Financial Crisis in detail

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Financial crisis 2008 Created by: Parshwadeep Lahane

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financial basics and crisis explained

Transcript of Financial Crisis in detail

Page 1: Financial Crisis in detail

Financial crisis 2008

Created by: Parshwadeep Lahane

Page 2: Financial Crisis in detail

Disclaimer

I am no financial expert. Made solely out of interest generated after

seeing the debacle on wall street

All content is based on research, readings on internet, newspapers

and my understanding from it.

Free to use. I hope people can take it as base and improve/update it

over time as crisis evolves

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Let’s start with Basics

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Bank

Operation

Take money as deposits on which they pay interests

Lend it to borrowers who use if for investment or consumption

Borrow money from other banks (inter bank market)

Make profit on the difference between interest paid and received

Source: The Economist: Making Sense of Modern Economy

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Potential problems in Bank

Most of bank liabilities have shorter maturity period than assets

This can be a potential cause of bank failure incase all depositors take

out money at once (bank run)

Credit risk

Possibility that borrowers will be unable to repay their loans

More risk in prosperity period as lending terms tends to be relaxed

Interest rate risk

Most deposits at floating rate

Loans at fixed rate

If floating rate is more than fixed rate bank loses ( S&LI ,America 1979)

Source: The Economist: Making Sense of Modern Economy

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Criticality of Banking system

As bank provide credit and operate payments- failure can have a

more damaging effect on the economy than the collapse of other

businesses

Hence need for more regulation by government

Reserve requirement – holding a proportion of bank deposits at the

central bank (CRR)

Match a proportion of risky assets (i.e loans) with capital in form of

equity or retained earnings Capital of internationally active banks should amount to at least 8% of the

value of risky assets. (Basel Accord)

Source: The Economist: Making Sense of Modern Economy

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Investment Banks

Help firms raise money in the capital markets (equity and bonds market)

Advise firms whether to finance themselves with debt or equity

Underwrite such issues by agreeing often with other banks in syndicate, to buy any unsold securities

Paid a commission for this service

Advice on mergers and acquisitions

(most lucrative work- not during

sub-prime crisis though!!)

Glass-Steagall act – prevented

commercial banks from giving Investment

banks servicesSource: The Economist: Making Sense of Modern Economy

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At most basic , they are simply vast pools of money

Institutional investors are Pension funds

Mutual funds

Insurance companies

Dominate the securities( stocks, bonds) market

Control a huge chunk of most rich countries retirement savings and other wealth

These have been growing at the expense of banking system

As biggest owners of stocks and bonds they have growing influence in corporate finance and hence corporate governance

Institutional investors

Source: The Economist: Making Sense of Modern Economy

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Pension funds

Designed for employees of companies or governments

Common form –Trust- overseen by trustees for the benefit plan members

In traditional pension plan, the employer guarantees a fixed pension in old age. The company and employee both pay monhtly contributions into pension fund, where the money is invested.

Trustee is responsible to make sure that the fund’s asset cover its liabilities. Usually actuaries hired to carry this out.

401K plans – allow for choosing from a menu of mutual funds. Blurring the distinction between mutual and pension funds

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Hedge funds

Try explicitly to make money whether markets are going up or down

Mostly private partnerships instead of public companies

Most regulators allow only rich to invest in them

Over the years shifted from being largely private funds for rich

families to being larger institutions whose investors are pension

funds, hospitals, endowments and foundations. 

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Insurance companies

Oldest type of institutional investor

From protection to savings + protection

Law of large numbers – risk can be managed by pooling individual

exposures in large portfolios

Catch1- law works if risk are not correlated

Catch2- losses in any 1 year may differ hugely from the long run trend

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Central Bank-US FED Primary purpose is to address banking panics To strike a balance between private interests of banks and the centralized responsibility

of government To supervise and regulate banking institutions To protect the credit rights of consumers

To manage the nation's money supply through monetary policy to achieve the sometimes conflicting goals of

maximum employment stable prices moderate long-term interest rates

To maintain the stability of the financial system and contain systemic risk in financial markets

To provide financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system

To facilitate the exchange of payments among regions

To respond to local liquidity needs

Source: Wikipedia

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Government securities/bonds

• Governments usually borrow by issuing securities, government bonds and bills to make up for the expenses and revenue (tax collected) differential

• One can treat it as commercial paper

• Least risky investment in US

Source: Wikipedia

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Credit Rating Agency (CRA)

Company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves

A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued

Ex: Moody's (U.S.), Standard & Poor's (U.S.)

Credit ratings are used by investors, issuers, investment banks, broker-dealers, and governments. For investors, credit rating agencies increase the range of investment

alternatives and provide independent, easy-to-use measurements of relative credit risk.

