SLOW DOWN IN ECONOMY 2008

SLOW DOWN IN ECONOMY 2008

Prepared byCA Neha AwasthiIntroduction

Now a days everybody talks about ,Economic Crisis, Slowdown, US Economy Meltdown, Jobs 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 upSuddenly 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 CrisisOn a national level, housing prices peaked in early 2005, began declining in 2006 and may not yet have hit bottom.Increased foreclosure rates in 20062007 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 BorrowersFor poor credit historyLimited income

Subprime LendersGreater risksHigh returns

Background: Subprime LendingProponents v. OpponentsProponents: Subprime lending extends credit to individuals who would otherwise be shut out of the credit market thereby depriving them of the ability to own their homes, cars etc.Opponents: Subprime lending encourages predatory lending and attracts borrowers who lack the resources to repay, thereby leading to default, seizure of collateral and foreclosure by the lender.Typical Subprime Borrower Profile Lower Credit Score FICO score of 620 or below FICO score is a measure of past credit historyHigher 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 rigorousNew Model of Mortgage Lending

Who are the Key Participants?Home BuyerMortgage BrokersSub Prime LendersBig BanksSecuritization, Manufacturers of CDOsRating CompaniesSecurities and CDOsInvestors

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.

9Modification 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 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.

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.The Housing Bust

Process Of Securitization

Model Of SecuritizationMORTGAGE BROKERLENDERBORROWERStep 1-Borrower obtains a Loan from Lender with the help of Mortgage Broker.SERVICERISSUER

TRUSTEEUNDERWRITERRATING AGENCIES

CREDIT ENHANCEMENT PROVIDERStep 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.INVESTORLoansCashLoanLoans ProceedsMonthly PaymentsMonthly PaymentsSecuritiesCashMonthly PaymentsStep 2-Lender Sells the Loans to Issuer an Borrower Begins Monthly Payments to Servicer. Step 3-The Issuer sells the Securities to the investor, Underwriter assist in sale, credit Rating Agencies Rate the Securities, Credit Enhancement may be provided. Securitization allowed a large number of high risk loans to be transferred to special purpose vehicles from the balance sheets of lending institutions through 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.

Role of Securitization in Current Financial Crisis

Liquidity CrisisAs 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 wasnt 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 CrisisThe Housing Downturn

Reduction in Interest RatesExcess supply of home inventorySub Prime LoanSales volume of new homes droppedReduced market prices Increasing foreclosure rates

BorrowersDifficulties in re-financingBegin to default on loansWalk away from propertiesFraudulent misrepresentations

Causes of the CrisisFinancial InstitutionsAttraction from high returnsOffered high-risk loan and incentivesBelieves that will pass on the risk to others

SecuritizationMortgage backed securitiesRisk readily transferred to other investorsFrom 54% in 2001 to 75% in 2006

Causes of the CrisisGovernment and RegulatorsCommunity Reinvestment Act, encourages the development of the subprime debacleGlass-Steagall Act contributes to the subprime crisis (FDIC back up)

Central banksLess concerned with avoiding asset bubblesReact after bubbles burst to minimize the impactNo determination on monetary policyInstitutions risk more because of Feds rescue

Domestic Impacts of the CrisisHome OwnersHousing prices down 10.4% in Dec. 07 vs. year-agoSales of new homes dropped by 26.4% in 07 vs. 06By 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

MinoritiesDisproportionate level of foreclosures in minority 46% Hispanics, 55% blacks got higher cost loans

Direct Impacts of the CrisisFinancial Institutions Bankruptcy

New Century Financial (USA) Apr. 2, 2007American Home Mortgage (USA) Aug. 6, 2007Sentinel management Group (USA) Aug. 17, 2007Ameriquest (USA) Aug. 31, 2007NetBank (USA) Sept. 30, 2007Terra Securities (Norway) Nov. 28, 2007American Freedom Mortgage Inc. (USA) Jan. 30, 2007

Direct Impacts of the CrisisFinancial Institutions Write-Downs

Citigroup (USA) - $24.1 blnMerrill Lynch (USA) - $22.5 blnUBS AG (Switzerland) - $16.7 blnMorgan Stanley (USA) - $10.3Credit Agricole (France) - $4.8 blnHSBC (United Kingdom) - $3.4 blnBank of America (USA) - $5.28 blnCIBC (Canada) 3.2 blnDeutsche Bank (Germany) - $3.1 bln

By 02/19/08 losses or write-downs > U.S. $150 blnBe expected exceeding $200 - $400 bln

Domestic Impacts of the CrisisEconomy ConditionRecessionSevere Liquidity and Credit CrunchLow GDP growth rateBusiness close out or lose money (banks, builders etc.)Weak financial marketLow consumer spendingInvestors have lost trillions of dollarsLose jobsDecrease in consumer wealthDecline in consumption led to decline in demand which in turn has affected the manufacturing and services industry.

Global Impacts of the CrisisInvestors will be very cautious to act Lack confidence in stock/bound marketConsumer spending will slowdownLack of cash or unwilling to spendWorld economy may slip into recession U.S. economy condition will affect global economyGDP growth will be lowLose businessesLose jobsEconomy slow down

Global Impacts of the CrisisFinancial market May take long time to recoverUnemployment rate may be highSlow economy increase unemployment rateExports will decrease in China, Korea, Taiwan GDP growth heavily depends on export

Regulatory Responses1. 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 20082. Housing and Economic Recovery Act of 2008Enacted 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 Responses3. Emergency Economic Stabilization Act of 2008

commonly referred to as a bailout of the U.S. financial system, is a lawauthorizing the United States Secretary of the Treasury to spend up to US$700billion to purchase distressed assets, especially mortgage-backed securities, andmake capital injections into banks The bailed-out banks are mostly U.S. or foreign banks, though the FederalReserve extended help to American Express, whose bank-holding application itrecently approved. The Act was proposed by Treasury Secretary Henry Paulson during the globalfinancial crisis of 2008. The bill, HR1424 was passed by the House on October 3, 2008 and signed intolaw.Impact of Financial Crisis on IndiaStock 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 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 goalsKey lessons for industriesDiversify GloballyLocal forayTighten Recruitment and Retention ProcessesAddress the Skills ShortageImprove ProductivityInnovate- do things differentlyKey lessons for IndividualsKnow your debtBorrow sensiblyDont over-leverageEvery investment has riskEverything is interlinkedDiversify for retirement planningDevelopment of Human CapitalSave during good timesFor investing in share marketsHave a long-term horizonOne should know when to invest.Size Matters, at least in EquitiesCrisis Survival GuideIncrease your savings rateAllocate to fixed incomeDont panicLook for alternate income sourcesGo for insuranceManage your portfolio

Dont worry what goes down will always go upMarkets will rebound these tips will prepare you to be a winnerThank You!