The Meltdown

Financial Meltdown and its impact on Financial Markets Created by: Ajay Kr Dhamija (N-1) Hanish Rajpal (N-67) Himanshu Goenka (N-22) Adil Zaidi (S-8) Snehal Soni (N-47) Geetanjali Aggarwal (S-20) Tripat Preet Singh (N-53) Radhika Gulati (S-40)

Agenda Terminology Historical Linkage & Timeline of Current Crisis Model of Mortgage Loan Complexity of Financial Products & Model Tea Break Faults in the Model & Aftermath Crisis Toll How does it affect India Terminology 2 Learning and change of the model Conclusion

Terminology Interest Rate Swap Credit Default Swap Securitization Asset-backed security Mortgage Backed Security Collatarized Debt Obligation Subprime Lending Terminology 3 Foreclosure Credit rating agency (CRA)

Interest Rate Swap The swap bank Swap makes ¼ % Bank 10 3/8 % 10 ½% LIBOR – ¼% LIBOR – 1/8% Bank Company LIBOR 10% Note that the total savings + ½% A ½ + ½ + ¼ = 1.25 % = QSD B A saves ½ % B saves ½ % COMPANY B BANK A DIFFERENTIAL Terminology 411.75% Fixed rate 10% 1.75% Floating rate LIBOR + .5% LIBOR .5% QSD = 1.25%

Credit default Swap Company A Company B - BB – B+ CRA Insurance Insurance (Moody’s) $1B A - AA $2B B - AA -> 10% B+ 12% 200 BP 100 BP Insurance 200 BP on B for Insurance = $200M $1B on B for Insurance $10B Terminology 5 on B for $2B Pension Hedge Pension Fund 2 Fund 1 Fund 1

Securitization Securitization -Structured Process -The assets are combined into a pool, and then that pool is split into shares. -The shares are sold to investors who share the risk and reward of the performance of those assets collectively - Present Value of Future Cash Flows Terminology 6 - Categorization

Motives for securitization Advantages to issuer •Reduces funding costs •Reduces asset-liability mismatch •Lower capital requirements •Locking in profits •Enables Transfer of risks by one who does not want to take it •Earnings Terminology 7 •Admissibility •Liquidity

Asset-backed security An asset-backed security is a type of debt security that is based on pools of assets, or collateralized by the cash flows from a specified pool of underlying assets. Backing assets-loans, lease, credit card debt, company receivables, royalty Non Mortgage Assets TerminologyHigh Prepayment Risk 8

Mortgage Backed Security A Mortgage-Backed Security (MBS) is an asset- backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans. Payments are typically made monthly over the lifetime of the underlying loans Prepayment Risk Low Government Guarantees Terminology 9

Collateralized Debt Obligation Securitized Interest in a pool of assets- ABS Constructed from Portfolio of fixed income assets. Types • CLO • CBO Non Mortgage loans or Bonds Multiple Tranches of Securities Senior (AAA) Terminology 10 Mezzanine(AA to BB) Equity(Unrated) Losses in reverse order of seniority of tranches Servicing Agent

Collateralized Debt Obligation $1B * 10% = $100M $1B $1B Bank Investment MBS Bank 1000 * $100K = $100M Mortgagors And $1B $1B $1000 K * 1M shares SPV Equity 300 M (300K shares @ 16.5% = $55M) Mezzanine 300 M (300K shares @ 7% = $21M) Terminology 11 CDO Senior 400 M (400K shares @ 6% = $24M) Investors

What is Subprime Lending? Near-prime, non-prime, or second chance lending Providing credit to borrowers who do not meet prime underwriting guidelines. A sub-prime lender is one who lends to borrowers who do not qualify for loans from mainstream lenders or prime financing terms- Low Credit Scores Subprime loans are not predatory loans Terminology 12

Why Subprime Lending ? Realization of a demand for loans to high-risk borrowers with imperfect credit. Fall in prime interest rates with real interest becoming negative- allowing modest subprime rates to flourish. Relaxation of usury laws - Confidence to foreclose assets in case of default. Terminology 13 Credit Repair Option.

How do we know a Sub-prime Borrower Payment delinquencies Reduced Repayment capacity as measured by credit scores Poor debt-to-income ratios Limited income or having poor credit scores Relatively high heightened perceived risk of default History of loan delinquency, Recorded bankruptcy, Terminology 14 Limited debt experience. Charge-offs, Set offs, judgments.

Credit profile keeping a borrower out of a prime loan may include the following Two or more loan payments paid past 30 days due in the last 12 months, or one or more loan payments paid past 90 days due the last 36 months; Judgments, foreclosure, repossession, or non-payment of a loan in the past; Bankruptcy in the last 5 years; Terminology 15 Hi default probability as evidenced by the credit score. Accuracy of the credit line data obtained by the underwriter.

Foreclosure Foreclosure is the legal and professional proceeding in which a mortgagee, or other lienholder, usually a lender, obtains a court ordered termination of a mortgagor's equitable right of redemption. Types of foreclosure 1. Judicial Foreclosure – Court Proceedings 2. Power of Sale- Where Sale Clause provided or a trust deed used Terminology 16

Credit Rating Agency (CRA) Is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments The Basel II guidelines Objectivity Independence Transparency Terminology 17

Agencies that assign credit ratings for corporations include: A. M. Best (U.S.) Baycorp Advantage (Australia) Dominion Bond Rating Service (Canada) Fitch Ratings (U.S.) Japan Credit Rating Agency (Japan) Malaysian Rating Corporation (Malaysia) Moody's (U.S.) Standard & Poor's (U.S.) Pacific Credit Rating (Peru) Terminology 18 Rating Agency Malaysia (Malaysia) Egan-Jones Ratings Company (U.S.) Capital Intelligence Ltd (Cyprus) CRISIL (India)

Historical Linkages -- Manias, Panics and Crashes Terminology 19

Rise of Securitized Mortgage Lending Mortgage Lending 1930s-80s: Funds derived primarily from deposits of the lending institution 1980-2007: Funds derived increasingly from credit markets through securitization process Period Home Loan Securitized Before 1970’s <1% Terminology 20 1980’s ~10% Late 2000’s – Sub Prime Crisis 56%+

Mechanism of A Meltdown There is a change in legislation/policy/practice - a loophole is discovered “Financial Asset” is innovated/ created around the loophole Mass “staged dealing” takes place, valuations are artificially blown up Sudden fall in fundamental asset Bull run turning into sudden “Meltdown” and panic impacting economy for long period Lets take last 20 years and see if there is a trend: Financial Meltdown Financial Assets which were overvalued Terminology 21 Late 1980’s – Saving & Loan Crisis Junk Bond Later 1990’s – Tech Bubble Internet Stock Late 2000’s – Sub Prime Crisis Sub-Prime Mortgages

Late 80’s – Saving and Loan Crisis In 1980 – US Congress allowed Thrift – (Saving and Loan) Associations to lend consumer loans/commercial loans, issue credit cards, - These were high risk and below investment grade loan Further in 1981 –S&L Associations were allowed to sell their risky loans and use cash generated to seek better returns – to invest in even riskier loans . Major Wall Street Firms started buying and these bonds at 60-90%, bundling and trading in them as Government Backed Bonds “Staged dealing” – back and forth trading amongst close group to establish Terminology outsiders (banks) “value” and sell it to 22 As the initial assets (loans) started defaulting – bonds became worthless Eventually Bond failed and created a trillion $ crisis for US taxpayers

Late 90’s – Tech Bubble Internet Stocks (A stock gets its value from underlying sales, growth and overall prospects of future) Company needs to prove themselves by being in existence for several years before they could be traded on stock exchanges – this standard was thrown away - That was the Loophole To pump up the value – companies engaged in “ staged dealings” – (back and forth sales/billing of ads on mutual sites to create false Revenues) These sales numbers were used to fraudulently value the companies and a Terminology 23 totally worthless companies. lot of money was raised on Eventually these companies failed and created another trillion $ crisis

Late 2000’s – Sub-Prime Crisis In current case – instrument - Sub Prime Mortgages. Previously Sub-Prime Mortgages had very little trading value. Only specialist use to deal in them. Mortgage Industry changed Lending standards and Wall Street innovated - “If we take LOTS of these mortgages and assemble them into large pools and then slice and dice the pools in various ways, we can sell the slices to banks and other investors as AAA paper” To pump up the value – Banks sold them (at a fee) to each other and due to Terminology declared them valuable. “ staged dealings” – 24 Eventually Housing Industry came under pressure and everyone on the top starting falling

