The document is a report on the US sub-prime crisis and its impact on the Indian economy. It discusses how the US housing market and leveraged security markets contributed to the crisis. The timeline of events leading to the crisis is examined. The roles of various parties like borrowers, financial institutions, and rating agencies are analyzed. The impact of the crisis on the US and world financial markets is assessed. Finally, the effects on India like its stock market, commodity prices, and economy are summarized.
1. The U.S. Sub-prime Crisis – A Study of the recent economic
development in the U.S. and their likely impact on the Indian Economy
A report submitted in partial fulfillment of the requirements of
MBA program at ICFAI Business School, Ahmedabad.
Submitted to: Submitted to:
Prof. Vivek Ranga Mr. Sunil Chandra
Faculty Guide (Country Head-DPM)
IBS, Ahmedabad. Almondz Global Securities Ltd.
0
2. A REPORT
ON
The U.S. Sub-prime Crisis – A Study of the recent economic
development in the U.S. and their likely impact on the Indian Economy
BY
PARAMJEET KAUR
AT
ALMONDZ GLOBAL SECURITIES LIMITED
NEW DELHI
A report submitted in partial fulfillment of the requirements of
MBA program at ICFAI Business School, Ahmedabad.
Submitted to: Submitted to:
Prof. Vivek Ranga Mr. Sunil Chandra
Faculty Guide (Country Head-DPM)
IBS, Ahmedabad. Almondz Global Securities Ltd.
1
3. SUMMER INTERNSHIP PROGRAMME
The U.S. Sub-prime Crisis – A Study of the recent economic
development in the U.S. and their likely impact on the Indian Economy
Submitted By: Name: Paramjeet Kaur
Enrollment No.:07 BS 2784
Mobile No.:09974339611
Email ID:paramjeet.kaur86@gmail.com
2
5. ACKNOWLEDGEMENT
Across the road to the Corporate World, Unknown pursuits came my way.
A ‘Thanks’ would be too small a token, for all that with what I stand today!
The fourteen weeks Summer Internship Programme needs a laudable appreciation for the novel
experience of practical knowledge and the true insights of the clichéd Corporate Culture.
Thanking all the affiliates’, veterans in knowledge and virtuoso in experience would be a mere
token of gratitude, which may not be sufficient for all the knowledge imparted, and all the
blessings bestowed upon me.
I would like to express my immense gratitude to Mr. Sunil Chandra (Country Head, Debt
Portfolio Management) for guiding me throughout the whole project with his impeccable
knowledge. I owe my gratitude to Ms. Rajni Dasgupta (Vice President) who taught me the first
lesson of corporate culture. Mr. Abhilash Kumar (Manager) owes a special mention for the
invaluable insights that he provided me, which would be carried forward as a legacy of
knowledge and learning all through my life.
I am also thankful to all the staff members’ of Almondz Global Securities Limited, who have
always guided me whenever I needed help and acquainted me with the minutest details of
etiquettes and behavioral aspects.
I sincerely thank Mr. Vivek Ranga, who has always been a continuous source of encouragement
all through the project. I am also thankful to my faculty members and Prof. P. Bala Bhaskaran
for guiding me all the way. All the more, ICFAI University needs to be praised which has
provided the students with such a bright opportunity to have an exposure of the real corporate
environment for the valuable period of three and a half months to get the corporate ambience
imprinted on our minds to carry forward the learning’s of this first tryst with corporates in the
future struggle in the path of professional success.
Last but not the least, a special mention must be made to all those who have knowingly and
unknowingly helped me in the completion of this project. I owe my gratitude to my parents who
have always encouraged me in the pursuit of excellence.
Paramjeet Kaur
07 BS 2784
4
6. TABLE OF CONTENTS
ABSTRACT 10
INTRODUCTION 11
Purpose of the Study 11
Scope of the Study 12
Limitations of the Study 12
Methodology of the Study 13
INTRODUCTION 14
HOUSING MARKETS IN U.S.A.: Major Contributor to Growth 16
Homeownership‐ The American Dream 16
Economic Impacts of the Housing Sector 18
Housing Sector having Macro‐economic Implications 20
Impact on Communities 20
Impact on Individuals 21
Housing Contribution to Society 22
LEVERAGED SECURITY MARKETS: The Double Edged Sword 23
Leveraging 23
Housing Sector: The Initial Fuel 23
Securitization: Prime Mover of the Crisis 24
Sub‐prime Crisis: A result of Leveraging 26
SUB‐PRIME LENDING: The Flaws 29
THE CRISIS AND CHRONONOLOGY OF EVENTS: Timeline of Implosion 32
Chronology of Events 36
5
7. THE PARTIES IN THE CRISIS AND THEIR ROLE: Walking the Line 53
Role of Borrowers 53
Role of Financial Institutions 55
Role of Securitization 56
Role of Mortgage Brokers and Mortgage Underwriters 57
Role of Government and Regulators 58
Role of Credit Rating Agencies 58
Role of Central Banks 59
IMPACT OF THE CRISIS ON THE U.S.A.: Entering A Possible Recession 61
Collapsing US Housing markets 63
Unemployment 68
Fed rate cut 69
Inflation 70
Falling dollar 71
Widening fiscal deficit 75
US GDP growth 77
IMPACT OF THE CRISIS ON THE WORLD FINANCIAL MARKETS 78
Impact on the Commodities Markets: Markets pivot on its head 82
Gold Markets 83
Crude Oil 85
Metals 86
On Stock Markets: Gravity proves itself 87
On Some of the Larger Economies: Euro and Japanese 91
6
8. IMPACT ON INDIA 96
The First Signs: First Blood 98
On Financial Markets: Stock Markets lose their Sheen 100
On Commodities markets with special emphasis on Crude oil: A fuel to inflation 102
On Money Markets and Interest Rates: The Hinges of Growth 104
On INR: Challenging the might of the Dollar 107
Indian Housing Markets: Following the Footsteps 109
On Indian Economy: Structural Changes: The proverbial struggle of Good vs. Bad 112
THE NEW WORLD ORDER: Rise Of the Behemoth 114
APPENDIX
Appendix 1: Borrowers Protection Act 2007 118
Appendix 2: Beige Book 125
Appendix 3: Fico Scores 127
Appendix 4: Role of Freddie Mac and Fannie Mae 129
Appendix 5: Housing Market Correction & Bursting of Housing Bubble 131
Appendix 6: Asian Currency Crisis 131
Appendix 7: Russian debt Crisis 132
Appendix 8: Long‐Term Capital Management 133
Appendix 9: Relation between Crude Oil & Dollar Value 134
Appendix 10: Relation between Gold Prices & Dollar Value 136
Appendix 11: Relation between Crude Oil & Gold Prices 138
Appendix 12: Theory of Decoupling 140
GLOSSARY 141
BIBLIOGRAPHY 143
7
9. TABLE OF FIGURES AND ILLUSTRATIONS
Figure 1: Housing Sector creates a vicious circle 14
Figure 2: Real Median Household Income 17
