MELTDOWN
Submitted to: Submitted by:
SANJEEV MEHTA GURJEIT SINGH

Preface I
Preface
The Project starts with meaning of “Economic Meltdown” and basics to
understand the term crises. The final chapter describes the long term measures taken by the
US govt. to overcome crises. The project is designed to make everybody aware of the current
prevailing crises in the global economy. Those readers who are familiar with some topics may
jump over to next sections without losing sight of the central theme.
The project report is divided into six chapters with subsections. The
1 chapter provides description about the meaning of recession & depression. Then about the
list of crises the world has faced earlier. The 2 chapter describes about the role of Freddie
Mac & Fannie Mae in the US economy and their contribution to the crises. The tools used by
these organizations are described further in the 3 chapter. And misconceptions regarding the
economic growth of the economy are discussed in chapter 4. Chapter 5 describes all about the
causes & effects of the crises on US economy as well as on developing countries. The last
chapter 6 describes about the measures taken by the US govt. to recover from the crises by
giving the bailout plans to the banks. The project report end with a conclusion discussing
wrong policies practiced to earn more profit leading to crises, which can be avoided.
Gurjeit Singh
MBA Ist Semester
Economic Meltdown Gurjeit Singh

Acknowledgement II
Acknowledgement
It is obvious that the development of a project of this scope needs the
support of many sources. I must thank the teacher; their encouragement and support enabled
the project to materialize and contributed to its success.
The project has been made to aware everybody of Economic Meltdown in
the global economy, which is problem for every human being. Every effort has been made to
describe the matter in clear and simple way so as to impart the reader a sound knowledge
about the subject. I would like to acknowledge the contributors who made this project
possible.
Gurjeit Singh
MBA Ist Semester
Economic Meltdown Gurjeit Singh

Contents
Table of Contents
Preface I
Acknowledgement II
Chapter 1 Introduction 1
1.1 Recession & Depression 4
1.2 List of Economic Crises 5
Chapter 2 Government Sponsored Enterprise 9
2.1 Fannie Mae 11
2.2 Freddie Mac 13
Chapter 3 MBS, CDS & ARM 14
3.1 Mortgage Backed Securities 16
3.2 Sub-types of MBS 16
3.3 Uses of MBS 17
3.4 Varieties of MBS 18
3.5 Collateralized Debt Obligation 18
3.6 Credit Default Swap 20
3.7 Adjustable Rate Mortgage 22
Chapter 4 Housing Bubble 24
4.1 Causes of Housing Bubble 26
4.2 Bubble Burst’s 28
Chapter 5 Subprime Crises 31
5.1 Vicious Cycle 33
5.2 Causes of Crises 35
5.3 Effects of Crises 39
5.4 Money Supply 42
5.5 Nationalize Finance 43
Chapter 6 Bailout Plan 44
6.1 Rational of Bailout Plan 45
6.2 Conclusion 47
Bibliography III
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Introduction Chapter|1
Chapter 1
INTRODUCTION
1.1 Recession & Depression
1.2 List of Economic Crises
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Introduction Chapter|1
The current upheaval in the global financial markets has caused more mayhem in a fortnight than the
world has seen in its entire economic history. Although there are many reasons responsible for
bringing the world to the doorstep of financial doom. The phrase ―economic meltdown‖ is a figure of
speech signifying the financial, monetary, and fiscal crisis currently experienced by governments,
institutions, and people. The meltdown metaphor graphically explains the dynamics we’re witnessing,
the emotions we’re feeling, and the uncertainty we’re sensing. The phrase ―meltdown‖ evokes images
of intense heat dissolving the current macroeconomic system from a solid structure into a sloppy,
slushy mess. Recently, there has been a sharp rise in subprime loaning in the US, which is causing an
upset in the US financial market and as a result affecting all the other sectors of business in the US
economy and world over as well. It has caused hiccups in international financial markets as well. The
terms Economic Meltdown or Economic Slowdown or Recession in 2008 all mean the same.
Economic slowdown is defined as an economy which has:
Declining aggregate demand
Contracting employment/rising unemployment
Sharp fall in business confidence & profits including a reduction in investment spending
Reduced inventory levels and heavy discounting
Falling demand for imports
Increased government borrowing
Lower central banks interest rates
For more than a decade, a massive amount of money flowed into the United States from investors
abroad. This large influx of money to U.S. banks and financial institutions — along with low interest
rates — made it easier for Americans to get credit. Easy credit — combined with the faulty assumption
that home values would continue to rise — led to excesses and bad decisions. Many mortgage lenders
approved loans for borrowers without carefully examining their ability to pay. Many borrowers took
out loans larger than they could afford, assuming that they could sell or refinance their homes at a
higher price later on. Both individuals and financial institutions increased their debt levels relative to
historical norms during the past decade significantly.
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Optimism about housing values also led to a boom in home construction. Eventually the number of
new houses exceeded the number of people willing to buy them. And with supply exceeding demand,
housing prices fell. And this created a problem: Borrowers with adjustable rate mortgages (i.e., those
with initially low rates that later rise) who had been planning to sell or refinance their homes before the
adjustments occurred was unable to refinance. As a result, many mortgage holders began to default as
the adjustments began.
These widespread defaults (and related foreclosures) had effects far beyond the housing market. Home
loans are often packaged together, and converted into financial products called "mortgage-backed
securities". These securities were sold to investors around the world. Many investors assumed these
securities were trustworthy, and asked few questions about their actual value. Credit rating agencies
gave them high-grade, safe ratings. Two of the leading sellers of mortgage-backed securities were
Fannie Mae and Freddie Mac. Because these companies were chartered by Congress, many believed
they were guaranteed by the federal government. This allowed them to borrow enormous sums of
money, fuel the market for questionable investments, and put the financial system at risk.
The decline in the housing market set off a domino effect across the U.S. economy. When home values
declined and adjustable rate mortgage payment amounts increased, borrowers defaulted on their
mortgages. Investors globally holding mortgage-backed securities (including many of the banks that
originated them and traded them among themselves) began to incur serious losses. Before long, these
securities became so unreliable that they were not being bought or sold. Investment banks such as Bear
Stearns and Lehman Brothers found themselves saddled with large amounts of assets they could not
sell. They ran out of the money needed to meet their immediate obligations. And they faced imminent
collapse. Other banks found themselves in severe financial trouble. These banks began holding on their
money, and lending dried up, and the gears of the American financial system began grinding to a halt.
Before we move further we need know, what is Recession? How it is different from Depression?
Answer to these questions has been discussed as follows.
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1.1 Recession & Depression
Recession is a general slowdown in economic activity over a sustained period of
time, or a business cycle contraction. Production as measured by Gross Domestic Product (GDP),
employment, investment spending, capacity utilization, household incomes and business profits all fall
during recession. It is declared when GDP falls (negative real economic growth) for at least two
quarters. Some economists prefer a definition of a 1.5% rise in unemployment within 12 months.
In the United States the Business Cycle Dating Committee of the National Bureau of Economic
Research (NBER) is generally seen as the authority for dating US recessions.
The NBER defines an economic recession as:
"A significant decline in [the] economic activity spread across the country, lasting more than a few
months, normally visible in real GDP growth, real personal income, employment (non-farm payrolls),
industrial production, and wholesale-retail sales."
Depression is really a prolonged or particularly excruciating or protracted version of
recession. Economists don't really have a watermark to indicate a depression. While the presence of a
recession is debatable, when a depression hits, the issue is no longer up for debate. Depressions are
generated by the same factors that cause a recession. Depression is an extended recession on the graph
of the business cycle wave. Unemployment rises; gross domestic product (GDP) drops off, stock prices
fall and the stock market crashes. Believe it or not, there's even an economists' joke that describes the
ambiguity between recessions and depressions: A recession is when your neighbor loses his job; a
depression is when you lose your job.
It is that we are facing financial crises for the first time. World has experienced many crises in a
century. We will discuss those who effected on the economies.
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Introduction Chapter|1
1.2 List of Economic Crises:
Following is a list of prominent economic crises world over in:
20th Century:
 Panic of 1907 — The Panic of 1907, also known as the 1907 Bankers' Panic, was a financial crisis
that occurred in the United States when the New York Stock Exchange fell close to 50% from its
peak the previous year. Panic occurred, as this was during a time of economic recession, and there
were numerous runs on banks and trust companies. The 1907 panic eventually spread throughout
the nation when many state and local banks and businesses entered into bankruptcy. Primary
causes of the run include a retraction of market liquidity by a number of New York City banks and
a loss of confidence among depositors.
