Sub Prime Crisis & Euro Zone Crisis A Presentation by- Siddhant Agarwal
Sub Prime Crisis…… and its rippling effects on the global economy
Contents$ About the Crisis$ Impact on USA$ Impact on the World$ Impact on India$ Conclusion: Is there light at the end of the tunnel?
About the crisis$ Post 2001, the US government had encouraged US banks to lend money to people, to encourage spending & investing mainly for the purpose of buying houses$ These banks granted loans to large number of borrowers despite having lower income levels, unsure employment status, unscrupulous credit history, etc.$ Huge number of borrowers availed of bank credit without evaluating their repayment capacities. The economy was flush with liquidity & stock markets were booming
The Bubble Burst$ A silent storm brewed in international financial markets with origins in the US housing market, which witnessed an unprecedented boom since 2001$ The boom was led by rising housing prices, low interest rates & aggravated by financial innovation viz. MBS, CDO and CDS$ Housing prices in USA began to drop in 2006. Rising interest rates & falling housing prices led to rise in sub prime mortgage delinquencies & resultant foreclosure$ Result: The housing bubble burst in Aug 2006
Impact of Sub Prime Crisis in USAThe chart above brings out the irony and shows that underlying sub prime houses are only a small percentage of the total housing market and it was the bubble formed due to financial instruments viz. MBS, CDO and CDS, that caused the real problem
Impact of Sub Prime Crisis in USA$ Initial impact was felt in March 2008, when investment bank, Bear Stearns was acquired by J.P. Morgan Chase, a commercial bank, for US$1.2 billion$ September 2008, witnessed major shakeouts in the US financial sector. The drama began with Lehman Brothers declaring bankruptcy on 15 September 2008, facing a refusal by the federal government to bail it out$ Washington Mutual is closed by the US government in the largest failure of a US bank. Its banking assets are sold to J.P. Morgan Chase for US$1.9 billion The problem with investment bank balance sheets was that on the left side nothing was right and on the right side nothing was left!
Impact of Sub Prime Crisis in USA$ US Federal Reserve provided an emergency loan of US$85 billion to insurance major, American International Group (AIG), which will be repaid by selling off assets of AIG$ Investment bank, Merill Lynch was acquired by Bank of America in September 2008 for $50 billion$ US Federal Reserve granted approval to investment banks, Goldman Sachs and Morgan Stanley to convert themselves into commercial banks$ US Treasury Department confirmed that both Fannie Mae and Freddie Mac, would be placed into conservatorship with the government taking over their management
Impact of Sub Prime Crisis in USA$ Wachovia Corp agrees to sell most of its assets to Citigroup Inc in a deal brokered by regulators. However, Wells Fargo, a commercial bank, drafted an agreement to acquire assets of Wachovia for US$15.1 blln$ The deal forced Wachovia to backtrack from the Citigroup deal worth US$2.2 billion which was backed by the US Government$ US Government releases a US$700 billion bailout package for its financial industry$ Dow Jones posts its largest point decline ever while the S&P 500 had its worst day since 1987 with an 8.8% dropWhats the difference between a guy who just lost everything in Las Vegas and an Investment Banker? A tie!
Domino Effect across the World$ Northern Rock Bank had difficulty finding finance to keep the business going and was nationalised in February 2008$ British bank Lloyds TSB Group Plc agrees to buy rival HBOS Plc, (UK’s largest mortgage lender) scooping up Britains biggest home loan lender in an all-share deal which values HBOS at over £12 billion (US$22.3 billion)$ In September 2008, British bank Bradford & Bingley was nationalised by the UK government, which will take control of the banks £50bn mortgages and loans, while its savings operations and branches are to be sold to Spains Santander
Domino Effect across the World$ The Dutch operations of Fortis, Europes largest victim of the credit crisis, have been nationalised in a €16.8 billion (£13 billion) deal aimed to calm investors in the troubled banking and insurance group$ Germany struggled to rescue lender Hypo Real Estate (Mortgage Giant), underlining the challenge facing European leaders, who vowed to restore stability in a banking system hit by the worst crisis since the 1930s$ In October 2008, the Australian government announced that AU$4 billion was to be raised to fund non-bank lenders that are unable to obtain funding to finance new loans. After industry feedback this was increased to AU$8 billion$ Japanese financial powerhouse, Nomura Holdings Inc. bought over Lehmans franchise in Europe and Asia Pacific, including Japan and Australia
Domino Effect across the World$ Stock markets tanked - Crisis caused panic in the financial markets and investors sold out and withdrew their money, resulting in sharp drop in stock prices.$ Many banks, mortgage lenders, real estate investment trusts & hedge funds suffered significant losses.$ Credit got tighter - banks became extremely careful parting with their capital and decreased lending activities either to business houses, retail customers and even to each other.$ Effect on jobs – Many employees lost their jobs, especially in the financial sector.