Figure 3: Homeownership trends in USA (in '000) 18
Figure 4: Mechanism of Securitization 25
Figure 5: Timeline of Implosion 34
Figure 6: US Foreclosure Filings 55
Figure 7: Home Ownerships in US 57
Figure 8: Relative Size of Variable Interest Rate Mortgages 65
Figure 9: Home Price Indices 65
Figure 10: Foreclosure starts rate 66
Figure 11: Unemployment in USA 68
Figure 12: Fed Rate cuts in US 69
Figure 13: Inflation Rate in USA 70
Figure 14: USD vs. Euro (Interbank Rate) 72
Figure 15: USD vs. JPY (Interbank Rate) 73
Figure 16: U.S. Treasury Yield Curve Rate 73
Figure 17: Federal Fiscal Position 75
Figure 18: US Economic Growth 77
Figure 19: World Economic Growth 79
Figure 20: Growth figures forecasted by IMF 80
Figure 21: Commodity Prices across the world 82
Figure 22: Gold Prices in USD/Ounces 83
Figure 23: Oil Prices in USD/Barrel 85
Figure 24: Base Metal Indices 86
8
10. Figure 25: Major stock market indices 87
Figure 26: Dow Jones Index 88
Figure 27: NASDAQ Index 89
Figure 28: Nikkei 225 Index 89
Figure 29: DAX Index 90
Figure 30: Main developments in major industrialized economies 91
Figure 31: BSE Sensex 100
Figure 32: Nifty Index 100
Figure 33: Bank Nifty 101
Figure 34: CRR (Cash Reserve Ratio) 104
Figure 35: Call Money Borrowing 105
Figure 36: INR vs. USD 107
Figure 37: Percentage Distribution of GDP as per sectors 112
TABLE OF BOXES
Box 1: Mechanism of Leveraging 26
Box 2: Types of Borrowers 54
Box 3: Predatory Lending Practices 57
Box 4: Potential Subprime Losses 61
Box 5: Main Credit Losses so Far 62
Box 6: Projected Economic Losses 67
Box 7: Major Market Falls in January 2008 87
Box 8: House Price Developments In Central & Eastern European Countries 93
Box 9: Indian Companies with Foreign Losses 98
Box 10: Market Intervention by RBI 108
9
11. ABSTRACT
The U.S. economy has over the past few decades enjoyed the status of being a financial
superpower. The housing sector was booming as more and more people were eager to fulfill the
‘American Dream’ of owning a home. The spiraling housing prices enticed the people to buy
homes with initial borrowing and lending rates that were extremely low; which helped to boost
the demand and supply of new and existing houses. The liquidity of the banks, eagerness of
borrowers to own a house and an inefficiently created structure of financial products lead to the
subprime debacle.
The financial systems were overflowing with liquidity, which made them construct a mechanism
of securitization that involved pooling of the loans and creating Collateralized Debt Obligations
(CDO) and Mortgage Backed Securities (MBS). The low-income borrowers were enticed by the
various types of mortgages such as Adjustable Rate Mortgages, Interest Only Mortgages (I/O)
etc. The borrowers readily accepted these loans as these short-term low rates reduced the burden
of the borrowers. All sorts of people with or without any income proof or documentation availed
of these loans. The pools of these debts were smartly issued to investors depending on the risk
attached to the instruments.
The housing market correction and bursting of the housing market bubble overturned the whole
scenario. This increased the delinquency rates and the number of foreclosures filings were
surging. To make matters worse, the increased unsold inventory further reduced the prices
making it difficult for the financial institutions to sell them and recover their loans. Due to the
complexity, sheer size and volume, presence of numerous players and major flaws in the
subprime lending the whole U.S. economic system now stands at the verge of a possible
collapse. The U.S. economy is witnessing a decline in the growth figures. The unemployment
rates are rising further aggravating the inflation numbers. The strengthening Euro and Yen stand
as evidence that the U.S. economy is in a downturn.
The effects from the possible recession in the U.S. and the reading of a world wide spread of the
‘economic fever’ has made the commodities prices to increase and for the capital markets to
tumble. Widespread losses across the markets have brought economies to reassess their exposure
to the U.S. economy and Central banks of these countries have taken steps (both reactive and
pre-emptive) to control any major contagion.
The Indian economy/markets may be comparatively safe due to the strict regulations of the RBI.
Even then, in the world of gross inter-linkages the chances of the system getting singed cannot
be ignored. The exposure of our economy to the U.S. markets may be limited; even then the
indirect impacts cannot be ignored. The study would then try to analyze the impacts both direct
and indirect on the Indian financial systems.
10
12. INTRODUCTION
The whole world being linked with the common ties of globalization has necessitated the study
of the turbulence in the U.S. economy and its impacts on the world with special relevance to the
Indian economy. The subprime crisis and its effects on the U.S. economy and the world
economies have been studied in detail moving onto the Indian economy.
PURPOSE OF THE STUDY
The main objective of the study is to have:
• An understanding of the ongoing Sub-prime crisis
• The impact on Financial Markets, Commodities Markets (Crude Oil), Money Market of
our country
• Study its impact on U.S.A, developed economies and the Indian Economy.
• Future implications on the World Economic system in general.
• Study the possible impact it may have on India.
• Expected changes to the Indian Economy post Subprime Crisis
The world economies are at present passing through one of the most difficult phases in recent
times. The sub-prime crisis, which has its roots in the U.S., threatens to rage onto the other
developed economies eventually to scathe the emerging market economies in wake. Sitting in
India, we may appear, at present, seem to be unaffected by the world economic problems.
Statements by heads of important agencies have time and again impressed that the Indian
economy has a very little exposure to the subprime and that, aside from scratches, the economy,
in general, would walk tall.
However, in spite of the Indian economic systems seemingly direct insulation from the impacts,
the fact remains that in the world of integrated economic systems, the U.S. recession is bound to
test the resilience of the domestic economy. Already the stock markets, which seem to have the
maximum exposure, have entered into a highly unpredictable and volatile state. The domino
effect on the other sectors would take some more time to incident.