Historical Linkages Terminology 25 Financial Meltdown

Crisis and Financial Meltdown Crisis is a result of change in legislative, its fraudulent use to create false value, a bull run and then… A Sudden Market Crash Full scale financial system break down – bankruptcies Economic Meltdown - fall in Industrial output, rise in unemployment,, household net-worth drops, Terminology 26

Time Line - Past Few Years Low interest rate regime and availability credit/ securitization resulting into increased liquidity since 2003 Lending to Sub Prime customers on increased Home Prices rise till 2005 and busting of housing bubble in 2005 Rise in Interest rate in 2006 – refinancing became difficult Defaults and foreclosure on rise through 2007-08 Average debt of American Terminology 27 American way of Debt

Time Line . . . . . Initial Impact: Mortgage Lenders Country wide Bears Stears Indy Mac Fannie Mac & Mae Secondary Impact : Investment Banks followed by Commercial Banks Lehman Brothers Merrill Lynch Terminology 28 and it spreads to rest of world

Timeline of current crisis January 11,2008 : Bank of America buys mortgage lender Countrywide Financial for $4 billion in an all-stock deal. March 16,2008 : JP Morgan Chase buys brokerage firm Bear Stearns for $2/share in a deal backed by the Fed and Treasury Department. The price is later revised to $10/share. July 11,2008 : IndyMac is seized by Terminologyperiod. This $1.3 the FDIC after depositors withdraw billion over an 11-day 29 brought to 12 the number of banks seized by FDIC in 2008. Source: www.investmentbankeronlife.com

Timeline of current crisis July 13,2008 : Government-sponsored mortgage finance companies Fannie Mae and Freddie Mac are nationalized by the federal government in an effort to support the U.S. housing market. Sep 7,2008 : The federal government takes control of financial giants Fannie Mae and Freddie Mac, which were nationalized in July. The two hold or guarantee about half the nation's $10 billion in mortgage loans. Sep 15,2008 : Investment bank Lehman Brothers files Terminology 30 for Chapter 11 bankruptcy protection. Rival Merrill Lynch agrees to be taken over by Bank of America. The Dow Jones fell 504 points, the index’s worst since the 2001 terrorist attacks. Top 10 Bankruptcies Source: www.investmentbankeronlife.com

Timeline of current crisis Sep 16,2008 : Insurer American International Group (AIG) is rescued by the federal government through an $85 billion loan package in return for an 80% stake in the company. The move comes amid a cash crunch, triggered by $18 billion of losses over three quarters, a sinking stock price and debt downgrades. Sep 19,2008 : U.S. Treasury Secretary Henry Paulson calls for the government to spend hundreds of billions of dollars to take toxic mortgage assets off the books of financial companies to restore financial stability . News of the bailout plan helps world stock markets soar. Sep 20,2008 : Terminology 31 outlines details of a Treasury Secretary Henry Paulson $700 billion bailout plan for firms troubled by bad mortgage debt. A U.S. bankruptcy judge approves a revised version of Barclays purchase of the core U.S. business of Lehman. Source: www.investmentbankeronlife.com

Timeline of current crisis Sep 21,2008 : Goldman Sachs Group Inc. and Morgan Stanley become bank holding companies regulated by the Fed, essentially ending Wall Street's investment banking model. Sep 23,2008 : Warren Buffett’s Berkshire Hathaway invests $5 billion in Goldman Sachs, citing the rescue plan as a contributing factor. Sep 25,2008 : Washington Mutual is seized by the FDIC, making it the largest U.S. bank failure, with $307 billion in Terminology 32 assets. JPMorgan Chase buys WaMu’s banking assets for $1.9 billion. Source: www.investmentbankeronlife.com

Timeline of current crisis Sep 29,2008 : U.S. House of Representatives rejects the $700 billion rescue plan in a stunning 228-205 vote. The Dow Jones falls by a record 777 points. Wachovia agrees to sell most of its assets to Citigroup in a deal brokered by regulators. Oct 1,2008 : U.S. Senate passes a modified U.S. financial rescue plan aimed at restoring global financial stability, sending the measure to the U.S. House of Representatives for a vote on Friday. Oct 3,2008 : Terminology historic $700 billion rescue bill President Bush signs the 33 approved just hours earlier by the U.S. House of Representatives in a 263-171 vote. Wells Fargo agrees to buy Wachovia for $15.4 billion or $7 a share, better than Citigroup’s earlier offer of about $1 a share. Source: www.investmentbankeronlife.com

Model of Mortgage Loan Mortgage Broker Sub-prime Mortgage Secondary Mortgage Market CRA Certification Investors – OTC Market Home Mortgage Evolution Repackaging into MBS, CDO Private Sub-prime Mortgage Process Terminology 34 Source: The Economist: Making Sense of Modern Economy

Mortgage Broker Mainly found in developed economies like US, Western Europe Professionals who are paid a fee to bring together lenders and borrowers Sells mortgage loans on behalf of businesses (ex. Banks) Terminology 35 Source: Wikipedia

Sub-prime mortgage – What’s that? Home loans made to borrowers with poor credit ratings — a group generally defined by FICO scores below 620 on a scale that ranges from 300 to 850 FICO - a number that is based on a statistical analysis of a person's credit report, and is used to represent the creditworthiness of that person. (FICO is the acronym for Fair Isaac Corporation, a publicly-traded corporation (under the symbol "FIC") that created the best-known and most widely used credit score model in the US.) Creditworthiness—the likelihood that the person will pay his or her Terminology 36 debts. Calculated by credit reporting agencies. Ex. Equifax, Experian, and TransUnion in US Source: Wikipedia

Secondary Mortgage markets The secondary mortgage market allows banks to sell mortgages, giving them new funds to offer more mortgages to new borrowers. If banks had to keep these mortgages the full 15 or 30 years, they would soon use up all their funds, and potential homebuyers would have a more difficult time to find mortgage lenders. Many of the mortgages on the secondary market are bought by Fannie Mae. Terminology 37 mortgage-backed securities, and sold to Other are packaged into investors. Source:http://www.urbandigs.com/2007/08/how_mortgage_backed_securities.html

Credit Rating Agency (CRA) Company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued Ex: Moody's (U.S.), Standard & Poor's (U.S.) Credit ratings are used by investors, issuers, investment Terminology 38 and governments. banks, broker-dealers, For investors, credit rating agencies increase the range of investment alternatives and provide independent, easy-to-use measurements of relative credit risk. Source: Wikipedia

OTC market A decentralized market of securities not listed on an exchange where market participants trade over the telephone, facsimile or electronic network instead of a physical trading floor. There is no central exchange or meeting place for this market. In the OTC market, trading occurs via a network of middlemen, called dealers, who carry inventories of securities to facilitate the buy and sell orders of investors Trading is private and prices and Terminology 39 volumes are not disclosed Price discovery non transparent Source : http://www.investopedia.com/terms/o/over-the-countermarket.asp

Evolution of home mortgage Home loan funding 1930s Principal + interest payable over long term Lender-Banks Borrower-Individuals • Owning a house was not affordable to many • Great Depression brought industry to a halt. Large scale defaulters and lenders could not recover by reselling • To simulate the industry again Government as part of New Deal policy created the Federal National Mortgage Association (Fannie Mae) in 1938. This created a secondary market for mortgages Bought loan Home loan funding Terminology 40 Cash Principal + interest payable over long term Transfer of credit risk, market risk Had Access to long term borrowing Lender-Banks Borrower-Individuals Bought only those which conformed to certain underwriting standard ( called Prime Mortgages) Source :http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,Subprime Mortgage Market Turmoil, Christopher L. Peterson, Asst Prof of Law, Univ of Florida

Evolution continued… Fannie Mae proved very successful . But by 1960s , borrowing done by it constituted a significant share of the debt owed by US government. 1968- Government National Mortgage Association (Ginnie Mae) was created to handle government guaranteed mortgages. Fannie Mae became federally chartered, privately held 1970- Ginnie Mae developed MBS -- shifted the market risk to investors -- eliminated debt incurred to fund government housing program 1970-Federal National Mortgage Corporation (Freddie Mac) created To securitize conventional mortgages Terminology to Fannie Mae Provide competition 41 Over time Fannie Mae and Freddie Mac together provided enormous amount of funding for US mortgage Since Fannie Mae and Freddie Mac guaranteed loans, much of credit risk stayed with them. Size and diversification allowed them to handle it. Source :http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,

