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ARTS & COMMERCE
Banking in Financial Systems
Class : S.Y.B.F.M.
PRESENTATION ON :
American crises in 2007
Submitted to : Vaibhav sir
Academic year : 2011-12
GENERAL INTRODUCTION ABOUT THE SECTOR :
The Indian economy is emerging as one of the strongest economy of
the world with the GDP growth of more than 8% every year. This has
given a great support for the development of banking industry in the
country. Due to globalization, competition among the banks has
drastically been increased. As India has a substantial upper and
middle class income hence the banks have immense opportunities to
increase their market shares. The consumer being on the receiving
end is in the comfortable position but the banks trying to increase
their market share have to continuously add value for consumers in
order to increase market share and sustain their growth.
BANKING SECTOR of America :
The banking sector is the most dominant sector of the financial
system in India. Significant progress has been made with respect to
the banking sector in the post liberalization period. The financial
health of the commercial banks has improved manifolds with
respect to capital adequacy.
Though the U.S. banking sector was in recovery mode in 2010, it still
managed to reach some highs and lows. There were 157 bank
failures in the country last year, the most since 1992, according to
the Federal Deposit Insurance Corporation (FDIC). And the number
of new bank charters was at an historic low -- 11, compared with 181
three years earlier. With so many banks leaving the sector and so
few entering it, a long-anticipated consolidation process is now
under way. The U.S. is expected to end up with no less than 6,529
commercial banks and 1,128 savings institutions by the end of this
INTRODUCTION of American crisis :
Since 2007, the world has experienced a period of severe financial
stress, not seen since the time of the Great Depression. This crisis
started with the collapse of the subprime residential mortgage
market in the United States and spread to the rest of the world
through exposure to U.S. real estate assets, often in the form of
complex financial derivatives, and a collapse in global trade. Many
countries were significantly affected by these adverse shocks,
causing systemic banking crises in a number of countries, despite
extraordinary policy interventions.Systemic banking crises are
disruptive events not only to financial systems but to the economy
as a whole. Such crises are not specific to the recent past or specific
countries almost no country has avoided the experience and some
have had multiple banking crises.
While the banking crises of the past have differed in terms of
underlying causes, triggers, and economic impact, they share many
commonalities. Banking crises are often preceded by prolonged
periods of high credit growth and are often associated with large
imbalances in the balance sheets of the private sector, such as
maturity mismatches or exchange rate risk, that ultimately translate
into credit risk for the banking sector.
Global financial stability has been shaken and America is facing a
growing economic crisis that could make the 1930s look like “good
times.” The U.S. banking system is on the verge of disaster, as banks
have recorded over $100 billion in losses, with hundreds of billions
What Is Sub-Prime Crisis ?
Subprime is the cause of USA Economymelt down. It is the
very popular news among everyone and it is become very serious
then expected. It caused more damage to all the
industries. Subprime crisis caused big loss to the banks and
now it is affecting the other industries like AutoMobile companies
(GM, Ford, etc.). In this blog I will write about what exactly is
the Subprime crisis and why USA banks created such a big
mistake in their era. Some experts comparing this disaster with
the 1930 Economy slow down in USA.
The subprime mortgages are subprime. In simple words, the
principle allows a person to purchase a property for a fixed
interest rate particularly low the first 2 years (e.g. 1.45%) and
then switch to a floating rate contains a risk premium (e.g. 8%).
In return, the property is mortgaged.
The latter sold their property with a capital gain (the U.S. housing
market growing 10% per year) enabling them to repay the loan
and interest. In 2007, Beneficiaries wishing to sell their subprime
real estate at the end of second year was leading a face down in
the U.S. housing market.
EFFECTS OF AMERICAN PUBLIC
The crisis started in the summer of 2007. Due to the surplus of homes
on the market, housing prices fell moderately—tipping the scales. Also
around this time, the first batch of interest rate resets came due. Faced
with exploding monthly payments, falling house prices, and an inability
to refinance their mortgages, many customers defaulted on their loans.
