Prayatna 2008
Paper presentation on
"U.S. subprime crisis"


Dated: 19th November 2008

By
Ankit Kanungo
Priya Jainani
MBA III Sem
Amity University Rajasthan
Amity Business School
Jaipur
 


Abstract

Is the 2007-2008 U.S. sub-prime mortgage financial crisis truly a new and different phenomena? I examined of the long reasons of US Subprime crises,specially (CDS) Credit Default Swap instrument. Specifically, the run-up in U.S. equity and housing prices (which, for countries experiencing large capital inflows, stands out as the best leading indicator in the financial crisis literature) closely tracks the average of the earlier crises. Another important aspect of analysis is India experienced its economy slowed in the eve of the crisis.

On these crises how Indian govt. reacted and taken the measures for facing liquidity crunch and inflation at a time is also a important aspect of this paper.

Measures suggested by me and comparison between current US sub prime crises with different major crises of world which will describe how all the crises are different and specific in its own and why current crises is dangerous from all of them.
---------------------------------------------------------------------------------------------------

Credit Default Swaps

The monster that ate US economy.

1994, Somewhere in Florida -The sea beach with sexy gals, lavishing food, hard core drinks and music, the bankers of J.P. Morgan met for an offsite weekend.

The guys were there to have a brain storming session about the money which US regulation make them to keep aside in case of their investment get bust. This money hardly earned any return. This brainstorming on ways to obviate the risk of default in financial securities and free up the reserve money for investment. All that brain storming led to the birth of a new concept-CDS. (Credit Default Swaps).

The modern financial system rests on 3 pillars:

1. Capital
2. Liquidity
3. Confidence

Currently, All of them under attack.

Capital :- Unprecedented losses have depleted financial institution's capital faster than their ability to raise new capital.

Liquidity:-Illiquid capital markets have made it hard for them to finanace their own debt.

Confidence :-Falling confidence has damaged inter-bank lending and made depositors jittery.

The total estimated fianacial damage till now is 1.5 trillion US $.

U.S Subprime Crisis

1. Concept :-

The prime guidelines of US regulation to give a simple loan with rules of minimum, interest rate charged by US central bank with a mortgage of security.

And the loan given by violation of these prime guidelines is known as sub prime loans.

1993, The era when US economy is going with a very good time,development rate was very high, interest rates are going down,no inflation,huge liquidity in stock markets.

And in this era, with a objective of giving a house to every poor and young people at US..The US Clinton govt. eased these prime guidelines by giving loan on very small or even on no security and the interest rates made higher by 2% for these loans, because of increased risk.

The banks started granting these loans. till now everything is going in a simple way but

Freddie Mac and Fannie Mae the 2 govt subsidary companies made whole situation complicated, who functions as an intermediary in the U.S by purchasing and securitizing mortgages, Fannie Mae facilitates liquidity in the primary mortgage market by ensuring that funds are consistently available to the institutions that do lend money to home buyers.

Now the intial topic CDS (credit debt secutirties )comes into picture.what is credit default swaps?

CDS is essentially a form of insurance in which the buyer of the swap makes a series of payments to seller of the swap and in return has the right to payoff if the financial security he has invested in defaults.usually not all default occur at one time but this time it does happened,let us see how ?

Fannie Mae buys loans from mortgage originators, repackages the loans as mortgage-backed securities and this mortgage backed securities (MBS) is a type CDS.

Fannie mae sells these MBS to investors in the secondary mortgage market in whole global market with a guarantee that principal and interest payments will be passed through to the investor in a timely manner. Also, Fannie Mae may hold the purchased mortgages for its own portfolio.By purchasing the mortgages, Fannie Mae and Freddie Mac provide banks and other financial institutions with fresh money to make new loans.

This all started a race between banks to make subprime loans and generting more revenues and become market leader and the greedy loan agent helped out them too.

