Subprime crisis


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Subprime crisis

  1. 1. What is Subprime Crisis?A situation starting in 2008 affectingthe mortgage industry due to borrowers being approved for loans they could notafford. As a result, a significant rise in foreclosures led to the collapse ofmany lending institutions and hedge funds. The financial crisis in the mortgageindustry also affected the global credit market resulting in higher interestrates and reduced availability of credit.Thus, subprime crisis simply means lending money to subprime borrowers i.e.lending to people with low or poor credit worthiness.The Subprime crisis is notreally a crisis due to over lending of banks, but situation created due tosubprime lending.What is subprime lending?The term “subprime” refers to the credit status of the borrower, not the interestrate on the loan itself. “Subprime” is any loan that does not meet “prime”guidelinesSubprime lending, also called B-paper, near-prime, or second chance lending, isthe practice of making loans to borrowers who do not qualify for the best marketinterest rates because of their deficient credit history. The phrase also refers topaper taken on property that cannot be sold on the primary market, includingloans on certain types of investment properties and certain types of self-employed individuals. Subprime lending is risky for both lenders and borrowersdue to the combination of high interest rates, poor credit history, and adversefinancial situations usually associated with subprime applicants. A subprime loanis offered at a rate higher than A-paper loans due to the increased risk.Who opt subprime lending?Individuals who have experienced severe financial problems are usually labelledas higher risk and therefore have greater difficulty obtaining credit, especially forlarge purchases such as automobiles or real estate. These individuals may havehad job loss, previous debt or marital problems, or unexpected medical issues,usually these events were unforeseen and cause a major setback in finances. Asa result, late payments, charge-offs, repossessions and even foreclosures mayresult.Due to these previous credit problems, these individuals may also be precludedfrom obtaining any type of loan for an automobile. To meet this demand, lendershave seen that a tiered pricing arrangement, one which allows these individualsto pay a higher interest rate, may allow loans which otherwise may not occur.
  2. 2. From a servicing standpoint, these loans have higher collection defaults andexperience higher repossessions and charge offs. Lenders use the higher interestrate to offset these anticipated higher costs.Provided a consumer will enter into this arrangement with the understandingthat they are higher risk, and must make diligent efforts to pay, these loans doindeed serve those who would otherwise be undeserved. The consumer mustpurchase an automobile which is well within their means, and carries a paymentwell within their budget.How the subprime crisis started?The subprime lending is 9% in 1996 but in 2004 it is 21%. Due to securitization,investor appetite for mortgage-backed securities (MBS), and the tendency ofrating agencies to assign investment-grade ratings to MBS, loans with a high riskof default could be originated, packaged and the risk readily transferred toothers. In addition to considering higher-risk borrowers, lenders have offeredincreasingly high risk loan options and incentives to them.Homeowners had been using the increased property value experienced in thehousing bubble to refinance their homes with lower interest rates and take outsecond mortgages against the added value to use the funds for consumerspending. Between 1997 and 2006, American home prices increased by124%.Easy credit combined with the assumption that housing prices wouldcontinue to appreciate also encouraged many subprime borrowers to obtain ARMthey could not afford after the initial incentive period. With housing prices nowdepreciating moderately in many parts of the U.S., refinancing has becomedifficult, leaving homeowners with higher payments than anticipated.Beginning in late 2006, the U.S. subprime mortgage industry entered what manyobservers have begun to refer to as a meltdown. A steep rise in the rate ofsubprime mortgage foreclosures has caused more than 100 subprime mortgagelenders to fail or file for bankruptcy, most prominently New Century FinancialCorporation, previously the USA’s second biggest subprime lender. The failure ofthese companies has caused prices in the $6.5 trillion mortgage backedsecurities market to collapse, threatening broader impacts on the U.S. housingmarket and economy as a whole.However, the crisis has had far-reaching consequences across the world. Sub-prime debts were repackaged by banks and trading houses into attractive-looking investment vehicles and securities that were snapped up by banks,traders and hedge funds on the US, European and Asian markets. Thus when thecrisis hit the subprime mortgage industry, those who bought into the marketsuddenly found their investments near-valueless. With market paranoia settingin, banks reined in their lending to each other and to business, leading to risinginterest rates and difficulty in maintaining credit lines. As a result, ordinary, run-of-the-mill and healthy businesses across the world with no direct connection
