Subprime crisis

WHAT IS SUBPRIME CRISES
 A situation starting in 2008 affecting the mortgage
industry due to borrowers being approved for loans they
could not afford.
As a result, a significant rise in foreclosures led to the
collapse of many lending institutions and hedge funds.
The financial crisis in the mortgage industry also affected
the global credit market resulting in higher interest rates
and reduced availability of credit.

Causes of subprime crises
• Boom and Burst in housing market
• Homeowner speculation
• High-risk mortgage loans and lending/borrowing
practices
• Securitization practises
• Inaccurate credit ratings
• Government Regulation
• Role of Fannie Mae and Freddie Mac
• Financial institution debt levels and incentives

Causes of subprime crises
 Boom and bust in the housing market
 Low interest rates and large inflows of foreign funds created easy credit
conditions for a number of years prior to the crisis, fueling a housing
market boom & encouraging debt-financed consumption.
 The USA home ownership rate increased from 64% in 1994 to an all-
time high of 69.2% in 2004.
 Between 1997 and 2006, the price of the typical American house
increased by 124%.
 By September 2008, average U.S. housing prices had declined by over
20% from their mid-2006 peak.
 As of March 2008, an estimated 8.8 million borrowers – 10.8% of all
homeowners – had negative equity in their homes.
 By September 2010, 23% of all U.S. homes were worth less than the
mortgage loan.

…Causes of subprime crises
Homeowner speculation
 During 2006, 22% of homes purchased were for
investment purposes, with an additional 14%
purchased as vacation homes. During 2005, these
figures were 28% & 12%.
 Housing prices nearly doubled b/w 2000 & 2006.
“ There was the greatest bubble ever seen .The entire American public
eventually was caught up in a belief that housing prices could not fall
dramatically."

 High-risk mortgage loans and lending/borrowing
practices
 In the years before the crisis, Lenders offered more and
more loans to higher-risk borrowers and
undocumented immigrants
 Subprime mortgages amounted to $35 billion (5% of
total originations) in 1994, 9% in 1996, $160 billion
(13%) in 1999, & $600 billion (20%) in 2006.
 In 2005, the median down payment for first-time
home buyers was 2%, with 43% of those buyers
making no down payment .

 High-risk mortgage loans and lending/borrowing practices
 The mortgage qualification guidelines began to change.
 The stated income, verified assets loans came out. Proof of
income was no longer needed. Borrowers just needed to "state"
it and show that they had money in the bank.
 The lender no longer required proof of employment. Borrowers
just needed to show proof of money in their bank accounts.
 The qualification guidelines kept getting looser in order to
produce more mortgages and more securities. This led to the
creation of NINA.
 All that was required for a mortgage was a credit score.

 Another example is the interest-only adjustable-rate
mortgage (ARM), which allows the homeowner to pay
just the interest during an initial period.
 Mortgage Underwritings standards declined
precipitously during the boom period. In 2007, 40%
of all subprime loans resulted from automated
underwriting.
 The Financial Crisis Inquiry Commission reported
in January 2011 that many mortgage lenders took eager
borrowers’ qualifications on faith, often with a "willful
disregard" for a borrower’s ability to pay.

 Securitization practises
 In the mid-2000s, GSE securitization declined dramatically
as a share of overall securitization, while private label
securitization dramatically increased.
 Most of the growth in private label securitization was
through high-risk subprime and Alt-A mortgages.
 As private securitization gained market share and the GSEs
retreated, mortgage quality declined dramatically.
 The total amount of mortgage-backed securities issued
almost tripled between 1996 and 2007, to $7.3 trillion.
 The securitized share of subprime mortgages increased
from 54% in 2001, to 75% in 2006.[

 Securitization practises
• American homeowners, consumers, and corporations owed
roughly $25 trillion during 2008.
• American banks retained about $8 trillion of that total
directly as traditional mortgage loans. Bondholders and
other traditional lenders provided another $7 trillion.
• The remaining $10 trillion came from the securitization
markets. The securitization markets started to close down
in the spring of 2007 and nearly shut-down in the fall of
2008.
• More than a third of the private credit markets thus
became unavailable as a source of funds.