The crisis occurred after the failure of an attempt in October 1907 to corner the market on stock of
the United Copper Company. When this bid failed, banks that had lent money to the cornering
scheme suffered runs that later spread to affiliated banks and trusts, leading a week later to the
downfall of the Knickerbocker Trust Company—New York City's third-largest trust. The collapse
of the Knickerbocker spread fear throughout the city's trusts as regional banks withdrew reserves
from New York City banks. Panic extended across the nation as vast numbers of people withdrew
deposits from their regional banks.
The panic may have deepened if not for the intervention of financier J. P. Morgan, who pledged
large sums of his own money, and convinced other New York bankers to do the same, to shore up
the banking system. At the time, the United States did not have a central bank to inject liquidity
back into the market.
 Wall Street Crash of 1929 — The Wall Street Crash of 1929 also known as the Great Crash or the
Stock Market Crash of 1929, was the most devastating stock market crash in the history of the
United States. Four phases—Black Thursday, Black Friday, then Black Monday, and Black
Tuesday—are commonly used to describe this collapse of stock values. All four are appropriate,
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for the crash was not a one-day affair. The initial crash occurred on Thursday, October 24, 1929,
but the catastrophic downturn of Monday, October 28 and Tuesday, October 29 precipitated
widespread alarm and the onset of an unprecedented and long-lasting economic depression for the
United States and the world. This stock market collapse continued for a month.
 Great Depression (1929-1939) — The worst depression of modern history - The Great Depression
was triggered by a sudden, total collapse in the stock market on 'Black Tuesday', October 29th,
1929. It was a worldwide economic downturn starting in most places in 1929 and ending at
different times in the 1930s or early 1940s for different countries. It was the largest and most
severe economic depression in the 20th century, and is used in the 21st century as an example of
how far the world's economy can decline. The Great Depression originated in the United States.
The depression had devastating effects in virtually every country, rich and poor.
International trade plunged by half to two-thirds, as did personal income, tax revenue, prices and
profits. Cities all around the world were hit hard, especially those dependent on heavy industry.
Construction was virtually halted in many countries. Farming and rural areas suffered as crop
prices fell by approximately 60 percent. Facing plummeting demand with few alternate sources of
jobs, areas dependent on primary sector industries such as cash cropping, mining and logging
suffered the most. Many countries started to recover by the mid-1930s, but the negative effects of
the Great Depression lasted until the start of World War II, when governments started to borrow
and spend on a scale sufficient to eliminate unemployment.
 OPEC oil crisis — On October 6, 1973, Syria and Egypt started the Yom Kippur War by
launching a military attack on Israeli occupied territories captured in the 1967 Six Day War. This
new round in the Arab-Israeli conflict triggered a crisis already in the making; the price of oil was
going to rise. The West could not continue to increase its energy consumption 5% annually, while
also paying low oil prices, and selling inflation-priced goods to the petroleum producers in the
developing Third World. The 1973 oil crisis started in October 1973, when the members of
Organization of Arab Petroleum Exporting Countries or the OAPEC (consisting of the Arab
members of OPEC, plus Egypt and Syria) proclaimed an oil embargo "in response to the
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U.S. decision to re-supply the Israeli military" during the Yom Kippur war; it lasted until March
1974. OAPEC declared it would limit or stop oil shipments to the United States and other
countries if they supported Israel in the conflict.
With the US actions seen as initiating the oil embargo, the long-term possibility of embargo-
related high oil prices, disrupted supply and recession, created a strong rift within NATO both
European nations and Japan sought to disassociate themselves from the US Middle East policy.
Arab oil producers had also linked the end of the embargo with successful US efforts to create
peace in the Middle East, which complicated the situation. Later there had been negotiations. The
promise of a negotiated settlement between Israel and Syria was sufficient to convince Arab oil
producers to lift the embargo in March 1974. By May, Israel agreed to withdraw from the Golan
Heights and the issue was resolved.
 Black Monday (1987) — In finance, Black Monday refers to Monday, October 19, 1987, when
stock markets around the world crashed, shedding a huge value in a very short time. The crash
began in Hong Kong, spread west through international time zones to Europe, hitting the United
States after other markets had already declined by a significant margin. The Dow Jones Industrial
Average (DJIA) dropped by 508 points to 1738.74 (22.61%). By the end of October, stock
markets in Hong Kong had fallen 45.8%, Australia 41.8%, Spain 31%, the United Kingdom
26.4%, the United States 22.68%, and Canada 22.5%. New Zealand's market was hit especially
hard, falling about 60% from its 1987 peak, and taking several years to recover. The Black
Monday decline was the largest one-day percentage decline in stock market history.
 1997 Asian financial crisis — The Asian Financial Crisis was a period of financial crisis that
gripped much of Asia beginning in July 1997, and raised fears of a worldwide economic
meltdown due to financial contagion. The crisis started in Thailand with the financial collapse of
the Thai baht (currency of Thailand ) caused by the decision of the Thai government to float the
baht, cutting its peg to the USD, after exhaustive efforts to support it in the face of a severe
financial overextension that was in part real estate driven.
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At the time, Thailand had acquired a burden of foreign debt that made the country effectively
bankrupt even before the collapse of its currency. As the crisis spread, most of Southeast Asia and
Japan saw slumping currencies, devalued stock markets and other asset prices, and a precipitous
rise in private debt. Indonesia, South Korea and Thailand were the countries most affected by the
crisis. Hong Kong, Malaysia, Laos and the Philippines were also hurt by the slump. The People's
Republic of China, India, Taiwan, Singapore, Brunei and Vietnam were less affected, although all
suffered from a loss of demand and confidence throughout the region.
21st Century:
 Financial Crises of 2007-2009 — The financial crisis of 2007–2009 has been called the most
serious financial crisis since the Great Depression by leading economists, with its global effects
characterized by the failure of key businesses, declines in consumer wealth estimated in the
trillions of U.S. dollars, substantial financial commitments incurred by governments, and a
significant decline in economic activity. Many causes have been proposed, with varying weight
assigned by experts. Both market based and regulatory solutions have been implemented or are
under consideration, while significant risks remain for the world economy.
 2008–2009 Icelandic Financial Crisis — The 2008–2009 Icelandic financial crisis is a major
ongoing economic crisis in Iceland that involves the collapse of all three of the country's major
banks following their difficulties in refinancing their short-term debt and a run on deposits in the
United Kingdom. Relative to the size of its economy, Iceland’s banking collapse is the largest
suffered by any country in economic history. The financial crisis has had serious consequences for
the Icelandic economy; the national currency has fallen sharply in value, foreign currency
transactions were virtually suspended for weeks, the market capitalization of the Icelandic stock
exchange has dropped by more than 90%, and a severe economic recession is expected.
Before studying Financial Crises of 2007-2009 meticulously, we need understand the terms Housing
Bubble, Mortgage Backed Securities (MBS), Sponsored Enterprises (GSEs). All these are discussed in
the coming chapters.
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Government Sponsored Enterprise Chapter|2
Chapter 2
GOVERNMENT
SPONSERED
ENTERPRISE
2.1 Fannie Mae
2.2 Freddie Mac
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Government Sponsored Enterprise Chapter|2
The government-sponsored enterprises (GSEs) are a group of financial services corporations created
by the United States Congress. Their function is to enhance the flow of credit to targeted sectors of the
economy and to make those segments of the capital market more efficient and transparent. The desired
effect of the GSEs is to enhance the availability and reduce the cost of credit to the targeted borrowing
sectors: agriculture, home finance and education. Congress created the first GSE in 1916 with the
creation of the Farm Credit System; it initiated GSEs in the home finance segment of the economy
with the creation of the Federal Home Loan Banks in 1932; and it targeted education when it chartered
Sallie Mae in 1972 (although Congress allowed Sallie Mae to relinquish its government sponsorship
and become a fully private institution via legislation in 1995). The residential mortgage borrowing
segment is by far the largest of the borrowing segments in which the GSEs operate. GSEs hold or pool
approximately $5 trillion worth of mortgages.
Congress established GSEs to improve the efficiency of capital markets and to overcome market
imperfections which prevent funds from moving easily from suppliers of funds to areas of high loan
demand. Presently, GSEs primarily act as financial intermediaries to assist lenders and borrowers in
housing and agriculture. The GSEs created a secondary market in loans through guarantees, bonding
and securitization. This has allowed primary market debt issuers to increase loan volume and decrease
the risks associated with individual loans. This also provides standardized instruments (securitized
securities) for investors.
Some of the GSEs, such as Fannie Mae and Freddie Mac, were privately owned but publicly chartered;
others, such as the Federal Home Loan Banks, are owned by the corporations that use their services.
