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US Subprime Crisis

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The project gives a detailed understanding of the US Sub prime Crisis and how things unfolded. Though the scope of the project is limited to a specific time frame, the project report entails all the ...

The project gives a detailed understanding of the US Sub prime Crisis and how things unfolded. Though the scope of the project is limited to a specific time frame, the project report entails all the nitty gritties of the occurrence of events

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    US Subprime Crisis US Subprime Crisis Document Transcript

    • The U.S. Sub-prime Crisis – A Study of the recent economicdevelopment in the U.S. and their likely impact on the Indian Economy A report submitted in partial fulfillment of the requirements of MBA program at ICFAI Business School, Ahmedabad.Submitted to: Submitted to:Prof. Vivek Ranga Mr. Sunil ChandraFaculty Guide (Country Head-DPM)IBS, Ahmedabad. Almondz Global Securities Ltd. 0  
    • A REPORT ON The U.S. Sub-prime Crisis – A Study of the recent economicdevelopment in the U.S. and their likely impact on the Indian Economy BY PARAMJEET KAUR AT ALMONDZ GLOBAL SECURITIES LIMITED NEW DELHI A report submitted in partial fulfillment of the requirements of MBA program at ICFAI Business School, Ahmedabad.Submitted to: Submitted to:Prof. Vivek Ranga Mr. Sunil ChandraFaculty Guide (Country Head-DPM)IBS, Ahmedabad. Almondz Global Securities Ltd. 1  
    • SUMMER INTERNSHIP PROGRAMME The U.S. Sub-prime Crisis – A Study of the recent economicdevelopment in the U.S. and their likely impact on the Indian Economy Submitted By: Name: Paramjeet Kaur Enrollment No.:07 BS 2784 Mobile No.:09974339611 Email ID:paramjeet.kaur86@gmail.com 2  
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    • ACKNOWLEDGEMENT Across the road to the Corporate World, Unknown pursuits came my way. A ‘Thanks’ would be too small a token, for all that with what I stand today!The fourteen weeks Summer Internship Programme needs a laudable appreciation for the novelexperience of practical knowledge and the true insights of the clichéd Corporate Culture.Thanking all the affiliates’, veterans in knowledge and virtuoso in experience would be a meretoken of gratitude, which may not be sufficient for all the knowledge imparted, and all theblessings bestowed upon me.I would like to express my immense gratitude to Mr. Sunil Chandra (Country Head, DebtPortfolio Management) for guiding me throughout the whole project with his impeccableknowledge. I owe my gratitude to Ms. Rajni Dasgupta (Vice President) who taught me the firstlesson of corporate culture. Mr. Abhilash Kumar (Manager) owes a special mention for theinvaluable insights that he provided me, which would be carried forward as a legacy ofknowledge and learning all through my life.I am also thankful to all the staff members’ of Almondz Global Securities Limited, who havealways guided me whenever I needed help and acquainted me with the minutest details ofetiquettes and behavioral aspects.I sincerely thank Mr. Vivek Ranga, who has always been a continuous source of encouragementall through the project. I am also thankful to my faculty members and Prof. P. Bala Bhaskaranfor guiding me all the way. All the more, ICFAI University needs to be praised which hasprovided the students with such a bright opportunity to have an exposure of the real corporateenvironment for the valuable period of three and a half months to get the corporate ambienceimprinted on our minds to carry forward the learning’s of this first tryst with corporates in thefuture struggle in the path of professional success.Last but not the least, a special mention must be made to all those who have knowingly andunknowingly helped me in the completion of this project. I owe my gratitude to my parents whohave always encouraged me in the pursuit of excellence.Paramjeet Kaur07 BS 2784 4  
    • TABLE OF CONTENTS ABSTRACT       10   INTRODUCTION                             11     Purpose of the Study                  11   Scope of the Study                  12   Limitations of the Study                12   Methodology of the Study                13   INTRODUCTION                             14 HOUSING MARKETS IN U.S.A.: Major Contributor to Growth      16   Homeownership‐ The American Dream            16   Economic Impacts of the Housing Sector            18   Housing Sector having Macro‐economic Implications        20   Impact on Communities                20   Impact on Individuals                 21   Housing Contribution to Society              22 LEVERAGED SECURITY MARKETS: The Double Edged Sword      23   Leveraging                    23   Housing Sector: The Initial Fuel              23     Securitization: Prime Mover of the Crisis            24   Sub‐prime Crisis: A result of Leveraging            26 SUB‐PRIME LENDING: The Flaws              29 THE CRISIS AND CHRONONOLOGY OF EVENTS: Timeline of Implosion    32    Chronology of Events                  36  5  
    • THE PARTIES IN THE CRISIS AND THEIR ROLE: Walking the Line        53   Role of Borrowers                  53  Role of Financial Institutions                55    Role of Securitization                  56    Role of Mortgage Brokers and Mortgage Underwriters        57              Role of Government and Regulators              58  Role of Credit Rating Agencies              58  Role of Central Banks                  59 IMPACT OF THE CRISIS ON THE U.S.A.: Entering A Possible Recession 61 Collapsing US Housing markets               63  Unemployment                  68  Fed rate cut                    69  Inflation                     70    Falling dollar                    71  Widening fiscal deficit                 75  US GDP growth                  77 IMPACT OF THE CRISIS ON THE WORLD FINANCIAL MARKETS 78   Impact on the Commodities Markets: Markets pivot on its head      82     Gold Markets                  83     Crude Oil                  85     Metals                   86  On Stock Markets: Gravity proves itself            87  On Some of the Larger Economies: Euro and Japanese        91  6  
    • IMPACT ON INDIA 96     The First Signs: First Blood                98   On Financial Markets: Stock Markets lose their Sheen                  100   On Commodities markets with special emphasis on Crude oil: A fuel to inflation  102   On Money Markets and Interest Rates: The Hinges of Growth                104   On INR: Challenging the might of the Dollar                      107   Indian Housing Markets: Following the Footsteps                     109   On Indian Economy: Structural Changes: The proverbial struggle of Good vs. Bad  112 THE NEW WORLD ORDER: Rise Of the Behemoth 114  APPENDIX Appendix 1:   Borrowers Protection Act 2007                        118  Appendix 2:    Beige Book                           125    Appendix 3:   Fico Scores                127  Appendix 4:   Role of Freddie Mac and Fannie Mae         129  Appendix 5:   Housing Market Correction & Bursting of Housing Bubble    131    Appendix 6:   Asian Currency Crisis              131  Appendix 7:   Russian debt Crisis              132  Appendix 8:   Long‐Term Capital Management          133  Appendix 9:   Relation between Crude Oil & Dollar Value        134  Appendix 10:   Relation between Gold Prices & Dollar Value      136    Appendix 11:   Relation between Crude Oil & Gold Prices        138    Appendix 12:   Theory of Decoupling             140 GLOSSARY                      141 BIBLIOGRAPHY                                                                                 143  7  
    • TABLE OF FIGURES AND ILLUSTRATIONS   Figure 1:       Housing Sector creates a vicious circle           14  Figure 2:  Real Median Household Income            17  Figure 3:   Homeownership trends in USA (in 000)          18  Figure 4:   Mechanism of Securitization              25  Figure 5:   Timeline of Implosion               34  Figure 6:   US Foreclosure Filings               55  Figure 7:   Home Ownerships in US              57  Figure 8:   Relative Size of Variable Interest Rate Mortgages                                    65  Figure 9:   Home Price Indices              65  Figure 10:   Foreclosure starts rate                66  Figure 11:   Unemployment in USA               68  Figure 12:   Fed Rate cuts in US                69  Figure 13:   Inflation Rate in USA                70  Figure 14:    USD vs. Euro (Interbank Rate)             72  Figure 15:   USD vs. JPY (Interbank Rate)              73  Figure 16:   U.S. Treasury Yield Curve Rate                        73  Figure 17:   Federal Fiscal Position                       75  Figure 18:   US Economic Growth                77  Figure 19:   World Economic Growth              79  Figure 20:   Growth figures forecasted by IMF           80  Figure 21:   Commodity Prices across the world            82  Figure 22:   Gold Prices in USD/Ounces              83  Figure 23:   Oil Prices in USD/Barrel              85  Figure 24:   Base Metal Indices                86  8  
    • Figure 25:   Major stock market indices              87  Figure 26:   Dow Jones Index                88  Figure 27:   NASDAQ Index                  89  Figure 28:   Nikkei 225 Index                89  Figure 29:   DAX Index                  90  Figure 30:   Main developments in major industrialized economies     91  Figure 31:   BSE Sensex                            100  Figure 32:   Nifty Index                           100  Figure 33:   Bank Nifty                            101  Figure 34:   CRR (Cash Reserve Ratio)                        104  Figure 35:   Call Money Borrowing                          105  Figure 36:   INR vs. USD                           107  Figure 37:   Percentage Distribution of GDP as per sectors                               112 TABLE OF BOXES   Box 1:   Mechanism of Leveraging                           26  Box 2:   Types of Borrowers                54  Box 3:   Predatory Lending Practices             57  Box 4:  Potential Subprime Losses                       61  Box 5:  Main Credit Losses so Far               62  Box 6:  Projected Economic Losses                          67  Box 7:  Major Market Falls in January 2008                       87  Box 8:  House Price Developments In Central & Eastern European Countries 93  Box 9:   Indian Companies with Foreign Losses                     98    Box 10:          Market Intervention by RBI                       108  9  
    • ABSTRACTThe U.S. economy has over the past few decades enjoyed the status of being a financialsuperpower. The housing sector was booming as more and more people were eager to fulfill the‘American Dream’ of owning a home. The spiraling housing prices enticed the people to buyhomes with initial borrowing and lending rates that were extremely low; which helped to boostthe demand and supply of new and existing houses. The liquidity of the banks, eagerness ofborrowers to own a house and an inefficiently created structure of financial products lead to thesubprime debacle.The financial systems were overflowing with liquidity, which made them construct a mechanismof securitization that involved pooling of the loans and creating Collateralized Debt Obligations(CDO) and Mortgage Backed Securities (MBS). The low-income borrowers were enticed by thevarious types of mortgages such as Adjustable Rate Mortgages, Interest Only Mortgages (I/O)etc. The borrowers readily accepted these loans as these short-term low rates reduced the burdenof the borrowers. All sorts of people with or without any income proof or documentation availedof these loans. The pools of these debts were smartly issued to investors depending on the riskattached to the instruments.The housing market correction and bursting of the housing market bubble overturned the wholescenario. This increased the delinquency rates and the number of foreclosures filings weresurging. To make matters worse, the increased unsold inventory further reduced the pricesmaking it difficult for the financial institutions to sell them and recover their loans. Due to thecomplexity, sheer size and volume, presence of numerous players and major flaws in thesubprime lending the whole U.S. economic system now stands at the verge of a possiblecollapse. The U.S. economy is witnessing a decline in the growth figures. The unemploymentrates are rising further aggravating the inflation numbers. The strengthening Euro and Yen standas evidence that the U.S. economy is in a downturn.The effects from the possible recession in the U.S. and the reading of a world wide spread of the‘economic fever’ has made the commodities prices to increase and for the capital markets totumble. Widespread losses across the markets have brought economies to reassess their exposureto the U.S. economy and Central banks of these countries have taken steps (both reactive andpre-emptive) to control any major contagion.The Indian economy/markets may be comparatively safe due to the strict regulations of the RBI.Even then, in the world of gross inter-linkages the chances of the system getting singed cannotbe ignored. The exposure of our economy to the U.S. markets may be limited; even then theindirect impacts cannot be ignored. The study would then try to analyze the impacts both directand indirect on the Indian financial systems. 10  
    • INTRODUCTIONThe whole world being linked with the common ties of globalization has necessitated the studyof the turbulence in the U.S. economy and its impacts on the world with special relevance to theIndian economy. The subprime crisis and its effects on the U.S. economy and the worldeconomies have been studied in detail moving onto the Indian economy.PURPOSE OF THE STUDYThe main objective of the study is to have: • An understanding of the ongoing Sub-prime crisis • The impact on Financial Markets, Commodities Markets (Crude Oil), Money Market of our country • Study its impact on U.S.A, developed economies and the Indian Economy. • Future implications on the World Economic system in general. • Study the possible impact it may have on India. • Expected changes to the Indian Economy post Subprime CrisisThe world economies are at present passing through one of the most difficult phases in recenttimes. The sub-prime crisis, which has its roots in the U.S., threatens to rage onto the otherdeveloped economies eventually to scathe the emerging market economies in wake. Sitting inIndia, we may appear, at present, seem to be unaffected by the world economic problems.Statements by heads of important agencies have time and again impressed that the Indianeconomy has a very little exposure to the subprime and that, aside from scratches, the economy,in general, would walk tall.However, in spite of the Indian economic systems seemingly direct insulation from the impacts,the fact remains that in the world of integrated economic systems, the U.S. recession is bound totest the resilience of the domestic economy. Already the stock markets, which seem to have themaximum exposure, have entered into a highly unpredictable and volatile state. The dominoeffect on the other sectors would take some more time to incident. 11  
    • SCOPE OF THE STUDYThe project involves studying the subprime crisis as a whole. The main topics under this projectare - Housing markets in the U.S.A, Leveraged Security Market & the Process of SubprimeLending. A study of the chronology of events will also be made to ascertain its incidence and theway it turned into a huge crisis engulfing the global economies. The project will also involvestudying the parties in the crisis such as borrowers, lenders, banks etc. and their role.After having an insight of all this the project shall move on to the impact and implications onU.S., some leading world economies and finally India. This will include studying: • The Commodities Market with special emphasis on the Crude oil market and how it effects inflation. • The Stock Markets of the world • Overall effect of subprime crisis on the money markets and interest rates in India. • Changes in forex rate of INR and the U.S.D. • The Structural Changes of Indian economy posed by the subprime crisis will also be done.LIMITATIONS OF THE STUDY Subprime crisis and the fallouts to the economy thereof is a very expansive area that has gripped the biggest economy of the world. No matter how deep one goes into it, the chances of understanding it to the core may be difficult. The study would also not include aspects that are topical to U.S.A and would include only those that are relevant in the Indian context or, which may have a bearing on India. Due to the ‘lag effect’ all the resultants may not manifest itself at the time of the study, so while a theoretical study may be made, a comparison of the actual results may leave a lot wanting. 12  
    • METHODOLOGYThe methodology comprises an in-depth search of various news articles, journals, reports,relevant laws and other literary work on this topic. The report involves an analysis of the latest movements in the U.S. and the Indian Financial Markets. A search on the internet and books is another aid to the successful completion. A systematic approach has been followed which involves concentrating on the lowest level accentuating the role of various parties who were party to the entire debacle. The next level of the study involved studying the timeline of how it transformed into such a huge problem. The impact of U.S. economy, then the inter-related world economies is the next step under the study. Finally the subprime crisis spreading its wings to the Indian Economy will be studied. 13  
    • INTRODUCTION “What began as a fairly contained deterioration in portions of the U.S. sub-prime market has metastasized into severe dislocations in broader credit and funding markets that now pose risks to the macroeconomic outlook in the United States and globally” Global Financial Stability Report, IMF, April 2008.The recent turmoil that has inflicted the world economies is the sub-prime crisis. Related to thehousing prices and engulfing the entire banking system of the U.S. economy, this crisis hasspread its wings to encompass the worldwide economies in its realm translating it into a majorfinancial crisis. The impact of this crisis has been so severe that the entire banking system of theworld’s largest economy may collapse, leaving little scope for recuperations out of this crisis.The fact that the housing crisis has led to the present imbroglio is obviously undeniable.IntroductionThe outburst of the crisis after the bursting of the housing bubble in the U.S. has made thiseconomy confront a new crisis with differently fabricated causes and effects. The high defaultrates on “sub-prime” and other higher-risk borrowers with lower income have resulted in thesub-prime crisis. Initially, the long term rising house prices and the attractive loan incentivesencouraged borrowers to assume mortgages with the fact that they shall be able to refinance lateron. However, the situation reversed when the housing prices started to drop in 2006-2007 inmany parts of the U.S. making it difficultto refinance the loans. This all resulted ina vicious circle as the number offoreclosures increased, the housinginventory escalated depressing the houseprices (figure 1).Being inter-related to other sectors of theeconomy, these trends have lead to acontraction in the construction industry,hurting overall U.S. economic activitiesmaking it enter into a possible recession.The problem of grave concern is thefalling home prices leading to a creditcrunch, which is actually driving up Figure 0: Housing Sector creates a vicious circle 14  
    • mortgage rates and making mortgages unavailable, leading to a further decline in home prices.The whole carnage revolves around sub-prime lending by financial institutions. Theseinstitutions being accompanied by other parties such as Credit Rating Agencies, MortgageBrokers and Underwriters etc. created a complex structure of lending and borrowing process,through the process of securitization. Being unified with common ties of globalization thisAmerican fiasco soon turned into a worldwide crisis affecting the major economies of the world.This project studies the entire housing sector, which saw great heights and steep depths within avery short period of time. How the booming housing sector, which was a major asset of theweakest people of the society through innovative instruments and loans facilitated by variousparties, saw its downfall is an interesting part, which is analyzed. Being one of the pillars of theAmerican economy, how the movement in this pillar affected the whole economy inter-linked invarious dimensions of employment, finances, and other macro-economic indicators (inflation,currency etc) has been thoroughly done. The world bonded by the Theory of Decoupling hasseen new changes in growth brackets, trade movements and other global changes throughout thisperiod.Being an emerging economy, the Indian economy has also seen new pursuits in its economicframework and there still remain unknown pursuits and dimensions connected to the globaleconomic architecture.This project thus has various pursuits to explore about the American economy, world economiesand Indian economy. There is a whole gamut of linkages between, inter-related and intra-relatedsectors, which have been studied in this project. 15  
    • HOUSING MARKETS IN U.S.A Major Contributors to GrowthThe real estate sector is amongst the largest sectors in the U.S.A. It has been a significantcontributor to the U.S. economy, providing millions of jobs and had been generating hundreds ofmillions of dollars of economic output each year. It has traditionally been an important source ofwealth building. The housing sector has been the main driver of economic growth of U.S.Therefore the weakening of this sector tends to have ominous implications for continuingexpansion in the period ahead.The housing sector accounts for about 6% of GDP, but has been a much more importantcomponent of growth, contributing 0.50% directly to GDP growth (translating to some U.S. $60billion/year) and on the average adding 30,000 new jobs monthly in 2005. Some estimatessuggested that wealth (home prices) and liquidity (home equity extraction) effects might havebeen contributing up to 1.5% to GDP growth in the last few years. Over the past four yearsending 2006, consumer spending and residential construction together have been accounting for90% of the total growth in GDP. And over two-fifths of all private sector jobs created since 2001till the advent of crisis have been in housing-related sectors, such as construction, real estate andmortgage broking.Homeownership – The American DreamHousing (or an availability of dwelling) is one of the most important wants of any human. As thesociety and civilizations progressed, so did the desire to have a comfortable home. This desirecuts across all the income segments, race, and income levels. However, the commondenominator remained – owning a house (see chart below).Two reasons why there was a housing boom was - Increased level of income and - Easy availability of money.Increased level of incomeSince 1967, the median household income in the United States had risen by 31%. The rise inhousehold income has been largely the result of an increase in personal income among collegegraduates, a group that had doubled in size since the 1960s, and women entering the labor force.Today, 42% of all households have two income earners. 16  
    • Overall, the median household income rose from $33,338 in 1967 to an all-time high of $44,922in 1999, and has since decreased slightly to $43,318. Decreases in household income have beenvisible during each recession, while increases have been visible during economic upturns.While per-capita, disposable income had increased 469% since 1972, it had only increasedmoderately when inflation is considered. In 1972, disposable personal income has beendetermined to be $4,129; $19,385 in 2005 dollars. In 2005, disposable personal income was,however, $27,640, a 43% increase. Since the late 1990s, household income had fallen slightly. Figure 1: Real Median Household IncomeFurther with the advent of complex financial systems, conduits, mechanisms and tools itsuddenly became easier to own a house. 67.5% of households realized this dream in 2001, whichtranslated into 72.6 million households as homeowners.Since then, the Bureau of the Census had projected an additional 11.7 million new householdswill form over the coming decade, with the larger percentage growth among minorities. Thedemand for housing, therefore, will continue to over the next decade. Freddie Mac estimated that50 million families will be buying homes in the next 10 years - more than 10 million of them forthe first time. Clearly, a substantial segment of society is and will continue to realize theAmerican Dream. Of course this was before the Sub-prime crisis roared its head. 17  
    • 140000 127,958 126,009 123,926 121,478 120,835 Vacant Total 122,187 119,628 119,043 119,280 117,280 Renter Total 115,620 112,655 114,137 110,948 Owner Total 109,716 106,281 108,317 107,277 105,731 17,652 104,631 16,437 120000 15,695 11,633 103,653 14,468 15,598 101,102 13,908 15,276 14,315 14,114 13,747 99,307 13,418 13,153 12,669 95,255 12,258 11,987 11,925 12,024 12,058 12,241 9,448 10,585 10,164 100000 8,908 34,194 35,147 33,678 33,014 34,417 33,506 33,687 34,470 34,831 80000 34,896 35,059 34,943 35,246 31,731 35,559 34,730 34,569 34,243 33,975 33,735 33,320 32,602 32,299 30,695 60000 40000 20000 55,652 63,452 56,844 57,915 58,700 59,755 60,248 61,010 61,823 62,999 63,131 64,740 66,041 67,143 68,637 70,098 71,250 72,593 71,278 72,053 73,575 74,553 75,378 75,159 0 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2006 Figure 2: Homeownership trends in U.S.A (in 000)Easy Availability of MoneyThe most prominent reason for the housing boom was the easy availability of money. After thedotcom bubble the Federal Reserve Bank had decreased the Fed fund rate 14 times from 6.5% to1% within two years since 2001. This had increased the liquidity in the market. As a result of thisoverflowing liquidity in the financial markets, the banks offered loans to borrowers thus makingmoney easily accessible to even the low-income borrowers. This also marked the period of thehousing boom.Economic Impacts of the Housing SectorHousing sector being a major contributor to the American growth, any shudder in this sector canengulf the whole economy. And, if it is the American economy, un doubtingly the tremors haveto reach across the globe. The following facts help U.S. to understand the contributions of theHousing industry to the economic growth of U.S.A. The housing sector contributed about 14 percent to the nation’s total production. Home equity constituted the largest share of household net worth. The stock of fixed residential assets was worth nearly $10 trillion – equivalent to one- year worth of U.S. GDP. 18  
    • About 1.5 million newly housing units were started each year. Housing starts have been one of the key factors in the macroeconomic business cycle. About 40 percent of monthly consumer expenditures were housing related. More than $1 trillion exchanged hands from the sale of existing and new homes. There were 288,273 establishments categorized as “real estate & rental & leasing with over 1.7 million paid employees. 40% of the employment growth in the entire economic expansion was a result of soaring home sales and prices. This included employment in home building directly as well as in ancillary factors such as supplies, real estate agents, appraisers, title searches and mortgage servicing.Thus the housing sector has been one of the main sectors, which contribute both directlyand indirectly to economic activity in the U.S.A.The two line items in GDP directly associated with the housing sector are residential fixedinvestment1 consisting of value-put-in-place of new housing units, production of mobile homes,brokers’ commissions on the sale of existing residential properties, expenditures related toimproving and additions to existing units, and net purchases of used structures from governmentagencies and housing service for personal consumption expenditures, purchased by residents inthe United States, in the form of rent for tenants or as rental equivalence for homeowners. In2000, residential fixed investment totaled $415 billion and housing service expenditure was $956billion. The combined total of $1.37 trillion represented 14 percent of GDP.Also, all economic activities produced a “Keynesian” multiplier effect. A home purchase usuallyresulted in further spending in other sectors of the economy (landscaping, appliances, and so on).The income earned by the landscapers was re-circulated into the economy as they spend,generating another round of income and purchases. The degree of multiplier depends on thedegree of monetary policy accommodation and the “crowding out” effect. The multiplier wasbetween 1.34 and 1.62 in the first year or two after an autonomous increase in spending. Thismeant that for each dollar increase in direct housing activity would increase the overall GDP by$1.34 to $1.62.Many people’s livelihoods depended on real estate. The February 2001 report showed that 1.49million workers were employed in the real estate industry. The Real Estate and Rental andLeasing sector, which comprises establishments primarily engaged in renting, leasing, selling,and buying real estate for others, and appraising real estate, totaled 288,273 establishments with1.7 million paid employees. The annual payroll amounted to $41.6 billion.Housing Sector Having Macro-economic Implication                                                            1 Consists of purchases of private residential structures and residential equipment that is owned by landlords andrented to tenants. From www.bea.gov 19  
    • In addition to its direct contribution to GDP, the housing sector has been playing an importantrole in the overall direction of the nation’s economy over the course of macroeconomic businesscycles. Conversely, housing starts have made just as dramatic a change, coming out of arecession. In fact, housing starts lead the rest of the economy preceding changes in GDP. Inother words, disruptions to the housing sector (arising from policy changes) are likely to befollowed by a significant macroeconomic slowdown, while a stimulus to housing can lead therest of the economy out of a slowdown.During an economic slowdown, the Federal Reserve has been lowering the interest rates, otherthings equal. Consequently, the fall in interest rates during an economic slowdown has beenacting as a strong buffer often providing a stimulus to the interest-sensitive housing sector. Adrop in mortgage rates means lower monthly mortgage payments. This, in turn, means a lowerqualifying income necessary to purchase a home. Conservatively, a one percentage drop inmortgage rates has translated into roughly 3 million additional households who would have thenecessary income to qualify for a mortgage for purchasing a median priced home. Furthermore,many homeowners have refinanced their mortgages with the falling interest rates, leavingadditional spending money to counter economic downturns. The economic slowdown from themid-2000 to 2001 is a prime example of how this scenario is being played out. Housing startsand home sales began declining in spring of 2000 as the Fed has raised interest rates to cool theexceptionally fast growing economy. However, the economy has cooled much more drasticallythan desired and the Fed began reversing the interest rate policy by cutting the rates in early2001. The subsequent falling interest rates have kept the housing starts and home sales torebound to healthy levels even as the overall economy began sinking further. The economywould have undoubtedly tipped into a recession in early 2001 without the support of the housingsector during this period.Impact on CommunitiesConstruction of new homes provided jobs and higher tax revenues for local, state, and federalgovernments. Construction of each new single-family home required 1,591 worker-hours or theequivalent of 0.869 year of full-time labor. Each multifamily unit required 0.402 year of full-time labor. Projecting these estimates and accounting for productivity and price changes over theyears, it is was estimated that the construction of 1,000 single-family homes generated 2,448full-time jobs in construction and construction-related industries, $79.4 million in wages, and$42.5 million in combined federal, state and local revenues and fees. The construction of 1,000multifamily units is estimated to have generated 1,030 full-time jobs in construction andconstruction-related industries, $33.5 million in wages; and $17.8 million in combined federal,state and local tax revenues and fees. Furthermore roughly 30 percent of the new homeoccupant’s income was spent on items produced by local businesses, such as hospitals, daycarecenters, dry cleaners, and auto repair shops. 20  
