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The Sub Prime Crisis
Feb 08, 2009
By A V Vedpuriswar
The state of the Global Financial System
“Increasingly complex financial
instruments have contributed to the
development of a far more flexible,
efficient and hence resilient financial
system than the one that existed a quarter
century ago.”
- Alan Greenspan, November 2005
“The bright new financial system – for all
its rich rewards and unimaginable wealth
for some – has failed the test of the
marketplace by repeatedly risking
a cascading breakdown of the system as
a whole.”
- Paul Volcker, April 2008
1
Taking Stock
The shakeout on Wall Street
What is special about the current meltdown?
Asset price deflation & deleveraging
Cross currents of inflation & disinflation
Greater intervention by government
The picture at a glance
The World of Derivatives
Type of
Derivative
Interest rate
H1 2008
End 2007
$464.7 trillion $382.3 trillion
Credit
$54.6 trillion
$62.2 trillion
Equity
$11.9 trillion
$10 trillion
H1 2001
$ 57.305
trillion
$ 631.497
billion
The complex world of CDS
Federal Funds Rate movement ( 2000-2008)
House Price trends
Key figures at a glance
Global GDP
$ 55 trillion
US GDP
$ 14 trillion
Estd Sub prime losses
$ 1 trillion
Declared losses
$ 600 billion
15
Value of US residential real estate (2007)
Real estate market
$ 23 trillion
Mortgage debt
$ 10.7 trillion
Homeowner equity
$ 12.3 trillion
Securitised mortgage
$ 6.3 trillion
17
Understanding the US mortgage markets
Agency Mortgage
Securitized portion
Non agency mortgage
18
US Securitized issuance ($ Billion)
Year
Agency
RMBS
2000
479
Non
Agency
RMBS
136
2001
1088
2002
CMBS
ABS
CDO
Total
49
184
86
933
267
74
250
61
1740
1443
414
60
248
56
2221
2003
2131
586
87
256
67
3127
2004
1019
864
102
246
115
2346
2005
965
1191
178
305
187
2826
2006
899
1145
214
278
326
2863
2007
1161
707
236
270
298
2671
2008 H-1
692
47
13
116
14
882
Source: UBS Essentials 2009
19
Agency share of mortgage issuance
1995 – 2003
75 – 85%
2004
54%
2005
45%
2006
45%
20
Reasons for drop in housing affordability
Rise in interest rates from mid – 2003
Rise in home prices
21
1998-99 sub prime crisis
Commercial banks reluctant
Independent specialty finance companies
Gain-on-sale accounting
1998 liquidity crisis
The sub prime lenders went bankrupt
Middle aged borrowers
Aim-to take equity out of home
No CDS  no mechanism to short mortgage credit
22
The sub prime crisis of 2007-2008
Low interest rates
Weak regulation
Securitization
Separation of origination process from ultimate credit risk
New derivatives
23
Virtuous sub prime cycle
Rise in home prices
Buyers priced out
New affordable products
Home sales rise
Buyers can now afford
24
Affordability
Betting on the future
Basic assumptions
Greater credit risk
25
What fuelled the crisis
Competitive pressures
Government – mantra of pro business, pro home ownership,
laissez-faire
Greed
Mislaligned incentives
28
Highly leveraged societies
Highly leveraged investment banks
A quick look at past crises
A tale of two bubbles
Global Economic outlook
Spreads remain high
Europe in recession
The world in recession
In an updated World Economic Outlook, published on November 6th, the IMF predicted that world GDP
growth would fall to 2.2% in 2009, based on purchasing-power parity (PPP) weights, from 5% in 2007
and 3.7% in 2008. Global growth of less than 3% implies a world recession, so its latest forecasts would
push the world over the edge. Some forecasts by private-sector firms are even gloomier, with several
now predicting global GDP growth of no more than 1.5% in 2009. Global GDP has never fallen in any
year since the 1930s Depression. Its worst years since then were 1982 and 1991, with growth of 0.9%
and 1.5% respectively
39
The Emerging Markets at a glance
Not much scope to cut interest rates
The road ahead
Serious challenges ahead
Role of the financial system
What lies ahead?
Why inflation may stage a comeback
High resource consumption in emerging markets
Rise in government deficits and public debt
Labour shortage due to demographic transition
46
The demographic crisis (1)
Country
Working* / Retired
Germany
2
Italy
2
Japan
2
Sweden
2.4
France
2.4
Britain
2.4
USA
3.33
Ireland
4.0
Working :
Age: 20 – 60
Retired:
Age > 60
Source: Robert Shapiro, “Future Cast 2020.”
47
The demographic crisis (2)
Country
% of older people
Still working
55-59
65-69
Italy
40
3-6
France
60-65
3-6
Germany
60-65
3-6
USA
69
25
Japan
76
37
Sweden
81
48
The demographic crisis (3)
Country
Retirement benefits
Last drawn pay
Italy
90%
Germany
70%
France
70%
Sweden
70%
Japan
59%
USA
50%
UK
50%
Ireland
37%
49
The demographic crisis (4)
Country
Public pension benefits in
2020
(% of GDP)
America
5.3
China
10
Sweden
11
Germany
13
Japan
13
France
15
Italy
15
50
The Health care crisis
Country
China
Health care % GDP, 2006
spending
2
Japan
8
UK
8
France
10-11
Germany
10-11
USA
16
51
Key implication
The financial system will have to deliver quickly and deliver to
meet these challenges.
52
The future of securitization
Volumes will fall.
Repackaging and pooling are valuable source of funds.
Securitization will remain.
Structures will become simpler.
Rating agencies will be more conservative.
Rating agencies will not be taken more seriously.
Originators will have more skin in the game.
53
Thank You