Subprime crisi

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WHAT IS SUBPRIME CRISESA situation starting in 2008 affecting the

mortgage industry due to borrowers being approved for loans they could not afford. As a result, a significant rise in foreclosures led to the collapse of many lending institutions and hedge funds. The financial crisis in the mortgage industry also affected the global credit market resulting in higher interest rates and reduced availability of credit.

Causes of subprime crises

• Boom and Burst in housing market• Homeowner speculation• High-risk mortgage loans and

lending/borrowing practices• Securitization practises• Inaccurate credit ratings• Government Regulation• Role of Fannie Mae and Freddie Mac• Financial institution debt levels and

incentives

Causes of subprime crises Boom and bust in the housing market

Low interest rates and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis, fueling a housing market boom & encouraging debt-financed consumption.

The USA home ownership rate increased from 64% in 1994 to an all-time high of 69.2% in 2004.

Between 1997 and 2006, the price of the typical American house increased by 124%.

By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak.

As of March 2008, an estimated 8.8 million borrowers – 10.8% of all homeowners – had negative equity in their homes.

By September 2010, 23% of all U.S. homes were worth less than the mortgage loan.

…Causes of subprime crisesHomeowner speculation

During 2006, 22% of homes purchased were for investment purposes, with an additional 14% purchased as vacation homes. During 2005, these figures were 28% & 12%.

Housing prices nearly doubled b/w 2000 & 2006.

“ There was the greatest bubble ever seen .The entire American public eventually was caught up in a belief that housing prices could not fall dramatically."

…Causes of subprime crisesHigh-risk mortgage loans and lending/borrowing

practices In the years before the crisis, Lenders offered

more and more loans to higher-risk borrowers and undocumented immigrants

Subprime mortgages amounted to $35 billion (5% of total originations) in 1994, 9% in 1996, $160 billion (13%) in 1999, & $600 billion (20%) in 2006.

 In 2005, the median  down payment for first-time home buyers was 2%, with 43% of those buyers making no down payment .

…Causes of subprime crises High-risk mortgage loans and lending/borrowing

practices

The mortgage qualification guidelines began to change. The stated income, verified assets loans came out. Proof of

income was no longer needed. Borrowers just needed to "state" it and show that they had money in the bank.

The lender no longer required proof of employment. Borrowers just needed to show proof of money in their bank accounts.

The qualification guidelines kept getting looser in order to produce more mortgages and more securities. This led to the creation of NINA.

All that was required for a mortgage was a credit score.

…Causes of subprime crisesAnother example is the interest-only adjustable-rate

mortgage (ARM), which allows the homeowner to pay just the interest during an initial period.

Mortgage Underwritings standards declined precipitously during the boom period.  In 2007, 40% of all subprime loans resulted from automated underwriting.

The  Financial Crisis Inquiry Commission  reported in January 2011 that many mortgage lenders took eager borrowers’ qualifications on faith, often with a "willful disregard" for a borrower’s ability to pay.

…Causes of subprime crisesSecuritization practises

In the mid-2000s, GSE securitization declined dramatically as a share of overall securitization, while private label securitization dramatically increased.

 Most of the growth in private label securitization was through high-risk subprime and Alt-A mortgages.

 As private securitization gained market share and the GSEs retreated, mortgage quality declined dramatically.

 The total amount of mortgage-backed securities issued almost tripled between 1996 and 2007, to $7.3 trillion.

The securitized share of subprime mortgages increased from 54% in 2001, to 75% in 2006.[

…Causes of subprime crisesSecuritization practises

• American homeowners, consumers, and corporations owed roughly $25 trillion during 2008.

• American banks retained about $8 trillion of that total directly as traditional mortgage loans. Bondholders and other traditional lenders provided another $7 trillion.

• The remaining $10 trillion came from the securitization markets. The securitization markets started to close down in the spring of 2007 and nearly shut-down in the fall of 2008.

• More than a third of the private credit markets thus became unavailable as a source of funds.

