sub-prime crisis and its aftermath

8/9/2019 Sub-Prime Crisis and Its Aftermath

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Sub-Prime Crisis And Its Aftermath

Mahesh Kumar

Amity Business School


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Objectives of the Session

What is Sub-Prime Crisis?

Its impact on India.

Lessons learnt.


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Introduction In US individuals have FICO scores.

FICO score is a credit score developed by Fao Issac &Co. and it determines the likelihood that credit userswill pay the bills.

Credit scores are arrived after taking into accountvarious factors like

a) Late payments.

b) The amount of time credit has been established.

c) The amount of credit used vs. amount of creditavailable.

d) Length of time at present residence.

e) Nature of credit information such as bankrupts, delayin installments etc.


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What is a Sub Prime Loan? The sub prime loans are given to

borrowers with low credit scores.

These are the loans which aregranted at interest rates above theprime lending rate.

These borrowers are subject to subprime lending on account of theircredit card defaults or any other typeof credit defaults or delays.


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Evolution of Sub-Prime Loans

After the tech bubble burst in 2000 and with fear of9/11 attack in 2001, US Fed began to cut ratesdrastically and the rates reached a level of 1% in

2003, which in central bank idiom is essentiallyzero.

The idea behind rate cut was to prevent economygoing into depression and to increase money supplyto encourage borrowing which would spur

investment and spending. This led to aggressive lending by banking andfinancial institutions with good proportion ofdemand from sub prime borrowers to which bankshappily lent as they offered higher returns.


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Evolution of Sub-Prime Loans

Every individual aspires to having his own houseand Americans were no exception to this rule.

The low interest rate and increased liquidity

increased demand for housing, which led to thecontinuous growth in the market value of theseassets (i.e. real estate) which was collateral for thedebt.

In order to capture the market, banks began to

value these assets higher and higher, as a highervaluation meant a higher loan amount, which couldenable them to win a deal over competition. Thishigher valuation also had an impact on the realmoney-value of the asset.


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Role of Investment Bank

What is an Investment Bank and how it isdifferent from Commercial Bank?Investment banking is a field of bankingthat aids companies in acquiring funds. In

addition to the acquisition of new funds,investment banking also offers advice for awide range of transactions a company mightengage in. A majority of investment banksoffer strategic advisory services formergers, acquisitions, divestiture or other

financial services for clients, such as thetrading of derivatives, fixed income, foreignexchange, commodity, and equity securities


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ModusO

perandi Our story begins with an American,

who like everybody else has a dreamto own a house.

Now in order to fulfill his dream heseeks a home loan.

However, his credit history is poor.

But things become easy for thisAmerican with the advent of subprime loans


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ModusO

perandi A sub-prime borrower (in our story American) takes a

mortgage from institution like Well Fargo Homemortgage.

As soon as deal is signed these institutions package

these mortgages into MBS (Mortgage BackedSecurities) and sell them off to other financialinstitutions like investment banks (Lehman brother,Morgan Stanley, etc).

The banks then proceed to securitize these loans,

chop them up, and proceed into products called CDO

sor Collateralized Debt Obligations, which entitle theholders to the cash flows from the underlyingmortgages.


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ModusO

perandi CDOs were typically sold in tranches and

they are graded accordingly, prime, Alt-Aand the now infamous Sub-Prime

These CDOs are then sold to other marketparticipants like hedge funds, pensionfunds, other banks and insurancecompanies based all over the world.

The CDO

s may then be traded like anyfinancial security and thus, ended up beingheld by banks and other marketparticipants all over the world.


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Role of

Rating Agencies in Sub Prime Crisis

A lot of criticism has been directed at therating agencies and underwriters of theCDOs and other mortgage-backed

securities. The argument is that rating agencies were

enticed to give better ratings in order tocontinue receiving service fees, or they runthe risk of the underwriter going todifferent rating agencies. However, the flipside is that its hard to sell a security if itsnot rated.


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How this situation led to Financial

Fiasco With the coming of these sub-prime loans

for few years things went pretty well, aswith low interest rates, economy started to

surge upwards, with value of real estatesassets touching the sky.

This situation made it easy for borrowers tomake payments, in case they did run intotroubled waters they could top-up theirloans, or re-finance their loans at morefavorable terms. So this was kind of happy-go-lucky times for financial institutions.


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How this situation led to FinancialFiasco

The slowdown began in late 2006 and early 2007.

With fast-growing economy, money started to flowinto equities and money supply reduced.

Following such a scenario FED started to increaseinterest rates. This situation made re-financing of

loans by borrowers difficult.

As loans became more expensive, the demand forhousing reduced, leading to a reduction in the valueof the asset.

Now this led to a chaotic situation, where borrowersbegan to default on their loans at an alarming rate.The investing institutions who held the securitiesbacked by this debt stood to loose.


