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  1. 1. SUBPRIME CRISIS AND THE WORLD Presented by: V.K.Malhotra
  2. 2. Introduction <ul><li>Little about the financial world - </li></ul><ul><li>Its rise </li></ul><ul><li>Banking and non-banking institutions </li></ul><ul><li>Different types of instruments </li></ul><ul><li>Control of the central bank/s over financial institutions </li></ul><ul><li>Debate grim in 1950s and 60s </li></ul><ul><li>Keynes, Friedman, Radcliffe, Gurley, Shaw, etc. </li></ul>
  3. 3. <ul><li>What is liquidity? </li></ul><ul><li>What is financial/credit market? </li></ul>
  4. 4. The crisis <ul><li>What is subprime crisis </li></ul><ul><li>Contracted liquidity in global financial market </li></ul><ul><li>Bail-out package of US$ 700 billion was presented in the US Congress </li></ul><ul><li>( Sep. 2008) </li></ul><ul><li>Dow Jones Index of largest companies declined by 22% in the following week – the worst ever in 118 year history </li></ul><ul><li>Assessed losses on Jan. 1, 2008 – US$ 8 trillion as the holdings of US Corporations had declined from $ 20 to 12 trillion </li></ul><ul><li>( a trillion is 1 million million i.e. one lac crore, so, US$ 800000 crore) </li></ul>
  5. 5. continued <ul><li>Liquidity concerns have driven central banks to take action to provide funds to worthy borrowers and restore confidence in financial market </li></ul><ul><li>USA has even opted for bail-outs – In a capitalist economy </li></ul><ul><li>Barrack Obama had made it a point in election campaign </li></ul><ul><li>Cut in interest rates and economic packages </li></ul>
  6. 6. Who failed? <ul><li>Failure of mortgage companies, </li></ul><ul><li>investment firms </li></ul><ul><li>and government sponsored enterprises </li></ul><ul><li>Some Corporates </li></ul><ul><li>HSBC </li></ul><ul><li>New Century Financial Group </li></ul><ul><li>Merrill Lynch </li></ul><ul><li>JP Morgan Chase </li></ul><ul><li>Goldman Sachs </li></ul><ul><li>Citicorp </li></ul><ul><li>AIG (America International Group) </li></ul>
  7. 7. <ul><li>The crisis has been fuelled by downturn in property (home) prices </li></ul><ul><li>Subprime mortgages </li></ul><ul><li>It had started to show in the middle of 2006 </li></ul><ul><li>Housing bubble </li></ul><ul><li>High default rate happening </li></ul><ul><li>High foreclosure rate due to delinquent accounts : up by 79% from 2006 </li></ul>
  8. 8. <ul><li>Variable amount </li></ul><ul><li>Foreclosure/ Delinquent accounts : 70 % of foreclosures are subprime loans though they account for only 12.5% of all mortgages </li></ul><ul><li>More than 30% of subprime loans had become 90 days delinquent </li></ul><ul><li>Prepayment Penalty </li></ul>
  9. 9. <ul><li>Adjustable Rate Mortgages (ARM) started in 2005 </li></ul><ul><li>It come at Teaser Interest Rates </li></ul><ul><li>Teaser Interest Rates : Initially only interest is charged with no principal repayment and the interest rates jump after some initial period of two-three years. These loans have high closing costs and pre-payment penalty. </li></ul><ul><li>So, after sometime when the loan is reset, the monthly payment starts skyrocketing, may be by 50-60%. That forces a borrower to opt for refinance. </li></ul><ul><li>First Mortgage </li></ul><ul><li>Second Mortgage </li></ul>
  10. 10. <ul><li>Keynesian economists Hyman Minsky described three types of speculative borrowing that can lead to collapse of asset value: </li></ul><ul><li>Hedge borrowers – one who borrows with an intent of making debt payments from cash flows of other investments </li></ul><ul><li>Speculative borrowers – one who borrows on the belief that they can service interest and they must roll over principal into new investments </li></ul><ul><li>Ponzi borrowers – one who assumes that appreciation in asset value would refinance or pay-off the debt </li></ul>
  11. 11. <ul><li>What s credit risk? </li></ul><ul><li>The risk in case of default </li></ul><ul><li>To protect against it, financial institutions can sell rights to the mortgage payments and related credit risk to the investors. </li></ul><ul><li>This process is called securitization </li></ul><ul><li>The securities that investors purchase are called Mortgage Based Securities (MBS) </li></ul><ul><li>Credit risk remains distributed in such manner </li></ul><ul><li>There are no investors for MBS now as they have burnt fingers </li></ul>
  12. 12. Causes <ul><li>Inability of homeowners to make payments </li></ul><ul><li>Poor judgement by the borrowers </li></ul><ul><li>Poor judgement by the lenders </li></ul><ul><li>Speculation during boom period : Increasing home values </li></ul><ul><li>Assumption that rising prices will not retreat in future </li></ul><ul><li>The home prices had doubled in five-six years </li></ul><ul><li>The people were taking second mortgage to finance their consumption </li></ul><ul><li>US household debt as percentage of income rose to 130% </li></ul><ul><li>Americans spent $ 800 billion per year more than what they earned, household debt stood at $ 14 trillion </li></ul><ul><li>In 2008 average American owned 13 credit cards </li></ul>
  13. 13. <ul><li>Risky mortgage products </li></ul><ul><li>High personal and corporate debt levels </li></ul><ul><li>Financial innovation that concealed risk element </li></ul><ul><li>Failure of central banks to regulate the economy </li></ul><ul><li>Growing consumerism </li></ul><ul><li>Erosion of asset value due to inventory of homes (over supply) </li></ul><ul><li>Nearly 8.8 million homeowners i.e. 11% of homeowners had negative equity that is their homes are lesser in worth as compared to their mortgages and they started to walk away even ignoring credit rating impact </li></ul><ul><li>Today inventory of homes stands at more than 10 months </li></ul>
  14. 14. <ul><li>Purchase of homes for investment and not for residence purpose </li></ul><ul><li>(it is known as ‘flipping ’ or selling homes without ever living in </li></ul><ul><li>those) </li></ul><ul><li>Ignoring credit rating : ignoring fundamentals </li></ul><ul><li>The subprime markup or risk premium had declined from 2.8 to 1.3 percentage point. </li></ul><ul><li>So, the risk premium required by lenders to offer a subprime loan had declined. </li></ul><ul><li>Ninja loans – No income, no job, no assets and no down payments </li></ul><ul><li>49% of buyers offering no down payments </li></ul><ul><li>Automated loan approvals – without subjecting approvals to appropriate reviews and documentation </li></ul><ul><li>Where lenders lost their minds </li></ul>
  15. 15. Some lessons: <ul><li>Do not ignore risk side of an equation </li></ul><ul><li>Asset value is not the whole thing </li></ul><ul><li>Assumptions have to be based on long-run observations </li></ul><ul><li>Borrowers have to be identified on these grounds- </li></ul><ul><li>Income level </li></ul><ul><li>Employment status </li></ul><ul><li>Down payment (own contribution) </li></ul><ul><li>Credit history </li></ul>