Subprime Crisis

FINANCIAL SERVICE PROJECT ON: ECONOMIC MELTDOWN

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The Glass Steagall Act The Glass Steagall Act was setup over 70 years ago by the United States Federal Deposit Insurance Corporation. The Glass Steagall Act was repealed 9 years ago in 1999 by President Bill Clinton. Some of the current financial problems in the United States in the mortgage industry could potentially be in part due to the repeal of the Glass Steagall Act. This has caused numerous financial advisors to look into the repeal Glass Stiegel Act. Glass-Stiegel, signed into law after a long string of bank failures, prevented banks from doing stock brokerage business, or stock brokers from doing most forms of banking business. It is admittedly something of an oversimplification, but the principle of this law was to compartmentalize America’s financial institutions. An act passed by Congress in 1933 that prohibited commercial banks from collaborating with full-service brokerage firms or participating in investment banking activities. The Glass Steagall Act helped compartmentize the U.S. financial industry in an effort to prevent future collapses and failures of U.S. banks such as what happened in the '30s. With the repeal of the Glass Stiegel/Glass Steagall act, the door was opened for a repeat of the pre-Glass Steagall Act era. One of the reasons the Glass-Steagall Act was important for the financial security of the United States was because of bank speculation, much like what is happening in the current subprime mortgage crisis in the U.S. Back in the 1930s, many American banks were said to be dangerously speculative. Many banks, in the hopes of reaping financial rewards, took large risks, thus endangering the entire financial market. The Glass-Steagall Act was created to prevent such speculation on behalf of the banks. We need to undo the Glass Stiegel repeal? Only time will tell as the Bush administration battles the financial crisis in the United States. A new form of the Glass-Steagall Act may be necessary to revive the U.S. markets because of OBAMA. The repeal of glass streagall did have something to do with the crisis, but innovation within the investment banking industry in the form of securitization, structure products creation and synthetic security formation (all of the activities that are usually summarized under the moniker "financial engineering") also had a significant impact in creating the problem. The industry started creating products that were virtually impossible to value and very thinly traded in the securities markets.

INTRODUCTION DINASOROUS WITH BEAR MARKET Dinasorous mean the subprime crises and the bear market is the beaten down market with no investor confidence "SUB PIME CRISIS" this word look small but not only the US but the whole world economy has got a jitter from this problem. The problem seems to be growing like a disease. Some banks have already declared their bankruptcy and some are on the verge of being declared bankrupt. Subprime crisis has made the global markets melt down, where people have not only incurred in loss but have shaved off all of their capital. Subprime crisis now seems to be growing for the other reason that is, there is a huge amount of liquidity crunch in the market, people have lost so much of money, that they don’t know where do they bring in money from, so whatever asset they have which can b quickly converted to money like silver, gold, stock, property they are just selling it to clear their debt lying in the market so everything is falling in a heap making things more tougher Thus liquidity should be provided in each of the global market to fight this global crisis. U.S GOVERNMENT has announced the bail out package. But the money has not yet hit the market. Subprime lending is the practice of making loans to borrowers who do not qualify for market interest rates owing to various risk factors, such as income level, size of the down payment made, credit history, and employment status. The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007

THE MELTDOWN The reasons for this crisis are varied and complex. The crisis can be attributed to a number of factors pervasive in both the housing and credit markets, which developed over an extended period of time. There are many different views on the causes, including • • • • • • •

The inability of homeowners to make their mortgage payments. Poor judgment by the borrower and/or the lender. Speculation and overbuilding during the boom period. Risky mortgage products. High personal and corporate debt levels. Financial innovation that distributed and perhaps concealed default risks. Central bank policies, and government regulation.

Let us simplify this issue to understand better how sub-prime loans work and how they brought the world down to its knees. It all begins with an American wanting to live the famed American dream. So he seeks a housing loan to give shape to his dream home. But there is a slight problem. He doesn't have good credit rating. This means that he is unable to clear all the stringent conditions that a bank imposes on an individual before it sanctions a loan. Since his credit is not good enough, no bank will give him a home loan as there is a fear that the chances of a default by him are high. Banks don't like customers who default on their payments. But, before the American dream can fade away, there enters a second American usually a robust financial institution who has good credit rating and is willing to take on some amount of risk. Given his good credit rating, the bank is willing to give the second American a loan. The bank gives the loan at a certain rate of interest. The second American then divides this loan into a lot of small portions and gives them out as home loans to lots of other Americans like the first American who do not have a great credit rating and to whom the bank would not have given a home loan in the first place. The second American gives out these loans at a rate of interest that is much higher rate than the rate at which he borrowed money from the bank. This higher rate is referred to as the sub-prime rate and this home loan market is referred to as the sub-prime home loan market. Also by giving out a home loan to lots of individuals, the second American is trying

to hedge his bets. He feels that even if a few of his borrowers default, his overall position would not be affected much, and he will end up making a neat profit. Now if this home loan market is sub-prime, what is prime? The prime home loan market refers to individuals who have good credit ratings and to whom the banks lend directly. Now let's get back to the sub-prime market. The institution giving out loans in the sub-prime market does not stop here. It does not wait for the principal and the interest on the sub-prime home loans to be repaid, so that it can repay its loan to the bank (the prime lender), which has given it the loan.

