Subprime Mortgage Crisis

SUBPRIME MORTGAGE CRISIS

Submitted to: Prof. Chandan Sharma

Submitted by: Chitra Yadav (91076) Neha Mittal (91095) Shweta Kathuria (91108) Sowmya Deepthi KVN

(91111)

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ACKNOWLEDGEMENT

We would like to thank Prof. Chandan Sharma, Fore School of Management, New Delhi for his support and guidance and also for imparting us with the knowledge and skills required to study the subject.

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Contents
Contents...............................................................................................................................3 1. OBJECTIVE....................................................................................................................5 2. INDICATIVE METHODOLGY.....................................................................................5 3. SOURCES TO COLLECT DATA..................................................................................5 4. SUBPRIME CRISIS AND ITS CAUSES – SHWETA KATHURIA (91108)...............6 4.1. Introduction...................................................................................................................6 4.2. Timeline of events.........................................................................................................6 4.3. The main causes of the crisis........................................................................................8 4.3.1 Formation and bursting of U.S. Housing bubble........................................................8 4.3.2 Speculation................................................................................................................10 4.3.3 High Risk Borrowing and Lending Practices...........................................................10 4.3.4 Securitization............................................................................................................12 4.3.5 Inaccurate credit ratings............................................................................................12 4.3.6 Government Policies.................................................................................................13 4.3.7 Policies of Federal Reserve.......................................................................................14 4.3.8 Debt levels of financial institutions..........................................................................15 4.3.9 Shadow Banking System..........................................................................................15 4.4. Vicious Cycle of Foreclosure and Bank Instability....................................................16 5. EFFECT ON USA – NEHA MITTAL (91095)............................................................17 5.1 Introduction – Impact on USA.....................................................................................17 5.2 TED Spread..................................................................................................................17 5.3 Stock market................................................................................................................19 5.4 Effect on Jobs in the financial sector...........................................................................19 5.5 Effects on Housing Prices............................................................................................20 5.6 Effect on Consumer Confidence..................................................................................21 5.7 USA Bank Earnings.....................................................................................................22 5.8 USA Money Supply ....................................................................................................23 5.9 USA Trade Deficit and % GDP...................................................................................25 5.10 Effect on IS-LM curve...............................................................................................25 5.11 Gross Domestic Product............................................................................................26 5.12 Inflation rates.............................................................................................................27 5.13 Manufacturing Index..................................................................................................28 5.14 Impacts worldwide.....................................................................................................29 6. EFFECT ON INDIA – CHITRA YADAV (91076)......................................................32 6.1. Introduction.................................................................................................................32 6.2. Impact of Global Crisis on India.................................................................................33 6.2.1 Visible Impacts.........................................................................................................34 6.2.2 Hidden Impacts.........................................................................................................36 3

6.3. RBI’s Response to Subprime Crisis............................................................................37 6.4. Analysis of RBI Policies.............................................................................................39 6.5. Recommendations.......................................................................................................41 7. REGULATIONS AND MEASURES UNDERTAKEN – SOWMYA DEEPTHI KVN (91111)...............................................................................................................................42 7. 1. Introduction................................................................................................................42 7.2. US Bailout Acts..........................................................................................................42 7.2.1 Major Acts................................................................................................................42 7.2.2 Term Auction Facility (TAF)....................................................................................44 7.2.3 Term Asset-Backed Securities Loan Facility (TALF)..............................................44 7.2.4 Troubled Asset Relief Program (TARP)...................................................................45 7.2.5 Total US Bailouts Till Date......................................................................................47 7.3. Policies in G-20 countries...........................................................................................48 7.4. Policy recommendations.............................................................................................49 7.4.1 Interest rates..............................................................................................................49 7.4.2 Easy Credit ..............................................................................................................49 7.4.3 Nationalization of Financial Institutions...................................................................49 7.4.4 Bailouts by the Government.....................................................................................50 7.4.5 Purchasing of Bad Assets..........................................................................................50 7.4.6 Bondholder Haircuts.................................................................................................50 7.4.7 Government Expenditure..........................................................................................50 7.4.8 Tax Rebates...............................................................................................................51 7.4.9 Homeowner Assistance.............................................................................................51 7.4.10 Establish a System Risk Regulator.........................................................................51 7.4.11 Capital Ratio Requirements....................................................................................52 7.4.12 Break up institutions that are Too Big to Fail.........................................................52 7.4.13 Regulating the Shadow Banking System................................................................52 7.4.14 Strict Mortgage Regulations...................................................................................52 7.4.15 A Financial Products Safety Commission..............................................................53 7.5. The exit strategy..........................................................................................................53 7.5.1 FED’s Exit Strategy..................................................................................................53 7.5.2 G-20’s Exit Strategy.................................................................................................54 7.6. IS-LM curves..............................................................................................................54 8. REFERENCES..............................................................................................................58

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1. OBJECTIVE
To understand and analyze the causes and impacts of the subprime mortgage crisis. To analyze the measures taken by the governments against the crisis.

2. INDICATIVE METHODOLGY
• • • Analyzing the causes of the subprime crisis Analyzing the impacts of the crisis largely on USA and India Analyzing the policies undertaken by the US government to counter the crisis

3. SOURCES TO COLLECT DATA
1. 2. 3. 4. 5. 6. Research papers IMF publications Online journals Newspapers and magazines RBI website US Bureau of Labor website and other US government websites

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4. SUBPRIME CRISIS AND ITS CAUSES – SHWETA KATHURIA (91108) 4.1. Introduction
The subprime mortgage crisis is the current real estate crisis and financial crisis which started as a result of dramatic rise in defaults in mortgage loan repayments and foreclosures in the United States. The crisis put many banks into bankruptcy and came as a big jolt for financial markets in the whole world. The crisis which exposed the underlying weakness in financial industry regulation started in the last decade of 20th century but it became more pronounced in 2007. The crisis is named so because it started as a result of defaults in loan repayment of subprime mortgage loans. The subprime loan is a type of loan that banks offer at an interest rate above the interest rate for prime loan to those individuals who do not qualify for the latter. Quite often, subprime borrowers are not able to get a loan from traditional lenders because of their low credit ratings that suggest that it is quite probable that they will default on their loan repayment. A mortgage represents a loan on a property/house that has to be paid over a specified period of time.

4.2. Timeline of events
Following is the timeline of events showing the United States enactment of government laws and regulations, as well as public and private actions which affected the housing industry and related banking and investment activity. 1913: A National banking system created by Federal Reserve Act 1914: Unfair or deceptive business practices prohibited by Federal Trade Commission Act 1933: Formulation of Glass Steagall Act which separated commercial banks from investment banks. 1968: It becomes mandatory for banks to disclose loan terms and fees. 1970: Weakening of Glass Steagall Act due to introduction of amendments in Bank Holding Company Act; allowing commercial banks to do both - accept deposits and make commercial loans via holding companies. 1978: Supreme Court allows banks to give loans in states other than where they are located. This led to lenders rushing to places with easy lending conditions. 6

1980: Demolition of usury caps for mortgages and rise in bar for prosecuting lenders. 1982: Deregulation of savings and loan industry under Depository Institutions Act 1984: Savings and Loans Industry starts crashing. 1986: Tax Reform Act provides taxpayers to pay off consumer debt form their home equity loans. 1987: Creation of Collateralized Debt Obligations Securities 1989 – 1995: Establishment of Resolution Trust Corporation (RTC) under the Financial Institutions Reforms, Recovery and Enforcement Act that led to closing of several insolvent loans and savings and shifting of regulatory authority to the Office of Thrift Supervision. 1992: Creation of Federal Housing Enterprises Financial Safety and Soundness Act to encourage Freddie Mac and Fannie Mae to lend to support affordable housing thus increasing their pooling and selling of such loans as securities. 1995: Congress enacts measures that make it difficult to sue companies for securities fraud. 1995 – 2001: Formation and collapse of Dot-com bubble. 1997: For conventional home purchasers Mortgage-denial rate increases to 29%. Purchase of more than $60 billion worth of mortgage backed securities by investors. 1998: Formation of housing bubble with appreciation in house prices. 1999: Easing of credit requirements by Fannie Mae thus encouraging banks to lend to high risk individuals. Deregulation of banking, insurance and securities into a financial services industry. 2000: Interest rates, currency prices and stock indexes defined as excluded commodities under Commodity Futures Modernization Act thus encouraging trade of credit-default swaps. 2000 – 2001: Lowering of interest rates from 6.5% to 1.75% leading to creation of easy credit conditions and growth of subprime mortgages. 2002 – 2003: Reduction in mortgage denial rate to 14% for conventional home purchasers. 2003: Federal Reserve’s key interest rate lowers to just 1%. 2003 – 2007: U.S. subprime mortgages increase to 292% due to private sector entering the mortgage bond market. Federal Reserve fails to exercise control over financial institutions foregoing loan standards. 2004 – 2007: A belief that housing prices would continue to go up lead to issuing of large amounts of debt and investment in mortgage backed securities by financial institutions. 2004: U.S. home ownership rate increases to 69.2% Lenders adopt automated loan approvals. SEC foregoes Net Capital Rule for Merrill Lynch, Lehman Brothers, Bear Stearns, Goldman Sachs and Morgan Stanley; thus allowing them to increase their

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leverage tremendously by buying mortgage backed securities and other risky investments. 2005: Abrupt halt in booming housing market; housing prices drop 3.3% nationwide. 2006: U.S. Home Construction Index dips tremendously. Many financial institutions go bankrupt. 2007: Home sales continue to fall. The subprime mortgage industry collapses. Foreclosure activity increases tremendously. Rising interest rates worsen the situation. 2008: Financial crisis escalates with collapse of major lenders and investors and the situation gets worsened by stock market collapse and severe job cuts; which is followed by steps to revive the economy.