There was huge increase in subprime loans and The overall U.S. home ownership rate increased from 64% in 1994 (about where it was since 1980) to a peak in 2004 with an all-time high of 69.2%.Subprime borrowing was a major contributor to an increase in home ownership rates and the demand for housing. This demand helped fuel housing price increases and consumer spending.

American home prices increased by 124%.

Many financial institutions borrowed enormous sums of money during 20042007 and made investments in mortgage-backed securities. The top five US investment banks each significantly increased their financial leverage during the 20042007 time period, which increased their vulnerability to the MBS losses.

Immediate impacts

1. Jan 2007, inflationary pressure started coming on america's economy, govt. started increasing lending rates and there is too much supply of homes upto that time.

Sub prime Credit holder started doing defaults and at time came when huge subprime credit holder made default at a time and that was a real mess up situation for us economy.

All the MBS or CDS are become worthless because the people whose loans are made as gurantee for them are no more.

Almost all the public companies have MBS and CDS are in their portfolio in huge amount. The financial sector began to feel the consequences of this crisis, in February 2007 with the $10.5 billion writedown of HSBC which was the first major CDO or MBO related loss to be reported

2. August 15, 2007, Biggest result of these crises came when the Dow dropped below 13,000.FII become impatient and started putting out their money from all over the world stock market.and all stock market gone down.

3. Sept 2007, The biggest 5 investment banks reported over $4.1 trillion in debt for fiscal year 2007, a figure roughly 30% the size of the U.S. economy. Three of the five either went bankrupt like Lehman Brothers or were sold at fire-sale prices to other banks like Bear Stearns and Merrill Lynch during September 2008, creating instability in the global financial system. The remaining two converted to commercial bank models, subjecting themselves to much tighter regulation like J.P.Morgan.

Main culprit :-At the end of day I hope u all people are supposing CDS as the main culprit to make a big messing US subprime financial crises but the story was not like that.

That was not CDS instrument that made all went wrong, but the wrong implementation of the security instrument,the preception of equating the sphosticated compliacted CDS with the simple life insurance of many finance company like AIG, Fannie Mae and Freddie Mac which resulted all of them into big bail out packages and US govt. subsidisation themselves and fall of whole world economy.

Impact on world:-

1. Apart from the fact that banks based in other parts of the world also suffered losses from the subprime market, there are two major ways in which the effect is felt across the globe.

    First, the US is the biggest borrower in the world since most countries hold their foreign exchange reserves in dollars and invest them in US securities.
    Thus, any crisis in the US has a direct bearing on other countries, particularly  those with large reserves like Japan, China and - to a lesser extent - India.

    Also, since global equity markets are closely interlinked through institutional investors, any crisis affecting these investors sees a contagion effect throughout the world.

Some of the instances which shows world is affected by subprime crises:-

  • The oil prices which were gone upto 150 US$ per barrel is now came to less than 60 US $.
  • Northern Rock, which was an eminent mortgage lender took refuge in the Bank of England for purposes of emergency financing in the month of September, 2007. Prospective purchasers for the mortgage lender are still being looked for.
  • Another instance in Germany, which implies the impact of US subprime crisis on Europe is when Germany 's IKB Deutsche Industrial bank accepted USD$11.1 billion from the Government as a bailout pertaining to its various United States mortgage investments.
  • BNP Paribas, the French Bank was compelled to take some drastic steps. It stopped all withdrawals from a fund of USD$2.2 billion pertaining to investment funds as the true value of the investment portfolios could not be ascertained.

IMF

The International monetary Fund works as :-

I. Increasing international monetary cooperation.
II. Promoting the growth of trade.
III. Promoting exchange rate stability.
IV Establishing a system of multilateral payments, eliminating exchange restrictions which hamper the growth of world trade, and encouraging progress towards convertibility of member currencies.
V.Building a reserve base.

In the current prices, IMF has issued bail out packages of many countries slashing economy like Iceland US$ 6 billion, Pakistan 9.6 billion.