So what does the institution do? It goes ahead and securitizes' these loans. Securitisation means converting these home loans into financial securities, which promise to pay a certain rate of interest. These financial securities are then sold to big institutional investors. Many investment banks (or institutions like the second American' in our story) sold complicated securities that were backed by debt which was very risky. And how are these investors repaid? The interest and the principal that is repaid by the sub-prime borrowers through equated monthly installments (EMIs) is passed onto these institutional investors. The institution giving out the sub-prime loans takes the money that it gets by selling the financial securities and passes it on to the bank he had taken the loan from, thereby repaying the loan. And everybody lives happily ever after. Or so it would have seemed. The sub-prime home loans were given out as floating rate home loans. A floating rate home loan as the name suggests is not fixed. As interest rates go up, the interest rate on floating rate home loans also go up. As interest rates to be paid on floating rate home loans go up, the EMIs that need to be paid to service these loans go up as well. With US interest rising, the EMIs too increased. Higher EMIs hit the sub-prime borrowers hard. A lot of them in the first place had unstable incomes and poor credit rating. They, thus, defaulted. Once more and more sub-prime borrowers

started defaulting, payments to the institutional investors who had bought the financial securities stopped, leading to huge losses. The problem primarily began with the United States keeping its interest rates very low for a very long time, thus encouraging Americans to go in for housing loans, or mortgages. Lower interest rates led to buyers wanting to take on bigger loans, and thus bigger and better homes. But life was fine. With the American economy doing well at that time and housing prices soaring on the back of huge demand for real estate and bigger and better homes, financial institutions saw a mouthwatering opportunity in the mortgage market. In their zeal to make a quick buck, these institutions relaxed the strict regulatory procedures before extending housing loans to people with unstable jobs and weak credit standing. Few controls were put in place to handle the situation in case the housing bubble' burst. And when the US economy began to slow down, the house of cards began to fall.

The crisis began with the bursting of the United States housing bubble. A slowing US economy, high interest rates, unrealistic real estate prices, high inflation and rising oil tags together led to a fall in stock markets, growth stagnation, job losses, lack of consumer spending, a virtual halt to new jobs, and foreclosures and defaults. Sub-prime homeowners began to default as they could no longer afford to pay their EMIs. A deluge of such defaults inundated these institutions and banks, wiping out their net worth. Their mortgage-backed securities were almost worthless as real estate prices crashed. The moment it was found out that these institutions had failed to manage the risk, panic spread. Investors realised that they could hardly put any value on the securities that these institutions were selling. This caused many a Wall Street pillar to crumble as defaults kept rising, these institutions could not service their loans that they had taken from banks. So they turned to other financial firms to help them out, but after a while these firms too stopped extending credit realizing that the collateral backing this credit would soon lose value in the falling real estate market. Now burdened with tons of debt and no money to pay it back, the bank of these financial entities broke, leading to the current meltdown

The problem worsened because institutions giving out sub-prime home loans could easily securitise it. Once an institution securitises a loan, it does not remain on the books of the institution. Hence that institution does not take the risk of the loan going bad. The risk is passed onto the investors who buy the financial securities issued for securitising the home loan. Another advantage of securitisation, which has now become a disadvantage, is that money keeps coming in. Once an institution securitises the first lot of home loans and repays the bank it has borrowed from, it can borrow again to give out loans. The bank having been repaid and made its money does not have any inhibitions in lending out money again Given the fact that institutions giving out the loan did not take the risk, their incentive was in just giving out the loan. Whether the individual taking the home loan had the capacity to repay the loan or not, wasn't their problem. Thus proper due diligence to give out the home loan was not done and loans were extended to individuals who are more likely to default. Other than this, greater the amount of loan that the institution gave out, greater was the amount it could securitise and, hence, greater the amount of money it could earn. After borrowers started defaulting, it came to light that institutions giving out loans in the sub-prime market had been inflating the incomes of borrowers, so that they could give out greater amount of home loans. By giving out greater amounts of home loan, they were able to securitise more, issue more financial securities and earn more money. Quite a vicious cycle, eh? And so the story continued, till the day borrowers stop repaying. Investors who bought the financial securities could be serviced.

THE VIEW OF ECONOMIC MELTDOWN THROUGH A REAL LIFE EXAMPLE Let’s presume a family of 4 people, Steve’s family. Steve’s father works in a Multinational firm on a regular salary with performance based bonus. Steve every week gets some weekly allowance from his dad, and so does his sister. Every week upon receiving the allowance of $100, Steve goes on his usual to spend on his needs, he is a very economically efficient person, he budgets all the money he receives very accurately with no wastage of money.

The Booming Years in the Family One day, his father’s boss calls his father into his office and tells him that they are going through a business deal which will get them massive amount of profits, and his father will receive 50% increment on his yearly salary. That is, instead of receiving $50,000 that year, his father will now get $75,000 every year. Steve’s father is really excited about this news. Since the Boss assured that the deal will go through, Steve’s dad goes to the local bank and takes a loan of $25,000. He plans that as soon as he will get the increment he will pay the loan back. He walks back to his home, and tells the news to everyone. Since he already has the cash in hand, he gives the proportional extra allowance to Steve, his sister and Steve’s mom. Now this small economy of 4 people has extra cash flow (which technically nobody is sure of), and people are ready to spend. Steve’s father goes and buys that new car he wanted. Steve’s mom gets new cell phone connections and hands the phone to Steve, his sister, and herself. Steve on the other hand, is now able to make a flashy girlfriend, since now he realizes that he can clearly afford to take her to expensive restaurants, to holiday on a beach, etc. He also gets a used Car for himself since now he will be able to afford the monthly fuel and maintenance expenditure. Months pass by, but there is no sign of deal going through. And soon a year passes by. The family has done large amount of expenditures, all perfectly economically calculated, adjusted for the $75,000 salary of Steve’s dad. Since Steve’s dad’s boss ensures that the deal will pass through and he will get his deserved increment, his Dad goes to another bank and takes another loan for $25,000.

Now the total loan on the family is $50,000 + Interest from the first loan. The family consistently gets another extra $25,000 this year. So everything continues the way it is. Another year passes by, and now Steve’s dad is worried about the financial liquidity of the family. The bank which gave his dad the first loan got in touch with him and somehow Steve’s dad convinced them that he will be able to pay their loan back to them.

