The

- An Analysis
Sub Prime Crisis
K V Sharat Chandra*

Nivedita S Joshi*

II. Some thoughts on the specific characters of the present crisis :

«  Three issues seem important for the understanding of what has happened.

«  1. The issue of transparency : it is at the heart of the present crisis. Why ? Because financial
so called “structured” products are more complex (they often combine low and high rated assets
in single instruments) and hard to understand let alone to gauge. This is so true that, when
liquidity evaporates, some of these assets are extremely difficult to value. Also because most of
the non banks -that hold such products and refinance themselves on the market- are not
supervised, are not listed and therefore are not subject to mandatory disclosure rules. The
amount of leverage they engage in is not precisely known in most cases. Thus, those investors
who have a mandatory requirement to hold investment-grade instruments, have been able to buy
portions of structured products with high ratings because of bundling techniques and rating
agencies methodologies. Therefore, the market place -when something goes wrong, as has been
the case with the recent increasing delinquency ratios in the US sub prime,- feels uncertain on
the quality of assets and confidence starts waning. That was when contagion spread out
irrationally from the subprime mortgage problem into the credit markets at large and ended up
in a widespread flight from risk. I could not overemphasize the importance of transparency for
preventing such systemic reactions.

«  2. The fabric of “the new financial world”, as it has developed over the last years, has
lowered risk assessments and encouraged credit laxity :

«  As we all know, the system has shifted from direct bank loans to market financing . There is
nothing wrong in this evolution. It has allowed an enormous rise in capital flows and has been a
major engine of world economic growth.

«  But significant deviations -which have often gone unnoticed- have occurred :

  « global expansionary monetary policy (which led to negative “real” US interest rates, in
terms of expected inflation, in 2002-2004) has allowed liquidity to increase in such a way that
the possibility of scarce money was not even a consideration in the mind of most of the market
players. This is always dangerous  ;
   « a number of financial institutions wanted to take advantage of the appetite for higher yields.
They have thus systematically sought to sell their initial credits to special vehicles. In doing so,
they saw two advantages : they made high fees on securitisation transactions and they got out of
their balance sheets costly (capital adequacy wise) and risky credits ;

  « one of the dangers of this wave of securitisation is that some banks tend to become less
vigilant on the quality of their loans and more interested in the quantity of credits to be
packaged at remunerative conditions. This was particularly the case of US subprime lenders . A
number of originators, -some non regulated like mortgage brokers, some directly regulated as
investment firms or banks-, were tempted to give too much weight to the growth of their
business, provided they found an arranger to bundle and sell the assets as well as proper bridge
refinancing. The same pattern is true for the arrangers : they only take the transitional
warehousing risk and the distribution risk. They may know that the underlying risk of the assets
is increasing but they don’t always care since they are not supposed to hold these assets. Their
reputation is nonetheless at stake.

  « the spreading out of risks through securitization was seen as protecting the financial system
from too much credit risk in banks balance sheets. But “the dispersal of structured credit
products has substantially increased uncertainty about the extent of the risks and where they are
ultimately held” , as well as about investors behaviour in case of a market reversal ;

  « but, perhaps the biggest danger lies in the proliferation and deterioration of “Special
vehicles” (SPVs). Initially, these off balance sheet vehicles were not exposed to liquidity risk as
they were fully covered by back-up lines granted by their “sponsoring” financial institutions.
But, more recently, sophisticated conduits -structured investment vehicles- (SIVs) were
established with partial back up lines. Their business was based on the premise that, in the
event, their high-grade assets would not fall down the rating curve suddenly but in an orderly
fashion that could be anticipated. They thought they would be able to sell down assets and
terminate hedges gradually, while still retaining high-grade debt status. All this has been
severely tested by recent events.

«  3. The issue of regulation :

  « Disintermediation, as it worked in its latest excesses, performed like a huge “quasi-

banking” machinery. A number of actors (mostly non regulated) sold packaged credit-based
instruments to investors worldwide. Indeed, the most sophisticated SPV conduits turned out to be
“virtual or synthetic” banks, taking the same range of risks -in terms of interest rates, cost of
risk and maturities-. But, contrary to banks, these entities had a very weak capital, no deposit
base and were not regulated. This funding mismatch was at the heart of the turmoil. The limits of
these vehicles were  : market acceptance to refinance them and the willingness of their bank’s
arrangers to set up liquidity lines.

«  So, the bottom line is that the main constraint that applies to these vehicles is, besides the
banks willingness to ensure liquidity eventually beyond the agreed back-up lines, market
behaviour.
   « But market behaviour can only be guided by information and disclosure. This information
was, in essence, provided by rating agencies. However it is a fact that the relaxation of lending
criteria for the sub-prime borrowers in the last two years has not been properly incorporated
into the rating process. Early observable signs of increasing delinquencies came late and could
not easily be interpreted in terms of expected losses. Furthermore, rating speaks to the
likelihood of default, but not to the amount that may be recovered in a post-default scenario. In
addition, ratings cannot be considered as precise predictions of default probabilities as they are
essentially linked to averages from past observations and do not grant much weight to recent
trends. More generally, it appears that the riskiness of some of the “individual tranches” of
mortgage pools has proved to be often underestimated.

«  So, if rating agencies cannot provide an adequate picture of looming potential risks, isn’t
there a case for more preventive action through regulation, or, at least, disclosure ? The issue
cannot be just brushed aside because “markets are always right”. After all, claiming that the
market is the best regulator finds its limits when Central Banks must intervene to avoid a
collapse of liquidity.

« It seems to me that, besides the subject of the subprime market -basically a
III. Suggested actions :
serious US consumer protection problem- different issues should be dealt with.

