

During the decade there was unequal distribution of wealth as supply wasn’t equal to demand.

As a result there was no middle class. Moreover credit cards created false demand. This further

triggered the great depression.

Effects of Great Depression:

• Real output (GDP) fell 29% from 1929 to 1933.

• Unemployment increased to 25% of labor force.

• Consumer prices fell by 25%; wholesale prices by 32%.

• Suicide rate rose more than 30% between 1928 -1932.

• Alcoholism rose sharply in urban areas.

• It brought hardship, homelessness and hunger to millions.

• Three times as many people were admitted to state mental hospitals as in normal times.

• Additionally, many people developed habits of savings & thriftiness,

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Great Depression v/s Sub-Prime Crisis

Though Sub-Prime Crisis holds similarities with Great Depression of 1929-39, but outshined by

certain differences, let us throw some lights on the same:

1929-39 was a period when universal banks were bifurcated into separate commercial

and investment banks, which led to ascension of big giants like Goldman Sachs, Morgan

Stanley and more. However current global turmoil has taken a reverse gear where many

of these investment banks are again turned into large commercial banks.

In 1930, Hawley Smoot act came along in decade of restrictive tariffs and international

disharmony. However sub-prime crisis is characterized by prominent degree of free

trade and global cooperation.

The era of 1929-39 was the one saw the absence of shock absorbers like such as social

security and deposit insurance which could safeguard people from economic crisis; the

same is not the case during sub-prime bubble.

Apart from this, the policies of Federal Reserve differ in both the periods. 1930’s policy

was “downturn as a force for good”; decrease liquidity in labor, stocks, farmers, so that

people will work harder and live more moral lives. However in today’s crisis Federal

Reserve is making full efforts to increase liquidity in stocks, to farmers and real estate.

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Dow Jones Crash Analysis

 

Left X Axis - Dow's price during the early part of the 20th century.

Right X Axis - Dow's price in modern times.

Data - Closing price of the Dow on November 11 of each year.

Inference:

As you can see by looking at the blue and pink lines, before both crashes there was a

sharp run-up in the value of the Dow. But the data shows that the pre-crash bubble is

much bigger now than it was prior to the Great Depression. While the Dow increased

about 2.5X during the period 21 years before the crash of 1929-1930, it increased over

6X from 1988 to 2008.

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In 1929, with Black Friday, the Dow began to deflate and it hit a bottom in 1932. By that

point, the Dow was down almost 75% from its peak a few years earlier. Today, the Dow

has fallen about 42% from its high of 13,850.

US Unemployment Rate:

Great Depression Sub-Prime Crisis

1929 3.2 2006 4.7

1930 8.7 2007 4.4

1931 15.9 2008 5.1

1932 23.6 2009 8.5

1933 24.9

1934 21.7

1935 20.1

1936 16.9

1937 14.3

1938 19

It is easily noticeable from the above figures that the employment during the great

depression was highly affected as compared to sub-prime period.

It’s true that current sub-prime crisis are nowhere in comparison to great depression, but still

there’s a need to put a full stop over these ongoing crisis, which is hard-hitting the nations

worldwide. The another difference which can be drawn over these two crisis is that in present

day there is president Barack Obama who promises to solve the crisis . The methods which he

plans to initiate are to follow policy of creation of jobs and more spending by American people.

Apart from this there have been bailout packages already becoming the breaking news.

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Therefore it can be said, roots of sub-prime crisis are similar to the great depression 1929-39

but the nature is totally different.

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Impact on World Economy

GLOBAL MARKETS16TH

JULY(BEFORE)

17TH

AUGUST(AFTER)CHANGE % FALL

DOW JONES 13950.98 13079.08 -871.9 6.249

NASDAQ 2697.34 2505.03 -192.31 7.129

BSE SENSEX 15311.22 14141.52 -1169.7 7.639

HANG SENG 22953.94 20387.13 -2566.81 11.182

KOSPI COMPOSITE 1949.51 1191.55 -757.96 38.879

NIKKIE 225 18217.27 15273.68 -2943.59 16.158

TAIWAN WEIGHTED

INDEX9417.32 8090.29 -1327.03 14.091

SHANGHAI INDEX 3896.19 4656.57 760.38 19.515

FTSE 100 6697.7 6064.2 -633.5 9.458

DAX(GERMANY) 8105.69 7387.29 -718.4 8.862

CAC 40 (FRANCE) 6125.6 5363.63 -761.97 12.439

IBOVESPA(BRAZIL) 57374 48558.76 -8815.24 15.364

SOURCE-BUSINESS TODAY 9YH SEPTEMBER 2007(PAGE 104)

The impact of sub-prime crisis is not limited to the U.S. economy only but also on world

economy. Impact has been so strong that the yield on 10 year treasury bill fell to 4.52% on 28 th

36

august , stock markets fell sharply , Consumption growth has declined in US , that is because of

less disposable income .The term commonly referred to as ‘housing bubble’ posing as a great

threat. The consumer (home loan borrower) spending has reduced to a great extent by the fear

of defaults. Housing market is in the worst shape. House prices have kept falling (backlog of

unsold houses rose to 16 year high). Construction bust (of new houses) will surely bring down

the US output growth.

