Financial Instruments Responsible For Global Financial Crisis

The global financial crisis of 2008 is a major ongoing financial crisis, the worst of its kind since the Great Depression. In the following report I have explained how a series of events in the US resulted in the ongoing financial crisis. The financial instruments (mortgage backed securities, collateral debt obligations, credit default swaps) that resulted in the stock market crash in the US and subsequently in the rest of the world were outside the regulatory purview of the Fed. Each and every thing that happened in the US market is linked and could have been avoided.

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.

An example of a foreclosure in US which rose 55 % in 2008 HOW DID MORTGAGE BACKED SECURITIES BRING DOWN THE US ECONOMY? In 2008, the United States teetered on the brink of financial disaster. Unemployment looked to reach its highest levels in two decades. Homeowners defaulted on their loans in record numbers. Enormous investment banks that had been in business for more than a century and had endured The Great Depression faced collapse. The economy, in other words, went belly up. Every last part of this looming economic disaster was due to a unique financial instrument called the mortgagebacked security. Now what is a mortgage backed security? Let me tell this to you by giving an example. Countrywide Financial Corporation, (CFC) the Brown family and Bank of America (BOA) are the 3 parties in this example. The brown family purchases a house with a loan of $200,000. Countrywide Financial Corporation loans out the money to brown family through the Bank of America, here Countrywide Financial Corporation receives commission on the business that they gave to the

Bank of America. Countrywide Financial Corporation in itself does not fund the loan through its deposits, instead it securitize's the loan, and sells it to Wall St investors, hedge funds and commercial banks. The investors used to get dividends on mortgage backed securities in the form of monthly installments which the borrowers of loans used to give to the banks. A pooling of mortgage only related loans is called as Mortgage Backed Security akin a bond. Collalterized Debt Obligation (CDO)– this can be defined as a pooling of not only mortgage related loans but also credit card loan of family X , subprime loan of family Y and so on.

Here is a small example A CDO is bought by a bank in Norway; the bank does not know its assets. I.e. it does not know the underlying asset of the CDO. It knows the CDO is rated AAA by Moody's. Alls well until the "asset" backing the securitized product hits a wall. I.e. there may be default in interest payment by the borrower. So the bank in Norway has to write down the value of such assets which reduces their capital ratio and in turn affects their ability to give loans. One question that you might get is by packaging and selling these MBS’ and CDO’ how does CFC and BOA get affected? - One thing to note is that the deposit money that is lended out to the borrower is not of Countrywide Financial Corporation but it is of BOA. So Countrywide Financial Corporation only sells the loan to us. It acts like an intermediary. It sells the loan to us at a rate of interest which is higher than rate of interest at which BOA sells. The difference in rates of interest is CFC’s profit .CFC also gets a good commission out of the securitized product (MBS) that it sells on Wall Street. All was perfectly fine until defaults started happening and because of defaults the portfolio of securitized products of Countrywide Financial Corporation reduced in value and it had to further bear the losses of the defaults that were taking place in home loans. All this had a cascading effect and Countrywide Financial Corporation and Bank of America suffered huge losses. Home loans in 2008 were so divided and spread across the financial spectrum, it was entirely possible a given homeowner could unwittingly own shares in his or her own mortgage. A person who bought a new home in January 1996 for $155,000 could reasonably

expect to make a profit of $100,000 when selling it in August 2006. But 2008 wasn't 2006; the housing market in the United States was no longer booming. And it was the mortgage-backed security that killed it. 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. With the introduction of MBS’, lenders no longer assumed the risk of a loan default. They simply issued the loan and promptly sold it to others who ultimately took the risk if payments stopped. And since MBS’ created early on were based on mortgages granted to the more dependable prime borrowers, the securities performed well. They performed so well that investors clamored for more. In response, lenders loosened their restrictions for mortgage applicants and borrowed heavily to create cash flow for loans in order to create more mortgages. Without mortgages, after all, there are no mortgagebacked securities. Subprime mortgage-backed securities, comprised entirely from pools of loans made to subprime borrowers, were riskier, but they also offered higher dividends. In just the month of August 2008, one out of every 416 households in the United States had a new foreclosure filed against it .When borrowers stopped making payments on their mortgages, MBS’ began to perform poorly. The average collateralized debt obligation (CDO) lost about half of its value between 2006 and 2008. And since the riskiest (and highest returning) CDO’ were comprised of subprime mortgages, they became worthless after the nationwide increase in loan defaults began. 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.

