the meltdown

Financial Meltdownand its impact onFinancial Markets

Created by:

Ajay Kr Dhamija (N-1) Hanish Rajpal (N-67) Himanshu Goenka (N-22) Adil Zaidi (S-8) Snehal Soni (N-47) Geetanjali Aggarwal (S-20) Tripat Preet Singh (N-53) Radhika Gulati (S-40)

Terminology 2

Agenda

Terminology

Historical Linkage & Timeline of Current Crisis

Model of Mortgage Loan

Complexity of Financial Products & Model

Tea Break

Faults in the Model & Aftermath

Crisis Toll

How does it affect India

Learning and change of the model

Conclusion

Terminology 3

Terminology

Interest Rate Swap

Credit Default Swap

Securitization

Asset-backed security

Mortgage Backed Security

Collatarized Debt Obligation

Subprime Lending

Foreclosure

Credit rating agency (CRA)

Terminology 4

Interest Rate Swap

Swap

Bank

LIBOR + ½%

10 3/8 %

LIBOR – 1/8%LIBOR – ¼%

10 ½%

B saves ½ %

Bank

A

Company

BA saves ½ %

The swap bank makes ¼ %

COMPANY B BANK A DIFFERENTIAL

Fixed rate 11.75% 10% 1.75%

Floating rate LIBOR + .5% LIBOR .5%

QSD = 1.25%

10% Note that the total savings ½ + ½ + ¼ = 1.25 % = QSD

Terminology 5

Credit default Swap

Company A - BB

Insurance A - AA

Pension Fund 1

CRA (Moody’s)

$2B10%

Pension Fund 2

Hedge Fund 1

Insurance B - AA ->

B+

Company B – B+

100 BPInsurance on B for $10B

$1B

12%

200 BP200 BP = $200M

Insurance on B for $2B

Insurance on B for $1B

Terminology 6

Securitization

Securitization

-Structured Process

-The assets are combined into a pool, and then that pool is split into

shares.

-The shares are sold to investors who share the risk and reward of

the performance of those assets collectively

- Present Value of Future Cash Flows

- Categorization

Terminology 7

Motives for securitization

Advantages to issuer•Reduces funding costs

•Reduces asset-liability mismatch

•Lower capital requirements

•Locking in profits

•Enables Transfer of risks by one who does not want to take it

•Earnings

•Admissibility

•Liquidity

Terminology 8

Asset-backed security

An asset-backed security is a type of debt security that is based on pools of assets, or collateralized by the cash flows from a specified pool of underlying assets.

Backing assets-loans, lease, credit card debt, company receivables, royalty

Non Mortgage Assets

Prepayment Risk High

Terminology 9

Mortgage Backed Security

A Mortgage-Backed Security (MBS) is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans. Payments are typically made monthly over the lifetime of the underlying loansPrepayment Risk LowGovernment Guarantees

Terminology 10

Collateralized Debt Obligation

Securitized Interest in a pool of assets- ABS

Constructed from Portfolio of fixed income assets.Types

• CLO• CBO

Non Mortgage loans or Bonds

Multiple Tranches of SecuritiesSenior (AAA)Mezzanine(AA to BB)Equity(Unrated)

Losses in reverse order of seniority of tranchesServicing Agent

Terminology 11

Collateralized Debt Obligation

Bank Investment Bank

SPV

Investors

Equity

Mezzanine

SeniorCDO

300 M (300K shares @ 16.5% = $55M)

Mortgagors

$1B

1000 * $100K = $100M

And $1B

MBS

$1000 K * 1M shares

$1B

300 M (300K shares @ 7% = $21M)

400 M (400K shares @ 6% = $24M)

$1B

$1B * 10% = $100M

Terminology 12

What is Subprime Lending?Near-prime, non-prime, or second chance lending

Providing credit to borrowers who do not meet prime underwriting

guidelines.

A sub-prime lender is one who lends to borrowers who do not

qualify for loans from mainstream lenders or prime financing terms-

Low Credit Scores

Subprime loans are not predatory loans

Terminology 13

Why Subprime Lending ?

Realization of a demand for loans to high-risk

borrowers with imperfect credit.

Fall in prime interest rates with real interest becoming

negative- allowing modest subprime rates to flourish.

Relaxation of usury laws - Confidence to foreclose

assets in case of default.

Credit Repair Option.

Terminology 14

How do we know a Sub-prime Borrower

Payment delinquencies

Reduced Repayment capacity as measured by credit scores

Poor debt-to-income ratios

Limited income or having poor credit scores

Relatively high heightened perceived risk of default

History of loan delinquency,

Recorded bankruptcy,

Limited debt experience.

Charge-offs, Set offs, judgments.