Lenders call it “jingle mail,” as so many homeowners are just turning in
Confronted with higher monthly payments on mortgages that are
greater than the value of their homes, homeowners are abandoning
their mortgages. Many feel no moral obligation to fulfill what they
promised to repay, believing it is better to walk away from their homes.
They feel that while this hurts their credit rating, in the short-term it
hurts less than the downward spiral toward bankruptcy.
As the crisis intensifies, mortgage defaults are multiplying. And
everyone is on the hook. “Monoline” insurance companies have
suddenly become liable for multiple billions of dollars of debt. Investors
have been left holding bonds that may never be repaid. Banks are
finding it difficult to sell additional bonds as investors have backed out
of the market, leery of poor investments. Thus, the banks’ fee income
has dried up—leaving them with massive deficiencies in capital.
As credit problems mount, banks have sharply reduced lending to each
other and the public, fearful the loans will not be repaid (the “credit
crunch”) as liquidity dries up and less money is available to finance
commercial loans. Recently, a group of bankers were unable to back
$14 billion of debt to finance an entertainment company. Other major
deals in the tens of billions are now in jeopardy. The credit crunch has
pushed beyond retail banking; it is now affecting major business deals
and even commercial real estate. And municipal bonds (used to fund
cities, colleges and hospitals), which were once considered safe
investments, can no longer readily find buyers.
Kings Become Beggars
Increasingly, America’s banks have been forced to look to other nations
for capital. Recently, U.S. banks received massive infusions of capital
from Asian and Middle Eastern sources that are purchasing larger
stakes in America’s largest bank institutions.
During the G7 meeting mentioned earlier, Toshihiko Fukui, governor of
the Bank of Japan, made a statement that could have serious
ramifications, as the banking crisis further deteriorates: “If everyone
does the same thing it won’t be any more effective. Each country needs
to do what is best for its own particular situation.”
In the near future, will countries that have so often supported America
financially stop doing so, causing the crisis to spiral out of control?
A Culture of Greed
In many cases, mortgage brokers misrepresented terms and conditions
to eager customers who provided them with fraudulent information.
Sometimes banks did not even bother to check the information
provided. Banks sold risky bonds as safe investments to unsuspecting
investors. Rating agencies, paid by the banks, rated risky bonds (those
with subprime components) as safe—even giving them the highest
rating.With substantial increases in real estate prices occurring every
year, builders went on a building spree around the nation.
In their quest for higher profits, banks no longer felt the need to
carefully screen loan applicants, as they once did. Customers who did
not qualify for loans under the banks’ standard lending procedures (i.e.,
“subprime” customers) were now targeted as a lucrative source of
income, and marketed aggressively to. Loans were provided to people
with no income, no job and no assets (so-called NINJA loans).
The 2008-2009 Financial Crisis – Causes and Effects
The recent market instability was caused by many factors, chief among
them a dramatic change in the ability to create new lines of credit,
which dried up the flow of money and slowed new economic growth
and the buying and selling of assets. This hurt individuals, businesses,
and financial institutions hard, and many financial institutions were left
holding mortgage backed assets that had dropped precipitously in value
and weren’t bringing in the amount of money needed to pay for the
loans. This dried up their reserve cash and restricted their credit and
ability to make new loans.
There were other factors as well, including the cheap credit which
made it too easy for people to buy houses or make other investments
based on pure speculation. Cheap credit created more money in the
system and people wanted to spend that money. Unfortunately, people
wanted to buy the same thing, which increased demand and caused
inflation. Private equity firms leveraged billions of dollars of debt to
purchase companies and created hundreds of billions of dollars in
wealth by simply shuffling paper, but not creating anything of value. In
more recent months speculation on oil prices and higher
unemployment further increased inflation.
How did it go so bad?
The American economy is built on credit. Credit is a great tool when
used wisely. For instance, credit can be used to start or expand a
business, which can create jobs. It can also be used to purchase large
ticket items such as houses or cars. Again, more jobs are created and
people’s needs are satisfied. But in the last decade, credit went
unchecked in our country, and it got out of control.
