World Financial Crisis Ii

World Financial Crisis II

Sensex

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In first part of the captioned report we discussed the current financial chaos and the aftermath actions of various governments like bailout programs and buying stakes in institutions by governments in order to rescue them. Now in this report, we will discuss the whole scenario at length.

What went wrong? The question that must be intriguing even a layman is what went wrong with the US institutions and the economy. This mess indeed happened not overnight. It was the result of a combination of factors like crony capitalism, connivances, lack of disclosures, reporting requirement policies and fragile financial systems.

Background Nifty

Deepak Tiwari Research Analyst [email protected] T: + 91 22 4063 3032

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It started in 2003 when there was a great demand for American home loans. Investment banks like Lehman Brothers would buy from the US banks and convert them into what was called as CDOs (Collateralized Debt Obligations). Simply speaking, this refers to buying home loans that banks has already issued to borrowers, cutting them into smaller pieces, packaging the pieces based on return (i.e. interest rate), value, tenure and selling them to investors like pension funds and insurance companies among others across the world with a fancy name, such as "High Grade Structured Credit Enhanced Leverage Fund". It is something like debt securitization. Such innovative products meant good business for both the banks who lent home loans and Investment banks who bought CDOs because the latter would allow banks to keep a significant part of the interest rate charged on the home loans besides paying upfront cash, which banks could use to issue more home loans. As home loans could go on for 20-30 years and it would have taken a long time for the banks to recover their money, such arrangement helped them maintain more liquidity. On the other hand, investment banks would sell CDOs to investors at the higher rate than the US treasury and in return such investors would receive a share of the monthly EMI paid by the person who took underlying home loans. Since US home prices were always going up, there were chances of defaults. So investment banks roped in insurance biggies like AIG by convincing them that it was a risk free income for them as even in case of defaulting EMIs, the home could be seized and sold for much higher prices. This whole premise was built on the assumption that home prices would keep rising. As demand for the CDOs started growing across the global investment community, the investment bankers who were meant to sell these instruments also started investing a significant part of their own capital in these. Gradually the markets for CDOs and Credit Default Swaps (CDS) started expanding with traders and investors buying and selling these as if they were hot stocks of a blue-chip company shunning the facts like the capacity of underlying people to repay. The problem begun when such investment banks started churning more and more home loans into CDOs and selling them or investing their own money, there was a pressure on the banks to issue more loans so that they could be sold to investment banks in return for a commission. Then the problem aggravated when banks started lowering the credit quality for availing a home loan and aggressively used agents to source new loans.

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And as a result a time came in 2005 when almost anyone in the US could buy a home without income proof, other assets, credit history or sometimes even without a proper job. Such loans were called NINA which stands for "No Income No Assets". To make things even worse, interest rates began to rise during 2004-2006. Many people had taken variable rate home loans that started getting reset to higher rates, which in turn meant higher EMIs that borrowers had not planned for. This led up to a chain of defaults making home prices going further down. Then in 2007 it came to the fore what we now know it as sub-prime crisis.

What is in store?

Post this financial crisis and bail out measures, we should expect more tight and transparent policies. We may see increased intervention from governments. Further, it will take some time to return to normalcy.

This hydra headed monster called sub-prime crisis has engulfed many financial giants that ruled the financial world for many decades and are a thing of past now. Only time will tell how the US bailouts plan of $700 billion to buy a pile of bad mortgage debt in an attempt to rescue the nation's credit markets will be effective. In subprime crisis, several firms have lost over $501 billion and there is speculation that worst is yet to come to the fore. (A list of such write downs is enclosed somewhere in the report). Banks and financial institutions are facing liquidity crunch across the globe particularly in the US and Europe. Respective governments are fighting tooth and nail and are pumping billions of cash into the banking system to stave off any liquidity crisis. We expect that the dust will settle in two three quarters. But this mortgage mess will certainly teach us many lessons. First and foremost, it must result into tighter and transparent regulations. No doubt, government interventions will increase but sometimes it’s good for the markets if it is aimed at bringing stability and normalcy to the equities and safety of the interests of hapless investors. Right now equities are reacting sharply while panic and fear ruling the game. There are wild rumours and speculations. Foreign investors have turned risk averse now and are trying to cash out to make up for their losses incurred in developed markets resulting in exodus of monies out of the emerging markets.

How it will impact us? Current global liquidity crunch has forced Reserve Bank to cut CRR by 150 bps. Some more such cuts are expected. FIIs exodus will continue in short term till normalcy returns to the markets. Further, the sectors that will be impacted hard by this mess are BFSI, real estate, infrastructure and IT.

Emerging economies including India cannot remain insulated from sinking US economies is now a fact difficult to swallow. Rising unemployment, declining factory orders and economic slowdown which are the pre cursor of the impending US recession is a matter of great concerns for India. Though India’s growth engines are set to ignite and we are still the second fastest growing economies at 7.5-8%. But we need foreign funds to sustain such growth. As of now FIIs are in panic mode and trying to take out their monies from the emerging markets. But we are of the view that the sense will prevail and they will return to us. It’s a just a matter of time. The nefarious subprime crisis is going to further impact sectors like BFSI, real estate, infrastructure and IT. Sectors that are likely to be impacted mildly are Power equipment & services, auto, retail, logistics, hospitality & tourism. The least impacted sectors however would be pharma, fertilizers energy, FMCG and media. And there are positive developments too such as receding crude price, levelling off inflation etc. RBI has cut CRR by 150 bps to release Rs 80,000 crore in the banking system. There may be more such rate cuts in the offing. Sebi has eased PN rules to attract FIIs while it has allowed foreign companies to buy Indian stocks. There will be more such congenial measures to rev up the markets sentiments in time to come.

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Once upon a time: It happened only in America

Home Loan Seeker

In 2003 there was great demand for house loan in the US. Like debt securitization, investment banks would buy home loans from the US banks while allowing them to keep a significant part of interest income besides paying upfront cash.

Bank (The lender)

In turn such investment bank would convert loans into CDOs and then sell them to investors across the globe giving them higher returns than the US treasury.

Investment bank

Investors (Pension funds or insurance companies)

Insurance Companies

The buyers who would buy CDOs would be entitled for a share of the monthly EMI.

Since home prices were consistently rising, insurance companies were easily convinced that even in case of default, house can be seized and sold at much higher prices, giving them risk free premiums.

This mounted pressure on banks to dole out more loans to create CDOs and in this process they started ignoring borrowers credentials like capacity to repay.

In 2004 interest rate began to rise which led up to a series of default. Since it was very lucrative business investment banks went overboard and leveraged their equities 30-40 times.

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Write downs/ losses and capital raised by respective worst hit companies

Companies

Write down/ Losses

Capital Raised

Citigroup

55.1

49.1

Merrill Lynch

51.8

29.9

UBS

44.2

28.3

HSBC

27.4

3.9

Wachovia

22.5

11

Bank Of America

21.2

20.7

IKB Deusches

15.3

12.6

RBS

14.9

24.3

Wasgington Mutual

14.8

12.1

Morgan Stanley

14.4

5.6

JP Morgan Chase

14.3

7.9

Deusches Bank

10.8

3.2

Credit Suisse

10.5

2.7

Wells Forgo

10

4.1

Barclays

9.1

18.6

Lehman Brothers

8.2

13.9

Societe Generale

6.8

9.8

ING Group

5.8

4.8

4

0

Goldman Sachs

3.8

0.6

Bear Stearns

3.2

0

ABN Amro

2.3

0

Others

130.7

89.8

Total

501.1

352.9

BNP Paribas

Figures in $ billion

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