A STUDY ON SUBPRIME CRISIS AND IT’S EFFECTS ON INDIA
Project submitted in partial fulfillment of the requirement for the award of the degree of
“MASTER O
!"S#$ESS A%M#$#STRAT#O$&
DECLARATION
I hereby declare that this project report titled “A STUDY ON SUBPRIME CRISIS AND IT’S EFFECTS ON INDIA” submitted by me to the department of Business Management of XXXX is a bonafide work undertaken by me and it is not submitted to any other University or Institute for the Award of any degree diploma/certificate or published any time before
!ame"
#ate"
$%ignature&
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ABSTRACT
'he sub prime lending crisis in the real estate sector In the U%A where in borrowers with a low or sub prime credit rating were given loans to invest in the booming real estate sector in ())*+), has led not only to a dig slow down of the U% economy but its effect was also felt over the major nations of the world . In this project it has been tried in the best way possible to analy-e the various ways in which the sub prime lending muddle actually started It has also been tried to analy-e the way the U% banking and lending agencies camouflaged their sub prime loans In to attractive ones and how backed by some credit rating agencies. were able to sell them off to other banks and investors by dividing them into collaterali-ed debt obligations $/#0s& 'his project also tries to give a comprehensive picture of the losses that the U% banking sector incurred and not just that but how the whole sub prime muddle effected and 1uestioned the banking practices in the world In the end it has been tired to take an Indian view of the whole sub prime fiasco and how India. though effected by this. thankfully not in a big way. can actually
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avoid such a scenario from occurring in the country and all the measures and practices that can been taken into consideration to avoid such a scenario
ACKNOWLEDGEMENT
I take this opportunity to thank all those who have been of help to me in the completion of this project
I would like to appreciate the guidance and co+operation provided to me by our project guide XXXX $faculty of Business Management& in the completion of this project
I am also grateful to XXXX. #irector XXXX and all the faculty members who have directly or indirectly helped me in preparing this project report
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TABLE OF CONTENTS:
1.
CHAPTER – I I!'20#U/'I0! 0bjective of the %tudy %cope of the %tudy 5imitations of the %tudy
pag !" + + + + 3 (4 (* (*
#.
CHAPTER $ II %ubprime 5ending /risis 7ffect of %ubprime /risis on U % A Actions taken to manage the crisis in U % A Implications on different countries + ,8 + + + (6 (3 *3
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CHAPTER $ III Impact on India 4 + 63
Measures that can be taken
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* CHAPTER – I%
%UMMA2: A!# /0!/5U%I0! + 3(
Bibliography
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/;A<'72 I
INTRODUCTION
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THE ECONOMY OF THE UNITED STATES OF AMERICA: 'he economy of the United %tates has been 7arth=s largest since the early >93)s ?>@ Its gross domestic product $A#<& was estimated as B>4 9 trillion in ())3 ?(@ It is a miCed economy and private firms make the majority of microeconomic decisions. while being regulated by the government 'he U % economy maintains a high level of productivity $A#< per capita. B*,.8)) in ())3 with the U % population hitting 4)( million&. although it is not the world=s highest 'he U % economy has maintained a high overall A#< growth rate. a low unemployment rate. and high levels of research and capital investment Major economic concerns in the U % include national debt. eCternal debt. entitlement liabilities for retiring baby boomers that have already begun entering the %ocial %ecurity system. corporate debt. mortgage debt a low savings rate. and a large current account deficit
Dundamental 7lements of the U % 7conomy"
'he United %tates is rich in mineral resources and fertile farm soil. and it is fortunate to have a moderate climate It also has eCtensive coastlines on both the Atlantic and <acific 0ceans. as well as on the Aulf of MeCico 2ivers flow from far within the continent. and the Areat 5akesEfive large. inland lakes along the
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U % border with /anadaEprovide additional shipping access 'hese eCtensive waterways have helped shape the country=s economic growth over the years and helped bind America=s ,) individual states together in a single economic unit 'he number of available workers and. more importantly. their productivity help determine the health of the U % economy 'hroughout its history. the United %tates has eCperienced steady growth in the labor force. a phenomenon both cause and effect of almost constant economic eCpansion 'he promise of high wages brings many highly skilled workers from around the world to the United %tates
In the United %tates. the corporation has emerged as an association of owners. known as stockholders. who form a business enterprise governed by a compleC set of rules and customs Brought on by the process of mass production. corporations such as Aeneral 7lectric have been instrumental in shaping the United %tates 'hrough the stock market. American banks and investors have grown their economy by investing and withdrawing capital from profitable corporations 'oday in the era of globali-ation American investors and corporations have influence all over the world 'he American government has also been instrumental in investing in the economy. in areas such as providing cheap electricity $such as from the ;oover #am&. and military contracts in times of war
Fhile consumers and producers make most decisions that mold the economy. government activities have a powerful effect on the U % economy in at least four areas %trong government regulation in the U % economy started in the early >8))s with the rise of the <rogressive MovementG prior to this the government promoted economic growth through protective tariffs and subsidies to industry.
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built infrastructure. and established banking policies. including the gold standard. to encourage savings and investment in productive enterprises
STABILI&ATION AND GROWTH:
'he federal government attempts to use both monetary policy $control of the money supply through mechanisms such as changes in interest rates& and fiscal policy $taCes and spending& to maintain low inflation. high economic growth. and low unemployment Dor many years following the Areat #epression of the >84)s. recessionsE periods of slow economic growth and high unemploymentEwere viewed as the greatest of economic threats Fhen the danger of recession appeared most serious. government sought to strengthen the economy by spending heavily itself or cutting taCes so that consumers would spend more. and by fostering rapid growth in the money supply. which also encouraged more spending In the >83)s. major price increases. particularly for energy. created a strong fear of inflation As a result. government leaders came to concentrate more on controlling inflation than on combating recession by limiting spending. resisting taC cuts. and reining in growth in the money supply Ideas about the best tools for stabili-ing the economy changed substantially between the >86)s and the >88)s In the >86)s. government had great faith in fiscal policyEmanipulation of government revenues to influence the economy %ince spending and taCes are controlled by the president and the U % /ongress. these elected officials played a leading role in directing the economy A period of high inflation. high unemployment. and huge government deficits weakened confidence in fiscal policy as a tool for regulating the overall pace of economic activity Instead. monetary policy assumed growing prominence a piece
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%ince the stagflation of the >83)s. the U % economy has been characteri-ed by somewhat slower inflation In >89,. the U % began its growing trade deficit with /hina In recent years. the primary economic concerns have centered on" high national debt $B8 trillion&. high corporate debt $B8 trillion&. high mortgage debt $over B>) trillion as of ()), year+end&. high unfunded Medicare liability $B4) trillion&. high unfunded %ocial %ecurity liability $B>( trillion&. and high eCternal debt $amount owed to foreign lenders&. high trade deficits In ())6. the U % economy had its lowest saving rate since >844 'hese issues have raised concerns among economists and unfunded liabilities and national politicians 'he U % economy maintains a relatively high A#<. a reasonably high A#< growth rate. and a low unemployment rate. making it attractive to immigrants worldwide
Na'("!a) D *':
'he national debt. also known as the U % public debt $part of which is the gross federal debt&. is the overall collective sum of yearly budget deficit owed by all branches of the United %tates government. plus interest Americans are controversial issues in the United %tates As of Hanuary 4). ())9. the total U % federal debt was approCimately B8 ( trillion or about B38.))) in average for each of the >>3 million American taCpayers 'he borrowing cap debt ceiling as of ()), stood at B9 >9 trillion In March ())6. /ongress raised that ceiling an additional B) 38 trillion to B9 83 trillion. which is approCimately 69I of A#< /ongress has used this method to deal with an 'he economic significance of this debt and its potential ramifications for future generations of
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encroaching debt ceiling in previous years. as the federal borrowing limit was raised in ())( and ())4 Fhile the U % national debt is the world=s largest in absolute si-e. a more convenient measure is that of its si-e relative to the nation=s A#< Fhen the national debt is put into this perspective it appears considerably less today than in past years. particularly during Forld Far II By this measure. it is also considerably less than those of other industriali-ed nations such as Hapan and roughly e1uivalent to those of several Festern 7uropean nations
E+' ,!a) D *': L(a*()('( - '" F", (g! ,-:
Aross U % liabilities to foreigners are B>6 4 trillion as at end ())6 'he U % Net International Investment Position (NIIP) deteriorated to a negative B( , trillion at the end of ())6. or about minus >8I of A#< 'he eCternal debt is an accounting entry that largely represents U% domestic assets purchased with trade dollars and owned overseas. largely by U% trading partners ;owever. this is not the whole picture. as foreign holdings of government debt currently amount to about (3I of the total. or some ( trillion dollars Dor countries like the United %tates. a large net eCternal debt is created when the value of foreign assets $debt and e1uity& held by domestic residents is less than the value of domestic assets held by foreigners In simple terms. as foreigners buy property in the U%. this adds to the eCternal debt Fhen this occurs in greater amounts than Americans buying property overseas. nations like the United %tates are said to be debtor nations. but this is not conventional debt like a loan obtained from a bank ;owever. foreigners also purchase U % debt instruments. such as government bonds. which are forms of conventional debt
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If the eCternal debt represents foreign ownership of domestic assets. the result is that rental income. stock dividends. capital gains and other investment income is received by foreign investors. rather than by U% residents 0n the other hand. when U% debt is held by overseas investors. they receive interest and principal repayments As the trade imbalance puts eCtra dollars in hands outside of the U%. these dollars may be used to invest in new assets $foreign direct investment. such as new plants& or be used to buy eCisting U% assets such as stocks. real estate and bonds Fith a mounting trade deficit. the income from these assets increasingly transfers overseas 0f major concern is the fact that the magnitude of the !II< $or net eCternal debt& is 1uite a bit larger than most national economies Dueled by the si-able trade deficit. the eCternal debt is so large that many wonder if the trade situation can be sustained in the long term /omplicating the matter is that many of America=s trading partners. such as /hina. depend for much of their entire economy on eCports. and especially eCports to America Many controversies eCist about the current trade and eCternal debt situation. and it is arguable whether anyone understands how these dynamics will play out in an historically unprecedented floating eCchange rate system Fhile various aspects of the U % economic profile have precedents in the situations of other countries $notably government debt as a percentage of A#<&. the sheer si-e of the U%. and the integral role of the U% economy in the overall global economic environment. create considerable uncertainty about the future
I!' ,!a'("!a) ',a.
'he United %tates is the most significant nation in the world when it comes to international trade Dor decades. it has led the world in imports while simultaneously remaining as one of the top three eCporters of the world
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As the major epicenter of world trade. the United %tates enjoys leverage that many other nations do not Dor one. since it is the world=s leading consumer. it is the number one customer of companies all around the world Many businesses compete for a share of the United %tates market In addition. the United %tates occasionally uses its economic leverage to impose economic sanctions in different regions of the world U%A is the top eCport market for almost 6) trading nations worldwide 'he U % is a member of several international trade organi-ations 'he purpose of joining these organi-ations is to come to agreement with other nations on trade issues. although there is some disagreement among U % citi-ens as to whether or not the U % government should be making these trade agreements in the first place %ince it is the world=s leading importer. there are many U % dollars in circulation all around the planet 'he stable U % economy and fairly sound monetary policy has led to faith in the U % dollar as the world=s most stable currency. although that may be changing in recent times In order to fund the national debt $also known as public debt&. the United %tates relies on selling U % treasury bonds to people both inside and outside the country. and in recent times the latter have become increasingly important Much of the money generated for the treasury bonds came from U % dollars which were used to purchase imports in the United %tates
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;aving taken a comprehensive view of the economy of ';7 U!I'7# %'A'7% 0D AM72I/A. it is only pertinent to get into the topic of this project+ 'he %ub <rime 5ending Mortgage /risis 5et us first ac1uaint ourselves with the terminology of this concept before venturing into the shock and awe that this terminology has created in the form of recession in the United %tates and how it rather than being limited to only the United %tates has effected almost all the major economies of the world
S/*p,(0 L !.(!g:
%ubprime lending $also known as B+paper. near+prime. or second chance lending& is the practice of making loans to borrowers who do not 1ualify for the best market interest rates because of their deficient credit history 'he phrase also refers to banknotes taken on property that cannot be sold on the primary market. including loans on certain types of investment properties and certain types of self+employed persons %ubprime lending is risky for both lenders and borrowers due to the combination of high interest rates. poor credit 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 the increased risk %ubprime lending encompasses a variety of credit instruments. including subprime mortgages. subprime car loans. and subprime credit cards. among others 'he term JsubprimeJ refers to the credit status of the borrower $being less than ideal&. not the interest rate on the loan itself %ubprime lending is highly controversial 0pponents have alleged that subprime lenders have engaged in predatory lending practices such as deliberately lending to borrowers who could never meet the terms of their loans. thus leading to default. sei-ure of collateral. and foreclosure 'here have also been charges of
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mortgage discrimination on the basis of race <roponents of subprime lending maintain that the practice eCtends credit to people who would otherwise not have access to the credit market 'he controversy surrounding subprime lending has eCpanded as the result of an ongoing lending and credit crisis both in the subprime industry. and in the greater financial markets which began in the United %tates 'his phenomenon has been described as a financial contagion which has led to a restriction on the availability of credit in world financial markets ;undreds of thousands of borrowers have been forced to default and several major American subprime lenders have filed for bankruptcy
Ba12g,"/!.
%ubprime lending evolved with the reali-ation of a demand in the marketplace and businesses providing a supply to meet it Fith bankruptcies and consumer proposals being widely accessible. a constantly fluctuating economic environment. and consumer debt loan on the rise. traditional lenders are more cautious and have been turning away a record number of potential customers %tatistically. approCimately (,I of the population of the United %tates falls into this category In the third 1uarter of ())3. %ubprime adjustable rate mortgages $A2Ms& only represent 6 9I of the mortgages outstanding in the U%. yet they represent *4 )I of the foreclosures started %ubprime fiCed mortgages represent 6 4I of outstanding loans and >( )I of the foreclosures started in the same period
D 3(!('("!
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Fhile there is no official credit profile that describes a subprime borrower. most in the United %tates have a credit score below 3(4 Dederal !ational Mortgage Association commonly known as Dannie Mae has lending guidelines for what it considers to be JprimeJ borrowers on conforming loans 'heir standard provides a good comparison between those who are Jprime borrowersJ and those who are Jsubprime borrowers J <rime borrowers have a credit score above 6() $credit scores are between 4,) and 9,) with a median in the U % of 639 and a mean of 3(4&. a debt+to+income ratio $#'I& no greater than 3,I $meaning that no more than 3,I of net income pays for housing and other debt&. and a combined loan to value ratio of 8)I. meaning that the borrower is paying a >)I down payment Any borrower seeking a loan with less than those criteria is a subprime borrower by Dannie Mae standards
S/*p,(0 ) !. ,'o access this increasing market. lenders often take on risks associated with lending to people with poor credit ratings %ubprime loans are considered to carry a far greater risk for the lender due to the aforementioned credit risk characteristics of the typical subprime borrower 5enders use a variety of methods to offset these risks In the case of many subprime loans. this risk is offset with a higher interest rate In the case of subprime credit cards. a subprime customer may be charged higher late fees. higher over limit fees. yearly fees. or up front fees for the card %ubprime credit card customers. unlike prime credit card customers. are generally not given a Jgrace periodJ to pay late 'hese late fees are then charged to the account. which may drive the customer over their credit limit. resulting in over limit fees 'hus the fees compound. resulting in higher returns for the lenders 'hese increased fees compound the difficulty of the mortgage for the subprime borrower. who is defined as such by their unsuitability for credit
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S/*p,(0 *",,"4 ,%ubprime offers an opportunity for borrowers with a less than ideal credit record to gain access to credit Borrowers may use this credit to purchase homes. or in the case of a cash out refinance. finance other forms of spending such as purchasing a car. paying for living eCpenses. remodeling a home. or even paying down on a high interest credit card ;owever. due to the risk profile of the subprime borrower. this access to credit comes at the price of higher interest rates 0n a more positive note. subprime lending $and mortgages in particular&. provide a method of Jcredit repairJG if borrowers maintain a good payment record. they should be able to refinance back onto mainstream rates after a period of time /redit repair usually takes twelve months to achieveG however. in the UK. most subprime mortgages have a two or three+year tie+in and borrowers may face additional charges for replacing their mortgages before the tie+in has eCpired
Aenerally. subprime borrowers will display a range of credit risk characteristics that may include one or more of the following"
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'wo or more loan payments paid past 4) days due in the last >( months. or one or more loan payments paid past 8) days due the last 46 monthsG Hudgment. foreclosure. repossession. or non+payment of a loan in the prior *9 monthsG Bankruptcy in the last 3 yearsG 2elatively high default probability as evidenced by. for eCample. a credit bureau risk score $DI/0& of less than 6() $depending on the product/collateral&. or other bureau or proprietary scores with an e1uivalent default probability likelihood
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TYPES:
S/*p,(0 0",'gag As with subprime lending in general. subprime mortgages are usually defined by the type of consumer to which they are made available According to the U % #epartment of 'reasury guidelines issued in ())>. J%ubprime borrowers typically have weakened credit histories that include payment delin1uencies and possibly more severe problems such as charge+offs. judgments. and bankruptcies 'hey may also display reduced repayment capacity as measured by credit scores. debt+to+income ratios. or other criteria that may encompass borrowers with incomplete credit histories J In addition. many subprime mortgages have been made to borrowers who lack legal immigration status in the United %tates %ubprime mortgage loans are riskier loans in that they are made to borrowers unable to 1ualify under traditional. more stringent criteria due to a limited or blemished credit history %ubprime borrowers are generally defined as individuals with limited income or having DI/0 credit scores below 6() on a scale that ranges from 4)) to 9,) %ubprime mortgage loans have a much higher rate of default than prime mortgage loans and are priced based on the risk assumed by the lender Although most home loans do not fall into this category. subprime mortgages proliferated in the early part of the (>st /entury About (> percent of all mortgage originations from ())* through ())6 were subprime. up from 8 percent from >886 through ())*. says Hohn 5onski. chief economist for Moody=s Investors %ervice %ubprime mortgages totaled B6)) billion in ())6. accounting for about one+fifth of the U % home loan market 'here are many different kinds of subprime mortgages. including"
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Interest+only mortgages. which allow borrowers to pay only interest for a period of time $typically ,L>) years&G J<ick a paymentJ loans. for which borrowers choose their monthly payment $full payment. interest only. or a minimum payment which may be lower than the payment re1uired to reduce the balance of the loan&G
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And initial fiCed rate mortgages that 1uickly convert to variable rates
'his last class of mortgages has grown particularly popular among subprime lenders since the >88)s /ommon lending vehicles within this group include the J(+(9 loanJ. which offers a low initial interest rate that stays fiCed for two years after which the loan resets to a higher adjustable rate for the remaining life of the loan. in this case (9 years 'he new interest rate is typically set at some margin over an indeC. for eCample. ,I over a >(+month 5IB02 Mariations on the J(+(9J include the J4+(3J and the J,+(,J
S/*p,(0 C, .(' Ca,./redit card companies in the United %tates began offering subprime credit cards to borrowers with low credit scores and a history of defaults or bankruptcy in the >88)s 'hese cards usually begin with low credit limits and usually carry eCtremely high fees and interest rates as high as 4)I or more In ())(. as economic growth in the United %tates slowed. the default rates for subprime credit card holders increased dramatically. and many subprime credit card issuers were forced to scale back or cease operations In ())3. many new subprime credit cards began to sprout forth in the market As more vendors emerged. the market became more competitive. forcing issuers to make the cards more attractive to consumers Interest rates on subprime cards now start at 8 8I but in some cases still range up to (*I annual percentage rate $A<2&
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%ubprime credit cards however can help a consumer improve poor credit scores Most subprime cards report to major credit reporting agencies such as 'ransUnion and 71uifaC /onsumers that pay their bills on time should see positive reporting to these agencies within 8) days
P,"p"! !'Individuals who have eCperienced severe financial problems are usually labeled as higher risk and therefore have greater difficulty obtaining credit. especially for large purchases such as automobiles or real estate 'hese individuals may have had job loss. previous debt or marital problems. or uneCpected medical issues. usually unforeseen and causing major financial setbacks As a result. late payments. charge+offs. repossessions and even foreclosures may result #ue to these previous credit problems. these individuals may also be precluded from obtaining any type of conventional loan for a large purchase. such as an automobile 'o meet this demand. lenders have seen that a tiered pricing arrangement. one which allows these individuals to receive loans but pay a higher interest rate. may allow loans which otherwise would not occur Drom a servicing standpoint. these loans have higher collection defaults and are more likely to eCperience repossessions and charge offs 5enders use the higher interest rate to offset these anticipated higher costs <rovided that a consumer enters into this arrangement with the understanding that they are higher risk. and must make diligent efforts to pay. these loans do indeed serve those who would otherwise be underserved /ontinuing the eCample of an auto loan. the consumer must purchase an automobile which is well within their means. and carries a payment well within their budget
C,('(1(-0
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/apital markets operate on the basic premise of risk versus reward Investors taking a risk on stocks eCpect a higher rate of return than do investors in risk+free 'reasury bills. which are backed by the full faith and credit of the United %tates 'he same goes for loans 5ess creditworthy subprime borrowers represent a riskier investment. so lenders will charge them a higher interest rate than they would charge a prime borrower for the same loan 'o avoid the initial hit of higher mortgage payments. most subprime borrowers take out adjustable+rate mortgages $or A2Ms& that give them a lower initial interest rate But with potential annual adjustments of (I or more per year. these loans can end up charging much more %o a B,)).))) loan at a *I interest rate for 4) years e1uates to a payment of about B(.*)) a month But the same loan at >)I for (3 years $after the adjustable period ends& e1uates to a payment of B*.(() A 6+percentage+point increase in the rate caused slightly more than a 3,I increase in the payment 0n the other hand. interest rates on A2Ms can also go down + in the U%. the interest rate is tied to federal government+controlled interest rates. so when the Ded cuts rates. A2M rates go down. too A2M interest rates usually adjust once a year. and the rate is based on an average of the federal rates over the last >( months Also. most A2Ms limit the amount of change in a rate 'he cycle of increased fees due to default+prone borrowers defaulting is a vicious cycle 'hough some subprime borrowers may be able to repair their credit rating. much default and enter the vicious cycle Fhile this enhances the profits of the subprime lender. it also leads to further vicious cycling as the subprime lenders are unable to recover what has been lent to subprime borrowers ;ence the current subprime mortgage crisis
M",'gag .(-1,(0(!a'("!
