The Subprime Crisis

List of contents
1. What is the subprime crisis? 2. Diff between Prime & Subprime 3. Characteristics of the subprime boom 4. Financial engineering that facilitated subprime crisis 5. Assumptions that turned wrong 6. Fallouts 7. Impact-US & Global 8. What is the scenario now? 9. Who will provide the solutions? 10.Impact on India 11.Is it likely to occur in India? 12.Learning lessons for India
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1. What is the subprime crisis?

In a nutshell, the US subprime mortgage crisis has been explained by the mainstream media as a situation whereby banks offer subprime loans to people with risky credit ratings. As these people began to default on their repayments, it led to a wave of repossessions and bank losses; and henceforth, the crisis.

Difference between Prime & Subprime?

Prime Mortgage
Borrow <80 % of House price Good record from credit bureau Monthly payment < 25 % income Good Credit Scoring

Sub-Prime Mortgage
Tarnished credit records Low Credit scoring Pay Higher Mortgage Rates

Characteristics of the subprime boom

Post 9/11/01 low interest rates and product innovation Capital from Wall Street irrational exuberance and financial engineering Underwriting standards relaxed as means of expanding market share Risk layering and failure of risk assessment
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Characteristics of the subprime boom

No true legal definition, more of term of art based on channel of lending Higher-cost credit made available to borrowers with impaired or thin credit or other unique circumstances Made possible by credit scoring, automation and secondary markets Traditionally came from finance companies such as Freddie Mac and Fannie Mae
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Financial engineering that facilitated subprime crisis

Mortgage assets grew at incredible pace, and Wall Street found new ways to offer piece of the action to investors Investment banks captured fee income at many stages Derivatives and derivatives of derivatives Many of the sophisticated products based on same models

Assumptions that turned wrong

Risk-based pricing of subprime loans and of financial instruments backed by loans Continued low-rate environment and home price appreciation continue to rise Borrowers would be able to refinance or sell their way out Healthy economy and continued demand worldwide for RMBS and related assets
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Fallouts
Citi posted its largest $18 billion loss of its 196 years of history recently. Merrill Lynch posted a whooping $9.8 billion fourth-quarter loss and $16.7 billion of write-downs on mortgagerelated investments and leveraged loans. UBS also wrote down $14.7 billion last year due to its U.S. subprime mortgages.

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Impact-US & Global

Stricter underwriting practices, meaning fewer loans will be made to consumers, others As less credit is now available for refinancing, consumers squeezed financially, not just on mortgage loans Centered on subprime market performance on prime/conventional market still good by historic measures

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Impact-US & Global

Rating agency downgrades Many of wholesale originators either bankrupt or out of business Subprime loans (funding) much harder to get private securitizations have ceased

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Impact-US & Global

A very long and deep US recession is possible Extent of damage depends on how far house prices fall If they fall a further 30-40 per cent, losses in the financial system could be anywhere between $1,000bn and $3,000bn. The latter would de-capitalise the US banking system Similar points of weakness can be seen in housing markets and financial systems elsewhere
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Impact-US & Global

The crisis signals a re-rating of risk. It also represents a move towards holding more transparent and liquid assets. This correction has been selective, however. It is a striking feature of what has happened that emerging markets have emerged as a safe haven. For emerging economies, this must be sweet revenge.
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Impact-US & Global

Has opened up big questions about the roles of central banks
How far, for example, do the responsibilities of central banks as lender-of-last-resort during crises stretch? Should they, as some argue, be marketmakers-of-last resort in credit markets? What, more precisely, should a central bank do when liquidity dries up in important markets?
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Impact-US & Global

Has exposed the loopholes in securitised lending
The argument in favour of securitised lending was that it would shift the risk of term-transformation (borrowing short to lend long) out of the banking system onto those best able to bear it. What happened, instead, was the shifting of the risk on to the shoulders of those least able to understand it.
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Impact-US & Global

Has exposed the loopholes in securitised lending (Contd.)
What also occurred was a multiplication of leverage and term-transformation, not least through the banks special investment vehicles. What we see today, as a result, is a rapid shrinkage of markets in asset-backed paper.

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What is the scenario now?

End 2008, havent hit bottom yet Financial institutions still struggling with valuation of assets Full extent of potential losses not known, particularly counterparty risk in credit default swaps ($41 Trillion) Worldwide liquidity crisis keyed to realization that market overheated

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What is the scenario now?

Downgrades continuing Defaults and foreclosures are climbing still Media feeding frenzy and the search for blame Reaching the third phase of any economic cycle, i.e. (1) Boom, (2) Bust, (3) Recrimination

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What is the scenario now?

Home price appreciation has become depreciation in many markets Increasing inventory of unsold homes the pocket phenomenon Non-bank originators continuing to shut down or be sold

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Who will provide the solutions?

Legislation Federal & State Regulation Federal Banking Agencies Market-Based Solutions

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Legislations
Comprehensive reform bills from US Congress Frank bill; Dodd bill Regulation of underwriting, loan terms, loan originators wont let this happen again Stricter monitoring of loan modifications, foreclosures Rep. Frank, others Economic stimulus package may contain mortgage-related relief
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Market based solutions

Loan modification and workout programs being implemented by industry participants Emerging community-based assistance programs (banks may be expected to help)

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Impact on India: BANKING

Indian banking system has remained fairly insulated from any direct impact This is because the Indian banks did not have significant exposure to subprime loans in the US.

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Impact on India: CAPITAL MARKETS

Indian capital markets are experiencing the echo There was a major impact on the equity markets as many foreign institutional investors (FIIs) sold off their investments into Indian companies to cover their huge losses.
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Impact on India: CAPITAL MARKETS

The FIIs have and, as of date, are continuing to withdraw money from the equity markets. Going forward, any subprime related tremors in the global markets are likely to cause further chaos in the Indian equity markets as well.
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Is it likely to occur in India?

Unlikely given the current state of affairs Despite rapid growth in recent years, the mortgage market in India is nowhere near the levels of developed countries, such as the US or the UK.

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Is it likely to occur in India?

Mortgages as a percentage of GDP in India are still at a small % as compared with the US and the UK. The approach of the Indian regulators has been balanced and forwardlooking. Its continuous doses of monetary tightening aims to ensure that the money supply (and hence inflation) is kept within manageable limits.
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Learning lessons for India-1

Utmost need to strengthen the system for assessment of the borrowers credit worthiness The regulator must ensure that banks do not follow imprudent and predatory lending practices by offering far too lenient lending terms than are warranted for.

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Learning lessons for India-2

Banks need to make sure that they share the credit history of borrowers to better assess the credit worthiness of borrowers. Encourage wider use of the services of the credit information bureau (CIB).

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Learning lessons for India-3

Rating models should be revamped to take into account newer risk implications arising from newer mortgage structures, such as the option adjustable rate mortgage, which is prone to payment shocks. Credit rating agencies required to modify their rating methodologies
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Learning lessons for India-4

Financial institutions must carry out proper due diligence of securities and borrowers, besides relying on credit ratings. Financial institutions need to strengthen their risk management framework in view of increasing complexities in products/services, and customers requirements.
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