New Model of mortgage lending Bought loan Home loan funding Cash Transfer of credit & market risk Lender-Banks Principal + interest payable over long term Securitization SPV Advantages Cash fees MBS • More liquidity in market • Risk spread out • Long term funding for mortgage lending Transfer of market risk Terminology 42 • MBS- allows originators to earn fee income from underwriting activities without exposure to credit, market or liquidity risks as they see the loans they make

Private Players joined 1977- Private label securitization started first done by BOA and Salomon Brothers 1980s- pricing, liquidity and tax hurdles were resolved in same Unlike 2-3 party , private label securitization has 10 or more different parties playing independent role Big private players in this field were Wells Frago • Indymac Lehman Brothers • Washington Mutual Terminology 43 Bear Stearns • Countrywide JP Morgan Goldman Sachs Bank Of America

Repackaging into MBS / CDO MBS MBS CDO Terminology 44 • Created in 1987 by now defunct investment firm Drexel Burnham Lambert • Not traded on exchange but OTC market

Details : Private Sub-prime mortgage process 1. Brokers identify borrowers 2. Originator and broker identify a loan for borrower after looking at his credit rating 3. Formal application for loan by borrower 4. Originator transfers the loan to the subsidiary of an investment banking firm ( Seller) 5. Seller(Investment bank) collects a pool of loans and call it as SPE/SIV/SPV. Off balance sheet instrument 6. SPV can be a corporation, partnership or limited liability company. Most often a Trust. It has nothing else except mortgage loans 7. Underwriter purchases all the securities (derivative income streams) 8. In designing SPV and its tranches underwriter works with credit rating agencies Terminology 45 9. Underwriter then sells the securities to the investors 10. High rated tranches might be guaranteed by a 3rd party insurance company 11. Seller also arranges to sell the rights to service the loan pool to a company or sometimes Originator takes these rights 12. MERS – document custodian. Company to keep track of mountains of paper work on loans Source : Subprime Mortgage Market Turmoil , testimony by Christopher L. Peterson in the pool. At National level.

Complexity of Financial Products & Models Mark to Market / Model Blame the models The fragility of models Four Major Implications VaR Market risk model CRA’s: SIV & Sub-prime Terminology 46 Unrealistic demands Use models but…

Mark to Market / Model Last year, Banta bought an apartment in Gurgaon. He spent Rs 1 Cr. His Real Estate agent says it’s worth Rs 60 Lac today. Banks are not lending, so no one is offering to buy Banta’s apartment. A drunk guy , Santa, met at the bar said he would pay Banta Rs. 5 Lac Rs 60 Lac is the Mark to Model. Rs 5 Lac is the Mark to Market. How much is Banta’s apartment worth? If he used it as collateral for a loan, how much would you lend him? A mark to model is less reliable Assumptions Terminology 47 is not present. May assign a liquidity which complex financial instruments no ready market => mark to model Source :http://innovationcreators.com/wp/?p=464

Blame the models Quality of Statistical Risk Models was much lower Ignored Black Swans ( the highly improbable and unpredictable events that have massive impact. ) - Fractals Theory & Chaos Theory no one managed to prove that the use of a model that does not work is neutral, volatility as an indicator of stability has fooled the banking system. Identification of fourth quadrant (danger zone) is important Ignored liquidity Ignored increase in correlation during downturn Ignored leverage ratios Ignored the fact that events are correlated and risks are auto correlated. Terminology 48made value & risk assessment difficult Trading in OTCEI further No standard contracts No information on holdings and pairings Sources: Blame the Models by Jon Daniielson , London School of Economics Ian Stewart, Does God Play Dice? The Mathematics of Chaos

The fragility of Models Finance is not physics; it is more complex. Endogenous risk: Statistical properties change under observation since market participants react to information We can only model aggregate behavior. Financial modeling changes the statistical laws in real-time, we can ignore endogenous risk in calm. In a crisis, we cannot. And that is when the models fail. Quality of assumptions Modelers tend to ignore what is difficult, not what is important. Terminology 49 been ignored in model design liquidity had generally Data quality Financial data have the annoying habit of being of short duration. The statistical properties of financial data change over time Source: Blame the Models by Jon Daniielson , London School of Economics

Four Main Implications 1. SF Pool Losses Don’t Recover 2. SF Pool Losses are Skewed 3. SF Pool Losses are Moving Target 4. SF Pool Loss Distribution Narrows Over Time Terminology 50 Source: Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions, Joseph R. Mason, Associate Professor of Finance, Drexel University & Joshua Rosner, Managing Director, Graham Fisher & Co.

VaR (Value at Risk) What is my worst case scenario (compare volatility) Three components: a time period, a confidence level (relatively high) and a loss amount (or loss percentage). What is the most I can - with a 95% or 99% level of confidence - expect to lose in dollars over the next month? 3 Methods Historical Method – actual historical distribution Variance-covariance Method – assumes normal distribution VaR = Value * Z * σdaily * (horizon Period)1/2 Terminology 51 σ* 10 = .75% for 10 day period 1% VaR of $400m with = $400m * .0075 * 2.326 = $22.07m daily Basel (rule based) : 8% of $400m = $32m Monte Carlo Simulation – any method of randomly generated trials Source :http://www.investopedia.com/articles/04/092904.asp

Market Risk Model Daily 99% VaR estimates for a $1000 portfolio of IBM for May 1, 2008 Sample size 1 year 4 years 10 years Estimation method Historical simulation $22.8 $17.7 $29.9 Moving window $24.7 $18.8 $32.6 Exponentially moving average $21.3 $21.3 $21.3 Normal GARCH $25.5 $23.4 $24.0 Fat tail GARCH $27.6 $20.6 $22.9 No easy way to pick the best method. Terminology we increase the number of assets. The model risk increases as 52 Aggregation Method & its associated assumptions ? Assets traded on different exchanges, time zones and opening hours,dates of holidays , asset categories Source: Blame the Models by Jon Daniielson , London School of Economics

CRA’s : SIV & Sub-prime Modeling process is much more complicated and harder to verify,which increases the risk of mistakes. Aggregation problem the short data sets mean that we can not obtain the default probabilities => need to model default probabilities. The rating agencies like Moody’s use historical credit data and ignore the actual loan applications Underestimated the importance of the business cycle and the presence of a speculative bubble in housing markets. default correlations and low rates of defaults of mortgages initially mortgage defaults become highly correlated in downturns Terminology 53 SIV’s often were not long enough to include a recession Data samples used to rate Didn’t include key data fields like debt-to-income,appraisal type,originating lender & rate,resets Moody’s Fiasco Source: Blame the Models by Jon Daniielson , London School of Economics

Unrealistic demands A high quality modeling process is harmonization between probability levels, sample sizes, and testing. Can’t use same models in all situations (95%,99%) Models which can’t be backtested , 99.9% model (risk of loss in every 1000 years), fat tail VaR model Exceptions are copulas etc. which are still at experimental level Dependence on Basel II Accord (based on regulation by models) could be problematic since model risk could go out of sync Terminology 54 Source: Blame the Models by Jon Daniielson , London School of Economics

Use models but … The financial institutions that are surviving this crisis best are those with the best management, not those who relied on models to do the management’s job. The solution to a problem like the sub-prime crisis is not Basel II but to understand the products ,interaction with institutions and risks involved Taleb’s Thumb rules Learn to love redundancy Terminology 55 numbers Beware presentations of risk Absence of Volatility is not absence of risk …… Source: Blame the Models by Jon Daniielson , London School of Economics

Faults in the model and aftermath… Financial Turbulence Sources of Market Failure Regulatory Shortcomings Reasons for forming of subprime mess Big Assumptions and Terminology 56 misaligned incentives

Financial Turbulence Crisis precipitated by failure of America’s financial sector to Manage Risk Allocate Capital Financial sector made Bad Loans & engaged in multi billion dollar gamble through derivatives & Credit Terminology 57 default Swaps. Source: The Economist: Making Sense of Modern Economy

Sources of Market Failure Poor Credit appraisal standards – Loans for NINJAS New dimension to bank liquidity Faulty Risk Management Tools & Models Role of Credit Rating Agencies – Understatement of Risk Weak Public disclosures of Risk & Exposures Terminology 58 Source: The Economist: Making Sense of Modern Economy