  3. 3. whatsoever to US sub-prime suddenly started facing difficulties or even foldingdue to the banks’ unwillingness to budge on credit lines.As a resultRight now there is “liquidity crisis” on wall street. Basically, because so manysubprime loans are in default, Wall Street investors are no longer supplyingmoney to market which lenders use to lend out over and over again. They makemoney by originating a loan and selling it to someone else who pays the lender apremium based on future revenue. If lenders cannot “sell” these loans theycannot generate new business. Since guidelines are now so tight, many of these“subprime” borrowers will not be able to refinance their loan. They took shortterm adjustable loans (2-3yr fixed) which are now adjusting to much higherrates.In the UK, some commentators have predicted that the UK housing market willin fact be largely unaffected by the US subprime crisis, and have classed it as alocalized phenomenon.However, in September 2007 Northern Rock, the UK’sfifth largest mortgage provider, had to seek emergency funding from the Bank ofEngland, the UK’s central bank as a result of problems in international creditmarkets attributed to the sub-prime lending crisis.There are direct and indirect implications not only for the United States but forthe entire world. Let us briefly study the effects of this crisis on the Indianeconomy.Firstly, the subprime crisis has led to near loss of confidence in the AmericanStock Markets, and this has accentuated the credit crunch. Many big investmentbanks have been brought down to their knees and many others are finding itextremely difficult to stay on their feet. In order to consolidate their respectivebalance sheets in the United States, these banks are unwinding positions indeveloping markets hence causing down swing in these markets. A simple casein point was the intra day 1400 points fall on the BSE in January 2008 that wasbrought about by Citi Bank unwinding its position in manyfront line stocks inIndia. The subprime that was brought upon by the American financial systemupon itself is spreading its tentacles around the world. People who were not evenremotely connected with the subprime crisis are being adversely affected.Secondly, the near recession situation in the USA has led to a loss of demand forIndian exports hence loss of export earnings for India. The Americans are knownto live beyond their means. However, on account of the subprime crisis, all theirsources of credit have dried up, and they are being forced to cut down on theirexpenditures. Thus demand for imports is falling, which implies loss of revenuesfor countries like India. Not only is there a loss in the goods sector, but the ITsector is also feeling the pinch. Softwaredevelopment for many US firms takesplace in India but as the American firms are facingan economic slowdown, theyare demanding less IT products, leading to a fall in thegrowth rate of the IndianIT sector.
  4. 4. Thirdly, investment banks and other financial institutions are on a job slashingspree to cut costs. This means that many jobs in India are at stake becausethese institutions have their BPO’s in India. So the first jobs to go will be the lowend Indian BPO jobs leading to increased unemployment in India.Fourthly, there will be serious implications for the banking sector as well. Thesubprime has meant that the Indian banks have to follow stricter norms whiledisbursing loans to the people. These tighter norms could prove to be countercyclical. The argument is this‐ people will be asked to provide collateral for theloans given to them. Anybody who is unable to furnish the collateral will bedenied a loan. This policy will exclude a majority of the population frominstitutional sources of credit, thereby affecting growth negatively.Fifthly, there is a risk of the financial contagion spreading to the entire world.Firms like Bear Sterns, Lehman Brothers, Meryl Lynch who once inspiredconfidence amongst theinvestor class have now gone bust. Other giants like CitiBank, Morgan Stanley, and AIG have been shaken from their very foundations.Freddie Mac and Fannie Mae are under the conservatorship of the USgovernment. The risk is, thus, the domino effect. If one more big financialinstitution fails there will be a collapse of the entire financial system of the USA.Impacts on IndiaThough in the beginning Indian official denied the impact of US meltdownaffecting the Indian economy but later the government had to acknowledge thefact that US financial crisis will have some impact on the Indian economy. TheUS meltdown which shook the world had little impact on India, because ofIndia’s strong fundamental and less exposure of Indian financial sector with theglobal financial market. Perhaps this has saved Indian economy from beingswayed over instantly. Unlike in US where capitalism rules, in India, market isclosely regulated by the government. 1. Impact on stock market The immediate impact of the US financial crisis has been felt when India’s stock market started falling. On 10 October, Rs. 250,000 crores was wiped out on a single day bourses of the India’s share market. The Sensex lost 1000 points on that day before regaining 200 points, an intraday loss of 200 points. This huge withdrawal from the India’s stock market was mainly by Foreign Institutional Investors (FIIs), and participatory-notes.
