Transcript SLOW DOWN IN ECONOMY 2008

Prepared by
CA Neha Awasthi
Introduction
 Now a days everybody talks about ,Economic Crisis, Slowdown, US Economy Meltdown, Jobs
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Cut, Industrial Loss.
We all know that market have Slumped.
People talks about at least 24 month of Recession, jobs losses.
Companies are closing, Sales are not picking up
Suddenly cash has Evaporated from the Market.
Profitability is severely hit.
Do you Know why suddenly Indian Market get affected by US Economy slowdown?
What was the Reason for GLOWBLE RECESSION ?
What is Subprime Mortgage Crisis ?
Causes
 The crisis, which has its roots in the closing years of the 20th century, became apparent in
2007 and has exposed pervasive weaknesses in financial industry regulation and the global
financial system.
 The subprime mortgage crisis is an ongoing financial crisis triggered by a dramatic rise in
mortgage delinquencies and foreclosures in the United State, with major adverse
consequences for banks and financial markets around the globe.
 Many USA mortgages issued in recent years are subprime, meaning that little or no down
payment was made, and that they were issued to households with low incomes and assets,
and with troubled credit histories. When USA house prices began to decline in 2006-07,
mortgage delinquencies soared, and security backed with subprime securities backed with
subprime mortgages, widely held by financial firms, lost most of their value. The result has
been a large decline in the capital of many banks and USA government sponsored
enterprises, tightening credit around the world.
Subprime Mortgage Crisis
 On a national level, housing prices peaked in early 2005, began declining in 2006 and
may not yet have hit bottom.
 Increased foreclosure rates in 2006–2007 by U.S. homeowners led to a crisis in August
2008 for the subprime.
 Sharp rise in home foreclosures in late 2006 .Only 9% in 1996, 13% in 1999, 20% in
2006 .$1.3 Trillion subprime mortgage as of March 2007. The delinquency rate had risen
to 21% by 2008.
 Subprime Borrowers
 For poor credit history
 Limited income
 Subprime Lenders
 Greater risks
 High returns
Typical Subprime Borrower Profile
 Lower Credit Score
– FICO score of 620 or below
– FICO score is a measure of past credit history
 Higher Loan-to-Value ratio
– Compares the value of the loan to market value of the property
– Indicator of borrower leverage
 Higher Income Ratio
– Compares monthly loan payments to monthly income
– Indicator of income adequacy
 Lower Documentation Standards
– Verification of income is less rigorous
New Model of Mortgage Lending
Who are the Key Participants?
1. Home Buyer
2. Mortgage Brokers
3. Sub Prime Lenders
4. Big Banks
5. Securitization, Manufacturers of CDO’s
6. Rating Companies
7. Securities and CDO’s
8. Investors
How does it all Work ?
Sub Prime Loan
 Lending to borrowers with a weak, substandard or
incomplete credit history
 Subprime loans are also called “B-paper” because they are
offered at interest rates that are higher than that of “A-paper”
or Prime credit risk.
 Subprime loans include the financing of homes, cars, credit
cards etc. However, most of the recent attention from the
media has been on subprime home mortgages.
Modification of Community Investment Act, 1995
 The Move encourage to Subprime Loan to Poorer Section to Society having poor
Credit Rating.
 Loan were bearing High Risk thus High Rate of Interest.
 The value of Sub prime Mortgage Loan stood $ 1.3 trillion as on March 2007.
 Low Interest Rate during the period of 2000 and 2004.
 Cheap funds triggered an increase in housing demand which in turn led to a rise in
housing prices.
The Housing Boom
 Between 1997 and 2006 home prices in the US increased by 124%. This led to huge
increase in construction activity.
 Banks offered NINJA Loans i.e. No income, No Jobs, Assets Loans, where no down payment
is required to be made.
 Easy payment ‘teaser’ loans(wherein the first few installments' are deceptively low and then
increase drastically as per the prevalent interest rates).
 Cheap and easy loans coupled with rising housing prices propelled an increase in home
demand both for residential as well as speculative purposes.
 Rising home prices also prompted home owners to obtain second mortgages against the
increased value for consumer spending thereby leading to a large increase in household
debt.
 Thus a large proportion of consumer spending was out of borrowed funds instead of from
genuine income of customers.
The Housing Bust
 Over Building in the Housing Sector, led to rise in interest rates, surplus inventory in
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housing markets.
Housing price begins to falls as a results of such inventory surplus and thus demand
declined.
By May 2008, housing prices had declined by more than 18% from their peak in Q2
2006.
Consumers found it difficult to refinance their mortgages.
By March 2008, the values of the homes were lower than the value of the mortgages
which provided the consumers an incentive to foreclose their loans and walk away
without their homes.
During 2007, nearly 1.3 million homes were subject to foreclosure activity, up 79%
from 2006.
The Housing Bust
 Thus, as can be concluded from above, while the real estate market boomed, lenders as well
as borrowers, both made merry; lenders by issuing easy loans to non deserving customers
and borrowers by availing these loans to fulfill the great American dream owing a home. But
these dreams crashed once interest rates shot up and housing prices began deflating.