The Burst Now at the end of third year, when Steve’s dad gets his salary of $50,000, he needs $25,000 immediately to adjust the family budget, but now his Credit history has gone so bad that he cannot get any more loans from any bank. So his Dad is now only able to allocate $100 per week to Steve, similarly, the rest of the family gets less money. This $50,000 is simply not sufficient to cover the various ventures, and new investments family has started. For example, there is no way the Cell phone bills can be paid now. Steve cannot fuel his Car anymore; he cannot spend on his girlfriend anymore.

The Meltdown And just when they thought that they have faced all the problems, they seem to be just started. The banks, from which Steve took loan, are now knocking on their doors demanding their money back. Steve’s family is now in big trouble. After days of consideration, Steve’s Dad comes up with two possible solutions. 1) Cut back all the excess expenditures, sell Steve’s car(that means Steve must dump his girlfriend), sell his Dad’s car, cancel all the Cell phone subscriptions, mortgage the house they live in, for Loan, return all the previous loans, and slowly buy their house back over the years. 2) Go to the local sub standard bank that does not need credit checks, take $75,000 loan from them and continue on their life and hope that they will pay the loan back once their life goes back to normal. This way Steve gets to keep his car, girlfriend, his cell phone, and nobody cuts down any expenditure. Steve terms it as the “Bailout Plan”.

Steve’s Mom’s arguments We cannot go to the local Mafia boss for loan; there is no way we will be able to pay that much amount of loan with our current expenditures. We must go for the first plan, let Steve’s car be sold, his girlfriend dumped, cell phones connection canceled, and over the years we will be able to pay all our loans back. If we choose the “Bailout option” we will not be solving the problem but only postponing it to eventually come back at us at even bigger level.

Steve’s arguments You have got to bail us out Dad. I need more liquidity. I have to pay my gas bills, phone bills, restaurant bills. If you don’t pay me, I will have no social life ever, I will become the most unpopular kid in the school, and surely you don’t want that, do you? So bail me out dad please, you know that I will pay you back that money as soon as you get that increment, and my allowance actually increases. If you don’t bail me out, then my social life will go to hell, I will be much more stressed, and won’t be able to concentrate on my studies, so I will not be able to become a successful man in future, if you don’t bail me out right now.

Steve’s Sister’s arguments This problem is all a result of Steve’s greed. What was the need for him to go and get a new girlfriend, and a car? Look at me, whenever I needed the car I just used Steve’s car. Whenever I had to dine out somewhere, I just tagged along with Steve on his date. Look how much savings I have done. We must choose the first option. [After she does some thinking that if Steve gets to keep his car she will also benefit from this] On second thoughts I support the Bailout option. Let’s bail Steve out with his situation; after all we need to maintain our social status too. Well here the story ends. Now let us view who is what in real world. Steve’s Dad is the Government. Steve’s Boss is Federal Reserve. Steve is the Market. Steve’s sister is the general public.

SO WHAT REALLY HAPPENED? The Federal Reserve inflated the money supply believing that it will result in more economic growth. It does not, so all that extra money resulted in massive economic mal investment. When all that investment eventually failed to balance the books all hell broke lose. Now the only solution is to let these companies fail and let’s start from scratch, but, that government has taken EVEN MORE loan, they are going to sustain all those mal investments by pumping even more money in the economy. It is like solving the problem by overdoing the cause of the problem.

SECURITISATION HAZARDS IN THE ERA OF LOOSE CREDIT “IF COUNTRIES WERE PEOPLE AMERICA WOULD BE A SUPERSTAR” WHAT IS SECURITIZATION?

“A bank selling its bad loans!! This might sound strange, but it has been made possible by securitization” Securitization is the process of conversion of existing assets into marketable securities. In other words, securitization deals with the conversion of assets which are not marketable into marketable ones. EXAMPLE  Suppose Mr. X wants to open a multiplex and is in need of funds for the same. To raise funds, Mr. X can sell his future cash flows (cash flows arising from sale of movie tickets and food items in the future) in the form of securities to raise money.  This will benefit investors as they will have a claim over the future cash flows generated from the multiplex. Mr. X will also benefit as loan obligations will be met from cash flows generated from the multiplex itself

LOOSE CREDIT A company extends credit to a large number of customer and tends to boost sales by giving the ability to purchase the merchandise even to those customers who don’t have cash . Unfortunately it leads to late payments and even defaults.

SUB PRIME MORTGAGE CRISIS IN AMERICA What is exactly sub prime mortgage crisis? It is basically money lent by a lender or bank to an individual who needs to pay up loan installments he has defaulted to another bank. Such a person with a bad credit history known as a sub-prime borrower gets a reprieve through the services of these banks or lenders who see a huge market for sub-prime mortgage.

A peep into America’s sub prime mortgage crisis  When the housing boom between 2001 and 2005, happened in the United States due to the low interest rates among other factors, property prices saw a phenomenal hike. Hence, many of the economically weaker borrowers who had defaulted installments saw a dramatic rise in their property value.  The lenders and banks targeted this section of the market sensing the market potential of this rise in property value. They lent money for these individuals to pay back their loans. The picture was rosy for these lenders until the bubble burst and the property market crashed. Many of these sub-prime mortgage lenders had to declare bankruptcy.

CAUSES OF THE SUBPRIME CRISIS The reasons for this crisis are varied and complex. The crisis can be attributed to a number of factors pervasive in both the housing and credit markets, which developed over an extended period of time. There are many different views on the causes, including the inability of homeowners to make their mortgage payments, poor judgment by the borrower and/or the lender, speculation and overbuilding during the boom period, risky mortgage products, high personal and corporate debt levels, financial innovation that distributed and perhaps concealed default risks, central bank policies, and government regulation .