Source: Wikipedia

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Mortgage Broker

Mainly found in developed economies like US, Western Europe Professionals who are paid a fee to bring together lenders and borrowers Sells mortgage loans on behalf of businesses (ex. Banks) Tasks undertaken:

Marketing to attract clients Assessment of the borrowers circumstances (Mortgage fact find forms interview). This

may include assessment of credit history (normally obtained via a credit report) and affordability (verified by income documentation)

Assessing the market to find a mortgage product that fits the clients needs (Mortgage presentation/recommendations)

Applying for a lenders agreement in principle (pre-approval) Gathering all needed documents (paystubs / payslips, bank statements, etc.), Completing a lender application form Explaining the legal disclosures Submitting all material to the lender

Source: Wikipedia

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Sub-prime mortgage – What’s that?

Home loans made to borrowers with poor credit ratings — a group

generally defined by FICO scores below 620 on a scale that ranges

from 300 to 850

 FICO - a number that is based on a statistical analysis of a person's

credit report, and is used to represent the creditworthiness of that

person. (FICO is the acronym for Fair Isaac Corporation, a publicly-traded corporation (under the symbol

"FIC") that created the best-known and most widely used credit score model in the US.)

Creditworthiness—the likelihood that the person will pay his or her

debts. Calculated by credit reporting agencies.

Ex. Equifax, Experian, and TransUnion in US

Source: Wikipedia

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Secondary Mortgage markets

The secondary mortgage market allows banks to sell mortgages,

giving them new funds to offer more mortgages to new borrowers.

If banks had to keep these mortgages the full 15 or 30 years, they

would soon use up all their funds, and potential homebuyers would

have a more difficult time to find mortgage lenders.

Many of the mortgages on the secondary market are bought by

Fannie Mae.

Other are packaged into mortgage-backed securities, and sold to

investors.

Source:http://www.urbandigs.com/2007/08/how_mortgage_backed_securities.html

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Mortgage Backed Security (MBS)

Source:http://www.urbandigs.com/2007/08/how_mortgage_backed_securities.html

STEP 1 - A pool of mortgages are owned by a bank or lender. They are grouped into categories by credit risk including subprime, alt-a (between subprime and prime), and prime.

STEP 2 - The pool of mortgages are packaged into a mortgage backed security.

STEP 3 - The mortgage backed security is then sliced and diced into different classes with varying maturities (called tranches). Each tranche offers varying degrees of risk to the investor. The first loan to default will be placed into the Junk tranche while the strongest loans receive the highest credit rating of 'AAA' and are placed at the top of the tranche division. As with any asset associated with risk, the highest risk tranche receives the highest rate of return or yield while the lowest risk (AAA rated) will receive the lowest yield.

STEP 4 - The tranches are then resold to investors who are willing to take on the varying degrees of risk and maturities.

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Collateralized Debt Obligation (CDO) simplified

MBS CDO

MBS

• Created in 1987 by now defunct investment firm Drexel Burnham Lambert

• Not traded on exchange but OTC market

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OTC market

A decentralized market of securities not listed on an exchange where

market participants trade over the telephone, facsimile or electronic

network instead of a physical trading floor. There is no central exchange

or meeting place for this market. 

In the OTC market, trading occurs via a network of middlemen, called

dealers, who carry inventories of securities to facilitate the buy and sell

orders of investors

Trading is private and prices and

volumes are not disclosed

Price discovery non transparent

Source : http://www.investopedia.com/terms/o/over-the-countermarket.asp

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Now we are ready to look into the mess !

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Evolution of home mortgage

Source :http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,Subprime Mortgage Market Turmoil, Christopher L. Peterson, Asst Prof of Law, Univ of Florida

1930s

Lender-Banks Borrower-Individuals

Home loan funding

Principal + interest payable over long term

• Owning a house was not affordable to many

• Great Depression brought industry to a halt. Large scale defaulters and lenders could not recover by reselling

• To simulate the industry again Government as part of New Deal policy created the Federal National Mortgage Association (Fannie Mae) in 1938. This created a secondary market for mortgages

Lender-Banks Borrower-Individuals

Home loan funding

Principal + interest payable over long term

Bought loan

Cash

Transfer of credit risk, market risk

Had Access to long term borrowing

Bought only those which conformed to certain underwriting standard ( called Prime

Mortgages)

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Evolution continued…

Fannie Mae proved very successful . But by 1960s , borrowing done by it constituted a significant share of the debt owed by US government.

1968- Government National Mortgage Association (Ginnie Mae) was created to handle government guaranteed mortgages.