«  I shall mention a few of these issues :

  « the issue of off balance sheet conduits and the reputational risks involved by sponsoring
banks. It is obvious to me that back-up lines deserve more scrutiny from the regulators. These
lines were not appropriately risk-weighted under Basle I and the large exposure regime (0 %
risk-weighting for lines shorter than one year). The new framework is better calibrated but may
still be challenged as partial liquidity lines may be insufficient and could lead to larger calls on
banks. In any case a swift and general implementation of Basle II is of the essence ;
  « the issue of risk concentration. Is it normal that some financial institutions have engineered
SIV’s whose assets amounted to several times their capital ? The off-balance sheet character of
these conduits seems to have encouraged some institutions to disregard the wise old rule of :
“never put more than 25 % of your equity on one client”. This is all the more relevant that many
SIVs are concentrated on one sector (for instance, mortgage or subprime). In this case also, the
reform of capital adequacy constraints addresses partly the issue (Pillar II) ;
  « the issue of rating agencies is, of course, on the list, and it is directly related to the way
regulation is conceived. I believe that rating agencies have been, de facto, too much used as
proxies for regulating markets whilst they are unable to play such a role. Furthermore, it is
clear that there is an imbalance between the incentives of rating agencies to get remuneration
from their clients on the one hand, and the rather weak incentive they have to follow up the
borrower’s quality on the other hand. This leads agencies to grant limited resources to the
surveillance of their ratings. Further thought on possible conflicts of interest and on the
methodology used by rating agencies to assess evolving risk quality and complex instruments, is
called for ;
  « the issue of transparency needs to be addressed, as I mentioned above, in its various
dimensions (valuation issues reporting by non-regulated entities, methodology of ratings for
complex products…). Firms must improve their understanding and monitoring of risks
(including liquidity risk) linked to credit transfer products. The need for transparency will
however be better satisfied by the relevance of information than by its abundance. The market
will only be confident when the true risks involved in such products are well understood. Some
products, in particular the more complex ones, should be known as risky from the start, while
others -more simple and widespread- should be constructed, marketed and publicised as largely
secured (liquidity wise) ;
  « the issue of whether -and, if so, how- unregulated entities, such as hedge funds or bank or
non-bank sponsored special vehicles (which have played a major role in spreading risk to
investors) should be regulated and subject to capital requirements, or, at least, be under
disclosure obligations ;
  « given the global nature of the liquidity problems, it is even more essential than ever to try
and reach, on fundamental principles, a global position among regulators and supervisors.

«  One should also have in mind the subject of asset management (structure of mutual funds,
maturities, exit conditions…).

«  Most of these matters can be dealt with through improved practices and standards by the
industry. Some are, in my view, of the competence of regulators. Hence, the importance of a
constructive dialogue between the private and the public sector. This dialogue should focus on
what is essential to restore investor confidence. But it should not, in any way, be construed as
hampering financial innovation which must remain alive and at the heart of our industry albeit
better explained and, if needed, better regulated.

«  Markets will recover even if that can take some time. We are fortunate that the fundamental
factors behind world growth remain healthy, that banks are strongly capitalized and that
Central Banks (especially the ECB and the Fed) have been wise and reactive in their
interventions as lenders of last resort. We must now do all we can to restore confidence among
investors while keeping in mind the need to correct in an intelligent fashion the world
imbalances which remain centred on the United States and Asia. »
* Indian institute of Management, Calcutta, Class of 2008

