Subprime Crisis- Lessons for India

8/9/2019 Subprime Crisis- Lessons for India

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Global Financial Crisis

Lessons for India

Institute of Public Enterprise

Hyderabad

March, 2010


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Global Crisis The Cascading

Effect

Sub-Prime Crisis

Financial Crisis

Economic Crisis

Unemployment Crisis

USA

Europe

Asia

Africa


3/18

Sub-prime Crisis

Sub-prime crisis can be best understood

by analyzing the following :

Problems in Housing Market

Problems in Financial Market

Government & Industry Responses


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Problems in Housing Market

Excess Housing Inventory ( Overbuilding during boom

period, speculation, easy credit policies, ARM practices

innovation for giving loans to new service entrants)

leading to Decline in housing prices ( Housing bubble bursts,

Household wealth declines) leading to

Inability to refinance mortgage ( poor lending borrowing

decisions, ARM Adjustments) leading to

Mortgage delinquency & foreclosure land consequentmortgage cash flow declines


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SECURITIZATION PROCESS

(Risk Transfer)

Borrowers Servicer Rating Investors

Arranger Credit Enhancement Structural Credit Enhancement

Originator

SPV(Pay Through / Pass

Through Certificates)

Senior

Mezzanine

Subordinate


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Credit Default Swap (CDS)Credit Default Swap (CDS)

A specific kind of counterparty agreement whichA specific kind of counterparty agreement whichallows the transfer of third party credit risk from oneallows the transfer of third party credit risk from oneparty to the other. One party in the swap, the party to the other. One party in the swap, the

protection buyer is a lender and faces credit riskprotection buyer is a lender and faces credit riskfrom a third party, and the counterparty in the creditfrom a third party, and the counterparty in the creditdefault swap , the protection seller agrees todefault swap , the protection seller agrees toinsure this risk in exchange of regular periodicinsure this risk in exchange of regular periodicpayments ( essentially an insurance premium). If thepayments ( essentially an insurance premium). If thethird party defaults, the party providing insurance /third party defaults, the party providing insurance /protection will have to purchase from the insured /protection will have to purchase from the insured /protected party the defaulted asset. In turn, theprotected party the defaulted asset. In turn, theinsurer pays the insured the remaining interest oninsurer pays the insured the remaining interest onthe debt, as well as the principal.the debt, as well as the principal.


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Characteristics of CDSCharacteristics of CDS

Underlying or reference creditUnderlying or reference credit can be eithercan be either aasingle entity or a group of entitiessingle entity or a group of entities

The exercise conditions,The exercise conditions, which can be awhich can be a creditcredit

eventevent( such as rating downgrade or a default), or an( such as rating downgrade or a default), or anincrease in the credit spreads.increase in the credit spreads.

The pay off functionThe pay off function, can be a fixed amount or a, can be a fixed amount or avariable amount with a linear or nonvariable amount with a linear or non--linear payofflinear payoff

A common feature of existing credit derivatives isA common feature of existing credit derivatives is

that their tenors are less than the maturity ofthat their tenors are less than the maturity ofunderlying creditunderlying credit(for example a credit default swap may specify that a payment is to(for example a credit default swap may specify that a payment is tobe made if a 10 year corporate bond defaults at any time duringbe made if a 10 year corporate bond defaults at any time duringthe next two years)the next two years)


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Credit Default SwapCredit Default Swap

Mechanism of OperationMechanism of Operation

Protection Buyer Protection Seller

Reference Credit


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Credit Default Swap MarketCredit Default Swap Market

The estimated size of world CDS market is around 62The estimated size of world CDS market is around 62trillion USDtrillion USD

This is about 3 times size ofUS stock market, 6 times ofThis is about 3 times size ofUS stock market, 6 times of

the mortgage market and 12 times ofUS treasury billthe mortgage market and 12 times ofUS treasury billmarket.market.

Top 25 banks were found to be holding $ 13 trillion in CDS.Top 25 banks were found to be holding $ 13 trillion in CDS.Speculative investors like hedge funds also buy and sellSpeculative investors like hedge funds also buy and sellCDS instruments from the sidelines without having anyCDS instruments from the sidelines without having anydirect relationship with the underlying credit. It is likedirect relationship with the underlying credit. It is like

betting on a sports event.betting on a sports event. The protection sellers also buy protection from others toThe protection sellers also buy protection from others to

hedge their position ( form of rehedge their position ( form of re--insurance). The chain goesinsurance). The chain goeson and on. The actual total credit exposure could be ason and on. The actual total credit exposure could be ashigh as $ 200 million on a $ 10 million loan.high as $ 200 million on a $ 10 million loan.


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CDS CharacteristicsCDS Characteristics

CDS is a swap instrument and as such is not regulatedCDS is a swap instrument and as such is not regulatedeither by banking or by insurance regulatory authority.either by banking or by insurance regulatory authority.