Regulatory Shortcomings Lax regulations which did not keep pace with the innovations happening in financial engineering Limited regulation on investment Banking Failure of regulators – overestimation of strength & resilience of financial system Terminology 59 Source: The Economist: Making Sense of Modern Economy

Leading to . . . Inadequate capital growth of unregulated exposures excessive risk-taking weak liquidity risk management. For eg : Hedge funds leverage ratio of the order of 500% Shortcomings associated with the valuation and financial reporting of structured products Terminology 60 derivatives trade on OTCEI CDOs and credit Source: The Economist: Making Sense of Modern Economy

Reasons for forming of Sub-prime mess Giant pool of money available for investment through savings of Oil exporters , economic development in BRIC countries. US kept interest rates too low for too long in post dotcom bust period Building up of the housing bubble Terminology 61

Reasons for forming of Sub-prime mess Private share in mortgage market growth in large part through origination and securitization of high risk sub-prime and Alt-A mortgages. To sum up in 3 words as noted by Harvard dean: Leverage(high), Transparency (low) and Liquidity (abundant) Terminology 62

Big assumptions & Misaligned incentives Banks kept on lowering lending standards, since they assumed they could sell the risk on. A widespread assumption that the process of “slicing and dicing” debt had made the financial system more stable. Terminology 63 Investors barely understood these complex products and believed the credit rating agencies. Source :http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

Big assumptions Cont.. “Churning” of capital “allows even an institution without a great amount of fixed capital to make a huge amount of loans, lending in a year much more money than it has Securitization conduit divides various lending tasks into Multiple corporate entities—a broker, an originator, a servicer, a document custodian, etc. Terminology 64 Prevents the accumulation of a large enough pool of at risk assets. Source :http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

Good days don’t last forever. Financial innovations like ARM (adjustable rate mortgage) mechanism led to complacency. By mid 2006, time to pay bigger amounts comes :-- Household income did not increase in same proportion as house prices Subprime mortgage owners start defaulting Rating agencies revise ratings of MBS/CDO as expected number of defaults turn out higher. Many ratings are lowered Terminology 65lost faith in ratings, many stop buying MBS/CDO Bewildered investors altogether.

Crisis at the door (mid 2006 onwards): Banks find themselves in non-comfortable position , stop making loans Housing prices plummet owing to increase in foreclosure, delinquency and stoppage of loans – prices fall exponentially in vicious cycle Perfectly good borrowers – Prime/A category – see the value of their houses also fall. This feeling of loss of wealth makes them spend less, putting the economy in to a further downturn due to lack of demand. => SUBPRIME CRISIS Terminology 66

Oh ! what a mess…. More frenzy -> more defaults -> again revised ratings -> further stoppage of funding & loans -> further fall in house prices as demand and supply mismatch....problem feeding itself in circular fashion. => SUBPRIME CRISIS Most of the player in the market, mortgage brokers, investment banks were running in debts caught unaware and are in insolvency and start tumbling down Central government start pumping in money as last resort but one Terminology returning soon and which is very vital in financial thing is surely not 67 industry -FAITH.

CDS CDS were used to profit from speculation. The volume of CDS outstanding increased 100-fold from 1998 to 2008.CDS market stated to be $62 trillion. Market is completely lacking in transparency and unregulated. Reasons for expansion of CDS market - Limited capital requirement for CDS - No need for funds to take risk through CDS Terminology 68 were active participants in CDS Thus Hedge funds

CDS Defaults increased the likelihood of “protection sellers” having to pay counter parties.Thus Insurance Companies ratings downgraded. “Counter party risk.” loomed large -party providing the insurance protection does not have the money to pay the insured buyer when default occurred. CDS transactions also one of the reasons for the crisis spreading to Terminology 69 main victim the insurance sector, the being AIG.

In Short When homeowners default, the amount of cash flowing into MBS declines and becomes uncertain. Investors and businesses holding MBS have been significantly affected. The effect is magnified by the high debt levels maintained by Terminology 70 ie individuals and corporations, financial leverage. Source :http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,

Crisis Toll “The Most serious financial crisis since the Great Depression of the 1930” “Real estate prices collapsed, credit Terminology 71 building stopped ... dried up, house

The Genesis .. . US Mortgage Market Home Prices were expected to rise forever . . . . . Home ownership rate reaches an all time high of 65 % Home mortgage debts as % of PDI rises to 75 % Overall Household leverage rises over 100% Weak link in chain : Subprime borrower Terminologystarts in subprime market Default 72 Sales fall Existing home sales nationwide fell 29%

“Any real-estate investment is a good investment … ” … NOT any more! Terminology 73 But Home Prices starts to fall.. Forty-six States Had Falling Prices in the Fourth Quarter 2007

The Mess . . . . Surge in Mortgage Loan Fraud leading to record Dollar losses Rising Inventory on books Forec lo sure r nc y is es ue linq All Leading too … de ec o rd R Leading financial Institution & Investment Bank going bankrupt Terminology 74 Bear Stearns goes belly up … American International Group (AIG) 85B. bailout C eize d by the FDI I ndyMac is s

Spillover to the Rest of the World 2 Financial Food and FIRE Shock 1 Energy Price Shock Federal Reserve Primary Reaction Function Deterioration Decline in Increase in Federal in U.S. U.S. U.S. Headline Reserve 5 Financial Economic Inflation Cuts Appreciation Conditions Activity Its Policy Rate of Euro ECB Deterioration Decline in Increase in Raises in Euro-Area Euro-Area Euro-Area Its Policy Financial Economic Headline Terminology 75 Rate 4 Conditions Activity Inflation 3 ECB Primary Reaction Function ICE

Financial Crises:- A Comparison … Banking Losses in Constant US$ Terms (and as a Percentage of GDP) In 2007 U.S. Dollar Terms (US$ bn.) 1600 10% of GDP 1400 1200 1000 15% of GDP 800 600 35% of GDP 400 2.5% of GDP 200 Terminology 76 0 U.S. S&L Crisis (1986-95) Japan Banking Crisis (1990-99) Asia Banking Crisis (1998-99) US Subprime Crisis (2007-08) Banking Losses Other Financial Losses Losses of over 1.4 trillion USD Source: IMF Global Financial Stability Report, October 2008, Chapter 1, p. 16.

Impact on US Credit Market Market for Liquidity Freezes Supply of credit decreased dramatically Lenders refusing to lend to other banks Lenders buy only government bonds – the “flight to quality” Firms, individuals holding money as cash, not loans – the “liquidity trap” Lenders are afraid of all loan types – subprime bonds, then student Terminology 77 loans, then home equity loans, then commercial paper (business, consumer loans), etc.

Impact on US Credit Market Cont.. Widening Spreads over 10 years treasury bonds: Municipal Bonds rises to a historic high of over 100 basis pts. Mortgage-Backed & High-yield Bonds rises to a historic high of over 1000 basis pts. Corporate Yield Spreads rises to over 500 basis pts. Terminology 78 Money Market Spreads Blow up to over 360 basis points ( US LIBOR / OIS) against a normal of 20 basis pts.

Impact on Markets … U.S. Equity Market Falls Back to 2003 Levels Unprecedented rise in Equity market volatility Financial Stocks Take Big Hits in Subprime Crisis Financial Conditions Index falls to historic low Terminology 79 worldwide Major losses for banks Commodity Prices : CRB Index Falls to 2003 Levels

Impact on Foreign Exchange Market Till end-July 2008, USD depreciated against major currencies on account of : Weaker equity markets Slowing manufacturing productivity growth Higher unemployment with downward non- farm payroll employment, & Low housing sales Terminology 80 Lowering consumer confidence

Deleveraging Starts….. Appreciation (+) / Depreciation (-) of USD vis- From early-August 2008, USD’s à-vis other currencies strength reflected Liquidation of positions in the overseas equity and bond markets by US investors Repatriation of the money back to US due to slowing growth in the Euro area Terminology 81

Financial restructuring starts … Wachovia, the 6th largest bank, taken over by Wells Fargo Bank Top Investment Bank : Lehman Brothers, Bears Stearns & Merrill Lynch cease to exist Goldman Sachs & Morgan Stanley were converted into Bank Holding Companies 15 Banks declared bankruptcy:- Washington Mutual filed for biggest ever bankruptcy. Terminology were made by Financial Institutions Majors write down 82

