Subprime Mortgage: Crisis And its Impact
Executive Summary
The subprime mortgage crisis is an ongoing
financial crisis triggered by a significant decline in housing prices
and related mortgage payment delinquencies and foreclosures in the
United States. This caused a ripple effect across the financial
markets and global banking systems, as investments related to housing
prices declined significantly in value, placing the health of key
financial institutions and government-sponsored enterprises at risk.
Funds available for personal and business spending (i.e., liquidity)
declined as financial institutions tightened lending practices. The
crisis, which has roots in the closing years of the 20th century but
has become more apparent throughout 2007 and 2008, has passed through
various stages exposing pervasive weaknesses in the global financial
system and regulatory framework.
The crisis began with the bursting of the United States
housing bubble and high default rates on "subprime" and
adjustable rate mortgages (ARM), beginning in approximately
2005–2006. Government policies and competitive pressures for
several years prior to the crisis encouraged higher risk lending
practices. Further, an increase in loan incentives such as easy
initial terms and a long-term trend of rising housing prices had
encouraged borrowers to assume difficult mortgages in the belief they
would be able to quickly refinance at more favourable terms. However,
once interest rates began to rise and housing prices started to drop
moderately in 2006–2007 in many parts of the U.S., refinancing
became more difficult. Defaults and foreclosure activity increased
dramatically as easy initial terms expired, home prices failed to go
up as anticipated, and ARM interest rates reset higher. Foreclosures
accelerated in the United States in late 2006 and triggered a global
financial crisis through 2007 and 2008. During 2007, nearly 1.3
million U.S. housing properties were subject to foreclosure activity,
up 79% from 2006.
Financial products called mortgage-backed securities
(MBS), which derive their value from mortgage payments and housing
prices, had enabled financial institutions and investors around the
world to invest in the U.S. housing market. Major banks and financial
institutions had borrowed and invested heavily in MBS and reported
losses of approximately US$435 billion as of 17 July 2008. The
liquidity and solvency concerns regarding key financial institutions
drove central banks to take action to provide funds to banks to
encourage lending to worthy borrowers and to restore faith in the
commercial paper markets, which are integral to funding business
operations. Governments also bailed out key financial institutions,
assuming significant additional financial commitments.
The risks to the broader economy created by the housing
market downturn and subsequent financial market crisis were primary
factors in several decisions by central banks around the world to cut
interest rates and governments to implement economic stimulus
packages. These actions were designed to stimulate economic growth
and inspire confidence in the financial markets. Effects on global
stock markets due to the crisis have been dramatic. Between 1 January
and 11 October 2008, owners of stocks in U.S. corporations had
suffered about $8 trillion in losses, as their holdings declined in
value from $20 trillion to $12 trillion. Losses in other countries
have averaged about 40%. Losses in the stock markets and housing
value declines place further downward pressure on consumer spending,
a key economic engine. Leaders of the larger developed and emerging
nations met in November 2008 to formulate strategies for addressing
the crisis. The Summit concluded that:
“….all countries must address the risks
associated with excessive leverage and improve their regulatory and
supervisory regimes in order to deliver improved risk assessment and
management by financial institutions, to enhance transparency and
accountability in financial markets, as well as to strengthen
international cooperation to identify and respond preemptively to
national and international systemic risks. Furthermore, we recognized
the need to improve the supervision and governance of financial
institutions, at both national and international levels. In this
regard, we should consider ways of enhancing the identification of
systemically important institutions and ensure proper oversight of
these institutions, including credit rating agencies. We should
ensure that all sectors of the financial industry, as appropriate,
are regulated or subjected to oversight. We agreed that it is
important to address the issue of pro-cyclicality in financial market
regulations and supervisory systems. We also agreed that financial
institutions should have common accounting standards and clear
internal incentives to promote stability and that action needs to be
taken, through voluntary effort or regulatory action, to avoid
compensation schemes which reward excessive short-term returns or
risk taking. Regulators and supervisors should enhance their
vigilance and cooperation with respect to cross-border flows.”
1
Impact of US subprime crisis on
Europe
Impact
of US Subprime crisis on Europe cannot be ignored. That this part of
the world is being impacted as well, can be concluded from the fact
that signs of the same have already started showing (like falling
prices of homes) in London.
Northern Rock, which was an eminent mortgage lender
took refuge in the Bank of England for purposes of emergency
financing in the month of September, 2007. Prospective purchasers for
the mortgage lender are still being looked for.
Another instance in Germany, which implies the impact
of US subprime crisis on Europe is when Germany 's IKB Deutsche
Industriebank accepted USD$11.1 billion from the Government as a
bailout pertaining to its various United States mortgage investments.
BNP Paribas, the French Bank was compelled to
take some drastic steps. It stopped all withdrawals from a fund of
USD$2.2 billion pertaining to investment funds as the true value of
the investment portfolios could not be ascertained.
Earlier real estate agents could quote the
prices of their choice while selling properties. However, things have
changed a lot down the line. Currently, the prices of homes are
dropping and there is a probable fear that the recession may be
reigning supreme in London next year. It is also being feared that
the US Subprime crisis may be falling upon as a grind. Owing to this
state of affairs, lenders around the globe are a bit apprehensive in
extending new loans to debtors.
Subprime and China
The impact of the subprime crisis on China is already
apparent. China's economic dependence on foreign trade is relatively
high, and as the US and European economies slide, this will seriously
affect China's export fields and enterprises, and this requires
corresponding readjustment and change of China's economic structure.
Second is the challenge of inflation. Since the United States itself
has massive debts, its moves in easing the pressure through cutting
interest rates and issuing money are bound to intensify rampant
liquidity in the international market, causing price hikes for
products in high demand; and since China's natural resources are
limited, the resulting inflationary pressure is increasing by the
day. In order to deal with inflation, China has recently intensified
its tight monetary policy.
Looking at the impact on the financial business, the
total amount of China's commercial banks' investment-grade bonds is
not great, and the direct impact of the subprime crisis is limited. A
number of listed banks this year have revealed the state of their
investment in subprime products and set aside reserves for losses on
the balance sheet.
Subprime and India
It seems that the direct effects of sub prime on the
Indian markets are pretty limited. We have to look only at the
collateral dimension, if there is any. Collateral damage can come in
two forms; one is through a generalized slowdown in the global
economy, more specifically in the US. If the US slows down, then the
decoupling for emerging markets cannot be too far away. We are
already facing a slowdown in the Indian economy as the GDP growth
rate has declined to 7.9% by August 2008. The other channel is
typically we are getting more financially integrated across the
world. Capital market integration means that if there is a liquidity
crisis coming out of the subprime crisis, then that can affect us in
some fashion. The liquidity crisis being witnessed in the foreign
market might reflect on the Indian markets too as the FII's inflows
has started drying up all around the globe.
The sub prime mortgage crisis and its potential impact
on US economic growth has raised concerns whether growth in India -
which averaged over 9% in the last three years - will be adversely
affected. The Indian economy showed signs of overheating in mid-2007,
with inflation rising above 6%. Although the central bank has pursued
a tight monetary policy, inflation is still around 9%. Buoyant
capital flows posed challenges for liquidity and macroeconomic
management, and the Reserve Bank of India responded effectively by
adopting a mix of policy measures including imposing capital
controls, allowing the rupee to appreciate, and liberalizing outflows
of capital.
The main channels through which a global credit crunch
and a recession in the US can affect India are: (i) a decline in
capital inflows and lower corporate access to credit in international
markets; (ii) slowdown in exports of goods and services from India to
the US; and (iii) remittances. The impact on Indian growth through
the first two of these channels is likely to be negative though the
structure of India's trade could mitigate the impact through trade.
Subprime Mortgage: Crisis And its Impact
Subprime lending is the practice of lending, mainly in
the form of mortgages for the purchase of residences, to borrowers
who do not meet the usual criteria for borrowing at the lowest
prevailing market interest rate. These criteria pertain to the
downpayment and the borrowing household's income level, both as a
fraction of the amount borrowed, and to the borrowing household's
employment status and credit history. If a homeowner is delinquent in
making payments to the bank (or other holder of the mortgage loan),
that entity can seize the home in a process called foreclosure.
The value of USA subprime mortgages was estimated at
$1.3 trillion as of March 2007, with over 7.5 million first-lien
subprime mortgages outstanding. In the third quarter of 2007,
subprime adjustable rate mortgages (ARMs) making up only 6.8% of USA
mortgages outstanding also accounted for 43% of the foreclosures
begun during that quarter. By October 2007, approximately 16% of
subprime adjustable rate mortgages (ARM) were either 90-days
delinquent or the lender had begun foreclosure proceedings, roughly
triple the rate of 2005. By January 2008, the delinquency rate had
risen to 21% and by May 2008 it was 25%.
The value of all outstanding USA mortgages, owed by
households to purchase residences was US$9.9 trillion as of yearend
2006, and US$10.6 trillion as of midyear 2008. During 2007, lenders
had begun foreclosure proceedings on nearly 1.3 million properties, a
79% increase over 2006. As of August 2008, 9.2% of all mortgages
outstanding were either delinquent or in foreclosure. 936,439 USA
residences completed foreclosure between August 2007 and October
2008.
