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The Subprime Crisis

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List of contents1. What is the subprime crisis?

2. Diff between Prime & Subprime3. Characteristics of the subprime boom4. Financial engineering that facilitated subprime

crisis

5. Assumptions that turned wrong6. Fallouts7. Impact-US & Global8. What is the scenario now?

9. Who will provide the solutions?10.Impact on India11.Is it likely to occur in India?12.Learning lessons for India

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1. What is the subprime crisis? In a nutshell, the US subprime

mortgage crisis has been explained bythe mainstream media as a situationwhereby banks offer subprime loansto people with risky credit ratings.

As these people began to default ontheir repayments, it led to a wave of

repossessions and bank losses; andhenceforth, the crisis.

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Difference between

Prime & Subprime?

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Borrow

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Tarnished credit records Low Credit scoring

Pay Higher Mortgage Rates

Sub-Prime Mortgage

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Characteristics of the subprime boom Post 9/11/01 low interest rates and

product innovation Capital from Wall Street irrational

exuberance and financial

engineering Underwriting standards relaxed as

means of expanding market share

Risk layering and failure of riskassessment

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No true legal definition, more of term of

art based on channel of lending Higher-cost credit made available to

borrowers with impaired or thin creditor other unique circumstances

Made possible by credit scoring,automation and secondary markets

Traditionally came from financecompanies such as Freddie Mac andFannie Mae

Characteristics of the subprime boom

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Financial engineering that facilitated

subprime crisis

Mortgage assets grew at incredible pace,

and Wall Street found new ways to offerpiece of the action to investors

Investment banks captured fee income at

many stages Derivatives and derivatives of derivatives

Many of the sophisticated products

based on same models

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Assumptions that turned wrong

Risk-based pricing of subprime loans

and of financial instruments backed byloans

Continued low-rate environment andhome price appreciation continue to rise

Borrowers would be able to refinance orsell their way out

Healthy economy and continueddemand worldwide for RMBS and relatedassets

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Fallouts

Citi posted its largest $18 billion loss of

its 196 years of history recently. Merrill Lynch posted a whooping $9.8

billion fourth-quarter loss and $16.7

billion of write-downs on mortgage-related investments and leveraged loans.

UBS also wrote down $14.7 billion last

year due to its U.S. subprime mortgages.

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Impact-US & Global

Stricter underwriting practices, meaning

fewer loans will be made to consumers,others

As less credit is now available for

refinancing, consumers squeezedfinancially, not just on mortgage loans

Centered on subprime market

performance on prime/conventionalmarket still good by historic measures

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Impact-US & Global Rating agency downgrades

Many of wholesale originatorseither bankrupt or out of business

Subprime loans (funding) muchharder to get privatesecuritizations have ceased

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Impact-US & Global

A very long and deep US recession ispossible

Extent of damage depends on how farhouse prices fall

If they fall a further 30-40 per cent,

losses in the financial system could beanywhere between $1,000bn and$3,000bn. The latter would de-capitalise

the US banking system Similar points of weakness can be seen

in housing markets and financial

systems elsewhere

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Impact-US & Global

The crisis signals a re-rating of risk.

It also represents a move towards

holding more transparent and liquidassets.

This correction has been selective,

however. It is a striking feature of what has

happened that emerging markets have

emerged as a safe haven. For emerging economies, this must be

sweet revenge.

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Impact-US & Global

Has opened up big questions aboutthe roles of central banks

How far, for example, do theresponsibilities of central banks aslender-of-last-resort during crises

stretch? Should they, as some argue, be market-

makers-of-last resort in credit markets?

What, more precisely, should a centralbank do when liquidity dries up inimportant markets?

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Impact-US & Global

Has exposed the loopholes insecuritised lending

The argument in favour of securitisedlending was that it would shift the risk ofterm-transformation (borrowing short tolend long) out of the banking system ontothose best able to bear it.

What happened, instead, was the shiftingof the risk on to the shoulders of thoseleast able to understand it.

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Impact-US & Global

Has exposed the loopholes insecuritised lending (Contd.)

What also occurred was a multiplicationof leverage and term-transformation, notleast through the banks specialinvestment vehicles.

What we see today, as a result, is a rapidshrinkage of markets in asset-backedpaper.

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What is the scenario now? End 2008, havent hit bottom yet

Financial institutions still strugglingwith valuation of assets

Full extent of potential losses not

known, particularly counterparty risk incredit default swaps ($41 Trillion)

Worldwide liquidity crisis keyed to

realization that market overheated

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What is the scenario now?

Downgrades continuing

Defaults and foreclosures are climbingstill

Media feeding frenzy and the search for

blame Reaching the third phase of any

economic cycle, i.e. (1) Boom, (2) Bust,

(3) Recrimination

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What is the scenario now?

Home price appreciation has

become depreciation in manymarkets

Increasing inventory of unsold

homes the pocketphenomenon

Non-bank originators continuingto shut down or be sold

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Who will provide the solutions?

Legislation Federal & State

Regulation Federal BankingAgencies

Market-Based Solutions

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Legislations Comprehensive reform bills from US

Congress Frank bill; Dodd bill Regulation of underwriting, loan terms,

loan originators wont let this happen

again Stricter monitoring of loan modifications,

foreclosures Rep. Frank, others

Economic stimulus package may containmortgage-related relief

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Market based solutions Loan modification and workout

programs being implemented byindustry participants

Emerging community-basedassistance programs (banks may

be expected to help)

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Impact on India: BANKING Indian banking system has

remained fairly insulated from anydirect impact

This is because the Indian banks

did not have significant exposureto subprime loans in the US.

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Impact on India: CAPITAL MARKETS

Indian capital markets are

experiencing the echo There was a major impact on the

equity markets as many foreigninstitutional investors (FIIs) sold offtheir investments into Indian

companies to cover their hugelosses.

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Impact on India: CAPITAL MARKETS

The FIIs have and, as of date, are

continuing to withdraw money fromthe equity markets.

Going forward, any subprimerelated tremors in the globalmarkets are likely to cause further

chaos in the Indian equity marketsas well.

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Unlikely given the current state of

affairs Despite rapid growth in recent

years, the mortgage market in India

is nowhere near the levels ofdeveloped countries, such as theUS or the UK.

Is it likely to occur in India?

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Mortgages as a percentage of GDP in

India are still at a small % ascompared with the US and the UK.

The approach of the Indian regulators

has been balanced and forward-looking. Its continuous doses ofmonetary tightening aims to ensurethat the money supply (and henceinflation) is kept within manageablelimits.

Is it likely to occur in India?

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Learning lessons for India-1

Utmost need to strengthen thesystem for assessment of theborrowers credit worthiness

The regulator must ensure thatbanks do not follow imprudent andpredatory lending practices byoffering far too lenient lendingterms than are warranted for.

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Learning lessons for India-2

Banks need to make sure that they

share the credit history ofborrowers to better assess thecredit worthiness of borrowers.

Encourage wider use of theservices of the credit information

bureau (CIB).

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Learning lessons for India-3 Rating models should be

revamped to take into accountnewer risk implications arisingfrom newer mortgage structures,

such as the option adjustable ratemortgage, which is prone topayment shocks.

Credit rating agencies required tomodify their rating methodologies

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Learning lessons for India-4

Financial institutions must carry out

proper due diligence of securitiesand borrowers, besides relying oncredit ratings.

Financial institutions need tostrengthen their risk managementframework in view of increasing

complexities in products/services,and customers requirements.