%ome subprime lending practices have raised concerns about mortgage discrimination on the basis of race Black and other minorities disproportionately 21
fall into the category of Jsubprime borrowersJ because of lower credit scores. higher debt+to+income ratios. and higher combined loan to value ratios Because they are higher risk borrowers. they are more likely to seek subprime mortgages with higher interest rates than their white counterparts 7ven when median income levels were comparable. home buyers in minority neighborhoods were more likely to get a loan from a subprime lender Interest rates and the availability of credit are often tied to credit scores. and the results of a ())* 'eCas #epartment of Insurance study found that of the ( million 'eCans surveyed. Jblack policyholders had average credit scores that were >)I to 4,I worse than those of white policyholders ;ispanics= average scores were ,I to (,I worse. while Asians= scores were roughly the same as whites African+ Americans are in the aggregate less likely to have a higher than average credit score and so take on higher levels of debt with smaller down+payments than whites and Asians of similar incomes
O*5 1'(6 - "3 '7 S'/.8:
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'o understand the meaning of N%ubprime /risisO 'o analy-e the effects of %ubprime /risis on the world
'o analy-e the impact of %ubprime crisis on India
'o understand the risks and causes of %ubprime crisis
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S1"p "3 '7 S'/.8"
'he study is to cover the impact of the subprime crisis that started in United %tates of America which led to huge loss in its economy 'he study also concentrates on impact of subprime crisis on Alobal economics in general and Indian economy in particular.
L(0('a'("!-:
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'he study is very much limited to understand the reasons behind the crisis at origin and its impact on Indian economy
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#ue to the short period of time it was not possible to gather all the data
%ince the crisis is 1uite recent there is no published manual available
/;A<'72 II
%ubprime /risis
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SUBPRIME MORTGAGE CRISIS
7veryone has been constantly reading in almost all newspapers about the U% subprime mortgage crisis which has been said to have the potential to bring the U% economy to a brink of a recession It has led to the ouster of top eCecutives of Merrill 5ynch. /itibank etc to name a few because of eCposure to the subprime mortgage turmoil Ironically. the same crisis has led to an Indian born banker+ Mikram % <undit being put at the helm of the worldPs largest bank L /itigroup %o what is eCactly the subprime crisis all aboutQ 'he following eCtract seeks to eCplain what we mean by the term Nsubprime lendingO 'hen we decipher what is the subprime mortgage lending crisis all about and what led to its happening 5astly. we seek to find its potential impact on the U% and Indian economy
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%ub prime lending refers to the category of borrowers with weak credit history 'hese borrowers usually find it tough to land mortgage+backed loans %ub prime lending is a general term that refers to the practice of making loans to borrowers who do not 1ualify for loans at market Interest rates because of problems with their credit history or the lacking of their ability to prove that they have enough income to support the monthly payment on the loan for which they are applying 'hus. a sub prime loan is one that is offered at an interest rate higher than A+paper $<rime& loans due to the increased risk
E33 1' "3 S/*p,(0 C,(-(- "! U.S.A
Ba12g,"/!. '" '7 1,(-('he -/*p,(0 0",'gag 1,(-(- was a sharp rise in home foreclosures which
started in the United %tates in late ())6 and became a global financial crisis during ())3 and ())9 'he crisis began with the bursting of the housing bubble in the U% and high default rates on JsubprimeJ and other adjustable rate mortgages $A2M& made to higher+risk borrowers with lower income or lesser credit history than JprimeJ borrowers 5oan incentives and a long+term trend of rising housing prices encouraged borrowers to assume mortgages. believing they would be able to refinance at more favorable terms later ;owever. once housing prices started to drop moderately in ())6+())3 in many parts of the U % . refinancing became more difficult #efaults and foreclosure activity increased dramatically as A2M
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interest rates reset higher
#uring ())3. nearly > 4 million U %
housing As of
properties were subject to foreclosure activity. up 38I versus ())6 would reach a level between U % B())+4)) billion
#ecember ((. ())3. a leading business periodical estimated subprime defaults
'he mortgage lenders that retained credit risk $the risk of payment default& were the first to be affected. as borrowers became unable or unwilling to make payments Major Banks and other financial institutions around the world have reported losses of approCimately U % B>,) billion as of Debruary ())9. as cited below #ue to a form of financial engineering called securiti-ation. many mortgage lenders had passed the rights to the mortgage payments and related credit/default risk to third+party investors via mortgage+backed securities $MB%& and collaterali-ed debt obligations $/#0& /orporate. individual and institutional investors holding MB% or /#0 faced significant losses. as the value of the underlying mortgage assets declined %tock markets in many countries declined significantly 'he widespread dispersion of credit risk and the unclear impact on financial institutions caused lenders to reduce lending activity or to make loans at higher interest rates %imilarly. the ability of corporations to obtain funds through the issuance of commercial paper was impacted 'his aspect of the crisis is consistent with a credit crunch 'he li1uidity concerns drove central banks around the world to take action to provide funds to member banks to encourage the lending of funds to worthy borrowers and to re+invigorate the commercial paper markets.
'he subprime crisis also places downward pressure on economic growth. because fewer or more eCpensive loans decrease investment by businesses and consumer spending. which drive the economy A separate but related dynamic is 27
the downturn in the housing market. where a surplus inventory of homes has resulted in a significant decline in new home construction and housing prices in many areas 'his also places downward pressure on growth Fith interest rates on a large number of subprime and other A2M due to adjust upward during the ())9 period. U % legislators and the U % 'reasury #epartment are taking action A systematic program to limit or defer interest rate adjustments was implemented to reduce the impact In addition. lenders and borrowers facing defaults have been encouraged to cooperate to enable borrowers to stay in their homes 'he risks to the broader economy created by the financial market crisis and housing market downturn were primary factors in the Hanuary ((. ())9 decision by the U % Dederal reserve to cut interest rates and the economic stimulus package signed by <resident Bush on Debruary >4. ())9 Both actions are designed to stimulate economic growth and inspire confidence in the financial markets
Ba12g,"/!. (!3",0a'("!:
A subprime loan is one that is offered at an interest rate higher than A+paper loans due to the increased risk %ubprime. therefore. is not the same as JAlt+AJ. because Alt+A loans 1ualify for the JA+ratingJ by Moody=s or other rating firms. albeit for an JalternativeJ means 'he value of U % subprime mortgages was estimated at B> 4 trillion as of March ())3. with over 3 , million first+lien subprime mortgages outstanding ApproCimately >6I of subprime loans with adjustable rate mortgages $A2M& were 8)+days delin1uent or in foreclosure proceedings as of 0ctober ())3. roughly triple the rate of ()), risen to (>I By Hanuary of ())9. the delin1uency rate had
%ubprime A2Ms only represent 6 9I of the loans outstanding in the U%. yet they represent *4 )I of the foreclosures started during the third 1uarter of ())3 ?A 28
total of nearly **6.3(6 U % household properties were subject to some sort of foreclosure action from Huly to %eptember ())3. including those with prime. alt+A and subprime loans 'his is nearly double the ((4.))) properties in the year+ago period and 4*I higher than the 444.6(3 in the prior 1uarter 'his increased to ,(3.3*) during the fourth 1uarter of ())3. an >9I increase versus the prior 1uarter Dor all of ())3. nearly > 4 million properties were subject to ( ( million foreclosure filings. up 38I and 3,I respectively versus ())6 Doreclosure filings including default notices. auction sale notices and bank repossessions can include multiple notices on the same property
'he estimated value of subprime adjustable+rate mortgages $A2M& resetting at higher interest rates is U % B*)) billion for ())3 and B,)) billion for ())9 2eset activity is eCpected to increase to a monthly peak in March ())9 of nearly B>)) billion. before declining An average of *,).))) subprime A2M are scheduled to undergo their first rate increase each 1uarter in ())9
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'he reasons for this crisis are varied and compleC Understanding and managing the ripple effect through the world+wide economy poses a critical challenge for governments. businesses. and investors #ue to innovations in securi-ation the risks related to the inability of homeowners to meet mortgage payments have been distributed broadly. with a series of conse1uential impacts 'he crisis can be attributed to a number of factors. such as the inability of homeowners to make their mortgage paymentsG poor judgment by either the borrower or the lenderG inappropriate mortgage incentives. and rising adjustable mortgage rates Durther. declining home prices have made re+financing more difficult 'here are three primary risk categories involved"
29
•
C, .(' R(-2: 'raditionally. the risk of default $called credit risk& would be assumed by the bank originating the loan ;owever. due to innovations in securiti-ation. credit risk is now shared more broadly with investors. because the rights to these mortgage payments have been repackaged into a variety of compleC investment vehicles. generally categori-ed as mortgage+backed securities $MB%& or collaterali-ed debt obligations $/#0& A /#0. essentially. is a repacking of eCisting debt. and in recent years MB% collateral has made up a large proportion of issuance In eCchange for purchasing the MB%. third+party investors receive a claim on the mortgage assets. which become collateral in the event of default Durther. the MB% investor has the right to cash flows related to the mortgage payments 'o manage their risk. mortgage originators $e g . banks or mortgage lenders& may also create separate legal entities. called special+purpose entities $%<7&. to both assume the risk of default and issue the MB% 'he banks effectively sell the mortgage assets $i e . banking accounts receivable. which are the rights to receive the mortgage payments& to these %<7 In turn. the %<7 then sells the MB% to the investors 'he mortgage assets in the %<7 become the collateral
•
A-- ' P,(1
R(-2: /#0 valuation is compleC and related Jfair valueJ
accounting for such J5evel 4J assets is subject to wide interpretation 'his valuation fundamentally derives from the collectibles of subprime mortgage payments. which is difficult to predict due to lack of precedent and rising delin1uency rates Banks and institutional investors have recogni-ed substantial losses as they revalue their /#0 assets downward Most /#0s re1uire that a number of tests be satisfied on a periodic basis. such as tests of interest cash flows. collateral ratings. or market values Dor deals with market value tests. if the valuation falls below certain levels. the /#0 may be re1uired by its terms to sell collateral in a short period of time. often at a steep loss. much like a stock brokerage account margin call If the risk is not legally contained within an
30
%<7 or otherwise. the entity owning the mortgage collateral may be forced to sell other types of assets. as well. to satisfy the terms of the deal In addition. credit rating agencies have downgraded over U % B,) billion in highly+rated /#0 and more such downgrades are possible %ince certain types of institutional investors are allowed to only carry higher+1uality $e g . JAAAJ& assets. there is an increased risk of forced asset sales. which could cause further devaluation
•
L(9/(.('8 R(-2: A related risk involves the commercial paper market. a key source of funds $i e . li1uidity& for many companies /ompanies and %<7 called structured investment vehicles $%IM& often obtain short+term loans by issuing commercial paper. pledging mortgage assets or /#0 as collateral Investors provide cash in eCchange for the commercial paper. receiving money+market interest rates ;owever. because of concerns regarding the value of the mortgage asset collateral linked to subprime and Alt+A loans. the ability of many companies to issue such paper has been significantly affected 'he amount of commercial paper issued as of 0ctober >9. ())3 dropped by (,I. to B999 billion. from the August 9 level In addition. the interest rate charged by investors to provide loans for commercial paper has increased substantially above historical levels
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Average investors and corporations face a variety of risks due to the inability of mortgage holders to pay 'hese vary by legal entity %ome general eCposures by entity type include"
•
Bank corporations" 'he earnings reported by major banks are adversely affected by defaults on mortgages they issue and retain /ompanies value
31
their mortgage assets $receivables& based on estimates of collections from homeowners /ompanies record eCpenses in the current period to adjust this valuation. increasing their bad debt reserves and reducing earnings 2apid or uneCpected changes in mortgage asset valuation can lead to volatility in earnings and stock prices 'he ability of lenders to predict future collections is a compleC task subject to a multitude of variables
•
Mortgage lenders and 2eal 7state Investment 'rusts" 'hese entities face similar risks to banks In addition. they have business models with significant reliance on the ability to regularly secure new financing through /#0 or commercial paper issuance secured by mortgages Investors have become reluctant to fund such investments and are demanding higher interest rates %uch lenders are at increased risk of significant reductions in book value due to asset sales at unfavorable prices and several have filed bankruptcy
•
%pecial purpose entities $%<7&" 5ike corporations. %<7 are re1uired to revalue their mortgage assets based on estimates of collection of mortgage payments If this valuation falls below a certain level. or if cash flow falls below contractual levels. investors may have immediate rights to the mortgage asset collateral 'his can also cause the rapid sale of assets at unfavorable prices 0ther %<7 called structured investment vehicles $%IM& issue commercial paper and use the proceeds to purchase securiti-ed assets such as /#0 'hese entities have been affected by mortgage asset devaluation %everal major %IM are associated with large banks
•
Investors" %tocks or bonds of the entities above are affected by the lower earnings and uncertainty regarding the valuation of mortgage assets and related payment collection Many investors and corporations purchased MB% or /#0 as investments and incurred related losses
32
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%ubprime borrowing was a major contributor to an increase in home ownership rates and the demand for housing 'he overall U % homeownership rate increased from 6* percent in >88* $about where it was since >89)& to a peak in ())* with an all time high of 68 ( percent 'his demand helped fuel housing price increases and consumer spending Between >883 and ())6. American home prices increased by >(*I %ome homeowners used the increased property value eCperienced in the housing bubble to refinance their homes with lower interest rates and take out second
33
mortgages against the added value to use the funds for consumer spending U % household debt as a percentage of income rose to >4)I during ())3. versus >))I earlier in the decade A culture of consumerism is a factor In the early ()))s recession that began in early ())> and which was eCacerbated by the %eptember >>. ())> terrorist attacks. Americans were asked to spend their way out of economic decline with Jconsumerism cast as the new patriotismJ 'his call linking patriotism to shopping echoed the urging of former <resident Bill /linton to Jget out and shopJ and corporations like Aeneral Motors produced commercials with the same theme 0verbuilding during the boom period. increasing foreclosure rates and unwillingness of many homeowners to sell their homes at reduced market prices have significantly increased the supply of housing inventory available %ales volume $units& of new homes dropped by (6 *I in ())3 versus the prior year By Hanuary ())9. the inventory of unsold new homes stood at 8 9 months based on #ecember ())3 sales volume. the highest level since >89> Durther. a record of nearly four million unsold eCisting homes was available 'his eCcess supply of home inventory places significant downward pressure on prices As prices decline. more homeowners are at risk of default and According to the %R<//ase+%hiller housing price indeC. by foreclosure
!ovember ())3. average U % housing prices had fallen approCimately 9I from their ())6 peak ;owever. there was significant variation in price changes across U % markets. with many appreciating and others depreciating 'he price decline in #ecember ())3 versus the year+ago period was >) *I As of Debruary ())9. housing prices are eCpected to continue declining until this inventory of surplus homes $eCcess supply& is reduced to more typical levels
R") "3 *",,"4 ,-
34
A variety of factors have contributed to an increase in the payment delin1uency rate for subprime A2M borrowers. which recently reached (>I. roughly four times its historical level 7asy credit. combined with the assumption that housing prices would continue to appreciate. also encouraged many subprime borrowers to obtain A2Ms they could not afford after the initial incentive period 0nce housing prices started depreciating moderately in many parts of the U %. refinancing became more difficult %ome homeowners were unable to re+finance and began to default on loans as their loans reset to higher interest rates and payment amounts 0ther homeowners. facing declines in home market value or with limited accumulated e1uity. are choosing to stop paying their mortgage 'hey are essentially Jwalking awayJ from the property and allowing foreclosure. despite the impact to their credit rating
Misrepresentation of loan application data is another contributing factor In a Hanuary >4. ())9 column in the !ew
rk 'imes. Aeorge Mason University economics professor 'yler /owen wrote. J'here has been plenty of talk about =predatory lending.= but =predatory borrowing= may have been the bigger problem As much as 3) percent of recent early payment defaults had fraudulent misrepresentations on their original loan applications. according to one recent study 'he research was done by Base<oint Analytics. which helps banks and lenders identify fraudulent transactionsG the study looked at more than three million loans from >883 to ())6. with a majority from ()), to ())6 Applications with misrepresentations were also five times as likely to go into default Many of the frauds were simple rather than ingenious In some cases. borrowers who were asked to state their incomes just lied. sometimes reporting five times actual incomeG other borrowers falsified income documents by using computers J U% #epartment of the 'reasury suspicious activity report of mortgage fraud increased by >.*>> percent between >883 and ()), 35
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A variety of factors have caused lenders to offer an increasing array of higher+ risk loans to higher+risk borrowers 'he share of subprime mortgages to total originations was ,I $B4, billion& in >88*. 8I in >886. >4I $B>6) billion& in >888. and ()I in ())6 A study by the Dederal 2eserve indicated that the average difference in mortgage interest rates between subprime and prime mortgages $the Jsubprime markupJ or Jrisk premiumJ& declined from ( 9 percentage points $(9) basis points& in ())>. to > 4 percentage points in ())3 In other words. the risk premium re1uired by lenders to offer a subprime loan declined 'his occurred even though subprime borrower and loan characteristics declined overall during the ())>+())6 period. which should have had the opposite effect combination is common to classic boom and bust credit cycles 'he
36
In addition to considering higher+risk borrowers. lenders have offered increasingly high+risk loan options and incentives 0ne eCample is the interest+ only adjustable+rate mortgage $A2M&. which allows the homeowner to pay just the interest $not principal& during an initial period Another eCample is a Jpayment optionJ loan. in which the homeowner can pay a variable amount. but any interest not paid is added to the principal Durther. an estimated one+third of A2M originated between ())*+())6 had JteaserJ rates below *I. which then increased significantly after some initial period. as much as doubling the monthly payment %ome believe that mortgage standards became laC because of a moral ha-ard. where each link in the mortgage chain collected profits while believing it was passing on risk
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a'("! %ecuriti-ation is a structured finance process in which assets. receivables or financial instruments are ac1uired. classified into pools. and offered as collateral for third+party investment 'here are many parties involved #ue to securiti-ation. investor appetite for mortgage+backed securities $MB%&. and the tendency of rating agencies to assign investment+grade ratings to MB%. loans with a high risk of default could be originated. packaged and the risk readily transferred to others Asset securiti-ation began with the structured financing of mortgage pools in the >83)s 'he securiti-ed share of subprime mortgages $i e . those passed to third+ party investors& increased from ,*I in ())>. to 3,I in ())6 Alan Areenspan stated that the securiti-ation of home loans for people with poor credit E not the loans themselves E were to blame for the current global credit crisis R") "3 0",'gag *,"2 ,Mortgage brokers don=t lend their own money 'here is not a direct correlation between loan performance and compensation 'hey have big financial incentives 37