CREDIT CRISIS

DEFAULT

SWAPS

-THE

NEXT

THE MONSTER THAT ATE WALL STREET How 'credit default swaps'—an insurance against bad loans—turned from a smart bet into a killer. Credit default swaps – have you ever heard of them? MBS’ and CDO’ are just the tip of the iceberg. The real crisis happened in this 62 trillion dollar market. Credit default swaps can be defined as a credit derivative or agreement between two counterparties, in which one makes periodic payments to the other and gets promise of a payoff if a third party defaults. The first party gets credit protection, a kind of insurance, and is called the "buyer." The second party gives credit protection and is called the "seller". The third party, the one that might go bankrupt or default, is known as the "reference entity." This can be explained with the help of an exampleSuppose there is Profitable Group (first party), Citibank (second party), and Toyota (third party). Toyota Company has issued bonds to the public. These bonds have been rated AAA by Moody’s and they show no signs of default at all. However Profitable Group owns bonds of Toyota and has insider knowledge that Toyota is going to get bankrupt and the bond holders will be defaulted. So what Profitable Group does is that it goes to Citibank and gets insurance on the bonds

that it holds. In doing so Citibank asks profitable group to pay quarterly/annual interest at say 5 % on the amount of the bonds that will be insured say (100000usd). So Profitable Group needs to pay 5000usd annually/quarterly to Citibank for say 5 years. In return the bonds of Toyota will be completely insured by Citibank. So in case there is a default in payment of interest by Toyota then profitable group will receive the entire amount from Citibank. And the insider knowledge does come true and Toyota goes bankrupt within a year .in such a case Citibank will have to pay 100000usd to Profitable Group. But profitable group would have already paid interest at 5 % quarterly which equals to 20,000usd. However it received a payment of 100000usd from Citibank within a year, which resulted in a profit of 80,000usd to profitable group. While a loss of 80000usd to Citibank. Citibank would have had thousands of such CDS is which they would have insured Toyota bonds. Generally CDS spreads will increase as credit-worthiness declines and decline as credit-worthiness increases. Today, the economy is teetering and Wall Street is in ruins, thanks to this derivative instrument. The country's biggest insurance company, AIG, had to be bailed out by American taxpayers after it defaulted on $14 billion worth of credit default swaps it had made to investment banks, insurance companies and scores of other entities. So much of what's gone wrong with the financial system in the past year can be traced back to credit default swaps, which ballooned into a $62 trillion market. Since credit default swaps are privately negotiated contracts between two parties and aren't regulated by the government, there's no central reporting mechanism to determine their value. And then came the housing boom. As the Federal Reserve cut interest rates and Americans started buying homes in record numbers, mortgage-backed securities became the hot new investment. Mortgages were pooled together, and sliced and diced into bonds that were bought by just about every financial institution imaginable: investment banks, commercial banks, hedge funds, pension funds. For many of those mortgage-backed securities, credit default swaps were taken out to protect against default. Soon, companies like AIG weren't just insuring houses. They were also insuring the mortgages on those houses by issuing credit default swaps. By the time AIG was bailed out, it held $440 billion of credit default swaps. The reason the federal government stepped in and bailed out AIG was that the insurer was something of a last backstop in the CDS market. While banks and hedge funds were playing both sides of the CDS business—buying and trading them and thus offsetting whatever losses

they took—AIG was simply providing the swaps and holding onto them. Had it been allowed to default, everyone who'd bought a CDS contract from the company would have suffered huge losses in the value of the insurance contracts they had purchased, causing them their own credit problems. The government later announced an 85 billion dollar bailout package for this floundering US giant. This money is paid by the US taxpayers themselves, US taxpayers are suffering from multiple fronts, the taxpayers are already feeling the pain from being put in these loans in the first place, many of them losing their homes to foreclosure because they were in these loans. There's also the larger impact: it's not always just the borrower that is affected, but also all of his neighbors. Even people who are not experiencing foreclosure experience a decline in their home value because of the foreclosures next door. So the taxpayers are really bearing the burden twice because of the initial failures of the market regulators. Credit Suisse has estimated that there will be more than 6.5 million foreclosures in the next three to four years. That's just the foreclosures themselves. Additionally, 46 million homeowners are estimated to see their home value drop by $356 billion. So really, it really goes beyond the financial markets.

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. Thus credit default swaps, mortgage backed securities and collateralized debt obligations were the 3 major instruments that helped the US economy to go into such a bad shape. If only all these had been regulated by the Fed then such a problem wouldn’t have arised. Most of the credit default swaps have been done over voicemail (no jokes), there should have also been tightly regulated lending practices in the US.