Fannie Mae became federally chartered, privately held

1970- Ginnie Mae developed MBS -- shifted the market risk to investors -- eliminated debt incurred to fund government housing program

1970-Federal National Mortgage Corporation (Freddie Mac) created To securitize conventional mortgages

Provide competition to Fannie Mae

Over time Fannie Mae and Freddie Mac together provided enormous amount of funding for US mortgage

Since Fannie Mae and Freddie Mac guaranteed loans, much of credit risk stayed with them. Size and diversification allowed them to handle it.

Source :http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,

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New Model of mortgage lending

Lender-Banks

Home loan funding

Principal + interest payable over long term

Bought loan

Cash

Transfer of credit & market risk

MB

S

Cas

h

Transfer of market risk

Advantages

• More liquidity in market

• Risk spread out

• Long term funding for mortgage lending

• MBS- allows originators to earn fee income from underwriting activities without exposure to credit, market or liquidity risks as they see the loans they make

SPV

Sec

uriti

zatio

n fe

es

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Further evolution..

1977- Private label securitization started first done by BOA and Salomon Brothers

1980s- pricing, liquidity and tax hurdles were resolved in same

Unlike 2-3 party , private label securitization has 10 or more different parties playing independent role

Big private players in this field were Wells Frago

Lehman Brothers

Bear Stearns

JP Morgan

Goldman Sachs

Bank Of America

• Indymac

• Washington Mutual

• Countrywide

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Details : Private Sub-prime mortgage process

1. Brokers identify borrowers

2. Originator and broker identify a loan for borrower after looking at his credit rating

3. Formal application for loan by borrower

4. Originator transfers the loan to the subsidiary of an investment banking firm ( Seller)

5. Seller(Investment bank) collects a pool of loans and call it as SPE/SIV/SPV. Off balance sheet instrument6. SPV can be a corporation, partnership or limited liability company. Most often a Trust. It has nothing else except mortgage loans7. Underwriter purchases all the securities (derivative income streams) 8. In designing SPV and its tranches underwriter works with credit rating agencies

9. Underwriter then sells the securities to the investors10. High rated tranches might be guaranteed by a 3rd party insurance company11. Seller also arranges to sell the rights to service the loan pool to a company or sometimes Originator takes these rights

12. MERS – document custodian. Company to keep track of mountains of paper work on loans in the pool. At National level. Source : Subprime Mortgage Market Turmoil , testimony by Christopher L. Peterson

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Possible inter linkage in the US subprime mortgage market

Source: http://www.norges-bank.no/templates/article____66901.aspx

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Reasons for forming of Subprime mess

Giant pool of money available for investment through savings of Oil exporters , economic

development in BRIC countries.

Private share in mortgage market growth in large part through origination and

securitization of high risk sub-prime and Alt-A mortgages.

Building up of the housing bubble

Private Banks made use of CDOs to sell to investors

• Lax regulations which did not keep pace with the innovations happening in financial

engineering

• US kept interest rates too low for too long in post dotcom bust period

• Hedge funds, Wall street firms and instructional investors found lower tranches in MBS

and CDO attractive which were highly risky

• Hedge funds leverage ratio of the order of 500%.

• To sum up in 3 words as noted by Harvard dean: Leverage(high), Transparency (low)

and Liquidity (abundant)

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Big assumptions

Belief that modern capital markets had become so much more advanced than their predecessors that banks would always be able to trade debt securities. This encouraged banks to keep lowering lending standards, since they assumed they could sell the risk on.

Many investors assumed that the credit rating agencies offered an easy and cost-effective compass with which to navigate this ever more complex world. Thus many continued to purchase complex securities throughout the first half of 2007 – even though most investors barely understood these products.

Most crucially, there was a widespread assumption that the process of “slicing and dicing” debt had made the financial system more stable. Policymakers thought that because the pain of any potential credit defaults was spread among millions of investors, rather than concentrated in particular banks, it would be much easier for the system to absorb shocks than in the past.

Housing prices will keep going up all time

Source :http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

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Misaligned incentives & pitfalls

“churning” of capital “allows even an institution without a great amount of fixed capital

to make a huge amount of loans, lending in a year much more money than it has

If an individual or class of victims obtains a large judgment, the lender’s management

can simply declare bankruptcy, liquidate whatever limited assets are left, and possibly

reform a new company a short time later.

Securitization conduit divides various lending tasks into multiple corporate entities—a

broker, an originator, a servicer, a document custodian, etc.—the conduit tends to

prevent the accumulation of a large enough pool of at risk assets to attract the

attention of class action attorneys, which tend to be the only actors capable of

obtaining system-impacting judgments.