Their lenders grant them favorable interest rates, and the buyers of their securities offer them high
prices, as the implicit involvement of the Federal government gives them a sense of financial security.
GSE securities carry no explicit government guarantee.
List of GSE organizations:
o Housing
The twelve Federal Home Loan Banks (1932)
Federal National Mortgage Association (Fannie Mae) (1938–2008)
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Government Sponsored Enterprise Chapter|2
Federal Home Loan Mortgage Corporation (Freddie Mac) (1970–2008)
Government National Mortgage Association (Ginnie Mae) (1968)
o Farming
Federal Farm Credit Banks (1916)
Federal Agricultural Mortgage Corporation (Farmer Mac) (1987)
2.1
The Federal National Mortgage Association (FNMA), commonly known as Fannie Mae, is a
stockholder-owned corporation chartered by Congress in 1968 as a government-sponsored enterprise
(GSE), but founded in 1938 during the Great Depression. The corporation's purpose is to purchase and
securitize mortgages in order to ensure that funds are consistently available to the institutions that lend
money to home buyers. Fannie Mae was established in 1938 as a mechanism to make mortgages more
available to low-income families. It was added to the Federal Home Mortgage association, a
government agency in the wake of the Great Depression in 1938, as part of Franklin Delano
Roosevelt's New Deal in order to facilitate liquidity within the mortgage market. From 1938 to 1968,
Fannie Mae was the sole institution that bought mortgages from depository institutions, principally
savings and loan associations, which encouraged more mortgage lending and effectively insured the
value of mortgages by the US government. In 1968, the government converted Fannie Mae into a
private shareholder-owned corporation in order to remove its activity from the annual balance sheet of
the federal budget. Consequently, Fannie Mae ceased to be the guarantor of government-issued
mortgages, and that responsibility was transferred to the new Government National Mortgage
Association (Ginnie Mae).
In 1970, the government created the Federal Home Loan Mortgage Corporation (FHLMC), commonly
known as Freddie Mac, to compete with Fannie Mae and, thus, facilitate a more robust and efficient
secondary mortgage market. Fannie Mae buys loans from approved mortgage sellers, either for cash or
in exchange for a mortgage-backed security that comprises those loans and that, for a fee, carries
Fannie Mae's guarantee of timely payment of interest and principal. The mortgage seller may hold that
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Government Sponsored Enterprise Chapter|2
security or sell it. Fannie Mae may also securitize mortgages from its own loan portfolio and sell the
resultant mortgage-backed security to investors in the secondary mortgage market, again with a
guarantee that the stated principal and interest payments will be timely passed through to the investor.
By purchasing the mortgages, Fannie Mae and Freddie Mac provide banks and other financial
institutions with fresh money to make new loans. This gives the United States housing and credit
markets flexibility and liquidity. In order for Fannie Mae to provide its guarantee to mortgage-backed
securities it issues, it sets the guidelines for the loans that it will accept for purchase, called
"conforming" loans. Mortgages that don't follow the guidelines are called "non-conforming"; typically
the secondary market for non-conforming loans deals in mortgages larger (termed "jumbo") than the
maximum mortgage that Fannie Mae and Freddie Mac will purchase. One part of Fannie Mae's income
is generated through the positive interest rate spread between the rate paid to fund the purchase of
mortgage investments and the return it earns on those retained mortgage investments. Fannie Mae's
mortgage portfolio was in excess of $700 billion as of August 2008.
Fannie Mae also earns a significant portion of its income from guaranty fees it receives as
compensation for assuming the credit risk on the mortgage loans underlying its single-family Fannie
Mae MBS and on the single-family mortgage loans held in its retained portfolio. Investors, or
purchasers of Fannie Mae MBSs, are willing to let Fannie Mae keep this fee in exchange for assuming
the credit risk; that is, Fannie Mae's guarantee that the scheduled principal and interest on the
underlying loan will be paid even if the borrower defaults.
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Government Sponsored Enterprise Chapter|2
2.2
The Federal Home Loan Mortgage Corporation (FHLMC), known as Freddie Mac, is a government
sponsored enterprise (GSE) of the United States federal government. The FHLMC was created in 1970
to expand the secondary market for mortgages in the US. Along with other GSEs, Freddie Mac buys
mortgages on the secondary market, pools them, and sells them as mortgage-backed securities to
investors on the open market. This secondary mortgage market increases the supply of money
available for mortgage lending and increases the money available for new home purchases. To provide
competition for the newly private Fannie Mae and to further increase the availability of funds to
finance mortgages and home ownership, Congress then established the Federal Home Loan Mortgage
Corporation (Freddie Mac) as a private corporation through the Emergency Home Finance Act of
1970. The charter of Freddie Mac was essentially the same as Fannie Mae's newly private charter: to
expand the secondary market for mortgages and mortgage backed securities by buying mortgages
made by savings and loan associations and other depository institutions. Freddie Mac's primary
method of making money is by charging a guarantee fee on loans that it has purchased and securitized
into mortgage-backed security bonds. Investors, or purchasers of Freddie Mac MBS, are willing to let
Freddie Mac keep this fee in exchange for assuming the credit risk, that is, Freddie Mac's guarantee
that the principal and interest on the underlying loan will be paid back regardless of whether the
borrower actually repays.
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MBS, CDS & ARM Chapter|3
Chapter 3
MBS, CDS & ARM
3.1 Mortgage Backed Security (MBS)
3.2 Sub-types
3.3 Uses
3.4 Varieties
3.5 Collateralized Debt Obligation (CDO)
3.6 Credit Default Swap (CDS)
3.7 Adjustable Rate Mortgage (ARM)
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MBS, CDS & ARM Chapter|3
Over the past 60 years, a variety of financial innovations have gradually made it possible for lenders to
sell the right to receive the payments on the mortgages they issue, through a process called
securitization. The resulting securities are called mortgage backed securities (MBS) and collateralized
debt obligations (CDO). Most American mortgages are now held by mortgage pools, the generic term
for MBS and CDOs. Of the $10.6 trillion of USA residential mortgages outstanding as of midyear
2008, $6.6 trillion were held by mortgage pools and $3.4 trillion by traditional depository institutions.
By the beginning of the 21st century, these innovations had created an "originate to distribute" model
for mortgages, which means that mortgage became almost as much securities as they were loans.
Because subprime loans have such high repayment risk, the origination of large volumes of subprime
loans by thrift institutions or commercial banks was not possible without securitization. There are five
primary types of risk in these markets:
Credit risk — the risk that the borrower will fail to make payments and/or that the collateral behind the
loan will lose value.
1) Asset price risk — the risk that asset itself (MBS or underlying mortgages in this case) will
depreciate in value, resulting in financial losses, markdowns and possibly margin calls
2) Counterparty risk — the risk that a party to an MBS or derivative contract other than the borrower
will be unable or unwilling to uphold their obligations.
3) Systemic risk — The aggregate effect of these and other risks has recently been called systemic
risk, which refers to sudden perceptual, or material changes across the entire financial system,
causing highly "correlated" behavior and possible damage to that system
4) Liquidity risk — at the institutional level, this is the risk that money in the system will dry up
quickly and a business entity will be unable to obtain cash to fund its operations soon enough to
prevent an unusual loss.
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MBS, CDS & ARM Chapter|3
3.1 MORTGAGE BACKED SECURITY
A mortgage-backed security (MBS) is an asset-backed security or debt obligation that represents a
claim on the cash flows from mortgage loans, most commonly on residential property. Mortgage loans
are purchased from banks, mortgage companies, and other originators. Then, these loans are assembled
into pools. This is done by government agencies, government-sponsored enterprises, and private
entities. Mortgage-backed securities represent claims on the principal and payments on the loans in the
pool, through a process known as Securitization. These securities are usually sold as bonds, but
financial innovation has created a variety of securities that derive their ultimate value from mortgage
pools.
Most MBSs are issued by the Government National Mortgage Association (Ginnie Mae), a U.S.
government agency, or the Federal National Mortgage Association (Fannie Mae) and the Federal
Home Loan Mortgage Corporation (Freddie Mac), U.S. government-sponsored enterprises.
Ginnie Mae, backed by the full faith and credit of the U.S. government, guarantees that investors
receive timely payments of principal and interests on its pass-through. Fannie Mae and Freddie Mac
also provide guarantee payment of principal and interest, while not backed by the full faith and credit
of the U.S. government; have special authority to borrow from the U.S. Treasury. Some private
institutions, such as brokerage firms, banks, and homebuilders, also securitize mortgages, known as
"private-label" mortgage securities.
