Sub-Prime Crisis: An Economic Perspective
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Transcript of Sub-Prime Crisis: An Economic Perspective
Collapsed (Individuals + Corporate + Banks)= Collapsed System
Sub-Prime Crisis An Economic Perspective
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The days of high levels of employment and high disposable income in the hands of individuals saw
1995 – 2006: The Bright and Sunny Days…
High demand for commodities and goods
Source: www.bloomberg.com PaisaMatters.com
1995 – 2006: The Bright and Sunny Days…
Increasing demand led to increased production levels
Jobs creation and an all around industrial and economic growth
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1995 – 2006: The Bright and Sunny Days…
Source: www.ofm.wa.govPaisaMatters.com
Source: epress.anu.edu.au
1995 – 2006: The Bright and Sunny Days…
1995 – 2006: The Bright and Sunny Days…
The consumer generated organic infusion of money generated strong liquidity in the economy
The increasing aspirations and risk taking ability coupled with low interest rates fuelled strong credit growth
Banking system flushed with liquidity felt a need to accelerate the credit growth
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High income levels and desire to own a dream home had already created a good mortgage loan portfolio
1995 – 2006: The Bright and Sunny Days…
Low interest rates made the housing more affordable and allowed to borrow more
The prime mortgage loan market was falling short of propelling the desired exponential credit growth
There was a huge population with ‘less than perfect credit’ to be tapped
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Borrowers with less than perfect credit - the Subprime borrowers, presented a mouthwatering opportunity for bankers in the mortgages market
1995 – 2006: The Bright and Sunny Days…
Banks started chasing the subprime borrowers with easy loans
People who otherwise could not have afforded a home, bought homes with the high interest rate loans
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1995 – 2006: The Bright and Sunny Days…
Welcome to the world of
Sub-Prime Mortgages
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1995 – 2006: The Bright and Sunny Days…
Subprime loans are mortgages given to borrowers with ‘less than perfect’ credit or poor credit history
Most subprime borrowers are ones with low and inconsistent income
Because subprime loans are riskier, they carry a higher rate of interest
Not all subprime mortgage loans were used for buying houses but to refinance other obligations like credit card debts, making them even more risky
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1995 – 2006: The Bright and Sunny Days…
Borrowers were happy to get loans without worrying about credit worthiness
Mortgage brokers were happy as they were paid to underwrite these easy selling subprime loans without a responsibility to recover
Bankers were happy with the credit growth and higher returns from subprime loans
A Win-Win for all, but not for long.
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1995 – 2006: The Bright and Sunny Days…
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1995 – 2006: The Bright and Sunny Days…
The bankers who originated subprime loans converted them to bundles of securities and sold the packaged Mortgage Backed Securities (MBS) in financial markets
This allowed banks to pass on the risk of default to investors of MBS
This allowed banks to get these loans off their balance sheet and borrow more, only to originate more subprime loans
The buyers of these subprime MBS thought they were taking a calculated risk of default in lieu of higher returns
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1995 – 2006: The Bright and Sunny Days…
In the “High Risk – High Reward” equation, the involved risks were grossly overlooked for the lucrative rewards
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1995 – 2006: The Bright and Sunny Days…
Low interest rates
+
Rising property prices
+
Banks chasing after borrowers with easy loan offers
Result
Swollen sub-prime mortgage portfolio &
huge debt ridden populationSource: i.ehow.com
Source: Flickr.com
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1995 – 2006: The Bright and Sunny Days…
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Q4 2006 – Q2 2007: The Gloomy Evenings
Too much money chasing too few goods resulted in increase in commodity prices and rising inflation rate
The interest rates started moving northwards
Because most of these loans were Adjustable Rate Mortgages (ARMs), the loan installment amount increased
Pressure started to mount on borrowers monthly cash outflows to meet the fixed obligations
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Q4 2006 – Q2 2007: The Gloomy Evenings..
Falling demand for properties led to a rapid decrease in property prices
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Q4 2006 – Q2 2007: The Gloomy Evenings..
Rising oil prices and falling stock markets saw an erosion of investments
Decreasing demand all around resulted in reduced production levels and job losses
Economic slowdown was slowly making an entry
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Q3 2007 Onwards: The Scary Nights…
The subprime borrowers with inconsistent and low incomes could not pay the increased loan installments
Banks started to tighten the credit norms preventing subprime borrowers to refinance existing debts to lower payments
Borrowers could not sell the property to repay debts as the house was worth less that what they bought for
This left borrowers with an option to bring in more money or miss the loan payments
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Q3 2007 Onwards: The Scary Nights…
Improving cash flows was a distant possibility for sub-prime borrowers, missing payments was obvious
The sub-prime loan defaults started mounting
With a further continuous increase in interest rates, it became almost impossible for borrowers to repay the increased mortgage bills
Loan foreclosures started increasing
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Q3 2007 Onwards: The Scary Nights…
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Q3 2007 Onwards: The Scary Nights…
Because there were not many buyers for foreclosed properties, banks could not recover their outstanding loans by selling the foreclosed properties
With tightened credit norms, fewer borrowers qualified for new loans leading to more homes to sell to fewer buyers
Banks left with no other option but to write off the outstanding defaulted loans
Once considered cash cows, the high return fetching mortgage backed securities (MBS) became worthless
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Q3 2007 Onwards: The Scary Nights…
In deteriorating economic conditions, sub-prime loan defaults were followed by defaults in
– prime mortgages
– home equity loans
– unsecured consumer loans (car loans, student loans, credit cards) and
– commercial loansPaisaMatters.com
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Q3 2007 Onwards: The Scary Nights…
Q3 2007 Onwards: The Scary Nights…
Tons of outstanding credit with no recovery in sight saw financial institutions broke
This caused more than two dozen lenders to close, sell themselves to larger firms or report unprecedented losses
Once massive, some financial institutions filed for bankruptcy
Source: nancarrow-webdesk.com
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Q3 2007 Onwards: The Scary Nights…
The panic started to spread
Stock markets crashed
Lost confidence in financial system
Wall street pillars started crumbling
USA is witnessing one of the largest systemic collapse in its history
Source: newsimg.bbc.co.uk
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Q3 2007 Onwards: The Scary Nights…
Financial Times – 20 September 2008
“…bank boards and bank executives have failed to understand complex mortgage-backed banking products, as have central bankers, regulators
and credit rating agencies.”
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?: The Dawn Ahead…
Costly though, surely, a lesson for the economy
Is the worst over yet? … Probably not !
How long before the economy starts looking-up again? …Nobody knows!
Hopefully Sooner, is the Dawn Ahead…
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