4.3. The main causes of the crisis
The crisis was a result of a number of factors that emerged over a number of years, prevalent in both real estate and credit markets

4.3.1 Formation and bursting of U.S. Housing bubble
Prevalence of easy credit conditions for a continued time period due to low interest rates and large inflows of foreign funds led to formation of housing bubble and encouraged debt-financed consumption. The USA home ownership rate increased to 69.2% in 2004. This increase in home ownership rates and rise in demand for housing that led to house prices to rise was caused mainly due to Subprime lending. There was a price rise of 124% between 1997 and 2006 in the price of a typical American house.

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Increase in housing prices resulted in more and more people to refinance their homes at lower interest rate or financing their spending by taking out second mortgages fuelled by increase in home prices. This constant increase in house prices and easy credit conditions led to a construction boom and led to a surplus of unsold houses which eventually caused to decline of U.S. Housing prices. People believed that housing prices would continue to go up, and prevalence of easy credit conditions encouraged borrowers to obtain adjustable rate mortgages. These mortgages charged a below market interest rate for a predetermined period of time followed by market interest rate for the rest of the loan’s term. Many borrowers could not make the higher payments after ending of the period of low interest rate; they would then go for refinancing their homes. As housing prices began to decline; refinancing homes became more difficult. And those borrowers who could neither pay loan amount back nor refinance their homes began defaulting. As more and more people started defaulting on their loan repayments, foreclosures as well as supply of homes for sales increased, which further led to decrease in housing prices. This decline in mortgage payments also lead to decrease in value of mortgage backed securities, which deteriorated the net worth and financial health of banks. This resulted in a vicious cycle which worsened the situation.

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By mid 2008, the U.S. housing prices declined considerably. This severe and sudden decline in house prices lead to a zero or negative equity of homes that translated to homes being worth less than the mortgages for the borrowers. Borrowers in this situation had an incentive to default on their mortgages. By 7 there was a great decline in the number of new homes sold. Further increasing rate of foreclosures increased the surplus of unsold homes which further led to decline in house prices. This worsened the situation as more people were now at the risk of foreclosure or default since refinancing became more difficult.

4.3.2 Speculation
Subprime mortgage crisis has been said to have also caused by a phenomenon called as speculative borrowing. During 2005, 28% of homes purchased (1.65 million units) were for investment purposes, with an additional 12% (1.07 million units) purchased as vacation homes. During 2006, these figures rose to 22% and 14%, respectively. In other words, a record level of nearly 40% of homes purchases were not intended as primary residences. Earlier homes had not been seen as investments but it happened during the housing boom. Homes under construction were being purchased and sold at profit without the seller even having lived in them. Speculators suddenly left the market in 2006, which caused investment sales to fall very fast bringing down the demand for homes.

4.3.3 High Risk Borrowing and Lending Practices
In the early 21st century, lenders became more risk-taking as they started offering loans to high risk borrowers including illegal immigrants. Subprime mortgages increased from 5% in 1994 to 20% in 2006. Also the difference between subprime and prime interest rates reduced significantly from 2001 to 2007.

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In addition to considering higher-risk borrowers, lenders started offering highly risky loan options and borrowing incentives. In 2005, the average down payment for first-time home buyers was just 2%. In fact, 43% of those buyers made no down payment at all. The mortgage qualification guidelines also began to change. First SIVA (Stated Income Verified Assets) loans were created. These loans did not require the borrowers to show proof of income. They were just required to state their proof of income and show that they had money in the bank. Then No Income Verified Assets (NIVA) loans were created which did not even require the borrowers to state their proof of income. They just had to show they had money in the bank. Strictness in loan approval process declined even further with the introduction of NINA (No Income No Assets). These loans did not even require the borrowers to show or state any money in the banks. Only credit score was required to get a mortgage. The interest-only adjustable-rate mortgage, which allows the homeowner to pay just the interest during an initial period, also enticed more borrowers. In 2007, 40% of all subprime loans resulted from automated underwriting. To sell more and more mortgages the lending standards kept declining. But the real problem was that in spite of the fact that housing prices were rising tremendously people were not earning proportionately more. The average household income did not change from 2000 to 2007. So, it was becoming difficult for people to repay their loan installments. That was the time when this housing bubble actually burst.

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4.3.4 Securitization
Earlier when a bank used to give loan to a borrower, the risk was retained by the bank itself. But, then the technique of securitization was created. It was based on originate to distribute model, in which several mortgage loans are pooled together into Mortgage backed securities and sold to investors. By selling the mortgages before maturity banks were able to get more money to lend even more. Thus, aim of the banks remained lending as much as possible with no regard to the credit quality of mortgages. Securitization became more prevalent in late 20th century. But it became thrice of its 1997 value by 2007.This practice declined considerably in 2007 and ended completely in 2008.This led to a sudden and steep decline in source of funds for banks. A major reason why securitizations lead to subprime mortgage crisis was because of the way rating agencies modeled the correlation of risks involved with various loans that form a part of the many loans pooled together in form of mortgage backed security. But, the problem with this rating technique was realized only after billions of dollars of subprime loans had already been sold in form of securities. When finally investors stopped buying mortgage backed securities which decreased the ability of banks to give out more mortgage loans – it was too late. The effects of crisis had already started showing.

4.3.5 Inaccurate credit ratings
Credit rating agencies then gave high rating (investment grade) to mortgage backed securities which was obviously faulty. These high ratings fuelled the sale of mortgage backed securities to investors and thus enabled banks to lend more. Due to the alleged advantages like credit default insurance and equity investors willing to bear first losses, these ratings were considered just.

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When credit rating agencies realized the fault with ratings they had previously awarded; they lowered the credit ratings on these securities. The credit ratings on mortgage backed securities declined by trillions of dollars from 2007 to 2008. In order to maintain their capital ratios several financial institutions had to reduce their mortgage backed securities value and get additional capital. To do this, banks had to sell the new shares of their stock thus bringing down the value of their existing shares.

4.3.6 Government Policies
American presidents have been keen in increasing the home ownership rates. The congress passed AMTPA (Alternative Mortgage Transactions Parity Act) which encouraged the lenders to give out adjustable rate mortgages. Many new loan types were created in the 80s like balloon-payment, adjustable-rate, option-adjustable rate and interest-only mortgages. Also, the government was unable to regulate and prevent the exploitation of these loans. Approximately, 80% of subprime mortgages are adjustablerate mortgages. In 1995, the GSEs like Fannie Mae began receiving government tax incentives for purchasing mortgage backed securities which included loans to low income borrowers. Combined purchases of these two GSEs increased significantly from 2002 to 2006. In late 2008 when it became evident that Freddie Mac and Fannie Mae will not be able to withstand the crisis, the government was forced to nationalize them. The Glass-Steagall Act was enacted after the Great Depression. It aimed at separating the commercial banks from investment banks. This was done because of conflicting 13

interests of the two. The act contributed to the crisis because conservative nature of commercial banking was dominated by risk taking culture of investment banking. This led to increased level of risk taking and high leverage during the high growth period before crisis.

4.3.7 Policies of Federal Reserve
Significant decrease of interest rates by Federal Reserve in early 21st century was a major contributor to real estate boom. From 2000 to 2003, the Federal Reserve lowered the interest rate target from as high as 6.5% to as low as 1.0%. This was done to soften the effects of the collapse of the dot-com bubble and of the September 2001 terrorist attacks, and to combat the perceived risk of deflation. Fed believed that since the rate of inflation was low, interest rates could be safely lowered. But, Fed ignored other important factors. Fed’s assumption was obviously faulty because calculated inflation in the years before crisis was below the real inflation. And thus the monetary policy by government lead to housing bubble.

When Fed realized that it had lowered the interest rates much below required and for a time period much above required, it started decreasing its interest rates. This made loan repayments for those borrowers more difficult who had taken adjustable rate mortgages. 14

This also led to bursting of housing bubble because houses as investment were not that lucrative and speculation became riskier.