Recapitalization of financial system Economic Stabilization Act was passed on Oct 3,2008 Troubled Assets Relief program, to purchase troubled assets of USD 700 Billion was passed. Limit on Deposit insurance was increased from USD 100000 to USD 250,000 per account Eligible collaterals and the eligible counterparties were expanded Foreign Exchange Swaps were created with major central banks for Terminology 83 ( Made unlimited on October 13 , 2008 ) infusing Dollar liquidity

Impact on World Markets: Equities Financial stress sweeps through global markets…. • MSCI Emerging Market Index is down by over 66 % from their peak • MSCI US and Euro Index are down by over 50 % from their peak Terminology 84 Source: Bloomberg

Impact on World Markets : Government Bonds Government bond yields declines in major advanced economies •Worsening Growth Expectation • Falling Inflation Outlook Terminology 85

Impact on World Markets : Short Term Int. Rate Short Term Interest showed a mixed trend in major advanced economies reflecting • Local Liquidity conditions • Policy Rates Terminology 86 3- Months money market rates

Macroeconomic risks continue to rise.. Continuous fall in Global Economic Activity Considerable deteriotion from April 2008 situation •Credit deterioration broadens • Market & Liquidity Risk •Fall in Risk Appetite •Tighter Monetary & Financial Terminology 87 conditions

Risk of Systemic Default on the rise .. Terminology 88

Impact of Financial Crisis on Europe . . . Payment incident index (*) Scale of sector risk in Western Europe 12 months moving rate 300 WORLD Germany France Italy 250 200 150 100 50 0 june 93 dec-93 june 94 dec-94 june 95 dec-95 june 96 dec-96 june 97 dec-97 june 98 dec-98 june 99 dec-99 june 00 dec-00 june 01 dec-01 june 02 dec-02 june 03 dec-03 june 04 dec-04 june 05 dec-05 june 06 dec-06 june-07 déc-07 Terminology 89 * Payment incident index 100: World 1995-2000 basis

Impact on Europe Cont.. United Kingdom, Spain, Ireland on negative watch Payment incident index (*) 12 months moving rate Economic growth Payment incident index Economic growth Payment incident index 7% 300 7% 300 6% 250 6% 250 5% 4,7% 200 5% 4,5% 4,4% 3,9% 200 4% 3,9% 3,9% 3,8% 3,2% 3,2% 3,0% 3,3% 4% 3,5% 3,1% 150 3,2% 2,7% 2,8% 3,0% 150 3% 2,8% 2,7% 2,3% 2,1% 3% 2,3% 1,9% 1,9% 100 100 2% 2% 1% Terminology 90 50 1% 50 0% 0 0% 0 2 0 0 7 (f) 2 0 0 8 (f) 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2 0 0 7 (f) 2 0 0 8 (f) 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Spain United Kingdom *Payment incident index 100: World 1995-2000 basis

US Economic Indicator : Snapshot ! GDP falls to less than 1% (YOY) in real terms Expectation 2009 : -1.30 % (YOY) Inflation : Less than ZERO % in 2008 = Worst in 17 years Unemployment: Rises to over 7.0 % Interest Rate: Falls to 0.250 % Terminology 91 fall in economic activity Unprecedented

Current Status of World Economy World economy entering a major downturn OECD countries in recession Enormous financial sector dislocation Unknown fiscal costs of bailouts Severe real economy dislocations Stagflation potential Terminology countries growth rates ex China & India Developing 92 reduced by half

Current Status of World Economy Cont.. Weakening global trade - world trade likely to decrease in 2009 for the first time since the 1982 recession, remittances dropping Emerging markets witnessing international reserves declining, volatile equity and foreign exchange markets Volatile commodity prices pose risks for importers & exporters Global Inflation Risk Moderated but Volatile Terminology 93 OECD Leading Economic Indicator Points to a Significant Slowdown

Impact of Financial Crisis on Domestic Financial Markets Economic Indicator: Snapshot Impact on financial markets Impact analysis on key sectors Terminology 94

Economic Indicator : Snapshot ! GDP for 2008-09 8.0-8.5% (YOY) Expectation 2009-10 : Less than 7 % Index of Industrial production fell to less than 1 % in Aug. Fiscal Deficit expected to touch over 5 % of GDP Inflation : Over 8.5% in 2008-09 Terminology 95 G-Sec yield is at less than 5 % Interest Rate: 10 years Equities Market down by over 60 % from their peak

Inflation – Number 1 concern now Inflation numbers : Rate in May/June 08 vs. (2007) •Japan - 7.1% 27 year record high •China - 7.7% (4.8%) •India - 7.8% (4.4%) •Malaysia - 7.7%, (2.0%) Terminology 96 •Vietnam - 25.2% (8.3%) •Singapore - 7.5% worst in 26 years

2009 = slowdown + uneasy financing for companies An expected slowdown of the World Economy, especially felt in industrialized countries Terminology 97 A more difficult access to financing for Companies because of tougher credit conditions

Impact on Equity Markets Global equities market more tightly linked Fall in Asian equities markets even more severe than in the U.S. Equity markets decline (Q3-2008): Japan - 34% China - 50% India - 45% Singapore - 30% Malaysia - 27% Reasons Withdrawal of foreign equity funds from Asia to cover losses in U.S Negative news about the health of financial institutions China and India markets over-heated Terminology 98 Extension of credit losses High inflation Fears over decline in corporate earnings

Impact on Financial Markets In India, Short term Int. rate rose initially and then fell • Local Liquidity conditions (Initial Rise) •Policy Measures (Fell) Terminology 99

Impact on Foreign Exchange Market Till end-July 2008, USD depreciated Appreciation (+) / Depreciation (-) of against major currencies on account of : USD vis-à-vis other currencies lowering consumer confidence weaker equity markets slowing manufacturing productivity growth higher unemployment with downward non-farm payroll employment, and low housing sales From early-August 2008, USD’s strength reflected liquidation of positions in the overseas Terminology 100 equity and bond markets by US investors repatriation of the money back to US due to slowing growth in the Euro area

Impact of Financial Crisis on Japan Japanese companies suffered from disappointing growth prospects Payment incident index (*) Scale of sectoral risk 12 months moving rate 300 WORLD 250 Japan 200 150 100 50 0 june 93 dec-93 june 94 dec-94 june 95 dec-95 june 96 dec-96 june 97 dec-97 june 98 dec-98 june 99 dec-99 june 00 dec-00 june 01 dec-01 june 02 dec-02 june 03 dec-03 june 04 dec-04 june 05 dec-05 june 06 dec-06 june-07 déc-07 Terminology 101 *Payment incident index 100: World 1995-2000 basis

Impact of Financial Crisis on Developing Countries Massive capital outflows, drastic drop off from previous record highs (from $1 trillion to nearly $500b, from 7.6 to 3 percent of GDP) Many hard hit developing countries already had: – Fiscally precarious positions – High levels of initial poverty and malnutrition – Limited capacity to implement targeted policy response Impact – Affects wages and employment as inflation passes through (inflation up 5% in most, >10% in more than half) – Sharp drop in investment, which has been driver of growth Terminology 102 – Falling remittances – Long term cost of coping mechanisms, loss of fiscal cushions

Impact of Financial Crisis on Developing Countries Financial flows are likely to drop precipitously …… Net private capital flows to developing countries $ billions $998 billion in 2007 1000 Possible 2008-09 800 600 East Asia Crisis 400 200 Terminology 103 0 20 P P 20 e 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 20 6 0 07 08 09 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 Source: World Bank staff estimates

Impact of Financial Crisis on India Liquidity conditions in Q2-2008 were eased on account of significant reduction in the cash balances of Central Govt. In Q3, liquidity conditions mostly remained in a deficit mode Indian financial markets in Q3 witnessed heightened volatility reflecting uncertain global situation Interest rates in money market moved in accordance with evolving liquidity conditions Daily avg. call rate continued to remain above the repo rate reflecting the impact of hikes in CRR and repo rate Indian rupee depreciated against major currencies In credit markets, lending rates of scheduled banks hardened Yields in govt. securities Liquidity Adjustment Facility and the Call Rate market decreased Indian equity markets Terminology 104 declined in tandem with trends in major international equity markets as well as edging up of domestic inflation

Impact of Financial Crisis on India Foreign Exchange Market Credit Market During FY2008-09, Indian rupee Scheduled commercial banks generally depreciated (from Rs 39.89 increased their deposit rates for to Rs 48.84 per USD ~ depreciated various maturities by 25-150 basis pts by 18%) (8.25-9.5% in Jun’08 to 8.75-10.25% in Due to FII outflows, bearish stock Sep’08) market conditions, high inflation and Benchmark lending rates of PSBs higher crude oil prices reflecting increased by 75-125 basis pts from higher demand for USD 12.5-14% in Jun’08 to 13.75-14.75% by Sep’08 Movement of Rupee vis-à-vis Major Currencies Deposit & Lending Rates-PSB 5.5% Terminology 105 18% 3.6%