11
13. SCOPE OF THE STUDY
The project involves studying the subprime crisis as a whole. The main topics under this project
are - Housing markets in the U.S.A, Leveraged Security Market & the Process of Subprime
Lending. A study of the chronology of events will also be made to ascertain its incidence and the
way it turned into a huge crisis engulfing the global economies. The project will also involve
studying the parties in the crisis such as borrowers, lenders, banks etc. and their role.
After having an insight of all this the project shall move on to the impact and implications on
U.S., some leading world economies and finally India. This will include studying:
• The Commodities Market with special emphasis on the Crude oil market and how
it effects inflation.
• The Stock Markets of the world
• Overall effect of subprime crisis on the money markets and interest rates in India.
• Changes in forex rate of INR and the U.S.D.
• The Structural Changes of Indian economy posed by the subprime crisis will also
be done.
LIMITATIONS OF THE STUDY
Subprime crisis and the fallouts to the economy thereof is a very expansive area that has
gripped the biggest economy of the world. No matter how deep one goes into it, the
chances of understanding it to the core may be difficult.
The study would also not include aspects that are topical to U.S.A and would include
only those that are relevant in the Indian context or, which may have a bearing on India.
Due to the ‘lag effect’ all the resultants may not manifest itself at the time of the study, so
while a theoretical study may be made, a comparison of the actual results may leave a lot
wanting.
12
14. METHODOLOGY
The methodology comprises an in-depth search of various news articles, journals, reports,
relevant laws and other literary work on this topic.
The report involves an analysis of the latest movements in the U.S. and the Indian
Financial Markets.
A search on the internet and books is another aid to the successful completion.
A systematic approach has been followed which involves concentrating on the lowest
level accentuating the role of various parties who were party to the entire debacle. The
next level of the study involved studying the timeline of how it transformed into such a
huge problem. The impact of U.S. economy, then the inter-related world economies is the
next step under the study.
Finally the subprime crisis spreading its wings to the Indian Economy will be studied.
13
15. INTRODUCTION
“What began as a fairly contained deterioration in portions of the U.S. sub-prime market has
metastasized into severe dislocations in broader credit and funding markets that now pose risks
to the macroeconomic outlook in the United States and globally”
Global Financial Stability Report, IMF, April 2008.
The recent turmoil that has inflicted the world economies is the sub-prime crisis. Related to the
housing prices and engulfing the entire banking system of the U.S. economy, this crisis has
spread its wings to encompass the worldwide economies in its realm translating it into a major
financial crisis. The impact of this crisis has been so severe that the entire banking system of the
world’s largest economy may collapse, leaving little scope for recuperations out of this crisis.
The fact that the housing crisis has led to the present imbroglio is obviously undeniable.
Introduction
The outburst of the crisis after the bursting of the housing bubble in the U.S. has made this
economy confront a new crisis with differently fabricated causes and effects. The high default
rates on “sub-prime” and other higher-risk borrowers with lower income have resulted in the
sub-prime crisis. Initially, the long term rising house prices and the attractive loan incentives
encouraged borrowers to assume mortgages with the fact that they shall be able to refinance later
on. However, the situation reversed when the housing prices started to drop in 2006-2007 in
many parts of the U.S. making it difficult
to refinance the loans. This all resulted in
a vicious circle as the number of
foreclosures increased, the housing
inventory escalated depressing the house
prices (figure 1).
Being inter-related to other sectors of the
economy, these trends have lead to a
contraction in the construction industry,
hurting overall U.S. economic activities
making it enter into a possible recession.
The problem of grave concern is the
falling home prices leading to a credit
crunch, which is actually driving up Figure 0: Housing Sector creates a vicious circle
14
16. mortgage rates and making mortgages unavailable, leading to a further decline in home prices.
The whole carnage revolves around sub-prime lending by financial institutions. These
institutions being accompanied by other parties such as Credit Rating Agencies, Mortgage
Brokers and Underwriters etc. created a complex structure of lending and borrowing process,
through the process of securitization. Being unified with common ties of globalization this
American fiasco soon turned into a worldwide crisis affecting the major economies of the world.
This project studies the entire housing sector, which saw great heights and steep depths within a
very short period of time. How the booming housing sector, which was a major asset of the
weakest people of the society through innovative instruments and loans facilitated by various
parties, saw its downfall is an interesting part, which is analyzed. Being one of the pillars of the
American economy, how the movement in this pillar affected the whole economy inter-linked in
various dimensions of employment, finances, and other macro-economic indicators (inflation,
currency etc) has been thoroughly done. The world bonded by the Theory of Decoupling has
seen new changes in growth brackets, trade movements and other global changes throughout this
period.
Being an emerging economy, the Indian economy has also seen new pursuits in its economic
framework and there still remain unknown pursuits and dimensions connected to the global
economic architecture.
This project thus has various pursuits to explore about the American economy, world economies
and Indian economy. There is a whole gamut of linkages between, inter-related and intra-related
sectors, which have been studied in this project.
15
17. HOUSING MARKETS IN U.S.A
Major Contributors to Growth
The real estate sector is amongst the largest sectors in the U.S.A. It has been a significant
contributor to the U.S. economy, providing millions of jobs and had been generating hundreds of
millions of dollars of economic output each year. It has traditionally been an important source of
wealth building. The housing sector has been the main driver of economic growth of U.S.
Therefore the weakening of this sector tends to have ominous implications for continuing
expansion in the period ahead.
The housing sector accounts for about 6% of GDP, but has been a much more important
component of growth, contributing 0.50% directly to GDP growth (translating to some U.S. $60
billion/year) and on the average adding 30,000 new jobs monthly in 2005. Some estimates
suggested that wealth (home prices) and liquidity (home equity extraction) effects might have
been contributing up to 1.5% to GDP growth in the last few years. Over the past four years
ending 2006, consumer spending and residential construction together have been accounting for
90% of the total growth in GDP. And over two-fifths of all private sector jobs created since 2001
till the advent of crisis have been in housing-related sectors, such as construction, real estate and
mortgage broking.
Homeownership – The American Dream
Housing (or an availability of dwelling) is one of the most important wants of any human. As the
society and civilizations progressed, so did the desire to have a comfortable home. This desire
cuts across all the income segments, race, and income levels. However, the common
denominator remained – owning a house (see chart below).
Two reasons why there was a housing boom was
- Increased level of income and
- Easy availability of money.