3.2 Mortgage-backed security sub-types include:
Pass-through mortgage-backed security is the simplest MBS, as described above. These can be
subdivided into:
o Residential mortgage-backed security (RMBS) — a pass-through MBS backed by mortgages on
residential property
o Commercial mortgage-backed security (CMBS) — a pass-through MBS backed by mortgages
on commercial property
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MBS, CDS & ARM Chapter|3
Collateralized mortgage obligation (CMO) — a more complex MBS in which the mortgages are
ordered into tranches by some quality (such as repayment time), with each tranche sold as a
separate security.
Stripped mortgage-backed securities (SMBS) — each mortgage payment is partly used to pay
down the loan's principal and partly used to pay the interest on it. These two components can be
separated to create SMBS's, of which there are two subtypes:
o Interest-only stripped mortgage-backed securities (IO) — a bond with cash flows backed by
the interest component of property owner's mortgage payments.
o Principal-only stripped mortgage-backed securities (PO) — a bond with cash flows backed by
the principal repayment component of property owner's mortgage payments.
3.3 Uses of MBS’s:
There are many reasons for mortgage originators to finance their activities by issuing mortgage-backed
securities. Mortgage-backed securities:
1. Transform relatively illiquid, individual financial assets into liquid and tradable capital market
instruments.
2. Allow mortgage originators to replenish their funds, which can then be used for additional
origination activities.
3. Can be used by Wall Street banks to monetize the credit spread between the origination of an
underlying mortgage (private market transaction) and the yield demanded by bond investors
through bond issuance (typically, a public market transaction).
4. Are frequently more efficient and lower cost sources of financing in comparison with other
bank and capital markets financing alternatives?
5. Allow issuers to diversify their financing sources, by offering alternatives to more traditional
forms of debt and equity financing.
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MBS, CDS & ARM Chapter|3
6. Allow issuers to remove assets from their balance sheet, which can help to improve various
financial ratios, utilise capital more efficiently and achieve compliance with risk-based capital
standards.
3.4 Varieties of underlying mortgages in the pool:
Prime: [conforming mortgages] prime borrowers, full documentation (such as verification of
income and assets), strong credit scores, etc.
Alternate-A paper: [an
ill-defined category]
generally prime
borrowers but non-
conforming in some
way, usually lower
documentation (or in
some other way vacation
home, etc.)
Subprime: [weaker credit scores] no verification of income or assets, etc.
3.5 COLLATERALIZED DEBT OBLIGATION
Collateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) whose
value and payments are derived from a portfolio of fixed-income underlying assets. CDOs are assigned
different risk classes, or tranches, whereby "senior" tranches are considered the safest securities.
Interest and principal payments are made in order of seniority, so that junior tranches offer higher
coupon payments (and interest rates) or lower prices to compensate for additional default risk. CDOs
offered returns that were sometimes 2-3 percentage points higher than corporate bonds with the same
credit rating. CDOs vary in structure and underlying assets, but the basic principle is the same. A CDO
is a type of Asset-backed security. To create a CDO, a corporate entity is constructed to hold assets as
collateral and to sell packages of cash flows to investors. A CDO is constructed as follows:
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A special purpose entity (SPE) acquires a portfolio of underlying assets. Common underlying
assets held include mortgage-backed securities, commercial real estate bonds and corporate loans.
The SPE issues bonds (CDOs) in different tranches and the proceeds are used to purchase the
portfolio of underlying assets. The senior CDOs are paid from the cash flows from the underlying
assets before the junior securities and equity securities. Losses are first borne by the equity
securities, next by the junior securities, and finally by the senior securities.
The risk and return for a CDO investor depends directly on how the CDOs and their tranches are
defined, and only indirectly on the underlying assets. In particular, the investment depends on the
assumptions and methods used to define the risk and return of the tranches. CDOs, like all Asset
Backed Securities, enable the originators of the underlying assets to pass credit risk to another
institution or to individual investors. Thus investors must understand how the risk for CDOs is
calculated.
The issuer of the CDO, typically an investment bank, earns a commission at time of issue and earns
management fees during the life of the CDO. The ability to earn substantial fees from originating and
securitizing loans, coupled with the absence of any residual liability, skews the incentives of
originators in favor of loan volume rather than loan quality. This is a structural flaw in the debt-
securitization market that greatly contributed to both the credit bubble of the 00's as well as the credit
crisis, and the concomitant banking crisis, of 2008.
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3.6 CREDIT DEFAULT SWAP
A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of
payments to the seller and, in exchange, receives a payoff if a credit instrument -- typically a bond or
loan -- goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be
a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded.
CDS contracts have been compared with insurance, because the buyer pays a premium and, in return,
receive a sum of money if one of the events specified in the contract occurs. However, there are a
number of differences between CDS and insurance. Basically, in a credit default swap contract, one
party promises to pay another party if a third party defaults.
The more technical definition of a credit default swap is a bilateral derivative contract that transfers
from one party to another the risk that a specified reference entity will experience a “credit event.”
(Credit events may include default, bankruptcy, restructuring, or credit rating downgrade). Typically,
the protection buyer pays a periodic fee to a protection seller in return for compensation if a reference
entity experiences a credit event. The reference entity, such as a large firm that has issued a bond or a
trust that has issued a mortgage-backed security (MBS), is not a party to the credit default swap
contract. The original protection buyer does not need to have ever owned the reference debt being
protected; therefore, it is not necessary for the protection buyer to realize an actual loss in order to be
eligible for compensation if a credit event occurs. The maturity of the credit default swap does not
have to match the maturity of the reference asset, that is, a 10-year bond may be protected by a credit
default swap that provides protection for only one year.
A financial institution buys a $1 million bond issued by a large manufacturing company. The financial
institution wants to protect itself from the credit risk of the bond but wants to retain other features. The
financial institution could pay a third party to protect the bond in case of a credit event, such as actual
default, or merely a downgrade of the manufacturing company’s bonds by a credit rating agency. For
the sake of this example, assume the financial institution pays the protection seller $1,000 annually in
return for a promise from the protection seller to pay the financial institution the cash value of the loss
from the credit event (cash payout). The protection contract is a credit default swap and can be traded
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in derivatives markets. In this scenario, trouble in the manufacturing industry causes a credit rating
agency to lower the rating of the bonds after two years. As a result, the market value of the bonds falls
by $12,000.
In this case, the financial institution will have paid two $1,000 payments and had the value of its bond
asset fall by $12,000. It would receive $12,000 from the protection seller. The net result for the
financial institution is a loss of the value of the $2,000 in annual fees, rather than the $12,000 loss from
the credit event. Note that the financial institution does not have to sell the bond at the new lower price
and experience an actual loss in order to collect the credit default swap payment. Although it is
common practice to create a credit default swap that fully covers the loss due to the credit event,
parties can contract for any payment they wish. In the example, the parties could have set the
protection payment ahead of time, such as a $10,000 payment in case of the credit event, rather than
the change in the value of the bond, $12,000. The parties may also contract for physical delivery of the
reference asset (the bond) at a pre-specified price that has the same effect as protecting the protection
buyer from loss in value.
Historically, credit derivatives were primarily used by banks to manage their credit exposure to large
loan customers. Banks and other institutions transfer some or all of their credit risk to other parties
through credit default contracts. Because the buyer is paying for protection against uncertain events,
credit default swaps perform a similar economic function as insurance; however, there are differences.
First, credit default swap contracts can be traded more easily than insurance policies. Second, the
protection buyer need never have had any asset at risk in order to purchase the swap and does not have
to experience an actual loss from the credit event in order to collect the payment. Because credit
default swaps can be originated, bought, and sold by parties with no direct exposure to the reference
asset, credit default swap markets are sometimes compared to gambling. However, a specialized lender
that is “overexposed” in one economic sector may wish to participate in credit default swaps for bonds
of firms in other economic sectors in order to manage risk; therefore, it can be difficult to distinguish
“gambling” from diversification.
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3.7 ADJUSTABLE RATE MORTAGE
An adjustable rate mortgage (ARM) is a mortgage loan where the interest rate on the note is
periodically adjusted based on a variety of indices. Among the most common indices are the rates on
1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London
Interbank Offered Rate (LIBOR). A few lenders use their own cost of funds as an index, rather than
using other indices. This is done to ensure a steady margin for the lender, whose own cost of funding
will usually be related to the index. Consequently, payments made by the borrower may change over
time with the changing interest rate (alternatively, the term of the loan may change). ARMs generally
permit borrowers to lower their initial payments if they are willing to assume the risk of interest rate
changes. In many countries, banks or similar financial institutions are the primary originators of
mortgages.