for selling compleC. adjustable rate mortgages $A2M=s&. since they earn higher commissions According to a study by Fholesale Access Mortgage 2esearch R /onsulting Inc . in ())* Mortgage brokers originated 69I of all residential loans in the U % . with subprime and Alt+A loans accounting for *( 3I of brokerages= total production volume 'he chairman of the Mortgage Bankers Association claimed brokers profited from a home loan boom but didn=t do enough to eCamine whether borrowers could repay
R") "3 0",'gag /!. ,4,(' ,Underwriters determine if the risk of lending to a particular borrower under certain parameters is acceptable Most of the risks and terms that underwriters consider fall under the three /Ps of underwriting" credit. capacity and collateral %ee mortgage underwriting In ())3. *) percent of all subprime loans were generated by automated underwriting An 7Cecutive vice president of /ountrywide ;ome 5oans Inc stated in ())* J<rior to automating the process. getting an answer from an underwriter took up to a week JFe are able to produce a decision inside of 4) seconds today And previously. every mortgage re1uired a standard set of full documentation J %ome think that users whose laC controls and willingness to rely on shortcuts led them to approve borrowers that under a less+automated system would never have made the cut are at fault for the subprime meltdown
38
R") "3 g"6 ,!0 !' a!. , g/)a'",%ome economists claim that government policy actually encouraged the development of the subprime debacle through legislation like the /ommunity 2einvestment Act. which they say forces banks to lend to otherwise un+ creditworthy consumers 7conomist 2obert Kuttner has critici-ed the repeal of the Alass+%teagall Act as contributing to the subprime meltdown A taCpayer+ funded government bailout related to mortgages during the %avings and 5oan crisis may have created a moral ha-ard and acted as encouragement to lenders to make similar higher risk loans %ome have argued that. despite attempts by various U % states to prevent the growth of a secondary market in repackaged predatory loans. the 'reasury #epartment=s 0ffice of the /omptroller of the /urrency. at the insistence of national banks. struck down such attempts as violations of Dederal banking laws In response to a concern that lending was not properly regulated. the ;ouse and %enate are both considering bills to regulate lending practices R") "3 1, .(' ,a'(!g ag !1( -
/redit rating agencies are now under scrutiny for giving investment+grade ratings to securiti-ation transactions holding subprime mortgages ;igher ratings are theoretically due to the multiple. independent mortgages held in the MB% per the agencies. but critics claim that conflicts of interest were in play
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/entral banks are primarily concerned with managing the rate of inflation and avoiding recessions 'hey are also the Nlenders of last resortO to ensure li1uidity 'hey are less concerned with avoiding asset bubbles. such as the housing
39
bubble and dotcom bubble /entral banks have generally chosen to react after such bubbles burst to minimi-e collateral impact on the economy. rather than trying to avoid the bubble itself 'his is because identifying an asset bubble and determining the proper monetary policy to properly deflate it are not proven concepts 'here is significant debate among economists regarding whether this is the optimal strategy Dederal 2eserve actions raised concerns among some market observers that it could create a moral ha-ard %ome industry officials said that Dederal 2eserve Bank of !ewrk involvement in the rescue of 5ong+'erm /apital Management in >889 would encourage large financial institutions to assume more risk. in the belief that the Dederal 2eserve would intervene on their behalf A potential contributing factor to the rise in home prices was the lowering of interest rates earlier in the decade by the Dederal 2eserve. to diminish the blow of the collapse of the dot+com bubble and combat the risk of deflation
IMPACT
I0pa1' "! -'"12 0a,2 '0n Huly >8. ())3. the #ow Hones Industrial Average hit a record high. closing above >*.))) for the first time By August >,. the #ow had dropped below >4.))) and the %R< ,))$S;P <== is an indeC containing the stocks of ,)) 5arge+/ap corporations. most of which are American. this indeC is developed by standard and poor& had crossed into negative territory year+to+date %imilar drops occurred in virtually every market in the world. with Bra-il and Korea being hard+ hit 5arge daily drops became common. with. for eCample. the K", a C"0p"-(' S'"12 P,(1 I!. + $K0%<I& dropping about 3I in one day. although ())3=s largest daily drop by the %R< ,)) in the U % was in Debruary. a result of the subprime crisis
40
Mortgage lenders and home builders fared terribly. but losses cut across sectors. with some of the worst+hit industries. such as metals R mining companies. having only the vaguest connection with lending or mortgages I0pa1' "! 3(!a!1(a) (!-'('/'("!-
Many banks. mortgage lenders. real estate investment trusts $27I'&. and hedge funds suffered significant losses as a result of mortgage payment defaults or mortgage asset devaluation As of Debruary >8. ())9 financial institutions had recogni-ed subprime+related losses or write+downs eCceeding U % B>,) billion <rofits at the 9.,44 U % banks insured by the Dederal #eposit Insurance /orporation $D#I/& declined from B4, ( billion to B, 9 billion $94 , percent& during the fourth 1uarter of ())3 versus the prior year. due to soaring loan defaults and provisions for loan losses It was the worst bank and thrift performance since the fourth 1uarter of >88> Dor all of ())3. these banks earned B>), , billion. down (3 * percent from a record profit of B>*, ( billion in ())6 0ther companies from around the world. such as IKB #eutsche Industriebank. have also suffered significant losses and scores of mortgage lenders have filed for bankruptcy 'op management has not escaped unscathed. as the /70s of Merrill 5ynch and /itigroup were forced to resign within a week of each other Marious institutions followed+up with merger deals
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'here is concern that some homeowners are turning to arson as a way to escape from mortgages they can=t or refuse to pay 'he DBI reports that arson grew *I
41
in suburbs and ( (I in cities from ()), to ())6 As of Han ())9. the ())3 numbers were not yet available
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A secondary cause and effect of the crisis relates to the role of municipal bond JmonolineJ insurance corporations By insuring municipal bond issues. those bonds achieve higher debt ratings ;owever. these insurers used premiums to purchase /#0 investments and have suffered a significant loss. which brings their ability to insure bonds into 1uestion Unless these insurers obtain additional capital. rating agencies may downgrade the bonds they insured or guaranteed In turn. this may re1uire financial institutions holding the bonds to lower their valuation or to sell them. as some entities $such as pension funds& are only allowed to hold the highest+grade bonds 'he impact of such devaluation on institutional investors and corporations holding the bonds $including major banks& has been estimated as high as B()) billion 2egulators are taking action to encourage banks to lend the re1uired capital to certain monoline insurers. to avoid such an impact
I0pa1' "! 7"0 "4! ,According to the %R<//ase+%hiller housing price indeC. by !ovember ())3. average U % housing prices had fallen approCimately 9I from their ())6 peak ;owever. there was significant variation in price changes across U % markets. with many appreciating and others depreciating 'he price decline in #ecember ())3 versus the year+ago period was >) *I %ales volume $units& of new homes dropped by (6 *I in ())3 versus the prior year By Hanuary ())9. the inventory of unsold new homes stood at 8 9 months based on #ecember ())3 sales volume. the highest level since >89>
42
;ousing prices are eCpected to continue declining until this inventory of surplus homes $eCcess supply& is reduced to more typical levels As MB% and /#0 valuation is related to the value of the underlying housing collateral. MB% and /#0 losses will continue until housing prices stabili-e As home prices have declined following the rise of home prices caused by speculation and as re+ financing standards have tightened. a number of homes have been foreclosed and sit vacant 'hese vacant homes are often poorly maintained and sometimes attract s1uatters and/or criminal activity with the result that increasing foreclosures in a neighborhood often serve to further accelerate home price declines in the area 2ents have not fallen as much as home prices with the result that in some affluent neighborhoods homes that were formerly owner occupied are now occupied by renters In select areas falling home prices along with a decline in the U % dollar have encouraged foreigners to buy homes for either occasional use and/or long term investments Additional problems are anticipated in the future from the impending retirement of the baby boomer generation It is believed that a significant proportion of baby boomers are not saving ade1uately for retirement and were planning on using their increased property value as a Jpiggy bankJ or replacement for a retirement+savings account 'his is a departure from the traditional American approach to homes where Jpeople worked toward paying off the family house so they could hand it down to their childrenJ I0pa1' "! 0(!",('( 'here is a disproportionate level of foreclosures in some minority neighborhoods About *6I of ;ispanics and ,,I of blacks who obtained mortgages in ()), got higher+cost loans compared with about >3I of whites and Asians. according to Dederal 2eserve data 0ther studies indicate they would have 1ualified for lower+ rate loans
Businesses filing for bankruptcy
43
B/-(! -!ew Dinancial American Mortgage %entinel Management Aroup Ameri1uest !etBank 'erra %ecurities American Dreedom Mortgage. Inc
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A<.#D *)! AF.# *)! AF.1 *)! AF.1 *)! A#.G *)! AF.< *)! A#.C *)! A1.=E *)! A#.1 *)! A1.1 *)! A#.I *)! A1.< *)! AF.G *)! AF.E *)! A1.C *)! AF.= *)! A=.FG= *)! A=.DIG *)! AF.F *)! A=.<D= *)! AF.< *)! A1.1 *)!
45
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<resident Aeorge F Bush announced a plan to voluntarily and temporarily free-e the mortgages of a limited number of mortgage debtors holding A2Ms. declaring JI have a message for every homeowner worried about rising mortgage payments" 'he best you can do for your family is to call >+9))+88,+;0<7 $sic&J 'he correct number is >+999+88,+;0<7 A refinancing facility called Dederal ;ousing Administration+ D;A+%ecure was also created 'his is part of an ongoing collaborative effort between the U% Aovernment and private industry to help some sub+prime borrowers called the ;ope !ow Alliance 'he ;ope !ow Alliance released a report in Debruary. ())9 indicating it helped ,*,.))) subprime borrowers with shaky credit in the second half of ())3. or 3 3 percent of 3 > million subprime loans outstanding in %eptember ())3 A spokesperson acknowledged that much more must be done 46
#uring Debruary ())9. a program called J<roject 5ifelineJ was announced %iC of the largest U % lenders. in partnership with the ;ope !ow Alliance. agreed to defer foreclosure actions for 4) days for homeowners 8) or more days delin1uent on payments 'he intent of the program was to encourage more loan adjustments. to avoid foreclosures 'he U % 'reasury #epartment is working directly with major banks to develop a systematic means of modifying loans for a significant portion of borrowers facing A2M increases. rather than working through loans on a case+by+case basis <resident Bush also signed into law on Debruary >4. ())9 an economic stimulus package of B>69 billion. mainly in the form of income taC rebates. to help stimulate economic growth
O'7 , a1'("!•
5enders and homeowners both may benefit from avoiding foreclosure. which is a costly and lengthy process %ome lenders have taken action to reach out to homeowners to provide more favorable mortgage terms $i e . loan modification or refinancing& ;omeowners have also been encouraged to contact their lenders to discuss alternatives /orporations. trade groups. and consumer advocates have begun to cite statistics on the numbers and types of homeowners assisted by loan modification programs 'here is some dispute regarding the appropriate measures. sources of data. and ade1uacy of progress A report issued in Hanuary ())9 showed that mortgage lenders modified ,*.))) loans and established >94.))) repayment plans in the third 1uarter of ())3. a period in which there were 49*.))) new foreclosures /onsumer groups claimed the modifications affected less than > percent of the 4 million subprime loans with adjustable rates that were outstanding in the third 1uarter
•
/redit rating agencies help evaluate and report on the risk involved with various investment alternatives 'he rating processes can be re+eCamined 47
and improved to encourage greater transparency to the risks involved with compleC mortgage+backed securities and the entities that provide them 2ating agencies have recently begun to aggressively downgrade large amounts of mortgage+backed debt
•
2egulators and legislators can take action regarding lending practices. bankruptcy protection. taC policies. affordable housing. credit counseling. education. and the licensing and 1ualifications of lenders 2egulations or guidelines can also influence the nature. transparency and regulatory reporting re1uired for the compleC legal entities and securities involved in these transactions /ongress also is conducting hearings help identify solutions and apply pressure to the various parties involved
•
'he media can help educate the public and parties involved It can also ensure the top subject material eCperts are engaged and have a voice to ensure a reasoned debate about the pros and cons of various solutions
•
Banks have sought and received additional capital $i e . cash investments& from sovereign wealth funds. which are entities that control the surplus savings of developing countries An estimated U % B68 billion has been invested by these entities in large financial institutions over the past year 0n Hanuary >,. ())9. sovereign wealth funds provided a total of B(> billion to two major U % financial institutions %uch capital is used to help banks maintain re1uired capital ratios $an important measure of financial health&. which have declined significantly due to subprime loan or /#0 losses %overeign wealth funds are estimated to control nearly B( 8 trillion Much of this wealth is oil and gas related As they represent the surplus funds of governments. these entities carry at least the perception that their investments have underlying political motives
•
5itigation related to the subprime crisis is underway A study released in Debruary ())9 indicated that (39 civil lawsuits were filed in federal courts
48
during ())3 related to the subprime crisis 'he number of filings in state courts were not 1uantified by are also believed to be significant 'he study found that *4 percent of the cases were class actions brought by borrowers. such as those that contended they were victims of discriminatory lending practices 0ther cases include securities lawsuits filed by investors. commercial contract disputes. employment class actions. and bankruptcy+related cases #efendants included mortgage bankers. brokers. lenders. appraisers. title companies. home builders. servicers. issuers. underwriters. bond insurers. money managers. public accounting firms. and company boards and officers
T7 F . ,a) R - ,6
Fithin the Dederal 2eserve. /hairman Ben Bernanke signals towards making interest rate cuts In early ())9. Ben Bernanke said" JBroadly. the Dederal 2eservePs response has followed two tracks" efforts to support market li1uidity and functioning and the pursuit of our macroeconomic objectives through monetary policy J 'ougher regulatory standards are proposed Additionally. a free-e of interest payments on certain sub+prime loans is announced 0n Hanuary ((. ())9. the Ded also slashed a key interest rate $the federal funds rate& by 3, basis points to 4 ,I. the biggest cut since >89*. followed by another cut of ,) basis points on Hanuary 4)th /entral banks have conducted open market operations to ensure member banks have access to funds $i e . li1uidity& 'hese are effectively short+term loans to member banks collaterali-ed by government securities /entral banks have also lowered the interest rates charged to member banks $called the discount rate in the U % & for short+term loans Both measures effectively lubricate the financial system. in two key ways Dirst. they help provide access to funds for those
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entities with illi1uid mortgage+backed assets 'his helps lenders. %<7. and %IM avoid selling mortgage+backed assets at a steep loss %econd. the available funds stimulate the commercial paper market and general economic activity
E+p 1'a'("!- a!. 3", 1a-'As early as the ())4 Annual 2eport issued by DairfaC Dinancial ;oldings 5imited. <rem Fatsa was raising concerns about securiti-ed products" JFe have been concerned for some time about the risks in asset+backed bonds. particularly bonds that are backed by home e1uity loans. automobile loans or credit card debt $we own no asset+backed bonds& It seems to us that securiti-ation $or the creation of these asset+backed bonds& eliminates the incentive for the originator of the loan to be credit sensitive 'ake the case of an automobile dealer <rior to securiti-ation. the dealer would be very concerned about who was given credit to buy an automobile Fith securiti-ation. the dealer $almost& does not care as these loans can be laid off through securiti-ation 'hus. the loss eCperienced on these loans after securiti-ation will no longer be comparable to that eCperienced prior to securiti-ation $called a SSmoralPP ha-ard& of #ecember 4>. ())4 in the U % 'his is not a small problem 'here is B> ) trillion in asset+backed bonds outstanding as Fho is buying these bondsQ Insurance companies. money managers and banks L in the main L all reaching for yield given the eCcellent ratings for these bonds Fhat happens if we hit an air pocketQ Unlike J 'he legacy of Alan Areenspan has been cast into doubt with %enator /hris #odd claiming he created the Jperfect stormJ Alan Areenspan has remarked that there is a one+in+three chance of recession from the fallout !ouriel 2oubini. a professor at !ewrk University and head of 2oubini Alobal 7conomics. has said that if the economy slips into recession Jthen you have a systemic banking crisis like we haven=t had since the >84)sJ
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0n %eptember 3. ())3. the Fall %treet Hournal reported that Alan Areenspan has said that the current turmoil in the financial markets is in many ways JidenticalJ to the problems in >893 and >889 'he Associated <ress described the current climate of the market on August >4. ())3. as one where investors were waiting for Jthe neCt shoe to dropJ as problems from Jan overheated housing market and an overeCtended consumerJ are Jjust beginning to emerge J Market Fatch has cited several economic analysts with %tifel !icolaus claiming that the problem mortgages are not limited to the subprime niche saying Jthe rapidly increasing scope and depth of the problems in the mortgage market suggest that the entire sector has plunged into a downward spiral similar to the subprime woes whereby each negative development feeds further deteriorationJ. calling it a Jvicious cycleJ and adding that they Jcontinue to believe conditions will get worseJ As of !ovember ((. ())3. analysts at a leading investment bank estimated losses on subprime /#0 would be approCimately U % B>*9 billion As of #ecember ((. ())3. a leading business periodical estimated subprime defaults between U % B())+4)) billion As of March >. ())9 analysts from three large financial institutions estimated the impact would be between U % B4,)+6)) billion Alan Greenspan, the former Chairman of the Federal Reser e, stated! "#he $%rrent $redit $risis &ill $ome to an end &hen the o erhan' of in entories of ne&l( )%ilt homes is lar'el( li*%idated, and home pri$e deflation $omes to an end+ #hat &ill sta)ili,e the no&%n$ertain al%e of the home e*%it( that a$ts as a )%ffer for all home mort'a'es, )%t most importantl( for those held as $ollateral for residential mort'a'e-)a$.ed se$%rities+ /er( lar'e losses &ill, no do%)t, )e ta.en as a $onse*%en$e of the $risis+ 0%t after a period of protra$ted ad1%stment, the 2+3+ e$onom(, and the &orld e$onom( more 'enerall(, &ill )e a)le to 'et )a$. to )%siness+"
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The "nited States subprime crisis in 'raphics
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I0p)(1a'("!- "3 -/*p,(0 1,(-(- "! 6a,("/- 1"/!',( -:
'hough the subprime crisis has had its effects on the economies of various countries across the world. for us it is of significance to know the amount of impact it has had on the major economies that share strong political. geographical and economic ties with the United %tates
I0pa1' "! Ca!a.a:
'he subprime crisis was supposed to be locali-ed to the U % As we see the write downs in /anadian banks one wonders when the problem will tip over to /anada 'he U % sub+prime mortgage fiasco is already s1uee-ing borrowers in /anada as bankers struggle to determine which lenders are eCposed to the greatest risk. says /raig Fright 2B/ chief economist 'he U % is moving into a recession 'he impact on the /anadian economy will be significant as the U % economy slows down <ropelled by the dramatic slowdown in the U % housing market is being offset by strong growth in American trade as a result of the weakening greenback 'he level of foreclosures has not hit the market yet 0nce the impact is felt both financial and from the perspective of consumer confidence the economy in the U % will deepen the move into recession 'he economies of /anada and B / are being helped by a long period of strong global growth but could be hit by Nfriendly fireO if the U % resorts to protectionist measures as a result of a weak dollar and a weak economy in an election year 0ne only needs to review the recent forestry sector difficulties last year 'he recent rise in the /anadian dollar has driven profitability out of the industry If the AmericanPs choose to reignite the softwood lumber dispute it will cripple one of the chief resource sectors in western /anada 'he impact of the loss of
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eCport volumes due to the strong /anadian dollar as well as U % protectionistPs measures could stimulate a recession in /anada 'he impact of both will certainly pop the real estate bubble in western /anada Fe are already seeing corrections in the /algary markets It is only a matter of time before we see a correction in the Mancouver real estate markets 'he impact of high ratio financing and higher debt loads on consumers will see an impact on the level of bankruptcies and debt consolidations