MORTGAGE SECURITISATION  Suppose you need to borrow money to buy a house, you go to a bank The bank gives you the money you needed to purchase the and you promised to repay back the money, with interest, over a certain length of time.  Today, it is quite uncommon for the bank that originally made the loan to you to be the institution that actually receives your interest payments.  Suppose A (belonging to the sub prime category i.e. with a poor credit history) needs money and takes loan from B (a sub prime loan) and keeps any of his asset as security. Now B in order to make more money issues security in form of bonds etc. to investors in the market which is backed by

or on the basis of the monthly payments that A would be making to B, and this security issued by B would be termed as MORTGAGE BACKED SECURITY.

The Culprits…!!!

At the Mortgage Broker’s…

High-Risk Customer: Gee, I’d like to buy a house, but I haven’t saved any money for a down payment and I don’t think I can afford the monthly payments. Can you help me? Mortgage Broker: Sure! Since the value of your house will always go up, we don’t need down payments anymore!

Mortgage Broker: And we can give you a really, really low interest rate for a few years. We’ll raise it later, okay?

High-Risk Customer: Sure. Ummm…there’s one other thing — my employer is a real prick and might not verify my employment. Would that be a problem? Mortgage Broker: Nope — we can get you a special “Liar’s Loan” and you can verify your own employment and income!

High-Risk Customer: You guys are awesome! You’re really willing to work with guys like me. Mortgage Broker: Well, we don’t actually lend you the money. A bank will do that. So we don’t really care if you repay the loan. We still get our commission. High-Risk Customer: Wow! Let’s get started!

A Few Weeks Later, at the Bank…

Banker: I’d better get rid of these crappy mortgage loans. They’re starting to stink up my office. Thankfully, the really smart guys in New York will buy them and perform their financial magic! I’ll call them right away!

Let’s See What the Smart Guys are doing…

Investment Banker Boss: Phew! We’d better get rid of these shitty mortgages before they start attracting flies. Investment Banker Underling: But who would buy this crap, boss?

Investment Banker Boss: I’ve got it! First we’ll create a new security and use these crappy mortgages as collateral. We’ll call it a CDO (or maybe a CMO). We can sell that CDO to investors and promise to pay them back as soon as the mortgages are paid off.

Investment Banker Underling: But crap is crap, isn’t it, boss? I don’t get it.

Investment Banker Boss: Sure! Individually, these are pretty crappy loans, but if we pool them together, only some of them will go bad — certainly not all of them. And since housing prices always go up, we really have very little to worry about. Investment Banker Underling: I still don’t get it.

Investment Banker Boss: The new CDO will work like this: it’ll be made up of three slices and we’ll call them: • • •

The Good The Not-So-Good The Ugly

Investment Banker Boss: If some of the mortgages fail, as surely some might, we’ll promise to pay investors holding the “Good” slice first. We’ll pay the “NotSo-Good” investors second, and the “Ugly” investors last.

Investment Banker Underling: I’m starting to get it. And because the “Good” investors have the least risk, we’ll pay them a lower interest rate than the other guys, right? The “Not-So-Goods” will get a better interest rate and the “Ugly” guys will get a nice fat interest rate.

Investment Banker Boss: Exactly. But wait — it gets better. We’ll buy bond insurance for the “Good” slice. If we do that, the rating agencies will give it a really good rating, in the AAA to A range. They’ll likely give the “Not-So-Good” slice a BBB to B rating. We won’t even bother asking them to rate the “Ugly” slice.

Investment Banker Underling: So you’ve managed to create AAA and BBB securities out of a pile of stinky, risky mortgage loans. Boss, you’re a genius! Investment Banker Boss: Yes, I know. Investment Banker Underling: Okay, now who are we going to sell the three slices to?

Investment Banker Boss: The assholes at the SEC won’t let us sell this stuff to widows and orphans, so we’ll sell them to our sophisticated institutional clients. Investment Banker Underling: Like who? Investment Banker Boss: Like insurance companies, banks, small towns in Norway, school boards in Kansas — anyone looking for a high-quality, safe investment.

Investment Banker Underling: But surely nobody would buy the “Ugly” slice, would they? Investment Banker Boss: of course not— anybody’s that stupid! We’ll keep that piece and pay ourselves a handsome interest rate.

Investment Banker Underling: This is all great, but since we’re only using the smelly mortgages as collateral on an entirely new security, we haven’t really gotten rid of them. Don’t we have to show them on our balance sheet? Investment Banker Boss: No, of course not! The guys who write the accounting rules allow us to set up a shell company in the Cayman Islands to take ownership of the mortgages. The crap goes on their balance sheet, not ours. The fancy name for this is “Special Purpose Vehicle”, or SPV.

Investment Banker Underling: That’s great, but why would they let us do that? Aren’t we just moving our own crap around? Investment Banker Boss: Sure, but we’ve convinced them that it’s vitally important to the health of the U.S. financial system that investors not know about these complex transactions and what’s behind them.

It Seemed Like a Good Idea at the Time…

Hi, I’m Joe. Managing partner of Joe’s Hedge Fund LLC. My buddies have given me $100 to invest. And I get to keep huge fees in return! I am investing in bonds backed by mortgages, which pay me 8 percent. If I invest my $100, I’ll make my investors $8 a year.

Hi, I’m Bob. Of Bob’s Bancorp. Joe, if you put up your $100, I’ll lend you another $3,000 to buy those mortgage securities. I’ll charge you 6 percent interest because money is cheap and the credit rating agencies say these bonds are rated AAA.

Joe: This means I can invest $3,100 in these mortgage bonds. At 8 percent, that will pay me $248. Even after I pay your $180 in interest, I still have $68 left. Which means I have earned a 68 percent return on the original $100 I invested. Even after I take out my fees, my investors will be very happy. Bob: And my shareholders are happy to see us getting this business.

…Then 2008 Rolls Around…

Bob: Um, Joe, it looks like those mortgage bonds weren’t worth quite what we thought. A bunch of the mortgages they contain are going bad and that’s making me nervous about whether you’re going to be able to pay my $3,000, so I can only lend you $1,000 and I need back the other $2,000 I lent you.