4.3.8 Debt levels of financial institutions
According to a SEC decision concerned with net capital rule, U.S. banks could issue more debt, use it and increase their leverage. This made them more vulnerable to declining value of Mortgage backed securities. During 2008, the three biggest U.S. investment banks went bankrupt or were taken over by other banks. These included Lehman Brothers, Bear Stearns and Merrill Lynch. These failures further increased the instability of economy worldwide. The rest of the investment banks like Morgan Stanley and Goldman Sachs became commercial banks, thereby subjecting themselves to more stringent regulation.

4.3.9 Shadow Banking System
The shadow banking system consists of non-bank financial institutions that play an increasingly critical role in lending businesses the money necessary to operate. Shadow banking institutions are typically intermediaries between investors and borrowers. They channel funds from the investors to the corporation, profiting either from fees or from the difference in interest rates between what it pays the investors and what it receives from the borrowers. In the years leading up to the crisis, the top four U.S. depository banks moved an estimated $5.2 trillion in assets and liabilities off-balance sheet into special purpose vehicles or other entities in the shadow banking system. This enabled shadow institutions like Bear Stearns and Lehman Brothers to essentially bypass existing regulations regarding minimum capital ratios, thereby increasing leverage and profits during the boom but increasing losses during the crisis.

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4.4. Vicious Cycle of Foreclosure and Bank Instability
Housing prices decline

Negative equity (Home worth less than mortgage)

Mortgage payments decline

Value of MBS declines

Banks incur losses

Home owners walk away or involuntary foreclosures increase

Economic activity slows and unemploy ment increases

Banks restrict lending

Bank capital (Loanable funds) decline

Increased supply of homes

The severity of the subprime mortgage crisis was exaggerated because of the fact that a cycle of events started occurring that led to further deterioration of the situation. Two cycles were taking place simultaneously. The first one involved lowering of housing prices. This led to a decline in equity of the home and thus refinancing of homes became difficult. Thus, more and more people started defaulting on their loan repayments. Foreclosures of homes increased substantially, both voluntary and involuntary. These foreclosed homes were put on auction by banks. But, there were not many buyers of these homes, so, supply was more than the demand. This further led to a decrease in the prices of homes, which was the starting point of this cycle. The second cycle starts from increased foreclosures. This led to a decreased collection of loan repayments by banks. So, the value of mortgage backed securities declined because they were sold by banks to investors as a combination of many mortgage loans. Thus, banks started to incur losses and this declined the capital with banks. Thus, fewer funds were now available to give away as loans. Thus, the lending practices of banks reduced significantly which led to economic slowdown and increased unemployment. Since, 16

people did not have much money to pay their loans and refinancing also became difficult, so, it further intensified the rate of foreclosures, which was the starting point of this cycle. This also links the two cycles together.

5. EFFECT ON USA – NEHA MITTAL (91095) 5.1 Introduction – Impact on USA
The impact of the subprime crisis was felt on the financial sector when in February 2007 HSBC bank wrote down of subprime-related MBS by $10.5 billion. This was just the first subprime related loss reported. During 2007, more than 100 mortgage companies had to shut down their operations. As the crisis deepened more firms suspended or merged. The mortgage defaults and the provisions for future expected defaults had a drastic impact on the US profits. The decline was $646 million in 4th quarter of 2007 for profits of the USA depository institutions insured by the FDIC. This was a decline of 98% from Q4-2006 to Q4-2007. In 2008 also the trend continued and the decline was 46% from Q12007 to Q1-2008. By August 2008 the financial firms all over the world had written down holdings of $501 billion. These holdings were of the subprime related securities. The crisis reached its peak when Lehman Brothers failed in September 2008. $150 billion were withdrawn from the US monetary funds. US lost 25% of their net worth between June 2007 and November 2008. The impacts in the stock index, housing prices, savings, jobs etc has been discussed in the further topics. The retirement assets of US also dropped by 22% in 2008 as compared to 2006. The total losses are estimated to be around $8.3 trillion by 2008. There have also been large numbers of foreclosures.

5.2 TED Spread
The measure used for the risk for interbank lending is the TED Spread. The higher the TED Spread, it indicates that the banks perceive it riskier to lend money to the banks. It is the difference between the 3 month US T-bill and the 3 month LIBOR rate. LIBOR rate is the rate at which the banks usually lend to each other. The US T-bill is considered as the risk free investment. As can be seen from the graph below, the TED Spread was highest during October 2008 and reached a peak of 450 basis points.

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500 450
Difference (basis points)

400 350 300 250 200 150 100 50 0
02-Jan-03 13-May-03 18-Sep-03 28-Jan-04 09-Jun-04 18-Oct-04 24-Feb-05 08-Jul-05 14-Nov-05 24-Mar-06 08-Aug-06 14-Dec-06 27-Apr-07 06-Sep-07 16-Jan-08 27-May-08 03-Oct-08

The diagram below shows that the 3 month Treasury bill yield movement was close to zero. This indicates that people were willing to forego interest only to keep their money safe for three months. This shows that there was a very high perception of risk and there was almost lending in those times. Also, it can be observed that LIBOR rate was at a peak during those times. This means that the instruments which had variable interest terms were becoming expensive. The instruments include car loans, mortgages, credit card interest rates etc.

Source: Wikipedia

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5.3 Stock market
There was a decline in the stock market.

5.4 Effect on Jobs in the financial sector
More than 34000 employees had been laid off by the financial institutions from July 2007 to March 2008 as per Bloomberg. Some of the statistics to show the amount of lay-offs are: • Citigroup announced 9000 layoffs for the rest of 2008 after already terminating 4200 jobs in January 2008 • Merrill Lynch announced layoff of 2900 jobs by 2008 end • Washington Manual cut the payroll of 3000 workers • RBS planned to cut 7000 jobs as per a report by Financial Times According to the Department of Labor, more than 65,400 jobs had been terminated from August 2007 to August 2008 by the financial institutions in the United States. The graph below shows that the peak employment level was at its lowest as compared to the last five recessions: 19

Source: Bureau of Labor Statistics The below graph indicates that the unemployment rate increased to 8.9% in April 2009, which was the highest level recorded since 1983:

Source: Bureau of Labor Statistics If the part time and discouraged workers are also considered, the unemployment rate would increase to 15.8% in April 2009. The average work week in April was 33.2 hours which was also the lowest in records. The U.S. unemployment rate had increased to 10.2% by October 2009.

5.5 Effects on Housing Prices

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As per the S&P/Case-Shiller housing price index, the average housing price had fallen 8% approximately by November 2007 from their mid 2006 peak. By June 2008, the decrease was 20%. The sales of new houses dropped by 26.4% in 2007.
US CASE-SHILLER HOUSE PRICE INDEX
100 90 80 70 60 50
2000Q1 2000Q4 2001Q3 2002Q2 2003Q1 2003Q4 2004Q3 2005Q2 2006Q1 2006Q4 2007Q3 2008Q2

Nominal

Real

5.6 Effect on Consumer Confidence
The consumer confidence index also decreased with the subprime crisis. The U.S. Consumer Confidence Index (CCI) is an indicator designed to measure consumer confidence, which is defined as the degree of optimism on the state of the economy that consumers are expressing through their activities of savings and spending.

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Source: The Conference Board

5.7 USA Bank Earnings

This above graph is based on the data from a quarterly report from the U.S. Federal Depository Insurance Corporation (FDIC), which is about the bank financial health and

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profitability. The graph clearly shows that the bank earnings in USA in the 3rd and 4th quarters of 2007 saw a negative value.

Q4 -- US Banking Industry
2007 Return on assets (%) Return on equity (%) Core capital (leverage) ratio (%) Noncurrent assets plus OREO (%) Net charge-offs to loans (%) 0.86 8.17 7.98 2006 1.28 12.30 8.22 2005 1.28 12.43 8.25 2004 1.28 13.20 8.11 2003 1.38 15.05 7.88 2002 1.3 2001 1.14

14.08 13.02 7.86 7.79

0.94

0.54

0.50

0.53

0.75

0.90

0.87

0.59

0.39

0.49

0.56 4.02

0.78 16.39

0.97 17.58

0.83 -0.48

Net operating -23.72 8.50 11.39 income growth (%) Source: FDIC – Quarterly Banking Profile

This shows that the US banking industry saw lowest returns on assets and equity in the year 2007 compared to the last 6 years. The quarter to quarter report also indicates negative net operating income growth in the 4th quarter of 2007.

5.8 USA Money Supply
• • • M0: This is the total physical currency with people and the central bank accounts which can be exchanged for the physical currency M1: This is the total physical currency plus the demand deposits M2: This is M1 plus the savings accounts, money market accounts, retail money market mutual funds, and small denomination time deposits (certificates of deposit of under $100,000) 23

•

M3: This is M2 plus all the other CDs (large time deposits, institutional money market mutual fund balances), deposits of Eurodollars and repurchases agreements.