    • Almost 70 percent of all tax revenues raised by local governments in the United States camefrom property taxes. Homeowners contributed about 43 percent of property taxes, whilecommercial property accounted for 57 percent of real property tax revenues. Construction of newhomes expanded the tax base and so increased the property tax revenues. using the average salesprice of new homes in 2000, the local tax revenue base will increase by $185 billion.Aside from tax revenue to local communities, home production and subsequent homeownershipprovided additional intangible values. Homeowners did not move as frequently as renters,providing a source of neighborhood stability. Neighborhood stability in turn conferred benefitsof higher social and community involvement such as crime prevention programs. Homeownershad a stake in their neighborhoods and communities, and so were likely to behave in ways thatprovided benefit to everyone in the community. Owners maintain their properties in bettercondition than do renters of comparable housing. Such behavioral differences had been observedregardless of the age or income of homeowners. All of these social benefits to homeownershipcan impact property values.Impact on IndividualsHomeownership also provided individuals with a way to accumulate wealth for the future whilebenefiting from the provision of shelter. A tabulation of household wealth from the FederalReserve’s Survey of Consumer Finances (1998) shows that home equity (the value of the homenet of mortgages) was the largest component of total wealth. Equity in primary residencesaccounted for 28% of the total family asset. Furthermore, the survey shows that 12.8% offamilies had some form of residential real estate in addition to primary residence (second homes,time shares, and other type of residential property), an increase from 11.8% in 1995. The valueof the asset in other residential property accounted for additional 5% of the total household asset.Retirement accounts were the largest financial assets outside of primary residence, with 19.8% ofthe total. Only for the very wealthy (income over $100,000 per year) did the home equity portionof wealth fall below 50% of the total household wealth.A separate survey from the Census Bureau also shows the dominant importance of home equityin determining household net worth. The Survey of Income and Program Participationperiodically collects detailed wealth and asset data as a supplement to its core questions aboutlabor force participation, income, demographic characteristics, and program participation. In1995, median household net worth was $40,200; Median home equity for home-owninghouseholds was $50,000. Home equity constituted the largest share of household net worth,accounting for 44 percent of total net worth.A privately owned home, therefore, was an important vehicle for wealth accumulation for a largesegment of society. In addition, home investment played an important role in portfoliodiversification. Home prices in the U.S., on average, have risen steadily, and have much lower 21  
    • volatility than stock or bond prices. The historically standard deviation for stocks and bonds hadbeen 20% and 9%, respectively. For housing, the standard deviation was about 4%. Furthermore,the correlation between home prices with stock or bond prices was very low. Homeowners werealso benefited from the easy availability of home equity loans. Whether as a readily availablesource of funds, or just the security of a credit source, certainly added value to homeownership.Housing Contribution to SocietyAlthough the level and benefits of community involvement are hard to measure, severalresearchers have found that homeowners tend to be more involved in their communities and localgovernments then renters. For instance, owners participated in a greater number of non-professional organizations and had higher voter participation rates. In addition to higher civicparticipation, owners also tend to remain in their homes longer, adding stability and familiarity tothe neighborhood, and also tend to spend more time and money maintaining their residence.Home equity is one of the largest sources of collateral for bank loans to start new businesses.Over 740,000 businesses in 1992 reported a mortgage or home equity loan as a source of start-upcapital for their business. It had been estimated in the UK that a 10 percent rise in the aggregatevalue of home equity increases the number of new business registration by 5 percent.Furthermore, people want to be homeowners. Fifty eight percent of the renters responded thatowning a home is either the top or very important priority according to 2000 Fannie Mae’sNational Housing Survey. Freedom to alter their homes or engaging in home maintenance andimproving may provide intrinsic joys.Furthermore, others have noted that the home buying process and homeownership improve self-efficacy or a person’s sense of control over life events. And from extensive psychological studiesself-efficacy is associated with better health status.Whether it be America’s dream or an economic indicator of growth or a tool for changing thecourse of Macro-economic policies, the American Housing Market was such an important sectorthat any vibrations in the housing led banking mechanism could lead to a shake up in the entireworld economies. The highly leveraged market and the whole dream of owning homes turnedinto a huge debacle. Economists call it bursting of the housing “bubble.” In the following pageswe have tried to present the build-up of this bubble, the dynamism of the leveraged securitymarkets, the role of parties in this crisis and the likely impact on the U.S. and other economies ofthe world. 22  
    • LEVERAGED SECURITY MARKETS The Double Edged Sword“…but in the modern fixed-income markets - where leverage is king and cheap credit is only the current jester - a move of that magnitude can do a lot of damage.” -Ryan Barnes, The Fuel That Fed The Sub-prime Meltdown.LeveragingThe leveraging procedure, which intended to multiply the investments, opened new horizons forbanks to offer the investors with innovatively designed debt instruments i.e. mortgage-backedsecurities (MBS), and collateralized debt obligations (CDO).Leveraging is borrowing to invest. Financial leverage takes the form of a loan or otherborrowings (debt), the proceeds of which are reinvested with the intent to earn a greater rate ofreturn than the cost of borrowing. The most familiar use of leverage is using a mortgage to buy ahome. In return for a down payment one receives funds to purchase an asset that wouldotherwise be too expensive. The homeowners either try to pay out the money from the rent thatwould be saved or from the income streams (the rent earned) that their vocations generate.Leveraging helps both the investor and the firm to invest or operate. While leverage can play apositive role in the financial system, problems can arise when financial institutions go too far inextending credit to their customers and counter parties. If an investor uses leverage to make aninvestment and the investment moves against the investor, his or her loss is much greater than itwouldve been if the investment had not been leveraged - leverage magnifies both gains andlosses. In the business world, a company can use leverage to try to generate shareholder wealth,but if it fails to do so, the interest expense and credit risk of default destroys shareholder value.The build-up of the sub-prime crisis is based on the mechanism of leveraging. The layer uponlayer of leverage that propelled the expansion is now operating in reverse as the leverage is beingunwound.Housing Sector: The Initial FuelHousing sector has been one of the prominent drivers of the U.S. economy. Not only has it madecontributions to the employment, production and GDP, it has also been a major stimulus for theoverall economic growth of this huge economy leading the global world. This sector has 23  
    • important linkages to every macroeconomic aggregate like GNP, savings, interest and inflationrate and also highlights its importance in public policy decisions. The American FinancialInstitutions being over-flooded with liquidity magnified the housing sector as a lucrative area.The leveraging mechanism with its off springs i.e. Mortgage-Backed Securities (MBS) andCollateralized Debt Obligations (CDO) generated great opportunities for even those who couldnot afford to pay the cash flow mandated as among the key requirements for taking loans.These sophisticated instruments, lackadaisical approach to adherence to prudent lending policyand the surplus of funds all contributed to the housing sector becoming the most boomingsectors. As it grew, it took with itself almost the entire economy. Then an asset bubble began toform, frenzy fed on frenzy and the prices started to soar beyond what can safely be said to be thefundamentally correct prices. However, perhaps the key reason why the sub-prime crisisentrenched itself deep into the very sinews of the financial system of the U.S. was the creation ofexotic leveraged instruments. That way banks now started lending more than the actual basemoney and that too to entities that had a very high risk-premium attached to it.Securitization: Prime Mover of the CrisisSecuritization, an innovative form of financial engineering introduced two new instruments i.e.Mortgage Backed Securities and Collateralized Debt Obligations. Securitization is a structuredfinance process in which assets; receivables or financial instruments are acquired, classified intopools, and offered as collateral for third-party investment. Due to securitization, investor need formortgage-backed securities (MBS), and collateralized debt obligations (CDO) as a profitableventure and the tendency of rating agencies to assign investment-grade ratings to these loanseven though having a high risk of default could be originated, packaged and the risk readilytransferred to others. The process of securitization has been explained with help of figure 4.Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDO’s) the twoinstruments of securitization played an important role in aggravating the whole sub-prime saga.A mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed bythe principal and interest payments of a set of mortgage loans mainly on residential property.Collateralized debt obligations (CDO’s) are also type of asset-backed security and structuredcredit product but they are constructed from a portfolio of fixed-income assets. These assets aredivided into different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB),and equity tranches (unrated). Here junior tranches offer higher coupons (interest rates) tocompensate for the added default risk while senior tranches offer the lowest coupon rate offeringhighest safety level. 24  
    •   Figure 3: Mechanism of Securitization                                                                                       STEP  1:    The  borrower  obtains  a  loan  from MORTGAGE BROKER   the lender with the help of mortgage brokers.   After  the  loan  is  made,  the  lender  and  the   mortgage  broker  do  not  have  any   interactions.   1    LOAN  STEP  2:    The  loan  is  then  sold  to  the  issuer   and the payments made by the borrower are LENDER   BORROWER provided to the issuer by the servicer.        LOAN PROCEEDS                                                                                                                                                                                                                                                                    TRUSTEE                                                                                                                                  MONTHLY PAYMENTS  UNDERWRITER   LOANS     2         RATING AGENCY  CASH SERVICER     CREDIT ENHANCEMENT PROVIDER   MONTHLY PAYMENTS  STEP  3:  The  loan  is  further  sold  to  the 4  investors.  The  issuer  is  assisted  by  the trustee,  underwriter,  rating  agency  and credit enhancement provider. ISSUER STEP  4:    The  servicer  acts  as  an 3 CASH intermediary  between  the  borrower  and the  issuer,  who  provides  the  payments  to the  investors.  The  delinquent  losses  are SECURITIES MONTHLY PAYMENTS  managed by the servicer & the trustee. INVESTOR 25   
    • CDO is a corporate entity constructed to hold assets as collateral and to sell packages of cashflows to investors. There exists a Special Purpose Vehicle (SPV) that acquires a portfolio ofcredits. The assets include mortgage-backed securities, high yield corporate loans etc. The SPVissues different classes of bonds and equity and the proceeds are used to invest in otherportfolios. The bonds and equity are entitled tothe cash flows from the portfolio of, inaccordance with the Priority of Payments. The       MECHANISM OF LEVERAGING senior notes are paid from the cash flows before Step  #1:  Collateralized  debt  obligationsthe mezzanine notes and junior notes. In this (CDOs)  that  pay  an  interest  rate  over  andway, losses are first borne by the equity or above  the  cost  of  borrowing  werejunior notes, next by the mezzanine notes, and purchased.  In  this instance  AAA  ratedfinally by the senior notes. In this way, the tranches  of  subprime,  mortgage‐backed securities were used. senior notes, mezzanine notes, and equity notesoffer distinctly different combinations of risk Step  #2:    Leverage  was  used  to  buy  moreand return. CDOs  than  one  could  pay  for  with  capital alone.  Because  these  CDOs  paid  an interest  rate  over  and  above  the  cost  of borrowing,  every  incremental  unit  ofSub-prime crisis: A result of the Leveraging leverage  added  to  the  total  expected return.  So,  the  more  leverage  one employed, the greater the expected returnSub-prime crisis was the result of the leveraged from the trade. instruments which were aimed to magnify thegains but resulted in amplifying the losses. Step  #3:  Credit  default  swaps  (CDS)  were used  as  insurance  against  movements  inIndividuals who were not able to finance the the  credit  market.  Because  the  use  ofhouse completely would get the help of banks. leverage  increased  the  portfolios  overallPeople would put down a deposit and take out a risk  exposure,  the  next  step  involved purchasing  insurance  on  movements  inloan for the rest. Let’s say an investor puts credit  markets.  These  "insurance"down $20,000 on a $200,000 house, borrowing instruments  called  credit  default  swaps,the remaining $180,000. He now has a were designed to profit during times whenleveraged ‘investment’ - with a gearing factor of credit concerns caused the bonds to fall in10. value,  effectively  hedging  away  some  of the risk. If house prices go up by 50% - i.e. the house Step  #4:  The  money  thus  rolled  in.  Whenbecomes worth $300,000 - he doesn’t just make the cost of the leverage (or debt) is net out50% of the initial investment: he makes 150% to  purchase  the  AAA  rated  subprimeprofit (once he sells, that is, and not counting debt,  as  well  as  the  cost  of  the  creditmortgage interest payments, solicitors’ fees and insurance, one is left with a positive rate ofso on). Conversely, if house prices drop by just return,  which  is  often  referred  to  as "positive carry" in hedge fund lingo.  10%, his entire deposit would be wiped out.And if prices drop further, the borrower will be Box 0: Mechanism of Leveraging 26  
    • in negative equity, owing the bank more than the current value of their house.Enticed by the high returns on the ever-appreciating value of housing many investment banks,hedge funds and other institutional investors have done so, making phenomenally good returnsover the five years starting year 2000.Then the worst that was feared occurred- these leveraged investments started to go awry. Insteadof profits, many investors have been hit by significant losses.In the above example where the individual had put down $20,000 and took a debt of $180,000,as long as he sells before the value of the asset becomes less than the value of the debt, thereisn’t any problem. Till the time it is secured on an asset that’s worth at least $180,000 the actualrisk is just $20,000. But what if the investor can’t set a stop-loss (as is usually the case- since thehouse is not just for investment purpose but is actually an asset purchased to reside). Suddenlythere’s no market for what his trying to sell or if everyone is so scared that nobody wants to put aprice on what his selling, for fear that it’s too low and will in turn cause them to lose vastamounts of money too, because they hold similar investments.Not long ago frenzy fed on frenzy and buoyed the prices up and now frenzy feeds on frenzy andpulling the prices down rather dramatically.Now here stands the trouble of the leveraged market. Because the leveraging factor was muchhigher than what the system could withstand, and because the sub-prime ‘network’ was ingrainedin almost the entire financial systems of the U.S., when the debacle happened, it simplycollapsed the whole system.The leveraging that helped the sector grow and propel the economy to boom is now dragging thesame down. In the previous chapter we had covered the importance of the Housing sector. Theeffect of this importance can be gauged by a simple fact – Housing sector bust is dragging theentire U.S. economy to recession. And no matter what levels of fire-fighting that the monetaryauthorities undertake, the chances are that the U.S. economy has been dealt a major blow and itwould take some serious and coordinated efforts to sail the boat through.That is where the U.S. economy stands today. Efforts range from prudent (cutting interest rates)to near desperate (lending money to commercial banks taking the tainted mortgage-backedsecurities as collateral) steps. The hope is that by accepting these investments at face valuecentral banks will release the credit blockage and get the U.S. economy moving again.Due to the high amount of liquidity, which was somehow to be put into use, leverage was neededto boost returns over the last few years, owing to a lack of distressed debt. This led to 7 times 27  
    • (and sometimes as much as 10 times) leverage on U.S. leveraged buyouts. In Europe, debtmultiples also were stretched, with leverage of 5.5 times in 2007, versus 4.7 times in 1998.Thus leveraging which was intended to increase the returns and provide shelter to the people ofU.S. plunged economy downwards and contributed to the chronicle of Sub-prime Crisis.In the global economy, effects in one area of investment quickly spread to others. So wheninstitutional investors started losing money on collateralized debt obligations (CDO’s) andresidential mortgage-backed securities (RMBS’s) because of the U.S. sub-prime crisis, theyquickly liquidized other investments in order to cover their losses.For example, some of them shifted cash out of the carry trade (in which money borrowed in low-interest currencies such as the Yen is invested in higher interest currencies such as the Pound),causing the Yen to rapidly appreciate and leading to a whole slew of currency investors losingmoney on their leveraged positions. These currency investors in turn had to find the money tocover their losses, perhaps by selling gold, temporarily shifting the gold price downwards andcausing a tranche of leveraged gold investors to face severe losses. And so it went on, andcontinues to go on.The total amount of leveraged investment in the world is unknown, but it has been estimated tobe many multiples of global GDP.Thus leveraging was a double-edged sword, which was aimed at multiplying the profits, but if itacted reversely, the losses would magnify much more than the expected profits. Perhaps, that iswhat happened in the U.S. economy, where the reverse took place and brought the world at theverge of this crisis. The tool of leveraging mechanism i.e. the sub-prime lending provides U.S. aninsight of how the construct of the sub-prime crisis took place. 28  
    • SUB PRIME LENDING The FlawsThe financial institutions overflowing with liquidity devised the securitization mechanism forwhich they classified the lending into three categories namely, The Prime category, the Alt-Acategory and Sub-prime category. The parameters of categorizing the credit seekers were: 1. Credit worthiness and documentation prudence 2. Ability to pay back the money 3. Ability to pay down payments 4. Whether it’s a first loan or an already mortgaged asset.While the prime category of borrowers fulfilled all the parameters, the sub-prime borrowersstood at fulfilling none. Alt-A borrowers mainly were short of documentation, including proof ofincome. Yet these borrowers had clean histories they either had higher loan-to-value or debt-to-income ratios.Sub-prime lending (also known as B-paper, near-prime, or second chance lending) is lending at ahigher rate than the prime rate. A higher rate of interest is charged due to limited or tarnishedcredit history or inadequate documentation, higher loan-to-value and debt-to-income ratios.However, with the higher rates comes additional risk for lenders because there is a lackof documentation - including limited proof of the borrowers income poor credit history, andadverse financial situations usually associated with sub-prime applicants.A high risk based pricing system is used in order to calculate the terms of loans, which areoffered to borrowers with varying credit histories. The sub-prime borrowers charge high rates ofinterest, but still credit risk is more than interest rate risks due to the increased chances ofdefaults and less opportunities to refinance the loans.Sub-prime lending was initially a helping hand to all those borrowers who aimed to fulfill theirdream of owning a home. Sub-prime loans increased opportunities for homeownership andadded 9 millions of households to the new status of homeowners in less than a decade andincreased employment opportunities thereby increasing the growth rate. 29  
    • However, providing loans to the low-income sections of the society was a benefit as well asfallout of the sub-prime loans. The availability of liquidity was the prominent factor thatprompted the banks to provide loans at high rates, on the surety that even if the borrower fails topay the loan amount, they may still have the option to sell the houses and recover the amount.The fact that the housing prices usually tend to appreciate, furthermore, made the bankers freefrom any apprehensions of recovering the losses. Also since sub-prime lending, a direct result ofhigh liquidity, prompted banks to issue loans without any strict regulations which could helpthem to earn high amount of profits by the securitization mechanism as explained later.Sub-prime borrowing was as such not flawed; rather it was the high quantum of sub-prime loansgranted without proper regulations that appeared to be the major reason for the fallout. Thepositive picture of profit earnings hid the shortcomings of improper regulations, irresponsiblelending and inefficient rating system by the credit rating agencies.Sub-prime lending became highly controversial: Sub-prime lenders often engaged inpredatory lending practices such as deliberately lending to borrowers who could never meet theterms of their loans, thus leading to default, seizure of collateral, and foreclosure. They oftenemployed unscrupulous means by enticing, inducing, and/or assisting a borrower in taking amortgage that carried high fees, a high interest rate etc.Property Fraud by Lenders: With the increase in sub-prime lending there was a similarincrease in the property frauds. By selling overpriced apartments to the unsuspecting buyers, thesellers took the money and disappeared. So now the entire deal was between the banks and heborrowers. In this way the sellers, earned huge amounts on the overpriced sold houses.Second Mortgages: Irrespective of the bad credit histories, the sub-prime lending had madesecond mortgages easier on the existing mortgaged houses. The repayment of another loanburdened the borrowers, which ultimately had to borne by the lenders i.e. the banks, when theborrowers defaulted in making the payments.Lax Lending Rules: Analysts say lax lending standards led some mortgage firms to grant homeloans to tens of thousands of borrowers who did not have the means to meet their mortgagepayments when interest rates increased.Irresponsible Credit Rating Agencies: Credit rating agencies such as Standard and Poors,Moodys and Fitch Ratings were urged by the panel to improve their influential reports andassumptions about a wide range of securities and corporations.Major Banks meanwhile were encouraged to disclose more information about the securitizationof complex credit instruments, such as mortgage, credit card and student loans, which theypackage or cut up and sell to other banks and investors. 30  
    • Besides that the other reason why the Sub-prime mortgage crisis unfolded the way it did had alsoto do with the complex financial wizardry that was devised around the lending that had the effectof ‘over-lending’. That is the financial systems geared up by multiples in excess of what theycould or rather should have. Due to the complexity, sheer size and volume, presence of numerousplayers and major flaws in the sub-prime lending have all caused the system to collapse. Newforces have played important roles in Sub-prime crisis that had in the post been absent. 1. Complex investments: Financial firms wield ever more sophisticated financial tools. CDOs and MBAs enabled complex and opaque investments. 2. New institutions: Players like hedge funds and buyout firms – also called Private Equity, represent a large and rising sharing of overall investment money. Hedge funds also have taken exposure to the subprime investments. These players are significantly less regulated than the listed companies-these are less transparent and generally have a free will to do pretty much what they want. Besides that Rating agency and Credit enhancers played a very important role in certifying the quality of the subprime credit. These too are outside the purview of the agencies. 3. Leverage: the growing use of Debt or leverage by financial players magnifies the first two forces. An era of easy money has enabled more risk taking built on borrowed funds. That can accentuate in both the ups and downs of a cycle, raising the chances of panic selling during down turns and frenzied buying in upturns. 4. Globalization: Today all the nations in the world are linked through easy movement of funds. In the less regulated markets money moves both in and out freely. In the medium regulated markets like India, the movement is not easy but even then the movement is copious enough to affect massive hemorrhage. This has very telling effect. In this case for example large banks across the world had exposure to the subprime conundrum. And when the damage occurred the ripple effect wiped out a lot of financial players across the globe.Given the gearing up and the various reasons as explained above, the subprime imbroglio was atime-bomb which was waiting to implode. And as it did it took down with it the most powerfuleconomy in this globe. 31  
    • THE CRISIS AND CHRONOLOGY OF EVENTS Timeline of Implosion “What began as a tremor in the sub-prime mortgage market that affected a relative few, has sadly gained momentum, creating a broader credit crisis that continues to threaten the middle class and overall economic growth.” -Senator Jack ReedThe U.S. economy was at the peak of invincible growth and incessant development with everysector enjoying a boom since the past two decades. The unemployment rates were fairly low,inflation under control, stock markets scaling new heights, banking sectors overflowing withliquidity and growth figures rising steadily accounting for 26% of the worlds GDP.The American economy flooded with enormous liquidity and the low income citizens striving tofulfill their imperative dream of shelter had an incomprehensible tryst with each other andresulted in the whole sub-prime saga.As it has been said that invention is the mother of necessity the financial institutions devised aninnovative mechanism of securitization with Mortgage Backed Securities and Collateral BondsObligations as the two offsprings. The low-income people who had tarnished credit histories orno documentation were issued loans without any such requirements to be fulfilled. The fundsgenerated from these instruments were used to create new investment vehicles i.e. MBS’s andCDO’s that were issued to investors by the bankers at varying rates of interest depending on theability of the borrowers to repay.The whole mechanism was a laudable creation of the financial know-how and desperatelyfulfilled dreams. So the sub-prime lending mechanism was an efficient fabrication of convertingattractive dreams to a moneymaking business with the creation of two ingeniously thought overinstruments.The boom in the housing sector, enticing interest rates and high profit margins kept on luring thefinancial institutions, that they shut their eyes to the pessimistic notion that if those borrowers 32  
    • failed to pay their debt obligations or if the collateralized houses faced a surge in the prices, theaftermath could result in the collapse in the whole banking segment on the threshold of whichlies a whole economy with all the sectors interlinked to each other presenting the cascadingeffect.Housing markets have gone bust, interest rates have touched the pinnacles, stock markets acrossthe world have collapsed, unemployment toll has increased, growth rates have plummeted,global inflation has been scaling to new heights, the fiscal deficit gaps are widening, corporategiants have been announcing billion dollar losses with colossal business houses being taken overat the lowest of their values. Figure 5 shows the timeline of the events. 33  
    • Figure 4: Timeline of Implosion 34  
    • S enate B anking  C ommittee holds  the first hearing addressing legislative  solutions to predatory lending. • New  C en tury  F in anc ial, stops  making loans. F ebruary • S enate  B anking   C ommittee  holds  a  hearing  to  investigate  the  • New  C entury  F inanc ial files   for  sharp  increase  in  defaults  and  foreclosures,  questioning  banking  March bankruptcy. • S ales   of  exis ting homes  falls 8.4%   in  regulators March from F ebruary April •“B orrower’s  P rotec tion Ac t  • F ederal O pen Market  of 2007 is introduced C ommittee leaves the  •“E x panding  Americ an Home  ov ernight fed funds rate at  O wners hip Ac t” is passed. 5.25% , • E uropean C entral B ank  and F ederal R eserv e pump  2007 billions of dollars of liquidity  into the markets. • G old man  S ac hs reports flat profit  • F ederal R es erve cuts the  from a year ago. discount rate by half a point Ma y • B ear S tearn s pledges up to $3.2  billion to bail out one of its hedge  • Investors of two bankrupt  hedge funds managed by  funds. B ear S tearns   file suit. • R ealty T rac announces surge in  • C ou ntrywid e F in anc ial,  foreclosures 90 %  in May from 19 %   the nation’s largest  in A pril. mortgage lender, draws  J une down $11.5 billion from its  credit lines • S tandard & P oor’s and Moody’s downgrade bonds backed by  subprime mortgages. J uly • B ear  S tearns announces  loss  of  • UB S reports its first quarterly  value  up  to  90%   on  its  two  hedge  los s in nine years and cuts 1500  funds  making  a  loss  equal  to  over  jobs. $1.4 billion. • Hope Now allianc e is  initiated  compris ing 11 mortgage s ervices   companies • C itigroup acknowledges  57 %   Augus t drop in third‐quarter profit and  writes  off $3.55 billion • F ederal R es erve releas es  its B eig e  • C itigroup, J P Morgan C has e,  B ook. and B ank of Americ a announce  • B ureau of L abor S tatis tic s   the creation of a new entity, called  announces  cut of 4,000 jobs from  a Mas ter L iquidity E nhanc em ent  S eptember payrolls  last month.22000 construction  C onduit, to rais e $200 billion jobs were lost in Augus t totaling  • S tandard & P oor’s cuts the  100,000 construction jobs  s ince S ept  credit ratings on $23.35 billion of  2006. s ecurities • Merrill L ync h & C o., the bigges t  T he bill,“T he Mortg ag e R eform  underwriter of collateralized debt  and A nti‐P redatory L ending  A c t  obligations , signals a hit in the third‐ of 2007” is  pas s ed quarter earnings • Merrill  L ync h writes   down  $7.9  O ctober • Merrill L ync h & C o. Inc .s  cuts its  billion  due  to  expos ure  to  C D O   &  jobs from F irs t F ranklin F inancial C orp.  s ubprime mortgages   and  takes  a  unit which lost $111 million through the  $2.3  billion  los s,  the  larges t  in  the  first half of 2007 firm’s history. T he U.S . Hous e of R epres entatives   • S hareholders  sue Merrill L ynch &  pas s es  E xpanding  Am eric an  C o for iss uing fals e and mis leading  Hom eowners hip A c t of 2007 s tatements • F ederal R es erve cuts  target federal  •F ederal R es erve B oard lowers   funds rate by a half point to 4.75 % . the federal funds  rate to 4.50 % .   35  
    • • C itig roup says it will take  an additional $8‐ 11 billion  • S wis s  bank UB S announces to write  write‐down related to  down an additional $10 B illion in  subprime mortgages and the  subprime losses C E O  announces his  resignation  November • Was hington Mutual expects its fourth  quarter loan losses to reach $1.6 B illion • HS B C  Holdings  P L C ,  • F ederal R es erve B oard announces  E urope’s biggest bank,  only 25 basis‐point cut in the discount  reports of $3.4 billion  rate to 4.75% .  impairment charge  • T he Mortg ag e F org ivenes s  Debt  • B arc lays  G roup P L C takes  R elief Ac t is introduced a $2.7 billion write‐down for  • Morgan S tanley announces writing  losses  D ecember down an additional $9.4 billion in losses  • S hares of C ountrywide, the  on subprime linked investments and a  largest U.S . Mortgage L ender,  sales of $5 billion dollar stake to a  close below $10 for the first  foreign investment fund. time in more than five years •R ealty T rac informs  of222,451 foreclosure filings  in November.  J anuary • L abor Dept announces unemployment rate   4.7%  to 5%  in D ec with a loss of 28,500 jobs  in residential construction & 7,000 jobs in  mortgage lending industry throughout 2007. • C ountrywide F inanc ial reports  late  • L abour Department  mortgage payments and foreclosures  announces loss of 17000  jobs in J anuary. 2008 reached the highest level. • B ank of A meric a, the nation’s second  • UB S reports a loss of  largest banking institution, announces that it  $11.3 billion loss  would buy C ountrywide F inancial, the  • P resident B ush signs a bill  nation’s largest mortgage lender. authoriz ing  $168 billion  • Merrill L ync h, the nation’s third largest  stimulus package offering  securities firm, announces to write down $15  tax rebates to 130 mn F ebruary bn. Americans • C itigroup, the largest bank in the U.S .,  • F annie Mae announces  announces a drop in mortgage portfolio by  $3.6 billion quarterly loss   $18.1 bn. following earnings of $604  • L ehman B rothers decides to cut 1300  million in the similar period a  jobs. year earlier • F ederal R es erve B oard lowers the federal  March funds rate to 3.50 from 4.25% .  • F ederal R es erve B oard announces a  further cut to 3%  from 3.50% . •F ederal R es erve B oard  announces  rate cut to 2.25%   from 3% .  •T he central bank approves  a  cut in its lending rate to  financial institutions to 3.25%   from 3.50% . • B ank of Am eric a announces   April to write down $6.5 billion in the  first‐quarter • B en B ernanke annonuces a  • J P  Morgan C hase & C o.  slight contract in the growth for  agrees  to buy rival B ear  the year. S tearns  C os , one of the  • UB S  reports to write down loss  nation’s  larges t underwriters of  worth $37 bn. mortgage bonds,for $236.2  million in one tenth of its   original value • C redit ratings  decreas ed  by  S &P  for G oldman S achs  and  L ehman to AA‐ for G oldman  and A+ for L ehman 36  