…Causes of subprime crises Inaccurate credit ratings

Credit rating agencies are now under scrutiny for having given investment-grade ratings to MBSs based on risky subprime mortgage loans.

These high ratings enabled these MBSs to be sold to investors, thereby financing the housing boom.

Between Q3 2007 and Q2 2008, rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities

Financial institutions felt they had to lower the value of their MBS and acquire additional capital so as to maintain capital ratios.

If this involved the sale of new shares of stock, the value of the existing shares was reduced.

Thus ratings downgrades lowered the stock prices of many financial firms

…Causes of subprime crises Government RegulationGovernment over-regulation, failed

regulation and deregulation have all been claimed as causes of the crisis.

Increasing home ownership has been the goal of several presidents including Roosevelt, Reagan, Clinton and George W. Bush

…Causes of subprime crises Decreased regulation of financial institutions

Some analysts believe the subprime mortgage crisis was due, in part, to a 2004 decision of the SEC that affected 5 large investment banks.

The critics believe that changes in the capital reserve calculation rule enabled investment banks to substantially increase the level of debt they were taking on, fueling the growth in mortgage-backed securities supporting subprime mortgages.

These banks dramatically increased their risk taking from 2003-2007.

By the end of 2007, the largest five U.S. investment banks had over $4 trillion in debt with high ratios of debt to equity, meaning only a small decline in the value of their assets would render them insolvent

…Causes of subprime crises Role of Fannie Mae and Freddie Mac

Fannie Mae and Freddie Mac are government sponsored enterprises (GSE) that purchase mortgages, buy and sell mortgage backed securities(MBS), and guarantee nearly half of the mortgages in the U.S.

A variety of political and competitive pressures resulted in the GSEs ramping up their purchase and guarantee of risky mortgages in 2005 and 2006, just as the housing market was peaking.

Fannie and Freddie were under both under political pressure to expand purchases of higher-risk affordable housing mortgage types, and under significant competitive pressure from large investment banks and mortgage lenders.

…Causes of subprime crisesRole of Fannie Mae and Freddie Mac

Several studies indicate Fannie and Freddie were not to blame for the crisis and that GSEs played no significant role in the subprime crisis.

By some estimates, more than 84 percent of the subprime mortgages came from private lending institutions in 2006 and the share of subprime loans insured by Fannie Mae and Freddie Mac decreased as the bubble got bigger.

 

…Causes of subprime crises Financial institution debt levels and incentives

A 2004 U.S. securities and Exchange commission (SEC) decision related to the net capital rule allowed USA investment banks to issue substantially more debt, which was then used to purchase MBS.

Over 2004–07, the top five US investment banks each significantly increased their financial leverage , which increased their vulnerability to the declining value of MBSs.

These five institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of USA nominal GDP for 2007.

The percentage of subprime mortgages originated to total originations increased from below 10% in 2001–2003 to between 18–20% from 2004–2006, due in-part to financing from investment banks.

…Causes of subprime crisesFinancial institution debt levels and incentives

During 2008, three of the largest U.S. investment banks either went bankrupt (Lehman Brothers) or were sold at fire sale prices to other banks (Bear Stearns  and Merrill Lynch).

These failures augmented the instability in the global financial system.

The remaining two investment banks, Morgan Stanley and Goldman Sachs, opted to become commercial banks, thereby subjecting themselves to more stringent regulation

IMPACT OF CRISES

Impact on U.S

Impact on

Europe

Financial market Impact

Impact on India

Impact on U.S. •Between June 2007 and November 2008, Americans lost more than a quarter of their net worth.

• By early November 2008, a broad U.S. stock index, the S&P 500, was down 45 percent from its 2007 high.

• Housing prices had dropped 20% from their 2006 peak, with futures markets signalling a 30–35% potential drop.

…Impact on U.S. • Total home equity in the United States, which

was valued at $13 trillion at its peak in 2006, had dropped to $8.8 trillion by mid-2008.

