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Following the dot-com boom bubble burst and the stock market
crash in 2000, the US economy went to recession in 2001. The tragic
event of September 11, 2001 further boosted the market decline. As a
result of this downturn in US economy the Federal Reserve reduced the
federal fund rate in order to stimulate demand. Credit was made
available to the people on a large scale at that time however they did
not realize at that time the consequences of such a monetary
expansion. The lower interest rates increased demand for housing and
big ticket items. People were able to take loans from banks at very low
rates of interests.
Because of this monetary measure in 2001 the demand for the
commodities increased right from 2001 to 2006 but the supply did not
increase proportionately, because of this the excess demand was
immediately passed on to the prices and there was an increase in the
general level of prices (or increase in inflation). In order to counter
inflation the FED raised short term interest rates. During the period of
2001 when loans were available at low rates, the banks gave loans to
people who were deemed subprime or under banked. ”subprime
lending” is a term that has been popularized by the media during the
credit crunch of 2007 and involves financial institutions providing credit
to borrowers deemed "subprime. Subprime borrowers have a
heightened perceived risk of default, such as those who have a history
of loan delinquency or default, those with a recorded bankruptcy, or
those with limited debt experience. In the US borrowers are deemed
as subprime when their FICO score (creditworthiness) is below 660.
These subprime borrowers started defaulting on their loans on a very
large scale
As a result, the banks started to foreclose (law to take possession of
property bought with borrowed money because repayment has not
been made) on the mortgage-defaulted homes. Most foreclosed homes
were worth less than their loans’ balance when their prices fell. For
that reason the banks had to short sell them. That means the banks
sold the houses for less than their loans’ principals and took the
losses.
Prior to the first decade of the 21st century, it was customary for a
U.S. bank to exercise due diligence (an investigation into the
applicant's history) when considering lending money for a mortgage.
Banks wanted to know all about an applicant's financial stability --
income, debt, credit rating -- and they wanted it verified. This changed
after the mortgage-backed security (MBS) was introduced. At this
situation the problem was that all the good quality customers already
owned homes and they dried up. So banks turned to customers they
had traditionally shunned i.e. they turned to subprime borrowers.
This would be the first domino in an effect that spread throughout the
U.S economy.
Because of all this chaos that was unfolding in the market. One effect
led to another. Now the next impact would affect the home builders.
Since the rate of foreclosures increased there were homes that were
available for people to purchase at deeply discounted prices. Now the
new homes that were coming up found no buyers. Since there was a
demand supply mismatch, Supply was increasing and the demand for
homes was not increasing proportionately. The presence of more
homes on the market brought down housing prices. Since MBS’ were
purchased and sold as investments, defaulted mortgages turned up in
all corners of the market. The change in performance of MBS’ took
place rapidly, and as a result, most of the biggest institutions were
laden with the securities when they went south. The portfolios of huge
investment banks, lousy with mortgage-backed securities, found their
net worth sink as the MBS’ began to lose value. This was the case with
Bear Stearns. The giant investment bank's worth sank enough that it
was purchased in March 2008 by competitor JP Morgan for $2 per
share. Seven days before the buyout, Bear Stearns shares traded at
$70.
This vicious cycle went on and on because these are illiquid markets,
lightly regulated than even casinos in Vegas and so all the mess.
This chart shows that higher the credit rating , lower is the default risk and lower is
the expected return and vice versa
Why did Lehman bros one of the top investment banks in the
world file for bankruptcy?
-Lehman Brothers had asset to equity leverage of about 30 that means
only 3.3% decline on its securities holding would wipe out its entire
capital and make it insolvent.
This investment bank had high leverage positions in mortgage back
securities and hence lost the most.
Lehman shares tumbled over 90% on September 15, 2008. The Dow
Jones closed down just over 500 points on September 15, 2008, which
was at the time the largest drop in a single day since the days
following the attacks on September 11 2001.
MBS’ and CDO’ are just the tip of the iceberg. The real crisis happened
in this 62 trillion dollar market.
Given the CDS' role in this mess, it's likely that the federal government
will start regulating them. But again I feel if you regulate it the
financial gurus will come up with something new that would get around
the regulations. Credit default swaps have been dramatically misused.
Warren buffet called this derivative instrument as "financial weapons of
mass destruction."
I feel that it is a very effective tool and shouldn’t be done away with
completely.
Composition of the United States 15.5 trillion US dollar CDS market at
the end of 2008 Q2. Green tints show Prime asset CDS’, reddish tints
show sub-prime asset CDS’. Numbers followed by "Y" indicate years
until maturity.
22nd June 2007 – Bear Sterns pledges up to 3.2 billion dollars in loans
to bail out one of its hedge funds which was collapsing because of bad
bets on subprime mortgages; it is the biggest rescue of a fund since
LTCM (long term capital management).