Adjustable rate mortgages are typically, but not always, less expensive than fixed-rate mortgages. Due
to the inherent interest rate risk, long-term fixed rates will tend to be higher than short-term rates
(which are the basis for variable-rate loans and mortgages). The fact that an adjustable rate mortgage
has a lower starting interest rate does not indicate what the future cost of borrowing will be (when rates
change). If rates rise, the cost will be higher; if rates go down, the rate will be lower.
In effect, the borrower has agreed to take the interest rate risk. Some studies have shown that on
average, the majority of borrowers with adjustable rate mortgages save money in the long term.
The most important basic features of ARMs are:
1. Initial interest rate — This is the beginning interest rate on an ARM.
2. The adjustment period — this is the length of time that the interest rate or loan period on an
ARM is scheduled to remain unchanged. The rate is reset at the end of this period, and the
monthly loan payment is recalculated.
3. The index rate — most lenders tie ARM interest rates changes to changes in an index rate.
Lenders base ARM rates on a variety of indices, the most common being rates on one-, three-,
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or five-year Treasury securities. Another common index is the national or regional average cost
of funds to savings and loan associations.
4. The margin — this is the percentage points that lenders add to the index rate to determine the
ARM's interest rate.
5. Interest rate caps — these are the limits on how much the interest rate or the monthly payment
can be changed at the end of each adjustment period or over the life of the loan.
6. Initial discounts — these are interest rate concessions, often used as promotional aids, offered
the first year or more of a loan. They reduce the interest rate below the prevailing rate (the
index plus the margin).
7. Negative amortization — this means the mortgage balance is increasing. This occurs whenever
the monthly mortgage payments are not large enough to pay all the interest due on the
mortgage. This may be caused by the payment cap contained in the ARM when are high
enough that the principal plus interest payment is greater than the payment cap.
8. Conversion — the agreement with the lender may have a clause that allows the buyer to convert
the ARM to a fixed-rate mortgage at designated times.
9. Prepayment — some agreements may require the buyer to pay special fees or penalties if the
ARM is paid off early. Prepayment terms are sometimes negotiable.
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Chapter 4
HOUSING BUBBLE
4.1 Causes of Housing Bubble
4.2 Bubble Burst’s
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Housing bubbles may occur in local or global real estate markets. In their late stages, they are typically
characterized by rapid increases in the valuations of real property until unsustainable levels are reached
relative to incomes, price-to-rent ratios, and other economic indicators of affordability. This may be
followed by decreases in home prices that result in many owners finding themselves in a position of
negative equity—a mortgage debt higher than the value of the property. The United States housing
bubble was an economic bubble affecting many parts of the United States housing market, including
areas of California, Florida, Nevada, Arizona, Oregon, Colorado, Michigan, the Northeast Corridor,
and the Southwest markets. At the national level, housing prices peaked in early 2005, started to
decline in 2006. Median home prices in the US were between $89,000 and $135,000 when adjusted for
inflation between 1890 and
1915. They dropped to $74,000 -
$98,000 between 1915 and 1945.
From 1945 - 2000 they ranged
between $98,000 and $135,000.
From 2000 - 2007 the inflation
adjusted price for the median
priced home in the United States
increased to between $135,000
and $225,000. In 2007 the median price fell.
From 1890 - 2007 the inflation adjusted median home value in the United States has ranged between
$74,000 and $225,000. For 80 of those years the median home price in the US when adjusted for
inflation ranged between $98,000 and $135,000. For thirty years (1915- 1945) the inflation adjusted
median home price was $74,000 - $98,000. For seven years (2000-2007) the median house price
adjusted for inflation was between $135,000 - $225,000.
Basically home prices increased to levels that are far above the historic norm for housing prices in the
United States of America.
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4.1 Causes of Housing bubble
Increase in residential housing prices was caused by the following:
1. Mania for home ownership - Americans' love of their homes is widely known and acknowledged,
many believe that enthusiasm for home ownership is currently high even by American standards,
calling the real estate market "frothy", "speculative madness", and a "mania". The overall U.S.
homeownership rate increased from 64 percent in 1994 (about where it was since 1980) to a peak
in 2004 with an all time high of 69.2 percent. The popular notion that, unlike stocks, homes do not
fall in value is believed to have contributed to the mania for purchasing homes.
2. Belief that housing is good investment - Among Americans, home ownership is widely accepted as
preferable to renting in many cases, especially when the ownership term is expected to be at least
five years. This is partly due to the fact that the fraction of a fixed-rate mortgage used to pay down
the principal builds equity for the homeowner over time, while the interest portion of the loan
payments qualifies for a tax break, whereas, except for the personal tax deduction often available
to renters but not to homeowners, money spent on rent does neither. However, when considered as
an investment, that is, an asset that is expected to grow in value over time, as opposed to the utility
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of shelter that home ownership provides, housing is not a risk-free investment. Whereas, Stock
prices are reported in real time, which means investors witness the volatility. However, homes are
usually valued yearly or less often, thereby smoothing out perceptions of volatility. This assertion
that property prices rise has been true for the United States as a whole since the Great Depression,
and appears to be encouraged by the real estate industry. Compounding the popular expectation
that home prices do not fall, it is also widely believed that home values will yield average or
better-than-average returns as investments. The investment motive for purchasing homes should
not be conflated with the necessity of shelter that housing provides.
3. Government policies - Policies were enacted by politicians in a bi-partisan fashion that required
banks to lower their lending requirements in an effort to allow easy money to be available so that
more people could purchase a house. Policies were enacted by some lending institutions to lower
their lending requirements even further then required by Congress and make money easy. There
are many small local banks that are not in the middle of a financial crisis because they did not
make a huge number of bad loans. In many cases the larger lending institutions had lower lending
standards then small local banks. It was easy to get mortgages even for people with bad credit, no
money for a down payment.
4. Crash of dot-com bubble - the stock market crash, especially in the dot-com and technology
sectors, in 2000 and the subsequent 70% (or so) drop of the NASDAQ composite index resulted in
many people taking their money out of the stock market and purchasing real estate, which many
believed to be a more reliable investment.
5. Lower interest rates - Consumers seemed convinced that housing prices would continue to rise at
unprecedented rates. Many “professionals” were “touting” the “fact” that home prices would
continue to rise. This list includes politicians from Parties, Realtors, mortgage brokers, lenders,
and many more. Basically it became far too easy to borrow money to purchase a house.
Consumers borrowed far too much money and lenders decided to allow consumers to borrow
excessive amounts. This “easy money” in turn forced home prices even higher!
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4.2 Bubble Burst’s
A United States housing market correction is a market correction or "bubble bursts” of a United States
housing bubble; the most recent began following a national home price peak first identified in July
2006. Because realty trades in illiquid markets relative to financial assets like common stock, timely
valuation lags true values from three months to a year. A housing bubble is characterized by rapid
increases in the valuations of real property such as housing until unsustainable levels are reached
relative to incomes, price-to-rent ratios, and other economic indicators of affordability. This in turn is
followed by a market correction in which decreases in home prices can result in many owners holding
negative equity, a mortgage debt higher than the value of the property. The booming housing market
halted abruptly for many parts of the U.S. in late summer of 2005, and as of summer 2006, several
markets faced the issues of ballooning inventories, falling prices, and sharply reduced sales volumes.
The median price of new homes dropped almost 3% since January 2006, that new-home inventories hit
a record in April and remained near all-time highs, that existing-home inventories were 39% higher
than they were just one year earlier, and that sales were down more than 10%.
In March 2007, the United States' subprime mortgage industry collapsed due to higher-than-expected
home foreclosure rates, with more than 25 subprime lenders declaring bankruptcy, announcing
significant losses, or putting them up for sale. The stock of the country's largest subprime lender, New
Century Financial, plunged 84% amid Justice Department investigations, before ultimately filing for
Chapter 11 bankruptcy on 2 April 2007 with liabilities exceeding $100 million. Financial analysts
predict that the subprime mortgage collapse will result in earnings reductions for large Wall Street
investment banks trading in mortgage-backed securities, especially Bear Stearns, Lehman Brothers,
Goldman Sachs, Merrill Lynch, and Morgan Stanley. The solvency of two troubled hedge funds
managed by Bear Stearns was imperiled in June 2007 after Merrill Lynch sold off assets seized from
the funds and three other banks closed out their positions with them. The Bear Stearns funds once had
over $20 billion of assets, but lost billions of dollars on securities backed by subprime mortgages.