Joe: But these bonds are worth 5 percent less now. If I sell off the bonds I bought for $2,000, I will have to take a $100 loss. Which means I’m wiped out, considering I only put up $100 to begin with.

Bob: Well, we really need our money back. Joe: But everyone else is getting these calls at the same time, and selling their bonds. So the price is now down 20 percent, which means I’m taking a $400 loss. That means not only am I wiped out, but you’re out $300 too.

THE GRAPHS SHOWING THE BANKRUPTCY AND THE DEFAULT RATES

Delinquency Rate for Sub-Prime Mortgages The sub-prime delinquency rate has pushed up past 17%.

Sub-Prime Mortgage Delinquency Rate 2007Q4

18.00

Percentage Points of Number

17.00

16.00

15.00

14.00

13.00

12.00

11.00 Source: MBA

10.00 1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Figure 3. Delinquency Rate in 2007 for Sub-prime Mortgage

Foreclosures Foreclosures started in the fourth quarter represent 83 basis points of all outstanding

mortgages. This is a quarterly rate.

Foreclosures Started 2007Q4 0.90

0.70

0.60

0.50

0.40

0.30

0.20

0.10 Source: Mortgage Bankers Association

Figure 4. Foreclosures in 2007

7

5

06

20 0

04

20

03

20 0

02

20

20

0

01

20

99

20

20 0

19

6

98

97

19

95

19

94

19 9

93

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92

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0

91

19

89

19

88

19 9

87

19

19

86

85

19

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3

84

19

82

19

81

19 8

80

19

19

19

79

0.00 19

Percentage Points Quarterly Rate

0.80

The Housing Price Crash

Those with money and those who wanted to make a quick buck all got into real estate although they did not really know what they were doing. This situation created real estate prices that were not sustainable. Figure 5. US House Price Trends

Source: Center for Responsible Lending/ OFHEO/NAR

Traditional v/s Sub-prime model before default

Traditional v/s Sub-prime model after the default

BUBBLE CROPPING UP  Banks and financial institutions often repackaged these debts with other high-risk debts and sold them to worldwide investors creating financial instruments called CDOs or collateralized debt obligations.  The serious sub prime mortgage crisis began in June of 2007 when two Bear Stearns hedge funds collapsed.  In 2007 financial firms have taken over $80B dollars in write downs which includes firms Citigroup Inc., Merrill Lynch & Co. and J.P. Morgan Chase &Co.  Credit Rating Agencies are now under scrutiny for giving investment-grade ratings to securitization transactions (CDOs and MBSs) based on subprime mortgage loans.

 Higher ratings were justified by various credit enhancements including overcollateralization (pledging collateral in excess of debt issued), credit default insurance, and equity investors willing to bear the first losses.  It is believed that conflicts of interest were involved, as rating agencies are paid by the firms that organize and sell the debt to investors, such as investment banks.

Will the US economy slide into deep recession in 2008? Will it drag the rest of the world with it? The sub-prime mortgage mess has crashed the US housing market, but it will get much worse in 2008 when most. It is expected that 3 million people will lose their homes. Nothing like it has been seen since the Great Depression. House prices may well drop in some areas by 40-50% due to a massive glut of homes on the market. The entire US homebuilders and mortgage industry has sustained enormous losses, with many companies going the way of the dinosaurs. The US is thought by many to be already in recession, with most of the last 2-3 years GDP 'growth' put down to credit spending via the mortgage ATM (which is no longer available due to the drop in house prices). The US FEDERAL BANK has been forced to cut interest rates to limit the damage to the real economy and to keep the US Stock market alive, but this means sacrificing the USD, which continues to tank against other currencies and against oil, which is causing serious concern in OPEC, which no doubt would prefer to do business in Euros.

Will the rest of the world be thrown into recession? Perhaps Japan and Europe can be thrown into recession. China's spectacular growth rate of 11% may come down to 5% which would cause severe difficulties in the Chinese economy which requires at least 8-9% growth to employ the 15 million Chinese peasants flowing to the cities each year.

CONCEQUENCES OF FINANCIAL MELTDOWN IN U.S AS WELL AS IN OTHER NATIONS The consequences of the financial meltdown now are sinking in with ordinary Americans, who worry whether their jobs, home values, children's futures and retirement plans are at risk. Eight in 10 fear the crisis will affect them directly. This is also affecting other nations like India, Pakistan etc who are majorly dependent on America as in India and other similar nations there is unemployment that has occurred, stock market has fallen down drastically which has even made many investors bankrupt. So, this US crisis has really affected the world.

Why Lehman and Merrill fell? Here's the route of loss, in chronological order. 2001-2005: House prices in the US begin to rise rapidly. Banks lend aggressively and create a sub prime industry. Sub-prime lending refers to lending (at slightly higher interest rates) to people who may not be eligible for a loan under normal circumstances. Maybe they don’t have a regular job or income, or have defaulted in the past. Banks traditionally did not lend to such people due to high risk of default. But since these loans were mortgaged against property and property prices were rising continuously, banks started doing so. If customers defaulted, they could sell the mortgaged property. 2005: The booming housing market halted abruptly in many parts of the US. 2006: Prices are flat, home sales fall. February 2007: Sub-prime industry collapses in the US; more than 25 sub-prime lenders declare bankruptcy, announce significant losses, or put themselves up for sale. While they were lending, banks did not factor in the possibility of a fall in property prices. When the Federal Bank (the US equivalent of RBI) started increasing interest rates, the sub-prime borrowers started defaulting and banks started selling off the mortgaged properties. As more and more properties came into the market for selling, the property prices fell. August 2007: Many leading mortgage lenders in the US filed for bankruptcy March 2008: Bear Sterns falls. September 2008: Lehman Brothers file for bankruptcy. Merrill Lynch sells off to Bank of America. Between 2001 and 2006, the US financial markets had developed a new product – a bond securitised against the mortgages. In simple terms it means that the mortgage banks borrowed money against the mortgages on the condition that they would repay to lenders as soon as they recovered their mortgages. The lenders in this case were financial institutions (like Bear Sterns, Lehman and Merril Lynch) who in turn sold retail bonds to individuals. Sadly, the repayment never happened. And institutions like Bear Sterns, Lehman, Merrill Lynch and AIG were the casualties. Since the mortgages were not honored, the banks could not repay these financial institutions who in turn could not repay retail investors.