    • Chronology of EventsDECEMBER 2006 December 28: Ownit Mortgage Solutions files for bankruptcy.FEBRUARY 2007 February 7: The Senate Banking Committee holds the first hearing of the 110th Congress addressing legislative solutions to predatory lending in the subprime sector. February 12: Res Mae Mortgage files for bankruptcy. February 20: Nova Star Financial reports a subprime loss.MARCH 2007 March 2: The Federal Reserve announces draft regulations to tighten lending standards. Lenders would be required to grant loans on a borrowers ability to pay the fully indexed interest rate that would apply after the low, initial fixed-rate period of two or three years. March 8: New Century Financial, the second largest subprime lender in 2006, stops making loans. March 20: People’s Choice files for bankruptcy. March 22: The Senate Banking Committee holds a hearing to investigate the sharp increase in defaults and foreclosures, questioning banking regulators who are criticized for failing to respond more quickly to curb the growth in risky home loans to people with weak credit. March 27: At a Joint Economic Committee, Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System, says housing market weakness does not appear to have spilled over to a significant extent.APRIL 2007 April 2: New Century Financial files for bankruptcy. April 6: American Home Mortgage writes down the value of risky mortgages rated one step above subprime. April 11: The Joint Economic Committee, chaired by Senator Charles Schumer, releases a report analyzing the subprime mortgage foreclosure problem April 18: Freddie Mac announces plans to refinance up to $20 billion of loans held by subprime borrowers April 18: Senator Dodd hosts the Homeownership Preservation Summit, bringing together some of the largest subprime lenders, securitizers, and servicers, as well as consumer and civil rights groups, to discuss ideas and develop solutions to crisis. April 24: The National Association of Realtors announces that sales of existing homes fell 8.4% in March from February, the sharpest month-to-month drop in 18 years.MAY 2007 37  
    • May3: Senator Schumer introduces the first comprehensive plan to help homeowners avoid foreclosures which includes $300 million in federal funds for refinancing mortgages. “Borrower’s Protection Act of 2007”2 is introduced which proposes federal regulation to avoid future defaults. May4: The House Financial Services Committee passes the “Expanding American Home Ownership Act”. The bill would allow Fannie Mae and Freddie Mac to purchase and securitize larger mortgages (up to $625,500 or the region’s median home price) in high-cost areas of the U.S. May9: The Federal Open Market Committee leaves rates unchanged. The FOMC continues to refer to the housing crisis as a “correction”. May17: At the Federal Reserve Bank of Chicago’s Annual Conference, Chairman Bernanke reiterates his March statement by saying the Fed does not foresee a broader economic impact from the growing number of mortgage defaults. May25: The National Association of Realtors reports that sales of existing homes fell by 2.6 % in April to a seasonally adjusted annual rate of 5.99 million units, the slowest sales pace since June 2003. The number of unsold homes reaches a record total of 4.2 million.JUNE 2007 June 6: Zip Realty Inc., a national real-estate brokerage firm, announces the increase in number homes listed for sale at 5.1% in May from April. June 12: Realty Trac announces U.S. foreclosure filings surged 90 % in May from 19 % in April. There were 176,137 notices of default, scheduled auctions and bank repossessions .The median price for a home drops by 1.8 % in the first three months. June 14: Goldman Sachs reports flat profit from a year ago. June 22: Bear Stearns pledges up to $3.2 billion to bail out one of its hedge funds. June 26: Senator Schumer convenes housing experts to examine how to protect homebuyers from subprime lending and also examines the Borrower’s Protection Act of 2007.JULY 2007 July 10: Standard & Poor’s and Moody’s downgrade bonds backed by subprime mortgages. Fitch follows suit. July 18 and 19: In two days of testimony in Congress, Chairman Bernanke said there will be “significant losses” due to subprime mortgages, but that such losses are “bumps” in “market innovations” (referring to hedge fund investments in subprime mortgages). Bernanke reiterated that problems in the subprime mortgage market have not spilled over                                                            2 See appendix 1 38  
    • into the greater system and states that the problem “likely will get worse before they get better.” July 18: Commerce Department announces housing starts are down 19.4 % over the last 12 months and a 7.5 % plunge in permits to build new homes, the largest monthly decline since January 1995. Permits are 25.2 % below their level a year ago, reflecting continued pessimism among builders over the near-term outlook for new homebuilding. July 18: Bear Stearns announces loss of value up to 90% on its two hedge funds making a loss equal to over $1.4 billion.. July 19: The Dow Jones industrials close above 14,000 for the first time. July 25: The JEC examines the impact of the subprime lending crisis on Cleveland, Ohio, one of the hardest hit communities in the nation. July 30: IKB Deutsche Industriebank, a German bank, is bailed out because of bad debts on U.S. mortgage-backed securities. July 31: Home prices continued to fall, marking the 18th consecutive decline, since December 2005.The 10-City Composite index showed a3.4% decline (biggest since 1991) and the 20-City Composite reported 2.8% decline.AUGUST 2007 August 1: Two hedge funds managed by Bear Stearns that invested heavily in subprime mortgages declare bankruptcy. Investors in the funds file suit against Bear Stearns. August 6: American Home Mortgage files for bankruptcy. August 7: Senators Schumer and Dodd urge the director of the Office of Federal Housing Enterprise Oversight (OFHEO) to consider temporarily raising the limit on purchases of home loans by Fannie Mae and Freddie Mac. August 7: The Federal Open Market Committee leaves the overnight federal funds rate at 5.25%, referring to tightening in the credit markets as a “correction”. August 9 and 10: European Central Bank and Federal Reserve intervene in markets by pumping billions of dollars of liquidity into the markets. August 9: American International Group, one of the biggest U.S. mortgage lenders, warns that mortgage defaults are spreading beyond the subprime sectors i.e. in the category just above subprime. August 9: BNP Paribas, a French bank, suspends three of its funds because of exposure to U.S. mortgages. August 9: President Bush addressing the housing market crisis assures that there is enough liquidity in the system to enable markets to correct. August 10: The federal regulator for Fannie Mae denies the mortgage finance companys request to grow its investment portfolio, but did not close the door on the possibility of lifting the cap in the future. August 13: Aegis Mortgage files for bankruptcy. 39  
    • August 16: Countrywide Financial, the nation’s largest mortgage lender, draws down $11.5 billion from its credit lines. August 16: All three major stock indexes were 10% lower than their July peaks – a marker indicating a correction of the stock market, due to tightening in the credit markets. August 17: The Federal Reserve cuts the discount rate by half a point. Stocks rally. August 22: Realty Trace Inc announces foreclosures were up 93% in July 2007 from July 2006. The national foreclosure rate in July was one filing for every 693 households. There were 179,599 filings reported last month, up from 92,845 a year ago. August 27: In a response to Schumer, Ben Bernanke writes: “The Federal Reserve, in cooperation with other federal agencies, is closely monitoring developments in financial markets,” and the twelve Federal Reserve Banks “are working closely with community and industry groups dedicated to reducing the risks of foreclosure and financial distress among homebuyers.” But Chairman Bernanke opposes Senator Schumer’s proposal to raise GES portfolio caps and calls upon the private and public sectors to develop new “mortgage products” more suited for “low-and moderate-income borrowers, including those seeking to refinance.” August 27: National Association of Realtors reports that existing home sales declined by 0.2 % in July, leaving the level of sales 9.0 % below the level 12 months prior. August 31: President Bush holds a press conference and says the “government has a role to play” in the growing crisis and calls upon the Federal Housing Administration to help subprime borrowers refinance into loans insured by the federal agency expected to assist 60,000 delinquent borrowers and announces an additional program expected to help another 20,000 homeowners by reducing insurance premiums . August 31: Representative Barney Frank (D-MA) responds to President Bush’s press conference and says that a greater public response is required with the Administrations cooperation and the portfolios of Fannie Mae and Freddie Mac can play a bigger role.SEPTEMBER 2007 September 5: The National Association of Realtors releases statistics on pending sales for existing homes. The figures reveal a 16.1 % decline in July from a year ago and a 12.2 % decline from the prior month. The July 89.9 levels the second lowest in the history of the index and its lowest since the September 11th attacks. September 5: The Federal Reserve releases its Beige Book3, a largely anecdotal report on the economy based on interviews with business leaders throughout the country. Counter to investor sentiment, the findings do not indicate that the housing crisis is expanding into the general economy. The Dow Jones industrial average drops nearly 200 points. September 5: Senator Christopher Dodd, chairman of the Senate Banking Committee, announces his intention to introduce a bill that would make it illegal for mortgage brokers                                                            3 See Appendix 2 40  
    • to steer borrowers eligible for standard mortgages into subprime loans. The bill also aims to eliminate additional predatory lending practices, such as hidden fees and prepayment penalties. September 6: The Mortgage Bankers Association releases a quarterly report showing that the delinquency rates on one-to four-Unit residential properties was 5.12 % of all loans outstanding in the second quarter of 2007. The delinquency rate was up from 13.77 in the first quarter to 14.82 % in the second quarter. The delinquency rate for prime loans rose from 2.58% to 2.73 %. Compared to this time last year, the seriously delinquent rate is 23 basis points higher for prime loans and 304 basis points higher for subprime loans. September 7: In response to the Bureau of Labor Statistics (BLS) releases figures, Senator Schumer calls on the Administration to act and demands strong leadership by the President, Secretary Paulson, and Chairman Bernanke. September 7: The U.S. Department of Labor’s Bureau of Labor Statistics (BLS) releases figures showing that employers cut 4,000 jobs from payrolls last month, the first net decrease since 2003. 22000 construction jobs were lost in August, with most related to residential specialty trade contractors. Nearly 100,000 construction jobs have been lost since September 2006. Following the release, the Dow Jones Industrial Average dropped 200.87 points. September 10: Representative Barney Frank, chairman of the House Financial Services Committee, implores Federal Reserve Chairman Ben Bernanke to raise investment caps on Fannie Mae and Freddie Mac. Frank also proposes to raise the Federal Housing Administration loan limit for single-family homes from $362,000 to $417,000. September 10: Senator Schumer introduces legislation to increase investment caps to alleviate the credit crunch and proposes increasing the maximum for home mortgages – from $417,000 to $625,000 – that Fannie Mae and Freddie Mac are allowed to hold on their books. September 11: Secretary Henry M. Paulson reiterates the Administration’s opposition to lifting the caps of the government-sponsored entities Fannie Mae and Freddie Mac. Secretary Paulson instead expresses support for more stringent regulation of the GSEs. September 14: Merrill Lynch & Co., the biggest underwriter of collateralized debt obligations, signals that the subprime mortgage crisis may hurt third-quarter earnings. September 17: Merrill Lynch & Co. Inc.s $1.3 billion bet on subprime lending takes a turn for the worse when the world’s largest brokerage confirms job cuts at its First Franklin Financial Corp. unit. Reports with U.S. banking regulators show that Merrill Lynch Bank & Trust Co., where a lot of the First Franklin franchise is housed, lost $111 million through the first half of 2007. September 17: Nova Star Financial Inc gives up its real estate investment trust, abandoning the lending business, because it cannot pay a $157 million dividend. 41  
    • September 18: Realty Trac Inc. announces that home foreclosure filings surged to 243,000 in August, up 115 % from August 2006 and 36 % from July, marking the highest number of foreclosure filings. The foreclosure filing rate is now one in every 510 homes. September 18: Federal Reserve cuts target federal funds rate by a half point to 4.75 %. It is the first rate reduction in four years and the steepest in nearly five years. In response to the rate cut, the Dow Jones industrial average jumps 200 points and closes up 335 points at 13, 739.39. September 18: The U.S. House of Representatives overwhelmingly passes H.R. 1852, the “Expanding American Homeownership Act of 2007,” which expands funding for housing counseling, authorizes lower down payments for borrowers who can afford mortgage payments. September 19: The Joint Economic Committee holds its second hearing on the subprime mortgage crisis. Opening the hearing, entitled “Evolution of an Economic Crisis?: The Subprime Lending Disaster and the Threat to the Broader Economy, Senator Schumer says: that the policy responses are not matching the magnitude of the risk that still lies ahead. September 19: Senator Schumer’s proposal to raise the limit on the size of home loans insurable by the Federal Housing Administration (FHA) up to $417,000 for a single- family home, is passed out of the Senate Banking Committee as part of a major FHA reform bill put forward by Senate Banking Committee Chairman Christopher Dodd. September 19: The Office of Federal Housing Enterprise Oversight (OFHEO) agrees to relax restrictions on the mortgage finance companies’ investment holdings, enabling Fannie Mae and Freddie Mac to buy $20 billion more in subprime mortgages September 19: The Commerce Department reports that construction of new homes fell by 2.6 % in August to the slowest pace in 12 years. September 20: Testifying before the House Financial Services Committee, Ben Bernanke says that the credit crisis has created significant market stress. Treasury Secretary Henry Paulson adds that the administration is considering raising the Fannie Mae and Freddie Mac loan limits he also emphasizes that any changes to include so called jumbo loans must include stricter regulations for oversight. September 21: HSBC Holdings announces its plans to close its U.S. subprime unit, Decision One Mortgage, and record an impairment charge of about $880 million. Approximately 750 U.S. employees are expected to be affected by the decision. September 25: The National Association of Realtors releases new statistics revealing sales of existing single-family homes dropped by 4.3 % in August, compared to July which pushes the inventory of unsold homes to a record 4.58 million in August. September 25: According to the S&P/Case-Shiller’s Home Prices Indices home prices continue to fall at an increasing rate. The 10-City Composite index shows an annual decline of 4.5 %– the largest in 16 years. 42  
    • September 27: Ruminant Mortgage Capital, a home-loan investment company, downgrades its second-quarter profit as the bankers seize assets. September 27: The Commerce Department reports decline in sales of single-family homes by 8.3% last month, the lowest level in seven years. The median price of a new home declined by 7.5% to $225,000 in August 2007 as compared to the same month a year ago. OCTOBER 2007 October 1: Former Federal Reserve Chairman Alan Greenspan says the housing crisis is far from over. As in similar situations of inventory excess, one would expect home prices declines to continue until the rate of inventory liquidation reaches its peak. October 1: UBS reports its first quarterly loss in nine years. The largest wealth manager in the world plans to write down$3.4 billion in its fixed-income portfolio and other departments and to cut 1,500 jobs in its investment bank. October 3: Residential foreclosures in New York City hit 698 during the third quarter. It represents a 64% increase from the same period last year. Miami’s foreclosure rate per household is 116% higher than Los Angeles and 852% higher than New York City. October 4: The credit ratings agency, Moody’s Investors Service, predicts that accelerating delinquencies from 2007 bonds are likely to surpass the number of delinquencies in 2006, which hit a peak not seen since 2000. October 9: The U.S. Securities and Exchange Commission (SEC) announces its intention to review potential conflicts of interest in the credit rating agencies due to questionable practices associated with the ratings given to mortgage-backed securities. October 10: the National Association for Realtors revises down its outlook for home sales. It lowers its prediction for existing home sales for the year from 5.92 million to 5.78 million. New home sales are projected to fall to 805,000 this year and to 752,000 next year. October 10: The Bush administration announces a new mortgage industry coalition to help homeowners stay in their homes. Treasury Secretary Henry M. Paulson Jr. estimates that Hope Now Alliance will assist 2 million homeowners. The coalition includes 11 of the largest mortgage service companies, which represent 60 % of all mortgages in the nation joined by mortgage counseling agencies, investors, and large trade organizations. October 11: Senator Charles E. Schumer introduces his plan to allow Fannie Mae and Freddie Mac to raise their portfolio caps by 10 percent in a six-month window. Of the total $147 billion increase, 85 % ($125 billion) is designated to aid subprime borrowers. Representative Barney Frank, chairman of the House Financial Services Committee, introduces a companion bill in the House. October 12: Paulson & Co., which has made money by betting on increasing foreclosures this year, announces its intention to donate $15 million to the Center for Responsible Lending and The National Association of Consumer Advocates. The two 43  
    • groups plan to use to the funding to establish an institute that offers legal aid to homeowners fighting foreclosure. October 15: Representative Barney Frank holds a committee field hearing entitled “Mortgage Lending Disparities” which focuses on mortgage lending disparities in the Boston area of Black and Latino borrowers who were much more likely than whites or Asians living the same area to receive higher-priced loans. October 15: Strongly urged to act by the Treasury Department, Citigroup, JPMorgan Chase, and Bank of America announce the creation of a new entity, called a Master Liquidity Enhancement Conduit, to raise $200 billion in order to purchase securities that are otherwise likely to be dumped on the market and further depress the housing debt crisis. October 15: Citigroup acknowledges that its risk management models failed its customers and shareholders during this summer’s credit crisis, leading to the company’s 57 % drop in third-quarter profit. Citigroup was forced to write off $3.55 billion and set aside $2.24 billion to cover anticipated losses stemming from failing mortgages and consumer loans. October 16: The National Association of Home Builders reports that its housing market index, which tracks builders’ perceptions of conditions and expectations for home sales over the next six months, dropped to 18, its lowest level since the inception of the index in 1985. The housing market index has declined for eight straight months October 17: The National League of Cities releases a report in which 7 out of 10 finance officers from major cities throughout the country offer pessimistic predictions for the economic future of their cities. They report that the housing downturn is causing a major decrease in city tax revenue and is only likely to worsen in the coming months. October 17: The Commerce Department reports that U.S. home construction starts fell 10.2 percent last month to their lowest level in more than 14 years. Building permit activity, an indicator of future construction plans, declined 7.3%, the largest drop since January 1995. October 17: The Federal Reserve’s “Beige Book,” a survey of businesses, indicates that the housing crisis is intensifying and that businesses are concerned that other areas of the economy are likely to suffer as a result. October 18: Standard & Poor’s cuts the credit ratings on $23.35 billion of securities backed by pools of home loans offered to borrowers during the first half of the year. The downgrades even hit securities rated AAA, which is the highest of the 10 investment- grade ratings and the rating of government debt. October 18: the Labor Department reports a surge in lay-offs with unemployment benefit claims far surpassing expectations. Applications increased 28,000 from the previous week, the largest one-week jump since February 10th. 44  
    • October 18: Senator Schumer calls upon the Securities and Exchange Commission (SEC) to investigate Countrywide Financial Corporation along with its chief executive Angelo Mozilla. October 22: Representatives Brad Miller (D-NC), Mel Watt (D-NC), and Barney Frank (D-MA) introduce comprehensive legislation to combat abuses in the mortgage lending market, and to protect mortgage consumers and investors. The bill, H.R. 3915, “The Mortgage Reform and Anti-Predatory Lending Act of 2007,” not only reforms mortgage practices for owners but also includes foreclosure protection for renters. October 24: the House Financial Services Committee, chaired by Congressman Barney Frank (D-MA), holds a hearing entitled “Legislative Proposals on Reforming Mortgage Practices.” October 24: Merrill Lynch writes down $7.9 billion due to exposure to collateralized debt obligations, complex debt instruments, and subprime mortgages. As a result, the firm takes a $2.3 billion loss, the largest in the firm’s history. October 25: The Joint Economic Committee releases a report analyzing the greater financial impact of the subprime foreclosure boom. The JEC report entitled, “The Subprime Lending Crisis: The Economic Impact on Wealth, Property Values and Tax Revenues, and How We Got Here” reveals that families, neighborhood property values, and state and local governments will lose billions of dollars as two million subprime mortgage homes are foreclosed.” October 29: John Robbins, former chairman of the Mortgage Bankers Association, says approximately a half of million U.S. mortgage borrowers each year for the next few years risk foreclosure. He expects that 1 million borrowers will lose favor with their lenders each year and that 500,000 of them will not be able to save their home loans. October 30: Shareholders sue Merrill Lynch & Co for issuing false and misleading statements regarding its exposure to risk mortgage investments. October 30: Reports from the S&P/Case-Sheller index indicate that housing prices have again fallen at record rates. In the largest drop since June 1991, the 10 city index declined 5 % in August 2007 as compared to the same month during the previous year. October 30: Addressing Women in Housing and Finance, Treasury Assistant Secretary David Nason outlines the Bush Administration’s foreclosure avoidance plan. The plan includes FHA modernization, changes in the Federal Tax Code related to mortgage debt cancellation and the Hope Now Alliance charged with coordinating efforts to reach more homeowners and find long-term solutions. October 31: The Federal Reserve Board lowers the federal funds rate by one-quarter percentage point to 4.50 %.NOVEMBER 2007 November 28: The National Association of Realtors reports that sales of existing single-family homes and condominiums dropped by 1.2 % in October to a seasonally 45  
    • adjusted annual rate of 4.97 million units. The median price of a home sold in October declined to $207,800, a drop of 5.1 % from October 2006. It is the single largest one year decline on record. November 28: With the subprime housing credit crisis spreading, the Commerce Department reports that orders to factories for big-ticket manufactured goods declined by 0.4 % in October. It was the third consecutive decline, the longest slump in nearly four years. November 29: According to RealtyTrac, there were 222,451 foreclosure filings last month. It is a 94 % increase from October 2006 and represents one foreclosure filing for every 555 households in the nation. The 2 % increase from September 2007 indicates that the subprime crisis is only getting worse. November 29: According to a government report released today, there were 516,000 new homes for sale at the end of October. It would take 8.5 months to clear that inventory at the current sales pace. November 29: Federal Reserve Chairman Ben Bernanke indicates that the economy may need another general rate cut. He expects consumers to suffer from the deepening Housing slump. November 29: California Governor Arnold Schwarzenegger rolls out a $1.2-million education campaign to help borrowers and lenders restructure loans before a home is lost to foreclosure. November 30: Representative Barney Frank (D-MA), holds a hearing entitled “Foreclosure Prevention and Intervention: The Importance of Loss Mitigation Strategies in Keeping Families in Their Homes.” November 26: Senator Charles E. Schumer urges the Federal Home Loan Bank System to stop extending advances backed by predatory mortgages peddled by lenders, such as Countrywide. Senator Schumer calls for stricter collateral guidelines to reduce exposure to risky mortgages and encourages banks to modify more of their unaffordable loans. November 21: Shares of Countrywide, the largest U.S. Mortgage Lender, close below $10 for the first time in more than five years. November 19: Fannie Mae shares are down 7.3 % to $37.70 on reports from Credit Suisse that the government sponsored entity may report a loss of between $1 billion to $5 billion on its subprime AAA portfolio. November 15: Senator Charles E. Schumer, the senior senator from New York, releases a new report revealing how 50,000 Upstate New Yorkers may have been duped into taking on costly subprime loans even though they could have qualified for more affordable, prime mortgages. November 15: The U.S. House of Representatives approves H.R. 3915, “The Mortgage Reform and Anti-Predatory Lending Act of 2007,” The historic bipartisan legislation reins in the abusive lending practices that contributed to the current mortgage crisis. 46  
    • November 15: Barclays Group PLC takes a $2.7 billion write-down for losses on securities linked to the U.S. subprime mortgage market collapse. November 2: Representative Barney Frank (D-MA), holds a hearing entitled “Progress in Administration and Other Efforts to coordinate and Enhance Mortgage Foreclosure Prevention.” One focus of the hearing is the “HOPE NOW” initiative formed by the Departments of Treasury and Housing and Urban Development. November 4: On top of the $5.9 billion write-down reported in early October, Citigroup says it will take an additional $8billion to $11 billion write-down related to subprime mortgages and the C.E.O. Charles O. Prince Mr. Prince announces his resignation and leaves with $105.2 million in cash and stock – in addition to the $53.1 million in compensation he took home over the past four years. November 6: David Trone, a securities analyst at Fox-Pitt Kelton, downgrades Morgan Stanley amid speculation that the brokerage firm will suffer losses of $6 billion due to the reduced value of credit investments. November 8: Testifying before the Joint Economic Committee, Ben Bernanke expresses his concern over the subprime housing crisis and floats the idea of providing governmental guarantees against defaults on so-called “jumbo” loans, those above the $417,000 limit on mortgages that can be backed by Fannie Mae or Freddie Mac. November 8: Senator Charles E. Schumer introduces legislation requiring better, simpler disclosure by mortgage lenders so that loan terms are conveyed to consumers in a clear and straightforward manner. The new template would display critical loan information— such as the monthly loan payment and interest rate, before and after resets—in a separate box, apart from other terms or details. November 14: According to Realty Trac, foreclosure filings rose in 77 of the largest 100 metropolitan areas from the prior quarter. Overall, residential foreclosure filings nearly doubled in the third quarter from a year earlier. November 14: HSBC Holdings PLC, Europe’s biggest bank, reports that it took a $3.4 billion impairment charge at its U.S. consumer finance division, HSBC Finance Corp.DECEMBER 2007 December 3: Credit agency Moody’s widens its debt review to downgrade debt worth $116bn. December 4: Fannie Mae issues $7bn of shares to cover losses linked to the housing markets. December 4: U.S. Senators Bob Casey (D-PA), Chris Dodd (D-CT), Charles Schumer (D-NY), and Sherrod Brown (D-OH) write to Treasury Secretary Henry Paulson to urge him to include as many borrowers as possible in his yet-to-be-announced subprime plan. December 5: Senator Clinton calls for a 90-Day moratorium on home foreclosures and a five-year freeze on fluctuating subprime rates. 47  
    • December 5: The Wall Street Journal reports that New York Attorney General Andrew M. Cuomo sent out subpoenas to Major Wall Street firms including Merrill Lynch, Morgan Stanley, Deutsche Bank, Bear Sterns, and Lehmann Brothers over the late summer to explore further their role in the packaging and selling of subprime mortgages. December 6: President Bush announces measures to help many struggling homeowners. President Bush touts the Hope Now Alliance as an example of government uniting members of the private sector to address voluntarily the housing crisis without taxpayer subsidies or government mandates. The President calls upon Congress to reform both the Federal Housing Administration and the Government Sponsored Enterprises Freddie Mac and Fannie Mae. December 6: Representative Barney Frank (D-MA), chairman of the House Financial Services Committee, holds a hearing entitled “Loan Modification and Foreclosure Prevention” which addresses “Mortgage Reform andante-Predatory Lending Act of 2007” and “Emergency Mortgage Loan Modification Act of 2007”. December 10: Swiss bank UBS announced it would write down an additional $10 Billion in subprime losses –possibly resulting in a net loss for all of 2007. UBS also announced it has solicited a cash infusion of $11.5 Billion from GIC, Singapore’s sovereign wealth fund, and an unknown Middle Eastern investor. December 10: Fannie Mae and Freddie Mac announce that they are changing their criteria for purchasing delinquent home loans. The two government-sponsored entities, which together own or guarantee approximately two-fifths of U.S. home mortgage debt, have recently set aside billions of dollars to compensate for bad home loans. Their profits have declined at a time when home prices are falling and defaults are soaring on high-risk mortgages. December 11: Contrary to the recommendations of several regional Fed Banks, the Federal Reserve Board announced only 25 basis-point cut in the discount rate to 4.75%. December 11: Washington Mutual announced that it expected its fourth quarter loan losses would reach $1.6 Billion and expected that 3,000 Washington Mutual employees would be laid off. December 14: The US Senate passed legislation giving needed tax relief to those at risk of foreclosure on their subprime Mortgages. The Mortgage Forgiveness Debt Relief Act both extends the tax deductions on mortgage insurance premiums and eliminates taxes accrued by receiving debt forgiveness. Previous to this legislation, debt forgiveness was treated as income and taxed accordingly, further crippling struggling American families. December 17: Treasury Secretary Henry Paulson announced he favors temporarily allowing Fannie Mae and Freddie Mac to purchase home loans in excess of $417,000.This allows Fannie Mae and Freddie Mac to provide home loans in more areas throughout the country. December 18: The Federal Reserve proposed new rules governing mortgage lenders. 48  
