US Subprime Crisis


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The project gives a detailed understanding of the US Sub prime Crisis and how things unfolded. Though the scope of the project is limited to a specific time frame, the project report entails all the nitty gritties of the occurrence of events

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US Subprime Crisis

  1. 1. The U.S. Sub-prime Crisis – A Study of the recent economicdevelopment in the U.S. and their likely impact on the Indian Economy A report submitted in partial fulfillment of the requirements of MBA program at ICFAI Business School, Ahmedabad.Submitted to: Submitted to:Prof. Vivek Ranga Mr. Sunil ChandraFaculty Guide (Country Head-DPM)IBS, Ahmedabad. Almondz Global Securities Ltd. 0  
  2. 2. A REPORT ON The U.S. Sub-prime Crisis – A Study of the recent economicdevelopment in the U.S. and their likely impact on the Indian Economy BY PARAMJEET KAUR AT ALMONDZ GLOBAL SECURITIES LIMITED NEW DELHI A report submitted in partial fulfillment of the requirements of MBA program at ICFAI Business School, Ahmedabad.Submitted to: Submitted to:Prof. Vivek Ranga Mr. Sunil ChandraFaculty Guide (Country Head-DPM)IBS, Ahmedabad. Almondz Global Securities Ltd. 1  
  3. 3. SUMMER INTERNSHIP PROGRAMME The U.S. Sub-prime Crisis – A Study of the recent economicdevelopment in the U.S. and their likely impact on the Indian Economy Submitted By: Name: Paramjeet Kaur Enrollment No.:07 BS 2784 Mobile No.:09974339611 Email 2  
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  5. 5. ACKNOWLEDGEMENT Across the road to the Corporate World, Unknown pursuits came my way. A ‘Thanks’ would be too small a token, for all that with what I stand today!The fourteen weeks Summer Internship Programme needs a laudable appreciation for the novelexperience of practical knowledge and the true insights of the clichéd Corporate Culture.Thanking all the affiliates’, veterans in knowledge and virtuoso in experience would be a meretoken of gratitude, which may not be sufficient for all the knowledge imparted, and all theblessings bestowed upon me.I would like to express my immense gratitude to Mr. Sunil Chandra (Country Head, DebtPortfolio Management) for guiding me throughout the whole project with his impeccableknowledge. I owe my gratitude to Ms. Rajni Dasgupta (Vice President) who taught me the firstlesson of corporate culture. Mr. Abhilash Kumar (Manager) owes a special mention for theinvaluable insights that he provided me, which would be carried forward as a legacy ofknowledge and learning all through my life.I am also thankful to all the staff members’ of Almondz Global Securities Limited, who havealways guided me whenever I needed help and acquainted me with the minutest details ofetiquettes and behavioral aspects.I sincerely thank Mr. Vivek Ranga, who has always been a continuous source of encouragementall through the project. I am also thankful to my faculty members and Prof. P. Bala Bhaskaranfor guiding me all the way. All the more, ICFAI University needs to be praised which hasprovided the students with such a bright opportunity to have an exposure of the real corporateenvironment for the valuable period of three and a half months to get the corporate ambienceimprinted on our minds to carry forward the learning’s of this first tryst with corporates in thefuture struggle in the path of professional success.Last but not the least, a special mention must be made to all those who have knowingly andunknowingly helped me in the completion of this project. I owe my gratitude to my parents whohave always encouraged me in the pursuit of excellence.Paramjeet Kaur07 BS 2784 4  
  6. 6. TABLE OF CONTENTS ABSTRACT       10   INTRODUCTION                             11     Purpose of the Study                  11   Scope of the Study                  12   Limitations of the Study                12   Methodology of the Study                13   INTRODUCTION                             14 HOUSING MARKETS IN U.S.A.: Major Contributor to Growth      16   Homeownership‐ The American Dream            16   Economic Impacts of the Housing Sector            18   Housing Sector having Macro‐economic Implications        20   Impact on Communities                20   Impact on Individuals                 21   Housing Contribution to Society              22 LEVERAGED SECURITY MARKETS: The Double Edged Sword      23   Leveraging                    23   Housing Sector: The Initial Fuel              23     Securitization: Prime Mover of the Crisis            24   Sub‐prime Crisis: A result of Leveraging            26 SUB‐PRIME LENDING: The Flaws              29 THE CRISIS AND CHRONONOLOGY OF EVENTS: Timeline of Implosion    32    Chronology of Events                  36  5  
  7. 7. THE PARTIES IN THE CRISIS AND THEIR ROLE: Walking the Line        53   Role of Borrowers                  53  Role of Financial Institutions                55    Role of Securitization                  56    Role of Mortgage Brokers and Mortgage Underwriters        57              Role of Government and Regulators              58  Role of Credit Rating Agencies              58  Role of Central Banks                  59 IMPACT OF THE CRISIS ON THE U.S.A.: Entering A Possible Recession 61 Collapsing US Housing markets               63  Unemployment                  68  Fed rate cut                    69  Inflation                     70    Falling dollar                    71  Widening fiscal deficit                 75  US GDP growth                  77 IMPACT OF THE CRISIS ON THE WORLD FINANCIAL MARKETS 78   Impact on the Commodities Markets: Markets pivot on its head      82     Gold Markets                  83     Crude Oil                  85     Metals                   86  On Stock Markets: Gravity proves itself            87  On Some of the Larger Economies: Euro and Japanese        91  6  
  8. 8. IMPACT ON INDIA 96     The First Signs: First Blood                98   On Financial Markets: Stock Markets lose their Sheen                  100   On Commodities markets with special emphasis on Crude oil: A fuel to inflation  102   On Money Markets and Interest Rates: The Hinges of Growth                104   On INR: Challenging the might of the Dollar                      107   Indian Housing Markets: Following the Footsteps                     109   On Indian Economy: Structural Changes: The proverbial struggle of Good vs. Bad  112 THE NEW WORLD ORDER: Rise Of the Behemoth 114  APPENDIX Appendix 1:   Borrowers Protection Act 2007                        118  Appendix 2:    Beige Book                           125    Appendix 3:   Fico Scores                127  Appendix 4:   Role of Freddie Mac and Fannie Mae         129  Appendix 5:   Housing Market Correction & Bursting of Housing Bubble    131    Appendix 6:   Asian Currency Crisis              131  Appendix 7:   Russian debt Crisis              132  Appendix 8:   Long‐Term Capital Management          133  Appendix 9:   Relation between Crude Oil & Dollar Value        134  Appendix 10:   Relation between Gold Prices & Dollar Value      136    Appendix 11:   Relation between Crude Oil & Gold Prices        138    Appendix 12:   Theory of Decoupling             140 GLOSSARY                      141 BIBLIOGRAPHY                                                                                 143  7  