The
- An Analysis
Sub Prime Crisis
K V Sharat Chandra*
Nivedita S Joshi*
Introduction
The sub prime mortgage crisis is
perhaps the most discussed issue in
financial and economic markets in the
recent past. The crisis has the US
economy in a recession and has fuelled
fears of spiraling into a prolonged global
crisis. The recent Fed rate cuts to boost
money supply do not seem to have
brought any respite to the ailing US
economy, just as Wall Street majors
continue to write down amounts every
quarter – Citibank and Merrill Lynch are
good examples, with write downs in
double digit billion dollar figures. In the
backdrop of this financial mayhem, the
future of Mortgage Backed Securities
markets, and the inter bank markets is an
interesting area of study. Does the sub
prime crisis have consequences
beyond the realm of financial markets?
One could wonder how world real estate
prices would be affected by the crisis.
This aarticle seeks to address the
following questions: (a) How did this
crisis develop? (b) What is the theory to
explain it? (c) What are the industry
estimates of the total losses on account
of the crisis? (d) What is its impact on
other leading financial hubs in Europe
and Asia? and (e) What can be done to
mitigate the crisis?
The Development of the Crisis
The Seeds are Sown
Though the crisis itself is only a year old, the seeds were sown quite
some time back – at the beginning of this decade. The year 2002 is
where the US economy moved towards where it finds itself today. The
financial year had not got off to a great start. In fact, the US markets
had lost 30% of their points between the months of March and July.
After a decade long bull run, the markets were estimated to be
overvalued. Hence, this was judged to be a correction to bring the
markets back towards their true value. No alarm bells were rung – the
bust cycle after years of boom was just considered natural. The
Federal Reserve intervened to restore liquidity in the market. As
before, the Federal Fund Rates was the instrument used (refer the
diagram below).
11
The Fed cut the rates by 50 basis points on November 6, 2002 to bring an already
low rate of 1.75% down to 1.25 %. This was followed by a further rate cut on June
25th, 2003 to bring the rate down to just 1%. The 3 month T-bill rate is a key rate in
the world markets. Many believe that, along with the 3 month LIBOR, the 3 month
T-bill rate is the benchmark rate that determines the level of the rate markets world
over. The 3m T-bill rate followed the Fed action to fall to less than 1.5% during this
period. It is also a key rate as the 3m T-bills are the instruments that the Treasury
and the Federal Reserve use to infuse money into the economy through Open
Market Transactions. Hence, the money supply tap had been opened full throttle.
It is very difficult to judge how much intervention by the Fed is good for the
economy. Economists vary widely in their views on the subject. There are as many
strong advocates of the hands-off policy as there are Fed intervention lobbyists.
However, in hindsight, one can always be a genius. And, in hindsight, the Fed cut
the rates beyond what was necessary to check the recessions. Also, some claim
that once the recession was over in a period of just a few months, it took too long to
restore rates to healthy levels again. The rates did not reach even 4.5% till 2006 – 4
years post the minor slowdown of 2002. As a result of unnaturally low rates, asset
prices sky rocketed. The asset this time was real estate. Outwardly, the US was in
the middle of period of prosperity. But, in truth, the boom was just a bubble that
could be deflated by the prick of a pin.
It is important to understand the fuzzier aspects of the situation that was created.
The general public does not know the lending side risks in the economy. The
supply side constraints are very often forgotten in the demand euphoria. Hence,
there is no surprise that nobody cared to pose checks on the loans banks were
extending. And there was no dearth of people queuing up for these loans. After
all, it is basic human nature to want to own a house. There were people who never
believed they would be able to save enough over their lives to be able to buy a
house someday. And, suddenly, they found banks willing to lend them money to
fulfill their dreams, and at unbelievably low rates.
The banks got caught in volumes and quality was heavily compromised. Anyone
with a FICO score of less than 620 falls in the sub prime category. Such borrowers
were extended loans to buy what was otherwise beyond their means. Investment
houses saw huge opportunities in the
mortgage backed security markets.
These are a special kind of asset
backed securities where mortgage
loans form the underlying assets. The
Wall Street created collateralized debt
obligations (CDOs) and other derivative
instruments with the sub prime
mortgages as the underlying asset.
Let us revisit Figure 1. The significant
date this time is 30th of June 2004. The
Fed hiked rates by 25 points to move it to
1.25 %. But this was hardly a one off
increase. The Fed entered into a cycle of
rate hikes of 25 basis points for exactly
two years, till the 29th of June, 2006. At
the end of this, the rate had been
increased by a magnitude of 425 basis
points from being the lowest ever since
1950s to becoming 5.25% in just a
period of 24 months. When the Fed
rates were increased, the market yield
went up. This resulted in two things.
Firstly, the real estate asset prices fell.
Secondly, the market lending and
borrowing rates increased. The overall
impact was a sharp decline in the
liquidity in the market for loanable funds.
With the same instrument with which it
had increased money supply, the Fed
this time had taken away liquidity from
the market.
The sub prime borrowers now found
themselves unable to pay the interest on
their loans. The price of their assets and
the collaterals had fallen at the same
time. The fall in the prices was so high
that, in most cases, the collateral was
not able to cover even for the interest
payments, with the principal still due.
These two parameters worked in
tandem and the banks found
themselves in a precarious position. It
was in August 2005 that the US real
estate market began losing value.
Housing and building rates prices
Whatever Goes up, Comes Down
1 Refer Appendix A for the table of the Fed Fund Rate Cuts from 2000-2008