As can be observed from the above graph, there was a steep decline in M1 which is basically the money with the people in the form of currency and demand deposits. This can be attributed to the subprime crisis as people did not have money in hand and thus also defaulted in the payment of the mortgages.

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5.9 USA Trade Deficit and % GDP

The USA current deficit had increased from 1.5% to 5.8% of GDP between 1996 and 2004. This was an increase by $650 billion. Now, to finance these deficits, USA had to borrow large sums of money from abroad, mostly from Asia and oil exporting nations which were running on trade surpluses. As per the Balance of Payments identity, the BoP=0, i.e. capital account surplus should match the current account deficit. Thus there were large capital funds (foreign) into USA to finance its imports. These foreign governments supplied funds by purchasing the USA Treasury bonds and thus they were not very directly impacted by the subprime crisis. USA households on the other side used funds from the foreigners.

5.10 Effect on IS-LM curve
US GDP saw a decline of -0.3% in the 3rd quarter of 2008 and this was mostly due to the fall in consumption which was -2.25% was a decline in fixed investment which was -0.83%. This decline in the consumption and investment has been due to the increase in the cost of credit and the availability of credit reduced. Also there was a fall in the confidence among consumers and the businesses about the future because of which the investment declined.

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Analysing this effect with the help of IS-LM curve, the fall in the consumer confidence of future leads to a leftward shift of IS curve. Moreover due to a decrease in stock price and disposable income led to decreased demand and thus the IS curve shifted leftwards.

5.11 Gross Domestic Product
Real gross domestic product is the output of goods and services produced by the labor and property. There was a decrease in the Real GDP of US following the subprime crisis, the largest decrease found in the ending quarters of 2008 and the beginning quarters of 2009.

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2008: 3 Gross Domestic Product ( Billions of US Dollars) Percent Change (Annual Rate)

Quarter 2008: 2009: 2009: 4 1 2

2009: 3

13324 .6 -2.7

13141 .9 -5.4

12925 .4 -6.4

12901 .5 -0.7

12990 .3 2.8

5.12 Inflation rates

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Year 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000

Jan 0.03% 4.28% 2.08% 3.99% 2.97% 1.93% 2.60% 1.14% 3.73% 2.74%

Feb 0.24% 4.03% 2.42% 3.60% 3.01% 1.69% 2.98% 1.14% 3.53% 3.22%

Mar 0.38% 3.98% 2.78% 3.36% 3.15% 1.74% 3.02% 1.48% 2.92% 3.76%

Apr 0.74% 3.94% 2.57% 3.55% 3.51% 2.29% 2.22% 1.64% 3.27% 3.07%

May 1.28% 4.18% 2.69% 4.17% 2.80% 3.05% 2.06% 1.18% 3.62% 3.19%

Jun 1.43% 5.02% 2.69% 4.32% 2.53% 3.27% 2.11% 1.07% 3.25% 3.73%

Jul 2.10% 5.60% 2.36% 4.15% 3.17% 2.99% 2.11% 1.46% 2.72% 3.66%

Aug 1.48% 5.37% 1.97% 3.82% 3.64% 2.65% 2.16% 1.80% 2.72% 3.41%

Sep 1.29% 4.94% 2.76% 2.06% 4.69% 2.54% 2.32% 1.51% 2.65% 3.45%

Oct 0.18% 3.66% 3.54% 1.31% 4.35% 3.19% 2.04% 2.03% 2.13% 3.45%

Nov NA 1.07% 4.31% 1.97% 3.46% 3.52% 1.77% 2.20% 1.90% 3.45%

Dec NA 0.09% 4.08% 2.54% 3.42% 3.26% 1.88% 2.38% 1.55% 3.39%

Average NA 3.85% 2.85% 3.24% 3.39% 2.68% 2.27% 1.59% 2.83% 3.38%

Note: Red indicates Deflation, NA indicates data not yet released.

Source: InflationData.com

There has been a decline in the inflation rates and 2009 saw a deflationary period.

5.13 Manufacturing Index
The US business sector is measured using the ISM manufacturing index, which was earlier termed as the PMI – Purchasing Manager’s Index. This index is released by the Institute of Supply Management in Arizona in the monthly report on the first working day. The five main indicators are production levels, new orders placed, inventory levels, supplier deliveries and employment environment. An ISM value of 50 is considered neutral, above 50 points as an expansion of the manufacturing sector and below 50 points as a decline in industrial production. MA AP FEB R R 36. 40. 35.8 3 1 48. 48.8 49 6 51. 52. 51.9 1 8 54. 55.4 5 56 MA Y 42.8 49.3 52.5 53.6 28 JU AU SE OC N JUL G P T 44. 48. 52. 52. 55. 8 9 9 6 7 49. 49. 49. 43. 38. 5 5 3 4 7 52. 51. 50. 50. 50. 9 9 6 5 2 52. 51. 3 53 53 8 51 NO V DE C

JAN 200 9 200 8 200 7 200 6 35.6 50.8 49.4 54.8

36.6 50.4 50

32. 9 49. 1 52. 2

200 5 200 4

56.6 60.8

54.8 59.9

54. 9 60. 6

52. 5 51 60. 6 61.4

52 60. 5

54 59. 9

51. 6 58. 5

56. 5 57. 4

57. 2 56.5 56. 3 56.2

54. 9 57. 2

Source: ISM Manufacturing Report on Business® PMI History

There was a decline in the manufacturing in USA in the year 2008. But now in the year 2009, there has been an increase in the manufacturing index.

5.14 Impacts worldwide
The financial crisis had its impacts in many advanced economies and led to a fall in household wealth and asset prices. As per an IMF research, the fall in asset prices led to a downfall in the financial and household assets and the net worth of households. In the first 3 quarters of 2008, the value of household financial assets decreased and the value of housing assets deteriorated with falling house prices. The decrease in household financial assets in United States was 8%, in United Kingdom by 8%, 6% in Europe and 5% in Japan.

29

Source:World Economic and Financial Surveys;World Economic Outlook;April 2009

Net worth is the total assets (i.e. housing and financial assets) minus the financial liabilities. The household wealth losses in United States in 2008 amounted to $11 trillion which included $8.5 trillion in financial assets and $2.5 trillion in housing assets. In UK, the losses were $1.5 trillion.

World share price indices:

30

225 200 175 150 125 100
16-May-05 14-May-07 29-Nov-04 21-Mar-05 19-Mar-07 27-Nov-06 24-Jan-05 12-Jun-06 23-Feb-04 09-Aug-04 06-Sep-05 27-Dec-05 21-Feb-06 07-Aug-06 04-Sep-07 24-Dec-07 19-Feb-08 09-Jun-08 14-Jun-04 22-Jan-07 04-Aug-08 29-Sep-08 19-Apr-04 11-Jul-05 31-Oct-05 04-Oct-04 17-Apr-06 02-Oct-06 09-Jul-07 29-Oct-07 14-Apr-08

75

US S&P500 UK FTSE100

JPN Nikkei225 HK Hang Seng

DJ Euro Stoxx AUS ASX S&P200

As can be seen from the above indices, there was a sudden fall in the price indices all over the world.

WORLD MARKET CAPITALIZATION:
The effect of subprime crisis has also been on the world market capitalization. Since March 2007 it had dropped by 20% and by 31% since December 2007. The worst performers have been the Indian, Russian and Chinese markets as observed by the indices. Mar 2007 to Dec-2007 Sept Dec-2007 to Sept 2008 to Sept Mar 2007 2008 (% 2008 to Sept Sep- (%chang change Sep- (%chang 2008 (% Country 08 e) ) Country 08 e) change) 139 United States 31 -21% -21% India 894 -51% 10% 347 Japan 9 -23% -30% Spain 734 -33% -285 United 271 Kingdom 3 -33% -295 Italy 703 -36% -36% 217 South China 0 -51% 31% Korea 660 -40% -20% 184 France 4 -33% -30% Taiwan 496 -29% -23% 161 Hong Kong 6 -39% -7% Russia 479 -52% -53% Canada 147 -16% -3% Argentina 418 -26% 5% 31

Germany Switzerland Australia Brazil

5 144 1 969 935 934

-35% -20% -34% -33%

-23% -22% -8% 23%

Sweden Mexico Singapore Total World

359 340 327 418 06

-38% -15% -34% -31%

-42% -7% -21% -20%

Source: Bloomberg

6. EFFECT ON INDIA – CHITRA YADAV (91076) 6.1. Introduction
Subprime Crisis is the major cause of the economic downturn that had engulfed a lot of big economies including US since the past one year. The major cause of this crisis was Subprime Lending, which refers to the process in which loans are given to people who have belongs to highest-risk categories and whose chances of default are very high. During 2008 the default rate on loans especially home loans was at its highest and people were losing their homes at an alarming rate. Along with that many lenders like Financial Banks were also losing their money and filed for bankruptcy. All this created a vicious circle in US economy and people started pulling their money out of stocks and banks which further escalated the problem. In this era of liberalization and globalization the impact of Subprime Crisis was not limited to US only. Instead a lot of other economies are bearing the brunt and trying hard to come out of so called recession. And India is one of those. Now most of our economists and analysts believe that this crisis did not affected India in a big way and it is much safer as compared to other economies. The reasons given by them for such estimations are:
•

Indian Banking System had no direct exposure to the mortgage assets and the financial institutions, like Lehman Brothers and had very limited securitized assets. The second reason given is that Indian consumer is very aspirational and its recent growth is driven primarily by domestic consumption and investment and exports account for less than 15 percent of our GDP.