    • December 18: The Commerce Department reported that housing construction was down 3.7 % for the month of November to a seasonally adjusted rate of 1.187 million units. This marked a 24.2 % drop in new home construction in the 12 month period and the lowest level of home construction in more than 16 years. December 19: Senator Chuck Schumer addressed the current subprime lending crisis as well as the potential for a recession in a speech at the Brookings Institution. In his speech, Schumer highlighted the shortcomings of the Bush administrations recent proposals to address the subprime mortgage crisis saying, “When we’re facing as many as 2.2 million foreclosures over the next two years, dealing with only 10% of the borrowers at risk is simply not good enough.” December 19: Morgan Stanley announced it would be writing down an additional $9.4 billion in losses on subprime linked investments and it would be selling a $5 billion dollar stake to a foreign investment fund. December 20: Senator Chuck Schumer, Chairman of the Joint Economic Committee and Congresswoman Carolyn Maloney, Vice Chair of the JEC, released the Committee’s Annual Economic Report that concluded that the subprime mortgage crisis was the result of a failure to oversee financial markets effectively. Schumer also criticized the administration.JANUARY 2008 January 4: The Labor department announced that the unemployment rate skyrocketed from 4.7% to 5% in December. These numbers were fueled by the loss of 28,500 jobs in residential construction and 7,000 jobs lost in the mortgage lending industry throughout 2007. The fall to 5% made December’s unemployment jump the largest unemployment increase since the days after Sept. 11, 2001. January 10: Countrywide Financial reported that late mortgage payments and foreclosures reached the highest level ever recorded this past December. The foreclosure rate on Countrywide’s mortgages grew from just 0.7% a year ago to 1.44%last month. On the announcement of this news, shares in Countrywide dropped to their lowest price in over a decade. January 11: Merrill Lynch, the nation’s third largest securities firm, announced it would need to write down more than double its initial projection i.e.$15 billion related to subprime mortgage losses instead of $7 billion. January 11: Bank of America, the nation’s second largest banking institution, announced that it would buy Countrywide Financial, the nation’s largest mortgage lender. This acquisition ended days of speculation that Countrywide, due to its role in the proliferation of subprime mortgages, would be forced to declare bankruptcy. January 11: Representative Barney Frank said that Bank of America’s purchase of Countrywide could be a positive development in the subprime crisis. 49  
    • January 15: Citigroup, the largest bank in the U.S., announced that its mortgage portfolio dropped in value by $18.1 Billion and its first quarterly loss in 16 years. January 17: Lehman Brothers said it would no longer continue the practice of wholesale mortgage lending. As a pioneer in issuing mortgage backed securities, Lehman Brothers also announced it would cut 1,300 jobs. These job cuts come on top of 2,500 other jobs eliminated since June 2007. January 22: The Federal Reserve Board lowers the federal funds rate by three-quarter percentage point to 3.50 from 4.25%. The Dow Jones industrial average closes 11,971, down 128 points, or 1.1%, after rebounding nearly 400 points off session lows and Standard & Poors 500 falls 15 points, or 1.1%, to 1,311. January 29: The number of houses in foreclosure rose 79% in 2007, states Realty Trac. January 30: Federal Reserve Board announced a 50 basis-point cut in the discount rate to 3% from 3.50%. January 30: Standards & Poor’s announces to cut credit ratings of $534 billion in subprime mortgage backed securities.FEBRUARY 2008 February 2: Labour Department announces loss of 17000 jobs in January, the first negative month for employment growth. February 5: UBS reports a loss of $11.3 billion loss related to mortgage-backed securities. February 6: President Bush signed a bill authorizing a $168 billion stimulus package that will offer tax rebates to 130 million Americans. February 8: S&P 500 fell 8.9% this week as fears of corporate debt defaults rose as the cost of insuring that debt rose to record highs. Weekly report claims jobless people at 345,000, a slight decrease from the prior weeks 356,000. February 14: Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke testify before the Senate Banking Committee in Washington. The Dow falls to 56 points, or 0.5%, to 12,321, while the S&P 500 is off 4 points. February 19: Credit Suisse, announces to write down $1 billion in subprime losses. February26: Fannie Mae announced $3.6 billion quarterly loss for the three months ending on Dec. 31, following earnings of $604 million in the similar period a year earlier. February 27: Federal Reserve Chairman Ben Bernanke told Congress that the worlds financial markets have been in turmoil since last summer, credit is tight and inflation is rising.MARCH 2008 March 6: HSBC announced a $17.2bn (£8.7bn) loss after the decline in the US housing market. 50  
    • March 6: Over 900,000 households are in the foreclosure process, up 71% from a year ago, according to a survey by the Mortgage Bankers Association. That figure represents 2.04% of all mortgages, the highest rate in the reports quarterly in the 36-year history. March10: A loss of 63000 jobs has been estimated in the month of February due to the recession. March 11: The Fed boosted the size of its 28-day loans to banks to $200 billion this month from $160 billion. The central bank announced on March 11 a $200 billion swap of Treasuries for mortgage bonds held by dealers to facilitate market-making. March 12: Foreclosure filings jumped 60 percent and bank seizures more than doubled in February, according to data from RealtyTrac Inc., a data vendor. More than 223,000 properties were in some stage of default, equal to 1 in every 557 U.S. households, March 16: The Fed acted just after JP Morgan Chase & Co. agreed to buy rival Bear Stearns Cos(one of the nation’s largest underwriters of mortgage bonds) for $236.2 million in a deal (one tenth of its original value) that represents a stunning collapse for one of the worlds largest and most venerable investment banks. It will provide up to $30 million to JP Morgan Chase to help it in financing. March16: The central bank approves a cut in its lending rate to financial institutions to 3.25% from 3.50%, effective immediately, and created another lending facility for big investment banks to secure short-term loans. The "discount" rate cut announced Sunday covers only short-term loans that financial institutions get directly from the Federal Reserve and does not apply to individual investors. March17: Mortgage losses at banks and investment firms now total $195 billion, according to Bloomberg calculations. Dollar tumbled to 12 year low against yen March 18: Federal Reserve Board announces a75 basis-point cut in the discount rate to 2.25% from 3%. March 19: Federal regulators agree to let Fannie Mae and Freddie Mac take on another $200 billion in subprime mortgage debt. March 23: Goldman Sachs Group and smaller rival Lehman Brothers Holdings have their credit-rating outlook cut to negative by Standard & Poor’s which affirmed its long- term credit rating of AA- for Goldman and A+ for Lehman. March 26: Bank of America announces to write down $6.5 billion in the first-quarter. March 28: The US Federal Reserve announces to make a further $100bn available to major banks in April, trying to ease concerns about a global credit crunch. March 31: The Fed would essentially serve as a financial markets moderator, stepping in if the nations markets were again threatened by an episode like the near collapse of Bear Stearns. The plan would also give the central bank greater oversight of investment banks and previously unregulated entities like hedge funds and private equity firms that have wielded growing influence in financial markets in recent years. 51  
    • APRIL 2008 April 1: US Treasury Secretary, Mr. Henry Paulson proposes new regulations vesting new powers in the Federal Reserve as a “market stability regulator”. The Commodity Future Trading Commission would be merged with the Securities and Exchange Commission. He further proposes the establishment of a “Mortgage Origination Commission” to set licensing standards for mortgage brokers. April 1: Swiss financial giant UBS reports that its write downs have more than doubled to about $37bn with a loss of $19bn for the last quarter of the fiscal year. Deutsch Bank reveals a write-down of $4 bn. April 3: Federal Chairman Ben Bernanke testified before Congresss Joint Economic Committee and announces that the US economy is likely to enter into a recession. He quoted that “It now appears likely that real gross domestic product (GDP) will not grow much, if at all, over the first half of 2008 and could even contract slightly”. April 4: US unemployment rate increases to 5.1% with payrolls falling to 80000. April 16: US release the “Beige Book” which announces weak economy due to the subprime meltdown. April 16: Privately owned housing starts fell to a seasonally adjusted 947,000 annual rate in March, according to the Commerce Department. April 18: Merrill Lynch reports a $2 billion loss in the first quarter of 2008. April 18: Citibank writes down $5.11 billion quarterly loss.The actual countdown began in the year 2004 when the Federal Reserve began a series of interestrate hikes that raised the cost of borrowing from the lowest levels since 1950. It increased theinterest rates seventeen times and paused only in June 2006 when the borrowing cost touched5.25 per cent. As a result of this housing market began sliding in August 2005 and that continuedthrough 2006. Building rates and housing prices tumbled. The leveraging process, thesecuritization mechanism and various parties helped to result in a whole subprime saga.Today the whole scenario has changed from what it was three years prior to this period. TheFederal Reserve Bank has been frequently lowering the fed interest rates. Billions of dollars arebeing pumped into the economy. Joint Economic Committee and Securities and ExchangeCommittee along with the federal bank left no stone unturned to help the economy from slippinginto recession. With all these events taking place it becomes necessary to understand the role ofvarious parties involved in the whole carnage. 52  
    • However, today the whole scenario has changed from what it was three years prior to thisperiod. The Federal Reserve Bank has been frequently lowering the fed interest rates. Billions ofdollars are being pumped into the economy. Joint Economic Committee and Securities andExchange Committee along with the federal bank left no stone unturned to help the economyfrom slipping into recession. With all these events taking place it becomes necessary tounderstand the role of various parties involved in the whole carnage. 53  
    • THE PARTIES IN THE CRISIS AND THEIR ROLE Walking the Line “US Financial markets, it turns out were characterized less by sophistication than by sophistry, which my dictionary defines as ‘a deliberately invalid argument displaying ingenuity in reasoning in the hope of deceiving someone’. E.g., repackaging dubious loans intocollateralized debt obligations creates a lot of perfectly safe, AAA assets that will never go bad.” - Paul KrugmanThe sub-prime carnage is the consequence of too much money in the economic system, overambitious lenders, innovatively created financial instruments that had their in-built flaws and laxregulatory systems. The unwillingness of many homeowners to sell their homes at reducedmarket prices, increasing foreclosure rates and overbuilding during the boom period, hadsignificantly increased the availability of housing inventory. American banks with greatliquidity, lax standards of the authorities, inefficient credit ratings by the agencies etc, eachcontributed to this carnage in their own ways. This excess supply of home inventory decreasedthe prices of the houses and more homeowners were at risk of default and foreclosure. A varietyof factors have contributed to an increase in the payment delinquency rate for sub-primeAdjustable Rate Mortgages borrowers.The role of various parties that have amplified this situation is elucidated below:Role of Borrowers "As the decision-maker, the role of the consumer is to acquire the financial acumen necessary and take advantage of the competitive marketplace, shop compare, ask questions and expect answers." - Harry Dinham, president of the National Association of Mortgage BrokersThe whole sub-prime saga started with the unsuitable borrowers having limited or tarnishedcredit history. The loans issued to these borrowers tend to carry more credit risk but less interestrate risk than securities backed by prime loans. This was because sub-prime borrowers had ashorter time horizon and fewer opportunities to refinance when interest rates fell. 54  
    • Sub-prime loans are made to those borrowers that display the following characteristics at thetime of origination: TYPES OF BORROWERS  • weakened credit histories that include payment Prime:  mortgages  under delinquencies and bankruptcies; $417,000  backed  by • reduced repayment capacity as measured by the credit government  guarantee  with stricter  loan  conditions  (also scores called conforming loans)  • high debt-to-income ratios (DTI above 55%); Jumbo:  mortgages  over • high loan-to-value ratio (LTV over 85%) $417,000  and  not  backed  by • incomplete credit histories. government guarantee  Alt‐A:  at  a  higher  rate  of interest  for  people  with poorer  credit  history  but better jobs Alt-A mortgages, though of higher quality than sub-prime Sub‐prime: at a higher rate ofmortgages are considered lower credit quality than prime interest  for  people  with  poormortgages due to one or more nonstandard features, related to credit history and low incomethe borrowers, property or loan. Alt-A loans were a moreflexible alternative to prime loans who met all the credit score, Box 0: Types of BorrowersDTI and LTV prime criteria but fell short of full incomedocumentation.Lured by the notion of fulfilling their “American Dream” the availability of easy credit alongwith the assumption that housing prices would continue to appreciate encouraged many sub-prime borrowers to obtain Adjustable Rate Mortgages they could not afford from banks.However, due to the Housing market correction and the housing bubble burst, the home pricesstarted depreciating and refinancing became difficult. Some homeowners were unable to re-finance and began to default on loans as their loans reset to higher interest rates and paymentamounts.Theses sub-prime borrowers when realized their inability to repay the loans, stopped paying theinterest obligations and became indifferent to it. When they noticed the decline in the homemarket values and limited value of equity they chose to stop paying the mortgages. They"walked away" from the property and allowed foreclosure, despite the impact to their creditrating. Since such activities further increased the supply of houses, resulting in fall of the prices,the situation kept on aggravating and thus became a colossal crisis submerging the entireeconomy into it.Besides this, misrepresentation of loan application data was another contributing factor, whichled to an indifferent attitude of the borrowers. As much as 70 percent of the early paymentdefaults had fraudulent misrepresentations on their original loan applications. The 55  
    • borrowers lied when required to state their incomes, and some other borrowers falsified income documents using computers to avail the home loans. The figure on left (Figure 6) shows the rate of U.S. foreclosure in the past one year. There has been as much as 50% increase in the foreclosure filings from the last year in the month of February 2008. It saw foreclosure filings, which included default notices, auction sale notices, and bank repossessions. The total value of home equity (percentage of a homes market value minus mortgage-related debt) also fell for the third straight quarter of 2007 to $9.65 trillion from a downwardly revised $9.93 trillion Q3 2007.8.8 million Figure 4: US Foreclosure Filings home owners, or about 10.3% of homes, had zeroed or negative equity by the end of March.Role of Financial InstitutionsFinancial institutions have played a major role in magnifying this problem. The financialinstitutions provided money to the borrowers and charged high rates of interest. Irrespective oftheir tarnished image and low FICO score4 the banks issued loans to the low income borrowers,expecting timely repayment of loans they pooled the money and issued Collateralized BondObligations and Mortgage Backed Securities to investors at comparatively low rates. This way,they earned a healthy spread on the costs and generated very good profits.Moreover, the average difference in mortgage interest rates between sub-prime and primemortgages (the "sub-prime markup" or "risk premium") declined from 2.8 percentage points in2001, to 1.3 percentage points in 2007. In other words, the risk premium required by lenders to                                                            4 FICO Score– The numerical credit score that credit bureaus give to you based on the amount of debt you have andwhether you pay your bills on time. FICO is named after Fair Issac Corp, the company that pioneered credit scoring.Scores average between 300 and 850, the higher the better. (Source: www.stearnslending.com/tools-resources/glossary.php). For more details see Appendix 4. 56  
    • offer a sub-prime loan declined. This occurred even though sub-prime borrower and loancharacteristics declined overall during the 2001-2006 period, which should have had the oppositeeffect. In essence this very less difference in the interest rates made the sub-prime loans allthe more attractive to the borrowers.In addition to considering higher-risk borrowers, lenders had offered increasingly high-risk loanoptions and incentives by introducing different types of mortgages such as: • Interest Only Mortgages: These loans require the borrower to pay only the interest portion of the loan for the first few years thus keeping the payment relatively low for the first few years before the interest only component expires. Then the borrower must pay the principle and interest component of the mortgage payment, which is a much higher amount. • Adjustable Rate Mortgages: Unlike traditional mortgages that have a fixed interest rate making the payment same each month, with an adjustable rate mortgage if interest rates rises (as they have been recently) the monthly mortgage payment goes up as well. An adjustable rate mortgage (ARM) is a mortgage loan where the interest rate is periodically adjusted based on a variety of indexes. • Low Initial Fixed Rate Mortgages: These mortgages that initially have very low fixed rates and then quickly convert to ARM.When the indices shot up, the interest rates on the Adjustable Rate Mortgages also increased andreset at higher levels. The resets caused payments to rise by at least 30 percent to an amount thatmany borrowers could no longer afford. Further payment of high interests and the initial amountof the house yet to be repaid, made the housing a very costly affair for them. This prompted thelow-income borrowers to leave the houses and let it be foreclosed.Role of securitizationSecuritization is a structured finance process in which assets, receivables or financial instrumentsare acquired, classified into pools, and offered as collateral for third-party investment. Due tosecuritization, investor appetite for Mortgage-Backed Securities (MBS), and Collateralized DebtObligations (CDO) and the tendency of rating agencies to assign investment-grade ratings tothese loans with a high risk of default could be originated, packaged and the risk readilytransferred to others.The borrower takes loan from the lender who underwrites and funds the loans with the help of amortgage broker. The lender then sells the loan to the issuer, who is a bankruptcy-remote specialpurpose entity (SPE) formed to facilitate a securitization and to issue securities to investors. The 57  
    • issuer further sells Figure 4: Home Ownerships In USthe loans to theinvestors. He isassisted by the ratingagency, trustee,underwriter andcredit enhancementprovider. It is theservicer who collectsthe monthlypayments from theborrowers and remitsthese payments to theissuer for distributionto the investor. Theservicer is generallyobligated tomaximize thepayments from the borrowers to the issuer, and is responsible for handling delinquent loans andforeclosures.(see figure 4 for securitization mechanism)In this way securitization facilitated market growth by dispersing risk, providing investors with asupply of highly rated securities with enhanced yield. In this way homeownership saw newheights until the outbreak of the crisis (see figure 7).Role of Mortgage Brokers & Mortgage Underwriters “Thebasic problem is the way that mortgage brokers PREDATORY LENDING present their services. They bill themselves as independent PRACTICES  operators but try to maximize their markup on the deal." Ninja  Loans:  no  income,  no job, no assets   -Jack Guttentag, 2/28: Mortgages that change professor of finance from  a  fixed  to  a  much emeritus at the higher  adjustable  rate  after Wharton School of first two years  the University of Prepayment  penalties:  High Pennsylvania. fees  for  trying  to  change terms of mortgage  (Source: www.bbc.co.in) Mortgage brokers acts as an intermediary who sourcesmortgage loans on behalf of individuals or businesses. Box 0: Predatory Lending PracticesThese brokers indulged into predatory mortgage lending, 58  
    • falsifying income/asset and other documentation etc which misguided the lenders to provideloans in good faith. Mortgage brokers being salesman maximizing their net income, their interestin providing the least expensive mortgage was limited. Besides this, since brokers bear little orno risk when a borrower failed in making payments they did not have any economic incentive inproviding loans that the borrower would be able to pay in the long run.Mortgage underwriting involves the lenders determining the risk of the borrower on the basis ofcredit, capacity and collateral. After reviewing all aspects of the loan, it was up to theunderwriter to assess the risk of the loan as a whole. Automated underwriting had streamlinedthe mortgage process by providing analysis of credit and loan terms in minutes rather than days.For borrowers that pose less risk, it reduced the amount of documentation needed and evenrequired no documentation of employment, income, assets or even value of the property. Manybanks also offered reduced documentation loans which allowed a borrower to qualify for amortgage without verifying items such as income or assets. Naturally these higher risk loans thatcame with higher interest rates were easily provided without any scrutiny of the credit history ofthe investors.Role of Government and Regulators Several legal milestones facilitated the development of subprime mortgage market. In 1980,interest rate caps imposed by states were pre-empted by federal legislation in 1980 while it wassince 1982 that lenders were allowed to offer adjustable rate mortgages. Besides this, the TaxReform Act of 1986 left residential mortgages as the only consumer loans on which interest wastax deductible which made home loans more beneficial.Certain Government policies like the Community Reinvestment Act encouraged the developmentof the subprime debacle. Through this legislation, banks were required to offer credit throughouttheir entire market area and prohibited them from targeting only wealthier neighborhoods withtheir services (known as Redlining Process). The purpose of this was to provide credit, includinghome ownership opportunities to underserved populations and commercial loans to smallbusinesses.Moreover, the Glass-Steagall Act 1933 the established the Federal Deposit InsuranceCorporation. FDIC provided deposit insurance and guaranteed checking and savings deposits inmember banks up to $100,000 per depositor. In this way all the borrowers were guaranteed witha minimum amount of $100,000 even those with weak credit histories.Thus the government in its zeal to provide its citizens with legislative umbrella to encouragehome ownership ended hasting the situation that the US economy now finds itself in. 59  
    • Role of Credit Rating Agencies "You cant expect an individual investor to know the details of these complex regulations, these complex packages. As society gets more complicated, we rely more and more on these credit rating agencies." -Senator Charles S SchumerCredit rating agencies have played a major role in escalating the problem of the sub-prime crisis.The credit rating agencies assigned credit ratings to different types of debt instruments. Thehigher levels, which were the last to take losses if and when mortgages defaulted, were givenhigh credit ratings and the lower levels that were the first to take losses were given the sub-primeratings.The process was that if an agency did not like the rating it received, it could opt to not pay thecredit agency that issued that rating. The system had been like this since the 1970s, when itshifted from investor to agency funding. At issue was the transparency of the ratings system,which had come under fire recently for its complicated terms.There was a contradiction between rating agencies receiving fees from a security’s creator andtheir ability to give an unbiased assessment of risk. Rating agencies were enticed to give betterratings to receive higher service fees. On the other hand, it was difficult to sell a security if it wasnot rated. They incorrectly gave investment-grade ratings to securitisation transactionsholding sub prime mortgages. This allowed investment bankers to sell off a large portion of thesub-prime loans as debt instruments with above prime credit ratings thus expanding the numberof potential buyers of that debt.Role of Central Bank “For the second time in seven years, the bursting of a major-asset bubble has inflicted great damage on world financial markets. In both cases--the equity bubble in 2000 and the credit bubble in 2007--central banks were asleep at the switch. The lack of monetary discipline has become a hallmark of unfettered globalization. Central banks have failed to provide a stable underpinning to world financial markets and to an increasingly asset-dependent global economy.” - Stephen Roach, Morgan Stanley 60  
    • The U.S. Central Bank being “the lender of last resort” is required to manage the economy bymanaging the rate of inflation and avoiding recessions through its various monetary policyreforms. So the Central Bank must ensure liquidity in the system, which the U.S. economy wasshort of. During the year 2006, the great amount of liquidity in the market along with low ratesof ARM’s assured the low-income borrowers that they will be able to repay the loans expectingthe rates to be low in the future.During the sub-prime crisis the Central bank was criticized to wake very late to this problem.On March 27, 2007, Fed Chairman Ben Bernanke said at a Joint Economic Committee, that thehousing market weakness “does not” appear to have spilled over to a significant extent. While onSeptember 20, 2007, that Chairman Bernanke acknowledged that the credit crisis has createdsignificant market stress.By the outburst of the crisis, the markets were already low overflowing with illiquid funds. Bythe time the central bank realized how grave this problem was, it was left with little option but topanic measures like reduce the Fed rates. This move, on one hand, aimed to increase the liquidityin the system, but on the other hand, it caused too much inflation. The Fed rate which was 5.25in September 2007 was reduced to as low as 2.25 in March 2008 (300 bps in the space of tmonths) to infuse more liquidity.Thus the Fed played a very inadequate role during the whole crisis and did not live up to itsresponsibility of the bank of the Country with mandate to monitor and control the financialsystems to avoid any severe situation.The sub-prime crisis which stands today as a housing market catastrophe and a financial marketblunder is mixed bag of anxious borrowers, short-sighted lenders, inefficiently knit mechanism ofsecuritization, lax set standards, easily ‘swayed by profits’ brokers and a hyper active economicsystem! It is this gamut of irresponsible behaviors of all the parties that the sub-prime crisis isfalling to new depths of losses and failures. 61  
    • 62  
    • IMPACT OF THE CRISIS ON THE U.S.A Entering a possible recession ``The greatest risk comes from the still-unfolding events in financial markets, particularly the potential that deep losses on structured credits related to the U.S. sub-prime mortgage market and other sectors would seriously impair financial-system capital and initiate a global de- leveraging that would turn the current credit squeeze into a full-blown credit crunch. - International Monetary Fund, 2 April 2008Perhaps the naive borrowers, the irresponsible lenders, lax lending standards, inefficient creditrating agencies and overlooking Federal Reserve would have never imagined that theirindifferent behavior would lead to such big crisis thatwould be so severe to devastate the financial POTENTIAL SUB‐PRIME LOSSES superpower that is the United States of America! Sub‐prime mortgages:   $1.3 trillion Quite obviously, the housing sector would be Distressed sub‐prime mortgages:   $625bn immensely hit with a large number of foreclosures Foreclosed sub‐prime mortgages:  and innumerable delinquencies, resulting in this $220bn‐$450bn sector taking a downturn. However, the impact on % Sub‐prime foreclosed:               financial slosses from mortgage foreclosures. The 15%‐25% sub-prime crisis has emerged as a challenge for the Current market value of sub‐prime think-tank of economists sitting in the chambers of mortgages:   $300bn ‐ $900bn the U.S. Senate. (Sources: Federal Reserve, Moodys.com) Since the outbreak of the crisis central banks, over the Box 0: Potential Subprime Lossesdeveloped economies have pumped massive amountsof liquidity into the markets; various laws, bills and Acts have been introduced to support thetumbling housing sector and the cascading financial sector. Market participants, politicians andgeneral public raise the question how exactly did the capital markets got into this serious troubleand have taken the Fed Officials to heels, are finding answers.The sub-prime crisis has changed the whole outlook of the U.S. economy. Since the crisiserupted late August 2006, the entire economy has undergone a sea change. The U.S. economy, a$15 trillion giant making up about 25% of the world economy has dragged down the world’sgrowth owing to the recent crisis. So powerful has been the effect of the housing boom that theeconomy saw an unprecedented growth in retail, construction and other housing relatedbusinesses and when the economy fell it took down everything with it. 63  
    • Millions of people resided in homes that were far more worth the value at which they werepurchased. Millions more saw heightening values of the net worth, enticing them to sell theirnewly purchased homes for buying another one. The low interest rates have encouraged them totake more credit than ever before.However, the housing market correction5 and bursting of the housing bubble has todayoverturned the rising figures of home ownership and raisedthe numbers of home delinquencies and defaults. MAIN CREDIT LOSSES SO FARPerhaps the situation would have been much visible in Citigroup: $40.7bn  1995, if there would have not been interruptions of Asian UBS: $38bn Currency Crisis6 followed by Russian Debt Crisis7, LTCM Merrill Lynch: $31.7bn collapse8 which diverted the minds of the world economies Bank of America: $14.9bn towards what, when and how of these crisis. To some extent Morgan Stanley $12.6bn  one could say that to prevent the U.S. economy from the HSBC: $12.4bn impacts of all these debacles, Fed began to cut its policyrates which made the home loan origination and mortgage Royal Bank of Scotland: $12bn backed securities markets to view new heights. The JP Morgan Chase: $9.7bn  economy had the prime focus on outward world problems Washington Mutual: $8.3bn  and the internal housing market was veiled by future Deutsche Bank: $7.5bn  hazards of the booming housing markets. Wachovia: $7.3bn   Credit Agricole: $6.6bn  Volumes were not insignificant even in 1995. Of the total Credit Suisse: $6.3bn  home loan origination on 1995 of $639, sub-prime Mizuho Financial $5.5bn  accounted for $65 billion i.e. 10 percent of the total. These Bear Stearns: $3.2bn  figures had increased to $850 billion in 1997 and the sub- Barclays: $3.2bn prime loans made up 14% of the total loans. Delinquency (Source: www.bbc.co.in) and loan defaults started to increase. As a result of this theissuance had reduced, however the difficulties in this Box 0: Main Credit Losses so Farsegment were overshadowed by other crisis ruling otherparts of the world. In lieu of the dotcom bubble, the Fed began to cut its policy rates and thehome loan origination boomed. In 2001, the total home loan origination was over $2 trilliontwice as large in the previous year in and sub-prime loan issuances was $173 billion at 8 percent.In 2003 the same figures stood at $3.8 trillion with sub-prime loan issuance was $173 billion at 8percent. Yet the total loan origination had declined sub-prime issuance continued to rise andexceeded 20 percent of total mortgage origination.                                                            5 See appendix 56 See appendix 67 See appendix 78 See appendix 8 64  