2 Appendix B contains the Daily Treasury Yield Curve Rates for the year 2002
Figure : 1
12
CAB CALLING April-June, 2008
tumbled with the same speed with what
they had sky rocketed in the early part
of the decade.
Default rates on mortgage loans in the
US reached a peak. The value of the
loans fell sharply as the banks realized
that they had been too liberal in
extending loans without taking credit
history into account. Many, including
experts in the real estate industry,
believed that real estate prices never
come down. A common explanation
offered is that real estate assets do not
get depreciated, unlike other fixed
assets. But the crisis taught all of us a
valuable lesson – “Whatever goes up,
come down – even real estate prices”.
New Century Financial was one of the
first firms to attract public attention over
the problems it had got into due to the
crises. One of the biggest sub prime
lenders, its shares got suspended in
March 2007. It filed for bankruptcy on
April 2, 2007, after it had been forced to
repurchase bad loans worth billions of
dollars. Accredited Home Lenders
Holdings (ironic name, given the
situation) was the next to offer its loans
for sale at a heavy discount. Other
followed along similar lines. The market
was waking up to the possibility of a
crisis, though it seemed to be of a very
small magnitude and spread at the time.
The alarm bells started ringing louder
when Bear Sterns Hedge Fund
declared bankruptcy. The effects of the
mortgage crisis had now spread to Wall
Street. The reason of the wide reach of
the sub prime mortgage crisis was the
derivative instruments that had been
created around it. The value of a
derivative instrument is derived out of
the following three parameters:
1) Value of the underlying asset
2) Time to maturity
3) Probability of redemption (volatility
and standard deviation)
The Spill-over Effects
Hence, if the underlying assets become worthless, the derivative, by definition,
can be of no value. All mortgage backed securities were of no value because the
underlying mortgages had gone bad. The spill-over effects were more serious
than the effects on the mortgage market alone. In ordinary circumstances, the
crisis would have just hit the mortgage market and the players involved in that
market – mortgage lenders, borrowers, real estate developers, architects, etc.
But, the effects were felt far beyond this market, as far as in the high rise offices of
some of the most powerful banks in the Wall Street. The world had taken notice of
the potentially destructive global crisis that was on hand.
The crisis hit inter-bank markets, with the banks no longer sure of how much write
downs the other bank could see. Banks used accounting tricks like transfer of
liability to SPVs (Special Purpose Vehicles), to hide losses on their balance sheets.
Markets became illiquid as optimism vanished. Citibank, Merrill Lynch, and UBS
have all had write downs in double digit billion dollar amounts. The US stock
markets saw large corrections which spread on to other markets in other
countries.
In a one week period in July 2007, DJIA Index lost 4.1% of its value – the largest
fall in a five-session period since 2002. S&P 500 and NYSE displayed similar
trends. In response, Mr. Bernanke went back to the old policy of the Federal
Reserve – in times of a slowdown, cut the rates. He cut the Fed Funds rate by 50
bps on September 18, 2007. But it had a very temporary positive impact on the US
and World Stock markets. In fact, the markets were expecting just a 25 bps cut.
When the Fed Funds Committee announced a 50 bps cut, many concluded that
the crisis was far bigger than they had initially imagined. After rallying back for a
week, the markets slipped further. Also, as the US increased the supply of the
Dollar, its value fell sharply with respect to other major currencies. The rates were
cut further and faster to help an ailing US economy, including a huge 75 bps cut on
January 22, 2008.
Minsky literature on financial instability explained this crisis even before it
occurred. Minsky talks of three kinds of firms in a growing economy – hedge firms,
speculative firms and ponzi firms. Hedge firms have a positive present and
expected cash flows and hence positive NPV. Speculative firms have negative
present cash flows but positive expected cash flows in near future. Ponzi firms
have negative present cash flows and negative cash flows in near future too.
These firms expect to have a very high positive cash flows in the later years to turn
profitable.
In the boom cycle, all these firms are able to sustain operations due to excess
liquidity and low interest rates. Hence, faulty asset allocation happens between
firms. The fragile speculative and ponzi firms acquire more assets than their true
worth allows them to. This is possible through readily available external finance in
the market. Then, the bust cycle hits the economy. The interest rates rise. At this
time, borrowing becomes difficult. Loan market loses liquidity. Now, all the firms
with misappropriated assets are unable to get external finance. Since they do not
generate cash flows internally, they turn bankrupt. The assets they had allocated
to them become worthless. Hence, a part of this asset market gets destroyed. This
leads to further negative sentiment and undervaluation of even the hedge firms. In
Understanding the Crisis
Minsky Hypothesis
13
CAB CALLING April-June, 2008
extreme cases, it may lead to the destruction of that entire section of the asset
market where even partial misappropriation was done.
The following graph shows the estimate of write-down by brokerage houses and
lenders directly on account of sub prime defaults and foreclosures.
What are the Estimates of Industry Losses?
As we can see from the graph, the estimate of losses on default of sub prime loans
has increased over the period July 2007 to February 2008. The current estimates
can be articulated as follows:
Current estimates
Base case 2007 2008E 2009E
Housing loans foreclosed ( Lehman
Bros. estimate) 2 million 1 million 1 million
Current estimate of subprime
writedown -USD 200 billion 100 billion 100 billion
Hence, implicit write down per home 100000 100000 100000
Challenging the assumptions
Average price of a US home in 2005-06 ( source of current
defaults) in USD 264000
Assumed loss in case of default (%) 50
Hence, reasonable estimate of expected loss in USD 132000