  9. 9. TABLE OF FIGURES AND ILLUSTRATIONS   Figure 1:       Housing Sector creates a vicious circle           14  Figure 2:  Real Median Household Income            17  Figure 3:   Homeownership trends in USA (in 000)          18  Figure 4:   Mechanism of Securitization              25  Figure 5:   Timeline of Implosion               34  Figure 6:   US Foreclosure Filings               55  Figure 7:   Home Ownerships in US              57  Figure 8:   Relative Size of Variable Interest Rate Mortgages                                    65  Figure 9:   Home Price Indices              65  Figure 10:   Foreclosure starts rate                66  Figure 11:   Unemployment in USA               68  Figure 12:   Fed Rate cuts in US                69  Figure 13:   Inflation Rate in USA                70  Figure 14:    USD vs. Euro (Interbank Rate)             72  Figure 15:   USD vs. JPY (Interbank Rate)              73  Figure 16:   U.S. Treasury Yield Curve Rate                        73  Figure 17:   Federal Fiscal Position                       75  Figure 18:   US Economic Growth                77  Figure 19:   World Economic Growth              79  Figure 20:   Growth figures forecasted by IMF           80  Figure 21:   Commodity Prices across the world            82  Figure 22:   Gold Prices in USD/Ounces              83  Figure 23:   Oil Prices in USD/Barrel              85  Figure 24:   Base Metal Indices                86  8  
  10. 10. Figure 25:   Major stock market indices              87  Figure 26:   Dow Jones Index                88  Figure 27:   NASDAQ Index                  89  Figure 28:   Nikkei 225 Index                89  Figure 29:   DAX Index                  90  Figure 30:   Main developments in major industrialized economies     91  Figure 31:   BSE Sensex                            100  Figure 32:   Nifty Index                           100  Figure 33:   Bank Nifty                            101  Figure 34:   CRR (Cash Reserve Ratio)                        104  Figure 35:   Call Money Borrowing                          105  Figure 36:   INR vs. USD                           107  Figure 37:   Percentage Distribution of GDP as per sectors                               112 TABLE OF BOXES   Box 1:   Mechanism of Leveraging                           26  Box 2:   Types of Borrowers                54  Box 3:   Predatory Lending Practices             57  Box 4:  Potential Subprime Losses                       61  Box 5:  Main Credit Losses so Far               62  Box 6:  Projected Economic Losses                          67  Box 7:  Major Market Falls in January 2008                       87  Box 8:  House Price Developments In Central & Eastern European Countries 93  Box 9:   Indian Companies with Foreign Losses                     98    Box 10:          Market Intervention by RBI                       108  9  
  11. 11. ABSTRACTThe U.S. economy has over the past few decades enjoyed the status of being a financialsuperpower. The housing sector was booming as more and more people were eager to fulfill the‘American Dream’ of owning a home. The spiraling housing prices enticed the people to buyhomes with initial borrowing and lending rates that were extremely low; which helped to boostthe demand and supply of new and existing houses. The liquidity of the banks, eagerness ofborrowers to own a house and an inefficiently created structure of financial products lead to thesubprime debacle.The financial systems were overflowing with liquidity, which made them construct a mechanismof securitization that involved pooling of the loans and creating Collateralized Debt Obligations(CDO) and Mortgage Backed Securities (MBS). The low-income borrowers were enticed by thevarious types of mortgages such as Adjustable Rate Mortgages, Interest Only Mortgages (I/O)etc. The borrowers readily accepted these loans as these short-term low rates reduced the burdenof the borrowers. All sorts of people with or without any income proof or documentation availedof these loans. The pools of these debts were smartly issued to investors depending on the riskattached to the instruments.The housing market correction and bursting of the housing market bubble overturned the wholescenario. This increased the delinquency rates and the number of foreclosures filings weresurging. To make matters worse, the increased unsold inventory further reduced the pricesmaking it difficult for the financial institutions to sell them and recover their loans. Due to thecomplexity, sheer size and volume, presence of numerous players and major flaws in thesubprime lending the whole U.S. economic system now stands at the verge of a possiblecollapse. The U.S. economy is witnessing a decline in the growth figures. The unemploymentrates are rising further aggravating the inflation numbers. The strengthening Euro and Yen standas evidence that the U.S. economy is in a downturn.The effects from the possible recession in the U.S. and the reading of a world wide spread of the‘economic fever’ has made the commodities prices to increase and for the capital markets totumble. Widespread losses across the markets have brought economies to reassess their exposureto the U.S. economy and Central banks of these countries have taken steps (both reactive andpre-emptive) to control any major contagion.The Indian economy/markets may be comparatively safe due to the strict regulations of the RBI.Even then, in the world of gross inter-linkages the chances of the system getting singed cannotbe ignored. The exposure of our economy to the U.S. markets may be limited; even then theindirect impacts cannot be ignored. The study would then try to analyze the impacts both directand indirect on the Indian financial systems. 10  
  12. 12. INTRODUCTIONThe whole world being linked with the common ties of globalization has necessitated the studyof the turbulence in the U.S. economy and its impacts on the world with special relevance to theIndian economy. The subprime crisis and its effects on the U.S. economy and the worldeconomies have been studied in detail moving onto the Indian economy.PURPOSE OF THE STUDYThe main objective of the study is to have: • An understanding of the ongoing Sub-prime crisis • The impact on Financial Markets, Commodities Markets (Crude Oil), Money Market of our country • Study its impact on U.S.A, developed economies and the Indian Economy. • Future implications on the World Economic system in general. • Study the possible impact it may have on India. • Expected changes to the Indian Economy post Subprime CrisisThe world economies are at present passing through one of the most difficult phases in recenttimes. The sub-prime crisis, which has its roots in the U.S., threatens to rage onto the otherdeveloped economies eventually to scathe the emerging market economies in wake. Sitting inIndia, we may appear, at present, seem to be unaffected by the world economic problems.Statements by heads of important agencies have time and again impressed that the Indianeconomy has a very little exposure to the subprime and that, aside from scratches, the economy,in general, would walk tall.However, in spite of the Indian economic systems seemingly direct insulation from the impacts,the fact remains that in the world of integrated economic systems, the U.S. recession is bound totest the resilience of the domestic economy. Already the stock markets, which seem to have themaximum exposure, have entered into a highly unpredictable and volatile state. The dominoeffect on the other sectors would take some more time to incident. 11  