 But the buck did not stop at the financial institutions who issued high risk sub prime mortgage
loans, instead of waiting for the principal and interest to be repaid on these loans over a
period of time, the banks went ahead and securitized these mortgage loans.
Process Of Securitization
Model Of Securitization
MORTGAGE
Step 1-Borrower obtains a Loan from Lender with
BROKER
the help of Mortgage Broker.
Loans Proceeds
LENDER
BORROWER
Step 2-Lender Sells the Loans to Issuer an Borrower
Begins Monthly Payments to Servicer.
Loan
Monthly Payments
Step 3-The Issuer sells the Securities to the investor,
Cash
SERVICER
Loans
Monthly Payments
Underwriter assist in sale, credit Rating Agencies Rate
the Securities, Credit Enhancement may be provided.
TRUSTEE
UNDERWRITER
RATING AGENCIES
ISSUER
CREDIT
ENHANCEMENT
PROVIDER
Securities
Cash
INVESTOR
Monthly
Payments
Step 4-The Servicer collect Monthly Payments from the
Borrower and remits the same to the Issuer. The Trustee and
the servicer manage the delinquent loans according to the
Pooling And service Agreement.
Role of Securitization in Current Financial Crisis
 Securitization allowed a large number of high risk loans to be transferred to
special purpose vehicles from the balance sheets of lending institutions through
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products such as MBOs and CDOs.
It also enabled the financial institutions to bundle off its mortgage loans
through securitized products to investors and generate immediate cash.
Securitization of loans also freed cash to allow financial institutions to make
more loans. This further fuelled the boom in the Housing Market.
Inaccurate credit risk measurement practices resulted in risky sub prime loans
being clubbed with prime loans within the same securitized products.
High credit ratings on securitized products encouraged the flow of investor
funds into these securities.
Moreover, in the booming housing market, there was a false sense of security,
that even if the borrowers defaulted on their payments, the value of the house
would be more than enough to cover the outstanding loan amounts.
Liquidity Crisis
 As defaults in the loans grew beyond expectations, the investors sought sell their positions.
The institutions holding these packages of loans had to sell some of their assets to meet
cash demands from their investors. However, there wasn’t anyone to buy these securities,
except as very low prices (pennies on the dollar). This started the liquidity crisis.
 It expanded when the same intuitions then sold their more solid assets to help meet the cash
demand from their investors. This included stocks with solid fundamentals, causing the stock
markets to fall.
 As a result rates for new loans rose in price to better reflect the realities of the market. New
borrowers were faced with rates that were substantially higher than just a few weeks ago.
Even well qualified borrowers encountered difficulties borrowing money as the lending
institutions “over reacted” to the credit problems.
 This is how we experienced the latest liquidity crisis which has caused much of the increase
in volatility we have been seeing the stock markets. Chapter XIV Regulatory responses to the
sub prime crisis .
Causes of the Crisis
 The Housing Downturn
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Reduction in Interest Rates
Excess supply of home inventory
Sub Prime Loan
Sales volume of new homes dropped
Reduced market prices
Increasing foreclosure rates
 Borrowers
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Difficulties in re-financing
Begin to default on loans
Walk away from properties
Fraudulent misrepresentations
Causes of the Crisis
 Financial Institutions
 Attraction from high returns
 Offered high-risk loan and incentives
 Believes that will pass on the risk to others
 Securitization
 Mortgage backed securities
 Risk readily transferred to other investors
 From 54% in 2001 to 75% in 2006
Causes of the Crisis
 Government and Regulators
 Community Reinvestment Act, encourages the development of the subprime
debacle
 Glass-Steagall Act contributes to the subprime crisis (FDIC back up)
 Central banks
 Less concerned with avoiding asset bubbles
 React after bubbles burst to minimize the impact
 No determination on monetary policy
 Institutions risk more because of Fed’s rescue
Domestic Impacts of the Crisis
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Home Owners
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Housing prices down 10.4% in Dec. 07 vs. year-ago
Sales of new homes dropped by 26.4% in 07 vs. 06
By Jan. 2008, the inventory of unsold new homes stood at 9.8 months, the highest
level since 1981.
Two million families will be evicted from their homes
Minorities
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Disproportionate level of foreclosures in minority
46% Hispanics, 55% blacks got higher cost loans
Direct Impacts of the Crisis
Financial Institutions – Bankruptcy
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New Century Financial (USA)– Apr. 2, 2007
American Home Mortgage (USA) – Aug. 6, 2007
Sentinel management Group (USA) – Aug. 17, 2007
Ameriquest (USA) – Aug. 31, 2007
NetBank (USA) – Sept. 30, 2007
Terra Securities (Norway) – Nov. 28, 2007
American Freedom Mortgage Inc. (USA) – Jan. 30, 2007
Direct Impacts of the Crisis
Financial Institutions – Write-Downs
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Citigroup (USA) - $24.1 bln
Merrill Lynch (USA) - $22.5 bln
UBS AG (Switzerland) - $16.7 bln
Morgan Stanley (USA) - $10.3
Credit Agricole (France) - $4.8 bln
HSBC (United Kingdom) - $3.4 bln
Bank of America (USA) - $5.28 bln
CIBC (Canada) – 3.2 bln
Deutsche Bank (Germany) - $3.1 bln
By 02/19/08 losses or write-downs > U.S. $150 bln
Be expected exceeding $200 - $400 bln
Domestic Impacts of the Crisis
 Economy Condition
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Recession
Severe Liquidity and Credit Crunch
Low GDP growth rate
Business close out or lose money (banks, builders etc.)