9th August 2007 – Bnp Paribas a French bank suspends 3 of its funds
because of exposure to US mortgages.
30th October 2007 – Merrill Lynch head Stanley O’Neal resigns after
an 8.4 billion dollar write-down by Merrill.
16th September 2008 - AIG was rescued by the Federal Reserve with
an 85 billion dollar bailout package.
As you know, when asset prices are rising, this system works
like a dream, but lets look at what happens when asset prices (in this
case – houses) move downward.
In scenario #1 above, if the price of the house decreases by $30,000,
as long as you don't sell, there are no problems because you have no
leveraged debt. In scenario #3 above – maximum leverage, if the
price of the house decreases by $30,000, here's what potentially
happens:
- Let's assume the bank that lent you the $99,000 decides that the
collateral (the value of the house) is no longer sufficient to cover the
loan. They may ask you to come up with the difference between the
current value of the home ($70,000) and the outstanding debt
($99,000). In order to protect the banks interests, they will want you
to come up with $29,000.
- Now you have two options. First, you can give the bank the $29,000.
But you probably didn't have it in the first place, so this is probably not
a realistic option. Secondly, you could refinance your mortgage with
another bank. But this probably won't work because you already have
$29,000 of negative equity. All banks are going to be reluctant to give
you money without collateral.
- So you most likely lose the house to foreclosure. This is exactly what
is happening to a number of homeowners today.
CREDIT CRUNCH
A credit crunch is a sudden reduction in the general availability of
loans (or credit), or a sudden increase in the cost of obtaining loans
from banks. A credit crunch is often caused by a sustained period of
careless and inappropriate lending which results in losses for lending
institutions and investors in debt when the loans turn sour and the full
extent of bad debts becomes known. These institutions may then
reduce the availability of credit, and increase the cost of accessing
credit by raising interest rates. In some cases lenders may be unable
to lend further, even if they wish, as a result of earlier losses. A credit
crunch makes it nearly impossible for companies to borrow because
lenders are scared of bankruptcies or defaults, which results in higher
rates. The consequence is a prolonged recession (or slower recovery),
which occurs as a result of the shrinking credit supply.
When lending institutions have suffered losses from previous
loans, they are generally unwilling or unable to lend. This occurs when
borrowers default and the properties underlying a defaulted loan
decline in value. In this situation, as borrowers default,
banks foreclose on the mortgages and attempt to sell these properties
to regain the funds they loaned out. Consequently, if home prices fall,
the bank is left selling at a loss. Because banks are required to retain
minimum levels of liquidity (capital), when they suffer losses, their
capital positions are reduced, which reduces the amount they are
able to lend out.
Overall, a credit crunch can do a lot of damage to the economy by
stifling economic growth through decreased capital liquidity and the
reduced ability to borrow. Many companies need to borrow money
from lending institutions to finance and/or expand operations; without
this ability, expansion is not possible and in some cases, companies
will need to cease operations. When coupled with a recession, a credit
crunch can often lead to many corporate bankruptcies.
So here we are today , with the US economy going into recession , and
subsequently the world is feeling the effects of this financial tsunami ,
so is there a way out of this crisis , when will the world economy again
bounce back and start growing ?
1. The central banks around the world should cut key interest rates
which can stimulate growth.
2> The Fed has purchased stocks of banks and thus shown the public
in the US that they are confident in the banking system of the nation
thus stemming the confidence crisis (to some extent)
3> Australian central bank have assured the Australian public that
their deposits are safe and have guaranteed to return the deposits
back to the public along with the interest if the banks fail .
4> Short selling has been banned (temporarily) by most of the
developed countries.
5> the root of this problem subprime lending should come under
regulation. Careless lending activities by banks which led to this
financial crisis should be regulated.
6>Credit default swaps –this 62 trillion dollar market should be
regulated.
7> RBI has been cutting key rates such as repo rate, reverse repo
rate; cash reserve ratio, and statutory liquidity ratio in order to infuse
more liquidity into the markets.
8> the three month LIBOR (London interbank offered rate) which had
crossed 6 % needs to come down to 4.6 % which is its traditional
level. Bank of England has taken various measures and the rate is
coming down slowly (which is a sign that the markets have been
stabilizing). Libor is extremely important because, it influences the
level at which lenders set rates on loans, especially mortgages, to
consumers. It also impacts on the amounts they will lend. It is the rate
at which banks lend to each other and is therefore a measure of how
much they trust each other and a measure of the credit crunch.
The current LIBOR as on 3rd November is 5.77%
9> Oil is now hovering at around 60 $ per barrel because of concerns
of a global slowdown. Oil easing down is helping inflation to come
down as well.
10>Prices of commodities have started to come down because of
concerns of a global slowdown.
11> Fii’s pulling money out of the Indian market have led to the rupee
weakening. In order to stop this, the regulations on participatory notes
should be eased which can again make the rupee stronger against the
greenback.