  13. 13. SCOPE OF THE STUDYThe project involves studying the subprime crisis as a whole. The main topics under this projectare - Housing markets in the U.S.A, Leveraged Security Market & the Process of SubprimeLending. A study of the chronology of events will also be made to ascertain its incidence and theway it turned into a huge crisis engulfing the global economies. The project will also involvestudying the parties in the crisis such as borrowers, lenders, banks etc. and their role.After having an insight of all this the project shall move on to the impact and implications onU.S., some leading world economies and finally India. This will include studying: • The Commodities Market with special emphasis on the Crude oil market and how it effects inflation. • The Stock Markets of the world • Overall effect of subprime crisis on the money markets and interest rates in India. • Changes in forex rate of INR and the U.S.D. • The Structural Changes of Indian economy posed by the subprime crisis will also be done.LIMITATIONS OF THE STUDY Subprime crisis and the fallouts to the economy thereof is a very expansive area that has gripped the biggest economy of the world. No matter how deep one goes into it, the chances of understanding it to the core may be difficult. The study would also not include aspects that are topical to U.S.A and would include only those that are relevant in the Indian context or, which may have a bearing on India. Due to the ‘lag effect’ all the resultants may not manifest itself at the time of the study, so while a theoretical study may be made, a comparison of the actual results may leave a lot wanting. 12  
  14. 14. METHODOLOGYThe methodology comprises an in-depth search of various news articles, journals, reports,relevant laws and other literary work on this topic. The report involves an analysis of the latest movements in the U.S. and the Indian Financial Markets. A search on the internet and books is another aid to the successful completion. A systematic approach has been followed which involves concentrating on the lowest level accentuating the role of various parties who were party to the entire debacle. The next level of the study involved studying the timeline of how it transformed into such a huge problem. The impact of U.S. economy, then the inter-related world economies is the next step under the study. Finally the subprime crisis spreading its wings to the Indian Economy will be studied. 13  
  15. 15. INTRODUCTION “What began as a fairly contained deterioration in portions of the U.S. sub-prime market has metastasized into severe dislocations in broader credit and funding markets that now pose risks to the macroeconomic outlook in the United States and globally” Global Financial Stability Report, IMF, April 2008.The recent turmoil that has inflicted the world economies is the sub-prime crisis. Related to thehousing prices and engulfing the entire banking system of the U.S. economy, this crisis hasspread its wings to encompass the worldwide economies in its realm translating it into a majorfinancial crisis. The impact of this crisis has been so severe that the entire banking system of theworld’s largest economy may collapse, leaving little scope for recuperations out of this crisis.The fact that the housing crisis has led to the present imbroglio is obviously undeniable.IntroductionThe outburst of the crisis after the bursting of the housing bubble in the U.S. has made thiseconomy confront a new crisis with differently fabricated causes and effects. The high defaultrates on “sub-prime” and other higher-risk borrowers with lower income have resulted in thesub-prime crisis. Initially, the long term rising house prices and the attractive loan incentivesencouraged borrowers to assume mortgages with the fact that they shall be able to refinance lateron. However, the situation reversed when the housing prices started to drop in 2006-2007 inmany parts of the U.S. making it difficultto refinance the loans. This all resulted ina vicious circle as the number offoreclosures increased, the housinginventory escalated depressing the houseprices (figure 1).Being inter-related to other sectors of theeconomy, these trends have lead to acontraction in the construction industry,hurting overall U.S. economic activitiesmaking it enter into a possible recession.The problem of grave concern is thefalling home prices leading to a creditcrunch, which is actually driving up Figure 0: Housing Sector creates a vicious circle 14  
  16. 16. mortgage rates and making mortgages unavailable, leading to a further decline in home prices.The whole carnage revolves around sub-prime lending by financial institutions. Theseinstitutions being accompanied by other parties such as Credit Rating Agencies, MortgageBrokers and Underwriters etc. created a complex structure of lending and borrowing process,through the process of securitization. Being unified with common ties of globalization thisAmerican fiasco soon turned into a worldwide crisis affecting the major economies of the world.This project studies the entire housing sector, which saw great heights and steep depths within avery short period of time. How the booming housing sector, which was a major asset of theweakest people of the society through innovative instruments and loans facilitated by variousparties, saw its downfall is an interesting part, which is analyzed. Being one of the pillars of theAmerican economy, how the movement in this pillar affected the whole economy inter-linked invarious dimensions of employment, finances, and other macro-economic indicators (inflation,currency etc) has been thoroughly done. The world bonded by the Theory of Decoupling hasseen new changes in growth brackets, trade movements and other global changes throughout thisperiod.Being an emerging economy, the Indian economy has also seen new pursuits in its economicframework and there still remain unknown pursuits and dimensions connected to the globaleconomic architecture.This project thus has various pursuits to explore about the American economy, world economiesand Indian economy. There is a whole gamut of linkages between, inter-related and intra-relatedsectors, which have been studied in this project. 15  
  17. 17. HOUSING MARKETS IN U.S.A Major Contributors to GrowthThe real estate sector is amongst the largest sectors in the U.S.A. It has been a significantcontributor to the U.S. economy, providing millions of jobs and had been generating hundreds ofmillions of dollars of economic output each year. It has traditionally been an important source ofwealth building. The housing sector has been the main driver of economic growth of U.S.Therefore the weakening of this sector tends to have ominous implications for continuingexpansion in the period ahead.The housing sector accounts for about 6% of GDP, but has been a much more importantcomponent of growth, contributing 0.50% directly to GDP growth (translating to some U.S. $60billion/year) and on the average adding 30,000 new jobs monthly in 2005. Some estimatessuggested that wealth (home prices) and liquidity (home equity extraction) effects might havebeen contributing up to 1.5% to GDP growth in the last few years. Over the past four yearsending 2006, consumer spending and residential construction together have been accounting for90% of the total growth in GDP. And over two-fifths of all private sector jobs created since 2001till the advent of crisis have been in housing-related sectors, such as construction, real estate andmortgage broking.Homeownership – The American DreamHousing (or an availability of dwelling) is one of the most important wants of any human. As thesociety and civilizations progressed, so did the desire to have a comfortable home. This desirecuts across all the income segments, race, and income levels. However, the commondenominator remained – owning a house (see chart below).Two reasons why there was a housing boom was - Increased level of income and - Easy availability of money.Increased level of incomeSince 1967, the median household income in the United States had risen by 31%. The rise inhousehold income has been largely the result of an increase in personal income among collegegraduates, a group that had doubled in size since the 1960s, and women entering the labor force.Today, 42% of all households have two income earners. 16  
