US Subprime Mortgage Crisis

(If anything can go wrong, it will go wrong)

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Introduction

In the year 2009-2010 the Indian government decided that it will give a huge fiscal stimulus to the Indian economy because all economies that were rising till 2007 fell down face first in 2008. We have all read in newspapers that something happened in 2007-2008 that not only crumpled USA’s economy but also severely and negatively impacted the emerging economies, especially ‘BRICS.’ The world economy has still not been able to recover from what happened in 2008. The Indian GDP Growth rate had gone up to 7, 7.5, 8, 8.5 and after that incident, fell down to 5/ 4.5 and is, majorly, rising now due to change in government determinants, not due to actual improvement in our situation. In this project I will provide an in- depth analysis of the subprime mortgage crises that will improve our understanding of the current situation in India and make us question an old saying, “greed is good” first coined in the movie Wall Street, which ironically, plays a major role in this crises and proves greed is anything but good. The principle (and problem) of economics is that human beings occupy a world of unlimited wants and limited means and the crisis is nothing else but a proof of the same.

I will proceed in the order given below because it is impossible to understand the crisis otherwise.

  • Important Definitions and Concepts
  • Housing Crisis Building
  • The Full Picture
  • Fallout and the Road ahead

1. Important Definitions and Concepts

(How is global business happening today? It is happening today due to an underlying skeleton called global financial system? A global financial system must constitute a system of-

  • Payments and receipts
  • Insurance
  • Information and markets)

1. Financial Globalisation:  The large scale flow of private capital across the world in the past 30 years aided by massive deregulation is called financial globalisation.

(Deregulation: Allowing large scale private capital flow. After 1980’s privates started moving money more than the International Monetary Fund and World Bank, known as the Bretton woods sisters.

Capitalism:  More and more private enterprises should be running the system and the government should play a role only in the background. )

Six Important developments came together:

A. Eclipsing of the Bretton Woods System

B. Deregulation of the Currency Markets

C. Domination of Private Capital Flows

D. Very poor Regulatory Frameworks

E. Domination of Wall Street’s/ NYSE’s Extreme Capitalism Model

F. Global Connectivity

2. Extreme Capitalism: A term used to denote the near total freedom enjoyed by Wall Street bankers and their massive greed, which directly lead to the 2008 US Housing Crisis.

3. Black Swan: As per Nassim Taleb, the author of the book ‘Black Swan’ famously known for predicting the crisis, “black swans” are highly unlikely events which turn out to be a reality. These are mostly negative in nature.

In a black swan situation, everyone agrees that an event can’t happen and hence put all their money in the other possible event. But as the unlikely event turns out to be a reality, the few people who invested in it take all their money and run home, while everyone else gets bankrupt. The US Subprime mortgage crisis is the purest example of it, but let us use an example we are all aware of to understand it – Everyone was sure that the Indian GDP Growth rate would rise in 2008 but the numbers told a different story. Many Schemes were announced because the government was sure that the money would keep coming in, but the dip in GDP growth was so destructive, that India had massive fiscal deficits instead of development! Now Modi government is facing a huge problem of actually increasing the GDP Growth rate and for that we need investment, but, we can’t invest in our own country due to lack of savings and others don’t want to invest due to lack of trust. That is why we are seeking aggressive campaigns to bring in foreign capital like Make in India Program. If the crisis had not happened, Kalam’s 2020 vision for India might have been a reality. This is the relation between the crisis and India.

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4. Wall Street and Real Street

Wall Street is the financial and investment world of the U.S. – largely centred in New York. Real Street is the actual economy where physical products are made and sold. An example of Real Street is a mobile company. Variation in stock prices of a mobile company like apple doesn’t affect the quality of an iPhone. The only connection between Wall Street and Real Street is that if apple sells more iPhones its stock price will increase and if it sells less iPhones its stock price will decrease. There should ideally be no other connection. But the extreme capitalism model of Wall Street caused a mixing of Wall Street and Real Street and this mixing caused the crisis. I explain this mixing in the next point.

5. Financial Contagion: It is a scenario where small shocks which initially affect a small part of the economy, spread to other financial sectors and countries, just like a medical disease. They destroy confidence. Imagine I have 1 crore rupees in cash. You can borrow from me but I have a rate of interest and will take a security. A man comes to me, takes 5 lakhs and gives me 5 or 10 lakh rupees worth of property papers. I am happy. Another man takes 10 lakh and gives me 10 or 15 lakh rupees worth of property papers. Many other people come and take money from me, give interest and property papers. But all these people give my money to someone else and those people give fake property documents in return. These people who gave fake property papers in return also loaned the money to some other people and got some fake and some real property papers. I have loaned 1 crore rupees, and my money is with people who are honest, somewhat honest or completely dishonest. Now RBI comes to me for an audit, checks my papers, is satisfied but calls my first borrower and informs that they are coming for an audit. RBI goes to my borrower, does an audit and realises that this person has got fake property papers in return of real money. Now those loans are declared NPAs (non performing assets) and therefore my loans are declared NPAs. People who have invested in my bank through the stock market get to know about this and a fear is implanted in their brain. An investor was going to invest 50 lakh in me but he got to know that my loans are duds, what will he or she do? NOT invest. THIS IS CREDIT CRISIS. Instead of me, he or she invests in gold or land and this is a spillover of a Wall Street problem into Real Street. Even if a genuine car company wants a loan from me now, wants to start a factory and give jobs to many people, I can’t give the loan because my investor fears that the loan will sink and my investor spreads this fear in others minds too. NOW NO ONE wants to invest! Credit Crisis.