 Inaccurate credit ratings
 Credit rating agencies are now under scrutiny for having given
investment-grade ratings to MBSs based on risky subprime mortgage
loans.
 These high ratings enabled these MBSs to be sold to investors, thereby
financing the housing boom.
 Between Q3 2007 and Q2 2008, rating agencies lowered the credit
ratings on $1.9 trillion in mortgage backed securities
 Financial institutions felt they had to lower the value of their MBS and
acquire additional capital so as to maintain capital ratios.
 If this involved the sale of new shares of stock, the value of the existing
shares was reduced.
 Thus ratings downgrades lowered the stock prices of many financial
firms

 Government Regulation
 Government over-regulation, failed regulation and
deregulation have all been claimed as causes of the
crisis.
 Increasing home ownership has been the goal of
several presidents including Roosevelt, Reagan,
Clinton and George W. Bush

 Decreased regulation of financial institutions
 Some analysts believe the subprime mortgage crisis was due, in
part, to a 2004 decision of the SEC that affected 5 large
investment banks.
 The critics believe that changes in the capital reserve
calculation rule enabled investment banks to substantially
increase the level of debt they were taking on, fueling the growth
in mortgage-backed securities supporting subprime mortgages.
 These banks dramatically increased their risk taking from 2003-
2007.
 By the end of 2007, the largest five U.S. investment banks had
over $4 trillion in debt with high ratios of debt to equity,
meaning only a small decline in the value of their assets would
render them insolvent

 Role of Fannie Mae and Freddie Mac
 Fannie Mae and Freddie Mac are government sponsored
enterprises (GSE) that purchase mortgages, buy and
sell mortgage backed securities(MBS), and guarantee nearly
half of the mortgages in the U.S.
 A variety of political and competitive pressures resulted in the
GSEs ramping up their purchase and guarantee of risky
mortgages in 2005 and 2006, just as the housing market was
peaking.
 Fannie and Freddie were under both under political pressure to
expand purchases of higher-risk affordable housing mortgage
types, and under significant competitive pressure from large
investment banks and mortgage lenders.

Role of Fannie Mae and Freddie Mac
 Several studies indicate Fannie and Freddie were not to
blame for the crisis and that GSEs played no
significant role in the subprime crisis.
 By some estimates, more than 84 percent of the
subprime mortgages came from private lending
institutions in 2006 and the share of subprime loans
insured by Fannie Mae and Freddie Mac decreased as
the bubble got bigger.

 Financial institution debt levels and incentives
 A 2004 U.S. securities and Exchange commission (SEC) decision
related to the net capital rule allowed USA investment banks to issue
substantially more debt, which was then used to purchase MBS.
 Over 2004–07, the top five US investment banks each significantly
increased their financial leverage , which increased their vulnerability
to the declining value of MBSs.
 These five institutions reported over $4.1 trillion in debt for fiscal year
2007, about 30% of USA nominal GDP for 2007.
 The percentage of subprime mortgages originated to total originations
increased from below 10% in 2001–2003 to between 18–20% from 2004–
2006, due in-part to financing from investment banks.

 Financial institution debt levels and incentives
 During 2008, three of the largest U.S. investment banks
either went bankrupt (Lehman Brothers) or were sold at
fire sale prices to other banks (Bear Stearns and Merrill
Lynch).
 These failures augmented the instability in the global
financial system.
 The remaining two investment banks, Morgan
Stanley and Goldman Sachs, opted to become
commercial banks, thereby subjecting themselves to more
stringent regulation

IMPACT OF
CRISES
Impact on
U.S
Impact on
Europe
Financial
market Impact
Impact on
India

•Between June 2007 and November 2008, Americans lost
more than a quarter of their net worth.
• By early November 2008, a broad U.S. stock index, the S&P
500, was down 45 percent from its 2007 high.
• Housing prices had dropped 20% from their 2006 peak,
with futures markets signalling a 30–35% potential drop.