•

32

•

Also there was a little or almost negligible presence of foreign banks in our country which minimized the impact of recession on domestic economy.

According to some of the analysts the real picture of economy in 2009 was as shown:

Capital Market

Indian Market
Availability of Debt Overseas Lender has Appetite

INR FII’s Pooling In

Manageable Liquidity Issue

Picture of Indian Economy as Projected by some analysts in 2009 However, the picture is not so good as it is projected by the analysts. Because if in reality Subprime had not affected our economy then it won’t have been the most talked about topic for all the newspapers, editorial sections, news channels, etc. Also we all have read a lot of news telling the suicides committed by a lot of people due to job losses as an impact of recession. Pune itself lost about 2,00,000 jobs and about 41 diamond workers committed suicide in a small time span of three months from November-08 to January09.

6.2. Impact of Global Crisis on India
The impacts of crisis can be divided into two parts, Visible Impacts and Hidden Impacts.

33

6.2.1 Visible Impacts
• The average GDP of India was about 9.4 percent during three successive years from 2005-06 to 2007-08, but it came down to 6.7 percent for 2008-09 which means our economy was back to what it was about five years ago. Industrial production was also hit hard. It grew by just 2.6 percent as compared to 7.4 percent in the previous year. Merchandise Sector was among the most affected sectors. Imports of India fell by around 12 percent and Exports by more than 20 percent. This put a lot of stress on other sectors too. Trade deficit also widened to around $120 billion in 2008-09 from $88.5 billion 2007-08.

•
•

• Trends in Exports of India and World from Jan-08 to Jan-09 FII’s i.e. Foreign Institutional Investors also withdraw from the stock market which led to a steep decline in the Sensex. Sensex fall by 1400 point in one single day in January, 09. The reduction in FII’s greatly impacted our forex and capital market because of lack of funds. The following graph shows the fluctuations in Sensex closing prices from May-08 to May -09:

34

Trends in BSE Sensex Prices from May-08 to May-09 The graphs show a steep fall in prices from a high of 16,000 to a very low of about 8,000 in the months of November and December-08. •
•

The amount of liquidity available in the market reduce to about one-third in FY 2008-09 from 2007-08. Net capital inflows from US were much lower in 2008-09 as compared to 200708. The following table shows the amount of FII’s, External Commercial Borrowings and Short term credit flow. As can be seen FII’s were negative in 2008-09 depicting an alarming situation. This was mainly because of the drop in confidence of investors in the stock market in US.

TRENDS IN CAPITAL FLOW (US $ MILLION) COMPONENT FIIs (net) External Commercial Borrowings (net) Short-term Trade Credits (net) PERIOD April – Sept 26 April- June 200708 15,508 6,990 200809 -6,421 1,559

April- June

1,804

2,173

35

Trends in FII’s in 2007-08 to 2008-09 All these factors led to a pressure on liquidity and credit position of due to fall in global trade and industrial output. These factors in cumulation had some implications on other sectors too.

6.2.2 Hidden Impacts
The above mentioned effects were those which can be quantified, but there are some other impacts which can’t be but they have a direct impact on us. Some of these are:
•

Rising Unemployment and Underemployment- Unemployment grew at a very high rate during recession. Companies mainly in Information Technology and Financial Sector saw large number of job cuts. All this had a direct impact on the consumer consumption and investment levels. Fall in demand for Labor- Due to decrease in income level of expenditure also decreased and people started saving money. Hence labor demand dropped to an all time low. Expansions in informal economy- Financial banks were not ready to lend money which expanded the base of informal economy.

•

•

36

•

SME’s were hit hard- SME’s i.e. Small and Medium Term Enterprises were among the worst hit sectors. They did not had enough money to support their functions and no one was ready to lend them money too. Downward Pressure on Wages- Since the liquidity position was not good, companies were into cost-cutting for which they cut down the wages and salaries of their employees. More Expensive Capital- Interest rates were increased to a high level as banks were lending to each other at higher rates.

•

•

6.3. RBI’s Response to Subprime Crisis
Following policies and steps were taken by RBI in order to protect the Indian Economy from recession. The source of the following information is http://www.rbi.org.in

RBI’s response as monetary authority
• Till August 2008, the RBI followed a tight monetary stance in view of the inflationary pressures arising from crude, commodity and food prices. In midSeptember 2008, severe disruptions of international money markets, sharp declines in stock markets across the globe and extreme investor aversion brought pressures on the domestic money and forex markets. The RBI responded by selling dollars consistent with its policy objective of maintaining orderly conditions in the foreign exchange market. Simultaneously, it started addressing the liquidity pressures through a variety of measures. A second repo auction in the day under the Liquidity Adjustment Facility (LAF) was also re-introduced in September 2008. The repo rate was cut in stages from 9 per cent in October 2008 to the current rate of 4.75 per cent. The reverse repo rate was brought down from 6 per cent to 3.25 per cent. The cash reserve ratio which was 9 per cent in October 2008 has been brought down to 5 per cent. To overcome the problem of availability of collateral of government securities for availing of LAF, a special refinance facility was introduced in October 2008 to enable banks to get refinance from the RBI against a declaration of having extended bona fide commercial loans, under a pre-existing provision of the RBI Act for a maximum period of 90 days. The statutory liquidity ratio requiring banks to keep 25 per cent of their liabilities in government securities was reduced to 24 per cent. These actions of the RBI since mid-September 2008 resulted in augmentation of actual/potential liquidity of nearly $50 billion. 37

•

•

•

•

•

RBI’s response as forex manager
• The RBI assured the markets that it would continue to sell foreign exchange (US dollar) through agent banks to augment supply in the domestic foreign exchange market or intervene directly to meet any demand-supply gaps, and did so, especially in October 2008. It also provided forex swap facility with a three month tenor, to Indian public and private sector banks having overseas branches or subsidiaries – this acted as a strong comfort to such banks in the context of the drying up of the overseas money markets. Further, for funding the swap facility, banks were allowed to borrow under the LAF for the corresponding tenor at the prevailing repo rate. The forex swap facility of tenor up to three months was extended up to March 31, 2010. The prudential limit on overseas borrowing by banks has been doubled. Taking into account the difficulties faced by exporters, as orders got cancelled and receivables mounted, the RBI extended the period of concessional preshipment and post-shipment export credit. The export credit refinance available to banks from the RBI was also increased. Interest rates on dollar and rupee deposits kept in Indian banks by non resident Indians are capped by the RBI in order to prevent hot money flows. In order to address the impact of slow down in capital flows, the ceiling rates on these deposits were raised. The ceiling on the interest rates at which companies could raise funds from abroad were increased and the end use restrictions that were placed on the deployment of such funds, to deal with the huge inflows in 2007-08, were restored to the status quo position.

•

•

•

RBI’s response for Employment intensive sectors –
• Following the announcement in the Union Budget 2008 in February 2008, the commercial banks, cooperative banks and regional rural banks implemented in the period till June 2008, the debt waiver (100 per cent waiver) program for small and marginal farmers and debt relief (25 per cent relief) program for other farmers, covering an estimated 40 million farmers to the extent of nearly Rs. 71,000 crore or $14.5 billion. The RBI took sector-specific measures to alleviate the stress faced by employment intensive sectors such as SME, export and housing. The RBI extended special refinance of $1.4 billion to Small Industries Development Bank of India (SIDBI) to enable it to on-lend to banks and financial institutions towards incremental SME loans. Banks were advised to carve out and monitor separate sub-limits of large companies to meet payment obligations to micro and small enterprises. 38

•

•

MSME (Refinance) Fund of Rs. 2000 crore ($400 million) was instituted and banks were asked to contribute towards this fund against their shortfall in their lending to the weaker sections as low interest deposits with SIDBI to be used by the latter for providing assistance to the MSME sector.

RBI’s response as debt manager
To contain the knock on effects of the global slowdown, the Government of India announced three fiscal stimulus packages during December 2008-February 2009. • These stimulus packages were in addition to the already announced post-budget expenditure towards farm loan waiver, rural employment guarantee and other social security programs , enhanced pay structure arising from the sixth pay commission, etc. • As a result, the net borrowing requirement for 2008-09 increased by nearly 2.5 times the original projection in 2008-09 from 2.08 per cent of GDP to 5.89 per cent of GDP. The inherent synergies in its multiple roles enabled the RBI to ensure orderly functioning of money, forex and government securities markets while dealing with capital flows, managing additional government market borrowing and ensuring adequate credit to restore growth momentum. •

6.4. Analysis of RBI Policies
RBI has taken a lot of fiscal and monetary policies as mentioned above which brought the economy under control. Government of India also stepped in at right time to increase spending in the economy. The various policies released about a potential liquidity of Rs. 4, 90,000 crores.