EFFECTS ON LEHMAN BROTHERS

Wall Street banks faced a glut of resumes from Lehman Brothers, as staff there are contacting colleagues at other firms directly to find new jobs after their investment bank were bankrupt. Some banks, including JP Morgan Chase & Co and Credit Suisse, have told headhunting firms looking to find jobs for former Lehman Brothers employees that they will not pay the firms for putting them in touch with these job candidates, because they are already inundated with direct applications. Lehman Brothers Holdings Inc, which filed for bankruptcy, has 26,000 employees. About 10,000 have been given jobs through at least the end of the year, after Barclays Capital bought Lehman's North American capital markets business and other assets. Headhunting firms said they are receiving scores of resumes from anxious former Lehman employees, but banks aren't interested in paying headhunters to interview these staffers. Firms pay some recruiters on a contingency basis, that is, a bank pays a recruiter for linking it up with a possible candidate. The glut of job-seekers from Lehman is the latest symptom of a broader jobs downturn on Wall Street which has gathered force in recent weeks as the financial crisis has intensified. In New York, some 40,000 bankers and brokers could be laid off, which would be 15,000 more than initially forecast Already this year, Citigroup has laid off some 14,000 employees, while Merrill Lynch had trimmed about 4,200. And when JP Morgan Chase & Co bought Bear Stearns Companies in March, about 60 percent of Bear Stearns staff lost their jobs. Credit Suisse and JP Morgan declined comment on their recruitment expenditures.

EFFECT OF CRISIS ON WORLD MARKET The subprime crisis in the US, following the collapse of the housing sector boom, has sent ripples through the economies of many countries. During the high demand period for housing loans in the US, when the real estate sector was booming, people with a bad credit history, and a higher chance of defaulting on on their payments, were provided loans at higher-than-normal interest rates (sub-prime rates). A decline in economic activity in the US resulted in lower disposable incomes and hence a decline in demand. Simultaneously there was a rise in supply due to repayments and foreclosures arising out of a higher interest rate. This triggered the subprime crisis. Over the last few months, the world has been hit by the heat of the US subprime

crisis. It was initially thought by some that other major world economies would not be significantly affected. However, the crisis is quickly becoming a problem, affecting major economies worldwide both directly and indirectly. Major banks of the U.S have been affected. Lehmann brothers have filed from bankruptcy. Merill lynch has been taken over by Bank of America. The government has come out with a $700 billion package to aid failing investments banks. Fannie Mae and Freddie Mac and AIG have been bailed out by the government. Moreover, financial markets throughout the world have crashed with intense liquidity crunch. This has affected all major economies of the world and is now spreading its wings to emerging economies.

Indirect economic effects The subprime crisis had a series of other economic effects. Housing price declines left consumers with less wealth, which placed downward pressure on consumption. Certain minority groups received a higher proportion of subprime loans and experienced a disproportional level of foreclosures. Home related crimes including arson increased.] Job losses in the financial sector were significant, with over 65,400 jobs lost in the United States as of September 2008. The sudden lack of credit also caused a slump in car sales. Ford sales in October 2008 were down 33.8% from a year ago, General Motors sales were down 15.6%, and Toyota sales had declined 32.3%. One in five car dealerships are expected to close in Fall of 2008

What was the effect on the swiss bank? Swiss bank had shares or stakes in many company now all of them have been beaten down completely so this loss has to b faced by swiss bank also Effect on UNITECH Unitech an indian company which builds luxary apartments had small stake in lehman brother becoz of that stake it has to face 2000cr loss in jan unitech price was 500 now it is 40.

Impact –Negative Affects

 The banks have to survive for existence now. They have leveraged more than their capital .Which resulted in bad loans bad debts  Major Cash crunch in the US especially which will lead to crash crunch all over the world. (no money)  The banks have lost trust in each other and aren’t lending to each other  Credit crunch- don’t have enough money to lend to People any more.  The crises have lead to re engineering, which will lead to job losses.  Rate of interest is cut so it will impact the common man  Equity market is falling so the capital of individuals is getting eroded.  Also has lead to physiological problems Example – a person in the US lost 1.6 million he killed himself and his family. The economic melt down has ruined people. They invested their live saving and all of it just vanished in a second leading to physiological problems  Capital eroding of both individuals as well as companies  Down turn in the economies purchasing power goes down. This will lead to major down turn in the economies of India and china who r the major exporters to the US and Europe.  People who once earned handsome salaries suddenly have had 50 percent cuts and not only that they have a fear of loosing their jobs. Top personnel are jobless in the states.