I0pa1' "! E/,"p :
'he impact of U% subprime crisis on 7urope is gaining prominence with every passing day. 7arlier real estate agents could 1uote the prices of their choice while selling properties ;owever. things have changed a lot down the line /urrently. the prices of homes are dropping and there is a probable fear that the recession may be reigning supreme in 5ondon neCt year It is also being feared that the U% %ubprime crisis may be falling upon as a grind 0wing to this state of affairs. lenders around the globe are a bit apprehensive in eCtending new loans to debtors Impact of U% %ubprime crisis on 7urope cannot be ignored 'hat this part of the world will be impacted as well. can be concluded from the fact that signs of the same have already started showing $like falling prices of homes& in 5ondon T !orthern 2ock. which was an eminent mortgage lender. took refuge in the Bank of 7ngland for purposes of emergency financing in the month of %eptember. ())3 <rospective purchasers for the mortgage lender are still being looked for T Another instance in Aermany. which implies the impact of U% subprime crisis on 7urope. is when AermanyPs IKB #eutsche Industriebank accepted U%#B>> > billion from the Aovernment as a bailout pertaining to its various United %tates mortgage investments
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T B!< <aribas. the Drench Bank was compelled to take some drastic steps It stopped all withdrawals from a fund of U%#B( ( billion pertaining to investment funds as the true value of the investment portfolios could not be ascertained
I0pa1' "! A3,(1a:
Africa was the least affected with %outh Africa and 7gypt being the only countries to record some minor disturbances Fhy has Africa remained so detached from the sub prime crisisQ 'he main reason why Africa has not felt the full effect of the sub+prime crisis which has since culminated in the slowdown of the U% economy is that most African financial markets still lag behind in terms of financial market sophistication in terms of products on offer as well as information asymmetry 'his is evident in the fact that most of the capital markets in Africa are still being developed with the eCception of the two advanced ones which are %outh Africa and 7gypt %ome African countries still have eCchange controls which restrict the flow of international capital thus limiting the contagion effect from foreign financial markets %ome African countries have just established %tock 7Cchanges which by and large lack li1uidity and market depth with a case in point being %wa-iland which has siC listed counters and an inactive bond market 0ther established eCchanges are illi1uid and in a way limit Africa=s eCposure to the global village
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According to the African #evelopment Bank. the African economy is eCpected to grow by 6.,I in ())9 driven by increased demand for resources from the booming /hinese and Indian 7conomies which will offset the decline in demand from the U% and 7urope 'he /hinese economy is eCpected to grow by 8. 6I in ())9 which is still high enough to benefit African economies despite the threat of a U% recession 'he indirect effect on African economies of a global slowdown emanating from the sub+prime crisis will be felt nevertheless through reduced demand for African goods and services
'he /hinese economy which is eCpected to grow by 8.6I down from the initial forecast >>.3I will insulate Africa and ensure some growth going forward despite a slowdown in the U% I0pa1' "! -"/'7 A0 ,(1a %o far. the sub+prime crisis has had a limited direct impact on 5atin AmericaPs mortgage markets In MeCico. the market for new low+and middle+income housing has grown rapidly. thanks to the creation of a market for residential mortgage securities in ())4 In the last 1uarter of ())3 alone. MeCican issuers sold B> , billion in new mortgage+backed securitiesG a significant portion of B* * billion outstanding. with only a slight drop in prices to reflect globally induced risk. according to the publication Asset %ecuriti-ation 2eport /hilean markets also have stayed relatively calm 'hese markets have been insulated in part because most investment in real estate+backed securities has come from local investors who often need to invest in local+currency markets Most important. 5atin AmericaPs mortgage markets and homeowners are very different from those in the U% NItPs natural that the state of global markets will have some kind of ripple effect.O says Areg Kabance.
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managing director for 5atin American structured finance at Ditch 2atings. the international credit ratings agency NBut 5atin American countries. from a credit standpoint. are a lot better off than they have ever been to withstand turbulence and weather global market problems O 'o their benefit. 5atin American governments have applied the lessons of the past MeCicoPs Nte1uila crisisO of >88*+>88, forced many homeowners into default when the peso fell by 3) percent and interest rates soared In MeCico. all mortgages carry fiCed interest rates. unlike the infamous NeCploding A2MsO that left U% homeowners ruing their choice of adjustable+rate mortgages when interest rates rose MeCican mortgages are indeCed to inflation. but the state mortgage agency links that indeC to the minimum wage and makes up the difference if mortgage interest adjustments for inflation outpace wage growth 'his protects both borrowers and lenders 'he silver lining of past financial crises in 5atin America is that most individuals carry far less debt than do Americans In MeCico. for eCample. mortgage debt represents less than >) percent of A#<. compared to about ,) percent of A#< in 7urope and 9( percent of A#< in the U% L a ratio that has increased more than fourfold in the last two decades
I0pa1' "! S"/'7 A-(a
J'he current subprime mortgage crisis in the United %tates will not seriously impact %outh Asian countriesJ. said %hanta #evarajan. Forld Bank /hief 7conomist for the %outh Asia 2egion N'he impact will be mild because of the structure of the regionPs trade and financial flows. and partly because of compensating effects O #evarajan attributed three factors that work well for the %outh Asian countries" >& 5ack of eCposure to U % mortgage securitiesG (& availability of li1uidity in 62
domestic marketsG and 4& the possibility that lower capital inflows could help countries such as India with macroeconomic management ;ighlighting that Indian companies do not have big eCposure to U % mortgage securities. #evarajan said. N7ven if the subprime crisis leads to a global credit crunch. it still may not have a big effect because there is 1uite a lot of li1uidity in domestic markets in countries like India O ;e believes that if a global credit crunch leads to a decline in capital flows. it may still not be a bad thing for India ;e pointed out that Indian policymakers recently were having difficulties in managing the sudden surge in capital inflows while trying to manage India=s eCchange and inflation rates %peaking on a possible slowing down of the United %tates economy. #evarajan said. N'he impact on %outh Asian countries will still be relatively mildO ;e drew attention to the fact that the share of %outh AsiaPs trade with the United %tates has been declining and that the U % is no longer India=s leading supplier %ri 5anka. which used to rely on the United %tates for its garment eCports. has now increased them to 7urope and other regions substantially 0n the other hand. #evarajan eCpects that N a slowdown of the United States’ economic growth will moderate the increase in prices of oil and other commodity prices which will have a favorable impact on So!th "sia O %ince all %outh Asian countries are net importers of these commodities. such a slowdown will provide some relief in their balance+of+payments N'he declining value of U% dollar will certainly affect IndiaPs I' companies that sell services to the United %tates. and already many I' companies are feeling the effect.O #evarajan said 'he Indian companies engaged in business processes such as mortgage documentation have seen a decline in work orders and loss of revenues as U % lenders have tightened their eCposure to credit market 'he
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Indian I' industry. which derives about 6,I of its revenues from the U % market. will also be adversely affected if the subprime crisis leads to a recession in the United %tates ;owever. #evarajan allayed the fears of a significant negative impact on IndiaPs overall economy and said. N'he share of I' services eCports in total eCports of India is not growing very fast because India has started eCporting more manufactured goods and other services O Also. he said that eCports are not the only determinant of economic growth in India ;e eCpects that domestic demand in India will continue to fuel economic growth even when there is a dampening of I' eCports to the United %tates
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/;A<'72 III
Impact on India
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7ven though the Indian markets are eCperiencing the echo. the Indian banking system has remained fairly insulated from any direct impact of the subprime crisis in the U% 'his is because the Indian banks did not have significant eCposure to subprime loans in the U% ;owever. there was a major impact on the e1uity Markets as many foreign institutional investors $DIIs& sold off their investments into Indian /ompanies to cover their huge losses 'he DIIs have and. as of date. are continuing to withdrawn from the e1uity Markets Aoing forward. any subprime related tremors in the global Markets are likely to cause further chaos in the Indian e1uity Markets as well Also. a subprime like scenario in India seems unlikely given the current state of affairs Dirst and foremost. despite rapid growth in recent years. the mortgage market in India is nowhere near the levels of developed countries. such as the U% or the UK Mortgages as a percentage of A#< in India are still at a small percentage as compared with the U% and the UK %econdly. the approach of the Indian regulators has been balanced and forward+looking Its continuous doses of monetary tightening aims to ensure that the money supply $and hence inflation& is kept within manageable limits Admittedly housing prices in India are affected but this has got more to do with the demand+supply factors
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M a-/, - '7a' 1a! * 'a2 !:
!evertheless. the events which have unfolded in the recent months offer valuable learning for an emerging country like India 0n the fundamental level. there is an utmost need to strengthen the system for assessment of the borrowerPs credit worthiness 'he root cause of the sub prime mortgage crisis is the unsound credit practices that emerged in the U% market Dake certification. which helps an ineligible person to raise a home loan. cannot be ruled out in India ;ousing 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 <ersonal 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 0versight at this stage is bound to cause repercussions in future. no matter how robust the subse1uent processes are 'he regulator will have to ensure that banks do not follow imprudent and predatory lending practices by offering far too lenient lending terms than are warranted for 0n the other hand. banks need to make sure that they share the credit history of borrowers to better assess the credit worthiness of borrowers 0ne such initiative could be to encourage wider use of the services of the credit information bureau $/IB& Membership as well as sharing of credit information with /IB may be made mandatory for all financial institutions so that the comprehensive credit information pertaining to individual borrowers can be made available to all the financial institutions A fundamental limitation has been that the rating models largely rely on the historical performance record. which has been eCcellent in case of mortgage backed securities But these models do not take into account newer risk implications arising from newer mortgage structures. such as the option
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adjustable rate mortgage. which is prone to payment shocks /redit models at the originators and rating agencies must tailored to address the potential risks in such innovations and ensure that they are ade1uately factored in their rating mechanisms !ot only that. they must also ensure continuous monitoring so that the changing conditions of the 7conomy are reflected in their processes /redit rating agencies should use learning from this episode to modify their rating methodologies + incorporate certain predictive elements. and add greater rigor in their timely surveillance of rating securities A swift move by credit rating agencies in identifying sticky mortgage backed securities will only help instill confidence in the efficiency of the entire rating system Dinancial institutions will also play a larger role in avoiding any shocks by carrying out proper due diligence of securities and borrowers. besides relying on credit ratings 'hey need to strengthen their risk management framework in view of increasing compleCities in products/services. and customersP re1uirements Although it would be compelling in such situations. one of the foremost things to note is that the regulator should not get carried away by the events in the global Markets to impose far too many stringent regulations to restrict credit growth 'his may lead to stifling of economic growth in the process 2ather. the approach should be to put in place right kind of enablers to identify the potent risks and deal with them appropriately in the Indian conteCt
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CHAPTER I%
SUMMARY
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SUMMARY AND CONCLUSION
N#erivatives are financial weapons of mass destruction. carrying dangers that. while now latent. are potentially lethal.O so said Farren Buffett. reportedly the third richest person in the world. in ())( ;is prophetic words are becoming true with the unraveling of the financial mess created by the sub+prime lending spree in the U % 'he developments will also affect emerging market countries such as India 'he developments that led to the eCplosive situation are traced here %ub+prime loans are those given to borrowers whose creditworthiness is below prime and hence are of low 1uality In India. sub+prime lending refers to loans carrying rates below the prime lending rate normally offered to high 1uality borrowers %ub+prime or low 1uality loans are mainly of three kinds" car loans. credit card loans and house mortgage loans 0f these. the biggest and the ones that can endanger the entire financial system are the house mortgage loans 'hese formed nearly one fifth of all U % mortgage loans in ())6. going up from 8 per cent till ())* 'he sub+prime loans were given to borrowers who did not have the capacity to service them $pay interest and repay principal& At the height of such lending. it was said. the borrowers were in the !I!HA $no income. no jobs also& category 'o lure such borrowers. some lenders adopted SpredatoryP practices 'hey lent deliberately knowing that there will be default and. when it occurred. sei-ed the houses mortgaged and sold them off to make a profit 'he basic 1uestion is why any lender $apart from the predatory ones& would give loans that carried the highest risk 0ne reason is that these carried higher 71
interest rates But. the main reasons seem to be two" large surplus funds with banks and the introduction of esoteric financial instruments that passed on the risk to unsuspecting investors %oon after the dotcom bubble burst in ())(. the Dederal 2eserve $central bank& of the U % pumped in money into the system 'oo much money in the system led inevitably to lower 1uality of lending 'he availability of credit derivative instruments. which basically transferred the risk to another party. accelerated the pace of sub+prime lending 'ypically. a bank or mortgage finance company $many of them owned by banks& lent to a sub+prime borrower to finance purchase of a house %ince the borrower did not have the means to even pay interest in the beginning. the lender sugar+ coated the loan through an adjusted rate mortgage $A2M& 0ne type of such a loan was called (+(9 #uring the first two years of a 4)+year mortgage loan. interest was pegged at a low fiCed rate of * per cent In the subse1uent (9 years. the rate was floating $variable& at around , per cent over a benchmark rate such as 5IB02 $5ondon Inter+Bank 0ffered 2ate&
'he lender hoped that even if the borrower could not service the loan after two years. he/she could always take refinance $raise a fresh loan against the same house& for a larger amount Implicit in this was the assumption that house prices will go on increasing 'his premise got a jolt when house prices started climbing down after peaking in ()),+)6 Fhen the first two years eCpired. the interest rate also moved up to very high levels Fith 5IB02 ruling at over , per cent. the mortgage rate shot up to >) per cent %uddenly. the 7MI $e1uated monthly installment& of such a loan nearly doubled" for a 2s , lakh loan. it is 2s *.*3) a month for a (9+year. >) per cent loan. against 2s (.*)) for a 4)+ year * per cent loan
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'he primary lenders $originators& of the sub + prime loans wanted to sell the loans to investors 'o make them attractive. they pooled such loans into baskets and created what are known as /#0s $collaterali-ed debt obligations& 'he baskets were sliced and spliced to make layers of /#0s $derivatives& carrying different risks 'he underlying assumption was that all borrowers would not default at the same time and a percentage of them would be prompt in payment 'he SsafeP portion was sold to investors averse to high risk and the balance to others 'he credit rating agencies put in their might behind the maneuver by giving the best rating to the portion deemed low risk %ome even alleged that the agencies helped in the splicing game 'hese /#0s were bought by some big investment banks and hedge funds in which the super rich invested for high returns 'hey. in turn. financed these investments by borrowing from banks against the security of /#0s 'he banksP action in passing on the risk to others boomeranged. with the same sub + prime loans coming back to them as security for loans 'he whole arrangement crumbled when things turned adverse with falling home prices and rising interest rates In early ())3. when !ew /entury Dinancial. a large sub+prime lender. collapsed. it resulted in Barclays Bank taking over sub+ prime loans of about B8)) million In Debruary. ;%B/. another big British bank. reported steep losses in sub+prime lending in the U % Many /anadian. Aerman and Drench banks followed suit Many of the big investment banks in the U % also reported large losses As a result. confidence in the banking system was rudely shaken And. no bank could be sure of the solvency of another bank and the inter bank money market. where short term lending was common. almost dried up Authorities in 7urope and the U % had to pump in money to prevent the whole system from collapsing 'hese developments had their impact on Indian stock markets in which many hedge funds and investment banks had invested Fhen
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they faced li1uidity problems in the U % . they sold part of their Indian holdings. sending the share indices down Fith the sub + prime loans taking different avatars and changing hands fre1uently. no one knows for sure which institution holds how much of the low 1uality loans Assessing the impact of this worldwide financial contagion will take months. if not years <erhaps. it could bring about a prolonged recession or very slow growth in the U % . as it happened in Hapan in the>88)s <art of the blame perhaps attaches to the U % Dederal 2eserve which detected the problem too late to take corrective action Ultimately. bankers will have to return to the time tested practice of prudence in lending if problems witnessed in sub + prime loans are not to recur
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BIBLIOGRAPHY
N 4-pap ,-: • • • • NET • • www google com www wikipedia org 'he ;indu 7enadu Business 5ine Business %tandard
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doc_136847757.doc
Project submitted in partial fulfillment of the requirement for the award of the degree of
“MASTER O
!"S#$ESS A%M#$#STRAT#O$&
DECLARATION
I hereby declare that this project report titled “A STUDY ON SUBPRIME CRISIS AND IT’S EFFECTS ON INDIA” submitted by me to the department of Business Management of XXXX is a bonafide work undertaken by me and it is not submitted to any other University or Institute for the Award of any degree diploma/certificate or published any time before
!ame"
#ate"
$%ignature&
1
ABSTRACT
'he sub prime lending crisis in the real estate sector In the U%A where in borrowers with a low or sub prime credit rating were given loans to invest in the booming real estate sector in ())*+), has led not only to a dig slow down of the U% economy but its effect was also felt over the major nations of the world . In this project it has been tried in the best way possible to analy-e the various ways in which the sub prime lending muddle actually started It has also been tried to analy-e the way the U% banking and lending agencies camouflaged their sub prime loans In to attractive ones and how backed by some credit rating agencies. were able to sell them off to other banks and investors by dividing them into collaterali-ed debt obligations $/#0s& 'his project also tries to give a comprehensive picture of the losses that the U% banking sector incurred and not just that but how the whole sub prime muddle effected and 1uestioned the banking practices in the world In the end it has been tired to take an Indian view of the whole sub prime fiasco and how India. though effected by this. thankfully not in a big way. can actually
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avoid such a scenario from occurring in the country and all the measures and practices that can been taken into consideration to avoid such a scenario
ACKNOWLEDGEMENT
I take this opportunity to thank all those who have been of help to me in the completion of this project
I would like to appreciate the guidance and co+operation provided to me by our project guide XXXX $faculty of Business Management& in the completion of this project
I am also grateful to XXXX. #irector XXXX and all the faculty members who have directly or indirectly helped me in preparing this project report
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TABLE OF CONTENTS:
1.