A commodity price bubble was created following the collapse in the housing bubble. The price of oil
nearly tripled from $50 to $140 from early 2007 to 2008, before plunging as the financial crisis began
to take hold in late 2008. Domino effect as housing bubble bursts is as follows:
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Following is the explanation of the above diagram:
Housing Market: As the housing bubble burst in late 2006 and prices declined, mortgage holders
counting on home price appreciation found themselves unable to pay their mortgages. Rates on
adjustable-rate mortgages increased. Mortgage payment delinquency rates and foreclosures
increased. With an oversupply of homes, housing construction declined. Housing value declines
meant consumers had less money available for consumption. This placed downward pressure on
economic growth, increasing the risk of recession.
Financial Market: Mortgage-backed securities (MBS) derive their value from housing prices and
mortgage cash flows. As these cash flows declined or became uncertain, financial institutions and
investors holding MBS faced large losses. In certain cases, they had to sell these assets to pay off
margin calls. Bank capital available for lending declined due to these losses. Several major banks
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and dozens of mortgage companies went out of business. Loans became more expensive (higher
interest rates) or unavailable to those without stronger credit. Compared to the boom period, credit
became considerably less available, placing downward pressure on both consumption and business
investment.
Government responses: Central banks have lowered interest rates to stimulate economies and make
it more profitable for banks to loan. Tax rebates (stimulus package) were provided to U.S.
taxpayers. Homeowners received assistance with re-financing their mortgages. Individual firms
received bailouts and in September-October 2008 a comprehensive, global solution to "recapitalize"
banks (e.g., to provide taxpayer funds in exchange for periodic dividend payments) was
implemented. It is important to note that government actions took place throughout the 2007-2008
periods, not just after the financial market impacts indicated. For example, the Federal Reserve
lowered interest rates several times during various stages of the crisis.
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Chapter 5
SUBPRIME CRISES
5.1 Vicious Cycle
5.2 Causes
5.3 Effects
5.4 Money Supply
5.5 Nationalize Finance
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The crisis has gone through four stages:
First, during late 2007, over 100 mortgage lending companies went bankrupt as subprime mortgage-
backed securities could no longer be sold to investors to acquire funds.
Second, starting in Q4 2007 and in each quarter since then, financial institutions have recognized
massive losses as they adjust the value of their mortgage backed securities to a fraction of their
purchased prices. These losses as the housing market continued to deteriorate meant that the banks
have a weaker capital base from which to lend.
Third, during Q1 2008, investment bank Bear Stearns was hastily merged with bank JP Morgan with
$30 billion in government guarantees, after it was unable to continue borrowing to finance its
operations.
Fourth, during September 2008, the system approached meltdown. In early September Fannie Mae and
Freddie Mac, representing $5 trillion in mortgage obligations, were nationalized by the U.S.
government as mortgage losses increased. Next, investment bank Lehman Brothers filed for
bankruptcy. In addition, two large U.S. banks (Washington Mutual and Wachovia) became insolvent
and were sold to stronger banks. The world's largest insurer, AIG, was 80% nationalized by the U.S.
government, due to concerns regarding its ability to honor its obligations via a form of financial
insurance called credit default swaps.
These sequential and significant institutional failures, particularly the Lehman bankruptcy, involved
further seizing of credit markets and more serious global impact. The interconnected nature of Lehman
was such that its failure triggered system-wide (systemic) concerns regarding the ability of major
institutions to honor their obligations to counterparties. The interest rates banks charged to each other
increased to record levels and various methods of obtaining short-term funding became less available
to non-financial corporations. It was this "credit freeze" that some described as a near-complete seizing
of the credit markets in September that drove the massive bailout procedures implemented by
worldwide governments in Q4 2008. Prior to that point, each major U.S. institutional intervention had
been ad-hoc; critics argued this damaged investor and consumer confidence in the U.S. government's
ability to deal effectively and proactively with the crisis. Further, the judgment and credibility of
senior U.S. financial leadership was called into question. Unsustainable U.S. borrowing and
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consumption were significant drivers of global economic growth in the years leading up to the crisis.
Record rates of housing foreclosures are expected to continue in the U.S. during the 2009-2011,
continuing to inflict losses on financial institutions. Dramatically reduced wealth due to both housing
prices and stock market declines are unlikely to enable U.S. consumption to return to pre-crisis levels.
5.1 Subprime crisis 2008 is a combination of two vicious cycles:
Cycle One: Housing Market
The first vicious cycle is within the housing market and relates to the feedback effects of payment
delinquencies and foreclosures on home prices. By September 2008, average U.S. housing prices had
declined by over 20% from their mid-2006 peak. This major and unexpected decline in house prices
means that many borrowers have zero or negative equity in their homes, meaning their homes were
worth less than their mortgages. As of March 2008, an estimated 8.8 million borrowers — 10.8% of all
homeowners — had negative equity in their homes, a number that is believed to have risen to 12
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million by November 2008. Borrowers in this situation have an incentive to "walk away" from their
mortgages and abandon their homes, even though doing so will damage their credit rating for a number
of years. The reason is that unlike what is the case in most other countries, American residential
mortgages are non-recourse loans; once the creditor has regained the property purchased with a
mortgage in default, he has no further claim against the defaulting borrower's income or assets. As
more borrowers stop paying their mortgage payments, foreclosures and the supply of homes for sale
increase. This places downward pressure on housing prices, which further lowers homeowners' equity.
The decline in mortgage payments also reduces the value of mortgage-backed securities, which erodes
the net worth and financial health of banks. This vicious cycle is at the heart of the crisis.
Cycle Two: Financial Market and Feedback into Housing Market
The second vicious cycle is between the housing market and financial market. Foreclosures reduce the
cash flowing into banks and the value of mortgage-backed securities (MBS) widely held by banks.
Banks incur losses and require additional funds (“recapitalization”). If banks are not capitalized
sufficiently to lend, economic activity slows and unemployment increases, which further increases
foreclosures.
As of August 2008, financial firms around the globe have written down their holdings of subprime
related securities by US$501 billion. Mortgage defaults and provisions for future defaults caused
profits at the 8533 USA depository institutions insured by the FDIC to decline from $35.2 billion in
2006 Q4 billion to $646 million in the same quarter a year later, a decline of 98%. 2007 Q4 saw the
worst bank and thrift quarterly performance since 1990. In all of 2007, insured depository institutions
earned approximately $100 billion, down 31% from a record profit of $145 billion in 2006. Profits
declined from $35.6 billion in 2007 Q1 to $19.3 billion in 2008 Q1, a decline of 46%.
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5.2 Causes of Crises:
Causes proposed include the inability of homeowners to make their mortgage payments, due primarily
to adjustable rate mortgages resetting, borrowers overextending, predatory lending, speculation and
overbuilding during the boom period, risky mortgage products, high personal and corporate debt
levels, financial products that distributed and perhaps concealed the risk of mortgage default, monetary
policy, international trade imbalances, and government regulation (or the lack thereof). Two important
catalysts of the subprime crisis were the influx of moneys from the private sector and banks entering
into the mortgage bond market and the predatory lending practices of mortgage brokers, specifically
the adjustable rate mortgage, 2-28 loans. Subprime loans have a higher risk of default than loans to
prime borrowers. If a borrower is delinquent in making timely mortgage payments to the loan servicer
(a bank or other financial firm), the lender may take possession of the property, in a process called
foreclosure.
Growth of the housing bubble — Easy credit, and a belief that house prices would continue to
appreciate, had encouraged many subprime borrowers to obtain adjustable-rate mortgages. These
mortgages enticed borrowers with a below market interest rate for some predetermined period,
followed by market interest rates for the remainder of the mortgage's term. Borrowers who could
not make the higher payments once the initial grace period ended would try to refinance their
mortgages. Refinancing became more difficult, once house prices began to decline in many parts of
the USA. Borrowers who found themselves unable to escape higher monthly payments by
refinancing began to default. During 2007, lenders had begun foreclosure proceedings on nearly 1.3
million properties, a 79% increase over 2006. This increased to 2.3 million in 2008, an 81%
increase vs. 2007. As of August 2008, 9.2% of all mortgages outstanding were either delinquent or
in foreclosure.
Easy credit conditions — From 2000 to 2003, the Federal Reserve lowered the federal funds rate
target from 6.5% to 1.0%. This was done to soften the effects of the collapse of the dot-com bubble
and of the September 2001 terrorist attacks, and to combat the perceived risk of deflation. The Fed
then raised the Fed funds rate significantly between July 2004 and July 2006. This contributed to an
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increase in 1-year and 5-year adjustable-rate mortgage (ARM) rates, making ARM interest rate
resets more expensive for homeowners. This may have also contributed to the deflating of the
housing bubble, as asset prices generally move inversely to interest rates and it became riskier to
speculate in housing.