Increased level of income
Since 1967, the median household income in the United States had risen by 31%. The rise in
household income has been largely the result of an increase in personal income among college
graduates, a group that had doubled in size since the 1960s, and women entering the labor force.
Today, 42% of all households have two income earners.
16
18. Overall, the median household income rose from $33,338 in 1967 to an all-time high of $44,922
in 1999, and has since decreased slightly to $43,318. Decreases in household income have been
visible during each recession, while increases have been visible during economic upturns.
While per-capita, disposable income had increased 469% since 1972, it had only increased
moderately when inflation is considered. In 1972, disposable personal income has been
determined to be $4,129; $19,385 in 2005 dollars. In 2005, disposable personal income was,
however, $27,640, a 43% increase. Since the late 1990s, household income had fallen slightly.
Figure 1: Real Median Household Income
Further with the advent of complex financial systems, conduits, mechanisms and tools it
suddenly became easier to own a house. 67.5% of households realized this dream in 2001, which
translated into 72.6 million households as homeowners.
Since then, the Bureau of the Census had projected an additional 11.7 million new households
will form over the coming decade, with the larger percentage growth among minorities. The
demand for housing, therefore, will continue to over the next decade. Freddie Mac estimated that
50 million families will be buying homes in the next 10 years - more than 10 million of them for
the first time. Clearly, a substantial segment of society is and will continue to realize the
American Dream. Of course this was before the Sub-prime crisis roared its head.
17
19. 140000
127,958
126,009
123,926
121,478
120,835
Vacant Total
122,187
119,628
119,043
119,280
117,280
Renter Total
115,620
112,655
114,137
110,948
Owner Total
109,716
106,281
108,317
107,277
105,731
17,652
104,631
16,437
120000
15,695
11,633 103,653
14,468
15,598
101,102
13,908
15,276
14,315
14,114
13,747
99,307
13,418
13,153
12,669
95,255
12,258
11,987
11,925
12,024
12,058
12,241
9,448
10,585
10,164
100000
8,908
34,194
35,147
33,678
33,014
34,417
33,506
33,687
34,470
34,831
80000
34,896
35,059
34,943
35,246
31,731
35,559
34,730
34,569
34,243
33,975
33,735
33,320
32,602
32,299
30,695
60000
40000
20000
55,652
63,452
56,844
57,915
58,700
59,755
60,248
61,010
61,823
62,999
63,131
64,740
66,041
67,143
68,637
70,098
71,250
72,593
71,278
72,053
73,575
74,553
75,378
75,159
0
1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2006
Figure 2: Homeownership trends in U.S.A (in '000)
Easy Availability of Money
The most prominent reason for the housing boom was the easy availability of money. After the
dotcom bubble the Federal Reserve Bank had decreased the Fed fund rate 14 times from 6.5% to
1% within two years since 2001. This had increased the liquidity in the market. As a result of this
overflowing liquidity in the financial markets, the banks offered loans to borrowers thus making
money easily accessible to even the low-income borrowers. This also marked the period of the
housing boom.
Economic Impacts of the Housing Sector
Housing sector being a major contributor to the American growth, any shudder in this sector can
engulf the whole economy. And, if it is the American economy, un doubtingly the tremors have
to reach across the globe. The following facts help U.S. to understand the contributions of the
Housing industry to the economic growth of U.S.A.
The housing sector contributed about 14 percent to the nation’s total production.
Home equity constituted the largest share of household net worth.
The stock of fixed residential assets was worth nearly $10 trillion – equivalent to one-
year worth of U.S. GDP.
18
20. About 1.5 million newly housing units were started each year. Housing starts have been
one of the key factors in the macroeconomic business cycle.
About 40 percent of monthly consumer expenditures were housing related.
More than $1 trillion exchanged hands from the sale of existing and new homes.
There were 288,273 establishments categorized as “real estate & rental & leasing with
over 1.7 million paid employees.
40% of the employment growth in the entire economic expansion was a result of soaring
home sales and prices. This included employment in home building directly as well as in
ancillary factors such as supplies, real estate agents, appraisers, title searches and
mortgage servicing.
Thus the housing sector has been one of the main sectors, which contribute both directly
and indirectly to economic activity in the U.S.A.
The two line items in GDP directly associated with the housing sector are residential fixed
investment1 consisting of value-put-in-place of new housing units, production of mobile homes,
brokers’ commissions on the sale of existing residential properties, expenditures related to
improving and additions to existing units, and net purchases of used structures from government
agencies and housing service for personal consumption expenditures, purchased by residents in
the United States, in the form of rent for tenants or as rental equivalence for homeowners. In
2000, residential fixed investment totaled $415 billion and housing service expenditure was $956
billion. The combined total of $1.37 trillion represented 14 percent of GDP.
Also, all economic activities produced a “Keynesian” multiplier effect. A home purchase usually
resulted in further spending in other sectors of the economy (landscaping, appliances, and so on).
The income earned by the landscapers was re-circulated into the economy as they spend,
generating another round of income and purchases. The degree of multiplier depends on the
degree of monetary policy accommodation and the “crowding out” effect. The multiplier was
between 1.34 and 1.62 in the first year or two after an autonomous increase in spending. This
meant that for each dollar increase in direct housing activity would increase the overall GDP by
$1.34 to $1.62.
Many people’s livelihoods depended on real estate. The February 2001 report showed that 1.49
million workers were employed in the real estate industry. The Real Estate and Rental and
Leasing sector, which comprises establishments primarily engaged in renting, leasing, selling,
and buying real estate for others, and appraising real estate, totaled 288,273 establishments with
1.7 million paid employees. The annual payroll amounted to $41.6 billion.
Housing Sector Having Macro-economic Implication
1
Consists of purchases of private residential structures and residential equipment that is owned by landlords and
rented to tenants. From www.bea.gov
19
21. In addition to its direct contribution to GDP, the housing sector has been playing an important
role in the overall direction of the nation’s economy over the course of macroeconomic business
cycles. Conversely, housing starts have made just as dramatic a change, coming out of a
recession. In fact, housing starts lead the rest of the economy preceding changes in GDP. In
other words, disruptions to the housing sector (arising from policy changes) are likely to be
followed by a significant macroeconomic slowdown, while a stimulus to housing can lead the
rest of the economy out of a slowdown.
