Sub-prime crisis and its potential impact on European and Asian Markets Flow Sub Prime lending leading to credit squeeze Trends of Sub Prime lending and defaults – Where are we heading? Known causes of the crisis What NEXT? Re-coupling or decoupling with other economies A different perspective Sources Nitin Agarwal [email_address] +91 99001 38830

Flow

Sub Prime lending leading to credit squeeze

Trends of Sub Prime lending and defaults – Where are we heading?

Known causes of the crisis

What NEXT?

Re-coupling or decoupling with other economies

A different perspective

Sources

US: A society of “economic freedom” - Credit Squeeze explained Tranche Prime Sub prime Individual Borrower US Housing Boom Mortgage Lender Commercial Bank Walls Street Lender Hedge Funds, Pension Funds other FI SIV Collateralized Debt obligations Mortgage Backed Securities Structured products Financial Counterpart / lender Central Banks Rating Agencies Inducting Money Interest Only Principle Only Z Bond Sub prime Loans NegAm Fannie & Freddie

Prime

Sub prime

Interest Only

Principle Only

Z Bond

Numbers and trends Note: Data exclude home equity loans. Source: United States Government Accountability Office Growth in Sub Prime lending Sub Prime foreclosures maximum Default and foreclosure increasing. They increase in recessing economy Sub Prime home purchasing increase Market Shares of the Minority Submarket for Home Purchase Mortgages ( in terms of number of loans) Default and foreclosure trends

Numbers and trends % of securitized loan balances increasing Interest Only loans and NegAm loans

Known Causes of the Crisis Proximate Causes: Unsustainable boom in house prices  easing of underwriting requirements Price collapse  marked rise in defaults Price declines and rising defaults cause drastic tightening of underwriting requirements hence no refinance available Factors Contributing to Defaults: Voracious loan providers Dysfunctional principal/agent relationships Toxic and poorly understood mortgages Grossly inadequate disclosures Accommodative appraisals

Proximate Causes:

Unsustainable boom in house prices  easing of underwriting requirements

Price collapse  marked rise in defaults

Price declines and rising defaults cause drastic tightening of underwriting requirements hence no refinance available

Factors Contributing to Defaults:

Voracious loan providers

Dysfunctional principal/agent relationships

Toxic and poorly understood mortgages

Grossly inadequate disclosures

Accommodative appraisals

Causes of the Crisis (Con’d) Factors Contributing to Metastisization New instruments, especially CDOs Colossal lack of judgment by credit rating agencies Losses in this market have always bunched Why was the system so unprepared – as indicated by the large number of firm failures? Complex loans –> Negative Amortization loans – good for short term but hurt in long term Shadow banking system – Off balance sheet vehicle of banks Unregulated banking system, hedge funds, private equity players Complexity increased with HIGHLY leveraged positions  margin calls  defaults

Factors Contributing to Metastisization

New instruments, especially CDOs

Colossal lack of judgment by credit rating agencies

Losses in this market have always bunched

Why was the system so unprepared – as indicated by the large number of firm failures?

Complex loans –> Negative Amortization loans – good for short term but hurt in long term

Shadow banking system – Off balance sheet vehicle of banks

Unregulated banking system, hedge funds, private equity players

Complexity increased with HIGHLY leveraged positions  margin calls  defaults

What NEXT? - Account for variable CHANGE Markets are unknown unknowns (Satyajit Das) No one can predict the way they behave – also governed by emotion and perception Black Swan A rare event With high-impact Hard to predict (pattern attributed post event) Hedge funds and private equity firms to be the next ones to get hit Government to intervene Is it justified to use the tax payers money? 700Bn $ package announced. Move to regulate the economy Revamp accounting systems and financial markets Selectively start Regulating the economy Rating agencies and Risk standards to be strengthened Strengthen the underwriting standards

Markets are unknown unknowns (Satyajit Das)

No one can predict the way they behave – also governed by emotion and perception

Black Swan

A rare event

With high-impact

Hard to predict (pattern attributed post event)

Hedge funds and private equity firms to be the next ones to get hit

Government to intervene

Is it justified to use the tax payers money?