Therefore, revised estimate of total losses ( foreclosure
number remaining constant) in USD 528 billion
The current estimates of sub prime losses are a slight underestimation. The chief
cause is the expectation of loss given default. Historically, defaulted loans have a
recovery of no more than 50%; most banks are assuming a recovery of 60-70%.
Contagion: Spread of Sub Prime
Losses to Europe and Asia
It is expected that owing to greater
integration among the world's financial
markets, a credit crunch in the American
economy will affect liquidity in European
and Asian markets on account of the
following reasons:
i) Global equity markets are sensitive to
credit risk. Credit crunch and related
liquidity issues prevent certain IPO
deals and leveraged acquisitions from
materializing. This affects the valuation
of firms in the equity market. Tremors in
the US markets affect sentiments
elsewhere in the world. Some informal
estimates put losses arising from sub
prime related equity meltdown to about
USD 7.7 trillion globally. There are other
reasons why losses sustained by US
based financial institutions can lead to
greater meltdown of equity markets in
emerging economies like India. In order
to compensate for domestic losses,
such institutions will book profits in
emerging markets where the indices are
on a rally. Sustained sell-off by
institutional investors may cause stock
indices to register sharp declines.
ii) Many European savers have
invested in global savings vehicles,
such as investment funds, which have
heavily invested in US mortgage
backed securities. European hedge
funds are holding collateralized debt
obligations (CDOs) that include
mortgage components, including some
sub prime tranches.
iii) In parts of Europe, for example Spain,
it is easier for poor immigrants from Latin
America to buy property than to rent it.
The Spanish economy is heavily
dependent on construction for its
economic growth. Spain's productivity
growth is the lowest in the EU, while
about 18% of economic output is related
to housing and construction – about half
is normal for most EU countries. The
method of indiscreet lending in Spain
follows patterns, suspiciously, similar to
those that created the US sub prime
mess in the first place.
14
CAB CALLING April-June, 2008
Closer home, in India and other Asian markets, there has been a trend towards
issuing credit cards without proper due diligence of the holder's credit history.
Although the assumption that defaults on such cards will grow to sub prime
equivalent proportions seems premature, its long run impact on spending
patterns and debt recoveries can be significant. The sub prime disaster leads to
a revaluation of credit spreads worldwide, in the prime markets, in CDOs, and in
mortgaged backed-securities. It will, thus, affect European and Asian
companies' ability to raise cheap finance.
It is highly probable that the market is actually far worse than what has come out
into the open already. Every day banks write down more assets from their balance
sheets. Freddie Mac, the second largest US buyer and backer of home loans
announced losses of USD 2.5 billion for the 4th quarter of 2007. It is estimated that
there are still as many bad assets in the books of the banks as those that have
already been announced – and possibly even more. In such a case, the banks do
not inspire any trust. This is the single largest reason for the liquidity crunch in the
inter bank markets in the USA and Europe. It is not possible for anyone to predict
how much is being hidden by whom.
Cosmetic solutions like rate cuts actually worsen the situation. Through rate cuts
artificial liquidity is infused into the market. Then, one hopes that the ponzi firms
can use this liquidity to turn themselves around. In reality, these measures only
lead to further misappropriation of assets and deepen the mess. The economics
behind this argument is as follows.
The natural rate of interest in any economy is the sum of the pure rate with the
debtors risk premium, the inflationary/deflationary price premium and the liquidity
premium. This rate, along with the actions of the Central Bank, creates the
nominal rate of interest. Consider any hypothetical value of the natural rate of
interest in a market, say 7 per cent. Now, consider how the market should operate.
There would be different players in the market with different credit and trust
worthiness. The people with the highest credit worthiness would be allocated the
asset that provides the highest return. Similarly, others would follow next. The last
unit that is allocated should be the marginal unit. This unit should have a 7 per
What Can be Done to Mitigate the Crisis?
cent return as, at the last unit, marginal
cost equals marginal benefit. If one
holds the money supply constant and let
the market decide the interest rate, then
the market rate will come down to the
natural rate of interest.
Now, consider the current state of the
US economy where the Central Bank
has reduced the rates below the natural
rate. This means that there is
misappropriation of funds, just as it was
in the beginning of the 2002 – where the
seeds for the crisis were actually sown.
It is ironic, to say the least, that the same
actions that created the crisis in the first
place are being proposed and
implemented to end it.
The only solution to such a situation lies
in coming out clean for once and all. All
the banks have to announce the
complete exposure to bad assets that
they have. The economy needs to be
allowed to hit its true level. The Central
Bank should restore interest rate to the
natural rate of interest and follow handsoff
policy. Transparency is the key to
build back the economy to a healthy
state from the mess it is in. To prevent
such an occurrence in the future too, the
regulators need to create such
transparent markets. A cure of the
symptoms is insignificant. Permanent
prosperity is possible only through the
eradication of the underlying problem.
Appendix A – Federal Funds Rate Changes
2008
30-Jan ... 50 3
22-Jan ... 75 3.5
2007
11-Dec ... 25 4.25
31-Oct ... 25 4.5
18-Sep ... 50 4.75
7-Aug ... ... 5.25
28-Jun ... ... 5.25
9-May ... ... 5.25
21-Mar ... ... 5.25
31-Jan ... ... 5.25
Date Change (bps) Level (%)
Increase Decrease
2006
12-Dec ... ... 5.25
25-Oct ... ... 5.25
20-Sep ... ... 5.25
8-Aug ... ... 5.25
29-Jun 25 ... 5.25* Indian institute of Management, Calcutta, Class of 2008