During an economic slowdown, the Federal Reserve has been lowering the interest rates, other
things equal. Consequently, the fall in interest rates during an economic slowdown has been
acting as a strong buffer often providing a stimulus to the interest-sensitive housing sector. A
drop in mortgage rates means lower monthly mortgage payments. This, in turn, means a lower
qualifying income necessary to purchase a home. Conservatively, a one percentage drop in
mortgage rates has translated into roughly 3 million additional households who would have the
necessary income to qualify for a mortgage for purchasing a median priced home. Furthermore,
many homeowners have refinanced their mortgages with the falling interest rates, leaving
additional spending money to counter economic downturns. The economic slowdown from the
mid-2000 to 2001 is a prime example of how this scenario is being played out. Housing starts
and home sales began declining in spring of 2000 as the Fed has raised interest rates to cool the
exceptionally fast growing economy. However, the economy has cooled much more drastically
than desired and the Fed began reversing the interest rate policy by cutting the rates in early
2001. The subsequent falling interest rates have kept the housing starts and home sales to
rebound to healthy levels even as the overall economy began sinking further. The economy
would have undoubtedly tipped into a recession in early 2001 without the support of the housing
sector during this period.
Impact on Communities
Construction of new homes provided jobs and higher tax revenues for local, state, and federal
governments. Construction of each new single-family home required 1,591 worker-hours or the
equivalent of 0.869 year of full-time labor. Each multifamily unit required 0.402 year of full-
time labor. Projecting these estimates and accounting for productivity and price changes over the
years, it is was estimated that the construction of 1,000 single-family homes generated 2,448
full-time jobs in construction and construction-related industries, $79.4 million in wages, and
$42.5 million in combined federal, state and local revenues and fees. The construction of 1,000
multifamily units is estimated to have generated 1,030 full-time jobs in construction and
construction-related industries, $33.5 million in wages; and $17.8 million in combined federal,
state and local tax revenues and fees. Furthermore roughly 30 percent of the new home
occupant’s income was spent on items produced by local businesses, such as hospitals, daycare
centers, dry cleaners, and auto repair shops.
20
22. Almost 70 percent of all tax revenues raised by local governments in the United States came
from property taxes. Homeowners contributed about 43 percent of property taxes, while
commercial property accounted for 57 percent of real property tax revenues. Construction of new
homes expanded the tax base and so increased the property tax revenues. using the average sales
price of new homes in 2000, the local tax revenue base will increase by $185 billion.
Aside from tax revenue to local communities, home production and subsequent homeownership
provided additional intangible values. Homeowners did not move as frequently as renters,
providing a source of neighborhood stability. Neighborhood stability in turn conferred benefits
of higher social and community involvement such as crime prevention programs. Homeowners
had a stake in their neighborhoods and communities, and so were likely to behave in ways that
provided benefit to everyone in the community. Owners maintain their properties in better
condition than do renters of comparable housing. Such behavioral differences had been observed
regardless of the age or income of homeowners. All of these social benefits to homeownership
can impact property values.
Impact on Individuals
Homeownership also provided individuals with a way to accumulate wealth for the future while
benefiting from the provision of shelter. A tabulation of household wealth from the Federal
Reserve’s Survey of Consumer Finances (1998) shows that home equity (the value of the home
net of mortgages) was the largest component of total wealth. Equity in primary residences
accounted for 28% of the total family asset. Furthermore, the survey shows that 12.8% of
families had some form of residential real estate in addition to primary residence (second homes,
time shares, and other type of residential property), an increase from 11.8% in 1995. The value
of the asset in other residential property accounted for additional 5% of the total household asset.
Retirement accounts were the largest financial assets outside of primary residence, with 19.8% of
the total. Only for the very wealthy (income over $100,000 per year) did the home equity portion
of wealth fall below 50% of the total household wealth.
A separate survey from the Census Bureau also shows the dominant importance of home equity
in determining household net worth. The Survey of Income and Program Participation
periodically collects detailed wealth and asset data as a supplement to its core questions about
labor force participation, income, demographic characteristics, and program participation. In
1995, median household net worth was $40,200; Median home equity for home-owning
households was $50,000. Home equity constituted the largest share of household net worth,
accounting for 44 percent of total net worth.
A privately owned home, therefore, was an important vehicle for wealth accumulation for a large
segment of society. In addition, home investment played an important role in portfolio
diversification. Home prices in the U.S., on average, have risen steadily, and have much lower
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23. volatility than stock or bond prices. The historically standard deviation for stocks and bonds had
been 20% and 9%, respectively. For housing, the standard deviation was about 4%. Furthermore,
the correlation between home prices with stock or bond prices was very low. Homeowners were
also benefited from the easy availability of home equity loans. Whether as a readily available
source of funds, or just the security of a credit source, certainly added value to homeownership.
Housing Contribution to Society
Although the level and benefits of community involvement are hard to measure, several
researchers have found that homeowners tend to be more involved in their communities and local
governments then renters. For instance, owners participated in a greater number of non-
professional organizations and had higher voter participation rates. In addition to higher civic
participation, owners also tend to remain in their homes longer, adding stability and familiarity to
the neighborhood, and also tend to spend more time and money maintaining their residence.
Home equity is one of the largest sources of collateral for bank loans to start new businesses.
Over 740,000 businesses in 1992 reported a mortgage or home equity loan as a source of start-up
capital for their business. It had been estimated in the UK that a 10 percent rise in the aggregate
value of home equity increases the number of new business registration by 5 percent.
Furthermore, people want to be homeowners. Fifty eight percent of the renters responded that
owning a home is either the top or very important priority according to 2000 Fannie Mae’s
National Housing Survey. Freedom to alter their homes or engaging in home maintenance and
improving may provide intrinsic joys.
Furthermore, others have noted that the home buying process and homeownership improve self-
efficacy or a person’s sense of control over life events. And from extensive psychological studies
self-efficacy is associated with better health status.
Whether it be America’s dream or an economic indicator of growth or a tool for changing the
course of Macro-economic policies, the American Housing Market was such an important sector
that any vibrations in the housing led banking mechanism could lead to a shake up in the entire
world economies. The highly leveraged market and the whole dream of owning homes turned
into a huge debacle. Economists call it bursting of the housing “bubble.” In the following pages
we have tried to present the build-up of this bubble, the dynamism of the leveraged security
markets, the role of parties in this crisis and the likely impact on the U.S. and other economies of
the world.
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24. LEVERAGED SECURITY MARKETS
The Double Edged Sword
“…but in the modern fixed-income markets - where leverage is king and cheap credit is only the
current jester - a move of that magnitude can do a lot of damage.”