•  Total retirement assets, Americans' second-largest household asset, dropped by 22 percent, from $10.3 trillion in 2006 to $8 trillion in mid-2008.

• During the same period, savings and investment assets lost $1.2 trillion and pension assets lost $1.3 trillion. Taken together, these losses total $8.3 trillion.

…Impact on U.S. Real gross domestic product (GDP) began contracting in

the Q3 2008 and did not return to growth until Q1 2010.The unemployment rate rose from 5% in 2008 to 10% by

late 2009, then steadily declined to 7.6% by March 2013.The number of unemployed rose from 7 million in 2008

to 15 million by 2009, then declined to 12 million by early 2013.

Residential private investment fell from 2006 pre-crisis peak of $800 billion, to $400 billion by mid-2009.

Non-residential investment peaked at $1,700 billion in 2008 and fell to $1,300 billion in 2010.

…Impact on U.S. Housing prices fell 30% on average from mid-

2006 peak to mid-2009.Stock market prices, fell 57% from October

2007 peak of 1,565 to 676 in March 2009. The net worth of U.S. households and NPO

fell from a peak of $67 trillion in 2007 to $52 trillion in 2009.

U.S. total national debt rose from 66% GDP in 2008 to over 103% by the end of 2012.

IMPACT ON EUROPE• Impact of US Subprime crisis on Europe cannot be

ignored. It can be concluded from the fact that signs of the same have already started showing (like falling prices of homes) in London.

• The crisis in Europe progressed from banking system crises to sovereign debt crises, as many countries elected to bailout their banking systems using taxpayer money.

…Impact on EUROPEMany European countries embarked on

austerity programs, reducing their budget deficits relative to GDP from 2010 to 2011.

Austerity measures referred to official actions taken by the government, during a period of adverse economic conditions, to reduce its budget deficit using a combination of spending cuts or tax rises.

…Impact on EUROPEGreece improved its budget deficit from

10.4% GDP in 2010 to 9.6% in 2011.

Iceland, Italy, Ireland, Portugal, France, and Spain also improved their budget deficits from 2010 to 2011 relative to GDP.

•Eurozone unemployment reached record levels in September 2012 to 11.6%, up from 10.3% the prior year.

…Impact on Europe• Northern Rock, an eminent mortgage lender

took refuge in the Bank of England for purposes of emergency financing in the month of September, 2007.

• Another instance in Germany, is when Germany 's IKB Deutsche Industrial bank accepted $11.1 billion from the Government as a bailout to its various US mortgage investments.  

The "Public debt to GDP ratio" is calculated as public debt divided by GDP. These figures are provided by Eurostat for each country. Public debt is money owed to investors by the government. It does not include private debts owed by individuals or corporations.

SOURCE: EUROSTAT

Statistical data indicating impact of US subprime crisis on Europe:

• Reports furnished by Nationwide Building Society, revealed that cost of homes dipped 0.5% in the month of December. In November the drop was 0.8%.  

• According to another source, during mid December, the prices of property dropped by 6.8%, that reflects an average downfall of approximately US$ 56,000.

Statistical data indicating impact of US subprime crisis on Europe:

• According to few economists, due to short demand of houses the increase of price is being expected to be 3% in Britain and as much as 5% in London.

• Another study state that Britain has the highest number of debtors i.e. approximately USD$2.7 trillion to be paid back on consumer loans.

What next?The biggest impact of US subprime crisis in Europe was yet to come

• It was being reckoned that in the forthcoming months, the economy would slowdown and become sluggish resulting in increasing rate of unemployment. • Owing to this situation, the properties

would had to be sold at a compromising rate.

Financial Market Impact 2007The crisis began to affect the financial sector in

February 2007, when HSBC, wrote down its holdings of subprime-related MBS by $10.5 billion, the first major subprime related loss to be reported.

During 2007, 100 Mortgage companies either shut down, suspended operations or were sold.

CEOs of Merrill Lynch and Citigroup resigned within a week of each other in late 2007.

As the crisis deepened, more financial firms either merged, or announced that they were negotiating seeking merger partners.