Extra knowledge: ICICI bought a small CDO of 1000 crore (will explain CDO in 3rd major heading) from an investment bank which went under due to the crisis. 1000 crore is nothing for ICICI but people got so scared that if America’s investment bank can go under, ICICI can also go under and everyone wanted to pull money out of ICICI because if the bank goes bankrupt, the people would never see a penny of their money again! The situation got so bad that RBI had to intervene and say that ICICI WAS SAFE. The confidence was shattered due to financial contagion and almost caused a ‘run on the bank’ situation for ICICI!

6. Sub-Prime Mortgages: Loans given to less worthy individuals to buy homes, during the U.S. housing bubble of 2000s. These eventually bust the bubble in 2007.

7. Government Bailout: When a  large corporate which employed large numbers and was profitable – suddenly goes bust, the government doesn’t let it happen due to many social considerations. The financial help given to avoid the bust is called a bailout. This is called “too big to fail.”

Extra Knowledge: In 2007 Lehman Brothers, a huge global financial services firm was going under and the government let it go under. By the time they realised that they had made a huge mistake, it had caused a financial contagion. The banks started drowning. The government could give it a huge check and say, “don’t drown, take MY money.” But, this flies straight in the face of capitalism which states that government should only play a role in the background, so why would American government, one of the best examples of capitalism, bailout banks? Would the bank having 50,000 employees change anything for the government? Yes it would, because now the bank is “too big to fail.” So where does the money in the check given to the bank come from? From OUR taxes. This is not capitalism, this is communism!

8. Credit risk and liquidity risk: Credit risk is the risk of loss due to non payment of debt owed to an entity. Liquidity risk refers to a situation where an entity will have insufficient cash to meet its obligations. This can happen when the company’s products are no longer in demand. Liquidity risk affects credit risk.

Extra Knowledge: Kingfisher airlines had a value of 4000 crore. It needed a loan of 5-7l crore and banks easily gave loans because of their value. But, shortly after taking the loan their business decreased and hence their liquidity fell. Banks claimed Vijay Malya to be a good man, and that if is given time, will surely repay the loan. But as time passed the company’s situation worsened and banks asked Vijay Malya to sell everything he owns and give as much money back as he can, since the company was in no situation to repay the loan. But, he didn’t.  Banks named him a wilful defaulter; he will never get a loan from anywhere again. This is how liquidity risk or LR is connected to Credit risk or CR.

9. Collateralised Debt Obligations: A security backed by a diversified pool of debt obligations such as bongs, loans or home mortgages.

10. Credit Default Swap: A financial contract between a protection buyer and a protection seller. Thus, it is an insurance against default.

Companies can borrow money directly from the people instead of banks by issuing CDP or Corporate debt paper. TATA issues a corporate debt paper available advertisement in the newspaper. You can give TATA money and in return get bonds with a particular rate of interest. You know that TATA will repay you and TATA knows that it will be able to repay you. But, if it is a small company and is uncertain about paying you back, it will take insurance from a protection seller and become a protection buyer. As long as the protection buyer is paying premium to protection seller, the equation between them is balanced and everything runs smoothly. If the protection buyer’s company is unable to pay premium, the protection buyer has to give the entire bonds value to the protection buyer and that bond value will go to the people the company sold the bonds to. This is case of default.

11. Quantitative Easing: Large scale bond buying program run by a central bank to pump liquidity in the system and protect it from stalling.

I hope you remember the example I gave, where an honest car company wanted a loan and I was unable to provide the loan due to a stalled economy caused by lack of investor confidence. The central bank (or Federal Reserve in America) understands the problem that the Real Street can’t stall. So it can print currency and push it into the market to increase liquidity. But, this would decrease the value of the currency. So what the central bank does is that it buys bank bonds. The banks now have money and forward it to the people who need it and hence QE is very important for stalled economies. Since this crises U.S. has been buying $80b of bonds every single month.

A question to keep you interested in reading this project.

Why did the Indian stock market collapse when the Federal Reserve chairman announced the tapering of quantitative easing in 2014?