Subprime lending — there is evidence that both government and competitive pressures contributed
to an increase in the amount of subprime lending during the 2004-2007 the crisis. Major U.S.
investment banks and government sponsored enterprises like Fannie Mae played an important role
in the expansion of higher-risk lending. Subprime mortgage payment delinquency rates remained in
the 10-15% range from 1998 to 2006, then began to increase rapidly, rising to 25% by early 2008.
Securitization practices — Securitization meant that those issuing mortgages were no longer
required to hold them to maturity. By selling the mortgages to investors, the originating banks
replenished their funds, enabling them to issue more loans and generating transaction fees. This
may have created moral hazard and increased focus on processing mortgage transactions rather than
ensuring their credit quality. A more direct connection between securitization and the subprime
crisis relates to a fundamental fault in the way that underwriters, rating agencies and investors
modeled the correlation of risks among loans in securitization pools. Steps of borrowing under
securitization structure:
1. The borrower obtains a loan from lender. This may be done with the help of a mortgage broker.
In many cases the lender and the mortgage broker have no further interaction with the borrower
after the loan is made.
2. The lender sells the loan to the issuer and the borrower begins making monthly payments to the
servicer.
3. The issuer sells the securities to the investors. The underwriter assists in the sale, the rating
agency rates the securities, and credit enhancement may be obtained.
4. The servicer collects monthly payments from the borrower and remits payments to the issuer.
The servicer and the trustee manage delinquent loans according to terms set forth in the pooling
and servicing agreement.
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Inaccurate credit ratings — Credit rating agencies are now under scrutiny for having given
investment-grade ratings to MBSs based on risky subprime mortgage loans. These high ratings
enabled these MBS to be sold to investors, thereby financing the housing boom. These ratings were
believed justified because of risk reducing practices, such as credit default insurance and equity
investors willing to bear the first losses. There are also indications that some involved in rating
subprime-related securities knew at the time that the rating process was faulty. The rating agencies
suffered from conflicts of interest, as they were paid by investment banks and other firms that
organize and sell structured securities to investors.
Government policies — both governments failed regulation and deregulation contributed to the
crisis. Increasing home ownership has been the goal of several presidents including Roosevelt,
Reagan, Clinton and G.W.Bush. In 1982, Congress passed the Alternative Mortgage Transactions
Parity Act (AMTPA), which allowed non-federally chartered housing creditors to write adjustable-
rate mortgages. Among the new mortgage loan types created and gaining in popularity in the early
1980s were adjustable-rate, option adjustable-rate, balloon-payment and interest-only mortgages.
These new loan types are credited with replacing the long standing practice of banks making
conventional fixed-rate, amortizing mortgages. Subsequent widespread abuses of predatory lending
occurred with the use of adjustable-rate mortgages.
Policies of Central Banks — Central banks manage monetary policy and may target the rate of
inflation. They have some authority over commercial banks and possibly other financial institutions.
They are less concerned with avoiding asset price bubbles, such as the housing bubble. Central
banks have generally chosen to react after such bubbles burst so as to minimize collateral damage to
the economy, rather than trying to prevent or stop the bubble itself. This is because identifying an
asset bubble and determining the proper monetary policy to deflate it are matters of debate among
economists.
Credit Default Swaps — the net worth of banks and other financial institutions deteriorated because
of losses related to subprime mortgages, the likelihood increased that those providing the insurance
would have to pay their counterparties. This created uncertainty across the system, as investors
wondered which companies would be required to pay to cover mortgage defaults. Like all swaps
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and other financial derivatives, CDS may either be used to hedge risks (specifically, to insure
creditors against default) or to profit from speculation.
Investment by foreigners — the USA borrow large sums from abroad, much of it from countries
running trade surpluses, mainly the emerging economies in Asia and oil-exporting nations. The
balance of payments identity requires that a country running a current account deficit also have a
capital account (investment) surplus of the same amount. Hence large and growing amounts of
foreign funds (capital) flowed into the USA to finance its imports. Foreign investors had these
funds to lend, either because they had very high personal savings rates (as high as 40% in China), or
because of high oil prices. Foreign governments supplied funds by purchasing USA Treasury bonds
and thus avoided much of the direct impact of the crisis. USA households, used funds borrowed
from foreigners to finance consumption or to bid up the prices of housing and financial assets.
Financial institutions invested foreign funds in mortgage-backed securities. USA housing and
financial assets dramatically declined in value after the housing bubble burst.
Shadow Banking System — The shadow banking system or the shadow financial system consists of
non-bank financial institutions that play an increasingly critical role in lending businesses the
money necessary to operate. The rapid increase of the dependency of bank and non-bank financial
institutions on the use of these off-balance sheet entities to fund investment strategies had made
them critical to the credit markets underpinning the financial system as a whole, despite their
existence in the shadows, outside of the regulatory controls governing commercial banking activity.
These entities were vulnerable because they borrowed short-term in liquid markets to purchase
long-term, illiquid and risky assets. This meant that disruptions in credit markets would make them
subject to rapid deleveraging, selling their long-term assets at depressed prices.
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5.3 EFFECTS OF SUBPRIME CRISES
On United States
Real gross domestic product — the output of goods and services produced by labor and property
located in the United States — decreased at an annual rate of approximately 6 percent in the fourth
quarter of 2008 and first quarter of 2009, versus activity in the year-ago periods. The U.S.
unemployment rate increased to 9.5% by June 2009, the highest rate since 1983 and roughly twice the
pre-crisis rate. The average hours per work week declined to 33, the lowest level since the government
began collecting the data in 1964. The macro effects of the subprime crisis:
The Banking Industry
o Immediate: Subprime crisis tears gaping hole in bank business models, eliminating volume and
income options. Net effect is large percentage reduction in credit available.
o Long-term: The clock has been wound back decades. Loan origination now implies retention of
the asset as default option. Banks have limited funding, revenue options.
Risk Preferences
o The subprime crisis has changed investor and lender preferences dramatically. Structured assets of
all ratings grades are being shunned in favor of simpler cash securities. Dealers are walking away
from low-risk markets due to concerns about capital availability and “fair value” risk.
o There has been a huge reduction in market liquidity overall, and with this a sharp decrease in
leverage used by all market participants.
Litigation
o The subprime crisis has made lenders and their advisers extremely vulnerable to a number of
different types of claims. Borrowers are bringing claims against lenders for violations as well as
loan suitability rules. End-investors are likewise suing lenders, dealers and rating agencies for
fraud.
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The Economy
o The forced liquidation of some $3 trillion in private label structured assets is depriving the
financial markets and the U.S. economy of a vast amount of liquidity that the banking system
simply cannot restore.
On India & China
The Impact of US subprime crisis on India, China, Brazil, UAE, Thailand, and Malaysia may not be
very large according to economists. It is being anticipated that the developing countries might be
spared for a year or two and neither of the countries would be affected either by economic recession in
the USA or the prevailing US subprime crisis. This notion was put forward by the leading economist
of the World Bank. Further, it is being fathomed that even if there is an impact of US subprime crisis
on India and China, etc., it will not be taking place earlier than two years. However, it will be wrongly
said if the developing nations like India and China would be entirely untouched by the ripple effect.
The prevailing economic condition in these countries are so strong that it may not feel the upheaval as
it would have felt had the economy of these countries been sluggish. Probable effects on financial
markets of India and China:
One possible impact of US subprime crisis on global markets would be certain unforeseen losses
pertaining to securities. If such a situation arises, it would further make credit conditions stringent.
Consequently, loss incurred on securities would increase. As a cumulative effect, the financial markets
would spiral downward causing the monetary policies to become looser.
With regard to equity markets, it is being anticipated that equity markets may go down and the cost of
capital (effective) may rise by 200 basis points as compared to the baseline. As a result of the credit
constraints, business investment in the United States of America would drop, unemployment would
rise and there would be a prolonged phase of depression in the consumer prices. The need of the hour
is to have a more open economy or be open to trade, attract investments, which would re kindle
innovative concepts and enhance foreign direct investment. The growth has to be such that it is
sustainable, only then will the impact of US subprime crisis on India and China is negligible.
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JULY-AUGUST 2007 saw completion of a decade since the East Asian crisis erupted. During July-
August 1997, the rather developed world was spared of the crisis and the emerging countries were
marred by flight of capital. Capital flew back to where it originated, resulting in a massive sell-off in
the East Asian market. Now, ten years down the line, it appears the crisis has turned full circle and
crippled the developed countries like USA, UK, Australia, France, etc. But there is one similarity
between the East Asian crisis and the sub prime mortgage crisis of USA - in the sub prime crisis, the
emerging countries and the developed countries are suffering whereas the developed countries were
not affected (at least to an extent) during the East Asian crisis.