39

But as it is said nothing comes free of cost. Government pressures increased due to increase in expenditure. The revenue deficit widened to about 4 percent in 2008-09 from 2 percent in 2007-08 as shown:

40

Trend in Revenue Deficit of Indian Government But overall the timely steps taken by RBI and Government of India restricted the negative impacts which the global downturn could have on the Indian economy.

6.5. Recommendations
Other than taking fiscal and monetary policies the government can try to achieve the following goals to: • Rapid and Intrusive Growth • • • • • Greater integration with rest of the world. Strengthen the democratic policies and safeguard its border . Invest in carbon-imperative projects, Carry on with its strengths of being a Multiethnic, Diversified and at the same time Integrated economy. Should try to bring harmony with its neighboring countries for a proper flow of goods and services.

41

7. REGULATIONS AND MEASURES UNDERTAKEN – SOWMYA DEEPTHI KVN (91111) 7. 1. Introduction
The crisis became apparent in August 2007. With more than 6 Million job cuts and over 100 financial institutions becoming insolvent within the US, the extent of damage caused by the crisis is unimaginable. The Federal Reserve and other central banks took steps which can be broadly classified as follows: o Increased open market operations o Term Auction Facility (TAF) and Term Asset-Backed Securities Loan Facility (TALF) to provide lending facilities against a plethora of collaterals o Drastically reduced Federal Funds rate and discount rate

7.2. US Bailout Acts 7.2.1 Major Acts
o The Economic Stimulus Act of 2008 was signed on 13 February 2008. Under this act, 168 Billion Dollars were sanctioned as tax rebates. However, a preliminary investigation revealed that, though the families who received the benefit spent 3.5% more than others, this cannot be attributed to be a good sign of recovery. The primary cause for such an increase in spending would have been the inflation, which occurred around the same time, leading to very high increases in prices of all food items and petroleum products. o The Student loan guarantees program of 2008, with an allocated amount of 195 Billion Dollars, was announced to assist financial institutions providing student loans. Out of the 195 Billions, 32.6 Billions have been spent under this program. o The Emergency Economic Stabilization Act of 2008 was signed in October 2008. Under this act, 700 Billion Dollars were to be used for purchase of distressed assets, also called Mortgage Backed Securities (MBS). This Act also announced facilitation of financial assistance to banks. o The American Recovery and Reinvestment Act (ARRA) of 2009 was signed in February 2009. Under this act, 787 Billion Dollars were to be spent in the form of extended unemployment benefits, tax rebates to common man, provisions for social welfare, spending in sectors like education, medical facilities, and infrastructure, including the energy sector and also various non-economic items as a part of future outlook. Out of the 787 Billions, 358 Billions have been spent under this Act. 42

o The Unemployment benefits extension Act was signed in February 2009. Under this act, a sum of 8 Billion Dollars was sanctioned to be provided in the form of assistance to the unemployed. o The Public-Private Investment Program was signed in June 2009. Under this program, a sum of 100 Billion Dollars was sanctioned to be used to buy up financial institutions bad assets worth 500 Billions Dollars. This 100Billions, as suggested by the name of the program are government funds which will be combined with private funds to achieve the purpose. Out of the 100 Billions, 23.3 Billions have been spent under this program. The table below lists the various programs formulated in the US to provide financial assistance. A sum of 1.2 Trillion Dollars has been allocated out of which 577.8 Billion Dollars have been spent till date. Program Economic Stimulus Act of 2008
•

Committed

Invested

$168 billion
• •

$168 billion
• •

Rebates for individuals Tax breaks for businesses

$117 billion $51 billion

$117 billion $51 billion

•

Unemployment benefit extension Student loan guarantees American Recovery and Reinvestment Act
• •

$8 billion

$8 billion

$195 billion

$32.6 billion

$787.2 billion
• •

$358.2 billion
• •

Tax relief Stimulus

$288 billion $499.2 billion $25 billion

$62.5 billion $295.6 billion $8 billion

Advanced Technology Vehicles Manufacturing

43

Program program Car Allowance Rebate System

Committed

Invested

$3 billion

$3 billion

7.2.2 Term Auction Facility (TAF)
The TAF is a Federal credit facility. In TAF, every participating depositary institution places a bid with a specified interest rate and amount of credit. An auction is conducted afterwhich the bids are opened and the winners of the auction are declared. The auctioned funds typically vary from 28 day to 84 day maturity periods. Since, the funds are of short term and decided by an auction, the name of the facility was coined as TAF. The main purpose of TAF is to allow for a wider range of collaterals against the funds auctioned. Also, any institution can participate in the bidding process until its financial condition is sound, as determined by its local central bank. Not only the present financial condition, but also the extent to which the institution can maintain the same in the near future also is taken into consideration before deciding on the participation permissions. Hence, a wider range of depositary institutions than possible for normal credit facilities, can take advantage of TAF. Using TAF, the Fed fulfils the function of providing financial assistance to institutions even when the interbank markets are under pressure. The amount of advances to be put under auction, the duration of the auction, the minimum interest rate and auction amount per institution, maximum auction amount in a bid by a depositary institution and other details are all specified well before the start of the bidding process. The participating institutions take part in the bidding process by placing their bids on the local central bank’s toll-free number. For this, the bid process start date and time, end date and time for each auction are also specified before hand.

7.2.3 Term Asset-Backed Securities Loan Facility (TALF)
Fresh issues of Asset Backed Securities (ABS) stopped in US around October 2008. During the same time period, the interest rates on AAA rated Securities (ABS) increased dramatically to reach highest levels. If this was to continue, then, the US economic activity would have further deteriorated as a direct consequence of low credit available to individuals and minor business 44

houses. Hence, the TALF came into picture. Under TALF, these sectors were facilitated with credit against ABS at an affordable interest rate instead of the abnormally high interest rates. A total of 200 Billion Dollars were announced under this program, when it was initialized in November 2008. But, the amount was later increased to 1 Trillion Dollars. The Fed would utilize this amount to extend credit to parties holding ABS which are AAA rated in the form of student loans, auto loans, credit card loans, loans guaranteed by the Small Business Administration (SBA), newly and recently originated consumer and small business loans. The main advantage of TALF is that it does not require approval of the Congress because it is not a part of US Treasury programs.

7.2.4 Troubled Asset Relief Program (TARP)
The troubled asset relief program 2008 is also called as Mortgage Bailout Bill. Unlike the TALF, this program is under the supervision and in the hands of the Treasury Secretary. TARP was initiated to buy out the bad assets of the financial institutions of US and transfer them to the Federal government. It was first rejected in the senate and then accepted in October 2008. TARP was planned in such a way as to not affect the financial markets and also prevent the use of taxpayer’s money. A total of 700 Billion Dollars has been allocated. An initial report was submitted to the congress after the first three months. Then, an additional report needs to be submitted for every additional 50 Billion Dollars spent under this program. Signs of recovery were detected under this program, when in June 2009, ten of the banks under this program decided to exit it. This decision was taken by the banks to save huge amounts of interests being paid on the amount borrowed under this program and also to break free of the terms and conditions inherent in case of borrowings under TARP. These banks were given permission to pay back 68 Billion Dollars of the amount borrowed. But, the Government still holds the right to buy shares of these banks even though the amount was repaid prior to the maturity date. There are controversies involved in this context, as the warrants are convertible only at fair market value and the fair market value is not that easy to predict. Below is the summary of the proceedings under TARP till date: Program Committed Invested

American International Group

$70 billion

$69.8 billion

45

Program Asset Guarantee Program
•

Committed $12.5 billion
•

Invested $5 billion
•

Auto Supplier Support Program
• •

$5 billion
•

$3.5 billion

Automotive Industry Financing Program

$80 billion $80.1 billion

Capital Purchase Program

$218 billion ($70.9 billion)

$204.7 billion ($70.9 billion)

Consumer and Business Lending Initiative

$70 billion

$20 billion

Making Home Affordable

$50 billion

$27.3 billion

Public-Private Investment Program Targeted Investment Program

$100 billion

$23.3 billion

$40 billion

$40 billion

Funds paid back

($73 billion)

($73 billion)

46

Program TARP total

Committed $700 billion

Invested $403.6 billion

7.2.5 Total US Bailouts Till Date
Type of Bailout TARP Fed Reserve Fed Stimulus AIG Bailout FDIC Fund Other Financial Other Housing Estimated Amount 700 6400 1200 182 45.4 1700 745 Invested Amount 403.6 1500 577.8 127.4 45.4 366.4 130.6

Estimated vs Invested
7000 6000 5000 4000 3000 2000 1000 0 TARP Fed Reserve Fed Stimulus AIG Bailout FDIC Fund Other Other Financial Housing

In Billion Dollars

Estimated Invested

As seen from the figure above, the Invested amount, except for AIG Bailout and FDIC funds, is much lesser than the Estimated Investment. So, there is still chance for the Government to pump

47

in more money with cautionary measures in place to reduce the inflationary trend that will arise as a result.