Impact of Financial Crisis on India Govt. Securities Market Equity Market - Primary Market Heightened inflationary expectations Witnessed slackness in resource mobilization emanating from sharp increase in global during Q2-Q3 commodity and crude oil prices led to Cumulatively, resources raised through public hardening of yield in Q1-Q2 issues declined sharply to Rs 12,361 crores Since Q3, yields have eased due to CRR during Q2 from Rs 31,850 crores during reduction to 250 basis pts and softening of corresponding Q2 of 2007 crude oil prices No. of issues declined from 60 to 32 (19 IPOs from Pvt. sector cos. constituting 16% of total resource mobilization) Avg. size of Public issue declined to Rs 386 cr Yields on Govt. Securities from Rs 531 Mobilization of Resources – Primary Market Terminology 106

Impact of Financial Crisis on India Stock Market Four distinct Phase - Phase I (Apr 1 & May 21’08) – Mkts staged recovery due to better results of Q4-2007 declared by IT majors, net purchases by FIIs in Indian equity mkt and some easing of international crude oil prices - Phase II (May 22 & July 16’08) – Mkt sentiment turned cautious on account of increase in in’tl crude oil prices , hike in retail fuel oil prices, rise in domestic inflation rate, rising trade deficit and depreciation of rupee, domestic political uncertainties, downward trend in in’tl equity mkts, etc - Phase III (Jul 17 & 7 Sep’08) – Mkt recovered on account of restoration of domestic political stability and decline in crude oil prices - Phase IV (7 Sep’08 onwards) – Mkt Indian Stock Market turned volatile due to decline in international stock mkts triggered by bankruptcy/sell-out/restructuring of some I II III IV Terminology 107 of world’s largest financial inst., heavy net sales by FIIs, sharp fall in value of rupee & slowdown in industrial growth Sectoral indices also witnesses downward trend P/E ratios of 30 scrips in BSE Sensex declined from 20.1 (end-Mar’08) to 16.2 (at end-Sep’08)

Impact on India – The Good, Bad and Ugly Indian companies with big tickets deals in the international market are seeing their profit margins shrinking Trade finance is drying up and is dragging down exports Terminology 108

Impact of Financial Crisis on India Indian Financial Services Indian Financial Services Most Impacted The US sub-prime market crisis, which so far caused losses worth $181 billion to the world’s top 45 banks by the end of FY08, has started hitting Indian banks also India’s largest private sector bank ICICI Bank was the first bank to announce a loss of about Rs. 1,056 crores owing to the sub prime crisis of US in the FY08 results The public sector banks have had a limited position in the structured products and therefore impact is expected to be minimal. However negative sentiments will hit harder Punjab national Bank, Bank of India, State Bank of India, Bank of Baroda were major banks having an exposure to the instruments issued by Lehman and Merrill Terminology 109 Lynch However the banking sector in general will have to face tight liquidity conditions apart from further mark-to-market losses. The net non performing assets of entire banking sector is less than 2% and it is well capitalized. The capital adequacy ratio is around 13% as against the statutory requirement of 8 to 9%.

Impact of Financial Crisis on India Indian Financial Services Chakra-view…..Exposed?? Indian Financial Services Chakra-view…..Exposed?? Terminology 110

Impact of Financial Crisis on India Real Estate Real Estate Most Impacted With the sudden collapse of world leading financial houses, the Indian real estate players who were already facing the problem of lack of funds due to economic slowdown & correction in prices are finding difficult in raising further funds Among the US Financial Houses --- Lehman Brothers was very bullish on Indian Reality Sector and had an investment in excess of US$ 700 mn (maximum amongst peers) Lehman’s real estate investments at project levels (including the big ones like DLF, Unitech & Future Capital) have been disbursed & it will not affect the ongoing projects Terminology remitainvestments made by US financial houses inflight of RBI’s directive not to 111 without permission is also step in positive direction and would restrict India capital However, stocks of companies in which sunked financial institutions have a direct exposure (as FII investments especially Lehman) would see selling pressure

Impact of Financial Crisis on India Automobiles Automobiles Mildly Impacted Auto companies have been seeing sluggish sales for the past few months due to higher interest rates and higher fuel prices Two wheelers have shown decent sales growth in the last 2 months, more due to the low base effect It would get tougher for passenger and commercial vehicles and it might start impacting two wheeler vehicle sales negatively Exports of auto companies might take some hit, however, the impact on exports might not have significant impact on the top-line of auto companies, as the percentage sales contribution from exports is less for Indian auto companies; but this might cause the auto companies to cut their export targets for the next two or Terminology 112 three years Sales Growth Description Jul'08 Aug'08 Passenger Vehicles ‐1.40% ‐4.35% Commercial Vehicles 2.00% ‐6.33% Three‐wheelers 1.50% ‐3.19% Two‐wheelers 19.50% 14.24%

Impact of Financial Crisis on India Hospitality ,, Travel and Tourism Hospitality Travel and Tourism Mildly Impacted Slowdown in travel demand: Travel budgets of companies have fallen by approx. 40% and a further fall of 10-15% is expected in the next 2 quarters Hotels face difficulty in maintaining occupancies - falling from the current 75% to 68-70% Growth in average rooms rates is expected to slowdown from 16-21% to 5- 9% With increasing competition and room tariff wars, hotels facing pressure on their profit margins Terminology 113 Lack of investments in properties will limit the hotels from expansion plans AIG bailout is likely to impact Indian Aviation as its subsidiary is among the world’s largest aircraft leasers to Indian companies

Learning & change of the model What has the crisis been about? India’s long term growth story remains intact Strong long term growth prospects Lessons from sub-prime crisis Controlling the crisis Terminology 114

What has the crisis been about This crisis is about three things: Too much liquidity. Fundamental structural problems in the credit industry, including the almost-total lack of regulation. Lack of transparency of complex financial instruments for which there is no public market, making them tough to value and nearly impossible to trade. There is fair distance to travel Banks have recognized only a fraction of the overall potential losses – approximately $50 billion to $75 billion so far on sub-prime debt alone.Total Terminology 115 (IMF estimate) bailout cost is around $1 trillion Source: Three Ways to Know When the Credit Crisis Hits Bottom, Keith Fitz-Gerald,Investment Director,Money Morning/The Money Map Report

India’s long term growth story remain intact India’s GDP growth is expected to continue as 85% comes from domestic market India a country of savers – low credit dependence Strong base of trained manpower Terminology 116

Strong long term growth prospects Growing insurable population in 20-60 years bracket Increasing disposable income Terminology 117

Lessons from sub-prime crisis Importance of observing prudent underwriting standards, verification of documents, and an ongoing monitoring of the borrowers affairs Liquidity Risk - Close link between market liquidity and an individual bank’s funding liquidity Importance of reliable valuations and transparency of risk exposures. Inappropriately optimistic valuation and modeling methodologies Technology does not obviate the need to assess a borrower carefully. Insufficient recognition of residual risks in the structured products Lack of transparency due to insufficient disclosure. Terminology 118 Compensation systems rewarded very short-term employee performance. Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

Lessons from sub-prime crisis Conflict of interest in the role of rating agencies Rating agencies are paid for their rating exercise by the issuers of securities and not by the investors in those securities. Appropriate mechanisms should be evolved to ensure that the information received by the rating agencies is reliable; Closer attention to the liquidity risks faced by the rated entity / product should be mandated for the rating agencies in their rating process; Terminology 119 Road map for the rating agency reforms, should be evolved to address the weaknesses revealed as also to promote competition in the rating industry Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

Controlling the crisis- better warning signals in future Strengthened Prudential oversight of capital, liquidity risk management Phased implementation of the Basel II norms Minimum capital requirement prescribed at higher levels of 9% . Banks exposure to sensitive sectors and their liquidity position monitored on a regular basis Broad guidelines for asset – liability management have been put in place and banks develop risk management policies under broad guidelines Terminology 120 Overnight unsecured market for funds has been restricted only to banks and primary dealers Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