Domino Effect across the WorldThe world market capitalisation has fallen by 20% since March 2007 and by 31%since December 2007. Year to date, the Indian and Chinese markets have been theworst performers amongst the larger indices
Domino Effect in India $ FII investments increased in most of 2007 in a booming Indian economy, as the Sensex was on its way to a historic peak of over 20,000 points $ Since the inflow of dollars in the Indian economy increased, the dollar exchange rate decreased $ In 2008, however, due to the effect of the sub prime crisis, FIIs liquidated their equity investments in a big way – leading to a crash in the stock markets $ Simultaneously commodity prices, including oil prices, were on a rise due increasing demand for these commodities $ The combined effect resulted in an increase in the dollar exchange rate
Is there light at the end of the tunnel?$ There are factors that indicate that there may be more trouble left in American equity markets viz. USA has a low private savings rate and a negative household savings rate, in addition to a large current account deficit and a currency that needs to depreciate further to reduce this gap$ There is also a severe financial crisis affecting all sectors of the economy. It does not seem likely the trouble has ended just yet$ However, Warren Buffett may have started to see some light and has invested $5bn in thepreference shares (attached with equity warrants) of Goldman Sachs and $3bn in the preference shares of General Electric$ Commodity prices (and hence inflation) are falling sharply and this will bring relief to the world and make a stronger case for lower interest rates. This also mitigates the impact of higher interest rates warranted by rising fiscal deficits of the governments being created to bail out/ takeover financial institutions
Is there light at the end of the tunnel?$ After an extended debate the US legislators have thought it fit, probably even profitable, to create a bailout fund of US$700bn. This has been widely endorsed by most while some still feel the amount to be grossly inadequate$ Central Banks around the world are putting up a concerted effort to provide liquidity to the globe by extending lines and cutting rates. This cannot but have a stemming effect$ The world’s Wealth is estimated at US$150 trillion, a lot of which was built in the last 3 years. Some of the current losses in stocks and wealth is of course very painful but in the long term may prove to be just a bad dream that led to some much needed reform and changes in global leadership, a nightmare which looks like it shall last a while$ Never before have housing, banks, hedge funds, insurance companies, commodities and currencies got so badly intertwined. Untangling them will take sometime. When done, this will create a new world order
Some quotes on the crisis“We were at the brink of something that would have made anything thatshappened in financial history look pale. We were very, very close to asystem that was totally dysfunctional and would have not only gummed upthe financial markets but gummed up the economy in a way that would takeus years and years to repair” – Warren Buffet“There could be a lot more bank closures in the coming months which couldcreate significant investment opportunities. As many as thousand bankscould go belly up” – Wilbur Ross“It is quite likely that the current synchronized global economic boom and theuniversal, all encompassing asset bubble will lead to a colossal bust” – Dr.Marc Faber“The money markets have completely broken down, with no trading takingplace at all. There is no market any more. Central banks are the onlyproviders of cash to the market, no one else is lending” – ChristopherReiger (Dresdner Kleinwort)
Eurozone Debt CrisisCAUSES, TIMELINE, EXTENT OF THE CRISIS, HOW IT IS BEING ADDRESSED AND HOW IT’LL AFFECT US
How the crisis unfolded?• Euro was born when European Union became a single economic zone.• EU comprised of strong (Germany, France) as well as weak (Greece, Portugal) economies.• Euro being the single currency in the union, there was no fear of local inflation, so banks lent indiscriminately.• World economy was in good shape, so direct correlation between economic and repayment strength was not evident.• Weaker economies of EU (PIIGS) overspent using borrowed money.• Now they are unable to pay back their debt
