i want a detailed information about US sub-prime crisis? what it is? how does it affect indian economy?

Question

basic lesson about us sub prime crisis? how it affects indian corporation and indian economy?

Answer 1

In reply to your question, I have furnished a very authoritative article which I am sure would address your queries and concerns very satisfactorily. Some charts and graphs have been ommitted. If you are interested to view the article as it appears on the net, please click on http://www.indianmba.com/Occasional_Papers/OP155/op155.html and have a broad overview.

US Sub-Prime Mortgage Crisis: 'An Unknown Unknown'
By
Akhil Bansal
PGDM (2006-08)
Alliance Business School
Bangalore

Introduction

Sub-prime stories continue to pour in. There is gloomy forecast that the US sub-prime mortgage crisis might convert into recession that could be as great as the Great Depression of 1930's that lasted over a decade. The sub-prime crisis that started in 2004 and 2005 is extended to the current economic cycle world over.

In US, homeowners select a mortgage lender who gives the loan after inquiring the borrower's creditworthiness and the property that serves as collateral. The lenders resell these loans to investors or Wall Street firms, who in turn bundle thousands of mortgage loans from different lenders into mortgage backed securities. These securities are often sliced and diced into different structures like Collateralized Debt Obligations (CDO), rated by rating agencies like Moody's, S&P, Fitch etc. and are finally sold to institutional investors worldwide- mutual funds, banks, hedge funds, central banks and pension funds.

The US mortgage-backed securities market is the largest fixed income market in the world, with over $8 trillion outstanding followed by US treasury market with around $5 trillion outstanding.

These mortgages do not create any problem for lenders until the mortgagers fulfill their commitments in time. But with rising payment obligations, sub-prime mortgagers ran for foreclosures. Sub-prime mortgage refers to the lending by the banks and other financial institutions to borrowers with poor or no credit history or variable income flows. Borrowers with the higher-than-average risk profile because of low creditworthiness are charged a higher interest rate for loans. These loans are considered sub-prime.

The demand for housing like any other commodity is dependent on demand and supply. So, the increase in disposable income and decline in interest rates on mortgages encouraged home ownership among US consumers.
The bubble burst when the demand decreases while the supply increases.
The increase in interest rates in US makes homeownership costlier for some buyers leading to defaults and foreclosures adding to supply in the market.
Similarly a decline in the general level of economic activity in US lead to less disposable income in the hands of consumer leading to decline in demand.
According to Bryson, US sub-prime market accounts for about 20% of the total US mortgage market. The heat of sub-prime crisis is not limited to US but is faced world-over. Though, China holds more than $250 billion and Japan holds close to $200 billion of mortgage backed securities, but the worst affected nation is UK because China and Japan have very low exposure to corporate mortgage-backed-securities where sub-prime mortgage sits. UK held $44 billion in corporate MBS accounting for the bulk of its exposure to US mortgages making it most susceptible to risk after the shocks. So far, losses have been reported from France, Germany, China, Australia, Japan and U.K. in addition to US. But this is just the tip of iceberg. There are likely to be many more casualties over the next two years.

Origin: Cause of Sub-Prime Crisis
In the recent times, many sub-prime mortgages are offered at below the market rate of interest-that marks the beginning of crisis. But the seeds of the crisis were sown long back by Alan Greenspan, ex-chairman of Federal Reserve Bank. The inflationary policies of Greenspan are largely responsible for the defaults in the US housing market. His plan to pump billions of dollars in the economy via lower interest rates paved the path for the economic slowdown.

Source: Federal Reserve, Bureau of Economic Analysis
The interest rates have declined from the high of 6.5% in 2000-01 to a low of just above 1% in 2003-04 before it started moving north. US middle income class saw it as golden opportunity to expand its stagnated income. Consumers took these mortgages with the hope to re-finance them after a few years at an affordable rate of interest. These mortgages are in-turn packaged into pools and sold as high-yielding securities to the investors. Investors even started borrowing money from the market to invest in high-yielding securities. This massive borrowing spree and uncalculated investment created a bubble in the market. By the time this bubble burst, it left millions of people in hell.