700Bn $ package announced. Move to regulate the economy

Revamp accounting systems and financial markets

Selectively start Regulating the economy

Rating agencies and Risk standards to be strengthened

Strengthen the underwriting standards

Re-coupling or Decoupling with other economies European Markets Fairly coupled with US Re-coupling of the economies Commodity prices Currency market Credit market The financial situation to move to Europe – negative ripple effect Bond yields to go down Companies invested in complex derivative instruments with leveraged positions to be in trouble and hence clean their balance sheet Less liquidity  Inflation to rise Consumption to take a hit More regulated society – Government to come to rescue – as a last lender resort EU as a whole may still be less impacted due to growth coming from some sectors / geography Opportunities Companies with sound / healthy balance sheets to expand Credit crunch will give companies less room to borrow Indian companies with less leveraged positions and positive growth outlook within the country will get a chance to taste the European markets  TATAS – CORUS, JLR Once the balance sheet is cleaned and the borrowers are free of their mortgage debts they will have more money to spend and the markets will revive. TIMING cannot be stated USA EU/UK US corporation EU/UK corporation Subsidiary of EU/UK corporation Subsidiary of US corporation 100% Ownership 100% Ownership Source: Book - Traders, guns and money

European Markets

Fairly coupled with US

Re-coupling of the economies

Commodity prices

Currency market

Credit market

The financial situation to move to Europe – negative ripple effect

Bond yields to go down

Companies invested in complex derivative instruments with leveraged positions to be in trouble and hence clean their balance sheet

Less liquidity  Inflation to rise

Consumption to take a hit

More regulated society – Government to come to rescue – as a last lender resort

EU as a whole may still be less impacted due to growth coming from some sectors / geography

Opportunities

Companies with sound / healthy balance sheets to expand

Credit crunch will give companies less room to borrow

Indian companies with less leveraged positions and positive growth outlook within the country

will get a chance to taste the European markets  TATAS – CORUS, JLR

Once the balance sheet is cleaned and the borrowers are free of their mortgage debts they will have more money to spend and the markets will revive. TIMING cannot be stated

Re-coupling or Decoupling with other economies Asian Markets – India Largely a regulated economy Absence of complex financial instruments Economy still will growth at good rate. Marked by local consumption and demand Growth may slow down due to re-coupling effect Inflation may be the problem to stay Tightening of monetary policy With the global turmoil the reforms in finance sector may slow down Growth of service sector to slow down a bit Faith in Dollar to be hit Due to less liquidity the SME to be impacted Opportunities Investors may have more faith in the positively regulated economies and with growth potential Time for consolidation and getting value picks in the Indian and foreign markets Cash rich companies can make the most of the opportunities – can do some value picking

Asian Markets – India

Largely a regulated economy

Absence of complex financial instruments

Economy still will growth at good rate. Marked by local consumption and demand

Growth may slow down due to re-coupling effect

Inflation may be the problem to stay

Tightening of monetary policy

With the global turmoil the reforms in finance sector may slow down

Growth of service sector to slow down a bit

Faith in Dollar to be hit

Due to less liquidity the SME to be impacted

Opportunities

Investors may have more faith in the positively regulated economies and with growth potential

Time for consolidation and getting value picks in the Indian and foreign markets

Cash rich companies can make the most of the opportunities – can do some value picking

A different perspective : An accounting crisis MTM losses to be accounted (made provision for) MTM profits not accounted – based on conservative principle of accounting There is lot of room for hocus pocus accounting hence the accounting system needs to be streamlined further Off Balance sheet SIVs

MTM losses to be accounted (made provision for)

MTM profits not accounted – based on conservative principle of accounting

There is lot of room for hocus pocus accounting hence the accounting system needs to be streamlined further

Off Balance sheet SIVs

Sources www.Wikipedia.org www.FT.com www.rgemonitor.com – Nouriel Roubini www.investopedia.com www.economist.com The Black Swan – Naseem Nicholas Taleb Traders, Guns and money – Satyajit Das

www.Wikipedia.org

www.FT.com

www.rgemonitor.com – Nouriel Roubini

www.investopedia.com

www.economist.com

The Black Swan – Naseem Nicholas Taleb

Traders, Guns and money – Satyajit Das

Thank You