Terminology 15

Credit profile keeping a borrower out of a prime loan may include the following

Two or more loan payments paid past 30 days due in the last

12 months, or

one or more loan payments paid past 90 days due the last 36

months;

Judgments, foreclosure, repossession, or non-payment of a

loan in the past;

Bankruptcy in the last 5 years;

Hi default probability as evidenced by the credit score.

Accuracy of the credit line data obtained by the underwriter.

Terminology 16

Foreclosure

Foreclosure is the legal and professional proceeding in which a mortgagee, or other lienholder, usually a lender, obtains a court ordered termination of a mortgagor's equitable right of redemption.

Types of foreclosure

1. Judicial Foreclosure – Court Proceedings

2. Power of Sale- Where Sale Clause provided or a trust deed

used

Terminology 17

Credit Rating Agency (CRA)

Is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments

The Basel II guidelinesObjectivityIndependenceTransparency

Terminology 18

Agencies that assign credit ratings for corporations include:

A. M. Best (U.S.)

Baycorp Advantage (Australia)

Dominion Bond Rating Service (Canada)

Fitch Ratings (U.S.)

Japan Credit Rating Agency (Japan)

Malaysian Rating Corporation (Malaysia)

Moody's (U.S.)

Standard & Poor's (U.S.)

Pacific Credit Rating (Peru)

Rating Agency Malaysia (Malaysia)

Egan-Jones Ratings Company (U.S.)

Capital Intelligence Ltd (Cyprus)

CRISIL (India)

Terminology 19

Historical Linkages --Manias, Panics and Crashes

Terminology 20

Rise of Securitized Mortgage Lending

Period Home Loan Securitized

Before 1970’s <1%

1980’s ~10%

Late 2000’s – Sub Prime Crisis 56%+

Mortgage Lending 1930s-80s: Funds derived primarily from deposits of the lending institution

1980-2007: Funds derived increasingly from credit markets through securitization process

Terminology 21

Mechanism of A Meltdown

There is a change in legislation/policy/practice - a loophole is discovered

“Financial Asset” is innovated/ created around the loophole

Mass “staged dealing” takes place, valuations are artificially blown up

Sudden fall in fundamental asset

Bull run turning into sudden “Meltdown” and panic impacting economy for

long period

Lets take last 20 years and see if there is a trend:

Financial Meltdown Financial Assets which were overvalued

Late 1980’s – Saving & Loan Crisis Junk Bond

Later 1990’s – Tech Bubble Internet Stock

Late 2000’s – Sub Prime Crisis Sub-Prime Mortgages

Terminology 22

Late 80’s – Saving and Loan Crisis

In 1980 – US Congress allowed Thrift – (Saving and Loan) Associations to lend consumer loans/commercial loans, issue credit cards, - These were high risk and below investment grade loan

Further in 1981 –S&L Associations were allowed to sell their risky loans and use cash generated to seek better returns – to invest in even riskier loans .

Major Wall Street Firms started buying and these bonds at 60-90%, bundling and trading in them as Government Backed Bonds

“Staged dealing” – back and forth trading amongst close group to establish “value” and sell it to outsiders (banks)

As the initial assets (loans) started defaulting – bonds became worthless

Eventually Bond failed and created a trillion $ crisis for US taxpayers

Terminology 23

Late 90’s – Tech Bubble

Internet Stocks (A stock gets its value from underlying sales, growth and

overall prospects of future)

Company needs to prove themselves by being in existence for several

years before they could be traded on stock exchanges – this standard was

thrown away - That was the Loophole

To pump up the value – companies engaged in “ staged dealings” – (back

and forth sales/billing of ads on mutual sites to create false Revenues)

These sales numbers were used to fraudulently value the companies and a

lot of money was raised on totally worthless companies.

Eventually these companies failed and created another trillion $ crisis

Terminology 24

Late 2000’s – Sub-Prime Crisis

In current case – instrument - Sub Prime Mortgages.

Previously Sub-Prime Mortgages had very little trading value. Only specialist use to deal in them.

Mortgage Industry changed Lending standards and Wall Street innovated -“If we take LOTS of these mortgages and assemble them into large pools and then slice and dice the pools in various ways, we can sell the slices to banks and other investors as AAA paper”

To pump up the value – Banks sold them (at a fee) to each other and due to “ staged dealings” – declared them valuable.

Eventually Housing Industry came under pressure and everyone on the top starting falling

Terminology 25

Historical Linkages

Financial Meltdown

Terminology 26

Crisis and Financial Meltdown

Crisis is a result of change in legislative, its fraudulent use to

create false value, a bull run and then…

A Sudden Market Crash

Full scale financial system break down – bankruptcies

Economic Meltdown - fall in Industrial output, rise in unemployment,,

household net-worth drops,

Terminology 27

Time Line - Past Few Years

Low interest rate regime and availability credit/ securitization

resulting into increased liquidity since 2003

Lending to Sub Prime customers on increased

Home Prices rise till 2005 and busting of housing bubble in 2005

Rise in Interest rate in 2006 – refinancing became difficult

Defaults and foreclosure on rise through 2007-08

Average debt of American

American way of Debt

Terminology 28

Time Line . . . . .