Greenspan's moves were aimed at masking the economy from the piling current account deficit. According to the Bureau of Economic Analysis (BEA), current account deficit (the broadest measure of the U.S. balance of trade in goods, services, and payments to the rest of the world) stood at $835 billion in the first quarter of 2006. This burgeoning US current account is financed by capital account inflows. It means that US must attract a net capital inflow of $70 billion per month to finance the current account deficit!!!!!

But how long can US depend on China and Japan to finance its trade deficit? The trade deficit is desirable and sustainable until it leads to an increase in productivity but if the excess expenditure are used met the consumption needs of the economy, it will further create the problem of repayment. China and Japan have huge trade surplus with US. The Asian Tigers instead of ploughing back its surplus in domestic economy were purchasing T-bills to prevent depreciation of their currencies. This helps China to maintain an export-led growth strategy. China's forex reserves stood at $1.2 trillion as on 31 March 2007. US consumers maintain their level of consumption owing to cheaper imports due to overvalued currency. But at the same time, it is creating the problem of excess consumption in the domestic economy. But once the Asian Tigers and Arab countries stop investing in US T-bills, it might create the problem of financing current account deficit.
When the dollar rises in value, U.S. exports become more expensive and import prices fall. Between 1995 and 2002, the dollar gained about 30% in value. This made imports costlier for US and they delayed their consumption expenditure and put the surplus money in non-tradables and since, they are not subject to international trade, their prices shot up. Here starts the creation of bubble in the US housing market.

The excess demand in the market pushed the housing prices to new heights. Rising prices, in turn, have a substantial affect on the spending of the consumers. US consumers lured by the increasing value of their homes went on borrowing spree. They started borrowing money for consumption by mortgaging their property.

But, two events that were assumed to have a low probability in a booming market in fact happened: first, interest rates increased and second, home prices began falling. This led to sub-prime mortgages resetting at shockingly high rates, with homeowners missing payments and foreclosing accounts. As a result, financial institutions holding mortgage-backed securities incurred losses and had to sell their assets to meet margin calls.

The slides of sub-prime crisis dates back to 30 June 2004 when Federal Reserve began the cycle of interest rate hikes that increased the cost of borrowings from the lowest levels registered since 1950s. It has increased it 17 times in a row before it paused in July

Finally, crisis broke out in March 2007, when the shares in New Century Financials, one of the largest sub-prime lenders in US were suspended amid fears that the firm is heading for bankruptcy. On April 2 2007, New Century Financials filed for bankruptcy after it was forced by its backers to purchase billions of dollars of bad loans. Another US-based sub-prime firm Accredited Home Lenders Holding said it would pass on $2.7 billion of its loans at a heavy discount. GE also decided to sell its sub-prime lending arm, WMC Mortgage, a subsidiary of GE Money, it brought in 2004. Bear Stearns, a Wall Street firm and the topnotch player in mortgage-backed securities market for over a decade, had to close down two hedge funds that lost over 95% of Net Asset Value (NAV).
Possible Solution

Now, the problem is-Can US come out of the current account deficits? The answer to this question calls for radical change in the economic policies of US. To keep the trade deficit from widening further, exports must grow 55% faster than imports. But in the facet of slowdown in the US economy this growth in US export seems impeccable without depreciation of dollar.

The gradual decline in the dollar and improvement in the current account deficit would provide the best outcome for the economy. An important point that should be noted is that US accounts for 30% of the global consumption, so any decline in demand from the US economy might create global recession. The only option left for the trading partners is to come forward to help US to correct its trade deficit. According to Financial Times, "The Group of 20 leading rich and emerging market nations have agreed on a co-ordinated effort to reduce the global trade imbalances by cutting the US fiscal deficits, reforms to boost growth in Europe and Japan and increasing exchange rate flexibility in Asia". But China one of the major trading partner of US, has refused to come to the rescue of US. Though China has increased the float margin of Yuan from 0.3% to 0.5% but it laid down the US demand to make it flexible. In an interview with the Financial Times, Li Ruogu, the deputy governor of People's Bank of China, warned the US not to blame other countries for its economic problems.