…Impact on U.S.
• Total home equity in the United States, which was
valued at $13 trillion 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.
• During the same period, savings and investment
assets lost $1.2 trillion and pension assets lost $1.3
trillion. Taken together, these losses total $8.3
trillion.

…Impact on U.S.
 Real gross domestic product (GDP) began contracting in
the Q3 2008 and did not return to growth until Q1 2010.
 The unemployment rate rose from 5% in 2008 to 10% by
late 2009, then steadily declined to 7.6% by March 2013.
 The number of unemployed rose from 7 million in 2008 to
15 million by 2009, then declined to 12 million by early 2013.
 Residential private investment fell from 2006 pre-crisis
peak of $800 billion, to $400 billion by mid-2009.
 Non-residential investment peaked at $1,700 billion in 2008
and fell to $1,300 billion in 2010.

…Impact on U.S.
 Housing prices fell 30% on average from mid-2006
peak to mid-2009.
 Stock market prices, fell 57% from October 2007 peak
of 1,565 to 676 in March 2009.
 The net worth of U.S. households and NPO fell from a
peak of $67 trillion in 2007 to $52 trillion in 2009.
 U.S. total national debt rose from 66% GDP in 2008 to
over 103% by the end of 2012.

• Impact of US Subprime crisis on Europe cannot be ignored.
It can be concluded from the fact that signs of the same have
already started showing (like falling prices of homes) in
London.
• The crisis in Europe progressed from banking system crises
to sovereign debt crises, as many countries elected to bailout
their banking systems using taxpayer money.

…Impact on EUROPE
 Many European countries embarked on austerity
programs, reducing their budget deficits relative to
GDP from 2010 to 2011.
 Austerity measures referred to official actions taken
by the government, during a period of adverse
economic conditions, to reduce its budget deficit using
a combination of spending cuts or tax rises.

…Impact on EUROPE
 Greece improved its budget deficit from 10.4% GDP in
2010 to 9.6% in 2011.
 Iceland, Italy, Ireland, Portugal, France, and Spain also
improved their budget deficits from 2010 to 2011
relative to GDP.
•Eurozone unemployment reached record levels in
September 2012 to 11.6%, up from 10.3% the prior year.

• Northern Rock, an eminent mortgage lender took refuge
in the Bank of England for purposes of emergency
financing in the month of September, 2007.
• Another instance in Germany, is when Germany 's IKB
Deutsche Industrial bank accepted $11.1 billion from the
Government as a bailout to its various US mortgage
investments.

The "Public debt to GDP ratio" is calculated as public debt divided by GDP. These figures
are provided by Eurostat for each country. Public debt is money owed to investors by the
government. It does not include private debts owed by individuals or corporations.
SOURCE: EUROSTAT

• Reports furnished by Nationwide Building Society,
revealed that cost of homes dipped 0.5% in the
month of December. In November the drop was
0.8%.
• According to another source, during mid December,
the prices of property dropped by 6.8%, that reflects
an average downfall of approximately US$ 56,000.

• According to few economists, due to short demand
of houses the increase of price is being expected to
be 3% in Britain and as much as 5% in London.
• Another study state that Britain has the highest
number of debtors i.e. approximately USD$2.7
trillion to be paid back on consumer loans.

The biggest impact of US subprime crisis in
Europe was yet to come
• It was being reckoned that in the forthcoming months,
the economy would slowdown and become sluggish
resulting in increasing rate of unemployment.
• Owing to this situation, the properties would
had to be sold at a compromising rate.

Financial Market Impact 2007
 The crisis began to affect the financial sector in
February 2007, when HSBC, wrote down its holdings
of subprime-related MBS by $10.5 billion, the first
major subprime related loss to be reported.
 During 2007, 100 Mortgage companies either shut
down, suspended operations or were sold.
 CEOs of Merrill Lynch and Citigroup resigned
within a week of each other in late 2007.
 As the crisis deepened, more financial firms either
merged, or announced that they were negotiating
seeking merger partners.