37

Effect on US Economy

With the country facing its worst crisis in recent years, top US bankers and officials are still

unsure about the final outcome of the crisis which is still not in sight and this can very well

continue in the next year as well. Subprime crisis has already shown its effects on the US

economy which is under the threat of going into recession. The effect of the crisis has rippled

through almost all the sectors/segments of the economy with housing and financial markets

being the worst hit.

GDP Growth

United States, the world’s largest economy grew at about 2.9 % in the 3rd quarter but since then

its growth forecast has been reduced to 1.5 % for the 4 th quarter. This reduction has largely

been because of the credit concerns due to subprime crisis, slump in housing prices due to

more than expected foreclosures and reduction in consumer spending. This will have an effect

on the overall growth for the year 2007 which is likely to come down by 0.75% compared to the

year 2006.

One of the major effect of the sub-prime crisis and subsequent slow down of US economy has

been the continue weakening of US dollar vis a vis other major currencies of the world. As is

clearly visible from the table above US $ has fallen maximum against the Euro in last few

months after the sub-prime woes. US$ as fallen nearly 8% against the Euro. It has also fallen

about 7.5 % against Japanese Yen. Its fall against INR has been about 2.2 % largely due to

intervention by the RBI, which stopped the rise of Rupee. The worst rally was seen in Canadian

dollar which rose at an exorbitant rate against the USD.

The result of falling US$ has resulted in steep rise in the oil , gold and other commodities as

investors were trying to hedge their risks against weakening dollar buy buying into

commodities. The oil nearly touched 100$/barrel mark, it’s all time high before cooling off in

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last few days. These rising prices, mainly that of oil has posed a risk of rise in inflation in the US

as well as in the Global economy.

Interest Rates

The benchmark interest rates of Fed Reserve was raised 17 times, to reach upto the level of

5.25% , but since Aug Fed reserve has cut its rate 3 more times by 25 basis point each time to

bring it to present level of 4.25%.

These rate cuts are the result of credit shortage in the economy due to sub prime losses. By

reducing the rates Fed reserve is trying to reduce the cost of borrowing for the banks which in

turn would result in lowering of lending costs to the consumers and businesses.

Manufacturing Sector

The U.S. manufacturing sector dropped 3.1 points to 47.7% on the Institute of Supply

Management’s Purchasing Managers Index (PMI) in December, and it is the first month that the

sector has failed to grow since January 2007The U.S. manufacturing sector dropped 3.1 points

to 47.7% on the Institute of Supply Management’s Purchasing Managers Index (PMI) in

December. The index is closely watched because a slowdown in factory production can

translate to job cuts, which in turn reduce consumer spending — a major component of the

economy.

”A PMI in excess of 41.9%, over a period of time, generally indicates an expansion of the overall

economy. Therefore, the PMI indicates that the overall economy is growing while the

manufacturing sector is contracting,” according to US experts.

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The economy is starting to show signs of weakness outside of the depressed housing sector.

Tighter credit as a result of subprime crisis seems likely to continue to restrain capital

expenditure.

Financial Sector & Stock Market

The sector, other than housing, which is worst hit by the Subprime crisis, is the Financial Sector.

The main concern in the US markets this time is that much of last quarter's damage came in the

financial sector, where operating earnings fell by as much as 25 percent, as banks and brokers

were badly hurt by losses from subprime mortgages and related investments. Analysts'

estimates compiled by Bloomberg indicate that the sector’s profits this quarter may decline by

more than 25 percent. The losses in financial sector have resulted in a huge reduction in the

capital reserve’s of various banks, which in turn means that their lending ability will be

drastically reduced. As a whole, Banks exposure in risky mortgages could reduce the availability

of credit to consumers and businesses by a whopping $2 trillion. And it is this credit crunch

which could result in the slowdown of other sectors of the economy resulting into an overall

recession.

Further to this, the sub-prime crisis has not only shown its effect on government bonds but also

on municipal (muni) bonds.