A major problem surfaced post sub-prime crisis is that credit markets have stopped working normally. There is sharp increase in the short term interest rate owing to tightening liquidity position in the market as banks are setting aside cash as a precaution against further losses from their bad investments and have become far more cautious about lending. In economic terms, the crisis that evolved is liquidity crunch. The creditworthy borrowers are unable to obtain the credit and the holders of risky assets are fleeing from the market to park their funds in safer assets such as T-bills. Federal Reserve Board has finally come as the lender of last resort to the rescue of borrowers when it pumped in $24 billion and another $38 billion in the economy on August 9 and August 10, 2007. It announced 50 basis points deduction in the discount rate on August 17, 2007. The European Central Bank (ECB) has also injected $131 billion (more than double of $61 billion injected in the market post 9/11 attacks) in the market on August 9, 2007.

Despite Fed intervention, there is uncertainty in the market whether the sub-prime will become full-blown crisis. The positive is Fed and ECB had injected billions of dollars into the market to eliminate liquidity crunch. But the penultimate question is-Whether Fed will intervene to bail out faltering institutions? If it does, it may encourage irresponsible business practices but if it stays away, it might lead to economic disaster.

Indian Scenario

US economy has registered a growth of 1.9% in first quarter of 2007 against the projected rate of 2.7%. A consumption-led slowdown in US economy will have an impact on its trading partners.

Indian economy has registered a robust growth rate of 9.3% in 2006-07 and the projections for 2007-08 are quite optimistic. India's exports may record a decline if the US slows down. In 2006-07, approximately 15% of India's exports were directed to US. The negative impact of the slowdown in exports can be partly offset by export of services.

On the financial side, Indian banks and financial institutions have a very low level of exposure to US mortgage backed securities. So, it is highly unlikely that India will bear brunt of US sub-prime mortgage crisis. But the sub-prime crisis has sent the equity markets into a tailspin. Indian markets have crashed by 10.13% over the past one month (July-August) before recovering back to normal grounds. The hedge funds are winding-up their positions in the domestic market to make up their losses in US sub-prime mortgage market.

On the credit side, Indian corporates have raised about $15 billion from external sources in the first five month (Jan-May) of 2007. At the extreme, Indian corporates could face higher cost of borrowings due to increasing credit market spread. Companies would have to tap into the domestic credit market as an alternative, thereby exerting upward pressure on the interest rates. This could carve down the growth rate.

But the question arises- Is there any sub-prime market in India? Lending to real estate and construction sector has been increasing at an annualized rate of 40-50% in the last 5 years. Is Indian housing sector a replica of US real estate sector? Reserve Bank of India, in the recent times, has taken a tough stance on lending to real estate sector. It has increased the exposure limit from 100% to 150% on bank's lending to housing or real estate sector. And, given the huge demand of real estate especially from IT and retail sector, it does not seem that the Indian markets are imitating the US housing market.

It is premature to comment on the extent of these repercussions given the short life of the crisis. However, the spillover of the US financial crisis to the Indian economy may not be significant enough to overwhelm the positive economic momentum already in place.

Answer 2

The basic lesson is that people will do anything, including ignoring credit ratings and loan history for short term monitary gain from placing loans to the point that they destroy the companies they work for and the finances of the people who loan money.
In simple terms (ha!), people were convinced to borrow money to buy homes with very low beginning mortgage interest rates that would increase later and follow the market interest rates then. These loans were gathered together into packages and sold to banks, pension funds, etc., based on the value of the homes and the higher income later on. When the higher interest rates kicked, the poor people "owning" the homes could not make payments and lost their homes, which went on the market at fire sale prices. Now the packages of loans lost much of their value as housing prices dropped and loans defaulted. Firms that had put a lot their own and their client's money went down the tubes.
As for India - I have no idea. Does it sound familiar to you?

Answer 3

we live in a globalized worldwide, the place financial institutions around the globe are interconnect. it incredibly is the reason at the back of jitters in Indian financial industry the final 2 weeks or so, however India parse isn't quickly plagued by skill of the sub best disaster in US.

Answer 4

when wall street sneezes
dalal street catches pnemonia