…Financial Market Impact 2007During 2007, the crisis caused panic in financial markets

and encouraged investors to take their money out of risky mortgage bonds and shaky equities and put it into Commodities as "stores of value".

Financial speculation in commodity futures following the collapse of the financial derivatives markets contributed to the world food price crisis  and oil price increases due to a "commodities super-cycle."

Mortgage defaults and provisions for future defaults caused profits at the 8533 USA depository institution insured by the federal deposit  insurance corporation to decline from $35.2 billion in 2006 Q4 to $646 million in the same quarter a year later, a decline of 98%.

…Financial Market Impact 20072007 Q4 saw the worst bank and thrift

quarterly performance since 1990. In all of 2007, insured depository institutions

earned $100 billion, down 31% from a record profit of $145 billion in 2006.

Profits declined from $35.6 billion in 2007 Q1 to $19.3 billion in 2008 Q1, a decline of 46%.

Financial Market Impact 2008By August 2008, financial firms around the

globe had  written down their holdings of subprime related securities by US$501 billion.

 The IMF estimates that financial institutions around the globe will eventually have to write off $1.5 trillion of their holdings of subprime MBSs.

About $750 billion in such losses had been recognized as of November 2008. These losses have wiped out much of the capital of the world banking system.

…Financial Market Impact 2008•When Lehman Brothers and other important financial institutions failed in September 2008, the crisis hit a key point.• During a two-day period in September 2008, $150 billion were withdrawn from USA money funds. The average two-day outflow had been $5 billion.• In effect, the money market was subject to a bank run. The money market had been a key source of credit for banks (CDs) and nonfinancial firms (commercial paper).

…Financial Market Impact 2008The TED SPREAD  quadrupled shortly after

the Lehman failure. This credit freeze brought the global financial system to the brink of collapse.

In a nine-day period from Oct. 1-9, the S&P 500 fell a251 points, losing 21.6% of its value.

 The week of Oct. 6-10 saw the largest percentage drop in the history of the  Dow Jones Industrial Average

 

…Financial Market Impact 2008During the last quarter of 2008, the central banks USA

Ferderal Reserve and European Central Bank purchased US$2.5 trillion of government debt and troubled private assets from banks.

This was the largest liquidity injection into the credit market, and the largest monetary policy action, in world history.

The governments of European nations and the USA also raised the capital of their national banking systems by $1.5 trillion, by purchasing newly issued Preffered stock in their major banks.

On Dec. 16, 2008, the Federal Reserve cut the Federal funds rate to 0-0.25%, where it has remained since then.

The third world countries were not affected as much as the developed countries.

…Financial Market Impact 2008The International Monetary Fund estimated

that U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009.

These losses are expected to top $2.8 trillion from 2007–10. U.S. banks losses were forecast to hit $1 trillion and European bank losses will reach $1.6 trillion.

The IMF estimated that U.S. banks were about 60 percent through their losses, but British and eurozone banks only 40 percent.

Sustained effectsIn 2011 there were a million homes in

foreclosure in the United States, several million more in the pipeline, and 872,000 previously foreclosed homes in the hands of banks. Sales were slow

economists estimated that it would take three years to clear the backlogged inventory.

…Sustained effects

The crisis had a significant and long-lasting impact on U.S. employment.

During the Great Recession, 8.5 million jobs were lost from the peak employment in early 2008 of 138 million to the trough in February 2010 of 129 million, 6% of the workforce.

Bailouts and failures of financial firms

Several major financial institutions either failed, were bailed-out by governments, or merged during the crisis.

While the specific circumstances varied, in general the decline in the value of mortgage backed securities held by these companies resulted in their insolvency

Firms had typically borrowed and invested large sums of money relative to their cash or equity capital, meaning they were highly leveraged and vulnerable to unanticipated credit market disruptions.