Source : Subprime Mortgage Market Turmoil , testimony by Christopher L. Peterson

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Good days turn bad. Crisis at the door (mid 2006 onwards):

Through financial innovations loans issued to borrowers at minimal rate,

adjusted rate. By mid 2006 time to pay bigger amounts comes

Household income did not increase in same proportion as house prices

Subprime mortgage owners start defaulting

Rating agencies revise ratings of MBS/CDO as expected number of

defaults turn out higher. Many ratings are lowered

Bewildered investors lost faith in ratings, many stop buying MBS/CDO

altogether

Alarm bell at SIV/SPVs

Banks find themselves in non-comfortable position , stop making loans

Housing prices plummet owing to increase in foreclosure, delinquency and

stoppage of loans

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what a mess….

More frenzy in market and more defaults, again revised ratings, again further

stoppage of funding and further stoppage of loans, further fall in house prices as

demand and supply mismatch....problem feeding itself in circular fashion.

As MBS/CDO market is shaken….investors start debating other derivatives true

worth…panic spreads across and people start getting out….further hurting the banks

The crisis unfolded as silent Tsunami on Wall Street where by the time people

realized the graveness of the mess they were in , it had gone beyond control.

Since, most of the player in the market, mortgage brokers, investment banks were

running in debts. They are suddenly caught unaware and are in insolvency and start

tumbling down….many are saved by nationalization as their fall would spread the

contagion way far .

Central government start pumping in money as last resort but one thing is surely not

returning soon and which is very vital in financial industry -FAITH.

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In Short

When homeowners default, the

amount of cash flowing into

MBS declines and becomes

uncertain.

Investors and businesses

holding MBS have been

significantly affected.

The effect is magnified by the

high debt levels maintained by

individuals and corporations,

sometimes called financial

leverage.

Source :http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,

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Those good old days were gone now!!

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How Subprime became Global Financial Crisis?

Lets look into it from start again:

 Industry data suggest that between 2000 and

2006, nominal global issuance of credit

instruments(MBS/CDO) rose twelvefold, to

$3,000bn a year from $250bn

Became intense from 2004, partly because

investors were searching for ways to boost returns

after a long period in which central banks had kept

interest rates low.

“slicing and dicing” was fuelling a credit bubble,

leading to artificially low borrowing costs, spiraling

leverage and a collapse in lending standards

Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

In b

illio

n U

S $

How could problems with subprime mortgages, being such a small sector of global financial markets, provoke such dislocation?

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Build up into a financial crisis…

In 2003, Bank of International Settlements(BIS) repeatedly warned that risk dispersion might not

always be benign. But US Federal Reserve was convinced that financial innovation had changed

the system in a fundamentally beneficial way.

No efforts made to correct debt to equity ratios of bank

Huge trust in the intellectual capital of Wall Street –supported by the fact that banks were making

big money.

When high rates of subprime default emerged in late 2006, market players assumed that the

system would absorb the pain.

Initial estimate of subprime loss put to $50bn-$100bn by US FED 

Subprime losses started to hit the financial system in the early summer of 2007 in unexpected

ways. As the surprise spread, the pillars of faith that had supported the credit boom started to

crumble.

Investors woke up to the fact that it was dangerous to use the ratings agencies as a guide for

complex debt securities.

In the summer of 2007, the agencies started downgrading billions of dollars of supposedly “ultra-

safe” debt – causing prices to crumble.

Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

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Poor Investors…. Shocked investors (sitting in all parts of the world) lost faith in ratings, many stopped buying complex

instruments altogether

That created an immediate funding crisis at many investment vehicles ( remember SIV), since most had

funded themselves by issuing notes in the asset-backed commercial paper market. 

Many banks had not yet passed on the risk to others. Many were holding asset-backed securities in

“warehouses” and were working on splicing them up into CDOs, getting them rated by a credit agency

such as Moody’s or Standard & Poor’s. Several banks were caught out not only because it took time to

structure the securities but because they deliberately held on to what they regarded as “safe” tranches of

loans. Ex. UBS was badly damaged by retaining “super-senior” CDO debt.

It also meant that banks were no longer able to turn assets such as mortgages into subprime bonds and

sell these on.

That in turn meant the key assumption that the capital markets would always stay liquid – was

overturned. 

Assumption that banks would be better protected from a crisis because of risk dispersion – also cracked.

As investment vehicles lost their ability to raise finance, they turned to their banks for help. That

squeezed the banks’ balance sheets at the very moment that they were facing their own losses on debt

securities and finding it impossible to sell on loans.

Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

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Desperate banks….

