Sub Prime Crisis and its rippling effects on the global economy

Contents

About the Crisis

Impact on USA

Impact on the World

Impact on India

Conclusion: Is there light at the end of the tunnel?

About the crisisPost 2001, the US government had encouraged US banks to lend money to people, to encourage spending & investing mainly for the purpose of buying houses

These banks granted loans to large number of borrowers despite having lower income levels, unsure employment status, unscrupulous credit history, etc.

Huge number of borrowers availed of bank credit without evaluating their repayment capacities. The economy was flush with liquidity & stock markets were booming

Source: Sub Prime Crisis - Presentation by Astha - May 2008

The bubble burstA silent storm brewed in international financial markets with origins in the US housing market, which witnessed an unprecedented boom since 2001

The boom was led by rising housing prices, low interest rates & aggravated by financial innovation viz. MBS, CDO and CDS

Housing prices in USA began to drop in 2006. Rising interest rates & falling housing prices led to rise in sub prime mortgage delinquencies & resultant foreclosure

Result: The housing bubble burst in Aug 2006

Sequence of eventsSource: Sub Prime Crisis - Presentation by Astha - May 2008

Impact of Sub Prime Crisis in USAThe chart above brings out the irony and shows that underlying sub prime houses are only a small percentage of the total housing market and it was the bubble formed due to financial instruments viz. MBS, CDO and CDS, that caused the real problem

Impact of Sub Prime Crisis in USA

Initial impact was felt in March 2008, when investment bank, Bear Stearns was acquired by J.P. Morgan Chase, a commercial bank, for US$1.2 billion

September 2008, witnessed major shakeouts in the US financial sector. The drama began with Lehman Brothers declaring bankruptcy on 15 September 2008, facing a refusal by the federal government to bail it out

Washington Mutual is closed by the US government in the largest failure of a US bank. Its banking assets are sold to J.P. Morgan Chase for US$1.9 billionThe problem with investment bank balance sheets is that on the left side nothing is right and on the right side nothing is left

Impact of Sub Prime Crisis in USA

US Federal Reserve provided an emergency loan of US$85 billion to insurance major, American International Group (AIG), which will be repaid by selling off assets of AIG

Investment bank, Merill Lynch was acquired by Bank of America in September 2008 for $50 billion

US Federal Reserve granted approval to investment banks, Goldman Sachs and Morgan Stanley to convert themselves into commercial banks

US Treasury Department confirmed that both Fannie Mae and Freddie Mac, would be placed into conservatorship with the government taking over their management

Impact of Sub Prime Crisis in USA

Wachovia Corp agrees to sell most of its assets to Citigroup Inc in a deal brokered by regulators. However, Wells Fargo, a commercial bank, drafted an agreement to acquire assets of Wachovia for US$15.1 blln

The deal forced Wachovia to backtrack from the Citigroup deal worth US$2.2 billion which was backed by the US Government

US Government releases a US$700 billion bailout package for its financial industry

Dow Jones posts its largest point decline ever while the S&P 500 had its worst day since 1987 with an 8.8% dropWhat's the difference between a guy who just lost everything in Las Vegas and an Investment Banker? A tie

Domino Effect across the World

Northern Rock Bank had difficulty finding finance to keep the business going and was nationalised in February 2008

British bank Lloyds TSB Group Plc agrees to buy rival HBOS Plc, (UKs largest mortgage lender) scooping up Britain's biggest home loan lender in an all-share deal which values HBOS at over 12 billion (US$22.3 billion)

In September 2008, British bank Bradford & Bingley was nationalised by the UK government, which 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

The Dutch operations of Fortis, Europe's largest victim of the credit crisis, have been nationalised in a 16.8 billion (13 billion) deal aimed to calm investors in the troubled banking and insurance group

Germany struggled to rescue lender Hypo Real Estate (Mortgage Giant), underlining the challenge facing European leaders, who vowed to restore stability in a banking system hit by the worst crisis since the 1930s

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

Japanese financial powerhouse, Nomura Holdings Inc. bought over Lehman's franchise in Europe and Asia Pacific, including Japan and Australia

Domino Effect across the World

Credit got tighter - banks became extremely careful parting with their capital and decreased lending activities either to business houses, retail customers and even to each otherEffect on jobs Many employees lost their jobs, especially in the financial sectorWhat's the difference between a bond and a bond trader? A bond matures Domino Effect across the WorldStock markets tanked - Crisis caused panic in the financial markets and investors sold out and withdrew their money, resulting in sharp drop in stock prices

Many banks, mortgage lenders, real estate investment trusts & hedge funds suffered significant losses

Domino Effect across the WorldThe world market capitalisation has fallen by 20% since March 2007 and by 31% since December 2007. Year to date, the Indian and Chinese markets have been the worst performers amongst the larger indices

Domino Effect in IndiaFII investments increased in most of 2007 in a booming Indian economy, as the Sensex was on its way to a historic peak of over 20,000 pointsSince the inflow of dollars in the Indian economy increased, the dollar exchange rate decreasedIn 2008, however, due to the effect of the sub prime crisis, FIIs liquidated their equity investments in a big way leading to a crash in the stock marketsSimultaneously international commodity prices, including oil prices, were on a rise due increasing demand for these commoditiesThe combined effect resulted in an increase in the dollar exchange rate

Is there light at the end of the tunnel?There are factors that indicate that there may be more trouble left in American equity markets viz. USA has a low private savings rate and a negative household savings rate, in addition to a large current account deficit and a currency that needs to depreciate further to reduce this gap

There is also a severe financial crisis affecting all sectors of the economy. It does not seem likely the trouble has ended just yet

However, Warren Buffett may have started to see some light and has invested $5bn in thepreference shares (attached with equity warrants) of Goldman Sachs and $3bn in the preference shares of General Electric

Commodity prices (and hence inflation) are falling sharply and this will bring relief to the world and make a stronger case for lower interest rates. This also mitigates the impact of higher interest rates warranted by rising fiscal deficits of the governments being created to bail out/ takeover financial institutions

Is there light at the end of the tunnel?After an extended debate the US legislators have thought it fit, probably even profitable, to create a bailout fund of US$700bn. This has been widely endorsed by most while some still feel the amount to be grossly inadequate

Central Banks around the world are putting up a concerted effort to provide liquidity to the globe by extending lines and cutting rates. This cannot but have a stemming effect

The worlds Wealth is estimated at US$150 trillion, a lot of which was built in the last 3 years. Some of the current losses in stocks and wealth is of course very painful but in the long term may prove to be just a bad dream that led to some much needed reform and changes in global leadership, a nightmare which looks like it shall last a while

Never before have housing, banks, hedge funds, insurance companies, commodities and currencies got so badly intertwined. Untangling them will take sometime. When done, this will create a new world order

Some quotes on the crisisWe were at the brink of something that would have made anything that's happened in financial history look pale. We were very, very close to a system that was totally dysfunctional and would have not only gummed up the financial markets but gummed up the economy in a way that would take us years and years to repair Warren Buffet

There could be a lot more bank closures in the coming months which could create significant investment opportunities. As many as thousand banks could go belly up Wilbur Ross

It is quite likely that the current synchronized global economic boom and the universal, all encompassing asset bubble will lead to a colossal bust Dr. Marc Faber

The money markets have completely broken down, with no trading taking place at all. There is no market any more. Central banks are the only providers of cash to the market, no one else is lending Christopher Reiger (Dresdner Kleinwort)Info.anup@gmail.com