Understanding credit
risk
Credit risk arises because a borrower has the option of
defaulting on the loan he owes. Traditionally, lenders (who were
primarily thrifts) bore the credit risk on the mortgages they issued.
Over the past 60 years, a variety of financial innovations have
gradually made it possible for lenders to sell the right to receive
the payments on the mortgages they issue, through a process called
securitisation. The resulting securities are called mortgage backed
securities (MBS) and collateralised debt obligations (CDO). Most
American mortgages are now held by mortgage pools, the generic term
for MBS and CDOs. Of the $10.6 trillion of USA residential mortgages
outstanding as of midyear 2008, $6.6 trillion were held by mortgage
pools, and $3.4 trillion by traditional depository institutions.
This "originate to distribute" model means
that investors holding MBS and CDOs also bear several types of risks,
and this has a variety of consequences. There are four primary types
of risk: credit risk on the underlying mortgages, asset price risk,
liquidity risk, and counterparty risk When homeowners default, the
payments received by MBS and CDO investors decline and the perceived
credit risk rises. This has had a significant adverse effect on
investors and the entire mortgage industry. The effect is magnified
by the high debt levels (financial leverage) households and
businesses have incurred in recent years.
Finally, the risks associated with American mortgage
lending have global impacts, because a major consequence of MBS and
CDOs is a closer integration of the USA housing and mortgage markets
with global financial markets.
Investors in MBS and CDOs can insure against credit risk
by buying Credit defaults swaps (CDS). As mortgage defaults rose, the
likelihood that the issuers of CDS would have to pay their
counterparties increased. This created uncertainty across the system,
as investors wondered if CDS issuers would honour their commitments.
Causes
The reasons for this crisis are varied and complex. The
crisis can be attributed to a number of factors pervasive in both the
housing and credit markets, which developed over an extended period
of time. There are many different views on the causes,[25]
including the inability of homeowners to make their mortgage
payments, poor judgment by the borrower and/or the lender,
speculation and overbuilding during the boom period, risky mortgage
products, high personal and corporate debt levels, complex financial
innovations that distributed and perhaps concealed default risks,
central bank policies, and government regulation (or alternatively
lack thereof).
In its 15 November 2008 "Declaration of the Summit
on Financial Markets and the World Economy," leaders of the
Group of 20 cited the following causes:
“ During
a period of strong global growth, growing capital flows, and
prolonged stability earlier this decade, market participants sought
higher yields without an adequate appreciation of the risks and
failed to exercise proper due diligence. At the same time, weak
underwriting standards, unsound risk management practices,
increasingly complex and opaque financial products, and consequent
excessive leverage combined to create vulnerabilities in the system.
Policy-makers, regulators and supervisors, in some advanced
countries, did not adequately appreciate and address the risks
building up in financial markets, keep pace with financial
innovation, or take into account the systemic ramifications of
domestic regulatory actions.”2
Low interest rates and large inflows of foreign funds
created easy credit conditions for many years leading up to the
crisis. Subprime lending and borrowing was a major contributor to an
increase in home ownership rates and the demand for housing. The U.S.
home ownership rate increased from 64% in 1994 (about where it was
since 1980) to a peak in 2004 with an all-time high of 69.2%.
This
demand helped fuel housing price increases and consumer spending.
Between 1997 and 2006, American home prices increased by 124%. For
the two decades until 2001, the national median home price went up
and down, but it remained between 2.9 and 3.1 times the median
household income. By 2004, however, the ratio of home prices to
income hit 4.0, and by 2006 the ratio was 4.6. Some homeowners used
the increased property value experienced in the housing bubble to
refinance their homes with lower interest rates and take out second
mortgages against the added value to use the funds for consumer
spending. U.S. household debt as a percentage of income rose to 130%
during 2007, versus 100% earlier in the decade. A culture of
consumerism is a factor "in an economy based on immediate
gratification".3
Americans spent $800 billion per year more than they earned.
Household debt grew from $680 billion in 1974 to $14 trillion in
2008, with the total doubling since 2001. During 2008, the average
U.S. household owned 13 credit cards, and 40 percent of them carried
a balance, up from 6 percent in 1970.
during the boom period eventually led to a surplus inventory of
homes, causing home prices to decline, beginning in the summer of
2006. Easy credit, combined with the assumption that housing prices
would continue to appreciate, had encouraged many subprime borrowers
to obtain adjustable-rate mortgages they could not afford after
Boom and bust in the housing market
the initial incentive period. Once housing prices
started depreciating moderately in many parts of the U.S.,
refinancing became more difficult. Some homeowners were unable to
re-finance and began to default on loans as their loans reset to
higher interest rates and payment amounts.
An estimated 8.8 million homeowners — nearly 10.8%
of total homeowners — had zero or negative equity as of March
2008, meaning their homes are worth less than their mortgage. This
provided an incentive to "walk away" from the home, despite
the credit rating impact.
Increasing foreclosure rates increased the supply of
housing inventory available. Sales volume (units) of new homes
dropped by 26.4% in 2007 versus the prior year. By January 2008, the
inventory of unsold new homes stood at 9.8 months based on December
2007 sales volume, the highest level since 1981. Further, a record of
nearly four million unsold existing homes were for sale, including
nearly 2.9 million that were vacant.
This excess supply of home inventory placed significant
downward pressure on prices. As prices declined, more homeowners were
at risk of default and foreclosure. According to the S&P/Case-Shiller
price index, by November 2007, average U.S. housing prices had fallen
approximately 8% from their Q2 2006 peak and by May 2008 they had
fallen 18.4%. The price decline in December 2007 versus the year-ago
period was 10.4% and for May 2008 it was 15.8%. Housing prices are
expected to continue declining until this inventory of surplus homes
(excess supply) is reduced to more typical levels.
Speculation
Speculation in real estate was a contributing factor.
During 2006, 22% of homes purchased (1.65 million units) were for
investment purposes, with an additional 14% (1.07 million units)
purchased as vacation homes. During 2005, these figures were 28% and
12%, respectively. In other words, nearly 40% of home purchases
(record levels) were not primary residences. Speculators left the
market in 2006, which caused investment sales to fall much faster
than the primary market.
While homes had not traditionally been treated as
investments like stocks, this behaviour changed during the housing
boom. For example, one company estimated that as many as 85% of
condominium properties purchased in Miami were for investment
purposes. Media widely reported the behaviour of purchasing
condominiums prior to completion, then "flipping" (selling)
them for a profit without ever living in the home. Some mortgage
companies identified risks inherent in this activity as early as
2005, after identifying investors assuming highly leveraged positions
in multiple properties.
Keynesian economist Hyman Minsky described three types
of speculative borrowing4
that can contribute to the accumulation of debt that eventually leads
to a collapse of asset values: the "hedge borrower" who
borrows with the intent of making debt payments from cash flows from
other investments; the "speculative borrower" who borrows
based on the belief that they can service interest on the loan but
who must continually roll over the principal into new investments;
and the "Ponzi borrower" (named for Charles Ponzi), who
relies on the appreciation of the value of their assets (e.g. real
estate) to refinance or pay-off their debt but cannot repay the
original loan.
The role of speculative borrowing has been cited as a
contributing factor to the subprime mortgage crisis.
High-risk mortgage
loans and lending practices
A variety of factors have caused lenders to offer an
increasing array of higher-risk loans to higher-risk borrowers,
including illegal immigrants. The share of subprime mortgages to
total originations was 5% ($35 billion) in 1994, 9% in 1996, 13%
($160 billion) in 1999, and 20% ($600 billion) in 2006. A study by
the Federal Reserve indicated that the average difference in mortgage
interest rates between subprime and prime mortgages (the "subprime
markup" or "risk premium") declined from 2.8
percentage points (280 basis points) in 2001, to 1.3 percentage
points in 2007. In other words, the risk premium required by lenders
to offer a subprime loan declined. This occurred even though subprime
borrower credit ratings and loan characteristics declined overall
during the 2001–2006 period, which should have had the opposite
effect. The combination is common to classic boom and bust credit
cycles.
In addition to considering higher-risk borrowers,
lenders have offered increasingly high-risk loan options and
incentives. These high risk loans included the "No Income, No
Job and no Assets" loans, sometimes referred to as Ninja loans.
In 2005 the median down payment for first-time home buyers was 2%,
with 43% of those buyers making no down payment whatsoever.
Another example is the interest-only adjustable-rate
mortgage (ARM), which allows the homeowner to pay just the interest
(not principal) during an initial period. Still another is a "payment
option" loan, in which the homeowner can pay a variable amount,
but any interest not paid is added to the principal. Further, an
estimated one-third of ARM originated between 2004 and 2006 had
"teaser" rates below 4%, which then increased significantly
after some initial period, as much as doubling the monthly payment.
Mortgage underwriting practices have also been
criticized, including automated loan approvals that critics argued
were not subjected to appropriate review and documentation. In 2007,
automated underwriting generated 40% of all subprime loans. The
chairman of the Mortgage Bankers Association claimed mortgage brokers
profited from a home loan boom but did not do enough to examine
whether borrowers could repay. Mortgage fraud has also increased.
Securitisation
practices
Borrowing under a
securitisation structure.