Controlling the crisis- better warning signals in future Enhancing transparency and valuation Strengthened the valuation norms and market discipline in respect of complex financial products including issuance of guidelines on valuation of various instruments Comprehensive guidelines on derivatives incorporating risk management and corporate governance aspects, suitability and appropriateness policy. Terminology 121 Set of disclosure requirements developed to enable assessment on capital adequacy, risk exposure, risk assessment processes and key business parameters Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

Controlling the crisis- better warning signals in future Changes in the role and uses of credit ratings Norms developed to ensure consistency in credit rating agencies by banks disallowing banks to cherry pick the assessments provided by different credit rating agencies Strengthening the authorities responsiveness to risks: A working group has been constituted to lay down a road map for adoption of a suitable frame work for cross border supervision and supervisory cooperation Robust arrangements for dealing with stress in the financial system Terminology 122have been put in place for liquidity management Institutional arrangements facilities, and open market operations, and market stabilisation schemes RBI has been empowered under existing legal framework to deal with the resolution for the weak and failing banks Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-618-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

Conclusion Risk of sub-prime Housing loan transferred : commercial bank -> investment bank -> investors through securitization Mortgagor defaults created havoc in real estate and in turn financial markets and leveraged financial institutions Models were too fragile to value complex financial instruments since they ignored vital variables like Black Swans , liquidity,leverage & correlated risks etc. Crisis is GLOBAL (geographically , sector-wise , market-wise etc.) In India: Banks,financial Services,IT,real estate & infrastructure are worst Terminology 123FMCG , Media & Entertainment least affected affected whereas pharma , Strengthening capital & liquidity risk management, Enhancing transparency and valuation , CRA’s overhaul & legal framework is important to avert these kind of crises

References 1. Financial Crisis 2008 - Parshwadeep Lahane 2. Annual Policy Review, RBI monthly bulletin November 2009 3. Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions, Mason & Rosner, Drexel University 4. Three Ways to Know When the Credit Crisis Hits Bottom, Keith Fitz-Gerald,Investment Director,Money Morning/The Money Map Report Terminology 124 5. The Black Swan, Nassim Nicholas Taleb 6. Fooled by Randomness, Nassim Nicholas Taleb 7. Global Financial Stability Report, Oct 2008 8. World Economic Outlook

Thanks Questions Terminology 125

Hyperlink Slides Terminology 126

A Longer-Term Perspective on Home Prices 1890=100 220 220 Current Boom 200 200 180 180 Great Depression 160 160 World World 1970’s 1980’s War I War II Boom Boom 140 140 120 120 100 100 Terminology 127 80 80 60 60 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Source: Robert J. Shiller, 2006.

Homeownership Rate Reaches Historic High in 2004 Percent 69.2% in September 2004 70 69 68 67 66 67.8% in March 2008 65 64 Terminology 128 63 62 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2008 Source: U.S. Census Bureau.

Home Mortgage Share of Household Liabilities : New High in 2007 Percent 75 70 65 60 Terminology 129 55 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 Source: Federal Reserve.

Ratio of Median Home Price to Median Household Income Surges Median Home Price/Median Household Income 5.0 4.5 4.0 3.5 Terminology 130 3.0 2.5 '68 '70 '72 '74 '76 '78 '80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06

Median Existing Single-family Home Price: Too Good to Last Percent change, year ago 20 15 10 5 0 -5 Terminology 131 -10 -15 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Sources: National Association of Realtors, Moody’s Economy.com.

History Repeats Itself: Home Prices Don’t Just Go Up Change in Home Prices in 100 plus years Percentage change, year ago 40% World Great World 1970’s 1980’s Current War I Depression War II Boom Boom Boom 30% 20% 10% 0% Terminology 132 -10% -20% 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Source: Robert J. Shiller, 2006.

Existing Home Sales Are Down Everywhere Over the Past Two Years Percent change in existing home sales Fourth-quarter 2005 through fourth-quarter 2007 Terminology 133 Existing home sales nationwide down 29% Source: Freddie Mac.

Forty-six States Had Falling Prices in the Fourth Quarter 2007 United States: - 9.3% (fourth-quarter annualized growth) Terminology 134 Source: Freddie Mac.

OECD Leading Economic Indicator Points to a Significant Slowdown 2007-08 Financial Crisis 2001-02 Worldwide Recession Terminology 135

Impact of Financial Crisis on United States Payment incident index (*) Scale of sector risk 12 months moving rate 300 WORLD 250 United States 200 150 100 50 0 Terminology 136 june 93 june 94 june 95 june 96 june 97 june 98 june 99 june 00 june 01 june 02 june 03 june 04 june 05 june 06 dec-93 dec-94 dec-95 dec-96 dec-97 dec-98 dec-99 dec-00 dec-01 dec-02 dec-03 dec-04 dec-05 dec-06 june-07 déc-07 *Payment incident index 100: World 1995-2000 basis

Inflation Expectations Are Trending Downward TIPS/10-Year Implied Breakeven Inflation Rate Terminology 137

Unemployment Expectation 7%-8% 2009 Forecasts 6.1 % Oct. 2008 4.4 % Oct. 2006 Terminology 138

Commodity Prices CRB Commodity Price Index Terminology 139

Baltic Dry Index Terminology 140

Mortgage Loan Fraud Surges Thousands 60 50 40 30 20 10 Terminology 141 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: Financial Crimes Enforcement Network.

S & P 500 Index Terminology 142

Equity Market Volatility S&P 500 Volatility Terminology 143

Bloomberg’s Financial Conditions Index Terminology 144

Market for Liquidity Freezes Thirty-Day AA Rated Commercial Paper Rates Percent 6.5 Asset-backed 6.0 Commercial 5.5 Paper 5.0 4.5 Nonfinancial Commercial 4.0 Paper 3.5 Financial 3.0 Commercial Paper 2.5 Terminology 145 2.0 1.5 May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May 07 07 07 07 07 07 07 07 08 08 08 08 08 Source: Federal Reserve.

Widening Spreads: Municipal Bonds Basis point spread over 10-year treasury bond 120 ML municipal master index yield spread 80 40 0 Terminology 146 -40 -80 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Source: Bloomberg.

Widening Spreads :Mortgage-Backed & High-yield Bonds Basis point spread above 10-year treasury bond 1200 ML BBB Mortgage-Backed Securities Index 1000 800 ML High-Yield Bond Index 600 400 Terminology 147 200 0 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Source: Bloomberg.

Money Market Spreads : U.S. Libor/OIS Spread U.S. Libor/OIS Spread Terminology 148

Credit Spreads : Baa Corporate/ Treasury Spread Terminology 149

The Dollar in 2007-08 Feb.-April 2008 From 1.45 to 1.60 May-July 2008. Sept.-Nov. 2007 Pause From 1.35 to 1.45 July.-Oct. 2008 Dec.Jan. From 1.60 to 1.36 Pause Terminology 150 January-August 2007 From 1.30 to 1.35

Financial Stocks Percentage change in price, December 2006–March 2008 -94% Bear Stearns -87% Countrywide -77% Washington M utual -63% Freddie M ac -56% M errill Lynch -56% Fannie M ae -53% Wachovia -52% UBS -52% Lehman Brothers -40% AIG -32% M organ Stanley Terminology 151 -29% Bank of America -18% Wells Fargo -17% Goldman Sachs -11% JP M organ & Chase -1 -0.8 -0.6 -0.4 -0.2 0 Source: Bloomberg.

Major losses for banks worldwide Losses/write-downs through May 27, 2008, US$ billions Citigroup 42.9 UBS 38.2 Merrill Lynch 37.0 HSBC 19.5 IKB Deutsche 16.1 Royal Bank of Scotland 15.4 Bank of America 14.8 Morgan Stanley 12.6 JPMorgan Chase 9.8 Credit Suisse 9.7 Terminology 152 Washington Mutual 9.1 Credit Agricole 8.4 Deutsche Bank 7.7 Wachovia 7.0 Source: Bloomberg.

Dollar Losses in Reported Cases of Mortgage Fraud US$ Millions 1,200 1,014 946 1,000 813 800 600 429 400 293 225 Terminology 153 200 0 2002 2003 2004 2005 2006 2007 Source: Federal Bureau of Investigation.