-Ryan Barnes, The Fuel That Fed The Sub-prime Meltdown.
Leveraging
The leveraging procedure, which intended to multiply the investments, opened new horizons for
banks to offer the investors with innovatively designed debt instruments i.e. mortgage-backed
securities (MBS), and collateralized debt obligations (CDO).
Leveraging is borrowing to invest. Financial leverage takes the form of a loan or other
borrowings (debt), the proceeds of which are reinvested with the intent to earn a greater rate of
return than the cost of borrowing. The most familiar use of leverage is using a mortgage to buy a
home. In return for a down payment one receives funds to purchase an asset that would
otherwise be too expensive. The homeowners either try to pay out the money from the rent that
would be saved or from the income streams (the rent earned) that their vocations generate.
Leveraging helps both the investor and the firm to invest or operate. While leverage can play a
positive role in the financial system, problems can arise when financial institutions go too far in
extending credit to their customers and counter parties. If an investor uses leverage to make an
investment and the investment moves against the investor, his or her loss is much greater than it
would've been if the investment had not been leveraged - leverage magnifies both gains and
losses. In the business world, a company can use leverage to try to generate shareholder wealth,
but if it fails to do so, the interest expense and credit risk of default destroys shareholder value.
The build-up of the sub-prime crisis is based on the mechanism of leveraging. The layer upon
layer of leverage that propelled the expansion is now operating in reverse as the leverage is being
unwound.
Housing Sector: The Initial Fuel
Housing sector has been one of the prominent drivers of the U.S. economy. Not only has it made
contributions to the employment, production and GDP, it has also been a major stimulus for the
overall economic growth of this huge economy leading the global world. This sector has
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25. important linkages to every macroeconomic aggregate like GNP, savings, interest and inflation
rate and also highlights its importance in public policy decisions. The American Financial
Institutions being over-flooded with liquidity magnified the housing sector as a lucrative area.
The leveraging mechanism with its off springs i.e. Mortgage-Backed Securities (MBS) and
Collateralized Debt Obligations (CDO) generated great opportunities for even those who could
not afford to pay the cash flow mandated as among the key requirements for taking loans.
These sophisticated instruments, lackadaisical approach to adherence to prudent lending policy
and the surplus of funds all contributed to the housing sector becoming the most booming
sectors. As it grew, it took with itself almost the entire economy. Then an asset bubble began to
form, frenzy fed on frenzy and the prices started to soar beyond what can safely be said to be the
fundamentally correct prices. However, perhaps the key reason why the sub-prime crisis
entrenched itself deep into the very sinews of the financial system of the U.S. was the creation of
exotic leveraged instruments. That way banks now started lending more than the actual base
money and that too to entities that had a very high risk-premium attached to it.
Securitization: Prime Mover of the Crisis
Securitization, an innovative form of financial engineering introduced two new instruments i.e.
Mortgage Backed Securities and Collateralized Debt Obligations. Securitization is a structured
finance process in which assets; receivables or financial instruments are acquired, classified into
pools, and offered as collateral for third-party investment. Due to securitization, investor need for
mortgage-backed securities (MBS), and collateralized debt obligations (CDO) as a profitable
venture and the tendency of rating agencies to assign investment-grade ratings to these loans
even though having a high risk of default could be originated, packaged and the risk readily
transferred to others. The process of securitization has been explained with help of figure 4.
Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDO’s) the two
instruments of securitization played an important role in aggravating the whole sub-prime saga.
A mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by
the principal and interest payments of a set of mortgage loans mainly on residential property.
Collateralized debt obligations (CDO’s) are also type of asset-backed security and structured
credit product but they are constructed from a portfolio of fixed-income assets. These assets are
divided into different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB),
and equity tranches (unrated). Here junior tranches offer higher coupons (interest rates) to
compensate for the added default risk while senior tranches offer the lowest coupon rate offering
highest safety level.
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26. Figure 3: Mechanism of Securitization
STEP 1: The borrower obtains a loan from MORTGAGE BROKER
the lender with the help of mortgage brokers.
After the loan is made, the lender and the
mortgage broker do not have any
interactions. 1
LOAN
STEP 2: The loan is then sold to the issuer
and the payments made by the borrower are LENDER BORROWER
provided to the issuer by the servicer.
LOAN PROCEEDS
TRUSTEE
MONTHLY PAYMENTS
UNDERWRITER
LOANS
2
RATING AGENCY CASH SERVICER
CREDIT ENHANCEMENT PROVIDER
MONTHLY PAYMENTS
STEP 3: The loan is further sold to the 4
investors. The issuer is assisted by the
trustee, underwriter, rating agency and
credit enhancement provider. ISSUER
STEP 4: The servicer acts as an
3 CASH
intermediary between the borrower and
the issuer, who provides the payments to
the investors. The delinquent losses are SECURITIES MONTHLY PAYMENTS
managed by the servicer & the trustee.
INVESTOR
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27. CDO is a corporate entity constructed to hold assets as collateral and to sell packages of cash
flows to investors. There exists a Special Purpose Vehicle (SPV) that acquires a portfolio of
credits. The assets include mortgage-backed securities, high yield corporate loans etc. The SPV
issues different classes of bonds and equity and the proceeds are used to invest in other
portfolios. The bonds and equity are entitled to
the cash flows from the portfolio of, in
accordance with the Priority of Payments. The MECHANISM OF LEVERAGING
senior notes are paid from the cash flows before
Step #1: Collateralized debt obligations
the mezzanine notes and junior notes. In this (CDOs) that pay an interest rate over and
way, losses are first borne by the equity or above the cost of borrowing were
junior notes, next by the mezzanine notes, and purchased. In this instance 'AAA' rated
finally by the senior notes. In this way, the tranches of subprime, mortgage‐backed
securities were used.
senior notes, mezzanine notes, and equity notes
offer distinctly different combinations of risk Step #2: Leverage was used to buy more
and return. CDOs than one could pay for with capital
alone. Because these CDOs paid an
interest rate over and above the cost of
borrowing, every incremental unit of
Sub-prime crisis: A result of the Leveraging leverage added to the total expected
return. So, the more leverage one
employed, the greater the expected return
Sub-prime crisis was the result of the leveraged
from the trade.
instruments which were aimed to magnify the
gains but resulted in amplifying the losses. Step #3: Credit default swaps (CDS) were
used as insurance against movements in
Individuals who were not able to finance the the credit market. Because the use of
house completely would get the help of banks. leverage increased the portfolio's overall
People would put down a deposit and take out a risk exposure, the next step involved
purchasing insurance on movements in
loan for the rest. Let’s say an investor puts
credit markets. These "insurance"
down $20,000 on a $200,000 house, borrowing instruments called credit default swaps,
the remaining $180,000. He now has a were designed to profit during times when
leveraged ‘investment’ - with a gearing factor of credit concerns caused the bonds to fall in
10. value, effectively hedging away some of
the risk.