Securitisation is structured finance process in which
assets, receivables or financial instruments are acquired, pooled
together as collateral for the third party investments (Investment
banks). There are many parties involved. Due to the securitisation,
investor appetite for mortgage-backed securities (MBS), and the
tendency of rating agencies to assign investment-grade ratings to
MBS, loans with a high risk of default could be originated, packaged
and the risk readily transferred to others. Asset securitisation
began with the structured financing of mortgage pools in the 1970s.
In 1995 the Community Reinvestment Act (CRA) was revised to allow for
the securitisation of CRA loans into the secondary market for
mortgages.
The traditional mortgage model involved a bank
originating a loan to the borrower/homeowner and retaining credit
(default) risk. With the advent of securitisation, the traditional
model has given way to the "originate to distribute" model,
in which the credit risk is transferred (distributed) to investors
through MBS. The securitised share of subprime mortgages (i.e., those
passed to third-party investors via MBS) increased from 54% in 2001,
to 75% in 2006. Securitisation accelerated in the mid-1990s. The
total amount of mortgage-backed securities issued almost tripled
between 1996 and 2007, to $7.3 trillion. The debt associated with the
origination of such securities was sometimes placed by major banks
into off-balance sheet entities called structured investment vehicles
(SIVs) or special purpose entities. Moving the debt "off the
books" enabled large financial institutions to circumvent
capital reserve requirements, thereby assuming additional risk and
increasing profits during the boom period. Such off-balance sheet
financing is sometimes referred to as the shadow banking system and
is thinly regulated. Alan Greenspan stated that the securitisation of
home loans for people with poor credit — not the loans
themselves — was to blame for the current global credit crisis.
However, instead of distributing mortgage-backed
securities to investors, many financial institutions retained
significant amounts. The credit risk remained concentrated within the
banks instead of fully distributed to investors outside the banking
sector. Some argue this was not a flaw in the securitisation concept
itself, but in its implementation.
Some believe that mortgage standards became lax because
of a moral hazard, where each link in the mortgage chain collected
profits while believing it was passing on risk.
Under the CRA guidelines, a bank gets credit originating
loans or buying on a whole loan basis, but not holding the loans. So,
this gave the banks the incentive to originate loans and securitise
them, passing the risk on others. Since the banks no longer carried
the loan risk, they had every incentive to lower their underwriting
standards to increase loan volume. The mortgage securitisation freed
up cash for banks and thrifts, this allowed them to make even more
loans. In 1997, Bear Sterns bundled the first CRA loans into MBS.
Credit rating agencies are now under scrutiny for giving
investment-grade ratings to securitisation transactions (CDOs and
MBSs) based on subprime mortgage loans. Higher ratings were believed
justified by various credit enhancements including
over-collateralisation (pledging collateral in excess of debt
issued), credit default insurance, and equity investors willing to
bear the first losses. However, there are also indications that some
involved in rating subprime-related securities knew at the time that
the rating process was faulty. Internal rating agency emails from
before the time the credit markets deteriorated, released publicly by
U.S. congressional investigators, suggest that some rating agency
employees suspected at the time that lax standards for rating
structured credit products would produce widespread negative results.
For example, one 2006 email between colleagues at Standard &
Poor's states "Rating agencies continue to create and
[sic] even bigger monster—the CDO market. Let's
hope we are all wealthy and retired by the time this house of cards
falters."5
Inaccurate credit ratings
High ratings encouraged the flow of investor funds into
these securities, helping finance the housing boom. The reliance on
ratings by these agencies and the intertwined nature of how ratings
justified investment led many investors to treat securitised products
— some based on subprime mortgages — as equivalent to
higher quality securities and furthered by SEC removal of regulatory
barriers and reduced disclosure requirements in the wake of the Enron
scandal. Critics claim that conflicts of interest were involved, as
rating agencies are paid by the firms that organize and sell the debt
to investors, such as investment banks. On 11 June 2008 the U.S.
Securities and Exchange Commission proposed far-reaching rules
designed to address perceived conflicts of interest between rating
agencies and issuers of structured securities.
Rating agencies lowered the credit ratings on $1.9
trillion in mortgage backed securities from Q3 2007 to Q2 2008. This
places additional pressure on financial institutions to lower the
value of their MBS. In turn, this may require these institutions to
acquire additional capital, to maintain capital ratios. If this
involves the sale of new shares of stock, the value of existing
shares is reduced. In other words, ratings downgrades pressured MBS
and stock prices lower.
Government policies
Both government action and inaction have contributed to
the crisis. Several critics have commented that the current
regulatory framework is outdated. President George W. Bush stated in
September 2008: "Once this crisis is resolved, there will be
time to update our financial regulatory structures. Our 21st century
global economy remains regulated largely by outdated 20th century
laws."6
The Securities and Exchange Commission (SEC) has conceded that
self-regulation of investment banks contributed to the crisis.
Increasing home ownership was a goal of both Clinton and
Bush administrations. There is evidence that the government
influenced participants in the mortgage industry, including Fannie
Mae and Freddie Mac (the GSE), to lower lending standards. The U.S.
Department of Housing and Urban Development's mortgage policies
fuelled the trend towards issuing risky loans.
In 1995, the GSE began receiving government incentive
payments for purchasing mortgage backed securities which included
loans to low income borrowers. This resulted in the agencies
purchasing subprime securities. Subprime mortgage loan originations
surged by 25% per year between 1994 and 2003, resulting in a nearly
ten-fold increase in the volume of these loans in just nine years.
These securities were very attractive to Wall Street, and while
Fannie and Freddie targeted the lowest-risk loans, they still fuelled
the subprime market as a result. In 1996 the Housing and Urban
Development (HUD) agency directed the GSE to provide at least 42% of
their mortgage financing to borrowers with income below the median in
their area. This target was increased to 50% in 2000 and 52% in 2005.
By 2008, the GSE owned or guaranteed nearly $5 trillion in mortgages
and mortgage-backed securities, close to half the outstanding balance
of U.S. mortgages. The GSE were highly leveraged, having borrowed
large sums to purchase mortgages. When concerns arose regarding the
ability of the GSE to make good on their guarantee obligations in
September 2008, the U.S. government was forced to place the companies
into a conservatorship, effectively nationalizing them at the
taxpayers expense.
Liberal economist Robert Kuttner has criticized the
repeal of the Glass-Steagall Act by the Gramm-Leach-Bliley Act of
1999 as possibly contributing to the subprime meltdown, although
other economists disagree. A taxpayer-funded government bailout
related to mortgages during the savings and loan crisis may have
created a moral hazard and acted as encouragement to lenders to make
similar higher risk loans.
Additionally, there is debate among economists regarding
the effect of the Community Reinvestment Act, with detractors
claiming it encourages lending to uncreditworthy consumers and
defenders claiming a thirty year history of lending without increased
risk. Detractors also claim that amendments to the CRA in the
mid-1990s, raised the amount of home loans to otherwise unqualified
low-income borrowers and also allowed for the first time the
securitisation of CRA-regulated loans containing subprime mortgages.
Policies of central
banks
Central banks are primarily concerned with managing
monetary policy, they are less concerned with avoiding asset bubbles,
such as the housing bubble and dot-com bubble. Central banks have
generally chosen to react after such bubbles burst to minimize
collateral impact on the economy, rather than trying to avoid the
bubble itself. This is because identifying an asset bubble and
determining the proper monetary policy to properly deflate it are a
matter of debate among economists.
Federal Reserve actions raised concerns among some
market observers that it could create a moral hazard. Some industry
officials said that Federal Reserve Bank of New York involvement in
the rescue of Long-Term Capital Management in 1998 would encourage
large financial institutions to assume more risk, in the belief that
the Federal Reserve would intervene on their behalf.
A contributing factor to the rise in home prices was the
lowering of interest rates earlier in the decade by the Federal
Reserve, to diminish the blow of the collapse of the dot-com bubble
and combat the risk of deflation. From 2000 to 2003, the Federal
Reserve lowered the federal funds rate target from 6.5% to 1.0%. The
central bank believed that interest rates could be lowered safely
primarily because the rate of inflation was low and disregarded other
important factors. The Federal Reserve's inflation figures, however,
were flawed. Richard W. Fisher, President and CEO of the Federal
Reserve Bank of Dallas, stated that the Federal Reserve's interest
rate policy during this time period was misguided by this erroneously
low inflation data, thus contributing to the housing bubble.
Financial institution debt levels and incentives
Many
financial institutions borrowed enormous sums of money during
2004–2007 and made investments in mortgage-backed securities
(MBS), essentially betting on the continued appreciation of home
values and sustained mortgage payments. Borrowing at a lower interest
rate to invest at a higher interest rate is using financial leverage.
This is analogous to an individual taking out a second mortgage on
their home to invest in the stock market. This strategy magnified
profits during the housing boom period, but drove large losses after
the bust. Financial institutions and individual investors holding MBS
also suffered significant losses as a result of widespread and
increasing mortgage payment defaults or MBS devaluation beginning in
2007 onward.
A SEC regulatory ruling in 2004 greatly contributed to
US investment banks' ability to take on additional debt, which was
then used to purchase MBS. The top five US investment banks each
significantly increased their financial leverage during the 2004–2007
time period (see diagram), which increased their vulnerability to the
MBS losses. These five institutions reported over $4.1 trillion in
debt for fiscal year 2007, a figure roughly 30% the size of the U.S.
economy. Three of the five either went bankrupt (Lehman Brothers) or
were sold at fire-sale prices to other banks (Bear Stearns and
Merrill Lynch) during September 2008, creating instability in the
global financial system. The remaining two converted to commercial
bank models, subjecting themselves to much tighter regulation.
