subprime_crisis

8/7/2019 subprime_crisis

http://slidepdf.com/reader/full/subprimecrisis 1/20

Sub Prime Crisis



Subprime Crisis (Subprime loans)

Sub-prime mortgage loans are loans

given to people with unstable

incomes or low creditworthiness.

These individuals are not financially

sound enough to be given a loanwhen judged under the strict

standards that should normally be

followed by a bank or lending

institution.



Mechanism of Sub Prime Lending

Three parties involved in sub prime mortgage loansare:

Banks (First American)

Financial Institution (Second American)

Borrower (Sub prime borrowers)



Securitization

Securitization means converting the home loans into financial securities,

which promising to pay a certain rate of interest.

These financial securities are then sold to big institutional investors through

an issuer (A bankruptcy-remote special purpose entity (SPE) formed to

facilitate a securitization and to issue securities to investors).Investors provide funding for the loans and assume varying degrees of credit

risk, based on the terms of the securities they purchase.

The interest and the principal that is repaid by the sub-prime borrowers

through equated monthly installments (EMIs) is passed onto these institutional

investors.

A S ervicer is appointed who collects these installments from the sub prime

borrower, passes on to the issuer which is eventually distributed to the investor.



Pros & cons of dealing in secuitization

The risk is passed onto the investors who buy the financial securitiesissued for securitising the home loan.

Proper due diligence to give out the home loan was not done and

loans were extended to individuals who are more likely to default.

By giving out greater amounts of home loan, the institutions were

able to securitise more, issue more financial securities and thereby earn

more money.

Credit / Default risk

Interest rate fluctuations

Advantages



Domino Effect The immediate cause or trigger of the crisis was the bursting

of the U nited S tates Housing bubble.

High default rates on "subprime" and adjustable rate

mortgages (AR M), began to increase quickly.

Falling prices resulted in homes worth less than the mortgageloan, providing a financial incentive for borrowers to enter

foreclosure.

Excess

housinginventory

H

ousing price decline

Inability to

refinancemortgage

M

ortgageforeclosure

Negative

effect oneconomy

� Housing

bubble burst

� Poor lending

& borrowing

decisions

� AR M

adjustments



Subprime mortgage crisis



Facts & Figures The USA home ownership rate increased from 64% in 1994 (about

where it had been since 1980) to an all-time high of 69.2% in 2004. Between 1997 and 2006, the price of the typical American house

increased by 124 %.

Household debt grew from $705 billion at year end 1974 (60% of

disposal personal income) to $7.4 trillion at year end 2000, and finally to

$14.5 trillion in midyear 2008, 134% of disposable personal income.

U.S. home mortgage debt relative to its GDP increased from an average

of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion.

As of March 2008, an estimated 8.8 million borrowers ² 10.8% of all

homeowners ² had negative equity in their homes, a number that is believed to have risen to 12 million by November 2008.

By January 2008, the inventory of unsold new homes was 9.8 times the

December 2007 sales volume, the highest value of this ratio since 1981. [60]

Furthermore, nearly four million existing homes were for sale.



Foreclosure graph



Federal Reserve & Govt Packages

Lowered the target for the Federal funds rate from 5.25% to 2%, and the

discount rate from 5.75% to 2.25%. Undertaken, along with other central banks, open market operations to ensure

member banks remain liquid. These are effectively short-term loans to member

banks collateralized by government securities

Created a variety of lending facilities to enable the Fed to lend directly to

banks and non-bank institutions, against specific types of collateral of varyingcredit quality.

On 17 February 2009, U.S. President Barack Obama signed the American

Recovery and Reinvestment Act of 2009, an $787 billion stimulus package with a

broad spectrum of spending and tax cuts.

The U.S. government passed the Emergency Economic Stabilization Act of

2008 (EESA or TARP) during October 2008. This law included $700 billion in

funding for the "Troubled Assets Relief Program" (TARP), which was used to

lend funds to banks in exchange for dividend-paying preferred stock.

On 18 February 2009, U.S. President Barack Obama announced a $73 billion program to help up to nine million homeowners avoid foreclosure.



IM

PACT OF SUBPRIM

ECRISIS

ON US ECONOMY

ON WORLD ECONOMY

ON INDIAN ECONOMY



ON US ECONOMY

� Americans lost more than a quarter of their net worth.