Initial Impact: Mortgage LendersCountry wide

Bears Stears

Indy Mac

Fannie Mac & Mae

Secondary Impact : Investment Banks followed by Commercial BanksLehman Brothers

Merrill Lynch

and it spreads to rest of world

Terminology 29

Timeline of current crisis

January 11,2008 : Bank of America buys mortgage lender Countrywide Financial for $4 billion in an all-stock deal.

March 16,2008 : JP Morgan Chase buys brokerage firm Bear Stearns for $2/share in a deal backed by the Fed and Treasury Department. The price islater revised to $10/share.

July 11,2008 : IndyMac is seized by the FDIC after depositors withdraw $1.3 billion over an 11-day period. This brought to 12 the number of banks seized by FDIC in 2008.

Source: www.investmentbankeronlife.com

Terminology 30


July 13,2008 : Government-sponsored mortgage finance companies Fannie Mae and Freddie Mac are nationalized by the federal government in an effort to support the U.S. housing market.

Sep 7,2008 : The federal government takes control of financial giants Fannie Mae and Freddie Mac, which were nationalized in July. The two hold or guarantee about half the nation's $10 billion in mortgage loans.

Sep 15,2008 : Investment bank Lehman Brothers files for Chapter 11 bankruptcy protection.

Rival Merrill Lynch agrees to be takenover by Bank of America.

The Dow Jones fell 504 points, the index’s worst since the 2001 terrorist attacks. Top 10 Bankruptcies


Terminology 31


Sep 16,2008 : Insurer American International Group (AIG) is rescued by the federal government through an $85 billion loan package in return for an 80% stake in the company. The move comes amid a cash crunch, triggered by $18 billion of losses over three quarters, a sinking stock price and debt downgrades.

Sep 19,2008 : U.S. Treasury Secretary Henry Paulson calls for the government to spend hundreds of billions of dollars to take toxic mortgage assets off the books of financial companies to restore financial stability . News of the bailout plan helps world stock markets soar.

Sep 20,2008 : Treasury Secretary Henry Paulson outlines details of a $700 billion bailout plan for firms troubled by bad mortgage debt.

A U.S. bankruptcy judge approves a revised version of Barclays purchase of the core U.S. business of Lehman.


Terminology 32


Sep 21,2008 : Goldman Sachs Group Inc. and Morgan Stanley become bank holding companies regulated by the Fed, essentially ending Wall Street's investment banking model.

Sep 23,2008 : Warren Buffett’s Berkshire Hathaway invests $5 billion in Goldman Sachs, citing the rescue plan as a contributing factor.

Sep 25,2008 : Washington Mutual is seized by the FDIC, making it the largest U.S. bank failure, with $307 billion in assets.

JPMorgan Chase buys WaMu’s banking assets for $1.9 billion.


Terminology 33


Sep 29,2008 : U.S. House of Representatives rejects the $700 billion rescue plan in a stunning 228-205 vote. The Dow Jones falls by a record 777 points.

Wachovia agrees to sell most of its assets to Citigroup in a

deal brokered by regulators.

Oct 1,2008 : U.S. Senate passes a modified U.S. financial rescue plan aimed at restoring global financial stability, sending the measure to the U.S. House of Representatives for a vote on Friday.

Oct 3,2008 : President Bush signs the historic $700 billion rescue bill approved just hours earlier by the U.S. House of Representatives in a 263-171 vote.

Wells Fargo agrees to buy Wachovia for $15.4 billion or $7 a share, better than Citigroup’s earlier offer of about $1 a share.


Terminology 34

Model of Mortgage Loan

Mortgage Broker

Sub-prime Mortgage

Secondary Mortgage Market

CRA Certification

Investors – OTC Market

Home Mortgage Evolution

Repackaging into MBS, CDO

Private Sub-prime Mortgage Process

Source: The Economist: Making Sense of Modern Economy

Terminology 35

Mortgage Broker

Mainly found in developed economies like US, Western Europe

Professionals who are paid a fee to bring together lenders and borrowers

Sells mortgage loans on behalf of businesses (ex. Banks)

Source: Wikipedia

Terminology 36

Sub-prime mortgage – What’s that?

Home loans made to borrowers with poor credit ratings — a group

generally defined by FICO scores below 620 on a scale that ranges

from 300 to 850

FICO - a number that is based on a statistical analysis of a person's

credit report, and is used to represent the creditworthiness of that

person. (FICO is the acronym for Fair Isaac Corporation, a publicly-traded corporation (under the symbol

"FIC") that created the best-known and most widely used credit score model in the US.)