CHAPTER – I I!'20#U/'I0! 0bjective of the %tudy %cope of the %tudy 5imitations of the %tudy
pag !" + + + + 3 (4 (* (*
#.
CHAPTER $ II %ubprime 5ending /risis 7ffect of %ubprime /risis on U % A Actions taken to manage the crisis in U % A Implications on different countries + ,8 + + + (6 (3 *3
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CHAPTER $ III Impact on India 4 + 63
Measures that can be taken
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* CHAPTER – I%
%UMMA2: A!# /0!/5U%I0! + 3(
Bibliography
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/;A<'72 I
INTRODUCTION
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THE ECONOMY OF THE UNITED STATES OF AMERICA: 'he economy of the United %tates has been 7arth=s largest since the early >93)s ?>@ Its gross domestic product $A#<& was estimated as B>4 9 trillion in ())3 ?(@ It is a miCed economy and private firms make the majority of microeconomic decisions. while being regulated by the government 'he U % economy maintains a high level of productivity $A#< per capita. B*,.8)) in ())3 with the U % population hitting 4)( million&. although it is not the world=s highest 'he U % economy has maintained a high overall A#< growth rate. a low unemployment rate. and high levels of research and capital investment Major economic concerns in the U % include national debt. eCternal debt. entitlement liabilities for retiring baby boomers that have already begun entering the %ocial %ecurity system. corporate debt. mortgage debt a low savings rate. and a large current account deficit
Dundamental 7lements of the U % 7conomy"
'he United %tates is rich in mineral resources and fertile farm soil. and it is fortunate to have a moderate climate It also has eCtensive coastlines on both the Atlantic and <acific 0ceans. as well as on the Aulf of MeCico 2ivers flow from far within the continent. and the Areat 5akesEfive large. inland lakes along the
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U % border with /anadaEprovide additional shipping access 'hese eCtensive waterways have helped shape the country=s economic growth over the years and helped bind America=s ,) individual states together in a single economic unit 'he number of available workers and. more importantly. their productivity help determine the health of the U % economy 'hroughout its history. the United %tates has eCperienced steady growth in the labor force. a phenomenon both cause and effect of almost constant economic eCpansion 'he promise of high wages brings many highly skilled workers from around the world to the United %tates
In the United %tates. the corporation has emerged as an association of owners. known as stockholders. who form a business enterprise governed by a compleC set of rules and customs Brought on by the process of mass production. corporations such as Aeneral 7lectric have been instrumental in shaping the United %tates 'hrough the stock market. American banks and investors have grown their economy by investing and withdrawing capital from profitable corporations 'oday in the era of globali-ation American investors and corporations have influence all over the world 'he American government has also been instrumental in investing in the economy. in areas such as providing cheap electricity $such as from the ;oover #am&. and military contracts in times of war
Fhile consumers and producers make most decisions that mold the economy. government activities have a powerful effect on the U % economy in at least four areas %trong government regulation in the U % economy started in the early >8))s with the rise of the <rogressive MovementG prior to this the government promoted economic growth through protective tariffs and subsidies to industry.
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built infrastructure. and established banking policies. including the gold standard. to encourage savings and investment in productive enterprises
STABILI&ATION AND GROWTH:
'he federal government attempts to use both monetary policy $control of the money supply through mechanisms such as changes in interest rates& and fiscal policy $taCes and spending& to maintain low inflation. high economic growth. and low unemployment Dor many years following the Areat #epression of the >84)s. recessionsE periods of slow economic growth and high unemploymentEwere viewed as the greatest of economic threats Fhen the danger of recession appeared most serious. government sought to strengthen the economy by spending heavily itself or cutting taCes so that consumers would spend more. and by fostering rapid growth in the money supply. which also encouraged more spending In the >83)s. major price increases. particularly for energy. created a strong fear of inflation As a result. government leaders came to concentrate more on controlling inflation than on combating recession by limiting spending. resisting taC cuts. and reining in growth in the money supply Ideas about the best tools for stabili-ing the economy changed substantially between the >86)s and the >88)s In the >86)s. government had great faith in fiscal policyEmanipulation of government revenues to influence the economy %ince spending and taCes are controlled by the president and the U % /ongress. these elected officials played a leading role in directing the economy A period of high inflation. high unemployment. and huge government deficits weakened confidence in fiscal policy as a tool for regulating the overall pace of economic activity Instead. monetary policy assumed growing prominence a piece
8
%ince the stagflation of the >83)s. the U % economy has been characteri-ed by somewhat slower inflation In >89,. the U % began its growing trade deficit with /hina In recent years. the primary economic concerns have centered on" high national debt $B8 trillion&. high corporate debt $B8 trillion&. high mortgage debt $over B>) trillion as of ()), year+end&. high unfunded Medicare liability $B4) trillion&. high unfunded %ocial %ecurity liability $B>( trillion&. and high eCternal debt $amount owed to foreign lenders&. high trade deficits In ())6. the U % economy had its lowest saving rate since >844 'hese issues have raised concerns among economists and unfunded liabilities and national politicians 'he U % economy maintains a relatively high A#<. a reasonably high A#< growth rate. and a low unemployment rate. making it attractive to immigrants worldwide
Na'("!a) D *':
'he national debt. also known as the U % public debt $part of which is the gross federal debt&. is the overall collective sum of yearly budget deficit owed by all branches of the United %tates government. plus interest Americans are controversial issues in the United %tates As of Hanuary 4). ())9. the total U % federal debt was approCimately B8 ( trillion or about B38.))) in average for each of the >>3 million American taCpayers 'he borrowing cap debt ceiling as of ()), stood at B9 >9 trillion In March ())6. /ongress raised that ceiling an additional B) 38 trillion to B9 83 trillion. which is approCimately 69I of A#< /ongress has used this method to deal with an 'he economic significance of this debt and its potential ramifications for future generations of
9
encroaching debt ceiling in previous years. as the federal borrowing limit was raised in ())( and ())4 Fhile the U % national debt is the world=s largest in absolute si-e. a more convenient measure is that of its si-e relative to the nation=s A#< Fhen the national debt is put into this perspective it appears considerably less today than in past years. particularly during Forld Far II By this measure. it is also considerably less than those of other industriali-ed nations such as Hapan and roughly e1uivalent to those of several Festern 7uropean nations
E+' ,!a) D *': L(a*()('( - '" F", (g! ,-:
Aross U % liabilities to foreigners are B>6 4 trillion as at end ())6 'he U % Net International Investment Position (NIIP) deteriorated to a negative B( , trillion at the end of ())6. or about minus >8I of A#< 'he eCternal debt is an accounting entry that largely represents U% domestic assets purchased with trade dollars and owned overseas. largely by U% trading partners ;owever. this is not the whole picture. as foreign holdings of government debt currently amount to about (3I of the total. or some ( trillion dollars Dor countries like the United %tates. a large net eCternal debt is created when the value of foreign assets $debt and e1uity& held by domestic residents is less than the value of domestic assets held by foreigners In simple terms. as foreigners buy property in the U%. this adds to the eCternal debt Fhen this occurs in greater amounts than Americans buying property overseas. nations like the United %tates are said to be debtor nations. but this is not conventional debt like a loan obtained from a bank ;owever. foreigners also purchase U % debt instruments. such as government bonds. which are forms of conventional debt
10
If the eCternal debt represents foreign ownership of domestic assets. the result is that rental income. stock dividends. capital gains and other investment income is received by foreign investors. rather than by U% residents 0n the other hand. when U% debt is held by overseas investors. they receive interest and principal repayments As the trade imbalance puts eCtra dollars in hands outside of the U%. these dollars may be used to invest in new assets $foreign direct investment. such as new plants& or be used to buy eCisting U% assets such as stocks. real estate and bonds Fith a mounting trade deficit. the income from these assets increasingly transfers overseas 0f major concern is the fact that the magnitude of the !II< $or net eCternal debt& is 1uite a bit larger than most national economies Dueled by the si-able trade deficit. the eCternal debt is so large that many wonder if the trade situation can be sustained in the long term /omplicating the matter is that many of America=s trading partners. such as /hina. depend for much of their entire economy on eCports. and especially eCports to America Many controversies eCist about the current trade and eCternal debt situation. and it is arguable whether anyone understands how these dynamics will play out in an historically unprecedented floating eCchange rate system Fhile various aspects of the U % economic profile have precedents in the situations of other countries $notably government debt as a percentage of A#<&. the sheer si-e of the U%. and the integral role of the U% economy in the overall global economic environment. create considerable uncertainty about the future
I!' ,!a'("!a) ',a.
'he United %tates is the most significant nation in the world when it comes to international trade Dor decades. it has led the world in imports while simultaneously remaining as one of the top three eCporters of the world
11
As the major epicenter of world trade. the United %tates enjoys leverage that many other nations do not Dor one. since it is the world=s leading consumer. it is the number one customer of companies all around the world Many businesses compete for a share of the United %tates market In addition. the United %tates occasionally uses its economic leverage to impose economic sanctions in different regions of the world U%A is the top eCport market for almost 6) trading nations worldwide 'he U % is a member of several international trade organi-ations 'he purpose of joining these organi-ations is to come to agreement with other nations on trade issues. although there is some disagreement among U % citi-ens as to whether or not the U % government should be making these trade agreements in the first place %ince it is the world=s leading importer. there are many U % dollars in circulation all around the planet 'he stable U % economy and fairly sound monetary policy has led to faith in the U % dollar as the world=s most stable currency. although that may be changing in recent times In order to fund the national debt $also known as public debt&. the United %tates relies on selling U % treasury bonds to people both inside and outside the country. and in recent times the latter have become increasingly important Much of the money generated for the treasury bonds came from U % dollars which were used to purchase imports in the United %tates
12
13
;aving taken a comprehensive view of the economy of ';7 U!I'7# %'A'7% 0D AM72I/A. it is only pertinent to get into the topic of this project+ 'he %ub <rime 5ending Mortgage /risis 5et us first ac1uaint ourselves with the terminology of this concept before venturing into the shock and awe that this terminology has created in the form of recession in the United %tates and how it rather than being limited to only the United %tates has effected almost all the major economies of the world
S/*p,(0 L !.(!g:
%ubprime lending $also known as B+paper. near+prime. or second chance lending& is the practice of making loans to borrowers who do not 1ualify for the best market interest rates because of their deficient credit history 'he phrase also refers to banknotes taken on property that cannot be sold on the primary market. including loans on certain types of investment properties and certain types of self+employed persons %ubprime lending is risky for both lenders and borrowers due to the combination of high interest rates. poor credit 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 the increased risk %ubprime lending encompasses a variety of credit instruments. including subprime mortgages. subprime car loans. and subprime credit cards. among others 'he term JsubprimeJ refers to the credit status of the borrower $being less than ideal&. not the interest rate on the loan itself %ubprime lending is highly controversial 0pponents have alleged that subprime lenders have engaged in predatory lending practices such as deliberately lending to borrowers who could never meet the terms of their loans. thus leading to default. sei-ure of collateral. and foreclosure 'here have also been charges of
14
mortgage discrimination on the basis of race <roponents of subprime lending maintain that the practice eCtends credit to people who would otherwise not have access to the credit market 'he controversy surrounding subprime lending has eCpanded as the result of an ongoing lending and credit crisis both in the subprime industry. and in the greater financial markets which began in the United %tates 'his phenomenon has been described as a financial contagion which has led to a restriction on the availability of credit in world financial markets ;undreds of thousands of borrowers have been forced to default and several major American subprime lenders have filed for bankruptcy
Ba12g,"/!.
%ubprime lending evolved with the reali-ation of a demand in the marketplace and businesses providing a supply to meet it Fith bankruptcies and consumer proposals being widely accessible. a constantly fluctuating economic environment. and consumer debt loan on the rise. traditional lenders are more cautious and have been turning away a record number of potential customers %tatistically. approCimately (,I of the population of the United %tates falls into this category In the third 1uarter of ())3. %ubprime adjustable rate mortgages $A2Ms& only represent 6 9I of the mortgages outstanding in the U%. yet they represent *4 )I of the foreclosures started %ubprime fiCed mortgages represent 6 4I of outstanding loans and >( )I of the foreclosures started in the same period
D 3(!('("!
15
Fhile there is no official credit profile that describes a subprime borrower. most in the United %tates have a credit score below 3(4 Dederal !ational Mortgage Association commonly known as Dannie Mae has lending guidelines for what it considers to be JprimeJ borrowers on conforming loans 'heir standard provides a good comparison between those who are Jprime borrowersJ and those who are Jsubprime borrowers J <rime borrowers have a credit score above 6() $credit scores are between 4,) and 9,) with a median in the U % of 639 and a mean of 3(4&. a debt+to+income ratio $#'I& no greater than 3,I $meaning that no more than 3,I of net income pays for housing and other debt&. and a combined loan to value ratio of 8)I. meaning that the borrower is paying a >)I down payment Any borrower seeking a loan with less than those criteria is a subprime borrower by Dannie Mae standards
S/*p,(0 ) !. ,'o access this increasing market. lenders often take on risks associated with lending to people with poor credit ratings %ubprime loans are considered to carry a far greater risk for the lender due to the aforementioned credit risk characteristics of the typical subprime borrower 5enders use a variety of methods to offset these risks In the case of many subprime loans. this risk is offset with a higher interest rate In the case of subprime credit cards. a subprime customer may be charged higher late fees. higher over limit fees. yearly fees. or up front fees for the card %ubprime credit card customers. unlike prime credit card customers. are generally not given a Jgrace periodJ to pay late 'hese late fees are then charged to the account. which may drive the customer over their credit limit. resulting in over limit fees 'hus the fees compound. resulting in higher returns for the lenders 'hese increased fees compound the difficulty of the mortgage for the subprime borrower. who is defined as such by their unsuitability for credit
16
S/*p,(0 *",,"4 ,%ubprime offers an opportunity for borrowers with a less than ideal credit record to gain access to credit Borrowers may use this credit to purchase homes. or in the case of a cash out refinance. finance other forms of spending such as purchasing a car. paying for living eCpenses. remodeling a home. or even paying down on a high interest credit card ;owever. due to the risk profile of the subprime borrower. this access to credit comes at the price of higher interest rates 0n a more positive note. subprime lending $and mortgages in particular&. provide a method of Jcredit repairJG if borrowers maintain a good payment record. they should be able to refinance back onto mainstream rates after a period of time /redit repair usually takes twelve months to achieveG however. in the UK. most subprime mortgages have a two or three+year tie+in and borrowers may face additional charges for replacing their mortgages before the tie+in has eCpired
Aenerally. subprime borrowers will display a range of credit risk characteristics that may include one or more of the following"
•
'wo or more loan payments paid past 4) days due in the last >( months. or one or more loan payments paid past 8) days due the last 46 monthsG Hudgment. foreclosure. repossession. or non+payment of a loan in the prior *9 monthsG Bankruptcy in the last 3 yearsG 2elatively high default probability as evidenced by. for eCample. a credit bureau risk score $DI/0& of less than 6() $depending on the product/collateral&. or other bureau or proprietary scores with an e1uivalent default probability likelihood
•
• •
17
TYPES:
S/*p,(0 0",'gag As with subprime lending in general. subprime mortgages are usually defined by the type of consumer to which they are made available According to the U % #epartment of 'reasury guidelines issued in ())>. J%ubprime borrowers typically have weakened credit histories that include payment delin1uencies and possibly more severe problems such as charge+offs. judgments. and bankruptcies 'hey may also display reduced repayment capacity as measured by credit scores. debt+to+income ratios. or other criteria that may encompass borrowers with incomplete credit histories J In addition. many subprime mortgages have been made to borrowers who lack legal immigration status in the United %tates %ubprime mortgage loans are riskier loans in that they are made to borrowers unable to 1ualify under traditional. more stringent criteria due to a limited or blemished credit history %ubprime borrowers are generally defined as individuals with limited income or having DI/0 credit scores below 6() on a scale that ranges from 4)) to 9,) %ubprime mortgage loans have a much higher rate of default than prime mortgage loans and are priced based on the risk assumed by the lender Although most home loans do not fall into this category. subprime mortgages proliferated in the early part of the (>st /entury About (> percent of all mortgage originations from ())* through ())6 were subprime. up from 8 percent from >886 through ())*. says Hohn 5onski. chief economist for Moody=s Investors %ervice %ubprime mortgages totaled B6)) billion in ())6. accounting for about one+fifth of the U % home loan market 'here are many different kinds of subprime mortgages. including"
18
•
Interest+only mortgages. which allow borrowers to pay only interest for a period of time $typically ,L>) years&G J<ick a paymentJ loans. for which borrowers choose their monthly payment $full payment. interest only. or a minimum payment which may be lower than the payment re1uired to reduce the balance of the loan&G
•
•
And initial fiCed rate mortgages that 1uickly convert to variable rates
'his last class of mortgages has grown particularly popular among subprime lenders since the >88)s /ommon lending vehicles within this group include the J(+(9 loanJ. which offers a low initial interest rate that stays fiCed for two years after which the loan resets to a higher adjustable rate for the remaining life of the loan. in this case (9 years 'he new interest rate is typically set at some margin over an indeC. for eCample. ,I over a >(+month 5IB02 Mariations on the J(+(9J include the J4+(3J and the J,+(,J
S/*p,(0 C, .(' Ca,./redit card companies in the United %tates began offering subprime credit cards to borrowers with low credit scores and a history of defaults or bankruptcy in the >88)s 'hese cards usually begin with low credit limits and usually carry eCtremely high fees and interest rates as high as 4)I or more In ())(. as economic growth in the United %tates slowed. the default rates for subprime credit card holders increased dramatically. and many subprime credit card issuers were forced to scale back or cease operations In ())3. many new subprime credit cards began to sprout forth in the market As more vendors emerged. the market became more competitive. forcing issuers to make the cards more attractive to consumers Interest rates on subprime cards now start at 8 8I but in some cases still range up to (*I annual percentage rate $A<2&
19
%ubprime credit cards however can help a consumer improve poor credit scores Most subprime cards report to major credit reporting agencies such as 'ransUnion and 71uifaC /onsumers that pay their bills on time should see positive reporting to these agencies within 8) days
P,"p"! !'Individuals who have eCperienced severe financial problems are usually labeled as higher risk and therefore have greater difficulty obtaining credit. especially for large purchases such as automobiles or real estate 'hese individuals may have had job loss. previous debt or marital problems. or uneCpected medical issues. usually unforeseen and causing major financial setbacks As a result. late payments. charge+offs. repossessions and even foreclosures may result #ue to these previous credit problems. these individuals may also be precluded from obtaining any type of conventional loan for a large purchase. such as an automobile 'o meet this demand. lenders have seen that a tiered pricing arrangement. one which allows these individuals to receive loans but pay a higher interest rate. may allow loans which otherwise would not occur Drom a servicing standpoint. these loans have higher collection defaults and are more likely to eCperience repossessions and charge offs 5enders use the higher interest rate to offset these anticipated higher costs <rovided that a consumer enters into this arrangement with the understanding that they are higher risk. and must make diligent efforts to pay. these loans do indeed serve those who would otherwise be underserved /ontinuing the eCample of an auto loan. the consumer must purchase an automobile which is well within their means. and carries a payment well within their budget
C,('(1(-0
20
/apital markets operate on the basic premise of risk versus reward Investors taking a risk on stocks eCpect a higher rate of return than do investors in risk+free 'reasury bills. which are backed by the full faith and credit of the United %tates 'he same goes for loans 5ess creditworthy subprime borrowers represent a riskier investment. so lenders will charge them a higher interest rate than they would charge a prime borrower for the same loan 'o avoid the initial hit of higher mortgage payments. most subprime borrowers take out adjustable+rate mortgages $or A2Ms& that give them a lower initial interest rate But with potential annual adjustments of (I or more per year. these loans can end up charging much more %o a B,)).))) loan at a *I interest rate for 4) years e1uates to a payment of about B(.*)) a month But the same loan at >)I for (3 years $after the adjustable period ends& e1uates to a payment of B*.(() A 6+percentage+point increase in the rate caused slightly more than a 3,I increase in the payment 0n the other hand. interest rates on A2Ms can also go down + in the U%. the interest rate is tied to federal government+controlled interest rates. so when the Ded cuts rates. A2M rates go down. too A2M interest rates usually adjust once a year. and the rate is based on an average of the federal rates over the last >( months Also. most A2Ms limit the amount of change in a rate 'he cycle of increased fees due to default+prone borrowers defaulting is a vicious cycle 'hough some subprime borrowers may be able to repair their credit rating. much default and enter the vicious cycle Fhile this enhances the profits of the subprime lender. it also leads to further vicious cycling as the subprime lenders are unable to recover what has been lent to subprime borrowers ;ence the current subprime mortgage crisis
M",'gag .(-1,(0(!a'("!