…Bailouts and failures of financial firmsThe five largest U.S. investment banks, with combined liabilities

or debts of $4 trillion, either went bankrupt (Lehman Brothers), were taken over by other companies (Bear stearns and Merrill lynch), or were bailed-out by the U.S. government (Goldman sachs and Morgan Stanley) during 2008.

Government-sponsored enterprises (GSE) Fannie mae and freddie Mac either directly owed or guaranteed nearly $5 trillion in mortgage obligations, with a similarly weak capital base, when they were placed into recevership in September 2008.

This $9 trillion in obligations concentrated in seven highly leveraged institutions can be compared to the $14 trillion size of the U.S. economy (GDP) or to the total national debt of $10 trillion in September 2008.

Impacts of the US Financial Crisis on

India

Impact on stock market

On 10 October, Rs. 2,50,000 crores wiped out on a

single day bourses of the India’s share market.

This huge withdrawal from India’s stock market was

mainly by Foreign Institutional Investors (FIIs), and

participatory-notes.

Impact on India’s tradeThe trade deficit was reaching alarming proportions because

of worker’s remittances, NRI deposits, FII investment and

many other reasons, the current account deficit was at around

$10 billion.

Further, the foreign exchange reserves of the country depleted

by around $57 billion to $253 billion for the week ended

October 31.

Impact on India’s export Indian exports ran into difficult times, since October.

Manufacturing sectors like leather, textile, gems and jewellery

were hit hard because of the slump in the demand in the US and

Europe.

About 15 per cent of there total export in 2006-07 was directed

towards USA, but it fell by 9.9 per cent in November 2008.

Exports dropped to $1.5 billion from $12.7 billion while imports

grew from $6.1billion to $21.5 billion.

Impact on India’s handloom sector, jewellry export and tourism

Reduction in demand in the OECD countries affected the Indian

gems and jewellery industry, handloom and tourism sectors.

Around 50,000 artisans employed in jewellery industry lost their jobs

as a result of the global economic meltdown.

The crisis affected the Rs. 3000 crores handloom industry and

exports dropped by 4.6 per cent in 2007-08, creating widespread

unemployment.

Indian tourism sector was badly affected as the number of tourist

flowing from Europe and USA decreased sharply.

Exchange rate depreciation

With the outflow of Foreign Institutional Investors,

Indian rupee depreciated approximately by 20 per cent

against US dollar and stood at Rs. 49 per dollar creating

panic among the importers.

FII and FDIDue to global recession, Foreign Institutional Investors

made withdrawal of $5.5 billion, whereas the inflow of

foreign direct investment (FDI) doubled from $7.5billion

in 2007-08 to $19.3 billion in 2008 (April-September).

Other sectorsSlowdown could be observed in the automobile sector, the real-

estate segment came down, and the same happened in textiles, and other areas as well.

Regulatory Responses To Subprime Crisis Regulators and legislators considered action

regarding lending practices, bankruptcy protection, tax policies, affordable housing, credit counseling, education, and the licensing and qualifications of lenders.

Regulations or guidelines also influence the nature, transparency and regulatory reporting required for the complex legal entities and securities involved in these transactions.

Congress also conducted hearings to help identify solutions and apply pressure to the various parties involved.

…Regulatory Responses To Subprime CrisisU.S. President   Barack Obama and key

advisers introduced a series of regulatory proposals in June 2009.

The proposals address consumer protection,  executive pay bank financial cushions or capital

requirements expanded regulation of the  shadow banking

system

…Regulatory Responses To Subprime CrisisTimothy Geithner  testified before Congress on October 29,

2009. His testimony included five elements he stated as critical to effective reform:

Expand the Federal Deposit Insurance Corporation  bank resolution mechanism to include  non-bank financial institutions.

Ensure that a firm is allowed to fail in an orderly way and not be "rescued“.

Ensure tax payers are not on the hook for any losses, by applying losses first to the firm's investors and including the creation of a pool funded by the largest financial institutions.

Apply appropriate checks and balances to the FDIC and Federal Reserve in this resolution process;

Require stronger capital and liquidity positions for financial firms and related regulatory authority.