  18. 18. Overall, the median household income rose from $33,338 in 1967 to an all-time high of $44,922in 1999, and has since decreased slightly to $43,318. Decreases in household income have beenvisible during each recession, while increases have been visible during economic upturns.While per-capita, disposable income had increased 469% since 1972, it had only increasedmoderately when inflation is considered. In 1972, disposable personal income has beendetermined to be $4,129; $19,385 in 2005 dollars. In 2005, disposable personal income was,however, $27,640, a 43% increase. Since the late 1990s, household income had fallen slightly. Figure 1: Real Median Household IncomeFurther with the advent of complex financial systems, conduits, mechanisms and tools itsuddenly became easier to own a house. 67.5% of households realized this dream in 2001, whichtranslated into 72.6 million households as homeowners.Since then, the Bureau of the Census had projected an additional 11.7 million new householdswill form over the coming decade, with the larger percentage growth among minorities. Thedemand for housing, therefore, will continue to over the next decade. Freddie Mac estimated that50 million families will be buying homes in the next 10 years - more than 10 million of them forthe first time. Clearly, a substantial segment of society is and will continue to realize theAmerican Dream. Of course this was before the Sub-prime crisis roared its head. 17  
  19. 19. 140000 127,958 126,009 123,926 121,478 120,835 Vacant Total 122,187 119,628 119,043 119,280 117,280 Renter Total 115,620 112,655 114,137 110,948 Owner Total 109,716 106,281 108,317 107,277 105,731 17,652 104,631 16,437 120000 15,695 11,633 103,653 14,468 15,598 101,102 13,908 15,276 14,315 14,114 13,747 99,307 13,418 13,153 12,669 95,255 12,258 11,987 11,925 12,024 12,058 12,241 9,448 10,585 10,164 100000 8,908 34,194 35,147 33,678 33,014 34,417 33,506 33,687 34,470 34,831 80000 34,896 35,059 34,943 35,246 31,731 35,559 34,730 34,569 34,243 33,975 33,735 33,320 32,602 32,299 30,695 60000 40000 20000 55,652 63,452 56,844 57,915 58,700 59,755 60,248 61,010 61,823 62,999 63,131 64,740 66,041 67,143 68,637 70,098 71,250 72,593 71,278 72,053 73,575 74,553 75,378 75,159 0 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2006 Figure 2: Homeownership trends in U.S.A (in 000)Easy Availability of MoneyThe most prominent reason for the housing boom was the easy availability of money. After thedotcom bubble the Federal Reserve Bank had decreased the Fed fund rate 14 times from 6.5% to1% within two years since 2001. This had increased the liquidity in the market. As a result of thisoverflowing liquidity in the financial markets, the banks offered loans to borrowers thus makingmoney easily accessible to even the low-income borrowers. This also marked the period of thehousing boom.Economic Impacts of the Housing SectorHousing sector being a major contributor to the American growth, any shudder in this sector canengulf the whole economy. And, if it is the American economy, un doubtingly the tremors haveto reach across the globe. The following facts help U.S. to understand the contributions of theHousing industry to the economic growth of U.S.A. The housing sector contributed about 14 percent to the nation’s total production. Home equity constituted the largest share of household net worth. The stock of fixed residential assets was worth nearly $10 trillion – equivalent to one- year worth of U.S. GDP. 18  
  20. 20. About 1.5 million newly housing units were started each year. Housing starts have been one of the key factors in the macroeconomic business cycle. About 40 percent of monthly consumer expenditures were housing related. More than $1 trillion exchanged hands from the sale of existing and new homes. There were 288,273 establishments categorized as “real estate & rental & leasing with over 1.7 million paid employees. 40% of the employment growth in the entire economic expansion was a result of soaring home sales and prices. This included employment in home building directly as well as in ancillary factors such as supplies, real estate agents, appraisers, title searches and mortgage servicing.Thus the housing sector has been one of the main sectors, which contribute both directlyand indirectly to economic activity in the U.S.A.The two line items in GDP directly associated with the housing sector are residential fixedinvestment1 consisting of value-put-in-place of new housing units, production of mobile homes,brokers’ commissions on the sale of existing residential properties, expenditures related toimproving and additions to existing units, and net purchases of used structures from governmentagencies and housing service for personal consumption expenditures, purchased by residents inthe United States, in the form of rent for tenants or as rental equivalence for homeowners. In2000, residential fixed investment totaled $415 billion and housing service expenditure was $956billion. The combined total of $1.37 trillion represented 14 percent of GDP.Also, all economic activities produced a “Keynesian” multiplier effect. A home purchase usuallyresulted in further spending in other sectors of the economy (landscaping, appliances, and so on).The income earned by the landscapers was re-circulated into the economy as they spend,generating another round of income and purchases. The degree of multiplier depends on thedegree of monetary policy accommodation and the “crowding out” effect. The multiplier wasbetween 1.34 and 1.62 in the first year or two after an autonomous increase in spending. Thismeant that for each dollar increase in direct housing activity would increase the overall GDP by$1.34 to $1.62.Many people’s livelihoods depended on real estate. The February 2001 report showed that 1.49million workers were employed in the real estate industry. The Real Estate and Rental andLeasing sector, which comprises establishments primarily engaged in renting, leasing, selling,and buying real estate for others, and appraising real estate, totaled 288,273 establishments with1.7 million paid employees. The annual payroll amounted to $41.6 billion.Housing Sector Having Macro-economic Implication                                                            1 Consists of purchases of private residential structures and residential equipment that is owned by landlords andrented to tenants. From 19  
  21. 21. In addition to its direct contribution to GDP, the housing sector has been playing an importantrole in the overall direction of the nation’s economy over the course of macroeconomic businesscycles. Conversely, housing starts have made just as dramatic a change, coming out of arecession. In fact, housing starts lead the rest of the economy preceding changes in GDP. Inother words, disruptions to the housing sector (arising from policy changes) are likely to befollowed by a significant macroeconomic slowdown, while a stimulus to housing can lead therest of the economy out of a slowdown.During an economic slowdown, the Federal Reserve has been lowering the interest rates, otherthings equal. Consequently, the fall in interest rates during an economic slowdown has beenacting as a strong buffer often providing a stimulus to the interest-sensitive housing sector. Adrop in mortgage rates means lower monthly mortgage payments. This, in turn, means a lowerqualifying income necessary to purchase a home. Conservatively, a one percentage drop inmortgage rates has translated into roughly 3 million additional households who would have thenecessary income to qualify for a mortgage for purchasing a median priced home. Furthermore,many homeowners have refinanced their mortgages with the falling interest rates, leavingadditional spending money to counter economic downturns. The economic slowdown from themid-2000 to 2001 is a prime example of how this scenario is being played out. Housing startsand home sales began declining in spring of 2000 as the Fed has raised interest rates to cool theexceptionally fast growing economy. However, the economy has cooled much more drasticallythan desired and the Fed began reversing the interest rate policy by cutting the rates