%ome subprime lending practices have raised concerns about mortgage discrimination on the basis of race Black and other minorities disproportionately 21
fall into the category of Jsubprime borrowersJ because of lower credit scores. higher debt+to+income ratios. and higher combined loan to value ratios Because they are higher risk borrowers. they are more likely to seek subprime mortgages with higher interest rates than their white counterparts 7ven when median income levels were comparable. home buyers in minority neighborhoods were more likely to get a loan from a subprime lender Interest rates and the availability of credit are often tied to credit scores. and the results of a ())* 'eCas #epartment of Insurance study found that of the ( million 'eCans surveyed. Jblack policyholders had average credit scores that were >)I to 4,I worse than those of white policyholders ;ispanics= average scores were ,I to (,I worse. while Asians= scores were roughly the same as whites African+ Americans are in the aggregate less likely to have a higher than average credit score and so take on higher levels of debt with smaller down+payments than whites and Asians of similar incomes
O*5 1'(6 - "3 '7 S'/.8:
• • • •
'o understand the meaning of N%ubprime /risisO 'o analy-e the effects of %ubprime /risis on the world
'o analy-e the impact of %ubprime crisis on India
'o understand the risks and causes of %ubprime crisis
22
S1"p "3 '7 S'/.8"
'he study is to cover the impact of the subprime crisis that started in United %tates of America which led to huge loss in its economy 'he study also concentrates on impact of subprime crisis on Alobal economics in general and Indian economy in particular.
L(0('a'("!-:
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'he study is very much limited to understand the reasons behind the crisis at origin and its impact on Indian economy
• •
#ue to the short period of time it was not possible to gather all the data
%ince the crisis is 1uite recent there is no published manual available
/;A<'72 II
%ubprime /risis
24
SUBPRIME MORTGAGE CRISIS
7veryone has been constantly reading in almost all newspapers about the U% subprime mortgage crisis which has been said to have the potential to bring the U% economy to a brink of a recession It has led to the ouster of top eCecutives of Merrill 5ynch. /itibank etc to name a few because of eCposure to the subprime mortgage turmoil Ironically. the same crisis has led to an Indian born banker+ Mikram % <undit being put at the helm of the worldPs largest bank L /itigroup %o what is eCactly the subprime crisis all aboutQ 'he following eCtract seeks to eCplain what we mean by the term Nsubprime lendingO 'hen we decipher what is the subprime mortgage lending crisis all about and what led to its happening 5astly. we seek to find its potential impact on the U% and Indian economy
25
%ub prime lending refers to the category of borrowers with weak credit history 'hese borrowers usually find it tough to land mortgage+backed loans %ub prime lending is a general term that refers to the practice of making loans to borrowers who do not 1ualify for loans at market Interest rates because of problems with their credit history or the lacking of their ability to prove that they have enough income to support the monthly payment on the loan for which they are applying 'hus. a sub prime loan is one that is offered at an interest rate higher than A+paper $<rime& loans due to the increased risk
E33 1' "3 S/*p,(0 C,(-(- "! U.S.A
Ba12g,"/!. '" '7 1,(-('he -/*p,(0 0",'gag 1,(-(- was a sharp rise in home foreclosures which
started in the United %tates in late ())6 and became a global financial crisis during ())3 and ())9 'he crisis began with the bursting of the housing bubble in the U% and high default rates on JsubprimeJ and other adjustable rate mortgages $A2M& made to higher+risk borrowers with lower income or lesser credit history than JprimeJ borrowers 5oan incentives and a long+term trend of rising housing prices encouraged borrowers to assume mortgages. believing they would be able to refinance at more favorable terms later ;owever. once housing prices started to drop moderately in ())6+())3 in many parts of the U % . refinancing became more difficult #efaults and foreclosure activity increased dramatically as A2M
26
interest rates reset higher
#uring ())3. nearly > 4 million U %
housing As of
properties were subject to foreclosure activity. up 38I versus ())6 would reach a level between U % B())+4)) billion
#ecember ((. ())3. a leading business periodical estimated subprime defaults
'he mortgage lenders that retained credit risk $the risk of payment default& were the first to be affected. as borrowers became unable or unwilling to make payments Major Banks and other financial institutions around the world have reported losses of approCimately U % B>,) billion as of Debruary ())9. as cited below #ue to a form of financial engineering called securiti-ation. many mortgage lenders had passed the rights to the mortgage payments and related credit/default risk to third+party investors via mortgage+backed securities $MB%& and collaterali-ed debt obligations $/#0& /orporate. individual and institutional investors holding MB% or /#0 faced significant losses. as the value of the underlying mortgage assets declined %tock markets in many countries declined significantly 'he widespread dispersion of credit risk and the unclear impact on financial institutions caused lenders to reduce lending activity or to make loans at higher interest rates %imilarly. the ability of corporations to obtain funds through the issuance of commercial paper was impacted 'his aspect of the crisis is consistent with a credit crunch 'he li1uidity concerns drove central banks around the world to take action to provide funds to member banks to encourage the lending of funds to worthy borrowers and to re+invigorate the commercial paper markets.
'he subprime crisis also places downward pressure on economic growth. because fewer or more eCpensive loans decrease investment by businesses and consumer spending. which drive the economy A separate but related dynamic is 27
the downturn in the housing market. where a surplus inventory of homes has resulted in a significant decline in new home construction and housing prices in many areas 'his also places downward pressure on growth Fith interest rates on a large number of subprime and other A2M due to adjust upward during the ())9 period. U % legislators and the U % 'reasury #epartment are taking action A systematic program to limit or defer interest rate adjustments was implemented to reduce the impact In addition. lenders and borrowers facing defaults have been encouraged to cooperate to enable borrowers to stay in their homes 'he risks to the broader economy created by the financial market crisis and housing market downturn were primary factors in the Hanuary ((. ())9 decision by the U % Dederal reserve to cut interest rates and the economic stimulus package signed by <resident Bush on Debruary >4. ())9 Both actions are designed to stimulate economic growth and inspire confidence in the financial markets
Ba12g,"/!. (!3",0a'("!:
A subprime loan is one that is offered at an interest rate higher than A+paper loans due to the increased risk %ubprime. therefore. is not the same as JAlt+AJ. because Alt+A loans 1ualify for the JA+ratingJ by Moody=s or other rating firms. albeit for an JalternativeJ means 'he value of U % subprime mortgages was estimated at B> 4 trillion as of March ())3. with over 3 , million first+lien subprime mortgages outstanding ApproCimately >6I of subprime loans with adjustable rate mortgages $A2M& were 8)+days delin1uent or in foreclosure proceedings as of 0ctober ())3. roughly triple the rate of ()), risen to (>I By Hanuary of ())9. the delin1uency rate had
%ubprime A2Ms only represent 6 9I of the loans outstanding in the U%. yet they represent *4 )I of the foreclosures started during the third 1uarter of ())3 ?A 28
total of nearly **6.3(6 U % household properties were subject to some sort of foreclosure action from Huly to %eptember ())3. including those with prime. alt+A and subprime loans 'his is nearly double the ((4.))) properties in the year+ago period and 4*I higher than the 444.6(3 in the prior 1uarter 'his increased to ,(3.3*) during the fourth 1uarter of ())3. an >9I increase versus the prior 1uarter Dor all of ())3. nearly > 4 million properties were subject to ( ( million foreclosure filings. up 38I and 3,I respectively versus ())6 Doreclosure filings including default notices. auction sale notices and bank repossessions can include multiple notices on the same property
'he estimated value of subprime adjustable+rate mortgages $A2M& resetting at higher interest rates is U % B*)) billion for ())3 and B,)) billion for ())9 2eset activity is eCpected to increase to a monthly peak in March ())9 of nearly B>)) billion. before declining An average of *,).))) subprime A2M are scheduled to undergo their first rate increase each 1uarter in ())9
U!. ,-'a!.(!g '7 1a/- - a!. ,(-2- "3 '7 -/*p,(0 1,(-(-
'he reasons for this crisis are varied and compleC Understanding and managing the ripple effect through the world+wide economy poses a critical challenge for governments. businesses. and investors #ue to innovations in securi-ation the risks related to the inability of homeowners to meet mortgage payments have been distributed broadly. with a series of conse1uential impacts 'he crisis can be attributed to a number of factors. such as the inability of homeowners to make their mortgage paymentsG poor judgment by either the borrower or the lenderG inappropriate mortgage incentives. and rising adjustable mortgage rates Durther. declining home prices have made re+financing more difficult 'here are three primary risk categories involved"
29
•
C, .(' R(-2: 'raditionally. the risk of default $called credit risk& would be assumed by the bank originating the loan ;owever. due to innovations in securiti-ation. credit risk is now shared more broadly with investors. because the rights to these mortgage payments have been repackaged into a variety of compleC investment vehicles. generally categori-ed as mortgage+backed securities $MB%& or collaterali-ed debt obligations $/#0& A /#0. essentially. is a repacking of eCisting debt. and in recent years MB% collateral has made up a large proportion of issuance In eCchange for purchasing the MB%. third+party investors receive a claim on the mortgage assets. which become collateral in the event of default Durther. the MB% investor has the right to cash flows related to the mortgage payments 'o manage their risk. mortgage originators $e g . banks or mortgage lenders& may also create separate legal entities. called special+purpose entities $%<7&. to both assume the risk of default and issue the MB% 'he banks effectively sell the mortgage assets $i e . banking accounts receivable. which are the rights to receive the mortgage payments& to these %<7 In turn. the %<7 then sells the MB% to the investors 'he mortgage assets in the %<7 become the collateral
•
A-- ' P,(1
R(-2: /#0 valuation is compleC and related Jfair valueJ
accounting for such J5evel 4J assets is subject to wide interpretation 'his valuation fundamentally derives from the collectibles of subprime mortgage payments. which is difficult to predict due to lack of precedent and rising delin1uency rates Banks and institutional investors have recogni-ed substantial losses as they revalue their /#0 assets downward Most /#0s re1uire that a number of tests be satisfied on a periodic basis. such as tests of interest cash flows. collateral ratings. or market values Dor deals with market value tests. if the valuation falls below certain levels. the /#0 may be re1uired by its terms to sell collateral in a short period of time. often at a steep loss. much like a stock brokerage account margin call If the risk is not legally contained within an
30
%<7 or otherwise. the entity owning the mortgage collateral may be forced to sell other types of assets. as well. to satisfy the terms of the deal In addition. credit rating agencies have downgraded over U % B,) billion in highly+rated /#0 and more such downgrades are possible %ince certain types of institutional investors are allowed to only carry higher+1uality $e g . JAAAJ& assets. there is an increased risk of forced asset sales. which could cause further devaluation
•
L(9/(.('8 R(-2: A related risk involves the commercial paper market. a key source of funds $i e . li1uidity& for many companies /ompanies and %<7 called structured investment vehicles $%IM& often obtain short+term loans by issuing commercial paper. pledging mortgage assets or /#0 as collateral Investors provide cash in eCchange for the commercial paper. receiving money+market interest rates ;owever. because of concerns regarding the value of the mortgage asset collateral linked to subprime and Alt+A loans. the ability of many companies to issue such paper has been significantly affected 'he amount of commercial paper issued as of 0ctober >9. ())3 dropped by (,I. to B999 billion. from the August 9 level In addition. the interest rate charged by investors to provide loans for commercial paper has increased substantially above historical levels
U!. ,-'a!.(!g '7 (0pa1' "! 1",p",a'("!- a!. (!6 -'",-
Average investors and corporations face a variety of risks due to the inability of mortgage holders to pay 'hese vary by legal entity %ome general eCposures by entity type include"
•
Bank corporations" 'he earnings reported by major banks are adversely affected by defaults on mortgages they issue and retain /ompanies value
31
their mortgage assets $receivables& based on estimates of collections from homeowners /ompanies record eCpenses in the current period to adjust this valuation. increasing their bad debt reserves and reducing earnings 2apid or uneCpected changes in mortgage asset valuation can lead to volatility in earnings and stock prices 'he ability of lenders to predict future collections is a compleC task subject to a multitude of variables
•
Mortgage lenders and 2eal 7state Investment 'rusts" 'hese entities face similar risks to banks In addition. they have business models with significant reliance on the ability to regularly secure new financing through /#0 or commercial paper issuance secured by mortgages Investors have become reluctant to fund such investments and are demanding higher interest rates %uch lenders are at increased risk of significant reductions in book value due to asset sales at unfavorable prices and several have filed bankruptcy
•
%pecial purpose entities $%<7&" 5ike corporations. %<7 are re1uired to revalue their mortgage assets based on estimates of collection of mortgage payments If this valuation falls below a certain level. or if cash flow falls below contractual levels. investors may have immediate rights to the mortgage asset collateral 'his can also cause the rapid sale of assets at unfavorable prices 0ther %<7 called structured investment vehicles $%IM& issue commercial paper and use the proceeds to purchase securiti-ed assets such as /#0 'hese entities have been affected by mortgage asset devaluation %everal major %IM are associated with large banks
•
Investors" %tocks or bonds of the entities above are affected by the lower earnings and uncertainty regarding the valuation of mortgage assets and related payment collection Many investors and corporations purchased MB% or /#0 as investments and incurred related losses
32
Ca/- - "3 '7 1,(-(-
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%ubprime borrowing was a major contributor to an increase in home ownership rates and the demand for housing 'he overall U % homeownership rate increased from 6* percent in >88* $about where it was since >89)& to a peak in ())* with an all time high of 68 ( percent 'his demand helped fuel housing price increases and consumer spending Between >883 and ())6. American home prices increased by >(*I %ome homeowners used the increased property value eCperienced in the housing bubble to refinance their homes with lower interest rates and take out second
33
mortgages against the added value to use the funds for consumer spending U % household debt as a percentage of income rose to >4)I during ())3. versus >))I earlier in the decade A culture of consumerism is a factor In the early ()))s recession that began in early ())> and which was eCacerbated by the %eptember >>. ())> terrorist attacks. Americans were asked to spend their way out of economic decline with Jconsumerism cast as the new patriotismJ 'his call linking patriotism to shopping echoed the urging of former <resident Bill /linton to Jget out and shopJ and corporations like Aeneral Motors produced commercials with the same theme 0verbuilding during the boom period. increasing foreclosure rates and unwillingness of many homeowners to sell their homes at reduced market prices have significantly increased the supply of housing inventory available %ales volume $units& of new homes dropped by (6 *I in ())3 versus the prior year By Hanuary ())9. the inventory of unsold new homes stood at 8 9 months based on #ecember ())3 sales volume. the highest level since >89> Durther. a record of nearly four million unsold eCisting homes was available 'his eCcess supply of home inventory places significant downward pressure on prices As prices decline. more homeowners are at risk of default and According to the %R<//ase+%hiller housing price indeC. by foreclosure
!ovember ())3. average U % housing prices had fallen approCimately 9I from their ())6 peak ;owever. there was significant variation in price changes across U % markets. with many appreciating and others depreciating 'he price decline in #ecember ())3 versus the year+ago period was >) *I As of Debruary ())9. housing prices are eCpected to continue declining until this inventory of surplus homes $eCcess supply& is reduced to more typical levels
R") "3 *",,"4 ,-
34
A variety of factors have contributed to an increase in the payment delin1uency rate for subprime A2M borrowers. which recently reached (>I. roughly four times its historical level 7asy credit. combined with the assumption that housing prices would continue to appreciate. also encouraged many subprime borrowers to obtain A2Ms they could not afford after the initial incentive period 0nce housing prices started depreciating moderately in many parts of the U %. refinancing became more difficult %ome homeowners were unable to re+finance and began to default on loans as their loans reset to higher interest rates and payment amounts 0ther homeowners. facing declines in home market value or with limited accumulated e1uity. are choosing to stop paying their mortgage 'hey are essentially Jwalking awayJ from the property and allowing foreclosure. despite the impact to their credit rating
Misrepresentation of loan application data is another contributing factor In a Hanuary >4. ())9 column in the !ew
rk 'imes. Aeorge Mason University economics professor 'yler /owen wrote. J'here has been plenty of talk about =predatory lending.= but =predatory borrowing= may have been the bigger problem As much as 3) percent of recent early payment defaults had fraudulent misrepresentations on their original loan applications. according to one recent study 'he research was done by Base<oint Analytics. which helps banks and lenders identify fraudulent transactionsG the study looked at more than three million loans from >883 to ())6. with a majority from ()), to ())6 Applications with misrepresentations were also five times as likely to go into default Many of the frauds were simple rather than ingenious In some cases. borrowers who were asked to state their incomes just lied. sometimes reporting five times actual incomeG other borrowers falsified income documents by using computers J U% #epartment of the 'reasury suspicious activity report of mortgage fraud increased by >.*>> percent between >883 and ()), 35R") "3 3(!a!1(a) (!-'('/'("!-
A variety of factors have caused lenders to offer an increasing array of higher+ risk loans to higher+risk borrowers 'he share of subprime mortgages to total originations was ,I $B4, billion& in >88*. 8I in >886. >4I $B>6) billion& in >888. and ()I in ())6 A study by the Dederal 2eserve indicated that the average difference in mortgage interest rates between subprime and prime mortgages $the Jsubprime markupJ or Jrisk premiumJ& declined from ( 9 percentage points $(9) basis points& in ())>. to > 4 percentage points in ())3 In other words. the risk premium re1uired by lenders to offer a subprime loan declined 'his occurred even though subprime borrower and loan characteristics declined overall during the ())>+())6 period. which should have had the opposite effect combination is common to classic boom and bust credit cycles 'he
36
In addition to considering higher+risk borrowers. lenders have offered increasingly high+risk loan options and incentives 0ne eCample is the interest+ only adjustable+rate mortgage $A2M&. which allows the homeowner to pay just the interest $not principal& during an initial period Another eCample is a Jpayment optionJ loan. in which the homeowner can pay a variable amount. but any interest not paid is added to the principal Durther. an estimated one+third of A2M originated between ())*+())6 had JteaserJ rates below *I. which then increased significantly after some initial period. as much as doubling the monthly payment %ome believe that mortgage standards became laC because of a moral ha-ard. where each link in the mortgage chain collected profits while believing it was passing on risk