    • Today, this “housing boom” paints a different picture. The economy has been succored with 300basis points of Fed funds rate cuts since late third quarter 2007, billions of dollars have beenpumped in cash and securities into the banking system, financial markets remain underconsiderable stress, inflation has seen new heights, dollar values and gold prices have seen newhighs and low, growth in consumer spending has slowed, labor markets have softened and theworld stock markets have seen unprecedented lows throughout this period.The sub-prime crisis has engulfed the whole economy into its realm and the ripple effects can beseen across all the sectors of the country that stands at the verge of a downfall. The studyattempts to analyze the impact on the U.S. Economy by looking at the following sectors 1. Collapsing U.S. Housing markets 2. Unemployment 3. Fed rate cut 4. Inflation 5. Falling dollar 6. Widening fiscal deficit 7. US GDP growthCollapsing U.S. Housing MarketsAfter 14 years of rising prices, the housing market has slowed down taking victims from mainStreet to Wall Street.Any decline in the home price growth could have serious implications on the whole economy.The rising prices of the homes enabled the people to borrow against the collateral and the lowinterest rates eased the burden of assuming this debt. Between 1997 and 2006 the real homeprices increased by 85% with an annual increase of 10% to 15% from 2001 to 2005. When thehome prices started to decline and the interest rates increased it became difficult for families toborrow money and buy a new home and thus reduced the consumption on other commodities,which were purchased on the collateral house. The new home sales and real mortgage rate beinginversely co related, a minimal change in any of them could have an adverse effect on the wholehousing sector, and this impact is clearly visible. For example in September 2006 when the realmortgages rose by 0.8 percent from 7.5 % to 8.3 % over the past year, the new homes salesdeclined from 323000 to 257000 which marked a 20.3 percent decrease, which was a hugenumber.The most important reason why the families could expand their credit faster than the value oftheir homes was the use of variable interest rates debt instead of fixed rate mortgages. Thesevariable interest rates allowed families to easily purchase new homes as the short term interestrates were lower than the long term interest rates which lured the low income people. The initial 65  
    • interest rates were at historic low levels with the expectations that the hopefully increasingincomes will enable them to pay for the future increasing interest rates. Besides this,homeowners financed their homes by borrowings on the basis of the equity, which had a veryless share in the whole home equity. This helped to keep the cost of the first mortgages low. Inaddition, many home equity lines also offered low rates that were initially lower than those offixed rate mortgages.So the ARM encouraged more and more low-income consumers to purchase homes withoutmuch worries of high interests. The share of ARM’s rose to 16% in 2004 as compared to 13% in2001 and the share of ARM’s and home equity lines out of total mortgage debt grew to 25% oftotal mortgage debt from 16% over the same period. Adjustable Rate Mortgages were, thus,preferred more for home purchases rather than fixed rate mortgages.As of the third quarter of 2007, 43 percent of foreclosures were on sub-prime ARM’s, 19 percenton prime ARM’s, 18 percent on prime fixed-rate mortgages, 12 percent on sub-prime fixed-ratemortgages, and 9 percent on loans with insurance protection from the Federal HousingAdministration. The fact that foreclosures have been dominated by ARM’s likely reflects theshift in the mortgage landscape from fixed to floating rates over the last few years. Indeed,anecdotal evidence suggests that foreclosures have primarily occurred well ahead of the resetperiod, suggesting that the deterioration thus far has been a function of fraud, speculation, over-extension by borrowers, and the effects of weak underwriting standards.Homeowners’ dependence on ARM’s increased sharply after 2000. While these variable interest ratemortgage instruments helped home buyers purchase a home in the middle of a housing boom, they alsoleft them more vulnerable to interest rate increases when the rates on the loans reset at higher levels. Theincreasing interest rate on the Adjustable Rate Mortgages increased the delinquency rates leadingto more of disclosures. This unexpected rise in the ARM rate left the low-income borrowers withthe only option of letting the homes to be foreclosed since they were unable to pay the monthlyinstallments, once the rates shot up much more than ever expected. The surging homeforeclosures increased the inventory, which reduced the prices of the houses to their minimum 66  
    • Figure 5: Relative Size of Variable Interest Rate MortgagesFigure 9 shows the falling home price indices. With the increase in unsold inventory the homeprices saw decline in the indices and continues to do so. Foreclosures are adding to the supply ofunsold homes and thats putting downward pressure on prices. Figure 5: Home Price Indices 67  
    • U.S. home prices dropped 8.9 % in the final quarter of 2007 compared with a year ago. Thenumber of homes facing foreclosure climbed 57 % in January from the previous year (see figure10) and more lenders are being forced to take possession of homes, which they are unable todump at auctions.Due to the declining prices investors are taking huge losses to rewrite the declining value ofsecurities backed by mortgages. Stalled by swelling inventories and weak demand, homebuildershave been recording record losses quarter after quarter. The unprecedented decline in U.S. houseprices will lead to further pain for financial institutions, who collectively own more than $1trillion worth of sub-prime debt. Economists worry the housing slump will plunge the broadereconomy into a recession.Figure 6: Foreclosure starts rateHousing sector contributing 12% of the total service sector to the GDP growth, any hit inthis sector can lead to huge losses engulfing the whole financial sector of the economy andultimately affecting other economies of the world linked through ties of globalization. 68  
    • PROJECTED ECONOMIC LOSSES‐JOINT ECONOMIC COMMITEE  * 2 million foreclosures will occur by the time the riskiest subprime adjustable rate mortgages  (ARMs) reset over the course of this year and next.    * Approximately $71 billion in housing wealth will be directly destroyed because each foreclosure  reduces the value of a home.    * More than $32 billion dollars in housing wealth will be indirectly destroyed by the spillover effect  of foreclosures, which reduce the value of neighboring properties.    * States will lose more than $917 million in property tax revenue as a result of the destruction of  housing wealth caused by subprime foreclosures.    * The ten states with the greatest number of estimated foreclosures are California, Florida, Ohio,  New York, Michigan, Texas, Illinois, Arizona and Pennsylvania.  But there are several others that are  close behind in the rankings.    * On top of the losses due to foreclosures, which this report examines, a 10 percent decline in  housing prices would lead to a $2.3 trillion economic loss.  *States and local governments will lose more then $917 million in property tax revenues as a result  of destruction of housing wealth caused by subprime foreclosures.  (Source: New JEC Report: Subprime Crisis To Cost Billions In Family Wealth, Property)Values, And Tax  Revenues Unless Action)   Box 0: Projected Economic Losses 69  
    • UnemploymentUnemployment rate has surged due to the crisis confronted by country. The U.S. lost jobs inMarch for the third consecutive month, adding to evidence the economy is in a recession.Payrolls fell by 80,000 in March this year, the most in five years, after a decline of 22,000 inJanuary and 63000 in February. The jobless rate rose to 5.1 %, reflecting a shrinking labor forceas depicted in Figure 11.Over the past 3 months, payroll employment has declined by 232,000 with a decline worth80,000 in the month of March, now, which has surged to 134,000 in April. The number ofpersons unemployed has risen to 7.8 million from 434,000 in March showing a 0.3 % pointincrease to 5.1% in this month. Comparing the figures with last year, the number of unemployedpersons has risen by 0.7 % point leading to a number summing up to 1.1 million.These figures have been attributed to a consequent decline in the main sectors of the economy.The employment in construction has declined by 51,000 in March out of which most of theunemployment was among specialty trade contractors. Manufacturing employment fell by48,000, totaling 310,000 over the past 12 months. Moreover, employment services reduced by42,000 leading to a total loss of 210,000 jobs. Employment in financial activities also saw a fallof 120,000 jobs in the last month. Figure 7: Unemployment In U.S.A (Source: www.tradingeconomics.com) 70  
    • The unemployment figures are rising, housing construction has slowed and related sectors arefacing downturn in their growth figures. With the Homebuilders trimming staff, the biggesthousing slump in a quarter century deepens.Fed Rate CutUS economy, sinking into recession has the last resort by the way of increasing the moneysupply by its monetary policy measure of reducing the interest rates thereby injecting moremoney into the economic system.The Federal Reserve Bank cuts this overnight interest rate and makes it easier for banks to lendand borrow among themselves due to the low interest rates. Banks then provide loans at a lowerrate of interest to the ultimate borrowers i.e. theretail borrowers thereby increasing the moneysupply in the whole economic system. (Aside thisFed also has the option of pumping in liquiditythrough Open Market Operation.)Since September 2007, the Federal Bank hasslashed the interest rates six times from 5.25% to2.25%. This 300 basis point cut has been done witha view to increase the liquidity situation. Bycutting interest rates the U.S. Fed expects tostimulate the consumption due to the lowermortgage payments and thus trigger a recovery in Figure 7: Fed Rate cuts in USthe U.S. economy.Interest rate cuts are expansionary tool used to provide growth to the economy since theytypically lead to more lending, generating, more business and growth. The federal funds rateaffects from how much consumers pay on credit cards and home equity lines of credit, to the ratepaid by many businesses on loans tied to banks prime rate.US economy, which is facing the severe credit crunch, finds no better resort then reducing thefund rates. However if more money is injected into the economy the direct and the most severeconsequence could be the increased inflation affecting the dollar that has been explained further. 71  
    • InflationInflation is a direct outcome of increase in the supply of money. The increased money supplyincreases the purchasing power thereby putting additional demand pressure on the prices. Sowhile the fed rate cut is considered to be a positive move to prevent the economy from slippinginto recession, inflation becomes the incidental side effect.The impact of fed rate cut in September 2007, from 5.25% to 2.25% in March 2008, spiked theinflation to its peak at 2.5% from 2.1% and is expected to climb further.In 2008, the Consumer Price Index rose 0.3%, compared to February. In the month of March theretail prices rose up by 4% over last year. 17% increase in the energy prices and 4.4% increase inthe Food and Beverage prices hiked the inflation rate. The 1% decrease in the weekly wages hasworsened thesituation.Fed official haveforecasted that thepersonalconsumptionexpenditures priceindex will rise 1.7% to 2 % next year.It is hard to escapea growing sense ofdisquiet about thedangers and theconsequences of Figure 7: Inflation Rate in USAthis aggressivemonetary policy. Real interest rates in U.S. are now negative, with average inflation of 3.1% andeven core inflation of 2.3% surpassing the nominal rate of interest. Since the 1st fed cut inSeptember the trade weighted dollar has fallen by about 6%, while a broad basket ofcommodities is up by around 19%. 72  
    • Falling Dollar “The dollar is our currency but your problem” Treasury Secretary John ConnallyThe decline in the value of dollar has one of the most severe effects that can cripple thewhole economy and paralyze the markets. The hit on the dollar has affected the value ofcurrencies worldwide with Euro and Yen trying to overtake the U.S. dollar.The depreciation of dollar implies a loss in its value in comparison to other currencies. In simplewords we can say that dollar can buy fewer foreign goods as it could previously. If the value ofdollar decreases then more dollars have to be paid to buy a commodity. This in turn implies thatforeign goods become expensive in comparison to the domestic goods. In such a case importshave to be decreased to avoid excessive outflow of currency and maintain the liquidity situation.But the shortage of liquidity could be met either by increasing the government savings(accumulated through more of tax collections) or by resorting to foreign aid i.e. debt. Since thereis a shortage of liquidity interest rates have to be decreased but again crops in the problem ofincreased liquidity further depreciating the dollars! But the major concern, which the U.S.economy is facing, is that has the liquidity dried up?Aggressive moves by the Fed Bank by reducing the Fed Rates and pumping in more cash intothe economy, leads to greater liquidity which reduces the value of the ‘excessively availablemoney (i.e. the dollar) leading to depreciation of dollar. This weakening of dollar strengthensother currencies.Moreover, a rate cut also means global currencies moving to countries that offer high interestrates due to arbitrage opportunities. This leads to appreciation of currencies across continents anddepreciation of U.S. Dollar. When dollar depreciates, goods from other countries become costlierin U.S. leading to inflation. The goods available in other markets at cheap prices encourageexports in the economy. Weakening of the dollar correspondingly strengthens the U.S. exports.However a weak dollar could erode interest of international investors in buying dollar-denominated securities and investments in treasuries as explained later. 73  
    • The sub-prime crisis has given a push to the value of other currencies especially the Euro, whichstands as the next currency for foreign reserves. “The euro is our currency but everyone’s asset” -Joseph Christl, member of Governing Board of the National Bank of Austria                     Figure 7: USD vs. Euro (Interbank Rate)With the decline in the value of dollar owing to the crisis, Euro has been the largest gainer. Thedollar has seen a 44% decline against the Euro since 2002. A large number of foreign-exchangereserves are held in U.S. Treasuries leading to an enormous downside risk. Euro on the otherhand, has established itself firmly in the capital markets and the bonds market.Even the traditionally weaker currency the JPY too has spurted up in the remote past. Among thereasons has been the unwinding of the carry trade. As the Dollar lost its value and space as animportant currency so did the faith in the investors in the Dollar denominated assets. Thus, whenthe U.S. economy sank, investors unwound their positions in the U.S. and capital took flight tothe originating country.Japan that has had a very low rate of interest had encouraged borrowing from their economicsystem and the same would then seek out better returns. In majority of the cases, either the U.S.was the final investment target (due to the housing sector boom) or the funds would be channeledthrough the U.S. financial systems since the U.S.D had universal acceptance. As a consequence,when the U.S. economy tumbled and U.S.D lost its sheen, the funds flew back to the homeeconomies. This put additional pressure on the U.S.D. 74  
    • Figure 8: U.S.D vs. JPY (Interbank Rate)Another important relation of the U.S. dollar is with the U.S. Treasury bond. Treasury bills,notes and bonds are sold by the U.S. treasury Department carrying low rates of interest. This lowinterest rate makes the bonds the safest investment since they are backed by the U.S.Government. Being auctioned at the open market the interest rate keeps on fluctuating andhereby affecting the fixed rate mortgages for which it serves as a benchmark. Figure 9: U.S. Treasury Yield Curve Rate 75  
    • Now as the Treasury note and bond yield increase so do the interest rates on fixed ratemortgages. This makes it more expensive to buy a home, decreasing the demand for homesthereby decreasing the prices. This then has a negative impact on the economy and can slow theGDP growth. However, the higher Treasury note and bond yields mean that the Govt. will beforced to pay a higher rate of interest to attract buyers. But the high level of U.S. debt could be acause of worry to the investors due to which they begin to purchase less t-notes and bonds evenat high interest rates.Usually, longer the time frame the higher the yield because investors want a higher return forallowing their money to be tied for a longer period of time, known as the yield curve. Howeverin January 2006, the yield started to flatten. This means the investors did not require a higheryield for longer term notes, because the investors started to believe the economy is entering intorecession.  76  
    • Widening Fiscal DeficitThe increasing trade deficit is another matter of concern worsening the situation. As statedearlier a decline in thevalue of dollar also has asubsequent impact on thetrade deficits as wellspecifically the currentaccount deficit. If there is adecline in the value ofdollar one has to pay moredollars for thecommodities, so value offoreign goods decreases.But the shortage ofliquidity jeopardizes thesituation. However theshortage of cash can becurbed by either increasingthe savings or takingforeign help i.e. debt.However, as the interest Figure 9: Federal Fiscal Positionrates are kept low by theFed (Fed rate), there is not much incentive to save9. Also as the economy takes a downswing, thesavings rate in the economy also slump. Thus the economy has no option but to borrow.A decline in dollar makes imports more expensive and exports more competitive, but if there isno accompanying rise in the nation’s aggregate saving, the result may be a strain on capacity anda rise in interest rates, resulting in a subsequent rebound in the dollar. Fiscal policy is directlyrelevant because government saving is part of national saving. When the government is dissavingit is placing pressure on the domestic use of resources and thus exerts pressure tending to widenthe trade deficit.The dollar has declined 32% against the euro in the last two years. In simple words, Americangoods and services are 32 % cheaper for Europeans. This means that U.S. companies are more                                                            9 Liquidity Trap: when the nominal interest rate is close or equal to zero, and the monetary authority is unable tostimulate the economy with traditional monetary policy tools. In this kind of situation, people do not expect highreturns on physical or financial investments, so they keep assets in short-term cash bank accounts or hoards ratherthan making long-term investments. This makes the recession even more severe, and can contribute to deflation. 77  
    • competitive and this increases exports. Exports have gone up 12% from $1.4 trillion in 2006 to$1.6 trillion in 2007 but there has been a subsequent increase in the imports as well from $1.86trillion in 2006 to $1.96 in 2007 or 5% widening the trade deficit gap.From 1997 to 2004, total U.S. saving fell by 4 % of GDP (from 17.6 % to 13.6 %). This was themain force driving the widening of the current account deficit by a similar amount (from 1.6 %of GDP to 5.7 %). In turn, a driving force in the decline of national saving was the downswing inthe U.S. fiscal balance by about 5 % of GDP from 2000 to 2004, even after taking out cyclicalinfluences. The U.S. fiscal erosion mainly reflected a decline in federal tax revenue, which fellfrom 20.9 % of GDP in 2000 to 16.3 % in 2004. The tax cuts of 2001 and 2003 were a keysource of this decline, accounting for a reduction of tax revenue by 2.6 % of GDP in 2004 fromlevels that otherwise would have been reached and private saving was also falling. From 1990 to2005, personal saving fell from about 7-1/2 % of disposable income to about 1-1/2 %. This wasmainly because the households felt richer due to the stock market boom, and then (even moreimportantly for most households) the housing market boom. With windfall gains more thancovering their target wealth accumulation, households saved less and less out of current income.Maybe that process will begin to reverse with the now stagnant housing market and more normalstock market conditions.The current account deficit has risen from 1.7 % of GDP in 1997 to about 7% in 2006. Themain factor driving the widening deficit has been the real appreciation of the value of dollar by28% from 1995 to 2002. The dollar fell by 13 % from 2002 to 2006.In 2007 the total U.S. trade deficit was $7078.5 billion that had improved by $50 billion over2006, owing to the higher exports a result of the declining dollar. An ongoing trade deficit couldbe detrimental to the nation’s economy over the long term because it is financed by debt.By purchasing goods overseas for a long enough period of time, U.S. companies no longer havethe expertise or even the factories to make those products. As the U.S. loses its competitiveness,the lower quality jobs increase and the standard of living declines. Due to the large size of thedeficit the investors lose confidence of getting their money back. So in order to get back aminimum amount invested and avoiding losing more, everyone starts selling their Treasury notesimmediately at any price. 78  
    • US GDP GrowthAmong the 40% contribution of service sector to GDP 12% of this growth is attributed to thehousing sector. So a small change in the housing sector can have a very large impact on theoverall GDP.After the robust growth in the summers the economic activities decelerated significantly in thefourth quarter. The U.S. growth had decelerated from 4.9% in third quarter to 0.6% in the lastquarter of 2007 due to the weakening manufacturing and housing sector activity, employment,and consumption.U.S. economy that grew 2.2 percent last year is expected to slow down to 1.5 percent this yearaccording to the IMF.After warning earlier this week that the worlds financial firms could end up shouldering $1trillion (£500bn) worthof losses from the creditcrunch, the IMF said itexpects the U.S. toachieve GDP growth ofjust 0.5% this year, and0.6% in 2009, with thehousing crash gettingeven worse.Conclusion Figure 9: US Economic GrowthThe fall in the housing starts, employment numbers, the declining production, falling incomelevels and decreased consumer spending are clearly evident of the deplorable scenario posed bythe sub-prime crisis. As a natural extension of capitalism where greed inspired innovation, therecovery of the mighty United States of America appears to be a herculean task for all economiesthat have resolved to fight the crisis. The irony of the crisis is that the impact cannot be summedup in numbers of growth, inflation or unemployment rather there is lot more which is yetunknown and hidden.It is clear that the current turmoil is more than simply a liquidity event, reflecting deep-seatedbalance sheet fragilities and a weak capital base which means its effects are likely to be broader,deeper and more protracted. 79  
    • IMPACT OF THE CRISIS ON THE WORLD FINANCIAL MARKETS``The financial shock that originated in the U.S. sub-prime mortgage market in August 2007 has spread quickly, and in unanticipated ways, to inflict extensive damage on markets and institutions at the core of the financial system. The global expansion is losing momentum in the face of what has become the largest financial crisis in the United States since The Great Depression. - World Economic Outlook, April 2008, International Monetary FundAfter having an overview of the repercussions of the Sub-prime crisis on the U.S. economy, theripple effect on the whole world needs to be studied to understand where the InternationalFinancial systems are headed. Though the U.S.A is the epicenter to the crisis the tremors havereached far and wide, taking down even the most resolute of financial structures in its wake -"reflecting the same overly benign global financial conditions, an inattention to appropriate riskmanagement systems, and lapses in prudential supervision."The International Monetary Fund (IMF) corrected its world economic growth rate to 3.7% for2008 against its previous projection of 4.1% in January 2008. As the sub-prime crisis deepens itsroots in the U.S. economy, the world-coupled with the common ties of globalization, seems tohave been bearing the full brunt of the force.According to the IMF the world economy may face a significant slowdown stemming from the sub-prime crisis, and this would be the biggest financial crisis since the Great Depression; with the U.S.having a 25% chance of entering into a recession. The euro region is forecasted to expand 1.3percent in 2008, the Japanese economy by 1.4 percent and China will by 9.3 percent this year.Growth in Asia excluding Japan will be 7.6 percent this year. Figure 19 shows the projections ofworld growth as stated by the IMF. 80  
    • The following figure shows that there has been a subsequent decrease in the growth rates of eachcountry and that of the entire world owing to the sub-prime crisis. There have been persistentliquidity shortages, pressure on capital of banks and other financial institutions, increasing creditrisks that are hampering the growth of other economies. The downside risks for global stability isincreasing the stress, forcing institutions to expand credit, making it difficult to maintain thebalance between the macroeconomic stability and the world growth. Figure 10: World Economic GrowthRising spreads have led to mark-to-market losses for banks on their holdings of debt securities.The cost of credit has thus increased as growth prospects have decreased. The pressures onequity valuations have also increased as the shares of companies have been hit really hard.As the developed economies face a rising tide of sub-prime turmoil’s mess, the emergingmarkets and developing economies seem to have been somewhat insulated from much directadverse impact, due to the strong productivity gains, improvements in terms of trade reflectinghealthy commodity prices, and improved policy frameworks that have helped sustain access tocapital. The fact that many of these markets still operate under a fairly strongly regulatedfinancial system, too helped reduce the impact to a large extent. The combination of stronginternal growth dynamics, a rising share in the global economy, and more resilient policyframeworks appear to have helped reduce the dependence of growth performance of emergingeconomies on the advanced economies business cycle. Though, it may be wrong to state that theEmerging market economies have been completely insulated, it may be safe to say that the 81  
    • impact could have been much wide-spread and tumultuous, had the economic systems had inter-linkages that were more profound.Spillovers have become smaller from what they were in the past, but they are still important.Spreads on debt of emerging market sovereign and corporate borrowers have widened sharplysince October 2007, and equity markets between the developing and emerging countries alsoretreated in early 2008. A number of countries were affected more severely than others,especially those whose underlying fundamentals were less sound and that relied on short-termcross-border borrowing i.e. lending by foreign banks or offshore borrowing by domestic banksespecially in eastern emerging Europe. On balance, it is expected that growth in emergingeconomies to ease on account of spillovers from advanced economies, but it would still remainrobust at 7 percent, largely on the strength of China and India.Spillover effect of U.S. Sub-prime Crisis on World EconomiesThe Sub-prime fallout has posed a downside risk for the global economy in 2008.The key risk isthe credit crunch that the U.S.economy is facing andimposing over othereconomies. A related riskpertains to a greater-than-projected decline in U.S.domestic demand arisingfrom the possible interactionof adverse financial events,the correction in the housingmarket, and householdbalance sheets. A severedownturn in the United Stateswould have spillover effectsthrough trade linkages onother advanced economies,particularly on those thathave substantial exposure tostructured products linked toU.S. mortgages. Weakergrowth in advanced countrieswould likely lead to a decline Figure 10: Growth figures forecasted by IMFin commodity prices (though 82  
    • the falling dollar is likely to provide price support to the prices); reducing capital flows to manyemerging markets, portending greater financial sector vulnerabilities and risks to their growthprospects. In particular, a number of countries that have relied on short-term cross-borderborrowing to finance large current account deficits are at greater risk.Keeping in view the recent crisis it is necessary to watch closely how banking systems and creditcreation both in advanced countries as well as emerging markets are moving. Thus far, credit tothe private sector has held up well; although measures of bank lending standards in someadvanced economies indicate a tightening in standards, reflecting partly banks desire to rebuildcapital bases in the wake of sub-prime-related losses. Although such a tightening of lendingstandards is already built into the projections, additional adverse shocks causing losses tomultiply to 2-3 times current levels could lead to much greater credit restraint as some majorfinancial institutions at the core of the system could face severe strains. The corrections in equityprices in early 2008 are likely to add to pressures on household finances.Second, inflation risks remain an important concern for policymakers, particularly in view ofrising oil, commodity and food prices. Global oil markets remain tight and supply shocks orheightened geopolitical concerns could increase oil prices from their currently high levels. Inadvanced economies, slowing growth has alleviated pressure on resources somewhat, but thereare increasing concerns, particularly in the euro area, that high headline inflation resulting fromsurging commodity prices might de-anchor inflation expectations and spillover into higher coreinflation. This risk complicates the monetary policy response to weakening growth prospects.Thirdly, large global imbalances remain a worrying downside risk for the global economy. TheU.S. current account deficit is projected to decline to 4.8 percent in 2008, but it is projected toremain large through the medium term in the absence of changes in major exchange rate.Unfortunately, the adjustment in exchange rates so far has fallen disproportionately on countrieswith flexible exchange rate regimes, and may be producing new misalignments or it may fueldamaging protectionist sentiment. At the same time, there is a risk that, the financing of the U.S.current account deficit may become more difficult.Emerging markets have so far been relatively insulated from the effects in mature markets, butthe earlier benign financial conditions and low interest rate environment have also meant thatrisk taking was higher in some of these countries. However, the stock markets, housing marketsand most notably, the commodities market have experienced the tremors affecting themadversely. 83  
    • Impact On The Commodities Markets Markets pivot on its headCommodity markets have not been immune to the contagion in the global financial turbulence. Being a demand driven sector, the prices of commodities have seen new heights. Besides commodity specific factors, the demand and supply forces play a major role to reinforce a supportive financial environment. There has been an increased demand for the commodities increasing the prices. The strong per-capita income growth, rapid industrialization and rapid growth in the population in major emerging countries i.e. China, India and Middle East have played a great role in increasing Figure 11: Commodity Prices across the world the demand of the commodities. This can be substantiated by thefact that about 56% of the growth in oil consumption during 2001-07 was mainly from China,India and Middle East.Moreover, the low interest rates and effective dollar depreciation have been a supporting factorto the price rise. The effective dollar depreciation seen over the past few years therefore hasmade commodities less expensive for consumers, thereby increasing the demand for thecommodities. On the supply side, the declining profits in local currency for producers outside thedollar area have put price pressures on the commodities.A decline in the effective value of the dollar reduces the returns on dollar-denominated financialassets in foreign currencies. In order to earn the profits otherwise earned, if the dollar would nothave declined and these reduce would not have reduced; the prices of these assets are increasedthereby leading to an increase in the prices of these financial assets. 84  