If house prices go up by 50% - i.e. the house
Step #4: The money thus rolled in. When
becomes worth $300,000 - he doesn’t just make the cost of the leverage (or debt) is net out
50% of the initial investment: he makes 150% to purchase the 'AAA' rated subprime
profit (once he sells, that is, and not counting debt, as well as the cost of the credit
mortgage interest payments, solicitors’ fees and insurance, one is left with a positive rate of
so on). Conversely, if house prices drop by just return, which is often referred to as
"positive carry" in hedge fund lingo.
10%, his entire deposit would be wiped out.
And if prices drop further, the borrower will be Box 0: Mechanism of Leveraging
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28. in negative equity, owing the bank more than the current value of their house.
Enticed by the high returns on the ever-appreciating value of housing many investment banks,
hedge funds and other institutional investors have done so, making phenomenally good returns
over the five years starting year 2000.
Then the worst that was feared occurred- these leveraged investments started to go awry. Instead
of profits, many investors have been hit by significant losses.
In the above example where the individual had put down $20,000 and took a debt of $180,000,
as long as he sells before the value of the asset becomes less than the value of the debt, there
isn’t any problem. Till the time it is secured on an asset that’s worth at least $180,000 the actual
risk is just $20,000. But what if the investor can’t set a stop-loss (as is usually the case- since the
house is not just for investment purpose but is actually an asset purchased to reside). Suddenly
there’s no market for what his trying to sell or if everyone is so scared that nobody wants to put a
price on what his selling, for fear that it’s too low and will in turn cause them to lose vast
amounts of money too, because they hold similar investments.
Not long ago frenzy fed on frenzy and buoyed the prices up and now frenzy feeds on frenzy and
pulling the prices down rather dramatically.
Now here stands the trouble of the leveraged market. Because the leveraging factor was much
higher than what the system could withstand, and because the sub-prime ‘network’ was ingrained
in almost the entire financial systems of the U.S., when the debacle happened, it simply
collapsed the whole system.
The leveraging that helped the sector grow and propel the economy to boom is now dragging the
same down. In the previous chapter we had covered the importance of the Housing sector. The
effect of this importance can be gauged by a simple fact – Housing sector bust is dragging the
entire U.S. economy to recession. And no matter what levels of fire-fighting that the monetary
authorities undertake, the chances are that the U.S. economy has been dealt a major blow and it
would take some serious and coordinated efforts to sail the boat through.
That is where the U.S. economy stands today. Efforts range from prudent (cutting interest rates)
to near desperate (lending money to commercial banks taking the tainted mortgage-backed
securities as collateral) steps. The hope is that by accepting these investments at face value
central banks will release the credit blockage and get the U.S. economy moving again.
Due to the high amount of liquidity, which was somehow to be put into use, leverage was needed
to boost returns over the last few years, owing to a lack of distressed debt. This led to 7 times
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29. (and sometimes as much as 10 times) leverage on U.S. leveraged buyouts. In Europe, debt
multiples also were stretched, with leverage of 5.5 times in 2007, versus 4.7 times in 1998.
Thus leveraging which was intended to increase the returns and provide shelter to the people of
U.S. plunged economy downwards and contributed to the chronicle of Sub-prime Crisis.
In the global economy, effects in one area of investment quickly spread to others. So when
institutional investors started losing money on collateralized debt obligations (CDO’s) and
residential mortgage-backed securities (RMBS’s) because of the U.S. sub-prime crisis, they
quickly liquidized other investments in order to cover their losses.
For example, some of them shifted cash out of the carry trade (in which money borrowed in low-
interest currencies such as the Yen is invested in higher interest currencies such as the Pound),
causing the Yen to rapidly appreciate and leading to a whole slew of currency investors losing
money on their leveraged positions. These currency investors in turn had to find the money to
cover their losses, perhaps by selling gold, temporarily shifting the gold price downwards and
causing a tranche of leveraged gold investors to face severe losses. And so it went on, and
continues to go on.
The total amount of leveraged investment in the world is unknown, but it has been estimated to
be many multiples of global GDP.
Thus leveraging was a double-edged sword, which was aimed at multiplying the profits, but if it
acted reversely, the losses would magnify much more than the expected profits. Perhaps, that is
what happened in the U.S. economy, where the reverse took place and brought the world at the
verge of this crisis. The tool of leveraging mechanism i.e. the sub-prime lending provides U.S. an
insight of how the construct of the sub-prime crisis took place.
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30. SUB PRIME LENDING
The Flaws
The financial institutions overflowing with liquidity devised the securitization mechanism for
which they classified the lending into three categories namely, The Prime category, the Alt-A
category and Sub-prime category. The parameters of categorizing the credit seekers were:
1. Credit worthiness and documentation prudence
2. Ability to pay back the money
3. Ability to pay down payments
4. Whether it’s a first loan or an already mortgaged asset.
While the prime category of borrowers fulfilled all the parameters, the sub-prime borrowers
stood at fulfilling none. Alt-A borrowers mainly were short of documentation, including proof of
income. Yet these borrowers had clean histories they either had higher loan-to-value or debt-to-
income ratios.
Sub-prime lending (also known as B-paper, near-prime, or second chance lending) is lending at a
higher rate than the prime rate. A higher rate of interest is charged due to limited or tarnished
credit history or inadequate documentation, higher loan-to-value and debt-to-income ratios.
However, with the higher rates comes additional risk for lenders because there is a lack
of documentation - including limited proof of the borrower's income poor credit history, and
adverse financial situations usually associated with sub-prime applicants.
A high risk based pricing system is used in order to calculate the terms of loans, which are
offered to borrowers with varying credit histories. The sub-prime borrowers charge high rates of
interest, but still credit risk is more than interest rate risks due to the increased chances of
defaults and less opportunities to refinance the loans.
Sub-prime lending was initially a helping hand to all those borrowers who aimed to fulfill their
dream of owning a home. Sub-prime loans increased opportunities for homeownership and
added 9 millions of households to the new status of homeowners in less than a decade and
increased employment opportunities thereby increasing the growth rate.