The $2.5 trillion muni bond market has also suffered the credit crunch's damage. Muni bonds

are issued by cities and states to raise money for projects such as schools, highways and

airports. Historically, they've been relatively safe investments because it's rare that

governments default on their debts.

But worries about the companies that insure hundreds of billions of dollars in muni bonds are

rippling through to muni bonds and rattling investors. The insurers, which have exposure to

risky mortgages, could see their credit ratings reduced. If that happened, the muni bonds they

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guarantee would be downgraded, too. Cities and states would find it harder to raise money.

Projects would be delayed. Taxpayers could face higher taxes.

Furthermore, in the aftermath of the subprime, the banks have tightened their lending

standards. This could come as a biggest hit to the economy as banks are making it harder for

businesses and consumers to borrow. This will result in slowdown in consumer expenditure and

investment in businesses. The plunge in financial profits is a triple whammy for the economy as

banks and other institutions pare payrolls, cut capital spending and become stringent with

loans.

Housing Sector

The sector worst hit by the subprime was housing sector, which shows its steepest decline since

1985. The Prices of residential property were at its lowest since 1999. The number of houses for

sale (550,000) in considerably more than the demand (about 400,000). The inventory situation,

in the month of November, shows that there is availability for the next 10 months. The housing

prices have shown decline in 1/3 rd of the US cities with the rest showing the stagnating prices.

According to the reports $71 billion will be destroyed directly because of the fore closures.

Apart from this about $31 billion will be indirectly destroyed due to the spillover effects of this

on the value of neighboring properties. In addition to this state and local governments will lose

more than $917 million in property tax revenue as a result of declining housing wealth due to

the subprime crisis.

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Impact on Indian Economy

The integration of the Indian economy into the world economy has brought about many

disadvantages and complications. The excess liquidity is slowly evaporating and premium on

risk is reappearing. It has started causing problems for Americans in the form of job losses, less

consumer spending and the fears of a slowdown, if not recession.

The fundamental issue is how to continue being an integral part of the globe and also remain

unaffected by the crisis happening in other parts of the world? This question may not be

related to a developed economy but for a developing economy like ours it holds true. If we are

affected to a great extent by a crisis arising in some other part of the globe, this will create

further complications and make our position quite vulnerable to the happenings of the outside

world. Some of the implications of the crisis are the following:-

Liquidity crunch in the economy

The US subprime crisis will reduce the flow of capital coming to the Indian stock market. India is

considered as a robust emerging market albeit with certain political and economic risks, in fact

it is a favorite among foreign investors after China. In the past these risks did not act as

deterrent as excess liquidity was chasing investment avenues in emerging markets, however

after the subprime crisis this excess liquidity will vanish and this could have an effect on the

amount of foreign capital coming into the Indian Stock Exchanges by way of Foreign

Institutional Investment. The exit of foreign investors would result in absorbing much of the

liquidity from the financial system, adversely affecting credit availability in the Indian market

and pushing up interest rates. If that happens the increase in growth provided by easy credit

would also be adversely affected, slowing growth.

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Correction of prices

The market will correct for the price of risks. Indian markets will see a correction on account of

high oil prices, high interest rates, slowing down of exports on account of the slowing down of

the US economy and rupee appreciation. This will definitely have an impact on the GDP growth

rate.

Rupee appreciation and slump in the economy

The slowing down of the US economy along with the appreciation of rupee could lead to a

reduction in exports from India thereby having a negative effect on India’s GDP. We are seeing

a slowdown in the automobile sector, some slowing down is already being witnessed in the

real-estate segment and, with exports coming down, it will not be too long before we see the

same in textiles, jewellery and other areas as well. Sharp slump in the growth of industrial

production in July 2007 at 7.1 per cent against 13.2 per cent in same month last year, is seen as

an early indication of deceleration in pace of economic expansion. The manufacturing sector

which accounts for 79.3 per cent of the index of industrial production has taken the maximum

hit with almost 50 per cent reduction in growth in July from 14.3 per cent in 2006 to 7.2 per

cent this year. The slowdown in manufacturing is prompted by slack in machinery, transport

equipments, metals, minerals and textile sector during April-July 2007 attributable to high

interest rates and rupee appreciation.

The capital goods sector has registered 12.9 per cent growth in July this year as compared to

18.3 per cent same period last year. With the merchandise exports growth slowing down to

18.52 per cent in July 2007 compared to 40.27 per cent growth in July 2006, it would be difficult

to maintain the growth momentum. As rupee appreciated by 8.2 per cent during April to July,

the export growth in rupee terms was mere 3.10 per cent this year against the growth of 31.77

per cent in the month of July previous year.