The
- An Analysis
Sub Prime Crisis
K V Sharat Chandra*
Nivedita S Joshi*
Introduction
The sub prime mortgage crisis is
perhaps the most discussed issue in
financial and economic markets in the
recent past. The crisis has the US
economy in a recession and has fuelled
fears of spiraling into a prolonged global
crisis. The recent Fed rate cuts to boost
money supply do not seem to have
brought any respite to the ailing US
economy, just as Wall Street majors
continue to write down amounts every
quarter – Citibank and Merrill Lynch are
good examples, with write downs in
double digit billion dollar figures. In the
backdrop of this financial mayhem, the
future of Mortgage Backed Securities
markets, and the inter bank markets is an
interesting area of study. Does the sub
prime crisis have consequences
beyond the realm of financial markets?
One could wonder how world real estate
prices would be affected by the crisis.
This aarticle seeks to address the
following questions: (a) How did this
crisis develop? (b) What is the theory to
explain it? (c) What are the industry
estimates of the total losses on account
of the crisis? (d) What is its impact on
other leading financial hubs in Europe
and Asia? and (e) What can be done to
mitigate the crisis?
The Development of the Crisis
The Seeds are Sown
Though the crisis itself is only a year old, the seeds were sown quite
some time back – at the beginning of this decade. The year 2002 is
where the US economy moved towards where it finds itself today. The
financial year had not got off to a great start. In fact, the US markets
had lost 30% of their points between the months of March and July.
After a decade long bull run, the markets were estimated to be
overvalued. Hence, this was judged to be a correction to bring the
markets back towards their true value. No alarm bells were rung – the
bust cycle after years of boom was just considered natural. The
Federal Reserve intervened to restore liquidity in the market. As
before, the Federal Fund Rates was the instrument used (refer the
diagram below).
11
The Fed cut the rates by 50 basis points on November 6, 2002 to bring an already
low rate of 1.75% down to 1.25 %. This was followed by a further rate cut on June
25th, 2003 to bring the rate down to just 1%. The 3 month T-bill rate is a key rate in
the world markets. Many believe that, along with the 3 month LIBOR, the 3 month
T-bill rate is the benchmark rate that determines the level of the rate markets world
over. The 3m T-bill rate followed the Fed action to fall to less than 1.5% during this
period. It is also a key rate as the 3m T-bills are the instruments that the Treasury
and the Federal Reserve use to infuse money into the economy through Open
Market Transactions. Hence, the money supply tap had been opened full throttle.
It is very difficult to judge how much intervention by the Fed is good for the
economy. Economists vary widely in their views on the subject. There are as many
strong advocates of the hands-off policy as there are Fed intervention lobbyists.
However, in hindsight, one can always be a genius. And, in hindsight, the Fed cut
the rates beyond what was necessary to check the recessions. Also, some claim
that once the recession was over in a period of just a few months, it took too long to
restore rates to healthy levels again. The rates did not reach even 4.5% till 2006 – 4
years post the minor slowdown of 2002. As a result of unnaturally low rates, asset
prices sky rocketed. The asset this time was real estate. Outwardly, the US was in
the middle of period of prosperity. But, in truth, the boom was just a bubble that
could be deflated by the prick of a pin.
It is important to understand the fuzzier aspects of the situation that was created.
The general public does not know the lending side risks in the economy. The
supply side constraints are very often forgotten in the demand euphoria. Hence,
there is no surprise that nobody cared to pose checks on the loans banks were
extending. And there was no dearth of people queuing up for these loans. After
all, it is basic human nature to want to own a house. There were people who never
believed they would be able to save enough over their lives to be able to buy a
house someday. And, suddenly, they found banks willing to lend them money to
fulfill their dreams, and at unbelievably low rates.
The banks got caught in volumes and quality was heavily compromised. Anyone
with a FICO score of less than 620 falls in the sub prime category. Such borrowers
were extended loans to buy what was otherwise beyond their means. Investment
houses saw huge opportunities in the
mortgage backed security markets.
These are a special kind of asset
backed securities where mortgage
loans form the underlying assets. The
Wall Street created collateralized debt
obligations (CDOs) and other derivative
instruments with the sub prime
mortgages as the underlying asset.
Let us revisit Figure 1. The significant
date this time is 30th of June 2004. The
Fed hiked rates by 25 points to move it to
1.25 %. But this was hardly a one off
increase. The Fed entered into a cycle of
rate hikes of 25 basis points for exactly
two years, till the 29th of June, 2006. At
the end of this, the rate had been
increased by a magnitude of 425 basis
points from being the lowest ever since
1950s to becoming 5.25% in just a
period of 24 months. When the Fed
rates were increased, the market yield
went up. This resulted in two things.
Firstly, the real estate asset prices fell.
Secondly, the market lending and
borrowing rates increased. The overall
impact was a sharp decline in the
liquidity in the market for loanable funds.
With the same instrument with which it
had increased money supply, the Fed
this time had taken away liquidity from
the market.
The sub prime borrowers now found
themselves unable to pay the interest on
their loans. The price of their assets and
the collaterals had fallen at the same
time. The fall in the prices was so high
that, in most cases, the collateral was
not able to cover even for the interest
payments, with the principal still due.
These two parameters worked in
tandem and the banks found
themselves in a precarious position. It
was in August 2005 that the US real
estate market began losing value.
Housing and building rates prices
Whatever Goes up, Comes Down
1 Refer Appendix A for the table of the Fed Fund Rate Cuts from 2000-2008
2 Appendix B contains the Daily Treasury Yield Curve Rates for the year 2002
Figure : 1
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CAB CALLING April-June, 2008
tumbled with the same speed with what
they had sky rocketed in the early part
of the decade.
Default rates on mortgage loans in the
US reached a peak. The value of the
loans fell sharply as the banks realized
that they had been too liberal in
extending loans without taking credit
history into account. Many, including
experts in the real estate industry,
believed that real estate prices never
come down. A common explanation
offered is that real estate assets do not
get depreciated, unlike other fixed
assets. But the crisis taught all of us a
valuable lesson – “Whatever goes up,
come down – even real estate prices”.
New Century Financial was one of the
first firms to attract public attention over
the problems it had got into due to the
crises. One of the biggest sub prime
lenders, its shares got suspended in
March 2007. It filed for bankruptcy on
April 2, 2007, after it had been forced to
repurchase bad loans worth billions of
dollars. Accredited Home Lenders
Holdings (ironic name, given the
situation) was the next to offer its loans
for sale at a heavy discount. Other
followed along similar lines. The market
was waking up to the possibility of a
crisis, though it seemed to be of a very
small magnitude and spread at the time.
The alarm bells started ringing louder
when Bear Sterns Hedge Fund
declared bankruptcy. The effects of the
mortgage crisis had now spread to Wall
Street. The reason of the wide reach of
the sub prime mortgage crisis was the
derivative instruments that had been
created around it. The value of a
derivative instrument is derived out of
the following three parameters:
1) Value of the underlying asset
2) Time to maturity
3) Probability of redemption (volatility
and standard deviation)
The Spill-over Effects
Hence, if the underlying assets become worthless, the derivative, by definition,
can be of no value. All mortgage backed securities were of no value because the
underlying mortgages had gone bad. The spill-over effects were more serious
than the effects on the mortgage market alone. In ordinary circumstances, the
crisis would have just hit the mortgage market and the players involved in that
market – mortgage lenders, borrowers, real estate developers, architects, etc.
But, the effects were felt far beyond this market, as far as in the high rise offices of
some of the most powerful banks in the Wall Street. The world had taken notice of
the potentially destructive global crisis that was on hand.
The crisis hit inter-bank markets, with the banks no longer sure of how much write
downs the other bank could see. Banks used accounting tricks like transfer of
liability to SPVs (Special Purpose Vehicles), to hide losses on their balance sheets.
Markets became illiquid as optimism vanished. Citibank, Merrill Lynch, and UBS
have all had write downs in double digit billion dollar amounts. The US stock
markets saw large corrections which spread on to other markets in other
countries.
In a one week period in July 2007, DJIA Index lost 4.1% of its value – the largest
fall in a five-session period since 2002. S&P 500 and NYSE displayed similar
trends. In response, Mr. Bernanke went back to the old policy of the Federal
Reserve – in times of a slowdown, cut the rates. He cut the Fed Funds rate by 50
bps on September 18, 2007. But it had a very temporary positive impact on the US
and World Stock markets. In fact, the markets were expecting just a 25 bps cut.
When the Fed Funds Committee announced a 50 bps cut, many concluded that
the crisis was far bigger than they had initially imagined. After rallying back for a
week, the markets slipped further. Also, as the US increased the supply of the
Dollar, its value fell sharply with respect to other major currencies. The rates were
cut further and faster to help an ailing US economy, including a huge 75 bps cut on
January 22, 2008.
Minsky literature on financial instability explained this crisis even before it
occurred. Minsky talks of three kinds of firms in a growing economy – hedge firms,
speculative firms and ponzi firms. Hedge firms have a positive present and
expected cash flows and hence positive NPV. Speculative firms have negative
present cash flows but positive expected cash flows in near future. Ponzi firms
have negative present cash flows and negative cash flows in near future too.
These firms expect to have a very high positive cash flows in the later years to turn
profitable.
In the boom cycle, all these firms are able to sustain operations due to excess
liquidity and low interest rates. Hence, faulty asset allocation happens between
firms. The fragile speculative and ponzi firms acquire more assets than their true
worth allows them to. This is possible through readily available external finance in
the market. Then, the bust cycle hits the economy. The interest rates rise. At this
time, borrowing becomes difficult. Loan market loses liquidity. Now, all the firms
with misappropriated assets are unable to get external finance. Since they do not
generate cash flows internally, they turn bankrupt. The assets they had allocated
to them become worthless. Hence, a part of this asset market gets destroyed. This
leads to further negative sentiment and undervaluation of even the hedge firms. In
Understanding the Crisis
Minsky Hypothesis
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CAB CALLING April-June, 2008
extreme cases, it may lead to the destruction of that entire section of the asset
market where even partial misappropriation was done.
The following graph shows the estimate of write-down by brokerage houses and