Banks are not required to allocate capital under capitalBanks are not required to allocate capital under capital

adequacy requirement for CDS exposuresadequacy requirement for CDS exposures Loans are required to be funded. For giving loans banksLoans are required to be funded. For giving loans banks

need to borrow / raise funds. However, for CDS exposure,need to borrow / raise funds. However, for CDS exposure,banks do not need prior funding.banks do not need prior funding.

Hedge funds operate in a big way in CDS market becauseHedge funds operate in a big way in CDS market becauseof absence of funding requirements. They offer creditof absence of funding requirements. They offer credit

protection much beyond their capital base.protection much beyond their capital base.


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Problems in Financial Market

Decline in mortgage cash flow resulted in bank losses

(loss on mortgages, loss on mortgage securities) lead todepletion of bank capital level Failure of Washington

Mutual, Wachovia and Lehman Brothers. Bank failures resulted in liquidity crunch for business

harder to get loans higher interest rates for loans

Overall negative effect on the economy Decline inbusiness environment, risk of increasing unemployment,stock market crash resulting in further reduction in

household wealth


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Government & Industry

Responses Central Bank Actions Lower interest rates, increased

lending, infusion of liquidity

Stimulus Packages

Selective Bailouts Systemic Rescue Bank recapitalization


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Third Regional Conference for

Middle East & North Africa at Doha

The conference decided to address the following corporategovernance issues :

(a) The regulatory and supervisory powers of central bankshould be extended to investment banking and related non-bank financial intermediation.(b) Risk management frameworks, processes, andimplementation practices require reform in order to redressthe shortcomings revealed by the turmoil.

The role and form of regulation of credit rating agenciesneed to be addressed

(d) Executive remuneration and incentive structures needto be linked to long-term performance and risk profile offirms. More disclosure on executive remuneration schemesis required and companies should put their remunerationschemes to shareholders scrutiny and approval.


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Doha Conference

Corporate governance practices need to be strengthened,in particular by increasing board competence andresponsibility. Board members need to have up-to-date

knowledge on financial issues and risk management tofulfill their functions. Board should conduct annualevaluations of their performance and report toshareholders.

Governance and accountability of regulators are equallyessential.

Effective creditor rights and insolvency systems and the

development of strong rescue and restructuringframeworks are important.

Good corporate governance is important not only for listedcompanies, but also for State and family ownedenterprises.


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Problems Identified and Lessons

Learned Health of economy is linked to the health of consumers ( Housing

bobble burst lead to economic crisis) Entire Credit Default Swap market was largely unregulated.

Being a form of credit insurance it was neither regulated bybanking regulatory authority nor by insurance regulatory

authority. CDS market should be regulated. Setting up anexchange to deal with CDS contracts would be advisable.

Change from an investor pay model to issuer pay model is theroot cause of problem with rating agencies.

Investment banks game or manipulate the rating process byreverse engineering the rating models. They engage insophisticated optimization to construct collateral pools andstructuring techniques to reap the desired results. Rating agencies

should not be permitted to do investment banking consultancyand deal structuring. Securitization market was largely unregulated. There should be

transparency as regards to off-balance sheet risks It is better to keep the credit risk and manage it rather than allow it

to grow in an unmanaged, unmeasured way.


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Problems Identified and Lessons

learned The Board must ensure integrity of risk management

system, analyze periodically risk exposures of thecompany and impact of new financial instruments on thefinancial health of the company.

The Board must have an appropriate whistle blowing policywithin the organization. Whistle blowing by employees canhide the ignorance of directors to save an imminentdisaster.

Securities and future markets need to be integrated. For conceptual & regulatory matters, regulation of all 4

industries, viz., banking, insurance, futures and securities

should be under a single umbrella. Crises of global dimension need to be tackled by a globalconsultative approach through better understanding,mutual help and coordinated efforts.

Multi-lateral institutions( IFC / World Bank etc) must helpeasing the crisis and averting the disaster


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Lessons for India

Strengthening Regulation Super Regulator?

Greater transparency for off-balance sheet risks / transactions.

Strengthening Corporate Governance Environment. Making Board moreaccountable, Enlightening/ educating Board, Prudential Disclosure, WhistleBlowing Policy etc.

Better regulation of Securitization deals Greater control / regulation of Rating Agencies Make them more responsible

and accountable.

Regulation of cross border deals and transactions of Indian Banks / FIs.

Framing suitable guidelines before new financial instruments are introduced.

Efficient credit allocation, puncturing market bubbles through appropriate

policy announcements. Timely intervention by Central Bank (RBI) & Finance Ministry to minimize the

damages.


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Thank You

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Subprime Crisis- Lessons for India