7.3. Policies in G-20 countries
According to IMF report, till date, the fiscal stimulus policies adopted by the G-20 countries total up to one-and-a-half percent of their GDP in 2008, one-and-a-half percent of their GDP in 2009 and are expected to be around one-one by fourth percent of their GDP in 2010. These figures are on an average basis. However, the actual figures of the stimulus packages vary both in amount and composition across the G-20 countries. The common policies across the countries were in the form of tax rebates especially in the personal taxes and some others like VAT. The Government stimulus directly has been in the form of expenditure in the infrastructure sector, financial assistance to state governments, housing aids and supporting small businesses.
o o

About half of these countries gave personal income tax rebates, one-third of them gave indirect tax rebates and about another half announced corporate tax rebates.

About seventy—five percent of countries have increased expenditure in infrastructure sector, specifically in the transportation sector. These vary in the form from direct spending by the central government to transfer to local governments
o

Many of these countries have also protected sectors vulnerable to becoming insolvent. They have also extended benefits to the unemployed, direct funds transfer to the down-trodden, retired and minors, credit facilities to the not so well to do section of their communities. About one-fourth of these countries have also extended credit to small business houses and other sectors like construction, defense, agriculture etc which are directly threatened by the bad economic position. A few of these countries are also laying the road ahead for future, by directing their spending appropriately. Some of the ways are expenditures in health care and education sectors or investing for development of environmental-friendly devices and mechanisms.

o

o

Automatic stabilizers working in the economy are helping to strengthen demand by further lowering tax rates and at the same time increasing government expenditure. But, the negative side is the worsening Balance of Payments for the countries.G-20 countries, most of them being developing economies, are in deeper trouble in this regard, than the developed economies. The higher levels of stimulus packages is being offered by increased government borrowing and thereby taking a serious hit in the Balance of Payments for the government. This effect is not to be neutralized in the short run in any 48

way. Long term outlook is what is forcing the Governments to think twice while implementing the stimulus packages. The repercussions will be felt in the near future. As estimated by the IMF, the Balance of Payment for the G-20 countries as a whole is expected to deteriorate by three-and-a-half percent of GDP in 2009 on an average rate.

7.4. Policy recommendations
Now, let us have a look at a plethora of solutions which have been proposed by various statesmen, economists, businessmen and journalists to the present crisis and also to prevent it from happening again. Some of these have been implemented and most of them have not made it to this day.

7.4.1 Interest rates
Lowering the interest rates is the first thing that comes to mind. This will stimulate the economy because the credit becomes cheaper. Banks will be the most benefitted by this policy, as they will borrow at a lower interest rate from depositors and then lend at a higher interest rate to the borrowers. But, the repercussions are that the capital outflows from the country may be high to countries offering higher interest rates, which in turn weakens the domestic currency. Also, it discourages saving and encourages spending. Once, the economy starts growing, there are high chances of demand driven inflation occurring.

7.4.2 Easy Credit
Credit easing is increasing the money supply in the economy. For example, Fed has done it through increasing open market operations and other tools like TAF and TALF. Even this method leads to weakening of the domestic currency and inflation.

7.4.3 Nationalization of Financial Institutions
Nationalization is the Government assuming partial or full control of financial institutions as part of bailout. Incase of full control, the suppliers, depositors and long-term debt holders are paid as per the money available and the equity share holders and entirely wiped out. The US and other countries have injected huge amounts of money into insolvent financial institutions, however, not through nationalization. The injected amount till date has been in the form of preferred stock or asset purchases. Economists Paul Krugman and Nouriel Roubini support Nationalization. The drawbacks are that the Government may not be able to run the institution better. Also, a threat of nationalization will lead to institutions not getting private funds. It is also a threat to the current shareholders, bond holders as well as the tax payers.

49

7.4.4 Bailouts by the Government
Governments bailout big institutions because their bankruptcy would mean huge stock market crashes or unavailability of credit to borrowers who are worthy. AIG was one of the big financial institutions to be bailed out during the crisis. But, one of the most pointed out drawback is that this creates a safety net for these institutions and proves to be a moral hazard. Journalist Nicole Gelinas harshly criticizes saying that in bailing out failing companies, we are confiscating money from productive members of the economy and giving it to failing ones. Hence, the government indirectly makes their resources being unavailable to other companies that can put them to better, more productive use. World Bank reported that country bailouts cost an average of fourteen percent of GDP.

7.4.5 Purchasing of Bad Assets
It is to purchase those assets of financial institutions which are significantly reduced in value due to payment delinquency which will lead to a winning situation if the institutions can get appropriate price for the assets sold. Added to it, transparency of financial institutions comes into picture in the economy, further improving investor confidence as these institutions can be valued for a fair market price. The Public-Private Partnership Investment Program by the US is an example. Economist Joseph Stilglitz criticized this measure stating that this is generally a loss for the tax payers because the assets are bought at a higher price than the market and sometimes even at the book value which is much higher.

7.4.6 Bondholder Haircuts
Bondholders of the financial institutions that received a bailout have been forced to accept a reduction in the principal amount and the interest rates. This creates a reduction of debt and on the balance sheet thereby improving the solvency situation of the institution. Economists Joseph Stilglitz and Jeffrey Sachs argue that this is the right way to deal with the situation as this method does not need infusion of extra tax payer’s money. Some Economists argue that if this step would have been implemented way back in 2008, the situation would have been much brighter. But, this would act as a repellant for investors. Insurance companies and other investors who hold bonds of these institutions will suffer huge losses. This fear of losing one’s investment would only worsen the recession.

7.4.7 Government Expenditure
Keynesian economics suggests that if spending by government is increased in the same proportion as the consumer expenditure and investment in business have declined, then the economic situation can be improved. US has approximately spent 968 Billion Dollars 50

under this measure. Economist Joseph Stiglitz says that stimulus can be seen as an investment and not just as spending, if used properly. Economists Alan Blinder and Alan Auerbach also support short term Government spending. But, Harvard professor Niall Ferguson and Economists Peter Schiff and John B. Taylor say that US is already facing long term funding and debt challenges and increasing stimulus would only lead to further debts. Conservatives have gone a step further by saying that government expenditure should be reduced. The reason being that, this would result in reduction of cost of inputs for the businesses and hence, they will be able to invest further, thereby providing more employment.

7.4.8 Tax Rebates
Having rejected the idea of increased government spending, instead the Conservatives and supply-side economists propose tax rebates. The tax rebates in the form of indirect or corporate tax cuts will lead to businesses investing further, which will prove to be truly productive and help in reviving the economy. But, the government needs the tax revenue if it has to keep up its regular expenditure levels or risk losing confidence of people. Also, spending on infrastructure such as roads and bridges has a higher impact on GDP and jobs than tax cuts.

7.4.9 Homeowner Assistance
Assistance was provided to the homeowners with case-by-case mortgage assistance, to lessen the impact of the foreclosures which were increasing rapidly. Up to nine million homes are expected to come forward for foreclosure in the next two years, compared to one million in a normal year. Economists Nouriel Roubini and Mark Zandi recommendation was to lower the mortgage balance, which would help lower monthly payments. This would prove to be an incentive to an estimated twenty million homeowners to enter voluntary foreclosure. But, such assistance may also further damage the financial condition of banks.

7.4.10 Establish a System Risk Regulator
The purpose of a systemic risk regulator would be to address the failure of any entity of sufficient scale which would threaten the financial system. Economists Nouriel Roubini and Lasse Pederson made some recommendations in January 2009. Firstly, the capital requirements for financial institutions should be proportional to the systematic risk they pose, which would be assessed by the established body. Secondly, each financial institution would pay an insurance premium to the government based on its systemic risk. Libertarians and conservatives argue for minimal intervention. The markets

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should be allowed to self-regulate. Extensive regulation of financial institutions will render then ineffective.

7.4.11 Capital Ratio Requirements
The solution is to have regulatory capital requirements to discourage financial institutions from becoming too big and to offset their competitive advantage. This must be combined with pre-planned levels of reserves as a safety against losses of loans and borrowers most likely to default on their borrowings. This will also ensure liquidity, as the credit facilities available in the market can freeze up. Both Joseph Stiglitz and Alan Greenspan recommend this. Economists Raghuram Rajan and Paul McCulley have gone a step ahead and suggested “counter-cyclical regulatory policy to help modulate human nature”. On the other hand, higher capital ratios or requirements mean, banks cannot lend as much of their capital base, which increases interest rates and theoretically places downward pressure on economic growth relative to freer lending regulations.