As a result, western banks found themselves running out of capital

Banks started hoarding cash and stopped lending to each other as financiers lost

faith in their ability to judge the health of other institutions – or even their own.

The London interbank offered rate(LIBOR), the main measure of interbank lending

rates, rose sharply

Firms became reluctant to participate in money markets ... as a result subprime credit

problems turned into a systemic liquidity crunch.

Vicious deleveraging spiral got under way. As banks scurried to improve their balance

sheets, they began selling assets and cutting loans to hedge funds.

But that hit asset prices, hurting those balance sheets once again.

Mark-to-market accounting forced banks to readjust their books after every panicky

price drop 

Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

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Lessons learned & Action plans ….

lesson of the CDO collapse is that technology does not obviate the need

to assess a borrower carefully. Neither banks nor credit agencies did this

well enough on behalf of investors and it proved a painful experience for

everyone

In the medium term, regulators are preparing reforms that aim to make the

system look credible

These would force banks to hold more capital and ensure that the

securitization process is more transparent

Separately, groups such as the IIF are trying to introduce measures that

could rebuild confidence in complex financial instruments

More immediately, the banks are trying to rekindle investor trust by

replenishing their capital bases

Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

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Subprime losses by Big Banks

Worldwide :US$ 586.2 billion and still counting

Source: Financial Times

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Finance & Economy

The collapse of an enormous financial institution stirs uncertainty,

and uncertainty rattles Wall Street. Lenders are happiest when they

are confident they will be repaid. If they think there's a chance that

borrowers will default, they simply don't make loans. Their refusal, in

turn, can shut down the economy and the financial system.

Financial system is what provides the funding for all the other

sectors of the economy, and if you have a broken financial system,

you have a broken economy

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Investments devalued across the Globe

Source: BBC News, http://news.bbc.co.uk/2/hi/talking_point/7644574.stm

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Subprime impact across globe

Source: Financial Times

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Impact of Financial crisis-felt across the globe

Source: Reuters, http://www.reuters.com/news/globalcoverage/creditcrisis

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Thanks

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Market share shifted from 2003 to mid 2006

76

43

24

57

0

20

40

60

80

100

2003 mid-2006

%

Year

Mortgage market % share

Government sponsered Private( Wall Street firms)

• Government share fell by 43% where as private share rose sharply by 138% over a period of 3 years

Between sub-prime and prime

• Subprime lending increased by massive 205% over 3 years • Alternative–A similarly expanded by 384%

• Increase in Prime was mere 16.7%

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Global pool of money

Source:http://www.rbnz.govt.nz/speeches/2968727.html

• After 1997/98 financial crisis – Developing countries focus on export-driven growth and the associated accumulation of foreign exchange reserves• The strength of exports relative to domestic demand has seen saving outstrip investment in most of these economies

• Accordingly, we have the ironic situation whereby a range of developing countries are (in net terms) the providers of capital to some of the world’s most developed economies.

• This rapidly rising “savings glut” has been a principal source of increased global liquidity.

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Rise of Global Liquidity (1998 onwards)

Source:http://www.rbnz.govt.nz/speeches/2968727.html

• The flow of increased global liquidity through markets has provided the impetus for many changes

• To generate a return on this liquidity has spurred massive growth in securitization of debt and the development of a vast array of derivatives. The propagation of these instruments can itself be seen as a source of liquidity growth. From a monetary policy perspective, this implies a very big increase in the liquidity that is not directly controlled by central banks. • •Bank for International Settlements, highlighted a number of important new features:

• the unbundling and re-pricing of risk through major advances in financial engineering, resulting in improved ability to lever lending via new markets such as for credit transfer products;• the emergence of new financial players such as hedge funds and private equity firms that have not been traditional intermediaries;• more reliance of financial firms on markets to handle growing complexity;• a reliance on market liquidity even in stress situations; and• a surge in volume and value of transactions.

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FED interest rate

• To catch up with dot com boom FED kept interest rate low for long• •This indirectly resulted in investors looking for other safe heavens

• They got attracted to housing market

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High Banks leverage ratio’s to fund MBS/CDO

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Building up of the housing bubble

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Housing prices and Income

Source: http://varbuzz.com/meltdown/

• Housing prices were increasing

•Income slope was almost flat

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Starting 2006 housing bubble busted

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LIBOR rate

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Credit rating of complex financial instruments

Source: IMF and WSJ

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Speedy Foreclosures

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Top 10 Bankruptcies

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The American way of debt

Source: http://www.nytimes.com/interactive/2008/07/20/business/20debt-trap.html?ei=5070

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Average debt of American in 2004

Source: http://www.nytimes.com/interactive/2008/07/20/business/20debt-trap.html?ei=5070