The Sub Prime Crisis Feb 08 2009 By

The Sub Prime Crisis Feb 08, 2009 By A V Vedpuriswar

The state of the Global Financial System “Increasingly complex financial instruments have contributed to the development of a far more flexible, efficient and hence resilient financial system than the one that existed a quarter century ago. ” - Alan Greenspan, November 2005 “The bright new financial system – for all its rich rewards and unimaginable wealth for some – has failed the test of the marketplace by repeatedly risking a cascading breakdown of the system as a whole. ” - Paul Volcker, April 2008 1

Taking Stock

The shakeout on Wall Street

What is special about the current meltdown? Asset price deflation & deleveraging Cross currents of inflation & disinflation Greater intervention by government

The picture at a glance

The World of Derivatives Type of Derivative Interest rate H 1 2008 End 2007 $464. 7 trillion $382. 3 trillion Credit $54. 6 trillion $62. 2 trillion Equity $11. 9 trillion $10 trillion H 1 2001 $ 57. 305 trillion $ 631. 497 billion

The complex world of CDS

Federal Funds Rate movement ( 2000 -2008)

House Price trends

Key figures at a glance Global GDP $ 55 trillion US GDP $ 14 trillion Estd Sub prime losses $ 1 trillion Declared losses $ 600 billion 15

Value of US residential real estate (2007) Real estate market $ 23 trillion Mortgage debt $ 10. 7 trillion Homeowner equity $ 12. 3 trillion Securitised mortgage $ 6. 3 trillion 17

Understanding the US mortgage markets Agency Mortgage Securitized portion Non agency mortgage 18

US Securitized issuance ($ Billion) Year Agency RMBS 2000 479 Non Agency RMBS 136 2001 1088 2002 CMBS ABS CDO Total 49 184 86 933 267 74 250 61 1740 1443 414 60 248 56 2221 2003 2131 586 87 256 67 3127 2004 1019 864 102 246 115 2346 2005 965 1191 178 305 187 2826 2006 899 1145 214 278 326 2863 2007 1161 707 236 270 298 2671 2008 H-1 692 47 13 116 14 882 Source: UBS Essentials 2009 19

Agency share of mortgage issuance 1995 – 2003 75 – 85% 2004 54% 2005 45% 2006 45% 20

Reasons for drop in housing affordability Rise in interest rates from mid – 2003 Rise in home prices 21

1998 -99 sub prime crisis Commercial banks reluctant Independent specialty finance companies Gain-on-sale accounting 1998 liquidity crisis The sub prime lenders went bankrupt Middle aged borrowers Aim-to take equity out of home No CDS no mechanism to short mortgage credit 22

The sub prime crisis of 2007 -2008 Low interest rates Weak regulation Securitization Separation of origination process from ultimate credit risk New derivatives 23

Virtuous sub prime cycle Rise in home prices Buyers priced out New affordable products Home sales rise Buyers can now afford 24

Affordability Betting on the future Basic assumptions Greater credit risk 25

What fuelled the crisis Competitive pressures Government – mantra of pro business, pro home ownership, laissez-faire Greed Mislaligned incentives 28

Highly leveraged societies

Highly leveraged investment banks

A quick look at past crises

A tale of two bubbles

Global Economic outlook

Spreads remain high

Europe in recession

The world in recession In an updated World Economic Outlook, published on November 6 th, the IMF predicted that world GDP growth would fall to 2. 2% in 2009, based on purchasing-power parity (PPP) weights, from 5% in 2007 and 3. 7% in 2008. Global growth of less than 3% implies a world recession, so its latest forecasts would push the world over the edge. Some forecasts by private-sector firms are even gloomier, with several now predicting global GDP growth of no more than 1. 5% in 2009. Global GDP has never fallen in any year since the 1930 s Depression. Its worst years since then were 1982 and 1991, with growth of 0. 9% and 1. 5% respectively

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The Emerging Markets at a glance

Not much scope to cut interest rates

The road ahead Serious challenges ahead Role of the financial system What lies ahead?

Why inflation may stage a comeback High resource consumption in emerging markets Rise in government deficits and public debt Labour shortage due to demographic transition 46

The demographic crisis (1) Country Working* / Retired Germany 2 Italy 2 Japan 2 Sweden 2. 4 France 2. 4 Britain 2. 4 USA 3. 33 Ireland 4. 0 Working : Age: 20 – 60 Retired: Age > 60 Source: Robert Shapiro, “Future Cast 2020. ” 47

The demographic crisis (2) Country % of older people Still working 55 -59 65 -69 Italy 40 3 -6 France 60 -65 3 -6 Germany 60 -65 3 -6 USA 69 25 Japan 76 37 Sweden 81 48

The demographic crisis (3) Country Retirement benefits Last drawn pay Italy 90% Germany 70% France 70% Sweden 70% Japan 59% USA 50% UK 50% Ireland 37% 49

The demographic crisis (4) Country Public pension benefits in 2020 (% of GDP) America 5. 3 China 10 Sweden 11 Germany 13 Japan 13 France 15 Italy 15 50

The Health care crisis Country China Health care % GDP, 2006 spending 2 Japan 8 UK 8 France 10 -11 Germany 10 -11 USA 16 51

Key implication ¨The financial system will have to deliver quickly and deliver to meet these challenges. 52

The future of securitization Volumes will fall. Repackaging and pooling are valuable source of funds. Securitization will remain. Structures will become simpler. Rating agencies will be more conservative. Rating agencies will not be taken more seriously. Originators will have more skin in the game. 53

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