Global Financial Crisis
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Global Financial Crisis

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This report tries to summarize all about Sub Prime Mortgage crisis and how it transformed into Global Financial Crisis.

This report tries to summarize all about Sub Prime Mortgage crisis and how it transformed into Global Financial Crisis.

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Global Financial Crisis Global Financial Crisis Document Transcript

  • Global Financial Crisis By Jitendra Garg MS (Finance), CFA 2nd March 2009
  • Global Financial Crisis Table of ContentsOverview ............................................................................................................................ 3The Origin of the Subprime Mortgage Crisis ................................................................ 3Transformation of Subprime Mortgage Crisis into Global Financial Crisis .............. 4Bursting the Subprime-CDO-CDS Bubble ..................................................................... 5Contagion Effects on world Economy ............................................................................. 5Deeper problems and Dramatic Measures ..................................................................... 62nd March 2009 Page 2
  • Global Financial CrisisOverviewIn the fall of 2008, the credit crunch, which had emerged a little more than a year before, began asa bursting of the U.S. housing market bubble and a rise in foreclosures has ballooned into WallStreet’s biggest crisis since the Great Depression. As hundreds of billion dollars in mortgage-related investments went bad, some of the largest and most venerable banks, investment houses,and insurance companies have either declared bankruptcy or have had to take enormous financialhit.In 2008, credit flows froze, lender confidence dropped, and one after another the economies ofcountries around the world dipped into recession. The crisis exposed fundamental weaknesses infinancial systems worldwide, and it continues despite coordinated easing of monetary policy,trillions of dollars in intervention by central banks of different countries, and several stimuluspackages by various governments. The crisis started in the US soon spread to Europe, and then toJapan and emerging markets. Governments of most of countries have scrambled to prop upbanks, broadened guarantees for deposits and agreed on a coordinated response.The Origin of the Subprime Mortgage CrisisThe origin of this crisis can primarily be attributed to large subprime lending due to plummetinghousing prices. Subprime lending is a kind of lending against mortgages to borrowers who mightnot normally qualify for a loan because of their poor credit worthiness or credit records.Price went up suddenly to unrealistic levelsThe genesis of the housing market slowdown lies in the loose credit regime that was unleashed bythe Fed in the aftermath of the dotcom bust in 2000-01. At that time, economy was in the grip ofrecession, so series of rate cut (between Mar 2001 and June 2003, the interest rate was reducedfrom 5 percent to 1 percent) to alleviate the investment slowdown and to encourage economicactivity took real interest rates into negative territory, creating what negative real interest ratesdo-asset price bubbles.Since stocks were heading down fromstratospheric levels at that time, theasset that increased in price washousing. Price went up suddenly tounrealistic levels. Between 1997 and2006, the price of the typicalAmerican house increased by 124%.During the two decades ending in2001, the national median home priceranged from 2.9 to 3.1 times medianhousehold income. This ratio rose to4.0 in 2004 and 4.6 in 2006. Risinghousing prices spurred speculation outof fear & greed. Fear of being pricedout forever from owning a housemotivated people into buying houses, they could ill-afford. Greed motivated speculators intobuying houses as they were perceived as safe investments. The temporary secular rising trendprovided both groups a false sense of security that they can’t loose in ‘housing investments’. Thishousing bubble was also fuelled by the loose credit policy of the Fed, return/profit focused hedge& investment funds and investment banks sitting in Wall Street – all far removed from the finalborrowers – completed the equation by providing more than ample liquidity to take house pricesto astronomical levels, further feeding the bubble & creating a sense of euphoria.2nd March 2009 Page 3
  • Global Financial CrisisAggressive lending to sub-primeBy 2005, more than US$635 billion of sub prime loans wereissued. In 2006 the amount was another US$600 billion. Thetotal cumulative amount of subprime rate mortgages hasbeen estimated to be upwards of US$1.3 trillion by 2007.That was, about 10% of the total value of the US housingmarket value & reached a peak of 22% of total lending in2006. Consequently, USA household debt as a percentage ofannual disposable personal income has increased to 127% atthe end of 2007, versus 77% in 1990.All these demand & supply factors led to a constructionboom and contributed to a substantial part of US growth upuntil 2006. Beginning in mid-2004; when the marketconditions eased, there was a slow rising of interest rates by475 basis points by Fed, in tranches until mid-2006 whichslowed down the demand for new houses, house building(supply), though, reacted with a lag to the demand slowdown. The above two (supply increase &demand slowdown) put together created a rising inventory of houses for sale. As a result,house price rises flattened & then began to decline.Transformation of Subprime Mortgage Crisis into Global Financial CrisisThe question now arises how did bad loans to subprime people in US become a global financialcrisis? The answer lies in what is called financial engineering. One of the outcomes of financialengineering is securitisation based instruments named as Collateralized debt obligations(CDOs). These are the type of structured Asset-Backed Security (ABS) whose value andpayments are derived from a portfolio of fixed-income underlying assets. For example, amortgage lender would make a house loan and then use the investment bank, hedge funds andother funds to sell bonds to fund debt. The money from the sale of bonds can be used to makenew loans. The lender accepts loan payments and passes the payments on to the bondholders.Later; these funds can also sell the paper to somebody else. The paper originally bought by thesefunds now becomes somebody else’s asset. Interestingly, investment banks themselves startedlending in subprime market and securitising such