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Losses to Banks

The Indian Banks are estimated to have lost US$ 2 billion as a result of the subprime crisis. The

said figure has been arrived at after a series of discussions between banks and rating agencies

in India.

Staff Cuts

Going by the examples, Mumbai-based WNS Holdings is in the process of redeploying its 500

people after one of its top 10 clients, First Magnus Financial Corporation filed for bankruptcy in

the US. Moreover, big companies like Infosys Technologies and iGate Global Solutions are also

subprime victims. After the US-based GreenPoint winded up its business, both the companies

lost big business and redeployed about 50 and 100 staff respectively.

Short-Term impact on the stock markets

Indian industry, still largely driven by local demand, could withstand the sub-prime situation

affecting the U.S. banks and mortgage companies, but there could be a short-term impact on

the stock markets and on credit instruments with overseas investments. This would primarily

be a result of the low liquidity in the Indian economy led by a backtrack of foreign investments

owing to the problem of subprime crisis.

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Learning’s from the crisis

Sound banking practices

The main cause of the sub-prime crisis is the unsound credit practices that were being resorted

to in the US market. Fake certification, which helps an ineligible person to raise a home loan,

cannot be ruled out in India. Housing 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. Personal 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.

While approving the home loans the banks should conduct a thorough background check of the

person applying for the loan and should ensure that the loan is not given to a fake person. Once

the background check is done the bank should check the credibility of the borrower and his

financial records and prior loan history should be checked. The bank should ensure that the

person applying for the loan is not a regular defaulter.

If any property is being mortgaged for obtaining the loan, the bank should ensure that the

property actually exists and is not just on the papers. It should also take care that the title

deed of the property is original and is in place and proper valuation is done by a registered

property valuation expert.

Controlled derivatives market

Derivatives are financial instruments, which can spread the default risk attaching to loans. All

the same, indiscriminate use of such derivatives can lead to havoc as happened in US.

Derivatives lead to such a chain reaction that it will be nearly impossible to quantify the risk of

exposure to bad loans and advances subsequently. RBI and GOI should prohibit indiscriminate

use of such derivatives if they intend to introduce such products in India.

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One of the wrong lessons that could be learnt from the sub-prime episode is about

securitization

Securitization of loans has developed over the last decade in India. This is a device that

enables the lender to create securities out of its loan assets and sell it to willing investors.

These assets get off the balance sheet, releasing that proportionate share of capital for fresh

lending. The investor in the securitized assets gets hold of assets with good returns. The risk is

transferred from the lender to the investor.

The securitization of loans in India is covered by a number of rigorous guidelines. The fact that

the sub-prime bust originated in securitized loans should not induce further restrictions on this.

It is a useful innovation and the RBI rules should take care not to scare it away totally.

Securitization is a good tool to be carefully used. Let not the RBI make the rules too strict. It is

more important to ensure that the originator of the loan practices the appropriate procedures

of lending — adequate security and monitoring of repayments in time.

Limited investment by Indian companies abroad

Prudent investment abroad should be the order of the day. Reckless investment in the

derivatives market abroad by banks and financial institutions has to be controlled. In the recent

crisis, BNP Paribas of France and Macquarie Bank of Australia have been affected because of

such overseas investments. The exposure of Indian banks to the subprime crisis of US is

minimal.

Quality inward investment

FDI should be given priority over FIIs as history has shown that flight of capital in case of FDI is

low compared to that in respect of FIIs. Due to their stable nature, FDI can help in the growth of

the country’s infrastructure.

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Reputation risk is as real as credit risk

The subprime crisis has led to huge losses for many banks and financial institutions which

have forced staff cuts and reduction in the business capacities. The banks have now realized

that the damage control would take years to complete and diligent efforts will have to be

made in order to regain lost ground, the sound goodwill of the banks which has taken a hit

due to the subprime crisis. Similarly, regulatory action against a financial institution which

exhibits noncompliance with laws/regulations can result in costly fines, burdensome

reporting and negative attention that could keep customers away for years – or in the

severest of cases, results in a total collapse of an institution.

Financial institutions can’t afford to be shortsighted

The saying “prevention is better than cure” will be an apt example to showcase the

importance of compliance on part of the financial institutions. The firms have started

responding to this issue only after getting hit by the crisis. Instead, they should have been

farsighted and should have inculcated the same before the damage was done, thus avoiding a

system breakdown.