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a'("! %ecuriti-ation is a structured finance process in which assets. receivables or financial instruments are ac1uired. classified into pools. and offered as collateral for third+party investment 'here are many parties involved #ue to securiti-ation. investor appetite for mortgage+backed securities $MB%&. and the tendency of rating agencies to assign investment+grade ratings to MB%. loans with a high risk of default could be originated. packaged and the risk readily transferred to others Asset securiti-ation began with the structured financing of mortgage pools in the >83)s 'he securiti-ed share of subprime mortgages $i e . those passed to third+ party investors& increased from ,*I in ())>. to 3,I in ())6 Alan Areenspan stated that the securiti-ation of home loans for people with poor credit E not the loans themselves E were to blame for the current global credit crisis R") "3 0",'gag *,"2 ,Mortgage brokers don=t lend their own money 'here is not a direct correlation between loan performance and compensation 'hey have big financial incentives 37for selling compleC. adjustable rate mortgages $A2M=s&. since they earn higher commissions According to a study by Fholesale Access Mortgage 2esearch R /onsulting Inc . in ())* Mortgage brokers originated 69I of all residential loans in the U % . with subprime and Alt+A loans accounting for *( 3I of brokerages= total production volume 'he chairman of the Mortgage Bankers Association claimed brokers profited from a home loan boom but didn=t do enough to eCamine whether borrowers could repay
R") "3 0",'gag /!. ,4,(' ,Underwriters determine if the risk of lending to a particular borrower under certain parameters is acceptable Most of the risks and terms that underwriters consider fall under the three /Ps of underwriting" credit. capacity and collateral %ee mortgage underwriting In ())3. *) percent of all subprime loans were generated by automated underwriting An 7Cecutive vice president of /ountrywide ;ome 5oans Inc stated in ())* J<rior to automating the process. getting an answer from an underwriter took up to a week JFe are able to produce a decision inside of 4) seconds today And previously. every mortgage re1uired a standard set of full documentation J %ome think that users whose laC controls and willingness to rely on shortcuts led them to approve borrowers that under a less+automated system would never have made the cut are at fault for the subprime meltdown
38
R") "3 g"6 ,!0 !' a!. , g/)a'",%ome economists claim that government policy actually encouraged the development of the subprime debacle through legislation like the /ommunity 2einvestment Act. which they say forces banks to lend to otherwise un+ creditworthy consumers 7conomist 2obert Kuttner has critici-ed the repeal of the Alass+%teagall Act as contributing to the subprime meltdown A taCpayer+ funded government bailout related to mortgages during the %avings and 5oan crisis may have created a moral ha-ard and acted as encouragement to lenders to make similar higher risk loans %ome have argued that. despite attempts by various U % states to prevent the growth of a secondary market in repackaged predatory loans. the 'reasury #epartment=s 0ffice of the /omptroller of the /urrency. at the insistence of national banks. struck down such attempts as violations of Dederal banking laws In response to a concern that lending was not properly regulated. the ;ouse and %enate are both considering bills to regulate lending practices R") "3 1, .(' ,a'(!g ag !1( -
/redit rating agencies are now under scrutiny for giving investment+grade ratings to securiti-ation transactions holding subprime mortgages ;igher ratings are theoretically due to the multiple. independent mortgages held in the MB% per the agencies. but critics claim that conflicts of interest were in play
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/entral banks are primarily concerned with managing the rate of inflation and avoiding recessions 'hey are also the Nlenders of last resortO to ensure li1uidity 'hey are less concerned with avoiding asset bubbles. such as the housing
39
bubble and dotcom bubble /entral banks have generally chosen to react after such bubbles burst to minimi-e collateral impact on the economy. rather than trying to avoid the bubble itself 'his is because identifying an asset bubble and determining the proper monetary policy to properly deflate it are not proven concepts 'here is significant debate among economists regarding whether this is the optimal strategy Dederal 2eserve actions raised concerns among some market observers that it could create a moral ha-ard %ome industry officials said that Dederal 2eserve Bank of !ew
rk involvement in the rescue of 5ong+'erm /apital Management in >889 would encourage large financial institutions to assume more risk. in the belief that the Dederal 2eserve would intervene on their behalf A potential contributing factor to the rise in home prices was the lowering of interest rates earlier in the decade by the Dederal 2eserve. to diminish the blow of the collapse of the dot+com bubble and combat the risk of deflationIMPACT
I0pa1' "! -'"12 0a,2 '0n Huly >8. ())3. the #ow Hones Industrial Average hit a record high. closing above >*.))) for the first time By August >,. the #ow had dropped below >4.))) and the %R< ,))$S;P <== is an indeC containing the stocks of ,)) 5arge+/ap corporations. most of which are American. this indeC is developed by standard and poor& had crossed into negative territory year+to+date %imilar drops occurred in virtually every market in the world. with Bra-il and Korea being hard+ hit 5arge daily drops became common. with. for eCample. the K", a C"0p"-(' S'"12 P,(1 I!. + $K0%<I& dropping about 3I in one day. although ())3=s largest daily drop by the %R< ,)) in the U % was in Debruary. a result of the subprime crisis
40
Mortgage lenders and home builders fared terribly. but losses cut across sectors. with some of the worst+hit industries. such as metals R mining companies. having only the vaguest connection with lending or mortgages I0pa1' "! 3(!a!1(a) (!-'('/'("!-
Many banks. mortgage lenders. real estate investment trusts $27I'&. and hedge funds suffered significant losses as a result of mortgage payment defaults or mortgage asset devaluation As of Debruary >8. ())9 financial institutions had recogni-ed subprime+related losses or write+downs eCceeding U % B>,) billion <rofits at the 9.,44 U % banks insured by the Dederal #eposit Insurance /orporation $D#I/& declined from B4, ( billion to B, 9 billion $94 , percent& during the fourth 1uarter of ())3 versus the prior year. due to soaring loan defaults and provisions for loan losses It was the worst bank and thrift performance since the fourth 1uarter of >88> Dor all of ())3. these banks earned B>), , billion. down (3 * percent from a record profit of B>*, ( billion in ())6 0ther companies from around the world. such as IKB #eutsche Industriebank. have also suffered significant losses and scores of mortgage lenders have filed for bankruptcy 'op management has not escaped unscathed. as the /70s of Merrill 5ynch and /itigroup were forced to resign within a week of each other Marious institutions followed+up with merger deals
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'here is concern that some homeowners are turning to arson as a way to escape from mortgages they can=t or refuse to pay 'he DBI reports that arson grew *I
41
in suburbs and ( (I in cities from ()), to ())6 As of Han ())9. the ())3 numbers were not yet available
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A secondary cause and effect of the crisis relates to the role of municipal bond JmonolineJ insurance corporations By insuring municipal bond issues. those bonds achieve higher debt ratings ;owever. these insurers used premiums to purchase /#0 investments and have suffered a significant loss. which brings their ability to insure bonds into 1uestion Unless these insurers obtain additional capital. rating agencies may downgrade the bonds they insured or guaranteed In turn. this may re1uire financial institutions holding the bonds to lower their valuation or to sell them. as some entities $such as pension funds& are only allowed to hold the highest+grade bonds 'he impact of such devaluation on institutional investors and corporations holding the bonds $including major banks& has been estimated as high as B()) billion 2egulators are taking action to encourage banks to lend the re1uired capital to certain monoline insurers. to avoid such an impact
I0pa1' "! 7"0 "4! ,According to the %R<//ase+%hiller housing price indeC. by !ovember ())3. average U % housing prices had fallen approCimately 9I from their ())6 peak ;owever. there was significant variation in price changes across U % markets. with many appreciating and others depreciating 'he price decline in #ecember ())3 versus the year+ago period was >) *I %ales volume $units& of new homes dropped by (6 *I in ())3 versus the prior year By Hanuary ())9. the inventory of unsold new homes stood at 8 9 months based on #ecember ())3 sales volume. the highest level since >89>
42
;ousing prices are eCpected to continue declining until this inventory of surplus homes $eCcess supply& is reduced to more typical levels As MB% and /#0 valuation is related to the value of the underlying housing collateral. MB% and /#0 losses will continue until housing prices stabili-e As home prices have declined following the rise of home prices caused by speculation and as re+ financing standards have tightened. a number of homes have been foreclosed and sit vacant 'hese vacant homes are often poorly maintained and sometimes attract s1uatters and/or criminal activity with the result that increasing foreclosures in a neighborhood often serve to further accelerate home price declines in the area 2ents have not fallen as much as home prices with the result that in some affluent neighborhoods homes that were formerly owner occupied are now occupied by renters In select areas falling home prices along with a decline in the U % dollar have encouraged foreigners to buy homes for either occasional use and/or long term investments Additional problems are anticipated in the future from the impending retirement of the baby boomer generation It is believed that a significant proportion of baby boomers are not saving ade1uately for retirement and were planning on using their increased property value as a Jpiggy bankJ or replacement for a retirement+savings account 'his is a departure from the traditional American approach to homes where Jpeople worked toward paying off the family house so they could hand it down to their childrenJ I0pa1' "! 0(!",('( 'here is a disproportionate level of foreclosures in some minority neighborhoods About *6I of ;ispanics and ,,I of blacks who obtained mortgages in ()), got higher+cost loans compared with about >3I of whites and Asians. according to Dederal 2eserve data 0ther studies indicate they would have 1ualified for lower+ rate loans
Businesses filing for bankruptcy
43
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45
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<resident Aeorge F Bush announced a plan to voluntarily and temporarily free-e the mortgages of a limited number of mortgage debtors holding A2Ms. declaring JI have a message for every homeowner worried about rising mortgage payments" 'he best you can do for your family is to call >+9))+88,+;0<7 $sic&J 'he correct number is >+999+88,+;0<7 A refinancing facility called Dederal ;ousing Administration+ D;A+%ecure was also created 'his is part of an ongoing collaborative effort between the U% Aovernment and private industry to help some sub+prime borrowers called the ;ope !ow Alliance 'he ;ope !ow Alliance released a report in Debruary. ())9 indicating it helped ,*,.))) subprime borrowers with shaky credit in the second half of ())3. or 3 3 percent of 3 > million subprime loans outstanding in %eptember ())3 A spokesperson acknowledged that much more must be done 46
#uring Debruary ())9. a program called J<roject 5ifelineJ was announced %iC of the largest U % lenders. in partnership with the ;ope !ow Alliance. agreed to defer foreclosure actions for 4) days for homeowners 8) or more days delin1uent on payments 'he intent of the program was to encourage more loan adjustments. to avoid foreclosures 'he U % 'reasury #epartment is working directly with major banks to develop a systematic means of modifying loans for a significant portion of borrowers facing A2M increases. rather than working through loans on a case+by+case basis <resident Bush also signed into law on Debruary >4. ())9 an economic stimulus package of B>69 billion. mainly in the form of income taC rebates. to help stimulate economic growth
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5enders and homeowners both may benefit from avoiding foreclosure. which is a costly and lengthy process %ome lenders have taken action to reach out to homeowners to provide more favorable mortgage terms $i e . loan modification or refinancing& ;omeowners have also been encouraged to contact their lenders to discuss alternatives /orporations. trade groups. and consumer advocates have begun to cite statistics on the numbers and types of homeowners assisted by loan modification programs 'here is some dispute regarding the appropriate measures. sources of data. and ade1uacy of progress A report issued in Hanuary ())9 showed that mortgage lenders modified ,*.))) loans and established >94.))) repayment plans in the third 1uarter of ())3. a period in which there were 49*.))) new foreclosures /onsumer groups claimed the modifications affected less than > percent of the 4 million subprime loans with adjustable rates that were outstanding in the third 1uarter
•
/redit rating agencies help evaluate and report on the risk involved with various investment alternatives 'he rating processes can be re+eCamined 47
and improved to encourage greater transparency to the risks involved with compleC mortgage+backed securities and the entities that provide them 2ating agencies have recently begun to aggressively downgrade large amounts of mortgage+backed debt
•
2egulators and legislators can take action regarding lending practices. bankruptcy protection. taC policies. affordable housing. credit counseling. education. and the licensing and 1ualifications of lenders 2egulations or guidelines can also influence the nature. transparency and regulatory reporting re1uired for the compleC legal entities and securities involved in these transactions /ongress also is conducting hearings help identify solutions and apply pressure to the various parties involved
•
'he media can help educate the public and parties involved It can also ensure the top subject material eCperts are engaged and have a voice to ensure a reasoned debate about the pros and cons of various solutions
•
Banks have sought and received additional capital $i e . cash investments& from sovereign wealth funds. which are entities that control the surplus savings of developing countries An estimated U % B68 billion has been invested by these entities in large financial institutions over the past year 0n Hanuary >,. ())9. sovereign wealth funds provided a total of B(> billion to two major U % financial institutions %uch capital is used to help banks maintain re1uired capital ratios $an important measure of financial health&. which have declined significantly due to subprime loan or /#0 losses %overeign wealth funds are estimated to control nearly B( 8 trillion Much of this wealth is oil and gas related As they represent the surplus funds of governments. these entities carry at least the perception that their investments have underlying political motives
•
5itigation related to the subprime crisis is underway A study released in Debruary ())9 indicated that (39 civil lawsuits were filed in federal courts
48
during ())3 related to the subprime crisis 'he number of filings in state courts were not 1uantified by are also believed to be significant 'he study found that *4 percent of the cases were class actions brought by borrowers. such as those that contended they were victims of discriminatory lending practices 0ther cases include securities lawsuits filed by investors. commercial contract disputes. employment class actions. and bankruptcy+related cases #efendants included mortgage bankers. brokers. lenders. appraisers. title companies. home builders. servicers. issuers. underwriters. bond insurers. money managers. public accounting firms. and company boards and officers
T7 F . ,a) R - ,6
Fithin the Dederal 2eserve. /hairman Ben Bernanke signals towards making interest rate cuts In early ())9. Ben Bernanke said" JBroadly. the Dederal 2eservePs response has followed two tracks" efforts to support market li1uidity and functioning and the pursuit of our macroeconomic objectives through monetary policy J 'ougher regulatory standards are proposed Additionally. a free-e of interest payments on certain sub+prime loans is announced 0n Hanuary ((. ())9. the Ded also slashed a key interest rate $the federal funds rate& by 3, basis points to 4 ,I. the biggest cut since >89*. followed by another cut of ,) basis points on Hanuary 4)th /entral banks have conducted open market operations to ensure member banks have access to funds $i e . li1uidity& 'hese are effectively short+term loans to member banks collaterali-ed by government securities /entral banks have also lowered the interest rates charged to member banks $called the discount rate in the U % & for short+term loans Both measures effectively lubricate the financial system. in two key ways Dirst. they help provide access to funds for those
49
entities with illi1uid mortgage+backed assets 'his helps lenders. %<7. and %IM avoid selling mortgage+backed assets at a steep loss %econd. the available funds stimulate the commercial paper market and general economic activity
E+p 1'a'("!- a!. 3", 1a-'As early as the ())4 Annual 2eport issued by DairfaC Dinancial ;oldings 5imited. <rem Fatsa was raising concerns about securiti-ed products" JFe have been concerned for some time about the risks in asset+backed bonds. particularly bonds that are backed by home e1uity loans. automobile loans or credit card debt $we own no asset+backed bonds& It seems to us that securiti-ation $or the creation of these asset+backed bonds& eliminates the incentive for the originator of the loan to be credit sensitive 'ake the case of an automobile dealer <rior to securiti-ation. the dealer would be very concerned about who was given credit to buy an automobile Fith securiti-ation. the dealer $almost& does not care as these loans can be laid off through securiti-ation 'hus. the loss eCperienced on these loans after securiti-ation will no longer be comparable to that eCperienced prior to securiti-ation $called a SSmoralPP ha-ard& of #ecember 4>. ())4 in the U % 'his is not a small problem 'here is B> ) trillion in asset+backed bonds outstanding as Fho is buying these bondsQ Insurance companies. money managers and banks L in the main L all reaching for yield given the eCcellent ratings for these bonds Fhat happens if we hit an air pocketQ Unlike J 'he legacy of Alan Areenspan has been cast into doubt with %enator /hris #odd claiming he created the Jperfect stormJ Alan Areenspan has remarked that there is a one+in+three chance of recession from the fallout !ouriel 2oubini. a professor at !ew
rk University and head of 2oubini Alobal 7conomics. has said that if the economy slips into recession Jthen you have a systemic banking crisis like we haven=t had since the >84)sJ50
0n %eptember 3. ())3. the Fall %treet Hournal reported that Alan Areenspan has said that the current turmoil in the financial markets is in many ways JidenticalJ to the problems in >893 and >889 'he Associated <ress described the current climate of the market on August >4. ())3. as one where investors were waiting for Jthe neCt shoe to dropJ as problems from Jan overheated housing market and an overeCtended consumerJ are Jjust beginning to emerge J Market Fatch has cited several economic analysts with %tifel !icolaus claiming that the problem mortgages are not limited to the subprime niche saying Jthe rapidly increasing scope and depth of the problems in the mortgage market suggest that the entire sector has plunged into a downward spiral similar to the subprime woes whereby each negative development feeds further deteriorationJ. calling it a Jvicious cycleJ and adding that they Jcontinue to believe conditions will get worseJ As of !ovember ((. ())3. analysts at a leading investment bank estimated losses on subprime /#0 would be approCimately U % B>*9 billion As of #ecember ((. ())3. a leading business periodical estimated subprime defaults between U % B())+4)) billion As of March >. ())9 analysts from three large financial institutions estimated the impact would be between U % B4,)+6)) billion Alan Greenspan, the former Chairman of the Federal Reser e, stated! "#he $%rrent $redit $risis &ill $ome to an end &hen the o erhan' of in entories of ne&l( )%ilt homes is lar'el( li*%idated, and home pri$e deflation $omes to an end+ #hat &ill sta)ili,e the no&%n$ertain al%e of the home e*%it( that a$ts as a )%ffer for all home mort'a'es, )%t most importantl( for those held as $ollateral for residential mort'a'e-)a$.ed se$%rities+ /er( lar'e losses &ill, no do%)t, )e ta.en as a $onse*%en$e of the $risis+ 0%t after a period of protra$ted ad1%stment, the 2+3+ e$onom(, and the &orld e$onom( more 'enerall(, &ill )e a)le to 'et )a$. to )%siness+"
51
The "nited States subprime crisis in 'raphics
52
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'hough the subprime crisis has had its effects on the economies of various countries across the world. for us it is of significance to know the amount of impact it has had on the major economies that share strong political. geographical and economic ties with the United %tates
I0pa1' "! Ca!a.a:
'he subprime crisis was supposed to be locali-ed to the U % As we see the write downs in /anadian banks one wonders when the problem will tip over to /anada 'he U % sub+prime mortgage fiasco is already s1uee-ing borrowers in /anada as bankers struggle to determine which lenders are eCposed to the greatest risk. says /raig Fright 2B/ chief economist 'he U % is moving into a recession 'he impact on the /anadian economy will be significant as the U % economy slows down <ropelled by the dramatic slowdown in the U % housing market is being offset by strong growth in American trade as a result of the weakening greenback 'he level of foreclosures has not hit the market yet 0nce the impact is felt both financial and from the perspective of consumer confidence the economy in the U % will deepen the move into recession 'he economies of /anada and B / are being helped by a long period of strong global growth but could be hit by Nfriendly fireO if the U % resorts to protectionist measures as a result of a weak dollar and a weak economy in an election year 0ne only needs to review the recent forestry sector difficulties last year 'he recent rise in the /anadian dollar has driven profitability out of the industry If the AmericanPs choose to reignite the softwood lumber dispute it will cripple one of the chief resource sectors in western /anada 'he impact of the loss of
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eCport volumes due to the strong /anadian dollar as well as U % protectionistPs measures could stimulate a recession in /anada 'he impact of both will certainly pop the real estate bubble in western /anada Fe are already seeing corrections in the /algary markets It is only a matter of time before we see a correction in the Mancouver real estate markets 'he impact of high ratio financing and higher debt loads on consumers will see an impact on the level of bankruptcies and debt consolidations
I0pa1' "! E/,"p :
'he impact of U% subprime crisis on 7urope is gaining prominence with every passing day. 7arlier real estate agents could 1uote the prices of their choice while selling properties ;owever. things have changed a lot down the line /urrently. the prices of homes are dropping and there is a probable fear that the recession may be reigning supreme in 5ondon neCt year It is also being feared that the U% %ubprime crisis may be falling upon as a grind 0wing to this state of affairs. lenders around the globe are a bit apprehensive in eCtending new loans to debtors Impact of U% %ubprime crisis on 7urope cannot be ignored 'hat this part of the world will be impacted as well. can be concluded from the fact that signs of the same have already started showing $like falling prices of homes& in 5ondon T !orthern 2ock. which was an eminent mortgage lender. took refuge in the Bank of 7ngland for purposes of emergency financing in the month of %eptember. ())3 <rospective purchasers for the mortgage lender are still being looked for T Another instance in Aermany. which implies the impact of U% subprime crisis on 7urope. is when AermanyPs IKB #eutsche Industriebank accepted U%#B>> > billion from the Aovernment as a bailout pertaining to its various United %tates mortgage investments
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T B!< <aribas. the Drench Bank was compelled to take some drastic steps It stopped all withdrawals from a fund of U%#B( ( billion pertaining to investment funds as the true value of the investment portfolios could not be ascertained
I0pa1' "! A3,(1a:
Africa was the least affected with %outh Africa and 7gypt being the only countries to record some minor disturbances Fhy has Africa remained so detached from the sub prime crisisQ 'he main reason why Africa has not felt the full effect of the sub+prime crisis which has since culminated in the slowdown of the U% economy is that most African financial markets still lag behind in terms of financial market sophistication in terms of products on offer as well as information asymmetry 'his is evident in the fact that most of the capital markets in Africa are still being developed with the eCception of the two advanced ones which are %outh Africa and 7gypt %ome African countries still have eCchange controls which restrict the flow of international capital thus limiting the contagion effect from foreign financial markets %ome African countries have just established %tock 7Cchanges which by and large lack li1uidity and market depth with a case in point being %wa-iland which has siC listed counters and an inactive bond market 0ther established eCchanges are illi1uid and in a way limit Africa=s eCposure to the global village
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According to the African #evelopment Bank. the African economy is eCpected to grow by 6.,I in ())9 driven by increased demand for resources from the booming /hinese and Indian 7conomies which will offset the decline in demand from the U% and 7urope 'he /hinese economy is eCpected to grow by 8. 6I in ())9 which is still high enough to benefit African economies despite the threat of a U% recession 'he indirect effect on African economies of a global slowdown emanating from the sub+prime crisis will be felt nevertheless through reduced demand for African goods and services
'he /hinese economy which is eCpected to grow by 8.6I down from the initial forecast >>.3I will insulate Africa and ensure some growth going forward despite a slowdown in the U% I0pa1' "! -"/'7 A0 ,(1a %o far. the sub+prime crisis has had a limited direct impact on 5atin AmericaPs mortgage markets In MeCico. the market for new low+and middle+income housing has grown rapidly. thanks to the creation of a market for residential mortgage securities in ())4 In the last 1uarter of ())3 alone. MeCican issuers sold B> , billion in new mortgage+backed securitiesG a significant portion of B* * billion outstanding. with only a slight drop in prices to reflect globally induced risk. according to the publication Asset %ecuriti-ation 2eport /hilean markets also have stayed relatively calm 'hese markets have been insulated in part because most investment in real estate+backed securities has come from local investors who often need to invest in local+currency markets Most important. 5atin AmericaPs mortgage markets and homeowners are very different from those in the U% NItPs natural that the state of global markets will have some kind of ripple effect.O says Areg Kabance.
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managing director for 5atin American structured finance at Ditch 2atings. the international credit ratings agency NBut 5atin American countries. from a credit standpoint. are a lot better off than they have ever been to withstand turbulence and weather global market problems O 'o their benefit. 5atin American governments have applied the lessons of the past MeCicoPs Nte1uila crisisO of >88*+>88, forced many homeowners into default when the peso fell by 3) percent and interest rates soared In MeCico. all mortgages carry fiCed interest rates. unlike the infamous NeCploding A2MsO that left U% homeowners ruing their choice of adjustable+rate mortgages when interest rates rose MeCican mortgages are indeCed to inflation. but the state mortgage agency links that indeC to the minimum wage and makes up the difference if mortgage interest adjustments for inflation outpace wage growth 'his protects both borrowers and lenders 'he silver lining of past financial crises in 5atin America is that most individuals carry far less debt than do Americans In MeCico. for eCample. mortgage debt represents less than >) percent of A#<. compared to about ,) percent of A#< in 7urope and 9( percent of A#< in the U% L a ratio that has increased more than fourfold in the last two decades
I0pa1' "! S"/'7 A-(a
J'he current subprime mortgage crisis in the United %tates will not seriously impact %outh Asian countriesJ. said %hanta #evarajan. Forld Bank /hief 7conomist for the %outh Asia 2egion N'he impact will be mild because of the structure of the regionPs trade and financial flows. and partly because of compensating effects O #evarajan attributed three factors that work well for the %outh Asian countries" >& 5ack of eCposure to U % mortgage securitiesG (& availability of li1uidity in 62
domestic marketsG and 4& the possibility that lower capital inflows could help countries such as India with macroeconomic management ;ighlighting that Indian companies do not have big eCposure to U % mortgage securities. #evarajan said. N7ven if the subprime crisis leads to a global credit crunch. it still may not have a big effect because there is 1uite a lot of li1uidity in domestic markets in countries like India O ;e believes that if a global credit crunch leads to a decline in capital flows. it may still not be a bad thing for India ;e pointed out that Indian policymakers recently were having difficulties in managing the sudden surge in capital inflows while trying to manage India=s eCchange and inflation rates %peaking on a possible slowing down of the United %tates economy. #evarajan said. N'he impact on %outh Asian countries will still be relatively mildO ;e drew attention to the fact that the share of %outh AsiaPs trade with the United %tates has been declining and that the U % is no longer India=s leading supplier %ri 5anka. which used to rely on the United %tates for its garment eCports. has now increased them to 7urope and other regions substantially 0n the other hand. #evarajan eCpects that N a slowdown of the United States’ economic growth will moderate the increase in prices of oil and other commodity prices which will have a favorable impact on So!th "sia O %ince all %outh Asian countries are net importers of these commodities. such a slowdown will provide some relief in their balance+of+payments N'he declining value of U% dollar will certainly affect IndiaPs I' companies that sell services to the United %tates. and already many I' companies are feeling the effect.O #evarajan said 'he Indian companies engaged in business processes such as mortgage documentation have seen a decline in work orders and loss of revenues as U % lenders have tightened their eCposure to credit market 'he
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Indian I' industry. which derives about 6,I of its revenues from the U % market. will also be adversely affected if the subprime crisis leads to a recession in the United %tates ;owever. #evarajan allayed the fears of a significant negative impact on IndiaPs overall economy and said. N'he share of I' services eCports in total eCports of India is not growing very fast because India has started eCporting more manufactured goods and other services O Also. he said that eCports are not the only determinant of economic growth in India ;e eCpects that domestic demand in India will continue to fuel economic growth even when there is a dampening of I' eCports to the United %tates
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Impact on India
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7ven though the Indian markets are eCperiencing the echo. the Indian banking system has remained fairly insulated from any direct impact of the subprime crisis in the U% 'his is because the Indian banks did not have significant eCposure to subprime loans in the U% ;owever. there was a major impact on the e1uity Markets as many foreign institutional investors $DIIs& sold off their investments into Indian /ompanies to cover their huge losses 'he DIIs have and. as of date. are continuing to withdrawn from the e1uity Markets Aoing forward. any subprime related tremors in the global Markets are likely to cause further chaos in the Indian e1uity Markets as well Also. a subprime like scenario in India seems unlikely given the current state of affairs Dirst and foremost. despite rapid growth in recent years. the mortgage market in India is nowhere near the levels of developed countries. such as the U% or the UK Mortgages as a percentage of A#< in India are still at a small percentage as compared with the U% and the UK %econdly. the approach of the Indian regulators has been balanced and forward+looking Its continuous doses of monetary tightening aims to ensure that the money supply $and hence inflation& is kept within manageable limits Admittedly housing prices in India are affected but this has got more to do with the demand+supply factors
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M a-/, - '7a' 1a! * 'a2 !:
!evertheless. the events which have unfolded in the recent months offer valuable learning for an emerging country like India 0n the fundamental level. there is an utmost need to strengthen the system for assessment of the borrowerPs credit worthiness 'he root cause of the sub prime mortgage crisis is the unsound credit practices that emerged in the U% market Dake certification. which helps an ineligible person to raise a home loan. cannot be ruled out in India ;ousing 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 <ersonal 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 0versight at this stage is bound to cause repercussions in future. no matter how robust the subse1uent processes are 'he regulator will have to ensure that banks do not follow imprudent and predatory lending practices by offering far too lenient lending terms than are warranted for 0n the other hand. banks need to make sure that they share the credit history of borrowers to better assess the credit worthiness of borrowers 0ne such initiative could be to encourage wider use of the services of the credit information bureau $/IB& Membership as well as sharing of credit information with /IB may be made mandatory for all financial institutions so that the comprehensive credit information pertaining to individual borrowers can be made available to all the financial institutions A fundamental limitation has been that the rating models largely rely on the historical performance record. which has been eCcellent in case of mortgage backed securities But these models do not take into account newer risk implications arising from newer mortgage structures. such as the option
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adjustable rate mortgage. which is prone to payment shocks /redit models at the originators and rating agencies must tailored to address the potential risks in such innovations and ensure that they are ade1uately factored in their rating mechanisms !ot only that. they must also ensure continuous monitoring so that the changing conditions of the 7conomy are reflected in their processes /redit rating agencies should use learning from this episode to modify their rating methodologies + incorporate certain predictive elements. and add greater rigor in their timely surveillance of rating securities A swift move by credit rating agencies in identifying sticky mortgage backed securities will only help instill confidence in the efficiency of the entire rating system Dinancial institutions will also play a larger role in avoiding any shocks by carrying out proper due diligence of securities and borrowers. besides relying on credit ratings 'hey need to strengthen their risk management framework in view of increasing compleCities in products/services. and customersP re1uirements Although it would be compelling in such situations. one of the foremost things to note is that the regulator should not get carried away by the events in the global Markets to impose far too many stringent regulations to restrict credit growth 'his may lead to stifling of economic growth in the process 2ather. the approach should be to put in place right kind of enablers to identify the potent risks and deal with them appropriately in the Indian conteCt
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CHAPTER I%
SUMMARY
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SUMMARY AND CONCLUSION
N#erivatives are financial weapons of mass destruction. carrying dangers that. while now latent. are potentially lethal.O so said Farren Buffett. reportedly the third richest person in the world. in ())( ;is prophetic words are becoming true with the unraveling of the financial mess created by the sub+prime lending spree in the U % 'he developments will also affect emerging market countries such as India 'he developments that led to the eCplosive situation are traced here %ub+prime loans are those given to borrowers whose creditworthiness is below prime and hence are of low 1uality In India. sub+prime lending refers to loans carrying rates below the prime lending rate normally offered to high 1uality borrowers %ub+prime or low 1uality loans are mainly of three kinds" car loans. credit card loans and house mortgage loans 0f these. the biggest and the ones that can endanger the entire financial system are the house mortgage loans 'hese formed nearly one fifth of all U % mortgage loans in ())6. going up from 8 per cent till ())* 'he sub+prime loans were given to borrowers who did not have the capacity to service them $pay interest and repay principal& At the height of such lending. it was said. the borrowers were in the !I!HA $no income. no jobs also& category 'o lure such borrowers. some lenders adopted SpredatoryP practices 'hey lent deliberately knowing that there will be default and. when it occurred. sei-ed the houses mortgaged and sold them off to make a profit 'he basic 1uestion is why any lender $apart from the predatory ones& would give loans that carried the highest risk 0ne reason is that these carried higher 71
interest rates But. the main reasons seem to be two" large surplus funds with banks and the introduction of esoteric financial instruments that passed on the risk to unsuspecting investors %oon after the dotcom bubble burst in ())(. the Dederal 2eserve $central bank& of the U % pumped in money into the system 'oo much money in the system led inevitably to lower 1uality of lending 'he availability of credit derivative instruments. which basically transferred the risk to another party. accelerated the pace of sub+prime lending 'ypically. a bank or mortgage finance company $many of them owned by banks& lent to a sub+prime borrower to finance purchase of a house %ince the borrower did not have the means to even pay interest in the beginning. the lender sugar+ coated the loan through an adjusted rate mortgage $A2M& 0ne type of such a loan was called (+(9 #uring the first two years of a 4)+year mortgage loan. interest was pegged at a low fiCed rate of * per cent In the subse1uent (9 years. the rate was floating $variable& at around , per cent over a benchmark rate such as 5IB02 $5ondon Inter+Bank 0ffered 2ate&
'he lender hoped that even if the borrower could not service the loan after two years. he/she could always take refinance $raise a fresh loan against the same house& for a larger amount Implicit in this was the assumption that house prices will go on increasing 'his premise got a jolt when house prices started climbing down after peaking in ()),+)6 Fhen the first two years eCpired. the interest rate also moved up to very high levels Fith 5IB02 ruling at over , per cent. the mortgage rate shot up to >) per cent %uddenly. the 7MI $e1uated monthly installment& of such a loan nearly doubled" for a 2s , lakh loan. it is 2s *.*3) a month for a (9+year. >) per cent loan. against 2s (.*)) for a 4)+ year * per cent loan
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'he primary lenders $originators& of the sub + prime loans wanted to sell the loans to investors 'o make them attractive. they pooled such loans into baskets and created what are known as /#0s $collaterali-ed debt obligations& 'he baskets were sliced and spliced to make layers of /#0s $derivatives& carrying different risks 'he underlying assumption was that all borrowers would not default at the same time and a percentage of them would be prompt in payment 'he SsafeP portion was sold to investors averse to high risk and the balance to others 'he credit rating agencies put in their might behind the maneuver by giving the best rating to the portion deemed low risk %ome even alleged that the agencies helped in the splicing game 'hese /#0s were bought by some big investment banks and hedge funds in which the super rich invested for high returns 'hey. in turn. financed these investments by borrowing from banks against the security of /#0s 'he banksP action in passing on the risk to others boomeranged. with the same sub + prime loans coming back to them as security for loans 'he whole arrangement crumbled when things turned adverse with falling home prices and rising interest rates In early ())3. when !ew /entury Dinancial. a large sub+prime lender. collapsed. it resulted in Barclays Bank taking over sub+ prime loans of about B8)) million In Debruary. ;%B/. another big British bank. reported steep losses in sub+prime lending in the U % Many /anadian. Aerman and Drench banks followed suit Many of the big investment banks in the U % also reported large losses As a result. confidence in the banking system was rudely shaken And. no bank could be sure of the solvency of another bank and the inter bank money market. where short term lending was common. almost dried up Authorities in 7urope and the U % had to pump in money to prevent the whole system from collapsing 'hese developments had their impact on Indian stock markets in which many hedge funds and investment banks had invested Fhen
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they faced li1uidity problems in the U % . they sold part of their Indian holdings. sending the share indices down Fith the sub + prime loans taking different avatars and changing hands fre1uently. no one knows for sure which institution holds how much of the low 1uality loans Assessing the impact of this worldwide financial contagion will take months. if not years <erhaps. it could bring about a prolonged recession or very slow growth in the U % . as it happened in Hapan in the>88)s <art of the blame perhaps attaches to the U % Dederal 2eserve which detected the problem too late to take corrective action Ultimately. bankers will have to return to the time tested practice of prudence in lending if problems witnessed in sub + prime loans are not to recur
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BIBLIOGRAPHY
N 4-pap ,-: • • • • NET • • www google com www wikipedia org 'he ;indu 7enadu Business 5ine Business %tandard
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