Weak financial market
Low consumer spending
Investors have lost trillions of dollars
Lose jobs
Decrease in consumer wealth
 Decline in consumption led to decline in demand which in turn has affected the
manufacturing and services industry.
Global Impacts of the Crisis
 Investors will be very cautious to act
 Lack confidence in stock/bound market
 Consumer spending will slowdown
 Lack of cash or unwilling to spend
 World economy may slip into recession
 U.S. economy condition will affect global economy
 GDP growth will be low
 Lose businesses
 Lose jobs
 Economy slow down
Global Impacts of the Crisis
 Financial market
 May take long time to recover
 Unemployment rate may be high
 Slow economy increase unemployment rate
 Exports will decrease in China, Korea, Taiwan
 GDP growth heavily depends on export
Regulatory Responses
1. Economic Stimulus Act of 2008:
 enacted February 13, 2008
 an Act of Congress providing for several kinds of economic stimuli intended to boost the
United States economy in 2008 and to avert or ameliorate a recession.
 The law provides for tax rebates to low- and middle-income U.S. taxpayers, tax incentives to
stimulate business investment, and an increase in the limits imposed on mortgages eligible
for purchase by government-sponsored enterprises (e.g., Fannie Mae and Freddie Mac).
 The total cost of this bill was projected at $152 billion for 2008
2. Housing and Economic Recovery Act of 2008
 Enacted on July 30,2008
 Lends money to mortgage bankers to help them refinance the mortgages of owner-
occupants at risk of foreclosure. The lender reduces the amount of the mortgage
(typically taking a significant loss), in exchange for sharing in any future appreciation in
the selling price of the house via the Federal Housing Administration. The refinancing
must have fixed payments for a term of 30 years;
 Requires that lenders disclose more information about the products they offer and the
deals they close;
 Helps local governments buy and renovate foreclosed properties
Regulatory Responses
3. Emergency Economic Stabilization
2008
Act of
• commonly referred to as a bailout of the U.S. financial system, is a law
authorizing the United States Secretary of the Treasury to spend up to US$700
billion to purchase distressed assets, especially mortgage-backed securities, and
make capital injections into banks
• The bailed-out banks are mostly U.S. or foreign banks, though the Federal
Reserve extended help to American Express, whose bank-holding application it
recently approved.
• The Act was proposed by Treasury Secretary Henry Paulson during the global
financial crisis of 2008.
• The bill, HR1424 was passed by the House on October 3, 2008 and signed into
law.
Impact of Financial Crisis on India
 Stock market steep fall.
 Liquidity crunch and weak rupee.
 Decline in exports and increase in trade deficits.
 Increase in job losses and unemployment rate.
 Higher cost of borrowing and General slowdown in the industry.
 Real Estate Market Crush.
 Lay off, Retrenchment, Closing down of Plants.
 capital markets drying up.
 Commodity Price increase.
Lesson From Crisis
Key Lessons for Governments
 Importance of sound information on what is happening on the ground as the crisis
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unfolds.
Short-term responses to a crisis cannot ignore longer term implications for
development in all its dimensions.
The macroeconomic stabilization response must be consistent with restoring them
growth process
Financial sector policies need to balance concerns about the fragility of the banking
system with the needs for sound longer-term financial institutions.
The social policy response must provide rapid income support to those in most
need, giving highest on the poorest amongst those affected, while preserving the
key physical and human assets of poor people and their communities.
Address the tradeoffs between rapid crisis response and longer-term development
goals
Key lessons for industries
 Diversify Globally
 Local foray
 Tighten Recruitment and Retention Processes
 Address the Skills Shortage
 Improve Productivity
 Innovate- do things differently
Key lessons for Individuals
 Know your debt
 Borrow sensibly
 Don’t over-leverage
 Every investment has risk
 Everything is interlinked
 Diversify for retirement planning
 Development of Human Capital
 Save during good times
 For investing in share markets
 Have a long-term horizon
 One should know when to invest.
 Size Matters, at least in Equities
Crisis Survival Guide
 Increase your savings rate
 Allocate to fixed income
 Don’t panic
 Look for alternate income sources
 Go for insurance
 Manage your portfolio
Don’t worry – what goes down will always go up
Markets will rebound – these tips will prepare you to be a winner
Thank You!