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31. However, providing loans to the low-income sections of the society was a benefit as well as
fallout of the sub-prime loans. The availability of liquidity was the prominent factor that
prompted the banks to provide loans at high rates, on the surety that even if the borrower fails to
pay the loan amount, they may still have the option to sell the houses and recover the amount.
The fact that the housing prices usually tend to appreciate, furthermore, made the bankers free
from any apprehensions of recovering the losses. Also since sub-prime lending, a direct result of
high liquidity, prompted banks to issue loans without any strict regulations which could help
them to earn high amount of profits by the securitization mechanism as explained later.
Sub-prime borrowing was as such not flawed; rather it was the high quantum of sub-prime loans
granted without proper regulations that appeared to be the major reason for the fallout. The
positive picture of profit earnings hid the shortcomings of improper regulations, irresponsible
lending and inefficient rating system by the credit rating agencies.
Sub-prime lending became highly controversial: Sub-prime lenders often engaged in
predatory lending practices such as deliberately lending to borrowers who could never meet the
terms of their loans, thus leading to default, seizure of collateral, and foreclosure. They often
employed unscrupulous means by enticing, inducing, and/or assisting a borrower in taking a
mortgage that carried high fees, a high interest rate etc.
Property Fraud by Lenders: With the increase in sub-prime lending there was a similar
increase in the property frauds. By selling overpriced apartments to the unsuspecting buyers, the
sellers took the money and disappeared. So now the entire deal was between the banks and he
borrowers. In this way the sellers, earned huge amounts on the overpriced sold houses.
Second Mortgages: Irrespective of the bad credit histories, the sub-prime lending had made
second mortgages easier on the existing mortgaged houses. The repayment of another loan
burdened the borrowers, which ultimately had to borne by the lenders i.e. the banks, when the
borrowers defaulted in making the payments.
Lax Lending Rules: Analysts say lax lending standards led some mortgage firms to grant home
loans to tens of thousands of borrowers who did not have the means to meet their mortgage
payments when interest rates increased.
Irresponsible Credit Rating Agencies: Credit rating agencies such as Standard and Poor's,
Moody's and Fitch Ratings were urged by the panel to improve their influential reports and
assumptions about a wide range of securities and corporations.
Major Banks meanwhile were encouraged to disclose more information about the securitization
of complex credit instruments, such as mortgage, credit card and student loans, which they
package or cut up and sell to other banks and investors.
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32. Besides that the other reason why the Sub-prime mortgage crisis unfolded the way it did had also
to do with the complex financial wizardry that was devised around the lending that had the effect
of ‘over-lending’. That is the financial systems geared up by multiples in excess of what they
could or rather should have. Due to the complexity, sheer size and volume, presence of numerous
players and major flaws in the sub-prime lending have all caused the system to collapse. New
forces have played important roles in Sub-prime crisis that had in the post been absent.
1. Complex investments: Financial firms wield ever more sophisticated financial tools.
CDOs and MBAs enabled complex and opaque investments.
2. New institutions: Players like hedge funds and buyout firms – also called Private
Equity, represent a large and rising sharing of overall investment money. Hedge funds
also have taken exposure to the subprime investments. These players are significantly
less regulated than the listed companies-these are less transparent and generally have a
free will to do pretty much what they want. Besides that Rating agency and Credit
enhancers played a very important role in certifying the quality of the subprime credit.
These too are outside the purview of the agencies.
3. Leverage: the growing use of Debt or leverage by financial players magnifies the first
two forces. An era of easy money has enabled more risk taking built on borrowed funds.
That can accentuate in both the ups and downs of a cycle, raising the chances of panic
selling during down turns and frenzied buying in upturns.
4. Globalization: Today all the nations in the world are linked through easy movement of
funds. In the less regulated markets money moves both in and out freely. In the medium
regulated markets like India, the movement is not easy but even then the movement is
copious enough to affect massive hemorrhage. This has very telling effect. In this case for
example large banks across the world had exposure to the subprime conundrum. And
when the damage occurred the ripple effect wiped out a lot of financial players across the
globe.
Given the gearing up and the various reasons as explained above, the subprime imbroglio was a
time-bomb which was waiting to implode. And as it did it took down with it the most powerful
economy in this globe.
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33. THE CRISIS AND CHRONOLOGY OF EVENTS
Timeline of Implosion
“What began as a tremor in the sub-prime mortgage market that affected a relative few, has
sadly gained momentum, creating a broader credit crisis that continues to threaten the middle
class and overall economic growth.”
-Senator Jack Reed
The U.S. economy was at the peak of invincible growth and incessant development with every
sector enjoying a boom since the past two decades. The unemployment rates were fairly low,
inflation under control, stock markets scaling new heights, banking sectors overflowing with
liquidity and growth figures rising steadily accounting for 26% of the worlds GDP.
The American economy flooded with enormous liquidity and the low income citizens striving to
fulfill their imperative dream of shelter had an incomprehensible tryst with each other and
resulted in the whole sub-prime saga.
As it has been said that invention is the mother of necessity the financial institutions devised an
innovative mechanism of securitization with Mortgage Backed Securities and Collateral Bonds
Obligations as the two offsprings. The low-income people who had tarnished credit histories or
no documentation were issued loans without any such requirements to be fulfilled. The funds
generated from these instruments were used to create new investment vehicles i.e. MBS’s and
CDO’s that were issued to investors by the bankers at varying rates of interest depending on the
ability of the borrowers to repay.
The whole mechanism was a laudable creation of the financial know-how and desperately
fulfilled dreams. So the sub-prime lending mechanism was an efficient fabrication of converting
attractive dreams to a moneymaking business with the creation of two ingeniously thought over
instruments.
The boom in the housing sector, enticing interest rates and high profit margins kept on luring the
financial institutions, that they shut their eyes to the pessimistic notion that if those borrowers
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34. failed to pay their debt obligations or if the collateralized houses faced a surge in the prices, the
aftermath could result in the collapse in the whole banking segment on the threshold of which
lies a whole economy with all the sectors interlinked to each other presenting the cascading
effect.
Housing markets have gone bust, interest rates have touched the pinnacles, stock markets across
the world have collapsed, unemployment toll has increased, growth rates have plummeted,
global inflation has been scaling to new heights, the fiscal deficit gaps are widening, corporate
giants have been announcing billion dollar losses with colossal business houses being taken over
at the lowest of their values. Figure 5 shows the timeline of the events.
33