Market share shifted from 2003 to mid 2006 Mortgage market % share 100 • Government share fell by 43% 80 24 where as private share rose 60 57 sharply by 138% over a period of 3 years % 40 76 20 43 0 2003 mid-2006 Year Government sponsered Private( Wall Street firms) • Subprime lending increased by massive 205% over 3 years Terminology 154 • Alternative–A similarly expanded by 384% • Increase in Prime was mere 16.7% Between sub-prime and prime

Global pool of money • After 1997/98 financial crisis – Developing countries focus on export- driven growth and the associated accumulation of foreign exchange reserves • The strength of exports relative to domestic demand has seen saving Terminology 155 outstrip investment in most of these economies • Accordingly, we have the ironic situation whereby a range of developing countries are (in net terms) the providers of capital to some of the world’s most developed economies. • This rapidly rising “savings glut” has been a principal source of increased global liquidity. Source:http://www.rbnz.govt.nz/speeches/2968727.html

Rise of Global Liquidity (1998 onwards) • The flow of increased global liquidity through markets has provided the impetus for many changes • To generate a return on this liquidity has spurred massive growth in securitization of debt and the development of a vast array of derivatives. The propagation of these instruments can itself be seen as a source of liquidity growth. From a monetary policy perspective, this implies a very big increase in the liquidity that is not directly controlled by central banks. • •Bank for International Settlements, highlighted a number of important new features: Terminology 156 • the unbundling and re-pricing of risk through major advances in financial engineering, resulting in improved ability to lever lending via new markets such as for credit transfer products; • the emergence of new financial players such as hedge funds and private equity firms that have not been traditional intermediaries; • more reliance of financial firms on markets to handle growing complexity; • a reliance on market liquidity even in stress situations; and • a surge in volume and value of transactions. Source:http://www.rbnz.govt.nz/speeches/2968727.html

FED interest rate • To catch up with dot com bust FED kept interest rate low for too long •This indirectly resulted in investors looking for other safe heavens • They got attracted to housing market Terminology 157

High Banks leverage ratio’s to fund MBS/CDO Terminology 158

Building up of the housing bubble Terminology 159

Housing prices and Income • Housing prices were increasing •Income slope was almost flat Terminology 160 Source: http://varbuzz.com/meltdown/

Starting 2006 housing bubble busted Terminology 161

LIBOR rate Terminology 162

Credit rating of complex financial instruments Terminology 163 Source: IMF and WSJ

Speedy Foreclosures Terminology 164

Top 10 Bankruptcies Terminology 165

The American way of debt Terminology 166 Source: http://www.nytimes.com/interactive/2008/07/20/business/20debt-trap.html?ei=5070

Average debt of American in 2004 Terminology 167 Source: http://www.nytimes.com/interactive/2008/07/20/business/20debt-trap.html?ei=5070

VaR Terminology 168 With 95% confidence, we expect that our worst daily loss will not exceed 4%. If we invest $100, we are 95% confident that our worst daily loss will not exceed $4 ($100 x -4%). Source :http://www.investopedia.com/articles/04/092904.asp

Effect of correlation n n n σp = ∑ wi2σ i2 + ∑ i =1 i =1 ∑w w σ σ j =1 i j i r j ij A series of securities Which have different priorities in Mortgages are originated… And pooled (tranches) are created Investors buy the repayment, and thus different together into a backed by the pool of individual securities levels of risk and yields trust mortgages… Mortgage Higher Propert $ for purchase or priority of Lower yield y refi Buy security repayment Mortgage P&I purchased AAA Security P&I paid Propert y AA Propert Mortgag y e pool A Propert y BBB BB Terminology 169 y Propert B Unrated Lower priority of repayment Higher yield AAA AA Synthetics (e.g. ABX) A CDO Pool BBB Other RE BB and non-RE obligations B Unrated Source: Where Did the Risk Go by Mason & Rosner

Black Swans Classical metaphor: A Turkey is fed for a The fate of close to 1000 financial institutions (includes 1000 days—every days confirms to its busts such as FNMA, Bear Stearns, Northern Rock, statistical department that the human Lehman Brothers, etc.). The banking system race cares about its welfare "with (betting AGAINST rare events) just lost > 1 Trillion increased statistical significance". On dollars (so far) on a single error, more than was the 1001st day, the turkey has a Terminology 170 surprise. ever earned in the history of banking. Turky Economics : we are in a new era of safety", and back-it up with thorough and "rigorous" analysis and so package of sub-prime loans (leveraged) gets sold on grounds that "30 years of history show that the trade is safe Source: The Black Swan, Nassim Nicholas Taleb

Fourth Quadrant Terminology 171 passage from theory to the real world presents two distinct difficulties • Inverse problem compounded by the small sample properties of rare events • Many asymptotic properties do’nt work well pre-asymptotically Source: The Black Swan, Nassim Nicholas Taleb

Volatility as an indicator of stability Random Walk—Characterized by volatility. Random Jump process—It is not You only find these in textbooks and in characterized by its volatility. Its exits essays on probability by people who the 80-120 range much less often, but have never really taken decisions under its extremes are far more severe. uncertainty. Terminology 172 hard-wired to demand an explanation for everything, Fooled by Randomness: humans are even when there is none, leading us to be fooled into thinking that something is not random when it really is. Sources: The Black Swan, Nassim Nicholas Taleb Fooled by Randomness , Nassim Nicholas Taleb

Fooled by Randomness An evil investment advisor sends letters to a thousand or so prospective clients, telling half that a particular stock will go up and the other half that it will go down. The second month, repeat the same mailing to the half of the list where the prediction happened to be correct. Keep repeating each month and at the end of ten months he'll have a (short) list of people who think he was correct for ten months in a row. Apply the same math to the world's pool of actual investment advisors and mutual fund managers and you'll find that the number of people with 10 year successful track records is about what you'd expect from pure chance! Terminology 173 Source: Fooled by Randomness , Nassim Nicholas Taleb

Moody’s Fiasco Moody’s discovered in February 2007 that the models used to rate CDO’s had a mistake that provided ratings up to four notches higher than they should have been. Key problems in modeling of CDO’s Incorrect assessments of correlations between the individual assets An AAA CDO tranche does not have the same risk characteristics as an AAA corporate. The average probabilities of defaults may have been similar, but the tails of the distribution are much fatter for CDOs. Credit spreads on high-grade corporate obligations tend to narrow in a crisis Terminologyto 174 We see the opposite with CDOs. because of flight quality. Why would an AAA rated SIV earn 200 basis points above an AAA rated corporate bond? Source: Blame the Models by Jon Daniielson , London School of Economics

SF Pool Losses don’t recover Cumulative Loss Level Corporate Investments % Loss on Asset Pool Expected Actual Mortgage Pool Terminology 175 Time: zero to maturity Source: Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions, Joseph R. Mason, Associate Professor of Finance, Drexel University & Joshua Rosner, Managing Director, Graham Fisher & Co.

SF Pool losses are Distributionally skewed Terminology 176 Source: Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions, Joseph R. Mason, Associate Professor of Finance, Drexel University & Joshua Rosner, Managing Director, Graham Fisher & Co.

Moving,Increasing,Skewed SF Pool Loss distribution narrows over time Cumulative Corporate Investment Performance Cumulative Mortgage Pool Performance Cumulative Loss Level Cumulative Loss Level µ µ µ µ µ µ µ µ µ µ µ µ µ µ µ µ µ µ µ µ % Loss on Asset Pool % Loss on Asset Pool µ Terminology 177 Time: zero to maturity Time: zero to maturity Source: Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions, Joseph R. Mason, Associate Professor of Finance, Drexel University & Joshua Rosner, Managing Director, Graham Fisher & Co.

Investments devalued across the Globe Terminology 178 Source: BBC News, http://news.bbc.co.uk/2/hi/talking_point/7644574.stm

Impact of Financial crisis-felt across the globe Terminology 179 Source: Reuters, http://www.reuters.com/news/globalcoverage/creditcrisis

Mortgage Loan Fraud Surges Thousands 60 50 40 30 20 10 Terminology 180 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: Financial Crimes Enforcement Network.

The Dollar in 2007-08 Feb.-April 2008 From 1.45 to 1.60 May-July 2008. Sept.-Nov. 2007 Pause From 1.35 to 1.45 July.-Oct. 2008 Dec.Jan. From 1.60 to 1.36 Pause Terminology 181 January-August 2007 From 1.30 to 1.35

U.S. and Euro-Area Credit Default Swaps During the 2007-08 Financial Crisis September 17, 2007 =100 Europe CDS U.S. CDS Terminology 182

U.S. and Euro-Area Swap Spreads During the 2007-08 Financial Crisis September 17, 2007 =100 Europe Swap Spreads U.S. Swap Terminology 183 Spreads

The Meltdown

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