in early2001. The subsequent falling interest rates have kept the housing starts and home sales torebound to healthy levels even as the overall economy began sinking further. The economywould have undoubtedly tipped into a recession in early 2001 without the support of the housingsector during this period.Impact on CommunitiesConstruction of new homes provided jobs and higher tax revenues for local, state, and federalgovernments. Construction of each new single-family home required 1,591 worker-hours or theequivalent of 0.869 year of full-time labor. Each multifamily unit required 0.402 year of full-time labor. Projecting these estimates and accounting for productivity and price changes over theyears, it is was estimated that the construction of 1,000 single-family homes generated 2,448full-time jobs in construction and construction-related industries, $79.4 million in wages, and$42.5 million in combined federal, state and local revenues and fees. The construction of 1,000multifamily units is estimated to have generated 1,030 full-time jobs in construction andconstruction-related industries, $33.5 million in wages; and $17.8 million in combined federal,state and local tax revenues and fees. Furthermore roughly 30 percent of the new homeoccupant’s income was spent on items produced by local businesses, such as hospitals, daycarecenters, dry cleaners, and auto repair shops. 20  
  22. 22. Almost 70 percent of all tax revenues raised by local governments in the United States camefrom property taxes. Homeowners contributed about 43 percent of property taxes, whilecommercial property accounted for 57 percent of real property tax revenues. Construction of newhomes expanded the tax base and so increased the property tax revenues. using the average salesprice of new homes in 2000, the local tax revenue base will increase by $185 billion.Aside from tax revenue to local communities, home production and subsequent homeownershipprovided additional intangible values. Homeowners did not move as frequently as renters,providing a source of neighborhood stability. Neighborhood stability in turn conferred benefitsof higher social and community involvement such as crime prevention programs. Homeownershad a stake in their neighborhoods and communities, and so were likely to behave in ways thatprovided benefit to everyone in the community. Owners maintain their properties in bettercondition than do renters of comparable housing. Such behavioral differences had been observedregardless of the age or income of homeowners. All of these social benefits to homeownershipcan impact property values.Impact on IndividualsHomeownership also provided individuals with a way to accumulate wealth for the future whilebenefiting from the provision of shelter. A tabulation of household wealth from the FederalReserve’s Survey of Consumer Finances (1998) shows that home equity (the value of the homenet of mortgages) was the largest component of total wealth. Equity in primary residencesaccounted for 28% of the total family asset. Furthermore, the survey shows that 12.8% offamilies had some form of residential real estate in addition to primary residence (second homes,time shares, and other type of residential property), an increase from 11.8% in 1995. The valueof the asset in other residential property accounted for additional 5% of the total household asset.Retirement accounts were the largest financial assets outside of primary residence, with 19.8% ofthe total. Only for the very wealthy (income over $100,000 per year) did the home equity portionof wealth fall below 50% of the total household wealth.A separate survey from the Census Bureau also shows the dominant importance of home equityin determining household net worth. The Survey of Income and Program Participationperiodically collects detailed wealth and asset data as a supplement to its core questions aboutlabor force participation, income, demographic characteristics, and program participation. In1995, median household net worth was $40,200; Median home equity for home-owninghouseholds was $50,000. Home equity constituted the largest share of household net worth,accounting for 44 percent of total net worth.A privately owned home, therefore, was an important vehicle for wealth accumulation for a largesegment of society. In addition, home investment played an important role in portfoliodiversification. Home prices in the U.S., on average, have risen steadily, and have much lower 21  
  23. 23. volatility than stock or bond prices. The historically standard deviation for stocks and bonds hadbeen 20% and 9%, respectively. For housing, the standard deviation was about 4%. Furthermore,the correlation between home prices with stock or bond prices was very low. Homeowners werealso benefited from the easy availability of home equity loans. Whether as a readily availablesource of funds, or just the security of a credit source, certainly added value to homeownership.Housing Contribution to SocietyAlthough the level and benefits of community involvement are hard to measure, severalresearchers have found that homeowners tend to be more involved in their communities and localgovernments then renters. For instance, owners participated in a greater number of non-professional organizations and had higher voter participation rates. In addition to higher civicparticipation, owners also tend to remain in their homes longer, adding stability and familiarity tothe neighborhood, and also tend to spend more time and money maintaining their residence.Home equity is one of the largest sources of collateral for bank loans to start new businesses.Over 740,000 businesses in 1992 reported a mortgage or home equity loan as a source of start-upcapital for their business. It had been estimated in the UK that a 10 percent rise in the aggregatevalue of home equity increases the number of new business registration by 5 percent.Furthermore, people want to be homeowners. Fifty eight percent of the renters responded thatowning a home is either the top or very important priority according to 2000 Fannie Mae’sNational Housing Survey. Freedom to alter their homes or engaging in home maintenance andimproving may provide intrinsic joys.Furthermore, others have noted that the home buying process and homeownership improve self-efficacy or a person’s sense of control over life events. And from extensive psychological studiesself-efficacy is associated with better health status.Whether it be America’s dream or an economic indicator of growth or a tool for changing thecourse of Macro-economic policies, the American Housing Market was such an important sectorthat any vibrations in the housing led banking mechanism could lead to a shake up in the entireworld economies. The highly leveraged market and the whole dream of owning homes turnedinto a huge debacle. Economists call it bursting of the housing “bubble.” In the following pageswe have tried to present the build-up of this bubble, the dynamism of the leveraged securitymarkets, the role of parties in this crisis and the likely impact on the U.S. and other economies ofthe world. 22  