…Financial Market Impact 2007
 During 2007, the crisis caused panic in financial markets
and encouraged investors to take their money out of risky
mortgage bonds and shaky equities and put it
into Commodities as "stores of value".
 Financial speculation in commodity futures following the
collapse of the financial derivatives markets contributed to
the world food price crisis and oil price increases due
to a "commodities super-cycle."
 Mortgage defaults and provisions for future defaults caused
profits at the 8533 USA depository institution insured by
the federal deposit insurance corporation to decline
from $35.2 billion in 2006 Q4 to $646 million in the same
quarter a year later, a decline of 98%.

 2007 Q4 saw the worst bank and thrift quarterly
performance since 1990.
 In all of 2007, insured depository institutions earned
$100 billion, down 31% from a record profit of $145
billion in 2006.
 Profits declined from $35.6 billion in 2007 Q1 to $19.3
billion in 2008 Q1, a decline of 46%.

Financial Market Impact 2008
 By August 2008, financial firms around the globe
had written down their holdings of subprime related
securities by US$501 billion.
 The IMF estimates that financial institutions around
the globe will eventually have to write off $1.5 trillion of
their holdings of subprime MBSs.
 About $750 billion in such losses had been recognized
as of November 2008. These losses have wiped out
much of the capital of the world banking system.

•When Lehman Brothers and other important financial
institutions failed in September 2008, the crisis hit a key
point.
• During a two-day period in September 2008, $150 billion
were withdrawn from USA money funds. The average
two-day outflow had been $5 billion.
• In effect, the money market was subject to a bank run.
The money market had been a key source of credit for
banks (CDs) and nonfinancial firms (commercial
paper).

 The TED SPREAD quadrupled shortly after the
Lehman failure. This credit freeze brought the global
financial system to the brink of collapse.
 In a nine-day period from Oct. 1-9, the S&P 500 fell
a251 points, losing 21.6% of its value.
 The week of Oct. 6-10 saw the largest percentage drop
in the history of the Dow Jones Industrial Average

 During the last quarter of 2008, the central banks USA Ferderal
Reserve and European Central Bank purchased US$2.5 trillion of
government debt and troubled private assets from banks.
 This was the largest liquidity injection into the credit market,
and the largest monetary policy action, in world history.
 The governments of European nations and the USA also raised
the capital of their national banking systems by $1.5 trillion, by
purchasing newly issued Preffered stock in their major banks.
 On Dec. 16, 2008, the Federal Reserve cut the Federal funds
rate to 0-0.25%, where it has remained since then.
 The third world countries were not affected as much as the
developed countries.

 The International Monetary Fund estimated that U.S.
and European banks lost more than $1 trillion on toxic
assets and from bad loans from January 2007 to
September 2009.
 These losses are expected to top $2.8 trillion from
2007–10. U.S. banks losses were forecast to hit $1
trillion and European bank losses will reach $1.6
trillion.
 The IMF estimated that U.S. banks were about 60
percent through their losses, but British and eurozone
banks only 40 percent.

Sustained effects
 In 2011 there were a million homes in foreclosure in the
United States, several million more in the pipeline,
and 872,000 previously foreclosed homes in the hands
of banks. Sales were slow
 economists estimated that it would take three years to
clear the backlogged inventory.

…Sustained effects
 The crisis had a significant and long-lasting impact on
U.S. employment.
 During the Great Recession, 8.5 million jobs were lost
from the peak employment in early 2008 of 138 million
to the trough in February 2010 of 129 million, 6% of
the workforce.

Bailouts and failures of financial firms
 Several major financial institutions either failed, were
bailed-out by governments, or merged during the
crisis.
 While the specific circumstances varied, in general the
decline in the value of mortgage backed
securities held by these companies resulted in their
insolvency
 Firms had typically borrowed and invested large sums
of money relative to their cash or equity capital,
meaning they were highly leveraged and vulnerable to
unanticipated credit market disruptions.