In 2006, Wall Street executives took home bonuses
totaling $23.9 billion, according to the New York State Comptroller's
Office. "Wall Street traders were thinking of the bonus at the
end of the year, not the long-term health of their firm. The whole
system—from mortgage brokers to Wall Street risk
managers—seemed tilted toward taking short-term risks while
ignoring long-term obligations. The most damning evidence is that
most of the people at the top of the banks didn't really understand
how those [investments] worked."7
Credit default swaps
Credit defaults swaps (CDS) are insurance contracts,
typically used to protect bondholders or MBS investors from the risk
of default. As the financial health of banks and other institutions
deteriorated due to losses related to mortgages, the likelihood that
those providing the insurance would have to pay their counterparties
increased. This created uncertainty across the system, as investors
wondered which companies would be forced to pay to cover defaults.
CDS may be used to insure a particular financial
exposure or may be used speculatively. Trading of CDS increased
100-fold from 1998 to 2008, with debt covered by CDS contracts
ranging from U.S. $33 to $47 trillion as of November 2008. CDS are
lightly regulated. During 2008, there was no central clearinghouse to
honour CDS in the event a key player in the industry was unable to
perform its obligations. Required corporate disclosure of CDS-related
obligations has been criticized as inadequate. Insurance companies
such as AIG, MBIA, and Ambac faced ratings downgrades due to their
potential exposure due to widespread debt defaults. These
institutions were forced to obtain additional funds (capital) to
offset this exposure. In the case of AIG, its nearly $440 billion of
CDS linked to MBS resulted in a U.S. government bailout.
In theory, because credit default swaps are two-party
contracts, there is no net loss of wealth. For every company that
takes a loss, there will be a corresponding gain elsewhere. The
question is which companies will be on the hook to make payments and
take losses, and will they have the funds to cover such losses. When
investment bank Lehman Brothers went bankrupt in September 2008, it
created a great deal of uncertainty regarding which financial
institutions would be required to pay off CDS contracts on its $600
billion in outstanding debts. Significant losses at investment bank
Merrill Lynch were also attributed in part to CDS and especially the
drop in value of its unhedged mortgage portfolio in the form of
Collateralised Debt Obligations after American International Group
ceased offering CDS on Merril's CDOs. Trading partner's loss of
confidence in Merril Lynch's solvency and ability to refinance
short-term debt ultimately led to its sale to Bank of America.
Impact
Financial sector downturn
Financial institutions from around the world have
recognized subprime-related losses and write-downs exceeding U.S.
$501 billion as of August 2008. Profits at the 8,533 U.S. banks
insured by the FDIC declined from $35.2 billion to $646 million (89%)
during the fourth quarter of 2007 versus the prior year, due to
soaring loan defaults and provisions for loan losses. It was the
worst bank and thrift quarterly performance since 1990. For all of
2007, these banks earned approximately $100 billion, down 31% from a
record profit of $145 billion in 2006. Profits declined from $35.6
billion to $19.3 billion during the first quarter of 2008 versus the
prior year, a decline of 46%.
The financial sector began to feel the consequences of
this crisis in February 2007 with the $10.5 billion writedown of
HSBC, which was the first major CDO or MBO related loss to be
reported. During 2007, at least 100 mortgage companies either shut
down, suspended operations or were sold. Top management has not
escaped unscathed, as the CEOs of Merrill Lynch and Citigroup were
forced to resign within a week of each other. Various institutions
followed up with merger deals.
Market weaknesses, 2007
On July 19, 2007, the Dow Jones Industrial Average hit a
record high, closing above 14,000 for the first time.
On August 15, 2007, the Dow dropped below 13,000 and the
S&P 500 crossed into negative territory for that year. Similar
drops occurred in virtually every market in the world, with Brazil
and Korea being hard-hit. Through 2008, large daily drops became
common, with, for example, the KOSPI dropping about 7% in one
day,[126]
although 2007's largest daily drop by the S&P 500 in the
U.S. was in February, a result of the subprime crisis.
Mortgage lenders and home builders fared terribly, but
losses cut across sectors, with some of the worst-hit industries,
such as metals & mining companies, having only the vaguest
connection with lending or mortgages.
Stock indices worldwide trended downward for several
months since the first panic in July–August 2007.
Market downturns and
impacts, 2008
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 has contributed to the
world food price crisis and oil price increases due to a "commodities
super-cycle." Financial speculators seeking quick returns have
removed trillions of dollars from equities and mortgage bonds, some
of which has been invested into food and raw materials.
Beginning in mid-2008, all three major stock indices in
the United States (the Dow Jones Industrial Average, NASDAQ, and the
S&P 500) entered a bear market. On 15 September 2008, a slew of
financial concerns caused the indices to drop by their sharpest
amounts since the 2001 terrorist attacks. That day, the most
noteworthy trigger was the declared bankruptcy of investment bank
Lehman Brothers. Additionally, Merrill Lynch was joined with Bank of
America in a forced merger worth $50 billion. Finally, concerns over
insurer American International Group's ability to stay capitalized
caused that stock to drop over 60% that day. Poor economic data on
manufacturing contributed to the day's panic, but were eclipsed by
the severe developments of the financial crisis. All of these events
culminated into a stock selloff that was experienced worldwide.
Overall, the Dow Jones Industrial plunged 504 points (4.4%) while the
S&P 500 fell 59 points (4.7%). Asian and European markets
rendered similarly sharp drops.
The much anticipated passage of the $700 billion bailout
plan was struck down by the House of Representatives in a 228–205
vote on September 29. In the context of recent history, the result
was catastrophic for stocks. The Dow Jones Industrial Average
suffered a severe 777 point loss (7.0%), its worst point loss on
record up to that date. The NASDAQ tumbled 9.1% and the S&P 500
fell 8.8%, both of which were the worst losses those indices
experienced since the 1987 stock market crash.
Despite congressional passage of historic bailout
legislation, which was signed by President Bush on Saturday, Oct. 4,
Dow Jones Index tumbled further when markets resumed trading on Oct.
6. The Dow fell below 10,000 points for the first time in almost four
years, losing 800 points before recovering to settle at -369.88 for
the day. Stocks also continued to tumble to record lows ending one of
the worst weeks in the Stock Market since September 11, 2001.
It is also estimated that even with the passing of the
so-called bailout package, many banks within the United States will
tumble and therefore cease operating. It is estimated that over 100
banks in the United States will close their doors because of the
financial crisis. This will have a severe impact on the economy and
consumers. It is expected that it will take years for the United
States to recover from the crisis .
Indirect economic effects
The subprime crisis had a series of other economic
effects. Housing price declines left consumers with less wealth,
which placed downward pressure on consumption. Certain minority
groups received a higher proportion of subprime loans and experienced
a disproportional level of foreclosures. Home related crimes
including arson increased. Job losses in the financial sector were
significant, with over 65,400 jobs lost in the United States as of
September 2008. Many renters became innocent victims, often evicted
from their homes without notice due to foreclosure of their
landlord's property.
The sudden lack of credit also caused a slump in car
sales. Ford sales in October 2008 were down 33.8% from a year ago,
General Motors sales were down 15.6%, and Toyota sales had declined
32.3%. One in five car dealerships are expected to close in Fall of
2008.
Responses
Various actions have been taken since the crisis became
apparent in August 2007. In September 2008, major instability in
world financial markets increased awareness and attention to the
crisis. Various agencies and regulators, as well as political
officials, began to take additional, more comprehensive steps to
handle the crisis.
Legislative and
regulatory responses
The Federal Reserve
The U.S. central banking system, the Federal Reserve, in
partnership with central banks around the world, has taken several
steps to address the crisis. Federal Reserve Chairman Ben Bernanke
stated in early 2008: "Broadly, the Federal Reserve’s
response has followed two tracks: efforts to support market liquidity
and functioning and the pursuit of our macroeconomic objectives
through monetary policy."8
Between
18 September 2007 and 30 April 2008, the target for the Federal funds
rate was lowered from 5.25% to 2% and the discount rate was lowered
from 5.75% to 2.25%, through six separate actions.
The
Fed and other central banks have conducted open market operations to
ensure member banks have access to funds (i.e., liquidity). These are
effectively short-term loans to member banks collateralised by
government securities. Central banks have also lowered the interest
rates charged to member banks (called the discount rate in the U.S.)
for short-term loans.
The
Fed is using the Term Auction Facility (TAF) to provide short-term
loans (liquidity) to banks. The Fed increased the monthly amount of
these auctions to $100 billion during March 2008, up from $60 billion
in prior months.
In
July 2008, the Fed finalized new rules that apply to mortgage
lenders. In October 2008, the Fed expanded the collateral it will
loan against to include commercial paper, to help address continued
liquidity concerns.
Regulation
Regulators and legislators are considering action
regarding lending practices, bankruptcy protection, tax policies,
affordable housing, credit counselling, education, and the licensing
and qualifications of lenders. Regulations or guidelines can also
influence the nature, transparency and regulatory reporting required
for the complex legal entities and securities involved in these
transactions. Congress also is conducting hearings to help identify
solutions and apply pressure to the various parties involved.