  24. 24. LEVERAGED SECURITY MARKETS The Double Edged Sword“…but in the modern fixed-income markets - where leverage is king and cheap credit is only the current jester - a move of that magnitude can do a lot of damage.” -Ryan Barnes, The Fuel That Fed The Sub-prime Meltdown.LeveragingThe leveraging procedure, which intended to multiply the investments, opened new horizons forbanks to offer the investors with innovatively designed debt instruments i.e. mortgage-backedsecurities (MBS), and collateralized debt obligations (CDO).Leveraging is borrowing to invest. Financial leverage takes the form of a loan or otherborrowings (debt), the proceeds of which are reinvested with the intent to earn a greater rate ofreturn than the cost of borrowing. The most familiar use of leverage is using a mortgage to buy ahome. In return for a down payment one receives funds to purchase an asset that wouldotherwise be too expensive. The homeowners either try to pay out the money from the rent thatwould be saved or from the income streams (the rent earned) that their vocations generate.Leveraging helps both the investor and the firm to invest or operate. While leverage can play apositive role in the financial system, problems can arise when financial institutions go too far inextending credit to their customers and counter parties. If an investor uses leverage to make aninvestment and the investment moves against the investor, his or her loss is much greater than itwouldve been if the investment had not been leveraged - leverage magnifies both gains andlosses. In the business world, a company can use leverage to try to generate shareholder wealth,but if it fails to do so, the interest expense and credit risk of default destroys shareholder value.The build-up of the sub-prime crisis is based on the mechanism of leveraging. The layer uponlayer of leverage that propelled the expansion is now operating in reverse as the leverage is beingunwound.Housing Sector: The Initial FuelHousing sector has been one of the prominent drivers of the U.S. economy. Not only has it madecontributions to the employment, production and GDP, it has also been a major stimulus for theoverall economic growth of this huge economy leading the global world. This sector has 23  
  25. 25. important linkages to every macroeconomic aggregate like GNP, savings, interest and inflationrate and also highlights its importance in public policy decisions. The American FinancialInstitutions being over-flooded with liquidity magnified the housing sector as a lucrative area.The leveraging mechanism with its off springs i.e. Mortgage-Backed Securities (MBS) andCollateralized Debt Obligations (CDO) generated great opportunities for even those who couldnot afford to pay the cash flow mandated as among the key requirements for taking loans.These sophisticated instruments, lackadaisical approach to adherence to prudent lending policyand the surplus of funds all contributed to the housing sector becoming the most boomingsectors. As it grew, it took with itself almost the entire economy. Then an asset bubble began toform, frenzy fed on frenzy and the prices started to soar beyond what can safely be said to be thefundamentally correct prices. However, perhaps the key reason why the sub-prime crisisentrenched itself deep into the very sinews of the financial system of the U.S. was the creation ofexotic leveraged instruments. That way banks now started lending more than the actual basemoney and that too to entities that had a very high risk-premium attached to it.Securitization: Prime Mover of the CrisisSecuritization, an innovative form of financial engineering introduced two new instruments i.e.Mortgage Backed Securities and Collateralized Debt Obligations. Securitization is a structuredfinance process in which assets; receivables or financial instruments are acquired, classified intopools, and offered as collateral for third-party investment. Due to securitization, investor need formortgage-backed securities (MBS), and collateralized debt obligations (CDO) as a profitableventure and the tendency of rating agencies to assign investment-grade ratings to these loanseven though having a high risk of default could be originated, packaged and the risk readilytransferred to others. The process of securitization has been explained with help of figure 4.Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDO’s) the twoinstruments of securitization played an important role in aggravating the whole sub-prime saga.A mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed bythe principal and interest payments of a set of mortgage loans mainly on residential property.Collateralized debt obligations (CDO’s) are also type of asset-backed security and structuredcredit product but they are constructed from a portfolio of fixed-income assets. These assets aredivided into different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB),and equity tranches (unrated). Here junior tranches offer higher coupons (interest rates) tocompensate for the added default risk while senior tranches offer the lowest coupon rate offeringhighest safety level. 24  
  26. 26.   Figure 3: Mechanism of Securitization                                                                                       STEP  1:    The  borrower  obtains  a  loan  from MORTGAGE BROKER   the lender with the help of mortgage brokers.   After  the  loan  is  made,  the  lender  and  the   mortgage  broker  do  not  have  any   interactions.   1    LOAN  STEP  2:    The  loan  is  then  sold  to  the  issuer   and the payments made by the borrower are LENDER   BORROWER provided to the issuer by the servicer.        LOAN PROCEEDS                                                                                                                                                                                                                                                                    TRUSTEE                                                                                                                                  MONTHLY PAYMENTS  UNDERWRITER   LOANS     2         RATING AGENCY  CASH SERVICER     CREDIT ENHANCEMENT PROVIDER   MONTHLY PAYMENTS  STEP  3:  The  loan  is  further  sold  to  the 4  investors.  The  issuer  is  assisted  by  the trustee,  underwriter,  rating  agency  and credit enhancement provider. ISSUER STEP  4:    The  servicer  acts  as  an 3 CASH intermediary  between  the  borrower  and the  issuer,  who  provides  the  payments  to the  investors.  The  delinquent  losses  are SECURITIES MONTHLY PAYMENTS  managed by the servicer & the trustee. INVESTOR 25   
  27. 27. CDO is a corporate entity constructed to hold assets as collateral and to sell packages of cashflows to investors. There exists a Special Purpose Vehicle (SPV) that acquires a portfolio ofcredits. The assets include mortgage-backed securities, high yield corporate loans etc. The SPVissues different classes of bonds and equity and the proceeds are used to invest in otherportfolios. The bonds and equity are entitled tothe cash flows from the portfolio of, inaccordance with the Priority of Payments. The       MECHANISM OF LEVERAGING senior notes are paid from the cash flows before Step  #1:  Collateralized  debt  obligationsthe mezzanine notes and junior notes. In this (CDOs)  that  pay  an  interest  rate  over  andway, losses are first borne by the equity or above  the  cost  of  borrowing  werejunior notes, next by the mezzanine notes, and purchased.  In  this instance  AAA  ratedfinally by the senior notes. In this way, the tranches  of  subprime,  mortgage‐backed securities were used. senior notes, mezzanine notes, and equity notesoffer distinctly different combinations of risk Step  #2:    Leverage  was  used  to  buy  moreand return. CDOs  than  one  could  pay  for  with  capital alone.  Because  these  CDOs  paid  an interest  rate  over  and  above  the  cost  of borrowing,  every  incremental  unit  ofSub-prime crisis: A result of the Leveraging leverage  added  to  the  total  expected return.  So,  the  more  leverage  one employed, the greater the expected returnSub-prime crisis was the result of the leveraged from the trade. instruments which were aimed to magnify thegains but resulted in amplifying the losses. Step  #3:  Credit  default  swaps  (CDS)  were used  as  insurance  against  movements  inIndividuals who were not able to finance the the  credit  market.  Because  the  use  ofhouse completely would get the help of banks. leverage  increased  the  portfolios  overallPeople would put down a deposit and take out a risk  exposure,  the  next  step  involved purchasing  insurance  on  movements  inloan for the rest. Let’s say an investor puts credit  markets.  These  "insurance"down $20,000 on a $200,000 house, borrowing instruments  called  credit  default  swaps,the remaining $180,000. He now has a were designed to profit during times whenleveraged ‘investment’ - with a gearing factor of credit concerns caused the bonds to fall in10. value,  effectively  hedging  away  some  of the risk. If house prices go up by 50% - i.e. the house Step  #4:  The  money  thus  rolled  in.  Whenbecomes worth $300,000 - he doesn’t just make the cost of the leverage (or debt) is net out50% of the initial investment: he makes 150% to  purchase  the  AAA  rated  subprimeprofit (once he sells, that is, and not counting debt,  as  well  as  the  cost  of  the  creditmortgage interest payments, solicitors’ fees and insurance, one is left with a positive rate ofso on). Conversely, if house prices drop by just return,  which  is  often  referred  to  as "positive carry" in hedge fund lingo.  10%, his entire deposit would be wiped out.And if prices drop further, the borrower will be Box 0: Mechanism of Leveraging 26  