7.4.12 Break up institutions that are Too Big to Fail
Economists Joseph Stiglitz and Simon Johnson have argued that institutions that are "too big to fail" should be broken up, perhaps by splitting them into smaller regional institutions because they are more prone to taking excessive risks due to the availability of support by the central bank should their bets go bad. This has been further supported by Wall Street journalists Martin Wolf and Niall Ferguson. So, when such a “biggie” fails, the creditors should take the hit, not the task payers.

7.4.13 Regulating the Shadow Banking System
Unregulated financial institutions called the shadow banking system, play a critical role in the credit markets. They can have a very high level of financial leverage i.e. they can have a higher level of lending in comparison to the amount of current assets they hold to pay up day-to-day claims. Market pressures to enhance profits by unimaginable levels of risk taking were prevalent everywhere in the economy before the recession. So, many state that the shadow banks need a regulation system in place. But, Economists Nouriel Roubini and Paul Krugman argue that this would impair innovation and anticompetitive economies of scale. Larger the size of financial institutions, the lesser it will be effected by the costs of regulation. The smaller institutions will definitely take a hit.

7.4.14 Strict Mortgage Regulations
At the height of the bubble in 2005, the median down payment for first-time home buyers was two-percent, with more than forty-three percent of those buyers making no down 52

payment. Economist Stan Leibowitz states that there should be a down payment of at least ten percent and monthly payments that can be easily afforded, keeping in view the income levels of the borrower. But, such a change in regulations will shatter the hopes of the people belonging to low-income groups and will also reduce the levels of economic growth.

7.4.15 A Financial Products Safety Commission
Economist Joseph Stiglitz proposed this and was accepted by the Obama administration and put on the to-do list. Such a commission, under the government supervision or as an independent body will review the risk levels of every new financial product. The results would then be periodically conveyed to investors as to which ones are risky and which are safe. The downside being that the rate of financial innovation will take a hit. Moreover, risk-free instruments already exist in the market. People can put their money in a bank account or open market instruments and government securities.

7.5. The exit strategy 7.5.1 FED’s Exit Strategy
The Fed has been reassuring financial markets about the long-term inflationary risks that might arise from pumping large amounts of liquidity into the economy and that, it has the necessary tools to soak up any excess liquidity once the economy starts to recover.
o

Gradual response to demand :

As the financial market picks up and the economy starts recovering, the Fed can gradually remove its stimulus as the demand for its credit facilities in the short-term goes down. Indeed, this process has already begun. By mid-July, short-term credit extended by the Fed to financial institutions and other market participants had fallen to less than 600 Billion Dollars from a peak of 1.5 Trillion Dollars at the end of 2008.
o

Reserve rates :

The Fed can increase the interest rates on the reserves of banks kept with Fed which will help regulate the interest rates in the market to reach federal funds rate target. Banks lend funds at a rate higher than the risk-free rate (the interest rate they earn at Fed) to borrowers. Hence, this would regulate by placing a minimum level on the interest rates charged in the short run.
o

Traditional tools :

The Fed also has a wide range of open market monetary policy instruments at its disposal. These will be used to soak up excess liquidity. These instruments primarily consist of large-scale reverse repurchase agreements with market participants, Treasury bills/ Treasury bond sales and the offering of term deposits to banks. 53

7.5.2 G-20’s Exit Strategy
According to the International Monetary Fund (IMF), the G-20 countries should follow an exit policy keeping in mind the following points: The timing of exits should depend on the position of the economy and the health of the financial system. Also, future growth in demand and supply and further revival of the economy should be kept in mind.
1.

The primary goal should be the consolidation of Fiscal stimulus and policies in place. This is due to the fact that Monetary policy can be more easily normalized than the Fiscal policy.
2. 3.

The Fiscal policy exit strategies should be transparent, throughout the economy, and communicated clearly. The aim should be to lower the debt levels and restore Balance of Payments in the economy with well-planned time frame in which to achieve it. First, the crisis related stimulus packages must be the target of exit strategies. Then, the debt levels and Balance of Payments management will automatically improve.
4. 5. 6. 7.

It is not necessary that unconventional monetary policy instruments be removed before the conventional monetary policy is restored to the original state. Prevailing economic situation, the stability of financial markets should be the primary decision criteria for the time frame in which Fiscal policy is to be restored. If the exit strategies of all the G-20 countries are consistent, they will be more effective. This however, does not mean that they have to be synchronized, but lack of coordination can cause adverse spillovers

7.6. IS-LM curves
The following figure shows the movement of IS-LM curves

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After the regulations were applied, the LM curve moved to the right and the interest rate fell. In principle, the income should have risen as shown below

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Since, initially, there was no increase in money supply, the shift in the LM curve to the rightwards caused inflation because in the M/P, the M remained constant, so for a rightwards shift, the P (Price levels) had to increase. The IS curve was expected to shift to right with the tax cuts and increase in Government Stimulus which would in turn increase the consumer expenditure and investment. But, the IS curve moved to left in reality, due to fall in the consumer confidence and the protectionist psychology that had started to prevail in the consumers and investors. Moreover, the decrease in stock price and disposable income as an effect of inflation further led to its shift leftwards.

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Hence, the interest rates fell further and the Income effect that would have been realized was infact not. With the economies now on the path of recovery, the IS curve will shift rightwards and the interest rates will rise as the expansionary monetary policy is repealed till the interest rates reach the normal levels.

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31. http://www.accountingforinvestments.com/meaning-of-sub-prime-mortgage-crisis 32. http://www.federalreserve.gov/newsevents/press/monetary/20081125a.htm 33. http://www.federalreserve.gov/monetarypolicy/bst_reports.htm#frsreports 34. http://www.federalreserve.gov/monetarypolicy/taf.htm 35. http://www.federalreserve.gov/monetarypolicy/tslf.htm 36. http://www.federalreserve.gov/monetarypolicy/talf.htm 37. http://www.federalreserve.gov/bankinforeg/tarpinfo.htm 38. http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm 39. http://money.cnn.com/news/storysupplement/economy/bailouttracker/index.html 40. http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm 41. http://www.forbes.com/2009/03/04/global-recession-insolvent-opinions-columnistsroubini-economy.html 42. http://www.ft.com/cms/s/0/9c158a92-1a3c-11de-9f91-0000779fd2ac.html? nclick_check=1 43. http://www.nytimes.com/2009/01/19/opinion/19krugman.html? _r=3&partner=rssnyt&emc=rss 44. http://www.charlierose.com/view/interview/9310 45. http://www.nytimes.com/2009/04/01/opinion/01stiglitz.html?_r=1 46. http://www.hussmanfunds.com/wmc/wmc090330.htm 47. http://cop.senate.gov/documents/testimony-011409-stiglitz.pdf 48. http://www.ft.com/cms/s/0/85106daa-f140-11dd-8790-0000779fd2ac.html 49. http://roomfordebate.blogs.nytimes.com/2009/04/01/the-art-of-persuasion-at-the-g-20summit/ 50. http://www.city-journal.org/2009/eon0323ng.html 51. http://www.forbes.com/2009/02/18/depression-financial-crisis-capitalism-opinionscolumnists_recession_stimulus.html 52. http://www.reuters.com/article/newsOne/idUSTRE51R16220090228? pageNumber=3&virtualBrandChannel=0 53. http://online.wsj.com/article/SB124657539489189043.html 54. http://edition.cnn.com/2008/POLITICS/09/17/stiglitz.crisis/ 55. http://www.washingtonpost.com/wpdyn/content/article/2009/06/14/AR2009061402443_pf.html 56. http://www.foxnews.com/story/0,2933,329565,00.html 57. http://www.govtrack.us/congress/billtext.xpd?bill=h110-5140 58. http://www.irs.gov/newsroom/article/0,,id=179181,00.html 59. http://en.wikipedia.org/wiki/subrpime crisis 60. http://stimulus.org/ 61. http://www.ft.com/cms/s/4d0add58-ee27-11dd-b7910000779fd2ac,Authorised=false.html?_i_location=http://www.ft.com/cms/s/0/4d0add58-ee2759

11dd-b7910000779fd2ac.html&_i_referer=http://en.wikipedia.org/wiki/Subprime_mortgage_crisis_solutio ns_debate 62. http://www.economist.com/finance/displaystory.cfm?story_id=13446173 63. http://media.pimco-global.com/pdfs/pdf/GCB%20Focus%20May%2009.pdf? WT.cg_n=PIMCO-US&WT.ti=GCB%20Focus%20May%2009.pdf 64. http://www.imf.org/external/np/g20/110709.htm 65. http://www.imf.org/external/np/g20/pdf/090309b.pdf 66. http://www.imf.org/external/np/g20/pdf/102909.pdf 67. http://www.imf.org/external/np/g20/pdf/100109a.pdf

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