The Job Scenario :-

1. The job scenario changed drastically in last one year and all because of above financial muddle.
Banking sector already gone with this mess, because the crisis starts only because,with,from the banks,all the big banks of world are facing problem.

2. All the export oriented industries jewellery,textile,handicrafts and many more,all suffering from liquidity crunch around the world.Low demand, low sales, low revenue, low profits simply means to stand by in present scenario cost cutting is only way and this cost cutting converts into no new recruitment at all,even in some sectors out way to the non performer employees.

India : The liquidity crunch :-

1 . Increase in banking rates :- To control the inflation RBI made a cut in all its key lending and policy rates like CRR,SLR,Repo,Reverse Repo etc. which strengthen the liquidity crunch.

2. FII money pull out :-As I already explained how FII pulled out their money from India and other part of world stock market.But in this money pulling the real looser is not the FII but the small investor because FII pulled out their huge money in bull rally,and leave the small investor in the bear market with huge stock market fall.

3. Backing of FDI :- USA has 17.08% share in FDI inflows to India, The US investor community was sharing confidence in the future of the Indian economy. Several areas like infrastructure, IT, Telecom sector, energy and other knowledge industries such as pharmaceuticals and biotechnology, possess immense potential for progressing economic cooperation between India and the US.

On investment front, USA covers almost every sector in India, which is open for private participants. Both government-to-government level and business-to-business level conduct regular interactions with each other to promote and strengthen the trade and economic interactions between the two countries.

FDI in banking is permitted up to 49%. US Success stories in this sector include Citicorp, GE Capital, and American Express. The insurance sector in India is opened up for up to 26% FDI. However, there are proposals to hike this limit to 49%. US companies that have successfully entered this field in India include New York Life, AIG etc.

A very important aspect of US India economic relations comes with the emergence of Business Process Outsourcing, where in many US companies are reaping the advantages offered by India's IT sector. India offers a large pool of trained, English speaking personnel, which offers huge cost benefits to the US MNCs.

4. Export decrease :- India's sizable population and growing middle and higher income class makes India a potentially large market for U.S. goods and services. According to the figure from government sources, U.S. exports to and imports from India in 2003, totalled US $5.0 billion and US $13.1 billion, respectively.
India's main exports to US are precious stones, metals (worked diamonds & gold jewellery), Woven apparel, Knit apparel, miscellaneous textile article, Fish and seafood (frozen shrimp), Textile floor coverings, Iron/steel products, Organic chemicals and Machinery (taps, valves, transmission shafts, gears, pistons, etc).

Among the major multi national corporations of USA that are doing a profitable business in India are- General Electric, Whirlpool Ford (India), 3M, Tecumseh Products (India) Limited, Pepsi, Proctor and Gamble (India), Microsoft, Intel, IBM Corporation, EDS, Sun Microsystems, Adobe Systems Inc, Agilent Technologies Inc, Oracle Corporation, Texas Instruments.

5. Panicing environment :-

This is not that much fundamentals of liquidity crunch effect the market but the influencing panic environment all over the country. The investor don't want to invest his money into any asset class because he don't perceive his money safe in any asset class by investing it to any asset class rather he belives best to keep his money safe in his bank account.