Governments bail out banks to avert global meltdown Governments across the world moved on Monday to shore up confidence in the tottering global financial system with a slew of bank bailout worth hundreds of billion of dollars. The moves were designed to stave off the world's worst financial crisis in nearly 80 years, which comes against a background of declining global economic growth to raise the threat of widespread recession. Britain would spend up to 37 bn pounds ($63.95 billion) buying into top UK banks. The French government will also create a 40 bn euro ($54.89 bn) fund to take stakes in banks, Germany will launch a rescue plan including a fund to provide up to 400 billion euros ($548.9 billion) in guarantees for banks, . In a joint announcement with the U.S. Federal Reserve, the European Central Bank,

the Bank of England and the Swiss National Bank said they would meet all bids from commercial banks at a fixed interest rate. The moves followed a weekend of crisis talks in the United States and Europe in which governments pledged to support the financial system, which has moved to the brink of collapse as it suffers from both steep losses in the credit market and a lack of trust in lending that has frozen the flow of capital. The need for bailouts has become particularly trenchant as a background of a global economic slowdown, with many countries facing recession. The crisis has swept across financial markets, sending many stock markets into free fall. MSCI's main world stocks index, for example, has lost a quarter of its value since the beginning of October. Equity investors appeared to be comforted by the government bailouts. "The recovery process is likely to be very long winded and will likely take about as long as the crisis has taken thus far." Money markets -- the heart of the credit crisis -- eased but remained tight. Three month dollar rates were some 4 percentage points higher than expectations the Federal Reserve will cut interest rates to at least 1.25 percent

Rising dollar, global slowdown quash impact of falling oil In spite of easing in crude oil price from record highs and rupee depreciating to a two-year low against the US dollar, Indian stock markets continue to be beaten down on rising fears of global recession. Strengthening of the dollar has contributed significantly to the current bout of rupee depreciation. This depreciation, which will hurt imports and external commercial borrowings, will not help inflation come down. Costly imports means higher cost of production,”

BAILOUT BY THE U.S GOVERNMENT

Government bailouts

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Northern Rock had difficulty finding finance to keep the business going and was nationalized on 17 February 2008. As of October 8th, 2008, UK taxpayer liability for the bank had climbed to £87Bn ($150Bn) according to Robert Chote, director of the Institute for Fiscal Studies Bear Stearns was acquired in March 2008 by J.P. Morgan Chase for $1.2 billion In order for the deal to go through, the Fed issued a nonrecourse loan of $29 billion to Bear Stearns In September 2008, the Treasury Department confirmed that both Fannie Mae and Freddie Mac would be placed into conservatorship with the government taking over management of the pair. The two GSEs have outstanding more than US$ 5 trillion in mortgage backed securities (MBS) and debt Merrill Lynch was acquired by Bank of America in September 2008 for $50 billion. Scottish banking group HBOS agreed on 17 September 2008 to be acquired by UK rival Lloyds TSB in an emergency takeover after its share price experienced significant falls amid fears over its exposure to toxic debt. The deal was encouraged by the UK government, who agreed to waive competition rules to allow the takeover to go ahead Lehman Brothers declared bankruptcy on 15 September 2008, facing a refusal by the federal government to bail it out. Treasury Secretary Hank Paulson cited moral hazard as a reason for not bailing out Lehman Brothers In September 2008, The Federal Reserve provided an emergency loan of $85 billion to AIG, which will be repaid by selling off assets of the company. This intervention gave the US government a 79.9% equity stake at AIG. Just over three weeks later the Fed reported that AIG had drawn down $70.3 billion of that $85 billion facility and AIG announced that it may tap an additional $37.8 billion in secured funding from the Federal Reserve In September 2008, Washington Mutual declared bankruptcy. The United States Office of Thrift Supervision (OTS) announced that it was seizing WaMu and would sell most of its functional assets to J.P. Morgan Chase.

On 29 September 2008, British bank Bradford & Bingley was nationalised by the UK government. The government 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. 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.

Indian Bailout Communist Party of India today strongly opposed any bailout package for Indian corporates, saying it would enrich the private sector. The Left party also warned the UPA government against forging any economic understanding with the United States to help India come out of the current economic meltdown, claiming ''it will weaken India''. Speaking on ''Financial Meltdown : Lessons from Sub-Prime Crisis'', CPI National Secretary D Raja also cautioned Reserve Bank to stop relaxing its monetary policies as these would directly benefit private trade and widen financial disparities across the social spectrum in the country. In a keynote address organised by industry chamber Assocham, the communist leader said the government should directly intervene with ''nationalisation threat'' in those utilities which intend to lay off people. ''The Prime Minister should come forward with a threat of nationalisation against those utilities in private sector that have secret plans to downsize their workforce with an intended purpose to further accelerate their profits on pretext of slowdown,'' said Raja. Opposing any bailout package for private sector, he said if any such package was in offing, it should go to public sector which has kept the country largely insulated from global financial crisis. The Left leader sought democratisation of multilateral institutions such as International Monetary Fund, World Bank and Asian Development Bank which, he said, are controlled by the United States. The economic and military hegemony of US should no longer be allowed to influence India as it is one of the most vibrant democracy in the world which would shortly become another economic superpower after China,'' Raja said. The communist leader said economic slowdown will last longer in India if public investments in agriculture and infrastructure are not increased. Mr Russell Green from the US Embassy, World Bank economist Dipak Dasgupta, Assocham vice president Dilip Modi among others also spoke at the interactive session. Barring Mr Raja, all panelists present were hopeful that India would be able to manage the current crisis as its financial system is well regulated and its economic fundamentals are sound.

Indian finance minister’s comment on bail out?

New Delhi, Sep 30 Amid fears of global financial meltdown hitting India, Finance Minister P Chidambaram today assured investors that Indian market is "sound and attractive" and promised them to take necessary action if needed. "There is nothing to worry about the Indian market. We are suffering the consequences of turbulence around the world. Basically, Indian market is a sound, attractive and well regulated market", he told reporters. The government is monitoring the situation round-the- clock, he said, adding "the regulations that are in place are adequate. But if the regulations are to be tweaked we will do so". He further added that steps would to be taken, if needed, for smooth functioning of the market.Commenting on withdrawal of FIIs from equity market, he said, "FIIs are selling but I do not think all FIIs are selling nor do I think they are selling all the time." They are selling because they have got payment obligations, he said, adding, "some FIIs are buying and perhaps more FIIs will buy having regard to the fact that India is still is a very attractive market to invest and Indian market is a well regulated market". Referring to the rejection of 700 billion-dollar bailout package by the US House of Representatives, Chidambaram said, "bailout package is a concern of US Congress and the US Government. It is agreed by everyone that bailout is necessary. How the Congress will reconcile to the views of two major political parities, it is not for me to comment." He said, "Of course, we will be greatly helped if a bailout package is quickly approved by the US Congress.