A
sweeping proposal was presented on 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. In response to a concern that lending
was not properly regulated, the House and Senate are both considering
bills to regulate lending practices.
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."
UK
regulators announced a temporary ban on short-selling of financial
stocks on September 18, 2008.
The
Australian federal government has announced an investment of AU$4
billion in non-bank lender mortgage backed securities in an attempt
to maintain competition in the mortgage market.
Economic Stimulus Act
of 2008
President Bush also signed into law on 13 February 2008
an economic stimulus package of $168 billion, mainly in the form of
income tax rebates, to help stimulate economic growth. The economic
stimulus package included the mailing of rebate checks to taxpayers.
Such mailings started the week of 28 April 2008. These mailings,
however, coincided with unexpected all-time jumps in food and
gasoline prices. This coincidence prompted some to question whether
the stimulus package would have the desired effect or whether
consumers would just use it to make up for the gap generated by the
higher food and fuel prices. Some Congressmen even contemplated
legislation for a second round of stimulus rebate checks to ensure
the initial intention of the stimulus package had the expected
effect. The Treasury Secretary strongly opposed such initiative.
Housing and Economic Recovery Act of 2008
The Housing and Economic Recovery Act of 2008 included
six separate major acts designed to restore confidence in the
domestic mortgage industry. The Act included:
Providing
insurance for $300 billion in mortgages estimated to assist 400,000
homeowners.
Establishing
a new regulator to ensure the safe and sound operation of the GSEs
(Fannie Mae and Freddie Mac) and Federal Home Loan banks.
Raising
the dollar limit of the mortgages the government sponsored
enterprises (GSEs) can purchase.
Providing
loans for the refinancing of mortgages to owner-occupants at risk of
foreclosure. The original lender or investor reduces the amount of
the original mortgage (typically taking a significant loss) and the
homeowner shares any future appreciation with the Federal Housing
Administration. The new loans must be 30-year fixed loans.
Enhancements
to mortgage disclosures.
Community
assistance to help local governments buy and renovate foreclosed
properties.
Government bailouts
Northern
Rock had difficulty finding finance to keep the business going and
was nationalized on 17 February 2008. As of October 8th, 2008, UK
taxpayer liability for the bank had climbed to £87Bn ($150Bn)
Bear
Stearns was acquired in March 2008 by J.P. Morgan Chase for $1.2
billion. In order for the deal to go through, the Fed issued a
nonrecourse loan of $29 billion to Bear Stearns.
In
September 2008, the Treasury Department confirmed that both Fannie
Mae and Freddie Mac would be placed into conservatorship with the
government taking over management of the pair. The two GSEs have
outstanding more than US$ 5 trillion in mortgage backed securities
(MBS) and debt. Merrill Lynch was acquired by Bank of
America in September 2008 for $50 billion.
Scottish
banking group HBOS agreed on 17 September 2008 to be acquired by UK
rival Lloyds TSB in an emergency takeover after its share price
experienced significant falls amid fears over its exposure to toxic
debt. The deal was encouraged by the UK government, who agreed to
waive competition rules to allow the takeover to go ahead.
Lehman
Brothers declared bankruptcy on 15 September 2008, facing a refusal
by the federal government to bail it out. Treasury Secretary Hank
Paulson cited moral hazard as a reason for not bailing out Lehman
Brothers.
In
September 2008, The Federal Reserve provided an emergency loan of $85
billion to AIG, which will be repaid by selling off assets of the
company. This intervention gave the US government a 79.9% equity
stake at AIG. Just over three weeks later the Fed reported that AIG
had drawn down $70.3 billion of that $85 billion facility and AIG
announced that it may tap an additional $37.8 billion in secured
funding from the Federal Reserve.
In
September 2008, Washington Mutual declared bankruptcy. The United
States Office of Thrift Supervision (OTS) announced that it was
seizing WaMu and would sell most of its functional assets to J.P.
Morgan Chase.
On
29 September 2008, British bank Bradford & Bingley was
nationalised by the UK government. The government will take control
of the bank's £50bn mortgages and loans, while its savings
operations and branches are to be sold to Spain's Santander.
In
October 2008, The Australian government announced that AU$4 billion
was to be raised to fund non-bank lenders that are unable to obtain
funding to finance new loans. After industry feedback this was
increased to AU$8 billion.
Emerging plan to bail out financial institutions
On 19 September 2008, the U.S. government announced a
plan to purchase large amounts of illiquid, risky mortgage backed
securities from financial institutions, which is estimated to involve
at minimum, $700 billion of additional commitments. This plan also
included a ban on short-selling of financial stocks. The mortgage
market is estimated at $12 trillion with approximately 9.2% of loans
either seriously delinquent or in foreclosure through August 2008. On
29 September 2008 the House of Representatives rejected a revised
version of the plan. On 1 October 2008 the U.S. Senate approved an
amended version of the plan, which was approved by the House on
October 3 and immediately signed into law by President Bush.
Lending industry
action
Lenders and homeowners both may benefit from avoiding
foreclosure, which is a costly and lengthy process. Some lenders have
taken action to reach out to homeowners to provide more favourable
mortgage terms (i.e., refinancing, loan modification or loss
mitigation). Homeowners have also been encouraged to contact their
lenders to discuss alternatives.
Corporations, trade groups, and consumer advocates have
begun to cite statistics on the numbers and types of homeowners
assisted by loan modification programs. There is some dispute
regarding the appropriate measures, sources of data, and adequacy of
progress. A report issued in January 2008 showed that mortgage
lenders modified 54,000 loans and established 183,000 repayment plans
in the third quarter of 2007, a period in which there were 384,000
new foreclosures. Consumer groups claimed the modifications affected
less than 1% of the 3 million subprime loans with adjustable rates
that were outstanding in the third quarter.
The State Foreclosure Prevention Working Group, a
coalition formed by 11 state attorney generals and bank regulators,
reported in April 2008 that the increasing pace of foreclosures
exceeds the ability of loan servicers to keep up. Seventy percent of
subprime mortgage holders are not getting the help required. Nearly
two-thirds of loan workouts require more than six weeks to complete
under the current "case-by-case" method of review. The
group has recommended applying a more systematic method of loan
modification that can automatically be applied to a large number of
struggling homeowners and slowing down the pace of foreclosures.
In response to a legal settlement with several states
announced 5 October 2008, Bank of America has announced a more
aggressive program to systematically help an estimated 400,000
homeowners stay in their homes. This includes limiting payments to a
specific level of income and writing down the values of mortgages.
In Australia several lenders have amended their policy
for low doc, no doc and no deposit loans that are considered to be
riskier than standard home loans. Overall these changes have been
relatively minor with the exception of the non conforming lenders
that lend to credit impaired and subprime borrowers. It is unknown if
this trend will continue or if Australian lenders will be forced to
withdraw from riskier loan products.
Hope Now Alliance
President George W. Bush announced a plan to voluntarily
and temporarily freeze the mortgages of a limited number of mortgage
debtors holding ARMs. A refinancing facility called FHA-Secure was
also created. This action is part of an ongoing collaborative effort
between the US Government and private industry to help some sub-prime
borrowers called the Hope Now Alliance.
The Hope Now Alliance released a report in February 2008
indicating it helped 545,000 subprime borrowers with shaky credit in
the second half of 2007, or 7.7% of 7.1 million subprime loans
outstanding in September 2007. A spokesperson acknowledged that much
more must be done. During February 2008, a program called "Project
Lifeline" was announced. Six of the largest U.S. lenders, in
partnership with the Hope Now Alliance, agreed to defer foreclosure
actions for 30 days for homeowners 90 or more days delinquent on
payments. The intent of the program was to encourage more loan
adjustments, to avoid foreclosures.
Bank capital
replenishment from private sources
Major financial institutions obtained over $260 billion
in new capital (i.e., cash investments) as of May 2008. Such capital
is used to help banks maintain required capital ratios (an important
measure of financial health), which have declined significantly due
to subprime loan or CDO losses. This capital was raised by issuing
such instruments as bonds
or preferred
stock to investors in exchange for cash. Such
capital raising has been advocated by the leaders of the U.S. Federal
Reserve and the Treasury Department. Well-funded banks are in a
better position to loan at favourable interest rates, which offsets
the liquidity and uncertainty aspects of the crisis.
The ability of some banks and securities firms to place
such large volumes of debt with investors is an indication to some
analysts that these firms will survive the credit crisis. In response
to the crisis, the last independent investment banks, Goldman Sachs
and Morgan Stanley, elected to become bank holding companies in order
to gain access to additional liquidity.
Banks have obtained some of this capital from sovereign
wealth funds, which are entities that control the surplus savings of
developing countries. An estimated U.S. $69 billion has been invested
by these entities in large financial institutions over the past year.
On 15 January 2008, sovereign wealth funds provided a total of $21
billion to two major U.S. financial institutions. Sovereign wealth
funds are estimated to control nearly $2.9 trillion. Much of this
wealth is oil and gas related. As they represent the surplus funds of
governments, these entities carry at least the perception that their
investments have underlying political motives.