  28. 28. in negative equity, owing the bank more than the current value of their house.Enticed by the high returns on the ever-appreciating value of housing many investment banks,hedge funds and other institutional investors have done so, making phenomenally good returnsover the five years starting year 2000.Then the worst that was feared occurred- these leveraged investments started to go awry. Insteadof profits, many investors have been hit by significant losses.In the above example where the individual had put down $20,000 and took a debt of $180,000,as long as he sells before the value of the asset becomes less than the value of the debt, thereisn’t any problem. Till the time it is secured on an asset that’s worth at least $180,000 the actualrisk is just $20,000. But what if the investor can’t set a stop-loss (as is usually the case- since thehouse is not just for investment purpose but is actually an asset purchased to reside). Suddenlythere’s no market for what his trying to sell or if everyone is so scared that nobody wants to put aprice on what his selling, for fear that it’s too low and will in turn cause them to lose vastamounts of money too, because they hold similar investments.Not long ago frenzy fed on frenzy and buoyed the prices up and now frenzy feeds on frenzy andpulling the prices down rather dramatically.Now here stands the trouble of the leveraged market. Because the leveraging factor was muchhigher than what the system could withstand, and because the sub-prime ‘network’ was ingrainedin almost the entire financial systems of the U.S., when the debacle happened, it simplycollapsed the whole system.The leveraging that helped the sector grow and propel the economy to boom is now dragging thesame down. In the previous chapter we had covered the importance of the Housing sector. Theeffect of this importance can be gauged by a simple fact – Housing sector bust is dragging theentire U.S. economy to recession. And no matter what levels of fire-fighting that the monetaryauthorities undertake, the chances are that the U.S. economy has been dealt a major blow and itwould take some serious and coordinated efforts to sail the boat through.That is where the U.S. economy stands today. Efforts range from prudent (cutting interest rates)to near desperate (lending money to commercial banks taking the tainted mortgage-backedsecurities as collateral) steps. The hope is that by accepting these investments at face valuecentral banks will release the credit blockage and get the U.S. economy moving again.Due to the high amount of liquidity, which was somehow to be put into use, leverage was neededto boost returns over the last few years, owing to a lack of distressed debt. This led to 7 times 27  
  29. 29. (and sometimes as much as 10 times) leverage on U.S. leveraged buyouts. In Europe, debtmultiples also were stretched, with leverage of 5.5 times in 2007, versus 4.7 times in 1998.Thus leveraging which was intended to increase the returns and provide shelter to the people ofU.S. plunged economy downwards and contributed to the chronicle of Sub-prime Crisis.In the global economy, effects in one area of investment quickly spread to others. So wheninstitutional investors started losing money on collateralized debt obligations (CDO’s) andresidential mortgage-backed securities (RMBS’s) because of the U.S. sub-prime crisis, theyquickly liquidized other investments in order to cover their losses.For example, some of them shifted cash out of the carry trade (in which money borrowed in low-interest currencies such as the Yen is invested in higher interest currencies such as the Pound),causing the Yen to rapidly appreciate and leading to a whole slew of currency investors losingmoney on their leveraged positions. These currency investors in turn had to find the money tocover their losses, perhaps by selling gold, temporarily shifting the gold price downwards andcausing a tranche of leveraged gold investors to face severe losses. And so it went on, andcontinues to go on.The total amount of leveraged investment in the world is unknown, but it has been estimated tobe many multiples of global GDP.Thus leveraging was a double-edged sword, which was aimed at multiplying the profits, but if itacted reversely, the losses would magnify much more than the expected profits. Perhaps, that iswhat happened in the U.S. economy, where the reverse took place and brought the world at theverge of this crisis. The tool of leveraging mechanism i.e. the sub-prime lending provides U.S. aninsight of how the construct of the sub-prime crisis took place. 28  
  30. 30. SUB PRIME LENDING The FlawsThe financial institutions overflowing with liquidity devised the securitization mechanism forwhich they classified the lending into three categories namely, The Prime category, the Alt-Acategory and Sub-prime category. The parameters of categorizing the credit seekers were: 1. Credit worthiness and documentation prudence 2. Ability to pay back the money 3. Ability to pay down payments 4. Whether it’s a first loan or an already mortgaged asset.While the prime category of borrowers fulfilled all the parameters, the sub-prime borrowersstood at fulfilling none. Alt-A borrowers mainly were short of documentation, including proof ofincome. Yet these borrowers had clean histories they either had higher loan-to-value or debt-to-income ratios.Sub-prime lending (also known as B-paper, near-prime, or second chance lending) is lending at ahigher rate than the prime rate. A higher rate of interest is charged due to limited or tarnishedcredit history or inadequate documentation, higher loan-to-value and debt-to-income ratios.However, with the higher rates comes additional risk for lenders because there is a lackof documentation - including limited proof of the borrowers income poor credit history, andadverse financial situations usually associated with sub-prime applicants.A high risk based pricing system is used in order to calculate the terms of loans, which areoffered to borrowers with varying credit histories. The sub-prime borrowers charge high rates ofinterest, but still credit risk is more than interest rate risks due to the increased chances ofdefaults and less opportunities to refinance the loans.Sub-prime lending was initially a helping hand to all those borrowers who aimed to fulfill theirdream of owning a home. Sub-prime loans increased opportunities for homeownership andadded 9 millions of households to the new status of homeowners in less than a decade andincreased employment opportunities thereby increasing the growth rate. 29  
