Subprime Crisis - An Indian Perspective-Part I

Genesis


Origin of Subprime crisis can be traced back to early 2000s when US was struggling under the grip of recession. Terror attack on September 11, 2001 added to their woes. Americans were asked, to enjoy their life by spending, by none other than their President, George W Bush. He said on 27.09.2001, “It's to tell the traveling public: Get on board. Do your business around the country. Fly and enjoy America's great destination spots. Get down to Disney World in Florida. Take your families and enjoy life, the way we want it to be enjoyed".

(Source:http://www.whitehouse.gov/news/releases/2001/09/20010927-1.html.)


Recovery of US economy


Americans decided to spend their way out of the economic decline. “Shopping More” was linked to patriotism. Federal Reserve took the initiative by cutting the Fed Rate drastically (key rates went down to 1.00% levels). Rules were relaxed in lending to subprime borrowers ( who otherwise not qualified to take loans at market interest rates due to various risk factors like low income level, size of the down payment made, poor credit history and not so good employment status). Subprime Loans were lent as Adjustable Rate Mortgages (ARMs) wherein the interest rates were kept lower during the initial repayment period and which are subject to subsequent rate hikes.


Structure of Subprime Lending

Subprime Borrowers took loans to buy property (housing loans) then taken multiple loans using the same property as collateral (mortgage loans). As every body was doing the same, the demand for homes had gone up artificially, the buyers were able to sell the property at higher levels in no time. The cost of funds was minimal as the initial interest rates were much lower (because of ARM). Huge margin of profit was available in such transactions. Money thus earned was spent lavishly in the name of patriotism. Banks were happy to see their business growing up and the government/ Federal Reserve was happy to see the country recovering from recession.

Investment Banks (housing Harvard/Oxford/Cambridge educated employees) sensed a new earning opportunity. Subprime loans were securitized (loans were pooled and sold as new asset class) into MBS and other complicated derivative products.

Commercial Banks, Insurance Companies, Fund Houses and other Financial Institutions found these new avenues to deploy their funds profitably and trade actively.

Millions became Billions and Billions became Trillions.





New Global Order


Thus found liquidity started to flow across various other markets. Asian countries, BRIC countries, Commodities and other asset classes started to witness huge fund inflows. US Dollar was pumped into every corner of the world resulting in weakening of US Dollar against every other major currency of the globe.

India too received its share (Few billions of Dollars). Sensex grown up from 3000 levels to 21000 points. Experts gave various reasons right from “Structural Bull Market”, “Super Power by 2050”, “Most Happening Place”, “Strong Fundamentals driving growth”, “ Long term Growth story” etc etc. (You can refer to the other article of the same blog – Layman Brothers Versus Lehman Brothers).

Arab Countries and Russia gave Oil, South American Countries gave commodities, Asian Countries (especially China) became factories and India became a back office for Americans to sustain their high level of spending. Every country was praying day and night that Americans should continue to spend more. There was growth every where in the world.

Dr. Marc Faber concluded his monthly bulletin (June 2008) with the following:

'The federal government is sending each of us a $600 rebate. If we spend that money at Wal-Mart, the money goes to China. If we spend it on gasoline it goes to the Arabs. If we buy a computer it will go to India. If we purchase fruit and vegetables it will go to Mexico, Honduras and Guatemala. If we purchase a good car it will go to Germany. If we purchase useless crap it will go to Taiwan and none of it will help the American economy. The only way to keep that money here at home is to spend it on prostitutes and beer, since these are the only products still produced in US. I've been doing my part.'

It may not surprise us in case, some of the foreign countries, who see the above comment, may prepare themselves to export beer and prostitutes also to US. It is not an exaggeration. Such has been the mad obsession of the world economies to see that Americans continue to spend money lavishly.


First Blink


While the home prices were peaking out, Subprime borrowers started defaulting as they were not able to repay in terms of higher EMIs(introduced after a certain initial period). Delinquency rates started rising. Western Banks refused to accept the truth and number of new derivative products like CDS (Credit Default Swaps) were introduced to the market in the name of innovation.

In February 2007, Federal Reserve admitted for the first time that there was a crisis in US financial markets. A short term correction followed in all the global markets. It was a tip of the Ice Berg. But this time, the newly found bulls in Emerging Economies including India (You can refer to the other article of the same blog – Layman Brothers Versus Lehman Brothers) refused to believe that such crisis might have strong ripple effects across the world in the future.


Liquidity Crunch


Big liquidity crunch happened in USA in January 2008. Societe General Collapsed. Equity markets witnessed big sell off in December 2007 and January 2008 across the globe. Federal Reserve added fuel to the fire by cutting interest rates in the name of facilitating easy liquidity to the struggling banks.

Bear Sterns became bankrupt in March 2008 and one more sell off in equity markets followed. Equity story appeared to be over for the smart people. Investment Bankers and Traders found new investment avenues in Oil, Gold and other commodities. Various stories right from US attack on Iran, more demand from emerging economies and last but not the least, US hurricanes were spread to justify speculation in oil prices.


Final Burst (?)

Nothing could save US and European Banks (who later joined their US counter part in the lucrative (?) subprime business). Entire “Reverse Pyramid”, hanging over the “Subprime Borrowers”, collapsed on its own weight. Delinquency rate spiked up. There was neither buyer for homes nor borrowers for loans. Mark to Market Provisions mounted up. Series of write-downs in billions of dollars followed up. Provision requirements were much higher than the net worth of the banks. Losses run in trillions. Remember, GDP of of entire India is just around one trillion dollars.

US Treasury initially tried to bail out the falling banks by providing additional capital. This also could not help the sinking ship. Final Burst of the bubble has started in the current month (September 2008). This time, commodity markets also joined the other markets in the Big-Bang fall. Flight capital deployed in other markets including emerging economies returned back to US thus helping the US Dollar to strengthen against other currencies.

This is the story of the latest bubble formed by the oldest bubble maker i.e. Greed, which has made even the smartest people to fail one more time. Now there are certain question in our minds.

What is in store for India now (coupling or decoupling)?
Whether this Big Bang fall will continue?
What are the lessons for our markets/ traders/government/monetary authorities?
What should be new policies by our government/ RBI to protect the country and investors from such fall?
Whether to invest now or just keep in cash?
In case of investment, where to invest now, Gold or Commodities or Real Estate or Stocks?
In case of Stocks, which sector and what Company?


Now it is an open forum. Readers are welcome to post their views and suggestions in the comments box.

Part II on the same subject will follow soon.