What did the PIIGS do?• Ireland underwent a massive real estate bubble, and its banks sustained giant losses. The Irish government wound up rescuing its banks, and now the country is burdened under a huge debt load.• Spain also experienced a huge housing bubble. The country didnt indulge in excessive borrowing, rather, it ended up with high deficits because it couldnt collect enough tax revenue to cover its expenses.• Greece not only borrowed beyond its means, but exacerbated the problem with lots of overspending, little economic production to make up the difference, and some creative bookkeeping to prevent euro zone authorities from realizing the true extent of the situation.• Italy and Portugal have huge debt to GDP ratios, high unemployment and are struggling with a weak economy
And now..• Given the huge size of the PIIGS debt, investors are reluctant to buy bonds from European countries, since many are in huge debts and others may have to assume responsibility for the black sheep.• We could be looking at depression for Europe and recession for rest of the world.• Uncertainty prevails asEU may break upSome countries may pull out of the EULeading to a rash of ban failures
Timeline of the crisis1999-2008•Euro is introduced, more countries join in.•In Dec ‘08 EU leaders agree on a 200bn-euro stimulus plan tohelp boost European growth following the global financial crisis.•2009•Slovakia joins EU, Estonia, Denmark and others makepreparations to join.•In April, the EU orders France, Spain, the Irish Republic andGreece to reduce their budget deficits•In December, Greece admits that its debts have reached 300bnEuros; 113% of GDP, nearly double the EU limit of 60
Timeline of the crisis (cont.)2010• Severe irregularities are found in Greece’s accounting procedures.• Talks start over austerity measures, sparking riots and protests• Euro continues to fall against Dollar and Pound.• In May, EU members and IMF agree on a 110 bn Euro bail- out package for Greece.• Ireland, Portugal, Spain, Italy come under review.• In November, the EU and IMF agree to a bailout package to the Irish Republic totaling 85bn Euros.• The Irish Republic soon passes the toughest budget in the countrys history.
Timeline of the crisis (cont.)2011• In February, eurozone finance ministers set up a permanent bailout fund, called the European Stability Mechanism, worth about 500bn euros.• In April, Portugal admits it cannot deal with its finances itself, leading to a 78bn-euro bailout.• Greece approves fresh round of austerity measures, the EU approves the latest tranche of the Greek loan, worth 12bn euros.• A second bailout of Greece is agreed upon, at 109 bn Euros
Timeline of the crisis (cont.)2012• S&P downgrades France and eight other euro zone countries, blaming the failure of euro zone leaders to deal with the debt crisis.• Euro zone service sector shrinks, unemployment rates hit all time high and European Commission predicts that the euro zone economy will contract by 0.3% in 2012.• Attention shifts to Spain and Italy, as they struggle to avoid going the ‘Greece way’.
Whose fault is it?• “Irresponsible" countries who borrowed too much, taking advantage of the low interest rates available to all euro member nations.• The euro as a single currency cant meet the needs of 17 different economies.• Typically, a countrys central bank can adjust a nations money supply to encourage or inhibit growth as a way of dealing with economic turmoil. However, the nations yoked together under the euro frequently havent had that option.• If Spain and Germany hadnt both spent the last several years on the euro, for example, then they wouldnt have been able to borrow at the same low interest rates.• If the PIIGS all still had their own individual currencies, they might be able to export their way out of the mess theyre in -- selling goods on the international market until their respective situations were a little less dire• The interconnectedness of the modern financial industry. Default by Italy or a departure of the eurozone by a fed-up Germany , could reverberate around the world.
What ‘s being done to avoid the crisis?•Stronger economies are pushing for stringent spendingcontrol guidelines, where a country’s spending will bedirectly proportional to its economic strength.•Several options are being discussed, such as, issuanceof Euro Bonds, backed by the entire EU.•Restructuring of debt, with strict austerity measuresplaced on countries at risk of default.•Troubled eurozone countries are pledging to cut backgovernment spending to show they can be trusted
How does it affect the world?• Stock market volatility.• Financial institutions exposed to the debt will write it down, affecting their bottom line.• Borrowing will get costlier as interest rate will remain high.• As a result, spending will be less leading to a longer recession.• Weak consumption and spending in Europe spells trouble for the rest of the world economy, that is struggling to get out of the downturn.