  5. 5. 2. Impact on India’s trade The trade deficit is reaching at alarming proportions. Because of worker’s remittances, NRI deposits, FII investment and so on, the current deficit is at around $10 billion. But if the remittances dry up and FII takes flight, then we may head for another 1991 crisis like situation, if our foreign exchange reserves depletes and trade deficit keeps increasing at the present rate. Further, the foreign exchange reserves of the country has depleted by around $57 billion to $253 billion for the week ended October 31.3. Impact on India’s export With the US and several European countries slipping under the full blown recession, Indian exports have run into difficult times, since October. Manufacturing sectors like leather, textile, gems and jewellery have been hit hard because of the slump in the demand in the US and Europe. Further India enjoys trade surplus with USA and about 15 per cent of its total export in 2006-07 was directed toward USA. Indian exports fell by 9.9 per cent in November 2008, when the impact of declining consumer demand in the US and other major global market, with negative growth for the second month, running and widening monthly trade deficit over $10 billions. Official statistics released on the first day of the New Year, showed that exports had dropped to $1.5 billion in November this fiscal year, from $12.7 billion a year ago, while imports grew by $6.1billion to $21.5 billion. 4. Impact on India’s handloom sector, jewelry export and tourism Again reduction in demand in the OECD countries affected the Indian gems and jewellery industry, handloom and tourism sectors. Around 50,000 artisans employed in jewellery industry have lost their jobs as a result of the global economic meltdown. Further, the crisis had affected the Rs. 3000 crores handloom industry and volume of handloom exports dropped by 4.6 per cent in 2007-08, creating widespread unemployment in this sector. With the global economy still experiencing the meltdown,
  6. 6. Indian tourism sector is badly affected as the number of tourist flowing from Europe and USA has decreased sharply. 5. Exchange rate depreciation With the outflow of FIIs, India’s rupee depreciated approximately by 20 per cent against US dollar and stood at Rs. 49 per dollar at some point, creating panic among the importers. 6. IT-BPO sector The overall Indian IT-BPO revenue aggregate is expected to grow by over 33 per cent and reach $64 billion by the end of current fiscal year (FY200).Over the same period, direct employment to reach nearly 2 million, an increase of about 375000 professionals over the previous year. IT sectors derives about 75 per cent of their revenues from US and IT- ITES (Information Technology Enabled Services) contributes about 5.5 per cent towards India’s total export. So the meltdown in the US will definitely impact IT sector. Further, if Fortune 500 hundred companies slash their IT budgets, Indian firms could adversely be affected. 7. FII and FDI The contagious financial meltdown eroded a large chunk of money from the Indian stock market, which will definitely impact the Indian corporate sector. However, the money eroded will hardly influence the performance real sector in India. Due to global recession, FIIs made withdrawal of $5.5 billion, whereas the inflow of foreign direct investment (FDI) doubled from $7.5biilion in 2007-08 to $19.3 billion in 2008 (April-September).Impacts on USSince 2000, the market for MBS has overtaken even those for US treasury notesand bonds. This led to a broad-based and devastatingimpact of the crisis. It ishard to overstate the extent of this reversal in fortunes, if only because it is hardto overstate theeffect that securitization has on financial markets.
  7. 7. Homeowners:A vicious circle was created when subprime loan payers defaulted on theirobligation, leaving foreclosure of their mortgages as the only perceived recoursefor investors in the loan. When other homeowners with mortgages also attemptto meet theirfinancial obligations, some of them put their homes up for sale,which drags down the price of other houses in their neighbourhood, not merelythose houses with subprime mortgages. Thus the entire real sector wasinvolved. Sales of previously owned homes fell in September to annual rate of5.04 million, the lowest since the records began in 1999, the NationalAssociation of Realtors said. Housing starts fell to a 14 year low.Investors:These defaults will lead to huge losses for investors, with predictions in therange of $200 billion or more just from sub-prime mortgage investments. Thelosses from so-called “contagion” effects are likely to be much larger.Mortgage lenders:Mortgage lenders are seeing their lines of credit dry up and Wall Street isunwilling to buy any mortgage loans because of the liquidity crunch. Hundredsof mortgage lenders have shut down and more than 50,000 people have losttheir jobs in 2007 alone. The situation is likely to worsen with smaller and mid-size lenders closing shop or forced to sell out.Homebuilders & real estate brokers:Both these groups are also trying to deal with the perfect storm. Manyhomebuilders will shut down and thousands of real estate brokers will go out ofbusiness.Wall Street firms:Wall Street firms, who issued and underwrote many of the mortgagebackedsecurities and structured vehicles (such as CDOs) that were sold to investorsworldwide, have suffered huge losses on their holdings and business has cometo a standstill. In addition, all banks have suffered losses in other markets fromthe “contagion”, which will likely continue.