    • Gold Markets “Golds traditional role as a safe haven asset in times of financial turbulence and instability is enforced in the current market as the metal recouped the majority of losses which occurred in a flight to cash in the beginning of August” Dr. Peter Richardson, strategist of Craton Capital.Gold markets have always been a safe haven due to its fundamental nature as a store of valuerather than return on value as in the case of stocks and currencies. Unlike currencies andGovernment Securities the value of gold is determined by the demand and supply forces, whichare not speculative innature. The price of goldbehaves in a completelydifferent manner as thatof prices of currenciesand exchange rate ofcurrencies.Due to the highly liquidstatus of gold it isconsidered to be thesafest in thecircumstances of globalshocks and monetarychanges. As soon as theinvestors sense any sortof weakness in theircurrency they swiftly Figure 11: Gold Prices in USD/Ouncesmove on to the bullion inorder to secure their wealth.As explained in the previous chapters, the sub-prime crisis is severely affecting the U.S. growthspurring lower interest rates and thus weakening the U.S. dollar that has given a boost to thedemand in gold investment.10 After the outbreak of the sub-prime crisis and the decreasedinvestor confidence, the investors started investing more into the bullion markets. Since the past                                                            10 See appendix 10 for relation between gold prices and Dollar value 85  
    • two years from January 2006 till 30 April 2008 there has been a remarkable increase in the valueof gold by nearly 71%, while the same period saw a subsequent decrease in the value of dollar of25%.Gold touched the pinnacle of $1023.50 an ounce on 17 March 2008 a day before the FederalReserve Bank announced the seventh rate cut in its process of injecting liquidity through itsmonetary mechanism. Figure 22 shows the increase in the value of gold due to high investor’sconfidence on gold as an investment instrument.The declining value of dollar has pushed the prices of gold making investors to hedge throughthe gold market. The long-term inverse correlation between gold and the U.S. dollar and thepersistent rise in gold investment demand since 2001 suggest that the gold might keep onstrengthening and remain an anchor to the Government reserves.Besides this, the changes in the real interest rates have marked impact on investor perceptionsabout the attractiveness of gold as a hedge against this financial asset risk. An inverserelationship between real interest rates and gold price further increases the demand of goldsurging the prices.As a result, the U.S. sub-prime credit crisis could be particularly beneficial to the gold prices. 86  
    • Crude OilThe change in the value of crude oil has a significant correlation with the value of dollar. Oilproducers sell their products in dollars. These dollars are used to purchase other goods ininternational markets. If the value of dollar declines, oil producers have to buy less in theinternational markets with those dollars that cannot tend to afford. The producers thus have toraise the price for oil so that they can compensate for the loss of buying power.As the value of dollars is declining against other currencies, the impact is clearly visible on theincreased crude oil prices in figure 2311. Figure 12: Oil Prices (USD/Barrel)Since 2005 oil prices have seen more than 100 % increase. The increased prices in oil havepartially been attributed to the declining value of dollar as has been explained with respect togold.                                                            11 See appendix 10 for relation between US dollar & crude oil prices and gold prices & crude oil prices 87  
    • MetalsCommodities market has been booming, prices of commodities especially nickel, tin, steel hasreached record highs in the recent months despite credit market turbulence and slowing activitiesin major advanced economies. Although buoyant global growth in recent years is one of thereasons for high prices, forecasts of slower global activity in 2008-09 have prompted concernsabout prospects for commodity markets.Metals market, like all other markets, being driven by the forces of demand and supply has seenincreased consumption due to urbanization and industrialization of emerging economies. Forexample: China accounted for 90% of increase in world consumption of copper. However, slowsupply responses have amplified price pressures. The inelastic demand for commodities, theeffect of rapid price increases on demand tends to be limited, which explains the large spikesseen in the commodity markets. Figure 13: Base Metal IndicesSource: www.kitco.comHowever it becomes necessary to develop a similar relation of the metals with the depreciatingdollar. The rapid expansion of commodities in the financial markets has lead to a direct exposureof the commodity prices to the macro financial shocks the U.S. dollar exchange rate affectscommodity prices because most commodities such as crude oil, precious metals, and industrialmetals are priced in U.S. dollars. The relationship has already been explained. 88  
    • On Stock Markets Gravity proves itselfThe stock markets easily swayed by the sentiments of the investors have witnessedunprecedented lows since the outbreak of the sub-prime crisis. The stock markets which dorequire not even the slighter of a second to foresee new changes, have primarily been driven bythe various sentiments in the mortgage markets.The world’s stock market has been in full churnever since BNP Paribus declared on 9 August2007 that it was unable to value its threeinvestments on Asset Backed Securities and totemporarily suspend its redemptions. IKBDeutsche Industriebank, a German bank was thefirst one who rocked the boat and the effectshave been evident since then on the collidingstock markets dominated by prominentvolatilities.There were volatile movements in equity marketsamid continuing stress in global financialmarkets which arose due to the disturbances inthe U.S. There have been considerable declinesand recoveries with each new announcement of arate cut or companies filing bankruptcy or new declarations of   January Market Fallers  losses. Euro area stock prices Turkey ‐22.7%   mirrored the China ‐21.4%  movements in Figure 13: Major stock market indices Russia ‐16.1%   the U.S. market, India ‐16%  albeit with a somewhat more pronounced amplitude. Paris ‐12.3%  London ‐8.9%  Such has been the impact of the changes in U.S. markets that a New York ‐6%  100 basis-point increase in U.S. short term rates leads to a 1.7 (Source: Standard and Poors)  percent appreciation of the U.S. dollar, whereas an equally sizedBox 0: Major Market Falls in increase in European short-term rates produces a much larger January 2008 appreciation, 5.7 percent, in the European exchange rate. 89  
    • Equities are much lower than at the beginning of the turmoil. Credit spreads have increasedsubstantially, and risk aversions remain high. Exposure to non-performing structured products,global shortage in U.S. dollar funding and widening interest rate differentials with respect to theU.S. dollar are further weakening the global markets. Lost investor confidence seems to furtheraggravate the whole situation.According to the Standard and Poor’s World markets have lost $5.2 trillion in the stock marketsin January 2008. 50 out of 52 share indexes around the world ended in southwards movingdirections.Volatility in world financial markets has increased substantially in recent months. The U.S.economy is experiencing a sharp slowdown, maybe even a recession. Figure 13: Dow Jones IndexAs figure 26 shows there has been substantial volatility in the Dow Jones Index which took oneyear to touch a peak of 14000 points but within 6 months it lost 2000 points due to the crisis.Similarly NASDAQ also saw similar trends in the indices. The declining NASDAQ index showsthat the net effect over the past two years has been a mere 10.12% increase after reaching highsup to 2859.12. 90  
    • Figure 14: NASDAQ IndexThe Japanese stock exchange has also moved in line with the world stock exchanges, moving in thedownwards direction. Figure 15: Nikkei 225 IndexAnother interesting result relates to differences in the reaction of U.S. and European exchangerates to movements in domestic interest rates. A 100 basis-point increase in U.S. short rates leadsto a 1.7 percent appreciation of the U.S. dollar, whereas an equally sized increase in Europeanshort-term rates produces a much larger appreciation, 5.7 percent, in the European exchange rate. 91  
    • Looking at international transmission shocks to U.S. short-term interest rates exert a substantialinfluence on euro area bond yields and equity markets, and explain as much as 10 percent ofoverall euro area bond market movements. In almost all cases the direct transmission of financialshocks within asset classes is magnified substantially, mostly by more than 50 percent, viaindirect spillovers through other asset prices.   Figure 16: DAX IndexDecline in the United States reflected downwards revision in investors perception of the outlookfor general economic activity and thus corporate profits in the U.S. economy. In line with theglobal stock market environment euro area stock prices declined over this period. 92  
    • On Some of the Larger Economies Euro and JapaneseAt the onset of the sub-prime crisis the world did not wake up, in spite of the forewarnings bymany economists. The world markets too ignored the possible linkages in the world economydue to the damage that the U.S. might face. It took a long time to identify what the crisis couldlead to, weakening of monetary base of major economies, increasing the prices of commoditiesunexpectedly, dipping growth curves and heightening inflation figures.Amongst these, the Japaneseeconomy and the Euro zone requiresa special mention as these were thenext most developed economicsystems after the U.S.A and even acursory study of these gives a birds-eye-view of the strong linkages thatpersist in the global economicsystems. These economies are stillstruggling with their own traumasand tribulations.When the sub-prime crisis eruptedby end third quarter 2006 in theU.S.A, the Japanese economy wasexpanding and consumer priceswere moving up. Due to internalreasons such as negativecontribution from public demandand private inventory investmentgrowth fell by 0.2%. By thebeginning of January 2007, the Figure 16: Main developments in major industrializedeconomic activities continued to economiesrecover steadily while inflation remained subdued.While most of the economies in the Euro zone had a declining growth in the last quarter of 2006,in some countries the growth momentum remained unchanged and strengthened.At this time the main risks to the global outlook related to a possibility of renewed increase in oilprices and concerns about possible disorderly developments due to global imbalances, wasslowly raising its head that was to prove a potent force later on. The world was very muchignorant of these tensions, which were all set to engulf the world in a very short span. 93  
    • In the first quarter of 2007 the Japanese economy continued to recover steadily with strongexports and robust domestic demand. The real GDP grew by 1.3% and the CPI inflation haddeclined. The overall outlook for the external environment was favorable.As a reaction to the spreading financial market turbulence the U.S. Federal Open MarketCommittee announced a 50 basis point reduction in the primary credit rate to 4.75% inSeptember 2007. However the Bank of Japan left the rates unchanged at 0.50%. Due to aslowdown in the private residential investment the real GDP grew by mere 0.1% against 0.8% inthe previous quarter. Negative contributions, most notably from housing, continued to dampenthe inflation. On the other hand, some of the European banks announced increases in the interestrates to counteract the inflationary pressures (this trend was to reverse soon).Throwing light on the housing situation, many of the non-euro area EU countries hadexperienced rapid growth in residential housing property. In most of the countries mortgageinstruments had become widely available at lower cost, longer maturities and on flexible terms.In many countries low nominal and real interest rates prevailed due to the improvedmacroeconomic stability and lower risk premia, along with other factors like output growth,rising employment and higher income expectations. (See Box 8) 94  
    • HOUSE PRICE DEVELOPMENTS IN CENTRAL AND EASTERN EUROPEAN COUNTRIES  In recent years many of the non‐euro area EU countries in Central and Eastern Europe (EU9) have experienced rapid growth in residential property prices.Between 2004 and 2006 the average annual growth rate was over 30% in the Baltic countries, Bulgaria and Romania, and between 6% and 8% in Polandand Slovakia. It becomes essential to know the main drivers, sustainability and macroeconomic implications of the housing boom.  Given the usual rigidity of housing supply, demand factors play a key role in determining house prices in the short to medium term. In most of thesecountries mortgage instruments have in recent years become more widely available at lower cost, longer maturities, and on more flexible terms (such aslower  amortization  requirements  and  higher  loan‐to‐value  ratios).This  is  attributable  to  the  deepening  of  and  increasing  competition  in  the  mortgageloan markets, reflecting both the low initial level of financial development and integration into the EU. Moreover, in many countries low nominal and realinterest rates have prevailed, owing to improved macroeconomic stability and lower risk premia.  Other  important  factors  are  strong  output  growth,  rising  employment  and  higher  income  expectations.  In  addition,  in  several  EU9  countries  fiscalincentives, such as subsidies to the residential property price indicators presented for the EU9 countries differ in statistical quality.   The  external  environment  of  the  euro  area  saving,  lower  interest  rates  on  mortgages,  tax  deductibility  of  interest  payments  and/or  reduced  propertytaxation, have also played a role. However, some of these measures have recently been curtailed.  In the past house prices in many of these countrieswere distorted owing to large‐scale public/municipal ownership and rent regulations, which effectively contained prices below their market value. Thus,the recent price increases might to some extent is viewed as a correction of these distortions.  Furthermore, strong demand for new houses may reflect the poor quality of the initial housing stock and the rapidly changing geographic concentrationof economic activities. In some countries, in connection with EU entry, foreign demand for housing has increased, primarily in capital cities and holidayresorts. Moreover, there was a temporary boost to demand around the time amid anticipation of higher house prices on account of hikes in the VAT rates onconstruction materials.  In the medium to longer run house prices are also determined by supply factors, especially by regulations in the housing markets. In several EU9 countriescomplicated spatial planning and construction procedures appear to have depressed supply.  One  of  the  main  channels  through  which  housing  market  developments  can  affect  the  economy  as  a  whole  is  the  link  with  household  consumption.Higher  property  prices  may  increase  households’  wealth  and  boost  consumption,  contributing  to  consumer  price  pressures.  The  impact  on  aggregateconsumption is, however, not straightforward, since not all households are affected in the same way. This depends, among other things, on whether ahousehold owns a property and, if it wishes to sell, whether it intends to trade up or down (for instance, a household climbing the “housing ladder” mayactually reduce consumption limitations for the EU9 countries).  Property prices may also affect consumption via the credit channel, since residential property can be used as collateral for borrowing. A rise in the valueof property may increase the collateral available to its owners. Although growing in importance, mortgage equity withdrawal instruments are relativelyrare in the EU9 countries. Housing market developments can also affect the economy as a whole via financial markets. Given the strong growth of loansfor house purchase, an increasing part of financial intermediaries’ assets in many EU9 countries has become linked to residential real estate values. It isdifficult to assess to what extent this reflects a catching‐up development and to what extent this may be excessive lending. Although average householddebt levels are still relatively low in several countries, rising interest rates may be negatively affecting the balance sheets of households. The interest ratechannel may be particularly important in Hungary, Poland and the Baltic countries, where the vast majority of mortgage loans are at a variable rate. Anadditional risk stems from the fact that in some EU9 countries a significant proportion of household loans are denominated in foreign currency, exposingborrowers to exchange rate shocks and challenging the effectiveness of monetary policy in controlling credit growth. Moreover, there may be a risk ofdeteriorating credit standards. In some countries loan‐to‐value and loan‐to‐income ratios have increased, making banks and households more vulnerableto falls in property prices and adverse shocks to income and interest rates.  Given the potentially important spillovers from the housing market to the rest of an economy it is important for central banks to monitor house pricesand  mortgage  developments,  analyze  their  main  drivers  and  identify  any  misalignments.  The  link  between  the  housing  market  and  financial  stabilitynecessitates  close  monitoring  of  the  mortgage  loan  markets  and,  where  necessary,  the  adoption  of  appropriate  prudential  measures  on  the  part  ofregulatory authorities. In addition, it is important that households in the EU9 countries become more aware of the risks when engaging in certain formsof mortgage borrowing, especially at variable interest rates and in foreign currency. These risks seem to be often underestimated by households.  Finally,  other  relevant  policy  areas  (such  as  fiscal  incentives  and  housing market  regulations)  should  be  overhauled  so  as  to  alleviate  housing  pricepressures.  Box 0: House Price Developments In Central & Eastern European Countries 95   
    • Even by the end of the year, the subprime crisis did not show much effect on the developedmarkets, even when the crisis were in full swing elsewhere. In December 2007 economicactivities in Japan recovered steadily which is evident by the 0.5% growth figures in the lastquarter of year 2007 against 0.4% in the previous quarter. The CPI fell to 0.4% from 0.6% inSeptember 2007. The growth in European economies was however unaffected by the turmoil andpersisted to grow at a favorable pace. However there were risks emanating from oil market andelevating oil prices.In January 2008, the global activities remained resilient due to the global repercussions of theUS slowdown. On account of higher commodity prices consumer price indices remained at ahigh level. Japanese economy as well as the European nations did not see much deviation in thegrowth figuresBy February, the Japanese economic had slowed down due to the revision in the BuildingStandard Law12 in June 2007 which resulted in a significant drop in housing corporateconstruction starts in the second half of 2007. The CPI inflation had turned to a positive figure upto 0.7%. Most of the European nations witnessed increased inflation along with a decreasedconsumer confidence. The Bank of England (BoE) decided to cut its main policy rate by 25 basispoints to 5.25%. Growth momentum decelerated on the back of tighter credit conditions,negative wealth effects stemming from the weakness in house and equity prices, and weakerforeign demand.During the month of March, due to the persistently high market volatility and new announceddata pronouncing weakness in U.S. economic activity, the global area had weakened in the lastmonth of the first quarter of 2008. In the fourth quarter of the year 2007, the real GDP grew by0.9% quarter-on-quarter basis due to strong exports. For the whole year the real GDP grew by2.1% against 2.4% in 2006. While the CPI stood at stood at 0.8% in the previous month. Bank ofEngland (BoE) further decided to leave the main policy rates unchanged after previous rate cutsin February. There were falling investments and employment intentions. Inflation rates wererising due to increases in prices of fuel and imports.In April, the outlook for the Japanese economy had become more uncertain. Risks had increasedon the downside, in the wake of the global financial turmoil and rising raw material prices thatcould lead to decreased private consumptions. The European countries, mainly Englandwitnessed a slow growth at 0.6% with down consumer confidence indicators and weak growth innon-food sales predominantly. Considering the rate cuts by Fed Bank, even the BoE decided tocut its main policy rate to 5.00% from 5.25%. Inflation in other countries remained at high levelsand the GDP growth in few nations (Denmark and Sweden) were just below long-term averagesfor each company.                                                            12 In 1981 the Building Standard law was amended to introduce plastic designs into architecture of buildings whichwere exposed to seismic forces, in order to protect humans and property from earthquakes. 96  
    • Both the weakness of U.S. economic activity and high financial market volatility are having adampening effect on the pace of the global expansions. However global economic activitiescontinue to be supported by the resilience of economic markets, mainly Asian market.Conclusion:The shortcoming of the not so inefficient sub-prime mechanism was that the quantum of lossesthat may result from the sub-prime lending mechanism was not understood well, nor was thetrajectory with which the contagion could spread engulfing the whole world economies. Finally,the high-liquidity fed, low risk priced global capital market is contextually not well equipped todeal with a situation where a trillion dollars or more of assets were to suddenly turn illiquid. 97  
    • IMPACT ON INDIA “India has always been outside the epicenter of events and yet we get drawn in by the sheer gravitational pull of our geography, resources and potential.” Anand Mahindra, Indian Economic Summit. 2-4 December 2007Life is usually always easier thousands of kilometers away from the epicenter of any crisis.While it augurs true for events of real nature, when it comes to economic affairs ripple-effectalmost always ensures that the chain of events does have some incidental fallouts (bothanticipated and unanticipated). The degree and intensity vary according to the proximity to theorigin of the ripple. In India’s case we lie in the outlier of the ripple, meaning that the effects ofthe events would be felt, only after a lag and that too the effects shall to a large extent remainmuted. The effects on the Indian economy would be either through the investments made indollar denominated investments, indispensable need of crude oil or hedging of gold – all beinggoverned by the mighty dollar. The Indian economy as one of the emerging market economies(EME’s) was not exposed to complicated mechanisms of the sub-prime lending and itsoffspring’s-CDO’s and MBS. Owing to the strong macroeconomic fundamentals, non-convertibility of current account and highly regulated financial systems the economy appeared tobe completely insulated from the emerging crisis. It was only later on that ICICI rocked the boatand sowed the seeds of doubt that the Indian economy may not be safe, altogether and that theremay actually be direct linkages.The world unified with common ties of globalization had always been hungry to relish the tasteof new instruments aimed at higher yields in shortest possible time. This threat in the immenselyexpanded universe of quantity and variety was satisfied by some Indian banks/companies aswell; which were yet to create both challenges and pitfalls manifold times then the reality.With inflationary pressures in the world economy, speculative bubbles in the Asian marketsdownfalls in the stock markets, increasing risks in the commodities markets, falling interest ratein the money market supported by the increasing domestic demand, Indian economy may, afterall, be feeling the ripple effects. Indirect though, the impact cannot be altogether ignored beingan emerging nation that is preparing itself to maintain its hegemony in the next few decades.Backed by the strong fundamentals, tight rules and regulations by RBI, the Indian economy hasalways played safe and emerged unscathed in the global volatility, which every now and then hasaffected the world. Be it the Asian Currency Crisis or the American dotcom bubble shaking one 98  
    • of the strongest income generating sectors, the Indian economy has been able to sustain itself andstood at such a pedestal through its skilled manpower and semi-controlled market setup.There have been several factors, which have insulated the economy from the adverse impacts: First and foremost, the promising figure of over 8% GDP makes India a booming economy which can very well nurture the financial inflow i.e. investments by the foreigners in our country, and translate them into more finances. The hot money entering into the economy provides lucrative avenues to the investors. Capital Account Convertibility, which prohibits the Indian investors to make direct investments abroad, acts as a shield that jeopardizes the money of Indian Investors. Moreover, our economy is highly regulated through various rules and regulations imposed by the Banking Mechanism. For example, there are caps on the Foreign Direct Investments (FDI) made in India and not every sector is open to FDI’s.Though Indian markets have managed to protect themselves from a greater damage, the Sub-prime Crisis is to be viewed as a wakeup call for the Indian regulatory authorities, to continue tobolster the economy and be on a stringent lookout with adequate measures in place. The muchmaligned regulations have worked in our favor and probably saved U.S. from the direconsequences. Nevertheless as we see in the following pages, our economy has been hurt by thesub-prime crisis and we have tried to trace the linkages. 99  
    • The First Signs First bloodThe first hit to the Indian banking sector came way back on 8 August 2007 when UBS securitiesreleased a report stating that India’s biggest private sector bank, ICICI Bank, is exposed to theU.S. sub-prime market. The report stated that ICICI has an Rs 1,800-crore exposure to the CDOmarket. According to the report, ICICI Bank had a total CDO exposure of Rs 6,000 crore (2% ofthe bank’s total balance sheet size), of which 30% is international. UBS Securities India statedthat the country’s biggest bank, SBI, might also face theheat of the sub-prime shakeout. Companies with forex losses  Net Loss (Rs cr) Later on 6th March 2008, when the ripples touched the ICICI Bank 1149.80 -400ICICI bank that announced mark-to- market (MTM) hit of Maruti 297.70 - 105$263 million (around Rs 1000 crore) in its loans andinvestment exposures. ICICI Bank and its overseas SBI 2442.31 -100banking subsidiaries had an aggregate exposure of $2.2 Ranbaxy 136.80 -79.80billion in credit derivatives, of which around $500 million Axis Bank 361.40 -72was in the books of its overseas subsidiaries. JSW Steel 461 -65.30A direct consequence of this was the provisions that it had Satyam 462.30 -46to create to cover up the losses, which were very large in Infosys 1249 -45terms of size as well as the magnitude. ICICI Bank had to Techmake additional provision of around $74 million in the Reliance 3912 -44 Indlast quarter of 2007-08, after already providing for $189 Bharti 1940 -41million in the previous quarters. These provisions Airtelaccounted for the bank and its subsidiaries in derivatives (Source: Business Standard)like Credit Linked Notes (CLN)13 and Credit DefaultSwaps (CDS). Box 0: Indian Companies with Foreign Losses                                                            13 CLN is a of credit derivative issued overseas for bonds floated by Indian companies. The total investment of thebank in CLNs was $330 million (around Rs 1,300 crore) at the end of December 2007. (Source: Business Standard,March 6, 2008). CDS is an insurance product against which ICICI earns a premium. In return, the risk of the Indiancompany defaulting is transferred to ICICI rather than the original lender. These instruments and other instrumentslike credit-linked notes can be traded. 100  
    • Among PSB’s, State Bank of India (SBI) is having the largest exposure of about $700-million toCredit-Linked Notes (CLN’s), issued on behalf of Indian corporate. SBI is followed by Bank ofIndia ($400 mn) and Bank of Baroda ($329 mn).SBI has confirmed that the bank may suffer a MTM loss of up to Rs 700 crore at the end ofMarch 2008 due to derivative transactions, after making a provision of Rs.40 crore in the lastquarter.Bank of India has reported to raise its provisioning by another Rs 4 crore, over its alreadyexisting present provisioning of about Rs 4 crore. On the other hand, the bank’s internationalbranches also have an exposure of up to $30 million, which are likely to result in a potential lossfor the bank.Bank of Baroda is also expected to set a provision for an additional $2.50 million (around Rs 10crore) for its investments in Credit Linked Notes.Moreover, private banks such as Axis Bank have also stated about the potential losses which theymay suffer. Axis Bank had stated in March 2008 that it has made a provision of $5 million fordepreciation in the value of credit-linked notes. It has also reported that at the end of March, itsclients were having 188 derivatives transactions with an aggregate MTM loss of Rs 673.55 crore.Of the 188 deals, 113 were outstanding transactions dealing in foreign exchange derivativeswhere the aggregate MTM loss was Rs 547.72 crore.Recently, mark-to-market losses worth Rs1365 crores have been recorded of 46 Indiancompanies on account of foreign exchange contracts, fluctuation in exchange rates andcommodity hedging. (See box 9)Internationally, the overall derivative market stands at $ 415 trillion with credit derivatives ataround $41 trillion, growing at more than 25%. The squeeze in the financial markets hassuddenly brought out the embedded risks in these products.Thanks to the RBI policies which have restricted the Indian Financial companies to makeinvestments in foreign markets directly, these companies are to a great extent impervious to thedirect vulnerabilities of CDO’s and MBS’s. 101  
    • On Financial Markets Stock Markets lose their sheenFinancial Sector being the heart of the turmoil is a source of higher potential instability. Figure 31: BSE SensexFinancial markets do the tasks of managing and sourcing capital for projects, helping theeconomy grow and prosper. 102  
    • When the fact of ICICI and SBI’s exposure to sub-prime losses first came into light in August2007, the markets saw a fall, which was however not very severe due to the confident denials bythese banks of any such exposures. As the Indian markets could not comprehend the likelyimpact which was to be seen by the economy in next six months, the markets declined for a verysmall period of time, trusting the statements of ICICI officials who refuted the claims of the UBSreport. However the full impact of the sub-prime crisis to the economy was seen when thealready dipping BSE Sensex fell 951 points on 17 March 2008, after the news of Bear Sternsbeing sold to JP Morgan Chase at about 98% less than its value.Similarly, the banking indices were already was feeble due to the unfavorable provisions in thebudget. The Bank Nifty Index moved in tandem with the plummeting Nifty and Sensex indices.The Bank Nifty Index saw a decline with the early prediction of exposures to the sub-primelosses on 8 August 2007. On 7th March when ICICI announced its provision worth $263 billion,the stock market indices further plunged towards the south marking unprecedented lows. Finallyon 17 March the index saw its lowest point to 6456.55 points after the news of Bear Sterns Figure 16: Bank Nifty Figure 32: Nifty Index 103  
    • fallout.Weak cues from global markets remained a dampening factor for the bourses, triggering sellingeven in the fundamentally strong stocks. While the markets have recovered from their lows of14809.89 on 17th March 2008 to 17434 on 17th May, 2008, it would be difficult to stateconfidently that the worst in now over.The stock markets which have always been ruled by the fundamentals, sentiments and momentumhave brought forward weak fundamentals, misguided sentiments and vociferous momentumwhich is ready to wipe out the entire yields dissuading the investors’ confidence in just one go. On Commodities Market with special emphasis on Crude Oil A fuel to inflationDollar has always been the supreme ruler of currencies across the world since the two worldwars; whether it is commodity prices, bullion values, crude oil prices or money markets, all ofthem have been dominated by then, once considered, mighty dollar.As it has been seen in the previous chapters, with the decline in the value of dollar, the prices ofcommodities have risen at a rapid pace. Gold prices have shot up 71%, oil prices surged by over100% within four years and metal indices have more than doubled. Indian economy alreadyburdened by high inflationary figures (due to food shortages and domestic demand) - theincreasing oil prices have added fuel to the fire. With the growing economy, the demand of oilhas further intensified the inflation situation.The change in the value of crude oil has a significant correlation with the value of dollar. Whenthe value of dollars declines, the price of oil has to be increased by the producers to make goodthe losses that they would suffer due to the depreciation of the currency. These high prices arepassed on to the oil importing countries. In this way, oil rises and leads to inflation that can betermed as the imported inflation. WPI Inflation and its composition 1995-2007(year-on-year basis) percentagesYear All Commodities Primary Articles Fuel Group Manufactured Products1995-1996 4.4 3.1 5.1 4.71996-1997 5.4 9.2 13.3 2.41997-1998 4.5 4.6 13.7 2.31998-1999 5.3 7.6 3.2 4.91999-2000 6.5 4 26.7 2.4 104  