Higher Defaults= Financial Failures = Lower Interest Rates = Inflation = Higher Oil = Higher Energy Costs= Contraction in Consumer Spending = Recession= Lowered Demand for Exports/Imports= World Recession

Following is a small list of how US biggest investment banks, mortgage lenders insurance giants faltered 2nd April 2007-New Century Financial one of nation’s biggest subprime mortgage lenders seeks bankruptcy protection, the company’s failure focuses the country’s attention on rise in mortgage defaults. 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. 16th August 2007 – Countrywide Financial the largest mortgage lender in the US draws down 11.5 billion dollars because it can no longer sell or borrow against home loans it had made.

14th September 2007 – Northern Rock a British bank turns to bank of England for an emergency loan, the crisis that began in the US has now spread across the Atlantic. 30th October 2007 – Merrill Lynch head Stanley O’Neal resigns after an 8.4 billion dollar write-down by Merrill. 5th November 2007 - Citigroup chief executive Charles o prince resigned in the wake of a 5.9 billion dollar write-down and a dramatic fall in profits. 11th July 2008 – IndymacBancorp is seized by federal regulators the bank was a part of countrywide financial and was the first major bank to shut its doors since the mortgage crisis erupted 16th September 2008 - AIG was rescued by the Federal Reserve with an 85 billion dollar bailout package.

Leverage – another cause of financial crisis Housing is cyclical and every 10 years or so we have a downturn flowered by a boom. Despite this being a much more severe downturn, you also have to remember prices almost doubled (boomed) before the collapse. What really caused the magnitude of the current financial crisis, in my opinion, was the amount leverage used in the housing market Leverage is a double-edged sword that is a powerful ally during boom times, but can quickly become your worst enemy during the ensuing bust. What is leverage and how does it work? Below is a simplified example using three scenarios: 1. (No leverage) Assume I purchase outright (in cash) a home valued at $100,000. If that house increases in value by $10,000 in one year, my rate of return (appreciation) against my $100,000 cash outlay (down payment) is 10% ($10,000/$100,000). Not bad.

2. (Partial Leverage) Now assume that I purchase a home valued at $100,000 and only contribute $10,000 as a down payment and finance the remaining $90,000 at 6% (equivalent to $5,400 in annual interest). If the house increases in value by $10,000 in one year, my rate of return (appreciation) on my outlay (down payment plus the interest costs) is $10,000 / ($10,000 + $5,400) = 65%. So, through leverage of about 10 to 1, I was able to increase my rate of return significantly compared to scenario one where I had no leveraged debt. 3. (Maximum Leverage) Now assume that I purchase the same home valued $100,000 and only put down $1,000 as a down payment and finance the remaining $99,000 at 6% ($5,940 annual interest). If the house increases in value by $10,000 in one year, my rate of return is (appreciation in value) divided by (the down payment and the interest costs), $10,000 / ($1,000 + $5,940) = 144%! So through leverage of about 100 to 1, I was able to increase my rate of return by triple digits. Picture doing this for several years and as long as value rise, I would accumulate tens of thousands of dollars on an investment of $1,000 + interest costs. See how this could be so enticing for investors. 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. Here is another example of leverage which resulted in financial firms and investment banks getting insolvent

1. assume that the financial institution in the above diagram in Lehman brothers , Lehman brothers borrow money from the investor at 5 % per annum , if the amount they have borrowed is 100000$ then they have to pay 5000$ to the investor annually 2. Now Lehman invests this 100000$ in a mortgage backed security (MBS), this MBS is giving interest at 8 % per annum, so they receive 8000$ annually from this investment. (MBS contains relatively higher risk mortgages). 3. All is fine until this system is working, there was housing boom from 2001 to 2007, so these investment banks made huge profits, but subprime mortgages resulted in higher defaults, because of huge defaults the mortgage backed securities started loosing their value and gave very low returns.

4. After the investors got to know that the profits of Lehman were decreasing they immediately demanded their deposits back, at such a high leverage amount many investment banks and mortgage companies suffered huge losses. In the future I hope the regulators do not allow such huge leverage ratios , and the home owners should also keep in mind to make at least 20 % down payment. So, the lesson of this story is not that leverage is bad; it just has to be understood for both the upside AND downside impacts.

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 ? Some of the steps that can be taken are: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. If you have invested through mutual funds in the stock market then this is not the time to redeem your investment and panic sell. In fact this is the time to buy shares of companies which are fundamentally sound. As the legendary Warren Buffet says “be fearful when others are greedy and be greedy when others are fearful”. There have been more than 300 crises’ in all parts of the world in the last 10 years; however nations have always recovered from it and again started growing. During The Great Depression unemployment was as high as 25 %, right now it is only 6 %. If the world got out of The Great Depression then why can’t it get out of this subprime/liquidity/confidence crisis?