Housing and Economic Recovery Act of 2008The Housing and Economic Recovery Act

of 2008 in the United States included acts to restore confidence in the domestic mortgage industry

Providing insurance for $300 billion in mortgages estimated to assist 400,000 homeowners.

Raises the dollar limit of the mortgages the GSEs can purchase.

..Housing and Economic Recovery Act of 2008

Enhancements to mortgage disclosures.Community assistance to help local

governments buy and renovate foreclosed properties.

An increase in the national debt ceiling by US$800 billion, to give the Treasury the flexibility to support the secondary housing markets and the 14 GSEs, if necessary.

Federal reserve powers

A sweeping proposal was presented 31 March 2008 regarding the regulatory powers of the U.S.

Federal Reserve, expanding its jurisdiction over other types of financial institutions and authority to intervene in market crises.

Expansion of government agency authority

The U.S House passed a bill in April, 2008 that would offer government insurance on $300 billion in new mortgages to refinance loans for an estimated 500,000 borrowers facing foreclosure

Also give additional 15 billion to affected states to buy and fix foreclosed homes.

Lending practices In response to a concern that lending was

not properly regulated, the House and Senate both considered bills to regulate lending practices.

U.S. Congressional ethics reformEthics experts and key senators recommend

that members of congress should be required to disclose information about their mortgages.

Capital reserve requirementsNon-depository banks (e.g., investment banks and mortgage

companies) are not subject to the same capital reserve requirements as depository banks.

Many of the investment banks had limited capital reserves to address declines in mortgage-backed securities or support their side of credit default derivative insurance contracts.

Nobel prize winner  Joseph Stiglitz  recommends that regulations be established to limit the extent of leverage permitted and not allow companies to become "too big to fail", by breaking them up into smaller entities.

He has also recommended reforming executive compensation, to make it less short-term focused; enhance consumer protection; and establish a regulatory review mechanism for new exotic types of financial instruments.

Short-selling restrictions

Short-selling is a method of profiting when a stock declines in value.

UK regulators announced a temporary ban on short-selling of financial stocks on September 18, 2008. When large, speculative short-sale bets accumulate against a stock or other financial asset, the price can be driven down.

Short sales were among the causes blamed for rapid price declines in Lehman Brother's stock price prior to its bankruptcy.

Short-selling restrictionsOn September 19 the U.S. Securities and

Exchange Commission  (SEC) followed by placing a temporary ban of short-selling stocks of financial institutions.

The SEC made it easier for institutions to buy back shares of their institutions. The halt of short-selling in the US was set to expire on October 2, but was extended until it expired at 11:59PM on October 8.

The action was based on the view that short selling in a crisis market undermines confidence in financial institutions and erodes their stability.

Proposed solutions A variety of regulatory changes have been proposed by economists,

politicians, journalists, and business leaders to minimize the impact of the current crisis and prevent recurrence. Many of the proposed solutions have not yet been implemented. These include:

Ben Bernanke : Establish resolution procedures for closing troubled financial institutions in the  shadow banking system, such as investment banks and hedge funds.

Joseph Stiglitz : Restrict the  leverage  that financial institutions can assume. Require executive compensation to be more related to long-term performance. Re-instate the separation of commercial (depository) and investment banking established by the Glass–Steagall Act in 1933 and repealed in 1999.

Simon Johnson : Break-up institutions that are "too big to fail" to limit  systemic risk.

Alan Greenspan : Banks should have a stronger capital cushion, with graduated regulatory capital requirements (i.e., capital ratios that increase with bank size), to "discourage them from becoming too big and to offset their competitive advantage."

Proposed solutionsWarren Buffett : Require minimum down

payments for home mortgages of at least 10% and income verification.

Raghuram Rajan : Require financial institutions to maintain sufficient "contingent capital" (i.e., pay insurance premiums to the government during boom periods, in exchange for payments during a downturn.)

Thank youSubmitted by:Anirudh joshiAmit SharmaMohammed Abbas MiyajiSakshi Bhardwaj