    • 2000-2001 4.9 -0.4 15 3.82001-2002 1.6 3.9 3.9 02002-2003 6.5 6.1 10.8 5.12003-2004 4.6 1.6 2.5 6.72004-2005 5.1 1.3 10.5 4.62005-2006 4.1 5.4 8.9 1.72006-2007 5.7 10.7 1 5.82007-2008 7.4 8.9 6.2 7.1 Table 1: WPI Inflation and its compositionThe Fuel Group holds a prominent share in the WPI inflation (in excess of 14%). Table 1 showsthat the previous year has been a significant contributor to the overall inflation. The inflicteddollar has already surged the prices and the increased domestic demand becomes another factorleading to inflation.It is very well evident in Table 2 that the crude requirements have increased significantly due tothe increased domestic demand. Within a year the crude requirements rose over 40%. Howeverthe subsequent increase in the price of oil from $67 per barrel to over $103 per barrel in March2008 cannot be ignored which exaggerates these figures. OIL TRADE ($ Billions) 2005-06 2006-07 2007-08IMPORTS Crude Oil 42.92 54.99 77.02 Oil Products 6.39 10.09 12 Total 49.31 65.08 90.02EXPORTS Oil Products 11.68 20.04 26.50NET IMPORTS 37.63 45.04 63.52 Table 2: Oil Trade (in $ Billions) (Source: Business Standard, 8 May 2008)Today oil has become such an important necessity that even a 5% scarcity in this essentialcommodity can send the prices soaring. Indias crude oil imports in the last financial yearincreased by about 0.5 million barrels per day (mbd). Global demand is growing by about 1.3mbd, so India continues to need more energy to fuel its growth, and if the already energy-hungryeconomies do not reduce their own demand for oil, then global demand will continue to rise.However, working as per the demand-supply mechanism and pondering over the supply side,there have been periodic disruptions in oil-exporting countries like Iraq and Nigeria. Without 105  
    • additional production the only possible outcome is higher prices, especially since alternativefuels like ethanol have quickly become a source of controversy.To further intensify the inflationary figures, the recent statement by Goldman Sachs stating‘crude oil prices could surge to $200 a barrel in the next two years, which would be none lessthan a super spike, considering the fact that within 10 years there has been a 120% increase from$10 to $120 per barrel since 1998’ provides no ray of hope to our economy confronted with theissue of inflation.Indian economy per se is strong enough to wither almost any economic crisis, given its strongmacroeconomic foundations and stable economic situation. The only nemesis which could digthe grave to the collapse of our economy could be the surging oil prices, ruled by global factors,which renders the economy helpless. On Money Markets and Interest Rates The hinges of growthThe money markets, unlike stock markets, are governed by RBI policies, macro-economicmechanism of demand and supply of money, and to a great extent, the global market forces. Oureconomy had till the recent past been resilient to the adverse impact of the sub-prime crisisinflicting some of the major world economies.As the country is confronted by inflation, RBI has played its moves to help the economy.Through its macro- economic tools of Cash Reserve Ratio, Statutory Liquidity Ratio, Repo andReserve Rates etc, it tried to channelize the liquidity of the entire nation, thereby calibratinggrowth and attempting to rein in inflation. 106  
    • Many changes have taken place since the very first news of sub-prime crisis in 2007. Animmediate impact was the brisk rise in the call money rate in the month of August. Call money isthe money borrowed or lent on demand for a very short period of time i.e for a day. Call moneyis the most active segment of the money market. The interest rates on call money are marketdetermined. Large intra-day variations are not uncommon depending on the demand and thesupply. An increase in the call money rate simply implies increased demand lead by either anyshortage or by any losses which may affect the economy in future. There was such a rapid rise ofabout 25% within a weeks time, which simply implies that the sub-prime crisis had moved themarket sentiments and moved the macro- economic foundations of the country. Figure 16: CRR (Cash Reserve Ratio) 107  
    • Perhaps the RBI had to modify its two very popular tools i.e.Cash Reserve Ratio 14(CRR) andStatutory Liquidity Ratio15 (SLR) to avoid the liquidity crunch which it would have possiblylocated in the near future. The CRR was increased 10 times since 2007, yet the SLR remainedthe same. Figure 16: Call Money Borrowing                                                            14 CRR is the mimimum amount of cash that banks have to maintain. It is the percentage of bank reserves to totaldeposits of the bank.15 Statutory Liquidity Ratio (SLR) is the amont which a abnk has to maintain in the form of cash, gold or approvedsecurities. 108  
    • However a noteworthy fact here is that while the major economies of the world were reducingtheir rates, RBI has been increasing the rates16. This simply implies that our economy hadabundance of liquidity ,unlike other nations who were short of it, undoubtingly directly affectedby the sub-prime crisis. This suffices the fact that our economy is not directly affected by thecrisis! But in the meanwhile, the economy had been struggling with its own domestic issuesprimarily inflation.However, a unique relation which tends to get ignored and veils the sub-prime impact is that ofthe surging oil prices with the inflationary trend of the economy. As it has been explained manya times of the declinig dollar ultimately leading to (imported) inflation, we can refute thestatement that our economy is insulated!Another major impact of the increased CRR is the reduction in liquidity hampering theinterlinked sectors of the economy. As the CRR increases, the interest rates increase and the costof borrowing decreases. This in turn decreases the production activities and negatively effects theGDP.The second aspect is the decreased spending power with the households. Since theproduction activities decrease employment opportunities are limited , the income levels areeffected and all this further lessens the GDP growth. The increased rates postpones many ofthose produvtive activities, which would have taken place otherwise.Many a times it becomes difficult for the RBI to strike a balance between the high ratesdampening the growth and low interest rates increasing inflation. Here lies the dilemma of afrowing economy. High growth with high inflation is as risky as a slow growing economy withlow inflation. Here lies the trick of maintaining optimum liquidity levels keeping in view theeconomy , the country and the globe.                                                            16 Most Central Banks are Cutting RatesCountry Key Policy Rate Change in Policy Rates (basis points CPI Inflation y-o-y since end March 2007) (March 2008)Euro Area Interest Rate on 25 3.6 refinancingUK Official Bank Rate -25 2.5USA Federal Funds Rate -300 4Brazil Selic Rate -100 4.7India CRR +200 5.5Indonesia BI rate -100 8.2Thailand 1-day Repurchase -125 5.3 Rate 109  
    • On INR Challenging the might of the DollarThe weakened dollar has brought along with it a subsequent strengthening of the Indian Rupee.As an emerging economy India has received its share of accolades and appreciations to withstandthe crisis, but there are yet many unexplored facts that have strengthened the Indian fiscal base. The strengthening of the rupee has brought more momentum into the growth path of our country. Indian rupee has increased by 12% in 2007. Fraught with volatility Figure 16: INR vs. USD through theyear, on 7 November, the Indian Rupee touched a 10-year high of 39.16 per dollar, but ended at39.33 that day amidst heavy intervention by the Indian banking regulator and has very recentlytouched the 41 mark.Once again a remarkable job has been done by the RBI to prevent the economy from the veryfrequent volatilities in the foreign currency markets. Even though the declining value of dollar isregistering a free fall against every other currency the impact on the Indian markets is not sograve. There are certain factors depreciating the Rupee such as: • The most prominent being the new heights witnessed by the oil prices. Recently the oil price touched $125 per barrel and is expected to rise further. This rise in prices creates a demand for dollars in order to fund the imports further depreciating the Rupee. • Secondly, whenever the stock markets witness increased selling activities by Foreign Institutional Investors (FII’s) the dollar supply increases reducing the value of the Rupee.The RBI through market intervention withdraws the currency. Whenever the supply of U.S.D ismore than the Rupee, the value of Rupee falls affecting the exports. It is then that RBI sucks up 110  
    • the excess of dollars and issues Rupees inexchange. The Reserve Bank of India has Market Intervention by RBIcontinuously been buying dollars from the marketthrough a few public sector banks to rein in therunaway appreciation of the rupee as a strong Supply of USD  › Supply of INR  local currency hurts exporters’ income in rupeeterms. It has bought more than $90 billion fromthe market this year. Value of Rupee The main reason behind the rising strength of the falls rupee is huge capital inflow into India. Foreigninstitutional investors have bought stocks worthmore than $16 billion this year net of their sale ofIndian equities. BSE Sensex touched a peak of Exports are  negatively affected20873 in Jan 2008 that was a 19.7% increase overthe year. Net capital flows were worth $81.9bnand Foreign Exchange Reserves stood at $275.3bn. This means that the Indian markets areproviding new avenues to foreign investors due to RBI sucks excess Dollars and issuesthe promising nature. Rupees The flourishing stock markets, stability in the Box  1: Market Intervention by RBIprices and the investors’ confidence thus keeps onattracting the foreign investors strengthening the Thus Rupee appreciation is Indian Rupee, marking it as the ace to India’s prevented helping the exporters path to progress.  111  
    • Indian Housing Markets Following the FootstepsThe Indian real estate sector has witnessed a revolution, driven by the booming economy,favorable demographics and liberalized foreign direct investment (FDI) regime. Growing at ascorching 30 per cent, it has emerged as one of the most appealing investment areas for domesticas well as foreign investors. Property prices in India are rising fast, and not just in the biggestcities. As the tech boom spreads across the country, as more Indians buy homes, and as theeconomy grows at faster than 8% a year, real estate is attracting more investors.The second largest employing sector in India (including construction and facilities management),real estate is linked to about 250 ancillary industries like cement, brick and steel throughbackward and forward linkages. Consequently, a unit increase in expenditure in this sector has amultiplier effect and the capacity to generate income as high as five times.Rising income levels of a growing middle class along with increase in nuclear families, lowinterest rates, modern attitudes to home ownership (the average age of a new homeowner in 2006was 32 years compared with 45 years a decade ago) and a change of attitude amongst the youngworking population from that of save and buy to buy and repay have all combined to boosthousing demand. According to Housing Skyline of India 2007-08, there will be demand for over 24.3 millionnew dwellings for self-living in urban India alone by 2015. Consequently, this segment is likelyto throw huge investment opportunities. In fact, an estimated U.S.$ 25 billion investment will berequired over the next five years in urban housing, says a report by Merrill Lynch also statingthat the Indian realty sector will grow from $12 billion in 2005 to $90 billion by 2015Prominent global players like Carlyle, Blackstone, Morgan Stanley, Trikona, Warbus Pincus,HSBC Financial Services, Americorp Ventures, Barclays, Merrill Lynch and Citigroup have allalready checked into the Indian realty market.In fact, real estate has been instrumental in India emerging as the top destination in Asia(excluding Japan) in attracting private equity investments during the first ten months of this year.Real estate accounted for 26 per cent of total value of private equity investments, with 32 dealsvalued at U.S.$ 2.6 billion expecting to pour another U.S.$ 10-20 billion into the sector in thenext three years. 112  
    • The prominent reasons for the housing sector boom are: 1. Indias real estate market is being driven by foreign investors17 from Middle East, U.S. and the UK who have driven prices up in both the commercial and the residential sector. These investors see opportunity in Indias growing middle class and their potential in the future to create housing demand. 2. Liberalization of the lending laws and a macro environment of global liquidity have resulted in easy credit. This scenario has been compounded with a number of foreign multinational banks willing to provide cheap credit. 3. A Growing middle class with high disposable income. Salaries have been growing at almost 12-15% per annum. 4. A booming stock market in the last 4 years has resulted in plenty of wealth creation. 5. A low inflationary global economy has resulted in a low interest rate environment.However there are many apprehensions about the booming real estate sector which forces theIndian economy to reconsider the developments in this sector and consider the fact that will theIndian Housing Market see the fate as the American housing sector did! After the new heightsseen in the real estate sector there is a frenzy that the housing bubble is about to burst in theIndian economy. But the next question which arises is that will the Indian economy face asimilar fallout as U.S. did!Luckily the Indian housing sector will not see such downfalls because there are no sub-primeborrowers prompted by flexible rate schemes by no financial institutions derived by profitmotive and there exist no instruments such as CDO or MBS which could magnify the losses incase of a downturn. But one cannot ignore the fact that there exists the housing bubble whichstands at the verge of exploding due to the following reasons:                                                            17 Foreign Companies investing in IndiaCompanies Investment plans of overseas investorsRoyal Indian Raj Intl $2.9 billionBlackstone Group $1 billionGoldman Sachs $1 billionEmmar Properties $800 millionPegasus Realty $150 millionCitigroup Property Investors $125 millionLee Kim Tah Holdings $115 million 113  
    • 1. A global liquidity crisis has forced banks in the U.S. to tighten credit for borrowers. This is resulting in real estate prices to fall in the U.S. If the credit worsens some of the multinational banks in India may need to tighten credit policies in India as well. 2. The prices have reached levels where it is practically unaffordable for the common man to buy any property in decent localities. Although wages have considerably increased, real estate prices are almost out of reach now for the common man in India. 3. Real estate prices are being driven up by speculators, foreign investors and business men who are buying houses purely for investment and not to reside in them. 4. Inflationary indicators are moving up showing signs of a recession in the U.S. or at least slow GDP growth in year 2008. A slowing down of U.S. economy will impact the exports of all the developing countries. 5. The strengthening of the rupee is beginning to hurt exporters in India. If the rupee strengthens further it has a potential to trigger a slide in the Indian stock market. 6. The Reserve Bank of India is taking steps to curb speculation in the Indian Real Estate Market.A real estate market is never as transparent as the stock market and any such predictions ofbooms or busts are only speculator in nature. However, the macroeconomic indicators arepointing to a change and the year 2008 will probably make it clear on whether these prices aresustainable. 114  
    • On Indian Economy: Structural Changes The proverbial struggle of Good vs. BadIndian economy has always been one of those economies that have always held a prominentposition in the world. There have been times when the world sang the songs of England theEmperor of The Colonies; Germany, The Stalwart of the West; U.S.S.R., The Mammoth OfEurope and finally The United States Of America, The Superpower. Today the world has shiftedits focus and all eyes are set on the emerging nations, the BRIC nations all set to rule the world.India, which forms one of the vital parts of the BRIC league, has lots to exhibit and prove itsexistence which the growth figures, dynamic taskforce and invincible educational system havealready spoken for and continue to do so.The progress of a nation can be marked by the structural shift of workforce from the agriculturalsector guided by more of uncertainty to service sector a product of knowledge, skills and logicalpredictability. Turning back the pages of history there has been a significant sectoral change inthe economic structure. Figure 17: Percentage Distribution of GDP as per sectors 1950-51 1980-81 1990-91 2000-01 2004-05PRIMARY 59 41.8 34.9 26.5 23SECTOR18SECONDARY 13 21.7 24.5 23.6 23.8SECTOR19TERTIARY 28 36.6 40.5 49.9 53.2SECTOR20TOTAL 100 100 100 100 100Figure 37 presents before U.S. an overview of the contributions made by the various sectors tothe GDP. As it is clearly evident the tertiary sector has almost doubled over the past fifty years.The doors opened towards the world after the liberalization and globalization reforms have madethe economy witnessed sea gone changes in all the sectors. While the agricultural sector hasreduced to a great extent, the corresponding increase has been witnessed in the services sector. Aremarkable feature of this change is that irrespective of the declining agricultural contribution,the country has successfully achieved the level of self-sufficiency and in fact started to exportfood items! This very well implies that the agricultural sector has not decreased rather it is the                                                            18 Primary sector comprises a) Agriculture and Allied activities b) Mining and quarrying19 Secondary sector consists of a) Manufacturing b) Construction c) Electricity, gas and water supply20 Tertiary Sector comprises a) Transport, Storage And Communication b) Trade Hotels And Restaurants c)Banking And Insurance d) Public Administration And Defense Services e) Real Estate And Business Services f) Other Services 115  
    • service sector, which has gained momentum and has brought new heights to the growth figuresof India.Shifting our focus to the financial services sector, no doubt we stand at the horizon where thedestiny of India is ready to take new leaps in the global arena. The surging stock markets due toconsistent investor’s confidence, rising commodities markets due to strong fundamentalsgoverned by macroeconomic policies and the favorable financial ambiance guided by tight rulesand regulations have brought the financial system at a stratum never explored or realized.Still there remains a question that the direction towards which we are headed, does it hold goodand really provide U.S. a platform to change the destiny of our conservative economy to rule theworld. The term ‘conservative’ is very much controversial. The opening of the Indian cocoon tothe mighty world far ahead of U.S. in terms of capital, know-how and technology questions theconservatism of the economy. These hurdles were, however, confidently confronted with whichruled out the notion that we might be blown away with these violent tides. But the contradictionto the above example is the ‘no current-account convertibility’. The RBI has always played therole of the idol, which safeguards the economy through the perils of the outwards world.Conservatism can thus be replaced by risk-averseness.So when one considers, criticizes or condemns the stringent rules and regulations and tightmonetary mechanism limiting the economy to an indefinite exposure to global financialinnovations, the sub-prime crisis will continue to present a successful example of efficientfinancial know how and strokes of monetary success!Conclusion:The Indian economy which has been known for her conservative approach towards the globalmarkets has been insulated to a great extent from this crisis which is engulfing the whole wideworld in its realms. However the strengthening Indian Rupee, increased investors confidence onIndian Markets all seem to open new door for the country which may lead the country to the pathof progress and development. 116  
    • The New World Order The rise of the behemoth From the stretch of the horizon, to the depth of the sea, Such will be the vigor of this nation that only India shall one see… -AnonymousYet again another crisis unfolded in the world markets, spreading its realm to financial marketsacross the globe, with a different magnitude, trajectory and consequence this time. The world hasalways re-adjusted itself into new brackets of growth figures after passing through such scenario.The financial systems and economic frameworks being incidental to the ‘lag effect’ complicatethe arrival to a clear conclusion. The mystifying question which has taken the whole world bystorm, left economists as well as entrepreneurs baffled, has traders as well as consumerswondering if the subprime crisis will mark the end of the hegemony of The United States ofAmerica! After the dotcom bubble, the housing sector was the next big thing! But very soon thehousing sector reached its saturation point and there could be no more lucrative ventures inhousing constructions. So when this tangible asset got exhausted the next thing to play with werethe finances and financial instruments. Does this reversal in the housing trends indicate a majorshift in the economic paradigm of this nation! The U.S. economy has over two decades seen suchheights, that this fall in the growth has not only been rapid but even steep enough that therecovery may not only be very slow but may even result in further slipping into the steep valleyof negative growth.Today the Indian economy stands at a point, which may change her course in the next fewdecades. Indian economy since long has been appreciated for its policies, which have protectedher from, localized financial mismanagements (in case of East Asian Crisis), overwhelmingsectoral growths (as in the case U.S. dotcom bubble), volatile structural changes (as in the caseof Housing Market Bubbles) and niftily created instruments (as in the case of Subprime Crisis).Call it conservatism or vigilance; we have emerged largely unscathed out of these fiascos andmany minor ones that keep cropping up but have an effect of far lesser magnitude. However thepast is never a perfect guide and India’s economy may still feel some after-shocks (if notshocks), yet the magnitude remains to be seen. 117  
    • The Rising Indian Economy: Two Sides of a CoinThere remains a lot unexplored with the Indian economy. It’s lately been gaining a lot ofattention for its huge size, surging growth figures, macro-economic fundamentals and anefficiently built financial system. Investor’s confidence remains upbeat and there is a generaloptimistic outlook towards progress and development. All these factors rule out the fact thatIndian economy could fall into a situation of turmoil. However, the penetration of the structuralchanges deep down the economies is and will remain unknown till long periods of time as isevident from the previous debacles.There is a very bright ray of optimism that proposes new pursuits of growth and development.Unlike the U.S. housing sector which had reached its saturation point, the Indian housing marketis much in its nascent stage where lot remains to be done to provide the people with homes. Theflourishing Indian stock markets have always fascinated foreign investors and may continue todo so. The underlying difference being that in the case of India, it is still on the trajectory ofgrowth, whereas in U.S.As case, the growth levels had reached a level of saturation. “With markets so exciting here, one may ask why invest abroad.”Richard C. Wastcoat Managing Director, Fidelity Investments International, on India’s prospect as an investment destination.Considering the present scenario, inspite of all the losses suffered by the Indian banks whichfigure out tso be minuscule in comparison to the trillions of losses suffered by the financialinstitutions world wide the economy stands upright and still promises investor confidence whoare anxious after this trubulence. The downfall in the U.S. dollar which has appreciated theIndian Rupee appears to provide an impetus to the Indian exports. Moreover, the developingIndian economy has much in its kitty to offer the world, which remains unknown and unexploredto her.Given below are quotes from some well known market practioners and academics. Almost all ofthem underline the strength of this economy.India is a long-term bet with stability ... China is a short-term bet with volatility. Stefan Krause Head of Sales and Marketing BMW AGNow things have changed - many Indians educated and working in America are returning to India because Indiahas changed. India is the new land of opportunities. 118  
    • Bala V Balachandran Padma Shri awardee Distinguished professor, Kellogg School of Management, ChicagoWhats struck me is the energy and restless ambition in India. You can actually, tangibly feel the drive... Peter Knapp Executive Creative Director Landor AssociatesBecause of the dynamism of the (Indian) economy, there is a very optimistic view of the direction of the country. Lee Howell, World Economic ForumIn the foregone pages we have covered in a fair bit of details on the crisis that the U.S. economyhas been facing and the fallouts that could possibly see the U.S. economy getting into recession(though now a new school of thought has emerged that says that the U.S. economy may notactually get into recession but would slowdown, already the probability of recession has beenreduced from 90% to 45%). The chances of these hitting India may not be ruled out. Though theeffects may be far muted than in U.S. and may be much insignificant, they would eventuallyreach India, both directly through direct exposures and indirectly through global inter-linkages.At the end though, India may stand to gain. For one as covered above, India is a strong growthstory (RBI’s anti-inflationary steps notwithstanding). As a growing economy India’s demand isconcentrated domestically. That means that so long as the central bank and the governmentconcentrate of keeping the buying power with its people, the chances of the economy doing wellcannot be questioned. The continuous rate cuts that happen in the U.S.A would make cheapcapital available for off take. As the confidence in the economy is still to build up, the chancesare that the capital would fly out of the U.S. and seek actively burgeoning markets or the EME’s.India and China figure on the top of that list. With funds flowing into an economy that needs thatfuel for growth, the economy is sure get the fillip.As the economy enters a state of pregnant uneasiness, with unsurely of the fallouts of the crisisand the deliberate slowdown measures taken by the central bank, there remains a space ofunpredictable ness and an unknown future. The high commodity price too adds to the cause.However, as the economic growth trajectory maintains (assuming that the Indian economygrowth rate does not go below 8.00%), it is sure that in another three to four decades the Indianeconomy would overtake the U.S. and the Japanese economy. The de-coupling theory, where in 119  
    • it was said that the EME’s would decouple from the rest of the world and continue on its owntrajectory, pulling the world in its wake, had been put to test at the time of subprime debacle. Atthat time the theory could not stand its ground. But perhaps with the ‘worse’ of the direct impactsout of the way and also with the ‘speculative’ elements laid to rest, the decoupling theory mayafter all be not just some words on paper.The coming half a century belongs to India. India as we know is changing. And it is changingfast. Big roads, bigger cars, malls, multiplexes, swanky hotels, expressways, dedicated webtechnology are all being redefined. The country is accepting this and wants more. Theinfrastructure is out of breath trying to keep pace with this fast development, the economicsystems are totally on an over drive lubricating the growth process and financial systems are in aconstant catch-up state. Economic progress is direct function of lot of variables-benignatmosphere for growth, easy credit situation, global stability and positive policy structure. Whileall these may not be favorable to India at this point, some of these surely are on track at varyingdegrees of success and therefore it’s just a matter of time before even the rest fall on track.Goldman Sachs had predicted in their report that the Indian economy would overtake the U.S. by2050. The U.S. subprime crisis seems to be a trigger to the change in the Indian fortune. It willact as a catalyst that would speed up this process of India emerging. How well the Indianeconomy uses these fallouts at its advantage and bolsters its growth is yet to be seen! 120  
    • APPENDIX   Appendix: 1 Borrower’s Protection Act 2007The Borrowers Protection Act was introduced on 3 May 2007 by Senator Charles Schumer. Thebill was introduced in lieu of the burgeoning subprime crisis that was growing to engulf thewhole of economy under it. The bill was aimed at helping the borrowers who were facingproblems of home foreclosures and loss in home ownership equity. A BILL 110th CONGRESS 1st Session S. 1299To establish on behalf of consumers a fiduciary duty and other standards of care for mortgage brokersand originators, and to establish standards to assess a consumers ability to repay, and for other purposes. IN THE SENATE OF THE UNITED STATES May 3, 2007Mr. SCHUMER (for himself, Mr. BROWN, and Mr. CASEY) introduced the following bill; which wasread twice and referred to the Committee on Banking, Housing, and Urban Affairs A BILLTo establish on behalf of consumers a fiduciary duty and other standards of care for mortgage brokersand originators, and to establish standards to assess a consumers ability to repay, and for other purposes. 121  
    • Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,SECTION 1. SHORT TITLE. This Act may be cited as the `Borrowers Protection Act of 2007.SEC. 2. MORTGAGE ORIGINATOR REQUIREMENTS. The Truth in Lending Act (15 sU.S.C. 1601 et seq.) is amended by inserting after section 129 the following new section:`SEC. 129A. DUTIES OF MORTGAGE ORIGINATORS. (a) Definitions- As used in this section-- (1) the term `home mortgage loan means an extension of credit secured by or to be secured by a security interest in the principal dwelling of the obligor; (2) the term `mortgage broker means a person who, for compensation or in anticipation of compensation, arranges or negotiates, or attempts to arrange or negotiate, home mortgage loans or commitments for such loans, or refers applicants or prospective applicants to creditors, or selects or offers to select creditors to whom requests for credit may be made; (3) the term `mortgage originator means-- (A) any creditor or other person, including a mortgage broker, who, for compensation or in anticipation of compensation, engages either directly or indirectly in the acceptance of applications for home mortgage loans, solicitation of home mortgage loans on behalf of borrowers, negotiation of terms or conditions of home mortgage loans on behalf of borrowers or lenders, or negotiation of sales of existing home mortgage loans to institutional or non- institutional lenders; and (B) any employee or agent of a creditor or person described in subparagraph (A); (4) the term `qualifying bond means a bond equal to not less than 1 percent of the aggregate value of all homes appraised by an appraiser of real property in connection with a home mortgage loan in the calendar year preceding the date of the transaction, with respect to which-- (A) the bond shall inure first to the benefit of the homeowners who have claims against the appraiser under this title or any other applicable provision of law, and 122  