Certain major banks have also reduced their dividend
payouts to increase liquidity and further dividend reductions are
expected by some analysts in 2008. Of the 3,776 U.S. FDIC insured
institutions that paid common stock dividends in the first quarter of
2007, almost half (48%) paid lower dividends in the first quarter of
2008, including 666 institutions that paid no dividends. Insured
institutions paid $14.0 billion in total dividends in the first
quarter, down $12.2 billion (46.5%) from a year earlier.
Litigation
Litigation related to the subprime crisis is underway. A
study released in February 2008 indicated that 278 civil lawsuits
were filed in federal courts during 2007 related to the subprime
crisis. The number of filings in state courts was not quantified but
is also believed to be significant. The study found that 43% of the
cases were class actions brought by borrowers, such as those that
contended they were victims of discriminatory lending practices.
Other cases include securities lawsuits filed by investors,
commercial contract disputes, employment class actions, and
bankruptcy-related cases. Defendants included mortgage bankers,
brokers, lenders, appraisers, title companies, home builders,
servicers, issuers, underwriters, bond insurers, money managers,
public accounting firms, and company boards and officers.
Former Bear Stearns managers were named in civil
lawsuits brought in 2007 by investors, including Barclays Bank PLC,
who claimed they had been misled. Barclays claimed that Bear Stearns
knew that certain assets in the Bear Stearns High-Grade Structured
Credit Strategies Enhanced Leverage Master Fund were worth much less
than their professed values. The suit claimed that Bear Stearns
managers devised "a plan to make more money for themselves and
further to use the Enhanced Fund as a repository for risky,
poor-quality investments." The lawsuit said Bear Stearns told
Barclays that the enhanced fund was up almost 6% through June 2007 —
when "in reality, the portfolio's asset values were plummeting."
In 2006, the OFHEO announced a suit against Franklin
Raines, former chairman and chief executive officer of Fannie Mae,
which was eventually settled.
Law enforcement
The number of FBI agents assigned to mortgage-related
crimes increased by 50% between 2007 and 2008. In June 2008, the FBI
stated that its mortgage fraud caseload has doubled in the past three
years to more than 1,400 pending cases. Between 1 March and 18 June
2008, 406 people were arrested for mortgage fraud in an FBI sting
across the country. People arrested include buyers, sellers and
others across the wide-ranging mortgage industry. On 19 June 2008,
two former Bear Stearns managers were arrested by the FBI, and were
the first Wall Street executives arrested related to the subprime
lending crisis. They were suspected of misleading investors about the
risky subprime mortgage market.
On 23 September 2008, two government officials stated
that the Federal Bureau of Investigation was looking into the
possibility of fraud by mortgage financing companies Fannie Mae and
Freddie Mac, Lehman Brothers, and insurer American International
Group.
Ethics investigation
On 18 June 2008, a Congressional ethics panel started
examining allegations that Democrat Senators Christopher Dodd of
Connecticut (the sponsor of a major $300 billion housing rescue bill)
and Kent Conrad of North Dakota received preferential loans by
troubled mortgage lender Countrywide Financial Corp.
Expectations and forecasts
Several years before the crisis Fairfax Financial's Prem
Watsa warned:
"We have been concerned for some time about the
risks in asset-backed bonds, particularly bonds that are backed by
home equity loans, automobile loans or credit card debt (we own no
asset-backed bonds). It seems to us that securitisation (or the
creation of these asset-backed bonds) eliminates the incentive for
the originator of the loan to be credit sensitive... With
securitisation, the dealer (almost) does not care as these loans can
be laid off through securitisation. Thus, the loss experienced on
these loans after securitisation will no longer be comparable to that
experienced prior to securitisation (called a moral hazard)... This
is not a small problem. There is $1.0 trillion in asset-backed bonds
outstanding as of December 31, 2003 in the U.S.... Who is buying
these bonds? Insurance companies, money managers and banks – in
the main – all reaching for yield given the excellent ratings
for these bonds. What happens if we hit an air pocket?9
Stifel Nicolaus, writing in MarketWatch, has claimed
that the problem mortgages are not confineed to the subprime niche:
"the rapidly increasing scope and depth of the problems in the
mortgage market suggest that the entire sector has plunged into a
downward spiral similar to the subprime woes whereby each negative
development feeds further deterioration," calling it a "vicious
cycle" and adding that lenders "continue to believe
conditions will get worse".10
The crisis has led to a drastic decline in new housing
starts in the USA. Historically, such declines precede a surge of
unemployment in the following year. This fact points to another
possible consequence of the crisis.
As of 22 November 2007, analysts at a leading investment
bank estimated losses on subprime CDO could eventually amount to
US$148 billion. As of 22 December 2007, a leading business periodical
estimated subprime defaults between U.S. $200–300 billion. As
of 1 March 2008 analysts from three large financial institutions
estimated the impact would be between U.S. $350–600 billion.11
On 20 March 2008, the Organization for Economic
Cooperation and Development downgraded its economic forecasts for the
United States, the Eurozone and Japan for the first half of 2008.12
Because debt instruments backed by suprime mortgages
were purchased worldwide, the International Monetary Fund (IMF) "says
that worldwide losses stemming from the USA subprime mortgage crisis
could run to $945 billion."13
The crisis has cast doubt on the legacy of Alan
Greenspan, the Chairman of the Federal Reserve System from 1986 to
January 2006. Greenspan has remarked that there is a one-in-three
chance of recession from the fallout. When asked to comment on the
crisis, Greenspan spoke as follows:
"The
current credit crisis will come to an end when the overhang of
inventories of newly built homes is largely liquidated, and home
price deflation comes to an end. That will stabilize the
now-uncertain value of the home equity that acts as a buffer for all
home mortgages, but most importantly for those held as collateral for
residential mortgage-backed securities. Very large losses will, no
doubt, be taken as a consequence of the crisis. But after a period of
protracted adjustment, the U.S. economy, and the world economy more
generally, will be able to get back to business." 14
Impact
on Indian economy
India’s
economy has been one of the stars of global economics in recent
years, growing 9.2% in 2007 and 9.6% in 2006. Growth had been
supported by markets reforms, huge inflows of FDI, rising foreign
exchange reserves, both an IT and real estate boom, and a flourishing
capital market.
Like
most of the world, however, India is facing testing economic times in
2008. The Reserve Bank of India had set an inflation target of 4%,
but currently it is little under 10%. The rising costs of oil, food
and the resources needed for India’s construction boom are all
playing a part.
The main channels through which a global credit crunch
and a recession in the US can affect India are: (i) a decline in
capital inflows and lower corporate access to credit in international
markets; (ii) slowdown in exports of goods and services from India to
the US; and (iii) remittances. The impact on Indian growth through
the first two of these channels is likely to be negative though the
structure of India's trade could mitigate the impact through trade
(explained later).
The bulk of India's remittances come from the Gulf and
are therefore unlikely to be impacted, significantly. Compensating
effects from increasing government expenditure, budget boosts for
consumption, infrastructure and investment spending may still keep
the aggregate demand side of the story intact, though there are signs
even here of credit growth and investment spending slowing down.
Capital inflows/Access to credit: India has never
raised a sovereign bond in global capital markets, so any effect of a
credit shortfall will be on the ability of Indian corporate to access
overseas capital and through capital inflows. India received $99
billion (approximately 10% of GDP) in net foreign exchange flows in
2007-08 including net FDI ($11 billion), portfolio flows ($41
billion), ECBs and overseas borrowings by Indian corporates ($33
billion), banking capital ($7.5 billion).
As the sub prime crisis unfolds, counterparty risk
aversion has become acute and has led to financial institutions
building up significant liquid assets as precautionary measures,
sometimes equivalent to 20-25% of their balance sheets. This has
resulted in banks cutting lending and shifting out of exposures to
corporate, a reversal of portfolio flows away from emerging markets
(including India), and widening spreads on emerging market paper
(including Indian paper). These developments will slow down capital
inflows into India, with estimates for 2008-09 ranging between $40
and $50 billion. The recent drop in the Indian equity markets, also a
reflection of the global rise in risk aversion and reduction in
liquidity, will have a negative impact on investment and consumption.
According to market estimates reported by the BIS,
outstanding asset-backed commercial paper reached $1.5 trillion in
March 2007, of which $300 billion was based on mortgage-backed
assets. So far, the total of all write-downs and credit loss for
major banks and brokerages is approximately $200 billion but far more
is expected as other asset classes (such as Liquidity Puts, Credit
Default Swaps and Leveraged Loans) get impaired.
The total global write-downs are expected to be around
$1 trillion (IMF estimates) of which the banks have so far written
down around $200 billion. The prospect of further losses and the need
for greater reserve provisioning suggests that the supply of new
credit is likely to become increasingly restricted - with tighter
credit standards, and higher spreads. Tight market liquidity has been
further exacerbated by fears of a US recession.
Issuance by Indian companies had increased rapidly in
recent years (albeit from a small base) driven by robust domestic
economic growth and the need to fund rapid overseas expansions by
corporate India. Indian companies were active in the foreign debt
markets (both primary and syndications) for financing overseas
expenditures denominated in foreign currency, mergers and
acquisitions, and the overseas needs of their clients
(banks/financial institutions). However, given the tight liquidity in
the foreign debt market and loss of risk appetite on the part of
banks, it is becoming increasingly difficult for Indian corporate and
banks to raise foreign loans. Pricing for foreign borrowing by even
top-tier Indian borrowers (e.g., Tata Motors, Reliance, ICICI, Exim)
has increased significantly since the beginning of January 2008.