…Bailouts and failures of financial firms
 The five largest U.S. investment banks, with combined liabilities
or debts of $4 trillion, either went bankrupt (Lehman
Brothers), were taken over by other companies (Bear
stearns and Merrill lynch), or were bailed-out by the U.S.
government (Goldman sachs and Morgan Stanley) during
2008.
 Government-sponsored enterprises (GSE) Fannie mae
and freddie Mac either directly owed or guaranteed nearly $5
trillion in mortgage obligations, with a similarly weak capital
base, when they were placed into recevership in September
2008.
 This $9 trillion in obligations concentrated in seven highly
leveraged institutions can be compared to the $14 trillion size of
the U.S. economy (GDP) or to the total national debt of $10
trillion in September 2008.

Impact on stock market
 On 10 October, Rs. 2,50,000 crores wiped out on a single
day bourses of the India’s share market.
 This huge withdrawal from India’s stock market was
mainly by Foreign Institutional Investors (FIIs), and
participatory-notes.

Impact on India’s trade
 The trade deficit was reaching alarming proportions because of
worker’s remittances, NRI deposits, FII investment and many
other reasons, the current account deficit was at around $10
billion.
 Further, the foreign exchange reserves of the country depleted
by around $57 billion to $253 billion for the week ended
October 31.

Impact on India’s export
 Indian exports ran into difficult times, since October.
 Manufacturing sectors like leather, textile, gems and jewellery
were hit hard because of the slump in the demand in the US
and Europe.
 About 15 per cent of there total export in 2006-07 was directed
towards USA, but it fell by 9.9 per cent in November 2008.
 Exports dropped to $1.5 billion from $12.7 billion while
imports grew from $6.1billion to $21.5 billion.

Impact on India’s handloom sector, jewellry export and
tourism
 Reduction in demand in the OECD countries affected the Indian gems
and jewellery industry, handloom and tourism sectors.
 Around 50,000 artisans employed in jewellery industry lost their jobs
as a result of the global economic meltdown.
 The crisis affected the Rs. 3000 crores handloom industry and exports
dropped by 4.6 per cent in 2007-08, creating widespread
unemployment.
 Indian tourism sector was badly affected as the number of tourist
flowing from Europe and USA decreased sharply.

Exchange rate depreciation
 With the outflow of Foreign Institutional Investors,
Indian rupee depreciated approximately by 20 per cent
against US dollar and stood at Rs. 49 per dollar creating
panic among the importers.

FII and FDI
 Due to global recession, Foreign Institutional Investors
made withdrawal of $5.5 billion, whereas the inflow of
foreign direct investment (FDI) doubled from $7.5billion
in 2007-08 to $19.3 billion in 2008 (April-September).

Other sectors
 Slowdown could be observed in the automobile sector, the real-estate
segment came down, and the same happened in textiles, and other
areas as well.

Regulatory Responses To Subprime
Crisis
 Regulators and legislators considered action regarding
lending practices, bankruptcy protection, tax policies,
affordable housing, credit counseling, education, and the
licensing and qualifications of lenders.
 Regulations or guidelines also influence the nature,
transparency and regulatory reporting required for the
complex legal entities and securities involved in these
transactions.
 Congress also conducted hearings to help identify
solutions and apply pressure to the various parties
involved.

…Regulatory Responses To Subprime Crisis
 U.S. President Barack Obama and key advisers
introduced a series of regulatory proposals in June
2009.
 The proposals address
consumer protection,
 executive pay
 bank financial cushions or capital requirements
 expanded regulation of the shadow banking system

…Regulatory Responses To Subprime
Crisis
 Timothy Geithner testified before Congress on October 29, 2009. His
testimony included five elements he stated as critical to effective
reform:
 Expand the Federal Deposit Insurance Corporation bank resolution
mechanism to include non-bank financial institutions.
 Ensure that a firm is allowed to fail in an orderly way and not be
"rescued“.
 Ensure tax payers are not on the hook for any losses, by applying losses
first to the firm's investors and including the creation of a pool funded
by the largest financial institutions.
 Apply appropriate checks and balances to the FDIC and Federal
Reserve in this resolution process;
 Require stronger capital and liquidity positions for financial firms and
related regulatory authority.