RBI Measures

  • To improve liquidity and check depreciation of rupee, finance ministry relaxed norms to allow companies in the mining, exploration and refineries sectors to bring in up to $500 million in external commercial borrowing (ECB) to the country for rupee expenditure. The earlier limit was $50 million.
  • 20 Oct 2008 (RBI) slashed its key lending rate by 100 basis points to 7.5 percent.
  • 1Nov, 2008, CRR cut by 350 basis points to 5.5 per cent,. This measure will release additional liquidity into the system of the order of Rs 48,000 crore.
  • Nov. 1, 2008, To reduce the repo rate or its main short-term lending rate by 50 basis points to 7.5 percent. Again both repo cut made a liquidity of 40000crore Rs. into system.
  • Increased interest rates on Non-Resident deposit schemes by 50 basis points, or 0.5 per cent
  • As a temporary measure, banks permitted to avail of additional liquidity support under the LAF to the extent of up to 1 per cent of their NDTL.
  • The mechanism of Special Market Operations (SMO) for public sector oil marketing companies instituted in June-July 2008 taking into account the extraordinary situation then prevailing in the money and forex markets will be instituted when oil bonds become available.
  • Under the Agricultural Debt Waiver and Debt Relief Scheme Government had agreed to provide to commercial banks, RRBs and co-operative credit institutions a sum of Rs.25,000 crore as the first instalment. At the request of the Government, RBI agreed to provide the sum to the lending institutions immediately.
  • Interest rates on FCNR (B) Deposits and NRE(R)A deposits were increased by 100 basis points each to Libor/Euribor/Swap rates plus 25 basis points and to Libor/Euribor/Swap rates plus 100 basis points, respectively.
  • Banks allowed to borrow funds from their overseas branches and correspondent banks up to a limit of 50 per cent of their unimpaired Tier I capital as at the close of the previous quarter or USD 10 million, whichever is higher, as against the existing limit of 25 per cent.
  • Special 14 days repo to be conducted every day upto a cumulative amount of Rs.20,000 crore with a view to enabling banks to meet the liquidity requirements of Mutual Funds.
  • Purely as a temporary measure, banks allowed to avail of additional liquidity support exclusively for the purpose of meeting the liquidity requirements of mutual funds to the extent of up to 0.5 per cent of their NDTL.
  • Under the existing guidelines, banks and FIs are not permitted to grant loans against certificates of deposits (CDs). Furthermore, they are also not permitted to buy-back their own CDs before maturity. It was decided to relax these restrictions for a period of 15 days effective October 14, 2008, only in respect of the CDs held by mutual funds.

These above are some measures which RBI has taken to face the world crises on India with a special effect of liquidity crunch and inflation at a time.

Measures suggested by us in context of Indian liquidity crunch :-

1. The key measure which even u and me too take with government is "don't panic".
"Panic" this is all what any financial crises is all about. Something unfortunate happen to the economy, and the reaction which comes out of that unusual event is the crises. after that unfortunate experience once suffered by investor they start concerning about their money and this concern about their money which results into cut in investment. The people start feeling more safe in saving the money instead of investing it. This creates a liquidity crunch into market and this is current situation of the market.

The govt. should take measures and educate the investor that this is the best time to invest their money, not in lumpsum but in trenches into the market because at this time all the securities are in corrected position.

2, Although, country's Foreign exchange reserves fell to $251.364 billion, from $252.883billion a week earlier.

But still government has that strength to make a announcement for a major buying in stock markets through different public sector units like LIC etc.

And I am sure, only a announcement will be enough and become a tool for removing the current liquidity crunch, the only announcement will make that major impact on the Indian investor next day u will see there is no stocks left for buying by LIC and there will be no space for execution of this announcement by govt.So the govt can use this influencing environment which made this crises worst, in a positive way.

In history many crisis happened, but the 2007 sub prime crises is the most dangerous because its spreads worldwide, a bundle of thanks to the cheap and strong telecom and media sector and all other communication modes which made it possible.
---------------------------------------------------------------------------------------------------

ACKNOWLEDGEMENT

It is a matter of great satisfaction and pleasure to present this presentation on "U.S. subprime crisis". I take this opportunity to owe my thanks to all my faculty members for their encouragement and able guidance at every stage of this report.

I thank Dr. Amit Dwivedi (Faculty of Finance, Amity University Rajasthan) for providing me a platform to present my knowledge & skills.

I express my gratitude towards all those people who have helped me directly or indirectly in completing this report.

Ankit Kanungo
Priya Jainani
M.B.A. III Sem
 


Ankit Kanungo
Priya Jainani
MBA III Sem
Amity University Rajasthan
Amity Business School
Jaipur
 

Source: E-mail November 28, 2008

 

         

 

Occasional Papers Main Page