MANAGERIAL ECONOMICS

Submitted By: Submitted To:

Mayank Jain Prof. Y. Maheshwari,
Roll No.410 Faculty,
B.B.A, LL.B (Hons.) Department of Management

December, 2007 – April, 2008 ASSIGNMENT 1

SUBPRIME FINANCIAL MORTGAGE CRISIS

The subprime mortgage financial crisis is a phenomenon, nothing less than the global talk
throwing a cold reception to 2008. The subprime mortgage is more like an international and trans
continental crisis, but it’s origin could be traced from the domestic housing markets of the United
States of America. This began initially with a sharp rise in home foreclosures the United States
during the fall of 2006 and became a global financial crisis within a year. It is an over spilling
talk in the newspapers and financial bogs referring to the Sub prime crisis in it’s common
parlance as the crisis began with the bursting of the housing bubble in the U.S.

Thus the origin of the subprime crisis could be traced through the ill regulated reality
sector norms of the US. As a result of the same there were high default rates on subprime and
other mortgage loans. The main fault took place essentially because the loans were extended
primarily to higher-risk borrowers with lower income and lesser credit history than the prime
borrowers. The housing prices in America had started to drop moderately in 2006-2007 in many
parts of the U.S., refinancing became more difficult.
 Defaults and foreclosure activity increased dramatically. The mortgage lenders who had
retained the risk of payment default, which is commonly known as Credit Risk, were the first to
be affected, as borrowers became unable or unwilling to make payments. Most of the blame for
this should be pointed at the mortgage originators (lenders) for creating these problems. It was
the lenders who ultimately lent funds to people with poor credit and a high risk of default.

Many lenders and buyers in the markets were playing an extremely risky game by buying
houses they could barely afford. They were able to make these purchases with non-traditional
mortgages (such as 2/28 and interest-only mortgages) that offered low introductory rates and
minimal initial costs such as "no down payment". Their hope lay in price appreciation, which
would have allowed them to refinance at lower rates and take the equity out of the home for use
in other spending. However, instead of continued appreciation, the housing bubble burst, and
prices dropped rapidly.

The combination of impacts due to credit risk and liquidity risk caused several major
corporations and hedge funds to shut down or file for bankruptcy. Stock market declines among
both depository and non-depository financial corporations were dramatic. Many hedge funds and
other institutional investors holding MBS also incurred significant losses.

The subprime crisis has resulted into something that places downward pressure on
economic growth, because significant losses from subprime loans have reduced the willingness
of banks to loan funds to other financial institutions and to consumers. Such loans increase
investment by businesses and consumer spending, which drive the economy. A separate but
related dynamic is the downturn in the housing market, where a surplus inventory of homes has
resulted in a significant decline in new home construction and housing prices in many areas.

Furthermore it is interesting to analyze the impact of the Subprime crisis on Indian

economy. The US has been a major investor in Indian markets. The slowdown could mean
decreased inflow of foreign funds in India, which has been responsible for the booming stock
market. This could lead to a sharp correction in the market.
 Many leading companies, particularly IT, BPO and exports, have flourished on the back
of a robust US economy. They have contributed a lion’s share to India’s foreign exchange
reserves. Any slowdown could mean a reduction in profitability in these sectors, which in turn
can lead to companies closing down and unemployment. This could lead to a slowdown in the
Indian economy as well. But the other side reflects that the Indian Companies are finding it
increasingly difficult to raise funds overseas due to the subprime crisis in the US. The crisis
triggered a sharp decline in overseas capital market offerings in August by domestic Companies
using American depository receipts, global depository receipts and foreign currency convertible
bonds.

The widespread dispersion of credit risk and the unclear impact on large banks, MBS,
CDO, and SIV caused banks to reduce their loans to each other or make them at higher interest
rates. Similarly, the ability of corporations to obtain funds through the issuance of commercial
paper was impacted. This aspect of the crisis is consistent with a credit crunch. The liquidity
concerns drove central banks around the world to take action to provide funds to member banks
to encourage the lending of funds to worthy borrowers and to re-invigorate the commercial paper
markets.

Statistics reveal that the Subprime mortgage originations grew from $173 billion in 2001
to a record level of $665 billion in 2005, which represented an increase of nearly 300%. There is
a clear relationship between the liquidity following September 11, 2001, and subprime loan
originations; lenders were clearly willing and able to provide borrowers with the necessary funds
to purchase a home.

In response to the crisis, central banks around the world tried to stimulate the economy.
They have now created capital liquidity through a reduction in interest rates. In turn, investors
sought higher returns through riskier investments. Lenders took on greater risks too, and
approved subprime mortgage loans to borrowers with poor credit.

The US subprime mortgage crisis is likely produce deeper problems than expected
because not all market players have "come out clean" about their losses, as has also already so
predicted by the International Monetary Fund. Most banks in the United States have not yet
marked their assets to genuine transaction prices. A systematic program to limit or defer interest
rate adjustments was implemented to limit the impact of the crisis has been launched in the US .
In addition, lenders and borrowers facing defaults have been encouraged to cooperate to enable
borrowers to stay in their homes. Restrictions on lending practices are under consideration. Many
lenders have stopped subprime lending or dramatically curtailed it.

The global markets turmoil that erupted last year amid rising defaults on US subprime
mortgages was in part due to a lack of appropriate measures to evaluate the risk of new financial
products. Subprime mortgages -- home loans given to people with poor credit histories -- were
packaged into structured securities such as collateralized debt obligations, of CDOs.

Following the collapse of the US subprime market in mid-2007, market worries about the
exposure of the structured securities to the subprime crisis caused a credit freeze that made many
market players use valuation models that no longer worked in the meltdown.

The Indian economy is likely to grow by a good 8.5 per cent, corporate earnings have
been reasonably good and credit growth is at a good 20 per cent. This being a clear indication
that consumption has not been drastically impacted. The stock markets have been very turbulent
and asset prices have been under pressure. Thus as a result , there has been inflationary pressures
forcing the Reserve Bank of India (RBI) to hike indicative rates like cash reserve ratio and repo
rate to reign in liquidity.

India is relatively less exposed to the aftermath of the US subprime mortgage collapse
crisis that has sent global stock markets into a tizzy. But if the crisis does continue and causes a
general economic down turn, India will not remain insulated. The biggest worry then would be of
a slowdown in the economy. The US subprime mortgage crisis is attributed largely to defaults
arising out of loans made to customers with low creditworthiness and history of defaults.
Because these mortgages are traded in the markets, it has a spillover effect on banks, hedge funds
and institutional investors who participate in it.

The root of the crisis started with lending of subprime mortgages. In contrast to prime
mortgages in which the loan is given based on the income and credit of the borrower, subprime
mortgages are issued based primarily on the value of the house with the income and credit of the
borrower. As long as housing prices continued to increase, sub-prime borrowers were able to
borrow more and more money with the ability to cash out these loans.
 Furthermore the various kinds of investments like the Hedge funds, FIIs and other
institutional investors, who have put money in mortgage-backed securities in the US, are usually
invested in emerging markets as well. These funds offset the losses suffered due to the subprime
loan crisis by divesting their portfolio in other markets.