3. Agenda
Subprime
•Traditional Model Vs Subprime Model
•Players in the Game
Bubble
•Housing Bubble
Why it burst?
Global Crisis
Impact
Events
Bailouts
What Next?
3
10. Players
Player 1: Fed
-- Fed kept the interest rate low during much of 1990s
and particularly 2001-2005 (low oil prices, and low
inflation prompted the policy), fueling the market
-- During the 2001-2005, FFR was in the 1% to 3%
range, and mostly in the 1% range
-- Fed encouraged more risky ARM lending
(Greenspan)
Player 2: Mortgage Salespersons
-- Worked on commission based on the number of
arms successfully twisted
10
11. Contd..
Player 3: Primary Lenders
-- No incentives for judicious lending
Banks no longer needed to hold on to the mortgage,
as use of mortgage-backed securities made risk
taking more appealing
-- Use of ARMs with low teaser rates (below market
rates for a while, followed by much higher rates
tied to index, LIBOR + some %). Teaser rates are
popular when long-term interest rates are at
historical lows (like much of this period), as they
help lenders benefit from ARMs as rates rise
-- Net Effect: Many loans were made to NINJA’s
(people with No Income, No Jobs or Assets).
11
12. Contd..
Player 4: Other Financial Institutions
-- Freddie Mac and Fannie Mae issued many
Mortgage Backed Securities
-- Other financial institutions that traded in
these as well as derivatives based on real
estate assets. Many of these were global
institutions
12
13. Contd..
Player 5: Credit rating Agencies and Analysts
-- Lack of market for many of these securities, so
models were used to price them
-- Inflated ratings, mostly in A range (similar to T-Bills)
-- Conflict of Interest: Investment bankers’ analysts
were rating investment bankers’ clients (scandal)
-- For example, 3 months prior to its demise, AIG was
rated strong buy (8 analysts), buy(3), hold (10))!!!
Player 6: Home Buyers (Taking Excessive Risk)
-- Home buyers were enjoying the ride
-- New ones were joining the ride, even if unqualified
-- Home ownership up from 60% in 1990s to 70%
13
16. Structure of a Bubble
Displacement (diffusion of new technology starts)
Take off (stock prices show abnormal increase)
Exuberance (stock prices grow at very high rate)
Critical Stage (stock price growth slows down)
Crash (stock prices start tumbling)
16
29. How did this turn into a crisis ?
Step 1 - The housing boom in the US started fading out in 2007
Step 2 - Boom had led to massive increase in supply of housing
Step 3 - Thus House prices started falling
Step 4 - This increased the default rate among sub-prime borrowers
Step 5 - These borrowers were no longer able/willing to pay high price for a house
that was declining in value
Step 6 – Security/Guarantee being the house being bought , this increased the
supply of houses for sale while lowering the demand, thereby lowering prices
even further and setting off a vicious cycle
29
36. Banks Writedown($ billion) Actions
Citigroup 55.1 Bailout by Fed Reserve($326 billion)
Merrill Lynch 51.8 Taken over by Bank of America
UBS 44.2 $5.3 billion Swiss government bailout
HSBC 27.4
Wachovia 22.5 Wells Fargo
Bank of America 21.2
Royal Bank of Scotland 14.9
Morgan Stanley 14.4 bank holding companies
JP Morgan chase 14.3
Lehman Brothers 8.2 Files for Bankruptcy
AIG 18.5 bailed out by Federal reserve
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37. Crashing Stock Indices
30000
25000
20000
Value
15000
10000
5000 17th Jan' 2008
25th Nov' 2008
0
Indices
37
39. Date Events
8th September Fannie Mae/Freddie Mac placed into conservatorship by U.S.
Government
14th September Bank of America agrees to purchase Merrill Lynch for $35B
15th September Lehman Brothers declares bankruptcy
16th September Reserve Primary Fund “breaks the buck” U.S. government seizes
control of AIG in $85B bailout
18th September Treasury Secretary Paulson announces bailout plan
19th September Governments worldwide announce short selling restrictions
Treasury establishes Temporary Guarantee Program for money
market funds
21st September Fed allows investment banks Goldman Sachs and Morgan Stanley to
become bank holding companies
23rd September Warren Buffett announces $5B investment in Goldman Sachs
39
40. Date Events
25th September Washington Mutual is seized by FDIC; assets sold to JPMorgan for
$1.9B
29th September Citigroup agrees to acquire Wachovia with FDIC guarantee; a
private transaction with Wells Fargo is later announced
First bailout bill is rejected by U.S. House of Representatives
3rd October - Congress passes TARP legislation
FDIC temporarily increases deposit insurance to $250,000
7th October Fed announces Commercial Paper Funding Facility (CPFF)
8th October Coordinated rate cut by central banks around the globe
13th October Mitsubishi UFJ finalizes $9B equity investment in Morgan
Stanley
14th October Mitsubishi UFJ finalizes $9B equity investment in Morgan
Stanley
Treasury announces TARP Capital Purchase Program
21st October Fed announces Money Market Investor Funding Facility
(MMIFF) 40
41. Loss in crisis
1000
900
800
700
600
500
Expon. (Series1)
400
300
200
100
0
savings and loan crisis(1986- Banking crisis(1990-99) Banking Crisis(98-99) Subprime crisis(2007-present)
95)
41
43. Country wise Action
United kingdom
Has lined up a $850-billion rescue plan, May nationalise Royal Bank of Scotland
Will recapitalise banks by up to $88 billion. Abbey, Barclays, HSBC, Llyods, Standard
Chartered, HBOS and Nationwide Building Society can draw from an aggregate of $44
billion to boost their Tier 1 capital
Bank of England will infuse liquidity of $351 billion through loans
The government will guarantee $439 billion worth of short-and-medium term debt
Britain has seized control of mortgage lender Bradford & Bingley
Earlier this year nationalised Northern Rock
Alarm: The total liabilities of Barclays of £1,300 billion (leverage ratio of over 60),