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How this situation led to FinancialFiasco

In this hue and cry banks stopped lending toeach other.

This led to a huge liquidity crunch in the globalmarkets and subsequently runs on and thecollapse of a few banks in Europe.

With nobody ready to lend money, overnightrates in the money markets skyrocketed setting

the stage for further runs on banks and even thefreezing or possible collapse of the entirebanking system.


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Repercussions of Sub Prime Crisis on India

Indias export can decline if US slows down.Roughly 18% of Indias export which is15% of Indias GDP is to US. The negativeimpact can be partly offset by exports ofservices.

As the US slows down, an effort to reducecosts could boost outsourcing of services.The IT sector has made and will makeimpressive strides. However the otherschool of thought is that due to large scaleunemployment in US the outsourcing jobsmay be shifted from India.


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Capital from external sources willbecome expensive for Indiancorporations who will have to tapdomestic credit market therebyexerting upward pressure ondomestic borrowing cost. This couldwhittle down economic growth rate.

Commodity markets to gain from subprime crisis.


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Capital Market- More emphasis on politicaland economic risks as liquidity tightens.Indian markets will see a correction onaccount of high oil prices, high interestrates and slowing down of exports onaccount of the slowing down of the USeconomy. This will definitely have animpact on the GDP growth rate. Indianstock markets moving in tandem with US

and other Asian markets. Short sellingbanned in order to boost up the marketsentiment.


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Tight Liquidity: Credit crunch. Monetarymeasures like reduction CRR, reduction inrepo rate, change in marking to market

norms. Banking and MF industry affected. Realty sector

Institutions holding US based mortgagesecurities are expected to suffer loss. The

reported exposure of banks are: ICICI:$1.5 billion; SBI: $900 million; Bank ofIndia: $440 million; and Axis Bank(formerly UTI): $150 million.


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Lessons Learnt Credit Appraisal: That the crisis arose in the mortgage

markets of the US and was fed by financial innovations,such as securitization, is an aspect that should be a wake-up call for all economies. In Indian mortgage markets,

there has been less of a tendency to indulge in excesses ofthe kind that US markets engaged in. The Indian housinglender is, by and large, more cautious and does not striveto take on the sub-prime markets, although in the pursuitof inclusive banking, there have been suggestions to banksto search out those below the poverty line for lending.While we have gone some extent in encouraging loans onlimited documentation, the stress of looking for personswithout a known income or job is not there. One lessonof the sub-prime crisis is that we should becautious and prudent even in our pursuit ofgrowing the housing loan book


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Lessons Learnt Securitization: One of the wrong lessons that could be

learnt from the sub-prime episode is aboutsecuritization. Securitization of loans has developed overthe last decade in India. This is a device that enables the

lender to create securities out of its loan assets and sellit to willing investors. These assets get off the balancesheet, releasing that proportionate share of capital forfresh lending. The investor in the securitized assets getshold of assets with good returns. The risk is transferredfrom the lender to the investor. The securitization of

loans in India is covered by a number of rigorousguidelines. The fact that the sub-prime bust originated insecuritized loans should not induce further restrictions onthis. It is a useful innovation and the RBI rules shouldtake care not to scare it away totally.


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Lessons Learnt Rating Agencies: One of the primary reasons for

the sub-prime mess in the US, was thecreditworthiness of the rating agencies. Theirrecord in this latest crisis has been clouded by a

number of missteps. So far as Indian ratingagencies are concerned, they are professionallymanaged and are adopting best practices. Maybe,there is need to be a bit more transparent abouttheir analysis. There is also need to evaluate howgood rating agencies are at anticipating likely

troubles. True, rating agencies serve a usefuleconomic purpose and should be regulated in thebest manner, following international best practices


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Lessons Learnt Central Bank & Its role in framing Monetary Policy:

One of the causes of the crisis was the rapid increases ininterest rates by the US Fed, which, in turn, led to sub-prime borrowers finding it impossible to maintain

repayments on adjustable rate mortgages as the ratewas reset from time to time. This is partly because intheir inflation fighting role, central banks tend not totake into account established borrowers who are lockedinto floating rates. While fighting inflation is all to thegood, it should not be a fight to the finish to finish off

all borrowers. Some safeguards are needed to ensurethat the unfortunate many who are linked to flexiblerates are protected from unanticipated consequences.Perhaps, this requires a careful review of both inflation-fighting tendencies.


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ConclusionFollowing are the abiding lessons that onetakes from sub prime crisis:

a) the RBI needs to take action to ensure thatlending practices are properly documented,

supervised and not lost in competitivepressure.

b) Securitization itself should be encouraged, butwith carefully-crafted guidelines.

c) The rate of growth of credit should not be

reduced out of fear of runaway increase inborrowals.d) The role of the RBI has to be to nurture growth

as well as stability.


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sub-prime crisis and its aftermath

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