loans. Banks and other financial institutionswhich are far off from the US started owning these assets having no real way of assessing thelikelihood of these original loans ever being repaid. According to best estimates, outstanding sizeof CDOs based on mortgaged assets was approximately US$2trillion by end of 2006.But the banks and other institutions that eventually sell theCDOs were, at least until the recent crisis began to appearin late summer 2007, not all that concerned about thequality of such derivative-CDOs. Their ability to take riskhad gone up by buying insurance for the CDO in the formof yet another derivative called a Credit Debt Swap or(CDS). A CDS is a credit derivative contract between twocounter parties. The buyer makes periodic payments(premium leg) to the seller, and in return receives a payoff(protection or default leg) if an underlying financialinstrument defaults. Yet another means by which banksattempted to insulate themselves from the shaky quality ofspeculative investment has been their creation of SecuredInvestment Vehicles (SIVs). These are in essence2nd March 2009 Page 4
  • Global Financial Crisiselectronic shadow banks set up by investment and commercial banks to offload potentially riskyCDOs from the banks balance sheets. And indeed, the volume of CDS has exploded with nuclearforce, nearly doubling every year since 2001 to reach a recent peak of $62 trillion at the end of2007, before receding to $54.6 trillion as of June 30, 2008 according to ISDA.But why did banks and other financial institutions buy these dirty assets? Part of the reason lies inrating agencies. These agencies are paid to rate the complex products of financial institutions fortheir riskiness, nothing more than that. If they rate some securities favourably vis-a-vis the other,that means there is little chance of losing money if someone invests in that particular security.Apart from it, the bank’s SIVs make money from marking up and selling the CDOs as well asfrom insuring them at an additional charge with credit debt swaps. It is therefore not surprisingthat mainline investment and commercial banks experienced compound profit growth of morethan 20 percent per year collectively for each year from 2004 through 2006—i.e., roughly theperiod of the most explosive growth of subprime mortgages bundled with CDOs.Bursting the Subprime-CDO-CDS BubbleThe rate resets on the subprime & adjustable rate mortgages have increased the monthlymortgages payments typically by 25% & upwards. Declining housing prices coupled withincreased rates meant that they could not reset their mortgage terms. As a result, defaultsincreased & houses went into repossessions & foreclosures.By mid-2006 it had become clear that the subprime mortgage market was in freefall. By latesummer 2007 it was estimated that there would be two to three million potential foreclosures overthe next few years. The value of subprime mortgages quickly plummeted and with them many ofthose CDOs in which they were imbedded. Consequently, all synthetic CDOs created in form ofCDS came under high pressure of default & spread of CDS had increased drastically.The Crisis Takes HoldAll entities having exposure in these instruments have faced redemption pressure & due tosettlement of all these liabilities; many of biggest financial institutions like Lehman Brothers,Merrill Lynch, AIG, Fortis Group, Wachovia Bear Stearns, Freddie Mac, Citigroup WashingtonMutual, Fannie Mae and so on have gone bankrupt or sold or bail out by Fed or cried for help.The Lehman brothers have outstanding exposure of US$597 bn at the time of filing bankruptcyand the same figure was US$441bn for A.I.G. Bear Stearns had sold to J.P. Morgan and the Fedcould not let Bear Stearns enter bankruptcy because and only because the billions of dollars ofcredit default swaps on its books would be wiped out. All the banks and institutions that hadinsurance written by Bear would not be able to say that they were insured or hedged anymore andthey would have to write-down billions and billions of dollars in losses that theyve been carryingat higher values because they could say that they were insured for those losses. The counterpartyrisk that all Bears trading partners were exposed to was so far and wide, and so deep, that if Bearwas to enter bankruptcy it would take years to sort out the risk and losses. The severity of theproblem is evident by the fact that major banks and financial institutions which borrowed andinvested heavily in MBS & related derivatives based on these MBS, have reported losses of morethan US$500 billion till now & this is expected to touch US$1 trillion due to spiral effect.Contagion Effects on world EconomyAll these events have created a cascading effect and crores of people have lost their jobs or faceddecline in their salaries. Due to fall in creditability & liquidity, banks have discontinued theirprevious policy of proving credit with free hands. Consequently, demand in the U.S. whichmainly depends on credit has come down & private consumption which constitutes over two-thirdof GDP went for a tail spin. Further, those economies like China & Japan and so on, whichmainly depend on exports to the U.S. has also come into trouble. All this have decreased thedemand for goods & services in different parts of the world. Accordingly, due to reduction in2nd March 2009 Page 5
  • Global Financial Crisisindustrial production & demand; oil prices after touching a height of US$147/b have come downto US$42.95/b (as on 26 Feb. 09) and world trade has also decreased. Thus some of bigeconomies have registered negative growth & whole world including emerging nations are facingslowdown in their GDP growth rate. Simultaneously, world stock markets have lostapproximately 40% of their value as on Jan. 2008 and in all, the slide from the height of the stockmarkets had wiped out more than US$8 trillion in wealth.Deeper problems and Dramatic MeasuresThe bleeding in the stock market stopped only after a huge bailout plan of US$700bn beingannounced by the federal govt. on Sept. 18, 2008. Other countries have also taken measures inresponse to this crisis & more than one trillion dollars have injected in world markets byrespective govts. to restore the confidence in financial system. Apart from it, U.S. has alsoannounced a stimulus package of US$789bn after Baraq Obama has taken over and key interestrates in world market have decreased dramatically to boost the world economy. Others measureshave also taken in forms of tax cut & subsidies.-----------------------------------------------------------------------------------------------------------------2nd March 2009 Page 6