� Housing prices had dropped 20% from their 2006 peak, with futuresmarkets signaling a 30-35% potential drop.

� Total home equity in the United States, which was valued at $13trillion 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.

� Savings and investment assets (apart from retirement savings) lost $1.2trillion and pension assets lost $1.3 trillion .

� Taken together, these losses total a staggering $8.3 trillion.



ON WORLD ECONOMY

� HSBC, the world's largest (2008) bank, wrote down its holdings of subprime-related MBS by $10.5 billion.

� 100 mortgage companies either shut down, suspended operations or were sold.

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

� Financial speculation in commodity futures following the collapse of the financial derivatives markets has contributed to the world food

price crisis and oil price increases .

� Lehman Brothers and other important financial institutions failed inSeptember 2008.

� Third-World economies, such as the Brazilian and Chinese ones, willnot suffer as much as those from more developed countries.



Cont.

Third-World economies, such as the Brazilian and Chinese ones, willnot suffer as much as those from more developed countries.

The InternationalMonetary Fund estimated that large U.S. andEuropean banks lost more than $1 trillion on toxic assets and from bad

loans.

The credit freeze brought the global financial system to the brink of collapse.

The securitization markets started to close down in the spring of 2007and nearly shut-down in the fall of 2008 .



ON INDIAN ECONOMY

DECLINE IN INDO-US TRADE.

FALL IN DOLLAR RATE TO RS 43.

CRR INCREASED TO 8.25% FROM 5%.

INFLATION IS AT ALL TIME HIGH AT 11.63% AS ON JULY

2008

CRUDE OIL PRICES & OIL PRICES IS ABOUT 100% RISE IN AN

YEAR.



EFFECTS ON INDIAN EXPORTERS LESS BUSINESS CONTRACTS FOR INDIA.

HIGH INFLATION LED TO HIGH OPERATING COSTS.

FALL IN DOLLAR PRICE LED TO LOWER REVENUES FOR

EXPORTERS.



EXPECTED TREND The current credit crisis will come to an end when the overhang of

inventories of newly built homes is largely liquidated.

Home price deflation comes to an end.

Very large losses will, no doubt, be taken as a consequence of the

crisis.

After a period of protracted adjustment, the U.S. economy, and theworld economy more generally, will be able to get back to business.



Summary

The subprime crisis was rooted from the credit boom. Therefore, when the

Federal Reserve started raising rates in June 2004, the Americans felt the ever

increasing pressure from its heavy financial burden. However, as the Americans

did not have savings to counter economic downturn, the loan delinquency

problem began to grow. The credit boom was then burst amid the sharp property

market correction. The financial institutions then tighten their lending standardsand do not have confidence in the creditworthiness of both the corporations and

individuals because of the huge losses suffered. The risk bearing ability is also

lowered aggressively. This led to the spread of the problems in subprime assets to

a wider range of financial products. Globalization of the financial markets spread

the subprime problems to the whole world.



Conclusion

The effect of the subprime and credit crisis will continue to surface. The worldeconomic growth will slow from the 30-year high of around 5% - 8% between 2004

and 2008 to its trend growth or even lower level. The future outlook remains highly

uncertain.

The subprime crisis marked the end of the relaxed lending environment. The US

employment market also weakens and would, no doubt, restrain the consumption power of the Americans. The real private consumption growth is expected to lag the

growth of real disposable income. The private consumption dominated economic

structure should be adjusted. Private consumption growth would remain weak in the

future.

The US economy will continue to face the risk of recession and might have multi-year economic difficulties, like Japan which suffered multi-year economic weakness after

the credit and housing bubble burst. Additionally, the subprime and credit crisis

clearly exposed the problems of the financial system and regulatory regime in the US.



Contd««..

All in all, both the developed economies, like the US, and the developing countries,

the global financial system and regulatory regime, should face a long period of

profound adjustments and rebalancing, in order to ensure a balanced, healthy and

sustainable growth in the future.

However, it is difficult to return to a new equilibrium in the near term. The world

economy would face the problem of unemployment, stagflation and economic

hardship. The Government from different countries needs to be prepared for the

long-term adjustments and implement the policies that can correct the imbalance

subprime_crisis

Documents