Sub-prime crisis and its potential impact on European and Asian Markets

Flow• Sub Prime lending leading to credit squeeze• Trends of Sub Prime lending and defaults – Where are we heading?• Known causes of the crisis• What NEXT?• Re-coupling or decoupling with other economies• A different perspective• Sources

Nitin Agarwal nitynz@gmail.com +91 99001 38830

Tranche

• Prime• Sub prime

Individual Borrower

US Housing Boom

Mortgage Lender Commercial BankWalls Street Lender

Hedge Funds, Pension Funds other FI

SIV

Collateralized Debt obligations Mortgage Backed SecuritiesStructured products

Financial Counterpart / lender

Central Banks

Rating Agencies

Inducting Money

US: A society of “economic freedom” - Credit Squeeze explained

• Interest Only• Principle Only• Z Bond

Sub prime LoansNegAm

Fannie & Freddie

Numbers and trendsMarket Shares of the Minority Submarket for Home Purchase Mortgages

(in terms of number of loans)

Note: Data exclude home equity loans.

Default and foreclosure trends

Source: United States Government Accountability Office

Growth in Sub Prime lending

Sub Prime foreclosures maximumDefault and foreclosure increasing.They increase in recessing economy

Sub Prime home purchasing increase

Numbers and trends

% of securitized loan balances increasing

Interest Only loans and NegAm loans

Known Causes of the Crisis

• Proximate Causes:• Unsustainable boom in house prices easing of underwriting

requirements• Price collapse marked rise in defaults• Price declines and rising defaults cause drastic tightening of

underwriting requirements hence no refinance available• Factors Contributing to Defaults:

• Voracious loan providers• Dysfunctional principal/agent relationships • Toxic and poorly understood mortgages• Grossly inadequate disclosures• Accommodative appraisals

Causes of the Crisis (Con’d)

• Factors Contributing to Metastisization• New instruments, especially CDOs• Colossal lack of judgment by credit rating agencies • Losses in this market have always bunched• Why was the system so unprepared – as indicated by the large

number of firm failures?• Complex loans –> Negative Amortization loans – good for short

term but hurt in long term• Shadow banking system – Off balance sheet vehicle of banks• Unregulated banking system, hedge funds, private equity players• Complexity increased with HIGHLY leveraged positions margin

calls defaults

What NEXT? - Account for variable CHANGE

• Markets are unknown unknowns (Satyajit Das)

• No one can predict the way they behave – also governed by emotion and perception

• Black Swan• A rare event• With high-impact• Hard to predict (pattern attributed post event)

• Hedge funds and private equity firms to be the next ones to get hit• Government to intervene

• Is it justified to use the tax payers money?• 700Bn $ package announced. Move to regulate the economy

• Revamp accounting systems and financial markets• Selectively start Regulating the economy• Rating agencies and Risk standards to be strengthened• Strengthen the underwriting standards

Re-coupling or Decoupling with other economies

European Markets• Fairly coupled with US• Re-coupling of the economies

• Commodity prices• Currency market• Credit market

• The financial situation to move to Europe – negative ripple effect• Bond yields to go down• Companies invested in complex derivative instruments with leveraged positions to be in trouble

and hence clean their balance sheet• Less liquidity Inflation to rise• Consumption to take a hit• More regulated society – Government to come to rescue – as a last lender resort• EU as a whole may still be less impacted due to growth coming from some sectors / geography

USA EU/UK

US corporation EU/UK corporation

Subsidiary of EU/UKcorporation

Subsidiary of US corporation

100% Ownership 100% Ownership

Source: Book - Traders, guns and money

Opportunities• Companies with sound / healthy balance sheets to expand• Credit crunch will give companies less room to borrow• Indian companies with less leveraged positions and positive growth outlook within the country will get a chance to taste the European markets TATAS – CORUS, JLR• Once the balance sheet is cleaned and the borrowers are free of their mortgage debts they will have

more money to spend and the markets will revive. TIMING cannot be stated

Re-coupling or Decoupling with other economies

Asian Markets – India• Largely a regulated economy• Absence of complex financial instruments• Economy still will growth at good rate. Marked by local consumption and demand • Growth may slow down due to re-coupling effect• Inflation may be the problem to stay • Tightening of monetary policy• With the global turmoil the reforms in finance sector may slow down• Growth of service sector to slow down a bit• Faith in Dollar to be hit • Due to less liquidity the SME to be impacted

Opportunities• Investors may have more faith in the positively regulated economies and with growth potential• Time for consolidation and getting value picks in the Indian and foreign markets• Cash rich companies can make the most of the opportunities – can do some value picking

A different perspective : An accounting crisis

• MTM losses to be accounted (made provision for)• MTM profits not accounted – based on conservative principle

of accounting• There is lot of room for hocus pocus accounting hence the

accounting system needs to be streamlined further• Off Balance sheet SIVs

Sources

• www.Wikipedia.org • www.FT.com• www.rgemonitor.com – Nouriel Roubini• www.investopedia.com • www.economist.com • The Black Swan – Naseem Nicholas Taleb• Traders, Guns and money – Satyajit Das

Thank You