Failure to anticipate impact

All the entities charged with the supervision of the economy failed to anticipate the huge

impact this housing crisis could have on the financial markets across the globe. The innovation

brought about by the financial institutions in terms of securitization of the mortgages had their

pros and cons. The regulatory framework was not too effective in curbing the impact on the

one hand, whereas on the other hand the impact was underestimated which caused a lot of

flutter in the financial markets.

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Conclusion

The Subprime crisis which occurred in the US in mid – 2007 has a lot of lessons to be learnt

from it even for the countries like India.

Firstly, India should be cautious about resorting to financial liberalization that is

reshaping its domestic financial structure. The structure is prone to crisis, as the

dotcom bust and the current crisis illustrates.

Second, India should refrain from over-investing in the doubtful securities that

proliferate in the US.

Third, India should opt out of high growth trajectories driven by debt-financed

consumption and housing spending, since these inevitably involve bringing risky

borrowers into the lending and splurging net.

Finally, India should be bewaring of international financial institutions and their

domestic imitators, who are importing unsavory financial practices into the domestic

financial sector. The problem, however, is that they may have already gone too far with

the processes of financial restructuring that having increased fragility on all these

counts

The losses are likely to occur over several years. But the impact will likely be broader than

subprime, as the added supply and withdrawn demand for housing will lead to a widespread

decline in housing values, creating a drag on U.S. growth. All consumer credit portfolios will

likely see an increase in losses, as the benefits of borrowers’ growing wealth had kept their

losses near-record lows.

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Finally, the question remains as to whether in becoming more efficient, have financial

systems also become more resilient, i.e. better able to absorb shocks. Or is the continuing

search for increased efficiency taking place at the price of weakening certain underlying

mechanisms? It will be crucial for central banks and financial authorities to analyze financial

developments in the coming months in order to provide an answer to this question.

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Write-downs on the value of loans, MBS and CDOs

due to the subprime mortgage crisis

Company     Business Type     Loss (Billion USD )    

Citigroup Bank $39.1 Billion

UBS AG Bank $37.7 Billion

Merrill Lynch Investment Bank $29.1 Billion

HSBC Bank $20.4 Billion

Royal Bank of Scotland Bank $15.2 Billion

Morgan Stanley Investment Bank $11.5 Billion

Wachovia Bank $11.1 Billion

American International Group Insurance $11.1 Billion

Credit Suisse Bank $9.0 Billion

Bank of America Bank $7.95 Billion

Deutsche Bank Bank $7.7 Billion

HBOS Bank $7.06 Billion

BayernLB Bank $6.7 Billion

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Mizuho Financial Group Bank $5.5 Billion

JP Morgan Chase Bank $5.5 Billion

Crédit Agricole Bank $4.8 Billion

Freddie Mac Mortgage GSE $4.3 Billion

Countrywide Mortgage Bank $4.0 Billion

Lehman Brothers Investment Bank $3.93 Billion

Ambac Financial Group Bond Insurance $3.5 Billion

Dresdner Bank Bank $3.49 Billion

IKB Deutsche IndustrieBank Bank $3.45 Billion

MBIA Bond Insurance $3.3 Billion

CIBC Bank $3.2 Billion

Barclays Capital Investment Bank $3.1 Billion

Société Générale Bank $3.0 Billion

Wells Fargo Bank $2.9 Billion

WestLB Bank $2.74 Billion

Bear Stearns Investment Bank $2.6 Billion

Washington Mutual Savings and Loan $2.4 Billion

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Fortis Bank $2.3 Billion

DZ Bank Bank $2.1 Billion

Swiss Re Re-Insurance $2.04 Billion

Bank of China Bank $2.0 Billion

Natixis Bank $1.75 Billion

Goldman Sachs Investment Bank $1.5 Billion

Lloyds TSB Bank $1.32 Billion

RBC Bank $1.2 Billion

LBBW Bank $1.1 Billion

CommerzBank Bank $1.1 Billion

Fannie Mae Mortgage GSE $0.896 Billion

BNP Paribas Bank $0.870 Billion

Hypo Real Estate Bank $0.580 Billion

ICBC Bank $0.448 Billion

Aozora Bank Bank $0.397 Billion

ICICI Bank Bank $0.264 Billion

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Bibliography

www.wikipedia.org

www.investopedia.com

www.economywatch.com

www.thehindubusinessline.com

http://specials.rediff.com/money/

www.marketoracle.co.uk

www.business-standard.com/india/

www.slideshare.com

http://economictimes.indiatimes.com/

http://wiki.answers.com/Q/

http://in.reuters.com/article/businessNews/

http://en.wikipedia.org/wiki/Great_Depression

http://books.google.co.in/books

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