    • second to the benefit of originating creditors that complied with their duty of good faith and fair dealing in accordance with this title; and (B) any assignee or subsequent transferee or trustee shall be a beneficiary of the bond, only if the originating creditor qualified for such treatment; and (5) the term `rate spread mortgage transaction means a home mortgage loan that has an annual percentage rate of interest that equals or exceeds the rate that would require reporting under the Home Mortgage Disclosure Act (12 U.S.C. 2801 et seq.) as a rate spread loan, without regard to whether such loan is otherwise subject to the Home Mortgage Disclosure Act. (b) Standard of Care- (1) FIDUCIARY RELATIONSHIP- In the case of a home mortgage loan, the mortgage broker shall be deemed to have a fiduciary relationship with the consumer, and each such mortgage broker shall be subject to all requirements for fiduciaries otherwise applicable under State or Federal law. (2) FAIR DEALING- Each mortgage originator shall, in addition to the duties imposed by otherwise applicable provisions of State or Federal law, with respect to each home mortgage loan in which the mortgage originator is involved-- (A) act with reasonable skill, care, and diligence; and (B) act in good faith and with fair dealing in any transaction, practice, or course of business associated with the transaction. (c) Assessment of Ability to Repay- (1) IN GENERAL- Each mortgage originator shall, before entering into or otherwise facilitating any home mortgage loan, verify the reasonable ability of the borrower to pay the principal and interest on the loan, and any real estate taxes and homeowners insurance fees and premiums. (2) VARIABLE MORTGAGE RATES- In the case of a home mortgage loan with respect to which the applicable rate of interest may vary, for purposes of paragraph (1), the ability to pay shall be determined based on the maximum possible monthly payment that could be due from the borrower during the first 7 years of the loan term, which amount shall be calculated by-- (A) U.S.ing the maximum interest rate allowable under the loan; and 123  
    • (B) assuming no default by the borrower, a repayment schedule which achieves full amortization over the life of the loan. (3) REQUIRED VERIFICATION DOCUMENTS- (A) IN GENERAL- For purposes of paragraph (1), a mortgage originator shall base a determination of the ability to pay on-- i) documentation of the income and financial resources of the borrower, including tax returns, payroll receipts, bank records, or other similarly reliable documents; and ii) the debt-to-income ratio and residual income of the borrower, as determined under section 36.4337 of title 38 of the Code of Federal Regulations, or any successor thereto. (B) LIMITATION- A statement provided by the borrower of the income and financial resources of the borrower, without other documentation referred to in this paragraph, is not sufficient verification for purposes of assessing the ability of the consumer to pay. (d) Rate Spread Mortgages- (1) ESCROW ACCOUNT REQUIRED- In the case of a rate spread mortgage transaction, the obligor shall be required to make monthly payments into an escrow account established by the mortgage originator for the purpose of paying taxes, hazard insurance premiums, and, if applicable, flood insurance premiums. (2) EXCEPTION- This paragraph does not apply in any case in which the mortgage originator reasonably believes that, following the loan closing, the obligor will be required, or will continue to be required, to make escrow payments described in paragraph (1) on the property securing the loan in connection with another loan secured by the same property. (3) LENDER AND BROKER LIABILITY- In any case in which a mortgage broker sells or delivers a rate spread mortgage loan to a lender, the lender shall be liable for the acts, omissions, and representations made by the mortgage broker in connection with that mortgage loan. (e) Steering Prohibited- (1) IN GENERAL- In connection with a home mortgage loan, a mortgage originator may not steer, counsel, or direct a consumer to rates, charges, principal amount, or prepayment terms that are not reasonably advantageous to the consumer, in light of all 124  
    • of the circumstances associated with the transaction, including the characteristics of the property that secures or will secure the extension of credit and the loan terms for which the consumer qualifies. (2) DUTIES TO CONSUMERS- If unable to suggest, offer, or recommend to a consumer a reasonably advantageous home loan, a mortgage originator shall-- (A) based on the information reasonably available and U.S.ing the skill, care, and diligence reasonably expected for a mortgage originator, originate or otherwise facilitate a reasonably advantageous home mortgage loan by another creditor to a consumer, if permitted by and in accordance with all otherwise applicable law; or (B) disclose to a consumer-- (i) that the creditor does not offer a home mortgage loan that would be reasonably advantageous to a consumer, but that other creditors may offer such a loan; and (ii) the reasons that the products and services offered by the mortgage originator are not available to or reasonably advantageous for the consumer. (3) PROHIBITED CONDUCT- In connection with a home mortgage loan, a mortgage originator may not-- (A) mischaracterize the credit history of a consumer or the home loans available to a consumer; (B) mischaracterize or suborn mischaracterization of the appraised value of the property securing the extension of credit; or (C) if unable to suggest, offer, or recommend to a consumer a reasonably advantageous home mortgage loan, discourage a consumer from seeking a home mortgage loan from another creditor or with another mortgage originator. (4) RULE OF CONSTRUCTION- Nothing in this subsection shall be deemed to prohibit a mortgage originator from providing a consumer with accurate, unbiased, general information about home mortgage loans, underwriting standards, ways to improve credit history, or any other matter relevant to a consumer. (f) Good Faith and Fair Dealing in Appraisal Process- 125  
    • (1) IN GENERAL- No mortgage originator may enter into a home mortgage loan with respect to which the mortgage originator has reason to believe that, with respect to the appraisal of the value of the property securing the loan-- (A) the appraiser failed to act in good faith and fair dealing with respect to the consumer in connection with the appraisal; (B) the appraisal was conducted other than in accordance with all applicable State and Federal standards required of certified appraisers, or was otherwise not accurate and reasonable; (C) the appraiser had a direct or indirect interest in the property or the transaction; (D) the appraiser charged, sought, or received compensation for the appraisal, and the appraisal was not covered by a qualifying bond; or (E) the appraisal order or any other communication in any form includes the requested loan amount or any estimate of value for the property to serve as collateral, either express or implied. (2) PROHIBITED INFLUENCE- No mortgage originator may, with respect to a home mortgage loan, in any way-- (A) seek to influence an appraiser or otherwise to encourage a targeted value in order to facilitate the making or pricing of the home mortgage loan; or (B) select an appraiser on the basis of an expectation that such appraiser would provide a targeted value in order to facilitate the making or pricing of the home mortgage loan. (3) LIMITATION ON DEFENSES- It shall not be a defense to enforcement of the requirements of this subsection that the mortgage originator U.S.ed another person in the appraisal process or to review the appraisal process. (4) NOTICE OF APPRAISAL- In any case in which an appraisal is performed in connection with a home mortgage loan, the mortgage originator shall provide a copy of the appraisal report to an applicant for a home mortgage loan, whether credit is granted, denied, or the application was withdrawn..SEC. 3. CONFORMING AND CLERICAL AMENDMENTS. The Truth in Lending Act (15 U.S.C. 1601 et seq.) is amended-- 126  
    • (1) in section 103(u) (15 U.S.C. 1602(u)), by striking `disclosures required by section 129(a) and inserting `provisions of section 129 and 129A; (2) in section 130 (15 U.S.C. 1640) by inserting `or 129A after `section 129 each place that term appears; and (3) in the table of sections for chapter 2 (15 U.S.C. 1631 et seq.), by inserting after the item relating to section 129 the following: `129A. Duties of mortgage originators. 127  
    • Appendix 2: Beige Book(Summary of Commentary on Current Economic Conditions by Federal Reserve District)The Summary of Commentary on Current Economic Conditions by Federal Reserve District, orBeige Book, comprises anecdotal and discussion-based summaries of regional economicactivities and provides the first chance to investors to see how the Fed draws logical and intuitiveconclusions from the raw data presented in other indicator releases. This report is published eighttimes per year i.e. two Wednesdays before every Federal Open Market Committee (FOMC)meeting.Each Federal Reserve Bank gathers anecdotal information on current economic conditions in itsDistrict through reports from Bank and Branch directors and interviews with key businesscontacts, economists, market experts, and other sources. The Beige Book summarizes thisinformation by District and sector. An overall summary of the twelve district reports is preparedby a designated Federal Reserve Bank on a rotating basis.This gives the investors to see and understand how the Fed draws logical and intuitiveconclusions from the raw data presented in other indicator releases.Strengths: • Contains forward-looking comments - the Fed districts aim to draw relative conclusions in the Beige Book, not just regurgitate facts already presented • Gives investors a "man on the street" perspective of economic health by taking first-hand accounts from business owners, economist, and the like • Aims to put pieces from different reports together into an explanatory whole, giving qualitative measurements instead of quantitative figures • Its the only indicator that gives reports by geographic region, rather than just by industry group or sector. • Most regions will report on the state of the service industries, an area not well covered in other indicator reports, although it is a large component of real gross domestic product.Weaknesses: • Rarely is any new statistical data presented, only anecdotal reports • Filled with measured "Fed-speak" • Specific industry conclusions are hard to draw from the report. 128  
    • • Each Fed district can use its discretion on what to include in its report; one region may discuss manufacturing activity while others dont report on the topic. • Private forecasts compiled by economists and analysts tend to closely match what is reported in the Beige Book, so estimates rarely change following the release.The Beige Book is not likely to send shock waves through the market on its release, but itprovides an original point of view about economic activity and is a marked departure from thedry raw data releases of the other indicators. It also gives investors insight into how the Fedapproaches its monetary policy decisions and responsibilities. 129  
    • Appendix 3: Fico ScoresA FICO score is a number which represents how credit worthy a person is considered which isbased on factors such as the amount of money that one earns, his record of paying back pastdebts, and how much debt he currently holds. The higher the score the better the credit isconsidered, and the more likely one is to get a loan.About credit scoresWhen one applies for credit – whether for a credit card, a car loan, or a mortgage – lenders wantto know what risk theyd take by loaning money. FICO scores are the credit scores most lendersuse to determine the credit risk. There are three FICO scores, one for each of the three creditbureaus: Experian, Trans Union, and Equifax based on the information the credit bureau keepson file about the borrower. As this information changes, the credit scores tend to change as well.Credit bureau scores are often called “FICOscores” because most credit bureau scoresused in the U.S. are produced from softwaredeveloped by Fair Isaac and Company. FICOscores are then provided to lenders by themajor credit reporting agencies.Borrowers who have a FICO credit scorebelow 620 (on a scale from 380 to 850) aregenerally defined as sub-prime borrowers.For the three FICO scores to be calculated, each of the three credit reports are required to containat least one account which has been open for at least six months. In addition, each report mustcontain at least one account that has been updated in the past six months. This ensures that thereis enough information in the report on which to base a FICO score on each report.FICO scores provide the best guide to future risk based solely on credit report data. The higherthe credit score, the lower the risk. But no score says whether a specific individual will be a“good” or “bad” customer.FICO scores have different names at each of the credit reporting agencies. All of these scores,however, are developed using the same methods by Fair Isaac, and have been rigorously tested toensure they provide the most accurate picture of credit risk possible using credit report data. 130  
    • Credit Reporting Agency FICO Score Equifax BEACON® Score Experian Experian/Fair Isaac Risk Model TransUnion EMPIRICA® In general, when people talk about "the score", theyre talking about the current FICO score. However, there is no one credit score used to make decisions. This is true because:• Credit bureau scores are not the only scores used. Many lenders use their own credit scores, which often will include the FICO score as well as other information about the borrowers.• FICO scores are not the only credit bureau scores. There are other credit bureau scores, although FICO scores are by far the most commonly used. Other credit bureau scores may evaluate credit report differently than FICO scores, and in some cases a higher score may mean more risk, not less risk as with FICO scores.• The credit score may be different at each of the main credit reporting agencies. The FICO score from each credit reporting agency considers only the data in the credit report at that agency. If your current scores from the credit reporting agencies are different, its probably because the information those agencies have on you differs.• FICO score changes over time. As your data changes at the credit reporting agency, so will any new credit score based on borrowers credit report. So the FICO score from a month ago is probably not the same score a borrower would get from the credit reporting agency today. 131   
    • Appendix 4: Role of Freddie Mac & Fannie MaeThe Federal National Mortgage Association (FNMA) commonly known as Fannie Mae is knownto be a government sponsored enterprise (GSE), which is a shareholder-owned corporationauthorized to make loans and loan guarantees. However in 1968, it was converted into a privatecorporation and ceased to be the guarantor of government issued mortgages. (This responsibilitywas transferred to Government National Mortgage Association (Ginnie Mae)). The FederalHome Loan Mortgage Corporation commonly known as Freddie Mac, like Fannie Mae is alsoauthorized to make loans and loan guaranteesFannie Mae and Freddie Mac purchased the various subprime and Alt-A mortgages. Presentlythey are in possession of more than 80% of all mortgages bought by investors in the first quarterof this year. After purchasing the mortgages it either held them in its own portfolio or sold themto the investors. Thus Fannie Mae and Freddie Mac did not directly lend to the home buyers.Rather they bought mortgages from banks and other lenders and thereby provided fresh capitalfor home loans. The companies kept some of the mortgages they bought, hoping to earn profitfrom them and sold the rest to the investors with the guarantee to pay off the loan if the borrowerdefaulted.Because of the widespread perception that the government would intervene if either companyfailed, they borrowed money at low interest rates than their competitors. As a result they earnedenormous profits that enriched shareholders and managers alike. From 1990 to 2000, eachcompany’s stock grew more than 500% and its top executives earned tens of millions of dollars.However, after the arrival of competitors in this business threatened their profits and later on itwas discovered that these companies had manipulated their profits. To keep the profits aloft thecompanies began buying huge numbers of subprime and Alt-A mortgages. By the end of lastyear the companies had invested or guaranteed in $717 billion of subprime and Alt-A loans.When the housing bubble burst, the companies revealed a $6 billion combined loss and the stockprices fell more than 25% in two weeks.Thus both these organizations acted as a cushion against any losses. Investors always had thisperception that they always earn returns because of the government backing on these loans (up tothe limit of $730,000 against previous $417,000).At the end of 2007, Fannie Mae held mortgages as investments worth $724 billion and had a corecapital comprising retained earnings and capital from shareholders worth $45billion. If the assetsdeclined because of foreclosures the company’s core capital will decline in order to cover upthese losses. Besides this, the company held guaranteed mortgages as liabilities worth $2.1 132  
    • trillion, which were guaranteed by the company. If the borrower failed to repay the mortgages,Fannie had to make up the differences, which had to be funded from the core capital. As per thelaws, it was necessary that core capital was 3% of the assets. So if Fannie Mae U.S.ed the corecapital to repay the mortgages reducing its core capital, the government would take over thecompany and would become responsible for the liabilities, which stood at $796 billion.In any case, the investors were confident due to the government backing that they shall not haveto suffer any losses. 133  
    • Appendix 5: Housing Market Correction and Bursting Of Housing BubbleA housing market correction is a market correction or "bubble bursting" of a housing bubble;that started in 2005. A real estate bubble is a type of economic bubble that occurs periodically inlocal or global real estate markets. A housing bubble is characterized by rapid increases in thevaluations of real property such as housing until unsustainable levels are reached relative toincomes, price-to-rent ratios, and other economic indicators of affordability. This in turn isfollowed by a market correction in which decreases in home prices can result in many ownersholding negative equity and a mortgage debt higher than the value of the property. Appendix 6: Asian Currency CrisisThe East Asian Financial Crisis was a period of financial crisis that gripped much of Asiabeginning in the summer of (July) 1997 and raised fears of a worldwide economic meltdown(financial contagion). Until 1997, Asia attracted almost half of the total capital inflow todeveloping countries. The economies of Southeast Asia in particular maintained high interestrates attractive to foreign investors looking for a high rate of return. As a result the regionseconomies received a large inflow of money and experienced a dramatic run-up in asset prices.At the same time, the regional economies of Thailand, Malaysia, Indonesia, the Philippines,Singapore, and South Korea experienced high growth rates, 8-12% GDP, in the late 1980s andearly 1990s. This achievement was widely acclaimed by financial institutions including the IMFand World Bank.The crisis started in Thailand with the financial collapse of the Thai baht caused by the decisionof the Thai government to float the baht, cutting its peg to the USD, after exhaustive efforts tosupport it in the face of a severe financial overextension that was in part real estate driven.Thailands economy developed into a bubble fueled by "hot money". More and more wasrequired as the size of the bubble grew. The same type of situation happened in Malaysia. At thetime of the mid-1990s, Thailand, Indonesia and South Korea had large private current accountdeficits and the maintenance of fixed exchange rates encouraged external borrowing and led toexcessive exposure to foreign exchange risk in both the financial and corporate sectors.As the U.S. economy recovered from a recession in the early 1990s, the U.S. Federal ReserveBank under Alan Greenspan began to raise U.S. interest rates to head off inflation. This made theU.S. a more attractive investment destination relative to Southeast Asia, which had attracted hotmoney flows through high short-term interest rates, and raised the value of the U.S. dollar, towhich many Southeast Asian nations currencies were pegged, thus making their exports less 134  
    • competitive. At the same time, Southeast Asias export growth slowed dramatically in the springof 1996, deteriorating their current account position. Many economists believe that the Asiancrisis was created not by market psychology or technology, but by policies that distortedincentives within the lender-borrower relationship. The resulting large quantities of credit thatbecame available generated a highly-leveraged economic climate, and pushed up asset prices toan unsustainable level. These asset prices eventually began to collapse, causing individuals andcompanies to default on debt obligations. The resulting panic among lenders led to a largewithdrawal of credit from the crisis countries, causing a credit crunch and further bankruptcies.In addition, as investors attempted to withdraw their money, the exchange market was floodedwith the currencies of the crisis countries, putting depreciative pressure on their exchange rates.In order to prevent a collapse of the currency values, these countries governments were forced toraise domestic interest rates to exceedingly high levels (to help diminish the flight of capital bymaking lending to that country relatively more attractive to investors) and to intervene in theexchange market, buying up any excess domestic currency at the fixed exchange rate withforeign reserves. The resulting depreciated value of those currencies meant that foreign currency-denominated liabilities grew substantially in domestic currency terms, causing morebankruptcies and further deepening the crisis.After the Asian crisis, international investors were reluctant to lend to developing countries,leading to economic slowdowns in developing countries in many parts of the world. Thepowerful negative shock also sharply reduced the price of oil, which reached a low of $8 perbarrel towards the end of 1998, causing a financial pinch in OPEC nations and other oilexporters. Such sharply reduced oil revenue in turn contributed to the Russian financial crisis in1998. Appendix 7: Russian Debt CrisisThe Russian financial crisis (also called "Ruble crisis") hit Russia on 17 August 1998. It wasexacerbated by the global recession of 1998, which started with the Asian financial crisis in July1997. Given the ensuing decline in world commodity prices, countries heavily dependent on theexport of raw materials, such as oil, were among those most severely hit. (Petroleum, natural gas,metals, and timber accounted for more than 80% of Russian exports, leaving the countryvulnerable to swings in world prices. Oil was also a major source of government tax revenue.)The sharp decline in the price of oil had severe consequences for Russia. However, the primarycause of the Russian Financial Crisis was not the fall of oil prices directly, but the result of non-payment of taxes by the energy and manufacturing industries 135  
    • Appendix 8: Long-Term Capital ManagementLong-Term Capital Management (LTCM) was a hedge fund founded in 1994 by JohnMeriwether (the former vice-chairman and head of bond trading at Salomon Brothers). Board ofdirector’s members included Myron Scholes and Robert C. Merton, who shared the 1997 NobelMemorial Prize in Economics. Initially enormously successful with annualized returns of over40% in its first years, in 1998 it lost $4.6 billion in less than four months and became aprominent example of the risk potential in the hedge fund industry. The fund folded in early2000.The company had developed complex mathematical models to take advantage of fixed incomearbitrage deals (termed convergence trades) U.S.ually with U.S., Japanese, and Europeangovernment bonds. The basic idea was that over time the value of long-dated bonds issued ashort time apart would tend to become identical. However, the rate at which these bondsapproached this price would be different, and more heavily traded bonds such as U.S. Treasurybonds would approach the long term price more quickly than less heavily traded and less liquidbonds.Thus, by a series of financial transactions (essentially amounting to buying the cheaper off-the-run bond and short selling the more expensive, but more liquid, on-the-run bond), it would bepossible to make a profit as the difference in the value of the bonds narrowed when a new bondcame on run.As LTCMs capital base grew, they felt pressed to invest that capital somewhere and had run outof good bond-arbitrage bets. This led LTCM to undertake trading strategies outside theirexpertise. Although these trading strategies were non-market directional, i.e. they were notdependent on overall interest rates or stock prices going up (or down), they were notconvergence trades as such. By 1998, LTCM had extremely large positions in areas such asmerger arbitrage and S&P 500 options. 136  
    • Appendix 9: Relation between Crude oil and Dollar ValueThere is an inverse correlation between Crude Oil and value of dollar. In simple words, as thevalue of dollar declines the prices of Crude Oil increase.The Study:The data of USD w.r.t. Euro were taken since 2002 and correlated with the data of Crude Oil(USD/gallon) for the same period. As per our hypothesis there exists a negative correlationbetween the two. Assumptions 1) Independent Variable: US Dollar (USD) 2) Dependent Variable: Crude Oil Prices 3) Using correlation we develop the following model.The Model:Y=1.026902 -0.0018XCoefficient of Correlation:r2= 0.48799231607r= 0.698564468 137  
    • Crude oil prices and value of dollar bear a negative relationship. The depreciation of dollarimplies a loss in its value in comparison to other currencies. In simple words we can say thatdollar can buy fewer foreign goods as it could previously. When the value of dollar declines theamount of crude oil which could be purchased initially, would not remain the same and moreamounts will have to be paid. This implies that crude oil becomes expensive when the value ofdollar declines.Thus our hypothesis holds good. 138  
    • Appendix 10: Relation between Gold Prices and Dollar ValueThere is an inverse correlation between gold and value of dollar. In simple words, as the value ofdollar declines the prices of gold increase.The Study:The data of USD w.r.t. Euro were taken since 2002 and correlated with the data of gold perounces for the same period. As per our hypothesis there exists a negative correlation between thetwo. Assumptions 1) Independent Variable: US Dollar (USD) 2) Dependent Variable: Gold Prices 3) Using correlation we develop the following model.The Model:Y= 3.387344 - 138.2134XCoefficient of Correlation:r2= 0.859885r= 0.9273 139  
    • Crude oil prices and gold bear a negative relationship. As the dollar depreciates it becomes easierto purchase the same quantity of Gold at lower prices. Since the sellers have to earn the initialprice they increase the amount of gold to cover up the value.Another reason for increased gold prices is the nature of gold as a safe haven, which makes theinvestors to purchase more quantities of Gold to hedge against the risks of currency.Thus we can conclude there this is a negative correlation between Gold and USD. 140  
    • Appendix 11: Relation between Crude Oil Prices and Gold PricesThere is a positive correlation between Crude Oil Prices and Gold Value. In simple words, as thevalue of dollar declines the prices of Crude Oil increase.The Study:The data of Crude Oil Prices were taken since 2002 and correlated with the corresponding valuesof Gold. As per our hypothesis there exists a positive correlation between the two. Assumptions 1) Independent Variable: Crude Oil Prices 2) Dependent Variable: Gold Prices 3) Using correlation we develop the following model.The Model:Y=1.11-0.000543XCoefficient of Correlation:r2= 0.5949028r=0.771299454 141  
    • Crude oil prices and gold bear a positive relationship, as clearly evident in the above figure.Being negatively correlated to the dollar both the Crude oil prices and gold prices move in thesame direction.Thus we can conclude that crude oil prices and gold bear a positive relationship. 142  
    • Appendix 12: Theory of Decoupling The theory of decoupling holds that the emerging economies from Europe and Asia havebroadened and deepened to such a point that these economies no longer depend on the UnitedStates for growth. In other words, they are insulated from a severe slowdown or even a fullyfledged recession. This faith in this theory has been so grave that stocks have outperformedirrespective of the subprime crisis inflicting the United States. In January 2008 as fears ofrecession mounted in the United States, stocks declined heavily.Contrary to what the decouplers would have expected, the losses were greater outside the UnitedStates, with the worst experienced in emerging markets and developed economies like Germanyand Japan. Exports make up especially large portions of economic activity in those places, butthat was not supposed to matter anymore in a decoupled world because domestic activity wasthought to be so robust.If this theory would have held truth then these economies would have witnessed a downfallmuch severe than the impact on the U.S. economy. But this did not happen due to the followingreasons: • Emerging markets collectively send more than half their total exports to other emerging markets. "Chinas growth in exports to America slowed to only 5% (in dollar terms) in the year to January, but exports to Brazil, India and Russia were up by more than 60%, and those to oil exporters by 45%," says The Economist. "Half of Chinas exports now go to other emerging economies. Likewise, South Koreas exports to the United States tumbled by 20% in the year to February, but its total exports rose by 20%, thanks to trade with other developing nations." • Emerging markets as a group now export more to China than to the United States. • IMF data make clear that in 2007, India and China accounted for more global growth than the U.S. • The four biggest emerging economies, which accounted for two-fifths of global GDP growth last year, are the least dependent on the United States: exports to America account for just 8% of Chinas GDP, 4% of Indias, 3% of Brazils and 1% of Russias. • Trade surpluses have allowed emerging markets to build up $3.2 trillion in foreign exchange reserves ($2.1 trillion excluding China), which provides a strong buffer against any credit market disruptions in the developed world. Assuming that emerging market fundamentals remain relatively insulated from developed world credit troubles, trade between emerging nations will flourish and demand for commodities will remain high.Thus the theory does not hold good keeping in view the above points. 143  
    • GLOSSARYRecession:A recession is a decline in a countrys real gross domestic product (GDP), or negative realeconomic growth, for two or more successive quarters of a year.Recession is a significant decline in economic activity spread across the economy, lasting morethan a few months, normally visible in real GDP, real income, employment, industrialproduction, and wholesale-retail sales. A recession begins just after the economy reaches a peakof activity and ends as the economy reaches its trough.A recession may involve simultaneous declines in coincident measures of overall economicactivity such as employment, investment, and corporate profits and may be associated withfalling prices (deflation), or, alternatively, sharply rising prices (inflation) in a process known asstagflation.Depression:A severe and prolonged recession characterized by inefficient economic productivity, highunemployment and falling price levels is termed as a depression. Although the distinctionbetween a recession and a depression is not clearly defined, it is often said that a decline in GDPof more than 10% constitutes a depression.Economic Expansion:An economic expansion is an increase in the level of economic activity, and of the goods andservices available in the market place. Typically it relates to an upturn in production andutilization of resources. Economic recovery and prosperity are two successive phases ofexpansion. It may be caused by factors external to the economy, such as weather, or by factorsinternal to the economy, such as fiscal policies, monetary policies, and the availability of credit,interest rates, regulatory policies or other impacts on producer incentives. Global condition mayinfluence the levels of economic activity in various countries.Economic contraction and expansion relate to the overall output of all goods and services, whilstthe terms inflation and deflation relate to the value of money.Inflation: An increase in the general level of prices in an economy that is sustained over a period of time iscalled inflation. The main causes for inflation is that too much money is available to purchase 144  
    • too few goods and services or when the demand is outpacing supply. This situation mainlyoccurs when an economy is buoyant that there are widespread shortages of labor and materials.People can charge higher prices for the same goods or services.Stagflation:It is the combination of high unemployment and economic stagnation with inflation. Thishappened in industrialized countries during 1970s when a bad economy was combined withOPEC raising oil prices.Deflation:It is when the general level of prices is falling. It is the opposite of inflation. 145  
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