lenders directly on account of sub prime defaults and foreclosures.

What are the Estimates of Industry Losses?
As we can see from the graph, the estimate of losses on default of sub prime loans
has increased over the period July 2007 to February 2008. The current estimates
can be articulated as follows:
Current estimates
Base case 2007 2008E 2009E
Housing loans foreclosed ( Lehman
Bros. estimate) 2 million 1 million 1 million
Current estimate of subprime
writedown -USD 200 billion 100 billion 100 billion
Hence, implicit write down per home 100000 100000 100000
Challenging the assumptions
Average price of a US home in 2005-06 ( source of current
defaults) in USD 264000
Assumed loss in case of default (%) 50
Hence, reasonable estimate of expected loss in USD 132000
Therefore, revised estimate of total losses ( foreclosure
number remaining constant) in USD 528 billion
The current estimates of sub prime losses are a slight underestimation. The chief
cause is the expectation of loss given default. Historically, defaulted loans have a
recovery of no more than 50%; most banks are assuming a recovery of 60-70%.
Contagion: Spread of Sub Prime
Losses to Europe and Asia
It is expected that owing to greater
integration among the world's financial
markets, a credit crunch in the American
economy will affect liquidity in European
and Asian markets on account of the
following reasons:
i) Global equity markets are sensitive to
credit risk. Credit crunch and related
liquidity issues prevent certain IPO
deals and leveraged acquisitions from
materializing. This affects the valuation
of firms in the equity market. Tremors in
the US markets affect sentiments
elsewhere in the world. Some informal
estimates put losses arising from sub
prime related equity meltdown to about
USD 7.7 trillion globally. There are other
reasons why losses sustained by US
based financial institutions can lead to
greater meltdown of equity markets in
emerging economies like India. In order
to compensate for domestic losses,
such institutions will book profits in
emerging markets where the indices are
on a rally. Sustained sell-off by
institutional investors may cause stock
indices to register sharp declines.
ii) Many European savers have
invested in global savings vehicles,
such as investment funds, which have
heavily invested in US mortgage
backed securities. European hedge
funds are holding collateralized debt
obligations (CDOs) that include
mortgage components, including some
sub prime tranches.
iii) In parts of Europe, for example Spain,
it is easier for poor immigrants from Latin
America to buy property than to rent it.
The Spanish economy is heavily
dependent on construction for its
economic growth. Spain's productivity
growth is the lowest in the EU, while
about 18% of economic output is related
to housing and construction – about half
is normal for most EU countries. The
method of indiscreet lending in Spain
follows patterns, suspiciously, similar to
those that created the US sub prime
mess in the first place.
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CAB CALLING April-June, 2008
Closer home, in India and other Asian markets, there has been a trend towards
issuing credit cards without proper due diligence of the holder's credit history.
Although the assumption that defaults on such cards will grow to sub prime
equivalent proportions seems premature, its long run impact on spending
patterns and debt recoveries can be significant. The sub prime disaster leads to
a revaluation of credit spreads worldwide, in the prime markets, in CDOs, and in
mortgaged backed-securities. It will, thus, affect European and Asian
companies' ability to raise cheap finance.
It is highly probable that the market is actually far worse than what has come out
into the open already. Every day banks write down more assets from their balance
sheets. Freddie Mac, the second largest US buyer and backer of home loans
announced losses of USD 2.5 billion for the 4th quarter of 2007. It is estimated that
there are still as many bad assets in the books of the banks as those that have
already been announced – and possibly even more. In such a case, the banks do
not inspire any trust. This is the single largest reason for the liquidity crunch in the
inter bank markets in the USA and Europe. It is not possible for anyone to predict
how much is being hidden by whom.
Cosmetic solutions like rate cuts actually worsen the situation. Through rate cuts
artificial liquidity is infused into the market. Then, one hopes that the ponzi firms
can use this liquidity to turn themselves around. In reality, these measures only
lead to further misappropriation of assets and deepen the mess. The economics
behind this argument is as follows.
The natural rate of interest in any economy is the sum of the pure rate with the
debtors risk premium, the inflationary/deflationary price premium and the liquidity
premium. This rate, along with the actions of the Central Bank, creates the
nominal rate of interest. Consider any hypothetical value of the natural rate of
interest in a market, say 7 per cent. Now, consider how the market should operate.
There would be different players in the market with different credit and trust