Housing and Economic Recovery Act of 2008
The Housing and Economic Recovery Act of 2008
in the United States included acts to restore
confidence in the domestic mortgage industry
 Providing insurance for $300 billion in mortgages
estimated to assist 400,000 homeowners.
 Raises the dollar limit of the mortgages the GSEs can
purchase.

..Housing and Economic Recovery Act of
2008
 Enhancements to mortgage disclosures.
 Community assistance to help local governments buy
and renovate foreclosed properties.
 An increase in the national debt ceiling by US$800
billion, to give the Treasury the flexibility to support
the secondary housing markets and the 14 GSEs, if
necessary.

Federal reserve powers
 A sweeping proposal was presented 31 March 2008
regarding the regulatory powers of the U.S.
 Federal Reserve, expanding its jurisdiction over
other types of financial institutions and authority
to intervene in market crises.

Expansion of government agency authority
 The U.S House passed a bill in April, 2008
that would offer government insurance on
$300 billion in new mortgages to refinance
loans for an estimated 500,000 borrowers
facing foreclosure
 Also give additional 15 billion to affected
states to buy and fix foreclosed homes.

Lending practices
 In response to a concern that lending was not properly
regulated, the House and Senate both considered bills
to regulate lending practices.
U.S. Congressional ethics reform
 Ethics experts and key senators recommend that
members of congress should be required to disclose
information about their mortgages.

Capital reserve requirements
 Non-depository banks (e.g., investment banks and mortgage
companies) are not subject to the same capital reserve
requirements as depository banks.
 Many of the investment banks had limited capital reserves to
address declines in mortgage-backed securities or support their
side of credit default derivative insurance contracts.
 Nobel prize winner Joseph Stiglitz recommends that
regulations be established to limit the extent of leverage
permitted and not allow companies to become "too big to fail",
by breaking them up into smaller entities.
 He has also recommended reforming executive compensation,
to make it less short-term focused; enhance consumer
protection; and establish a regulatory review mechanism for new
exotic types of financial instruments.

Short-selling restrictions
 Short-selling is a method of profiting when a stock declines
in value.
 UK regulators announced a temporary ban on short-
selling of financial stocks on September 18, 2008. When
large, speculative short-sale bets accumulate against a
stock or other financial asset, the price can be driven down.
 Short sales were among the causes blamed for rapid price
declines in Lehman Brother's stock price prior to its
bankruptcy.

Short-selling restrictions
 On September 19 the U.S. Securities and Exchange
Commission (SEC) followed by placing a temporary ban of
short-selling stocks of financial institutions.
 The SEC made it easier for institutions to buy back shares
of their institutions. The halt of short-selling in the US was
set to expire on October 2, but was extended until it
expired at 11:59PM on October 8.
 The action was based on the view that short selling in a
crisis market undermines confidence in financial
institutions and erodes their stability.

Proposed solutions
 A variety of regulatory changes have been proposed by economists, politicians,
journalists, and business leaders to minimize the impact of the current crisis
and prevent recurrence. Many of the proposed solutions have not yet been
implemented. These include:
 Ben Bernanke : Establish resolution procedures for closing troubled financial
institutions in the shadow banking system, such as investment banks and
hedge funds.
 Joseph Stiglitz : Restrict the leverage that financial institutions can assume.
Require executive compensation to be more related to long-term performance.
Re-instate the separation of commercial (depository) and investment banking
established by the Glass–Steagall Act in 1933 and repealed in 1999.
 Simon Johnson : Break-up institutions that are "too big to fail" to
limit systemic risk.
 Alan Greenspan : Banks should have a stronger capital cushion, with
graduated regulatory capital requirements (i.e., capital ratios that increase with
bank size), to "discourage them from becoming too big and to offset their
competitive advantage."

Proposed solutions
 Warren Buffett : Require minimum down payments
for home mortgages of at least 10% and income
verification.
 Raghuram Rajan : Require financial institutions to
maintain sufficient "contingent capital" (i.e., pay
insurance premiums to the government during boom
periods, in exchange for payments during a
downturn.)

Thank you
Submitted by:
Anirudh joshi
Amit Sharma
Mohammed Abbas Miyaji
Sakshi Bhardwaj

Subprime crisis

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