surpass Britain's GDP
43
44. Contd..
Belgium
The government took partial control of the struggling Fortis Bank
France, Belgium and Luxembourg stumped up $93 billion to recapitalise Dexia, a
French-Belgian lender that ran up huge losses in its US operations
Alarm: Fortis Bank's liabilities are several times larger than the GDP of Belgium
(leverage ratio of 33)
Iceland
The government has nationalised three of Iceland's biggest banks
Accounts in these banks stand frozen
44
45. Contd..
United states
May pick up ownership in failing US banks (Morgan Stanley is reported to be one)
Fed ready to lend directly to stressed companies
Germany
Has guaranteed all bank deposits
Has organised a credit lifeline of euros 35 billion for blue-chip commercial real estate
lender Hypo Real Estate Holding
Alarm: The total liabilities of Deutsche Bank (leveraging ratio of over 50) amount to
2,000-billion euro, which is more than 80 per cent of the GDP of Germany
45
46. Contd..
Singapore
Eased monetary policy for the first time since 2003 after sinking into its first
recession in six years, hit by the meltdown in financial markets
The government revised its 2008 growth forecast to around 3 per cent from an
earlier estimate of 4 to 5
Italy
UniCredit Bank has announced plans to raise its capital ratio by spinning of
property assets
Ireland
Has guaranteed all bank deposits
46
47. Contd..
Spain
Will spend 50 billion Euros ($68 billion) to buy bank assets, almost a third of the
proposed 2009 central government budget
Japan
Yamato Life Insurance failed with $2.7 billion in debt
The government may revive a bank-rescue law of the 1990s banking
crisis
Tokyo may set up a $100-billion fund to prop up smaller lenders
Alarm: Real estate companies are folding up, forcing regional banks to
raise reserves against bad loans
47
49. Rationale for the Bailout
Stabilise the Economy
Improve Liquidity Second
Bailout of
Comprehensive Strategy $800 billion
Immediate and Significant announced
yesterday
Broad Impact by FED
Investor Confidence
Impact on Economy and GDP
49
51. When the music stops in terms of liquidity, things will
get complicated. But as long as the music is playing,
you've got to get up and dance. We're still dancing. -
Chuck Prince, Citigroup
51
53. Liquidity Crunch
The reduced availability of liquidity
Interest rate premiums
U.S.: Banks not lending to each other
ROW: London Interbank Offered Rate (Libor)
Libor is used to set rates on the $360
trillion of financial products worldwide.
Three month Libor set an all time high last
week at 5.34%.
53
54. Overview of Credit Exposures and Estimated Losses
(September 2008; billions of US dollars)
Amount Outstanding Estimated Losses
Residential Credit:
Depository Institution Loans $2,889 $308
Non-Agency Securities $2,531 $523
GSE Exposures $4,807 $76
Subtotal $10,227 $907
Non Residential Credit:
Loans $7,670 $195
Non-Agency Securities $5,440 $475
Subtotal $13,110 $670
Total $23,337 $1,577
54
55. Estimated Costs of Banking Crisis
Country Period Estimated Cost as % of
GDP
United States 1980 2.5 %
Japan 1990 20.0 % est.
Norway 1987-89 4.0 %
Korea 1997 60.0 % p
Indonesia 1997 80.0 % p
U.S.A. 2007-2010 $700 billion = 5.0 %
$1600 billion = 11.4 %
$3200 billion = 22.8 %
55
56. Is Depression Imminent:
During the Great Depression
Combined GDP of 7 largest economies dropped by
20%
during 1929-1932
There were no deposit insurance, so people withdrew
money from banks and many banks failed
Fed increased interest rate (!!) and reduced liquidity
U.S. imposed heavy tariffs and other countries
reciprocated lowering world trade by 70%
The situation is much different as a lot is learned from
experiences of the Great Depression
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