worthiness. The people with the highest credit worthiness would be allocated the
asset that provides the highest return. Similarly, others would follow next. The last
unit that is allocated should be the marginal unit. This unit should have a 7 per
What Can be Done to Mitigate the Crisis?
cent return as, at the last unit, marginal
cost equals marginal benefit. If one
holds the money supply constant and let
the market decide the interest rate, then
the market rate will come down to the
natural rate of interest.
Now, consider the current state of the
US economy where the Central Bank
has reduced the rates below the natural
rate. This means that there is
misappropriation of funds, just as it was
in the beginning of the 2002 – where the
seeds for the crisis were actually sown.
It is ironic, to say the least, that the same
actions that created the crisis in the first
place are being proposed and
implemented to end it.
The only solution to such a situation lies
in coming out clean for once and all. All
the banks have to announce the
complete exposure to bad assets that
they have. The economy needs to be
allowed to hit its true level. The Central
Bank should restore interest rate to the
natural rate of interest and follow handsoff
policy. Transparency is the key to
build back the economy to a healthy
state from the mess it is in. To prevent
such an occurrence in the future too, the
regulators need to create such
transparent markets. A cure of the
symptoms is insignificant. Permanent
prosperity is possible only through the
eradication of the underlying problem.
Appendix A – Federal Funds Rate Changes
2008
30-Jan ... 50 3
22-Jan ... 75 3.5
2007
11-Dec ... 25 4.25
31-Oct ... 25 4.5
18-Sep ... 50 4.75
7-Aug ... ... 5.25
28-Jun ... ... 5.25
9-May ... ... 5.25
21-Mar ... ... 5.25
31-Jan ... ... 5.25
Date Change (bps) Level (%)
Increase Decrease
2006
12-Dec ... ... 5.25
25-Oct ... ... 5.25
20-Sep ... ... 5.25
8-Aug ... ... 5.25
29-Jun 25 ... 5.25
10-May 25 ... 5
28-Mar 25 ... 4.75
31-Jan 25 ... 4.5
2005
13-Dec 25 ... 4.25
1-Nov 25 ... 4
Date Change (bps) Level (%)
Increase Decrease
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Date Change (bps) Level (%)
Increase Decrease
11-Aug 25 ... 1.5
30-Jun 25 ... 1.25
2003
25-Jun ... 25 1
2002
6-Nov ... 50 1.25
2001
11-Dec ... 25 1.75
6-Nov ... 50 2
2-Oct ... 50 2.5
Date Change (bps) Level (%)
Increase Decrease
20-Sep 25 ... 3.75
9-Aug 25 ... 3.5
30-Jun 25 ... 3.25
3-May 25 ... 3
22-Mar 25 ... 2.75
2-Feb 25 ... 2.5
2004
14-Dec 25 ... 2.25
11-Nov 25 ... 2
21-Sep 25 ... 1.75
Appendix B
Monthly Treasury Yield Curve Rates - Starting January 2002
(Source: The USA Department of Treasury – Interest Rate Statistics)
Date 1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr
01/31/02 1.69 1.76 1.89 2.29 3.16 3.70 4.42 4.82 5.07 5.68 5.44
02/28/02 1.76 1.79 1.87 2.25 3.06 3.64 4.27 4.70 4.88 5.61 N/A
03/28/02 1.76 1.79 2.12 2.70 3.72 4.31 4.91 5.29 5.42 6.03 N/A
04/30/02 1.77 1.77 1.91 2.35 3.24 3.83 4.53 4.88 5.11 5.74 N/A
05/31/02 1.72 1.74 1.91 2.34 3.22 3.73 4.37 4.77 5.08 5.77 N/A
06/28/02 1.69 1.70 1.75 2.06 2.90 3.37 4.09 4.52 4.86 5.65 N/A
07/31/02 1.73 1.71 1.70 1.80 2.23 2.67 3.53 4.09 4.51 5.41 N/A
08/30/02 1.70 1.69 1.67 1.74 2.14 2.50 3.22 3.78 4.14 5.06 N/A
09/30/02 1.60 1.57 1.51 1.53 1.72 2.02 2.63 3.25 3.63 4.75 N/A
10/31/02 1.48 1.44 1.43 1.46 1.68 2.05 2.81 3.45 3.93 5.03 N/A
11/29/02 1.25 1.22 1.30 1.56 2.08 2.51 3.28 3.88 4.22 5.18 N/A
12/31/02 1.20 1.22 1.23 1.32 1.61 1.99 2.78 3.36 3.83 4.83 N/A
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10-May 25 ... 5
28-Mar 25 ... 4.75
31-Jan 25 ... 4.5
2005
13-Dec 25 ... 4.25
1-Nov 25 ... 4
Date Change (bps) Level (%)
Increase Decrease
15
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Date Change (bps) Level (%)
Increase Decrease
11-Aug 25 ... 1.5
30-Jun 25 ... 1.25
2003
25-Jun ... 25 1
2002
6-Nov ... 50 1.25
2001
11-Dec ... 25 1.75
6-Nov ... 50 2
2-Oct ... 50 2.5
Date Change (bps) Level (%)
Increase Decrease
20-Sep 25 ... 3.75
9-Aug 25 ... 3.5
30-Jun 25 ... 3.25
3-May 25 ... 3
22-Mar 25 ... 2.75
2-Feb 25 ... 2.5
2004
14-Dec 25 ... 2.25
11-Nov 25 ... 2
21-Sep 25 ... 1.75
Appendix B
Monthly Treasury Yield Curve Rates - Starting January 2002
(Source: The USA Department of Treasury – Interest Rate Statistics)
Date 1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr
01/31/02 1.69 1.76 1.89 2.29 3.16 3.70 4.42 4.82 5.07 5.68 5.44
02/28/02 1.76 1.79 1.87 2.25 3.06 3.64 4.27 4.70 4.88 5.61 N/A
03/28/02 1.76 1.79 2.12 2.70 3.72 4.31 4.91 5.29 5.42 6.03 N/A
04/30/02 1.77 1.77 1.91 2.35 3.24 3.83 4.53 4.88 5.11 5.74 N/A
05/31/02 1.72 1.74 1.91 2.34 3.22 3.73 4.37 4.77 5.08 5.77 N/A
06/28/02 1.69 1.70 1.75 2.06 2.90 3.37 4.09 4.52 4.86 5.65 N/A
07/31/02 1.73 1.71 1.70 1.80 2.23 2.67 3.53 4.09 4.51 5.41 N/A
08/30/02 1.70 1.69 1.67 1.74 2.14 2.50 3.22 3.78 4.14 5.06 N/A
09/30/02 1.60 1.57 1.51 1.53 1.72 2.02 2.63 3.25 3.63 4.75 N/A
10/31/02 1.48 1.44 1.43 1.46 1.68 2.05 2.81 3.45 3.93 5.03 N/A
11/29/02 1.25 1.22 1.30 1.56 2.08 2.51 3.28 3.88 4.22 5.18 N/A
12/31/02 1.20 1.22 1.23 1.32 1.61 1.99 2.78 3.36 3.83 4.83 N/A
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