US recession turns into an Indian headache FOR MORE than a year now, the US dollar has been falling in value against other currencies due to faltering real estate prices, sub-prime meltdown, excessive consumer debt and skyrocketing imported energy prices. And when the dollar

drops, it has economic insinuations for all of us. But how serious is it? At a meeting of finance ministers in France, US treasury secretary, John Snow,made the seemingly casual comment that the recent drop has been ’modest’. But that prompted the further dumping of dollars on world currency markets, driving the value even lower. Investors worldwide are becoming skeptical and have started started pulling their money out of the United States. They have realised that the people and the country cannot live beyond their means in the long term. The US dollar’s exchange rate is starting to crumble as a result of this withdrawal. Gone are the days when an American finance minister could boast, “The dollar is our currency, but it’s your problem.” Now or never? One has to reap what one sows; the industry watchers see a significant linkage between the rising work hours, layoffs, pink slips, downsizing, termination or workforce reduction – call it by any name and the recent appreciation of the rupee against the US dollar, which has impacted the bottom lines. According to various reports, the information technology (IT) sector is facing and moving further towards a recession. Every IT organisation, whether small or big, is reducing its workforce. So, in order to offset this quandary, recently the Indian job market has been flooded with news like TCS laying-off 500 employees, Yahoo! Asking 45 employees to leave, IBM laying off more than 700 employees from its Indian offices etc. The average salaries offered and the average annual hike in the salaries in the IT sector have also seen a downfall. TCS, the leader in the software service providers in India, have reduced the variable pay or the incentives of its employees for the first quarter of 2008 by 1.5 per cent. Justifying the lay-offs, most of the organisations argue that the employees were asked to leave (not fired) because of the regular termination of services of workers performing below expectations and not related to a widely anticipated contraction in spending on information technology by customers in America. The average salaries being offered in the industry have also come down in the sector. Similarly, all the organisations are undertaking the cut in salaries of the employees for various reasons, which remains ‘a deep sea clandestine’. In the IT sector, the latest news of layoffs has come from almost all the sectors of the industry. “I think the US economy may bounce back and there is no conclusive evidence of recession in that economy. However, if there is slowdown in the US, Europe and other parts of the world, it will affect our exports,”Finance Minister P Chidambaram said in Davos. India is worried although the official financial ministry keeps saying there is no problem if America hits a recession. Since the 1990s, India has transformed itself into a trading nation instead of a producing nation. Indian oligarchs bring in western goods and services and package

them to sell the same to hungry and poor native Indians eager to get a piece of the ’American Dream’. It sells men and women to the American and European companies by the name of information technology and business process outsourcing. It is nothing but slave trading of the present age. With the American economy in a severe depression, India Inc is getting wiped out. These yuppies on the ’high’ Indian oligarchs even bought American and European companies. They will soon find they lost it all as the western world is faced with economic meltdown and depression. In conclusion, India finally realises what a blunder it committed by becoming a trading nation rather than a producing nation. The slump in the market is not the result of poor fundamentals in these countries but of the slouch in America’s economy, especially its sub-prime housing market where defaults and foreclosures have been on the rise. The institutions rolling under the knock-on effects of that crisis are selling out in Asian markets to find the money to re-balance their capital structures or meet their commitments. On hearing the climb in the Indian rupee value, the Indians should ‘be as happy as Larry’. But, this has made the Indians only sadder than ever, which implies how much we are dependable on the American economy! Most of the IT companies in India have 90 per cent of their clients from America. The craze for the software jobs is increasing day by day amongst the people in India. Thus, the other opportunities in India are side stepped for various reasons. Even though China’s economy is related to that of America’s, we know China presents opportunities and challenges for the rest of the world. A misunderstood land of contrasts, conflicts and confusion, China appears to some analysts to be on the verge of world supremacy. Others believe that China will collapse under the weight of an overheated economy and difficult environmental problems. China which is a restless giant provides opportunities for all not only in the IT field, but also in other core manufacturing fields. So, it’s in the hands of the government and the companies and the people to exact this set back. The government and the IT giants should work together to handle such kind of money appreciation and depreciation. And, China can be the best example to take for their extraordinary developments in flourishing industries in all fields giving equal importance to all sectors, thus benefiting everybody. Example isn’t another way to teach, it is the only way to teach.

RECOMMENDATION Loan modification, pumping money into market may slow down the crisis.

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Establish rescue funds for borrowers facing short-term problems caused by illness, layoffs or other one-time events. Establish a bond fund to pay for switching borrowers out of unaffordable ARMs. Refinance loans for victims of predatory lending. This would involve working with Fannie Mae, the quasi-governmental corporation.

Changing loan terms is a mess, borrower and lender must accept to the terms, lenders may be unwilling to change terms but Fed interference will work out. But lender will accept to change in terms to avoid foreclosures. Pumping money into markets, reducing bank reserves may temporarily weaken the crisis, but these this is two fold operation, pumping money will increase inflation which will results in increase in subprime lending, and reducing bank reserves to small extent is better but as whole destabilize the whole financial system.

GUIDELINES FOR FUTURE * Never respond favorably to a solicitation without first checking other options. If you deal with only one loan provider, your prospects are better if you make your selection by throwing a dart at the yellow pages than by accepting a solicitation. * Check your eligibility for mainstream financing with mainstream lenders. The easiest way to do that is on-line. Some sites that I like for this purpose are Eloan.com, Amerisave.com, and NationalMortgageAlliance.com. These are all Upfront Mortgage Lenders. * If you can’t qualify with any of them, your best bet is an Upfront Mortgage Broker. They may charge sub-prime applicants a little more because they require more time. You will know what they charge, however, and you will know that you are getting the wholesale price posted by the lender, which means you won’t be exploited.