Very little foreign borrowing by Indian companies has
been done in the last few months because of ECB restrictions (the
interest rate cap in some cases is lower than the applicable market
spread), other than offshore M&A transactions. A prolonged period
of inability to access international bond markets for private Indian
companies, coupled with increasing spreads in the domestic market is
likely to lower investment and growth.
The big question that arises is how a major correction
in the international capital markets, the "flight to quality,"
and lower risk appetite of financial institutions and international
institutional investors will impact India's ability to finance its
large infrastructure needs. Given that credit growth has not been
responsive to liquidity injecting measures by central banks (the Fed
has cut rates by 225 bps since January 22 2008), it would be
reasonable to assume that the supply of long-term financing for
infrastructure projects world-wide will reduce over the next 12-24
months, while spreads will increase. The need, therefore, for
developing the local long-term debt market has assumed even higher
urgency.
Trade: On the trade front, the impact of a
slowdown in US economic growth is likely to be less significant
because of the structure of India's trade and the declining
importance of the US as a trading partner. A possible favourable
consequence of lower US demand for commodities such as oil and food
grains could be a lowering of their prices, which have been surging
lately (India is a net importer of these commodities). The downside
will come from a decline in demand for Indian exports, mainly IT (the
US accounts for nearly 65% of the revenues of IT vendors) and BPO
services. However, the bigger picture shows that India's overall
exposure to the US market is limited and declining. However, the
impact of the US slowdown could be felt through Europe, which is also
likely to slowdown. In sum, the expected impact of a global credit
crunch and slowdown in the US economy on India appears to be
relatively small through the trade channel, as exports are
diversified; the financial channel effects are likely to be more
significant through a reduction in capital inflows - in the event
that lower global interest rates do not lead to more credit becoming
available and banks continue to pull back lending (to counter
illiquidity) and shift out of exposures to corporates - globally and
in India - to safer assets.
India has to compete ever harder in the global energy
market in particular and has not been as adept at securing new fossil
fuel sources as the Chinese. The Indian Government is looking at
alternatives, and has signed a wide-ranging nuclear treaty with the
US, in part to gain access to nuclear power plant technology that can
reduce its oil thirst.
As
part of the fight against inflation a tighter monetary policy is
being followed, but this slowed the growth of the Indian economy
still further, as domestic demand is dampening. external demand is
also slowing, further adding to the downside risks.
The
Indian stock market has fallen more than 60% in six months from its
January 2008 high. Over $8b of foreign funds have flown out of the
country in this period, reacting both to slowing economic growth and
perceptions that the market was over-valued.
It is not all doom
and gloom, however.
The
Indian government certainly hopes that is the case. It views
investment in the creaking infrastructure of the country as being a
key requirement, and has ear-marked 23.8 trillion rupees,
approximately $559 billion, for infrastructure upgrades during the
11th five year plan. It expects to fund 70% of project costs, with
the other 30% being supplied by the private sector. Ports, airports,
roads and railways are all seen as vital for the Indian Economy and
have been targeted for investment.
Further
hope comes from the confidence of India’s home bred companies.
As well as taking over the domestic reins, where they now account for
most of the economic activity, they are also increasingly expanding
abroad. India has contributed more new members to the Forbes Global
2000 than any other country in the last four years.
India’s strengths
There has been a significant and
positive change in the way India has been managing its external
sector with respect to changes in the global scenario. Appropriate
exchange rate methods and good external debt management are some of
the positive traits of the Indian economy. New policies and mature
governance has helped India face numerous global crises and yet
maintain an enviable growth rate.
However hard Indian banks deny the damage, they have
indirectly hinted at cutting RBI’s (Reserve Bank of India)
lending rate to save them. The banking sector in India is very
well regulated and do not practice subprime lending, but the funds
soared mainly because of two things, FDI volume (Foreign Direct
Investments) that shrunk and the market panic. Listening to the
bank’s plea, the repo rate (as it is referred to) has been
reduced by RBI from 9% in August to current 7.75%. We hope that it
would maintain a healthy liquidity in the market!
Experts say that so far the industry was in the denial
mode, but 2009 will not be that easy. Automotive industry, the key
economic contributor has faced severe damages in the mayhem. Adding
to the woes are manufacturing and commodity markets. Factors
contributing to it are lesser consumer spending and cash-strapped
banks. Indian industry, too has so far been reluctant, even though
the current crisis has affected most of the blue chip companies.
Realty industry is by far the worst hit, partly also due to
high interest rates around 12% on the home loans. IT companies have
started to feel the heat, but are bullish on their growth plans next
year.
The story is not over yet! There are a few solutions to
avoid the spiralling financial disaster. An increased government
intervention looks inevitable. American government has already
acquired significant shares in ailing banks. Europe is imitating as
well. In India, PSUs play important role in driving the country’s
economy and are expected to do so in this turbulent time. But with
election to several state assemblies already on which are to be
followed by election for the Lok Sabha a significant amount of liquid
cash is expected to flow into the economy and therefore inflation
control may indeed prove to be difficult.
Impact on China
In amongst all of the turmoil surrounding Lehman
Brothers, Merrill Lynch and the Fannie and Freddie twins, there has
been little discussion of the impact of subprime and broader US
economic woes in the Chinese economy. It is common knowledge
today that the Chinese economy is growing at extreme speeds, and that
it is driven by a booming manufacturing sector. But what about
financial markets? What about the Chinese equivalents of the
financial providers that are experiencing so much hardship in the US
and Europe?
Some experts believe that with only 0.09% of their
assets in the subprime market, China is effectively far removed from
the turmoil across the Pacific. In order to keep their economy
stable, China's banks are more heavily invested in US government
bonds, which tend to perform better in times such as these.What's
more, China's largest bank, Industrial & Commercial Bank of China
(ICBC) announced profits of US$9.4 billion for first 6 months of
2008, and has assets amounting to around US$1.4 trillion. The
Commercial Banks industry is expected to show growth of 'only' 4.5%
in 2008, interrupting a long streak of double digit growth, a trend
that will continue from 2009 until the foreseeable future.
Similarly, but more spectacularly, China's Securities
Investment industry is set to grow by 25.6% in 2008 and 35.4% in
2009, shrugging off any concerns about a global downturn, and taking
investment money that is being directed away from riskier US options.
While this does not quite compare to the astonishing 221.5% growth
the industry had in 2006, it is still rock-solid performance in a
nervous international market.
All in all, according to these experts, there are few
indications that China's financial institutions will suffer any
serious or long-lasting effects from the current turmoil taking place
on Wall Street, and may well be the source of any potential recovery.
However, according to Charles Freeman of Center for
Strategic and International Studies, the above assessment may not be
altogether correct. He believes that Chinese banks are significantly
less transparent in reporting their holdings than many international
counterparts. He says that it came as a surprise to many when on
January 21 the Bank of China announced holdings of some $8 billion of
subprime loans, of which it planned to write down 25 percent.
According to Freeman, other Chinese banks are in the process of
writing down their holdings, which may be less in aggregate but will
still be significant. These are significant losses that the banks can
almost certainly tolerate but which point out an overall lack of
transparency and accountability in the Chinese financial system,
which should worry both international investors and Chinese
regulators.
More fundamentally, the dramatic drop in share prices in
Chinese and other Asian markets in response to that in the U.S.
markets suggests that the Chinese economy is not as “decoupled”
from the U.S. economy as some economists have argued. In recent
years, as Europe has passed the United States as China’s
largest export market and Latin America has increased in importance
as a market for China, a number of experts have suggested a softening
of the U.S. economy will not have a dramatic impact on China.
Impact on Asia15
Earlier this year most businessmen and investors hoped
that Asia’s emerging economies could withstand the economic and
financial turmoil in the developed world. Now, however, stockmarkets
seem to be betting on a rerun of Asia’s deep recession after
its own crisis in 1997-98. Share prices in the region have plunged by
an average of two-thirds (in dollar terms) from their peak in
2007—almost as much as they fell during the Asian financial
crisis. Is Asia really heading for such a painful economic slump?
The latest figures are certainly worrying. Japan is now
in recession. China’s economy is slowing much more sharply than
expected, with the 12-month growth in its industrial production
falling from 18% to 8% over the past year. Indian spending is being
squeezed by the credit crunch: commercial-vehicle sales fell by 36%
in the year to October. Hong Kong and Singapore are already in
recession, with GDP having fallen for two consecutive quarters.
Asia is more reliant on exports than is any other
region, so it is bound to be hurt by the rich world’s worst
recession since the 1930s. China’s exports have so far held up
surprisingly well, growing by 19% in the 12 months to October. South
Korea’s have increased by 10%. But in Singapore and Taiwan
exports have plunged this year. An Indian official has said that
exports in October were 15% lower than a year ago.
Asia’s foreign sales are being choked by the
global credit squeeze as well as weak demand. Cargoes pile up on the
dockside and ships wait empty because exporters cannot get letters of
credit to secure payment on delivery. Robert Subbaraman, an economist
at Nomura in Hong Kong, reckons that over the next year exports from
Asia (excluding Japan) could fall by 20%—roughly the same drop
as during the 2001 dotcom crash. Weaker exports will dent investment
and consumer spending. Yet Mr Subbaraman reckons emerging Asia as a
whole will see GDP growth of 5.6% in 2009. That would be well down on
the 9% seen in 2007 and perhaps 7% this year, but it would be
slightly faster than during the 2001 downturn and much stronger than
the 2% average growth in 1998.