Mortgage brokers, acting only as middle men, determined who got
loans, then passed on the responsibility for those loans on to others in
the form of mortgage backed assets (after taking a fee for themselves
originating the loan). Exotic and risky mortgages became commonplace
and the brokers who approved these loans absolved themselves of
responsibility by packaging these bad mortgages with other mortgages
and reselling them as “investments.”
Thousands of people took out loans larger than they could afford in the
hopes that they could either flip the house for profit or refinance later
at a lower rate and with more equity in their home – which they would
then leverage to purchase another “investment” house.
A lot of people got rich quickly and people wanted more. Before long,
all you needed to buy a house was a pulse and your word that you
could afford the mortgage. Brokers had no reason not to sell you a
home. They made a cut on the sale, then packaged the mortgage with a
group of other mortgages and erased all personal responsibility of the
loan. But many of these mortgage backed assets were ticking time
bombs. And they just went off.
The housing market declined
The housing slump set off a chain reaction in our economy. Individuals
and investors could no longer flip their homes for a quick profit,
adjustable rates mortgages adjusted skyward and mortgages no longer
became affordable for many homeowners, and thousands of mortgages
defaulted, leaving investors and financial institutions holding the bag.
This caused massive losses in mortgage backed securities and many
banks and investment firms began bleeding money. This also caused a
glut of homes on the market which depressed housing prices and
slowed the growth of new home building, putting thousands of home
builders and laborers out of business.
Depressed housing prices caused further complications as it made
many homes worth much less than the mortgage value and some
owners chose to simply walk away instead of pay their mortgage.
The credit will dried up
These massive losses caused many banks to tighten their lending
requirements, but it was already too late for many of them… the
damage had already been done. Several banks and financial institutions
merged with other institutions or were simply bought out. Others were
lucky enough to receive a government bailout and are still functioning.
The worst of the lot or the unlucky ones crashed.
The economic bailout is desiged to increase the flow of credit.
Many financial institutions that are saddled with risky mortgage backed
securities can no longer afford to extend new credit. Unfortunately,
making loans is how banks stay in business. If their current loans are
not bringing in a positive cash flow and they cannot loan new money to
individuals and businesses, that financial institution is not long for this
world – as we have recently seen with the fall of Washington
Mutual and other financial institutions.
The idea behind the economic bailout is to buy these risky mortgage
backed securities from financial institutions, giving these banks the
opportunity to lend more money to individuals and businesses,
hopefully spurring on the economy.
HOW COSTLY ARE THE 2007-2009 SYSTEMIC BANKING CRISES?
We estimate the cost of each crisis using three metrics: direct fiscal
costs, output losses, andthe increase in public sector debt relative to
GDP. Direct fiscal costs include fiscal outlayscommitted to the financial
sector from the start of the crisis up to end and capture the direct fiscal
implications ofintervention in the financial sector.20 Output losses are
computed as deviations of actual GDP from its trend, and the increase
in public debt is measured as the change in the public debt-to-GDP
ratio over the four-year period beginning with the crisis year.21 Output
losses and theincrease in public debt capture the overall real and fiscal
implications of the crisis.
New crises (2007-2009)
INCREASE PUBLIC OUTPUT LOSSES
Note: New crises include Austria, Belgium, Denmark, Germany, Iceland,
Ireland, Latvia, Luxembourg,Mongolia, Netherlands, Ukraine, United
Kingdom, and United State.
What Caused the Current Financial Crisis?
As you are all probably aware, the US is currently experiencing the
biggest financial crisis after the Great Depression.
And just like this past worldwide economic downturn, marked with
massive bank failures and the stock market crash.
Preceding Factors Contributing to the Financial Crisis
When examining the causes for the financial crisis most people start
directly with the real estate market (the place where the crisis really
began) focusing on the subprime mortgages and unscrupulous lenders
and casting the blame on the unsustainable real estate bubble which
began to collapse in 2006.
Whereas this is true, it is not the whole story. The whole real estate
bubble originated mainly as a response to the huge demand of financial
assets. And since not many places can actually provide such assets,
naturally in such situations speculative bubbles come on the stage and
become part of the supply response of financial assets to the demand
of such assets.