During the East Asian crisis, the Indian economy was in the regime of limited convertibility (current
account and capital account) thanks to the careful and gradual move towards globalization decreed by
the RBI and GOI, which worked as a blessing in disguise and we were not particularly affected.
Things have changed since and owing to various international obligations and the understanding that
capital is important for the overall growth of the economy, the RBI and GOI have liberalized a lot on
both the current and capital accounts. Integration of the Indian economy into the world economy has
brought about many disadvantages too.
The question is how to continue as an integral part of the world and also remain unaffected by the
crisis happening in other parts of the world? This question may not be so pertinent to a developed
economy but for an emerging economy like ours, if we are affected to a great extent by a crisis arising
in another part of the world, this will imply one step forward and two steps backward.
The present crisis in US may not have such an impact on the world economy because it is confined to
one sector of the economy, viz., mortgage and housing but one cannot deny that housing is a sector
with large-scale implications. Then what do we learn from this housing crisis?
1. Sound banking practices: The root cause of the sub prime mortgage (even prime mortgage loans are
in trouble in US; e.g., trouble in Countrywide, America’s biggest home loan lender) crisis is the
unsound credit practices that emerged in the US market. Fake certification, which helps an
ineligible person to raise a home loan, cannot be ruled out in India. Housing loan frauds are not
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uncommon in the cities of India and the aggressiveness with which housing loans are being sold by
banks and financial companies in violation of sound credit practices cannot be ignored. Personal
loans and overdue credit cards are the other sectors which the regulators and bankers should handle
carefully because they have the potential to plunge the Indian banking sector into a crisis.
2. Controlled Derivatives market: Derivatives are financial instruments, which can spread the default
risk attaching to loans. All the same, indiscriminate use of such derivatives can lead to havoc as in
US. Derivatives lead to such a chain reaction that it will be nearly impossible to quantify the risk of
exposure to bad loans and advances subsequently. RBI and GOI should prohibit indiscriminate use
of such derivatives if they intend to introduce such products in India.
3. Limited investment by Indian companies abroad: Prudent investment abroad should be the order of
the day. Reckless investment in the derivatives market abroad by banks and financial institutions
has to be controlled. In the recent crisis, BNP Paribas of France and Macquarie Bank of Australia
have been affected because of such overseas investments. The exposure of Indian banks to the sub
prime crisis of US is minimal.
4. Quality Inward Investment: FDI should be given priority over FIIs as history has shown that flight
of capital in case of FDI is low compared to that in respect of FIIs. Due to their stable nature, FDI
can help in the growth of the country’s infrastructure.
5.4 MONEY SUPPLY
The focus on managing the money supply has been de-emphasized in recent history as inflation has
moderated in developed countries. A sudden increase in the money supply might result in an increase
in interest rates to ward off inflation or inflationary expectations. The U.S. government creates large
quantities of money to help it purchase toxic mortgage-backed securities and other poorly-performing
assets from banks; there is risk of inflation and dollar devaluation relative to other countries. This risk
is of less concern to the Fed than deflation and stagnating growth. Further, the dollar has strengthened
as other countries have lowered their own interest rates during the crisis. This is because demand for a
currency is typically proportional to interest rates; lowering interest rates lowers demand for a currency
and thus it declines relative to other currencies.
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5.5 NATIONALIZE FINANCE
Thus we can see that there is a cruel dilemma in capitalist economies for governments, the public and
also for the left. When a financial crisis threatens, or begins, there seem to be only two options: bail
out the financial capitalists in some way or suffer a more severe financial crisis, which in turn will
cause an even more severe crisis in the economy as a whole, which will cause widespread misery and
hardships.
The only way to avoid this cruel dilemma is to make the economy less dependent on financial
capitalists. And the only way to accomplish this greater independence from financial capitalists is for
the government itself to become the main provider of credit in the economy, especially for home
mortgages, and perhaps also for consumer loans, and maybe even eventually for business loans. In
other words, finance should be nationalized and operated by the government in the interest of public
policy objectives.
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Bailout Plan Chapter|6
Chapter 6
BAILOUT PLAN
6.1 Rational of Bailout Plan
6.2 Conclusion
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Bailout Plan Chapter|6
The Emergency Economic Stabilization Act 2008 (EESA) is the largest act of governance the U.S.
financial markets have seen since the Great Depression. It is commonly referred to as a bailout of the
U.S. financial system. Under the EESA, the government is not a laissez-faire entity in American
capitalism -- it becomes a major player. It is a law enacted in response to the subprime mortgage crisis
authorizing the United States Secretary of the Treasury to spend up to US$700 billion to purchase
distressed assets, especially mortgage-backed securities, and make capital injections into banks. Both
foreign and domestic banks are included in the bailout. The Federal Reserve also extended help to
American Express, whose bank-holding application it recently approved. The Act was proposed by
Treasury Secretary Henry Paulson during the global financial crisis of 2008. The original proposal was
three pages, as submitted to the United States House of Representatives. The purpose of the plan was
to purchase bad assets, reduce uncertainty regarding the worth of the remaining assets, and restore
confidence in the credit markets. The text of the proposed law was expanded to 110 pages.
6.1 RATIONAL OF BAILOUT PLAN
Treasury Secretary Henry Paulson summarized the rationale for the bailout:
Stabilize the economy: Avoid a continuing series of financial institution failures and frozen credit
markets that threaten American families' financial well-being, the viability of businesses both small
and large, and the very health of our economy.
Improve liquidity: Bad loans have created a chain reaction and credit markets froze – even some
Main Street non-financial companies had trouble financing their normal business operations.
Comprehensive strategy: Decisive action to fundamentally and comprehensively address the root
cause of this turmoil. And that root cause is the housing correction which has resulted in illiquid
mortgage-related assets that are choking off the flow of credit which is so vitally important to
economy.
Immediate and significant: Troubled asset relief program has to be properly designed for immediate
implementation and be sufficiently large to have maximum impact and restore market confidence. It
must also protect the taxpayer to the maximum extent possible, and include provisions that ensure
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transparency and oversight while also ensuring the program can be implemented quickly and run
effectively.
Broad impact: Troubled asset purchase program on its own is the single most effective thing that
can be done to help homeowners, the American people and stimulate economy.
Fed Chairman Ben Bernanke summarized the rationale for the bailout:
Investor confidence: Among the firms under the greatest pressure were Fannie Mae and Freddie
Mac, Lehman Brothers, and, more recently, American International Group (AIG). As investors lost
confidence in them, these companies saw their access to liquidity and capital markets increasingly
impaired and their stock prices drop sharply. Purchasing impaired assets will create liquidity and
promote price discovery in the markets for these assets, while reducing investor uncertainty about
the current value and prospects of financial institutions
Impact on Economy and GDP: Extraordinarily turbulent conditions in global financial markets
caused equity prices to fall sharply. The cost of short-term credit—where available—to spike
upward, and liquidity to dry up in many markets. Losses at a large money market mutual fund
sparked extensive withdrawals from a number of such funds. A marked increase in the demand for
safe assets—a flight to quality—sent the yield on Treasury bills down to a few hundredths of a
percent. By further reducing asset values and potentially restricting the flow of credit to households
and businesses, these developments pose a direct threat to economic growth.
Once stable, the securities the government purchased should increase in value and can be sold again at
a higher price. The act could also harm taxpayers, since it's not guaranteed the government will make a
return on such a large investment. If a shortfall occurs between the combined purchase and sale prices,
the act calls for a proposal by the president to be submitted to force EESA-participating financial
institutions to make up the difference. The act also requires proposals for new oversights of the
financial markets.
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6.2 CONCLUSION
The ancient Indian economists taught us to save a portion of our earnings for hard days. They told us
to maintain a sustainable standard of living so that we don’t have the misfortune to reduce the standard
of living during the days of recession. They advised us to save enough to invest in the education of the
next generation because those wise men knew that empowering the young through education holds the
key in ensuring the future security of the society. Whereas the American economists want people to
spend, spend and spend regardless of their financial capacity. If you have no money, use credit cards,
buy today and pay later so that manufacturing industry will survive and so their employees. Then when
they reach the saturation point, people don’t buy anymore, manufacturers produce less, jobs are cut,
those already bought up to their credit limits cannot pay up and the whole system collapses. Luxurious
living became more important than safeguarding the interest of the next generation.
Irresponsible over-consumption and artificial credit creation are responsible for today’s economic
disaster. Long ago, Abraham Lincoln, the first Presidents of the USA said, ―You cannot build a strong
economy on borrowed funds‖ and he was absolutely right!
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Bibliography III
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Economic Meltdown Gurjeit Singh