12. Leverage: Borrowing huge chunks of money to earn huge profits by scaling up deal sizes.

13. Fannie Mae (FNMA) and Freddie Mac (FHLMC): These are 2 giant American PSU’s created to develop secondary mortgage market in US.

Housing Crises Building

Many factors lead to the buildup.

  • The most common assumption was that housing prices would always rise and will never fall.
  • In 1999 the U.S. government passed Gramm – leach – Bliley Financial Modernisation Act.” It replaced the Glass – Steagall Act of 1933 and broke the boundaries between commercial banks, investment banks and investment companies. Insurance corporations genuinely assess risk and take premium accordingly, so how can they partner with banks? Commercial banks’ job is to assess collateral and only then give loan, so how can they partner with investment banks and insurance? Investment banks job is to take more and more risk, how can they partner with commercial banks and Insurance Corporation? If they partner, enumerable crimes can happen. That’s why they were separated right after the great depression of 1929. But after 1999, 3 combinations were made and the crisis’ making began. Commercial banks started doing insurance and started giving out as much insurance as possible and hence defaulters increased. Commercial banks + investment banks is the most dangerous combination! Commercial banks usually give long and very long term loans (Example: home loans extend to 20 years) while investment banks give money today and want a 20% return the very next day (that is their job). But, when they mix, investment banks will make CDO commercial banks’ papers, apply CDS on it and sell it across the world and no one will know where the bombs explode. I have just told you what happened in the crisis.

C. Break down of basic wisdom:

1. Always live within your means

2. Consume what you produce

3. You cannot borrow your way to prosperity.

D. Asian countries like China and Japan were exporting huge capital to the U.S.

CRISES

The Full Picture
Home buyers take loans from commercial banks.

Brokers get the deals done.
The homes are the collateral assets.
Mortgage papers remain with the commercial banks.

Big investment banks see the opportunity and are loaded with tons of leverage.
They buy the mortgage paper from commercial banks, and they turn them into
fancy CDOs.
The CDO is rated by a third party and 3 categories are made, named: safe, ok and
risky.

Investment banks get big insurance companies like AIG on board and AIG
promises to cover their losses if any family is unable to pay the debt.
AIG gets so many clients that it stops checking risk and gives insurance to every
single family.
Return-hungry investors like pension funds buy the safe slices of the CDO.
Okay and risky slices are sold to more risk taking players.
Rate of return on an investment is directly proportional to the risk.
It is a fantastic system and that’s why everyone wants more.
Hence, sub-prime lending starts. (Turning Point)
Finally, as loan takers start defaulting those homes are repossessed and are up for
sale in open market. Thus, liquidity risk begins.

As inventory piles up, prices start dropping.
Prime family home value falls, as many houses go up for sale and their loans are
greater than their home’s value, so they refuse to pay loans and give their homes
to the bank.

The prices fall further, the bubble is bust!
Many big names like Lehman brothers, Wachovia bank, Washington Mutual, go
bankrupt.
Panic Spreads.
Credit to normal business starts to suffer.

Hence, the credit crisis starts. (Real Street)
Because the CDOs were sold globally, the panic spreads globally.
Iceland goes bankrupt.
Fannie Mae (FNMA) and Freddie Mac (FHLMC) which gave money to commercial
banks to give to families for home loans stopped profiling/ calculating risk and got
2-3% in return. Today half of the people involved are already in prison.
Fannie Mae (FNMA) and Freddie Mac (FHLMC) believed their NPAs were 8 and 6
billion while they were $110 and $250 billion dollars respectively.
Both Fannie Mae (FNMA) and Freddie Mac (FHLMC) needed bailout.
TARP is started (troubled assets relief program)
U.S. government starts fiscal stimulus program. (Tax relief, bailout, etc is fiscal
stimulus)
Federal Reserve starts quantitative easing to stop the recession.

Occupy Wall Street moment (2010) {99% vs. 1% movement} where people asked
the government why the 99% have to suffer due to the greedy 1%.

Fallout and the Road ahead
A. In 2005 an economist in U.S. called Raghuram Rajan announced the crisis.
B. Fortunately, other than a few like ICICI, Indian companies were left untouched
as they had not invested in the CDOs.
C. Capitalism as practiced in the U.S. took a serious beating.
D.  The government passed the Dodd Frank Wall Street Reform and Consumer
Protection Act 2010 and reinforced the Glass – Stegall Act of 1933
E. There is enough for everyone’s need on this planet, but not enough for a single
man’s greed – Mahatma Gandhi
F. If the pension funds, mutual funds, sovereign funds, foreign investment banks
and hedge funds had not put pressure on American investment banks to make
more money, that pressure would have never been transferred to commercial
banks and brokers, everyone would still be making money today and the crisis
would have been avoided, but alas, Gandhiji was not born in America.

 

(Edited by Kaveri Deshpande)

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