In 1998 Hong Kong, Indonesia, Malaysia, South Korea and
Thailand all suffered slumps in GDP of more than 6%. Even the
gloomiest forecasters do not expect anything so dire this time. A
few, such as JPMorgan, expect GDP to decline next year in Hong Kong,
and Hong Kong’s chief executive, Donald Tsang, expects growth
to be flat or negative in all the region’s “mature”
economies, including his own and Singapore. But everywhere else
should see positive growth (see chart), and generally remain stronger
than during the 2001 dotcom crash. Only Taiwan is likely to have a
worse year in 2009 than in 1998.
Mr Subbaraman also believes that Asia will
recover sooner than other parts of the world, because most
governments have ample room to ease policy and their economies are in
better shape than those elsewhere. China, India, South Korea,
Singapore, Taiwan and Hong Kong have all cut interest rates in the
past two months. Falling energy and food prices will push inflation
lower, and so allow further rate cuts.
All the main Asian emerging economies, apart from
India’s, have public debt-to-GDP ratios well below the average
in rich economies, giving them room to boost public spending or cut
taxes in order to spur domestic demand. China, Malaysia, South Korea,
Taiwan and Thailand have already announced fiscal stimuli. Singapore
is expected to fire its hefty fiscal ammunition soon. Hong Kong’s
Mr Tsang is “up to his eyeballs in contingency plans”.
In contrast to the late 1990s, most Asian economies are
in relatively good shape, if not Pakistan’s. Elsewhere,
foreign-exchange reserves exceed short-term foreign debts. Almost all
the region’s countries have current-account surpluses, though
India and South Korea have deficits, which explains why they have
seen large currency depreciations this year.
Most Asian households and companies are also modest
borrowers. The black sheep is South Korea, where households and firms
are even more indebted than in America. But total domestic debt
(private and public) fell to 143% of GDP in emerging Asia in 2007,
compared with 251% of GDP in America. As its exports stumble, Asia
faces a nasty cyclical downturn. But it is spared the deep structural
problems, such as excessive debt, which could depress growth
elsewhere for several years.
Tortoise
or tiger?
All the Asian economies will slow sharply next year, but
some more than others. As the most open economies that are also big
financial centres, Singapore and Hong Kong have been hit hardest.
India is the least dependent on exports, at only 22% of its GDP,
compared with a regional average of over half. So, in theory, it
should be the least affected by the global slump. But India has two
disadvantages. First, it is more exposed to the global credit crunch
as a result of its previous reliance on large capital inflows. The
sudden reversal of capital has sharply increased the cost of
borrowing, forcing firms to cut investment—an important driver
of growth in recent years. The Reserve Bank of India has cut interest
rates and pumped liquidity into the banking system, but borrowing
rates remain high.
A second problem is that, unlike China, the Indian
government has little room for a fiscal stimulus. Its budget deficit
is running at an estimated 8% of GDP (including off-budget items).
Whereas China is boosting infrastructure spending to prop up demand,
India’s plans to build roads and power plants with the help of
private money may be delayed by the credit squeeze. The finance
minister, Palaniappan Chidambaram, declared this week that growth
will “bounce back” to 9% next year. Many economists
reckon it is likely to be closer to 6%, while China’s slows to
8%.
Among the South-East Asian economies, Indonesia seems to
be holding up best, with GDP up by 6.1% in the year to the third
quarter. As a big exporter of commodities it will be squeezed by
falling prices. But Malaysia, which is much more dependent on foreign
demand, will be hit harder. Its exports are equivalent to over 100%
of its GDP—proportionally, more than three times bigger than
Indonesia’s. Thailand, where Asia’s financial crisis
began in 1997, has learnt its lesson the hard way. Its
foreign-exchange reserves are now four times as large as its
short-term foreign debt, and it has a current-account surplus. It is
not about to suffer another crisis. But as exports fall, business and
consumer confidence remain depressed by political uncertainty.
Thailand will remain one of Asia’s slowcoaches.
On the surface, the massive debts of South Korea’s
households and firms might suggest serious trouble ahead. However,
the government has been quick to bail out its banking system, and
most economists reckon that a large fiscal boost and the cheaper won
(down by 29% this year) will help to cushion the economy, resulting
in modest growth, of around 3% next year.
In contrast, Taiwan is already in recession. Its GDP
fell by 1% in the year to the third quarter, dragged down both by a
collapse in exports and by weak domestic demand. Some economists
forecast growth of only 1% next year. To lift consumer demand, the
government this week said that it would give everybody NT$3,600
($108) in shopping vouchers to spend in shops and restaurants.
Such measures are a far cry from 1997, when rather than
urging households to spend, governments in Asia begged them to hand
over their gold jewellery to be melted down to bolster official
reserves. Times have changed. Asia is certainly not immune to the
rich world’s recession, nor will its economies quickly regain
their previous rapid growth trajectory. But the current gloom and
doom among investors in the region might yet prove overdone.
Impact on Aviation
The most immediate concern is aircraft financing, which
already had gone through waves of uncertainty after the subprime
mortgage debacle emerged in mid-2007. Industry lenders say that while
deals are still getting done, airlines' access to capital is
curtailed or more expensive. the good news is that the credit crunch
is the result of the banking industry's internal problems, not a loss
of faith in the aircraft industry's fundamentals. After the 9/11
terrorist attacks "no bank was willing to touch aircraft,"
he recalls. "Today we still have a significant number of banks
participating in aircraft funding." Another plus, he says, is
that 15-20% of Boeing's sales are now financed by regional banks in
places such as China, Russia, Morocco, Egypt, South Africa and
Australia. Those institutions tend to be more conservative and are
fairly isolated from the credit crisis, he says.It remains to be seen
what will happen to one of Boeing's largest customers, aircraft
leasing giant International Lease Finance Corp. (ILFC). The U.S. has
agreed to pay $85 billion to rescue and take a controlling interest
in its parent, insurance company American International Group (AIG).
AIG is now hoping to sell off non-core assets such as ILFC to raise
cash. ILFC, which holds more than $50 billion in aircraft and
equipment assets, recently tapped its credit lines for $6.5 billion
and said the money should cover its obligations into the first
quarter of 2009.Airlines could also feel the chill of the crisis in
fewer well-heeled travelers. European carriers, for instance, have
been relying heavily on premium traffic for profits. As the crisis in
the world's financial markets unfolds, funds are starting to dry up
and are coming from fewer sources
The market is set to go through a radical change as the
number of active banks in aviation finance has shrunk to about 30,
down from 50 in the last downturn. The tightening market will
inevitably see the airframers moving again into aircraft financing,
many believe.
U.S. carriers are going deeper than expected and 33
airports around the country are expected to lose commercial service
altogether. The scale of the decline in the U.S. market is worse than
the previous schedule analysis showed, with airlines taking 265,000
flights out of operation this quarter. Capacity has dropped on both
Atlantic and Pacific routes -- two areas that had been considered
likely drivers of growth. According to the director general of the
European Regional Airlines airline bankruptcies around the world are
set to double over the winter to at least 70 for the year,
3
Lasch, Christopher. "The Culture of Consumerism".
Consumerism 1. Smithsonian Center for Education and Museum
Studies.
4
http://www.dailyreckoning.co.uk/economic-forecasts/hyman-minsky-why-is-the-economist-suddenly-popular.html
6
President's Address to the Nation September 2008,
http://www.whitehouse.gov/news/releases/2008/09/20080924-10.html
7
Ben Steverman and David Bogoslaw. "The Financial Crisis Blame
Game” – BusinessWeek;
http://www.businessweek.com/investor/content/oct2008/pi20081017_950382.htm?chan=top+news_top+news+index+-+temp_top+story
8
Ben S. Bernanke. "Financial
Markets, the Economic Outlook, and Monetary Policy";
http://www.federalreserve.gov/newsevents/speech/bernanke20080110a.htm
9
Effect on municipalities;
http://www.maximsnews.com/news20080227waterkathyschandlingfinance10802270101.htm
11
"U.S. mortgage, housing markets seen caught in 'vicious cycle'
- MarketWatch" (2008).
http://www.marketwatch.com/news/story/story.aspx?guid={F21EA14D-E00C-46C7-9291-424B724864FE}&siteid=rss
“I
Hope I’m Wrong About Rising Unemployment”;
http://www.wallstreetandtech.com/career-management/showArticle.jhtml?articleID=208700381
"Bank capital" (2008).
http://www.economist.com/finance/displaystory.cfm?story_id=10191747
"The credit crunch”;
http://www.economist.com/opinion/displaystory.cfm?story_id=10334574
15
This section is reproduced from “Sittin' on the dock of a
bay”, The Economist, November 2008,
http://www.economist.com/world/asia/displayStory.cfm?story_id=12641750&fsrc=nwlptwfree
1 comment:
Read your blog.Liked it.Here is mine,from an Austrian point of view.Kindly read and post comments.
http://www.reasonforliberty.com/government/the-cure-for-inflation.html
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