The Problem with Securitization of Mortgages
Basically, securitization is a wonderful financial vehicle. Mortgages are
pooled together as securities and sold to investors. Of course, as
securities, they can also be resold. Securitization creates diversification
and liquidity. It also "smoothes out" the idiosyncratic risk of defaulting
or going bankrupt.
Despite the existing lack of clarity and transparency (investors did not
fully understand these vehicles and after all, it was hard to get
information which houses are included in the pool) regular conforming
mortgage backed securities were considered very low risk and were
sold to investors not only in the US but also around the world.
And then, the idea of generating higher returns originated. Mortgages
were now offered to high risk borrowers too, at the cost of significantly
higher mortgage rates. Those subprime mortgages were put in big
pools of assets from which the so called "Mortgage Backed Securities"
were created. Often, the mortgages were actually broken into pieces
and grouped and packaged with other mortgage pieces of the same
type. Thus, financial instruments and vehicles like SIV, CMO, CDO, MBS
and etc. seemed like a great solution to the great demand of assets and
the idea was that the yields on such securitized subprime mortgages
would also be higher.
However, the problem with securitization stems from the fact that it
does not provide protection against systematic risk. And unfortunately,
such a systematic risk was also not priced into the subprime mortgage
pools... not until things went wrong and subprime borrowers started
defaulting on their mortgages.
Reasons behind the Large Scale of the Crisis
As we already noted, credit rating agencies didn't take into account the
possible systematic risk and blessed the apparently low risk securities
with AAA rating. Pension funds, mutual funds, some money market
funds, banks and investors from all over the world purchased such
securities thinking that they are safe. And as for the riskier securities,
they also had their clientele - the hedge funds. Thus, the markets
absorbed enormous amounts of these securities.
Additionally, because investors considered such securities low risk, they
leveraged them. In other words they invested more than they actually
had capital for.
This liquidity and the fact that these instruments became so widely
spread among investors of all types and sizes now stand behind the
great scale of this financial crisis.
The subprime lending increased the homeownership rate in the United
States significantly and about 5 million people went from tenants to
homeowners. As a result, rents went down and house prices went up
till they reached unsustainable heights relative to rents.
Thus, when the rise in housing prices stopped in 2006, inevitably many
subprime borrowers had difficulty making their mortgage payments.
The housing bubble and particularly the excesses of the subprime
mortgage market became even more evident when many subprime
mortgage lenders began declaring bankruptcy around March 2007. This
problem started to gain crisis proportions and yet, the financial
authorities and the Federal Reserve believed that it was an isolated
phenomenon. Well, they were wrong.
Instead, in mid-2007, the losses in the subprime mortgage markets
triggered surprising turmoil throughout the international financial
system, given the presumed small size of the US subprime market
compared to the global financial markets. The crisis spread with
amazing speed to other markets and even to financial institutions that
had no direct exposure to the subprime mortgage market.
First, the recent crisis was concentrated in advanced economies, in
particular those with large and integrated financial systems, unlike
many of the boom-bust in the past that centered on emerging market
economies. Liquidity shortages at systemically important, globally
interconnected financial institutions in these advanced economies
prompted large-scale government interventions.
Second, while the intensity of policy interventions has been comparable
to past crisis episodes, the speed of intervention and implementation
of resolution policies was faster this time. This in part reflects that most
of the crisis-affected countries are high income countries with strong
legal, political, and economic institutions that create an enabling
environment for an effective and speedy crisis resolution.
Recapitalization contributing to lower direct fiscal outlays.
Third, countries used a much broader range of policy measures
compared to past episodes, including unconventional monetary policy
measures, asset purchases and guarantees, and significant fiscal
stimulus packages. These large scale public interventions were possible
in part because most of the crisis-affected countries are high-income
countries with relatively greater institutional quality and credibility of
Fourth, preliminary estimates indicate that the overall economic costs
of the recent crises are higher in terms of output losses and increases in
public debt compared to past crises, though fiscal costs associated with
financial sector interventions are lower