  31. 31. However, providing loans to the low-income sections of the society was a benefit as well asfallout of the sub-prime loans. The availability of liquidity was the prominent factor thatprompted the banks to provide loans at high rates, on the surety that even if the borrower fails topay the loan amount, they may still have the option to sell the houses and recover the amount.The fact that the housing prices usually tend to appreciate, furthermore, made the bankers freefrom any apprehensions of recovering the losses. Also since sub-prime lending, a direct result ofhigh liquidity, prompted banks to issue loans without any strict regulations which could helpthem to earn high amount of profits by the securitization mechanism as explained later.Sub-prime borrowing was as such not flawed; rather it was the high quantum of sub-prime loansgranted without proper regulations that appeared to be the major reason for the fallout. Thepositive picture of profit earnings hid the shortcomings of improper regulations, irresponsiblelending and inefficient rating system by the credit rating agencies.Sub-prime lending became highly controversial: Sub-prime lenders often engaged inpredatory lending practices such as deliberately lending to borrowers who could never meet theterms of their loans, thus leading to default, seizure of collateral, and foreclosure. They oftenemployed unscrupulous means by enticing, inducing, and/or assisting a borrower in taking amortgage that carried high fees, a high interest rate etc.Property Fraud by Lenders: With the increase in sub-prime lending there was a similarincrease in the property frauds. By selling overpriced apartments to the unsuspecting buyers, thesellers took the money and disappeared. So now the entire deal was between the banks and heborrowers. In this way the sellers, earned huge amounts on the overpriced sold houses.Second Mortgages: Irrespective of the bad credit histories, the sub-prime lending had madesecond mortgages easier on the existing mortgaged houses. The repayment of another loanburdened the borrowers, which ultimately had to borne by the lenders i.e. the banks, when theborrowers defaulted in making the payments.Lax Lending Rules: Analysts say lax lending standards led some mortgage firms to grant homeloans to tens of thousands of borrowers who did not have the means to meet their mortgagepayments when interest rates increased.Irresponsible Credit Rating Agencies: Credit rating agencies such as Standard and Poors,Moodys and Fitch Ratings were urged by the panel to improve their influential reports andassumptions about a wide range of securities and corporations.Major Banks meanwhile were encouraged to disclose more information about the securitizationof complex credit instruments, such as mortgage, credit card and student loans, which theypackage or cut up and sell to other banks and investors. 30  
  32. 32. Besides that the other reason why the Sub-prime mortgage crisis unfolded the way it did had alsoto do with the complex financial wizardry that was devised around the lending that had the effectof ‘over-lending’. That is the financial systems geared up by multiples in excess of what theycould or rather should have. Due to the complexity, sheer size and volume, presence of numerousplayers and major flaws in the sub-prime lending have all caused the system to collapse. Newforces have played important roles in Sub-prime crisis that had in the post been absent. 1. Complex investments: Financial firms wield ever more sophisticated financial tools. CDOs and MBAs enabled complex and opaque investments. 2. New institutions: Players like hedge funds and buyout firms – also called Private Equity, represent a large and rising sharing of overall investment money. Hedge funds also have taken exposure to the subprime investments. These players are significantly less regulated than the listed companies-these are less transparent and generally have a free will to do pretty much what they want. Besides that Rating agency and Credit enhancers played a very important role in certifying the quality of the subprime credit. These too are outside the purview of the agencies. 3. Leverage: the growing use of Debt or leverage by financial players magnifies the first two forces. An era of easy money has enabled more risk taking built on borrowed funds. That can accentuate in both the ups and downs of a cycle, raising the chances of panic selling during down turns and frenzied buying in upturns. 4. Globalization: Today all the nations in the world are linked through easy movement of funds. In the less regulated markets money moves both in and out freely. In the medium regulated markets like India, the movement is not easy but even then the movement is copious enough to affect massive hemorrhage. This has very telling effect. In this case for example large banks across the world had exposure to the subprime conundrum. And when the damage occurred the ripple effect wiped out a lot of financial players across the globe.Given the gearing up and the various reasons as explained above, the subprime imbroglio was atime-bomb which was waiting to implode. And as it did it took down with it the most powerfuleconomy in this globe. 31  
  33. 33. THE CRISIS AND CHRONOLOGY OF EVENTS Timeline of Implosion “What began as a tremor in the sub-prime mortgage market that affected a relative few, has sadly gained momentum, creating a broader credit crisis that continues to threaten the middle class and overall economic growth.” -Senator Jack ReedThe U.S. economy was at the peak of invincible growth and incessant development with everysector enjoying a boom since the past two decades. The unemployment rates were fairly low,inflation under control, stock markets scaling new heights, banking sectors overflowing withliquidity and growth figures rising steadily accounting for 26% of the worlds GDP.The American economy flooded with enormous liquidity and the low income citizens striving tofulfill their imperative dream of shelter had an incomprehensible tryst with each other andresulted in the whole sub-prime saga.As it has been said that invention is the mother of necessity the financial institutions devised aninnovative mechanism of securitization with Mortgage Backed Securities and Collateral BondsObligations as the two offsprings. The low-income people who had tarnished credit histories orno documentation were issued loans without any such requirements to be fulfilled. The fundsgenerated from these instruments were used to create new investment vehicles i.e. MBS’s andCDO’s that were issued to investors by the bankers at varying rates of interest depending on theability of the borrowers to repay.The whole mechanism was a laudable creation of the financial know-how and desperatelyfulfilled dreams. So the sub-prime lending mechanism was an efficient fabrication of convertingattractive dreams to a moneymaking business with the creation of two ingeniously thought overinstruments.The boom in the housing sector, enticing interest rates and high profit margins kept on luring thefinancial institutions, that they shut their eyes to the pessimistic notion that if those borrowers 32  
  34. 34. failed to pay their debt obligations or if the collateralized houses faced a surge in the prices, theaftermath could result in the collapse in the whole banking segment on the threshold of whichlies a whole economy with all the sectors interlinked to each other presenting the cascadingeffect.Housing markets have gone bust, interest rates have touched the pinnacles, stock markets acrossthe world have collapsed, unemployment toll has increased, growth rates have plummeted,global inflation has been scaling to new heights, the fiscal deficit gaps are widening, corporategiants have been announcing billion dollar losses with colossal business houses being taken overat the lowest of their values. Figure 5 shows the timeline of the events. 33  
  35. 35. Figure 4: Timeline of Implosion 34