Creditworthiness—the likelihood that the person will pay his or her

debts. Calculated by credit reporting agencies.

Ex. Equifax, Experian, and TransUnion in US

Source: Wikipedia

Terminology 37

Secondary Mortgage markets

The secondary mortgage market allows banks to sell mortgages,

giving them new funds to offer more mortgages to new borrowers.

If banks had to keep these mortgages the full 15 or 30 years, they

would soon use up all their funds, and potential homebuyers would

have a more difficult time to find mortgage lenders.

Many of the mortgages on the secondary market are bought by

Fannie Mae.

Other are packaged into mortgage-backed securities, and sold to

investors.

Source:http://www.urbandigs.com/2007/08/how_mortgage_backed_securities.html

http://www.urbandigs.com/2007/08/how_mortgage_backed_securities.html

Terminology 38

Credit Rating Agency (CRA)

Company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves

A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued

Ex: Moody's (U.S.), Standard & Poor's (U.S.)

Credit ratings are used by investors, issuers, investment banks, broker-dealers, and governments.

For investors, credit rating agencies increase the range of investment alternatives and provide independent, easy-to-use measurements of relative credit risk.

Source: Wikipedia

Terminology 39

OTC market

A decentralized market of securities not listed on an exchange where

market participants trade over the telephone, facsimile or electronic

network instead of a physical trading floor. There is no central exchange

or meeting place for this market.

In the OTC market, trading occurs via a network of middlemen, called

dealers, who carry inventories of securities to facilitate the buy and sell

orders of investors

Trading is private and prices and

volumes are not disclosed

Price discovery non transparent

Source : http://www.investopedia.com/terms/o/over-the-countermarket.asp

http://www.investopedia.com/terms/o/over-the-countermarket.asp

Terminology 40

Evolution of home mortgage Home loan funding

1930sPrincipal + interest payable over long term

Borrower-IndividualsLender-Banks• Owning a house was not affordable to many

• Great Depression brought industry to a halt. Large scale defaulters and lenders could not recover by reselling

• To simulate the industry again Government as part of New Deal policy created the Federal National Mortgage Association (Fannie Mae) in 1938. This created a secondary market for mortgages

Lender-Banks Borrower-Individuals

Home loan funding

Principal + interest payable over long term

Bought loan

Cash

Transfer of credit risk, market risk

Had Access to long term borrowing

Bought only those which conformed to certain underwriting standard ( called Prime

Mortgages)

Source :http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,Subprime Mortgage Market Turmoil, Christopher L. Peterson, Asst Prof of Law, Univ of Florida

http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm

Terminology 41

Evolution continued…

Fannie Mae proved very successful . But by 1960s , borrowing done by it constituted a significant share of the debt owed by US government.

1968- Government National Mortgage Association (Ginnie Mae) was created to handle government guaranteed mortgages.

Fannie Mae became federally chartered, privately held

1970- Ginnie Mae developed MBS -- shifted the market risk to investors --eliminated debt incurred to fund government housing program

1970-Federal National Mortgage Corporation (Freddie Mac) created To securitize conventional mortgages

Provide competition to Fannie Mae

Over time Fannie Mae and Freddie Mac together provided enormous amount of funding for US mortgage

Since Fannie Mae and Freddie Mac guaranteed loans, much of credit risk stayed with them. Size and diversification allowed them to handle it.

Source :http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,


Terminology 42

New Model of mortgage lending

Lender-Banks

Home loan fundingBought loan

Cash

Transfer of credit & market risk

MBS

Ca

Principal + interest payable over long term

Advantages

• More liquidity in market

• Risk spread out

• Long term funding for mortgage lending

• MBS- allows originators to earn fee income from underwriting activities without exposure to credit, market or liquidity risks as they see the loans they make

SPV

Secu

ritiz

atio

n fe

es

sh

Transfer of market risk

Terminology 43

Private Players joined

1977- Private label securitization started first done by BOA and Salomon Brothers

1980s- pricing, liquidity and tax hurdles were resolved in same

Unlike 2-3 party , private label securitization has 10 or more different parties playing independent role

Big private players in this field wereWells Frago

Lehman Brothers

Bear Stearns

JP Morgan

Goldman Sachs

Bank Of America

• Indymac

• Washington Mutual

• Countrywide

Terminology 44

Repackaging into MBS / CDOMBS

MBS CDO

• Created in 1987 by now defunct investment firm Drexel Burnham Lambert

• Not traded on exchange but OTC market

Terminology 45

Details : Private Sub-prime mortgage process

1. Brokers identify borrowers

2. Originator and broker identify a loan for borrower after looking at his credit rating

3. Formal application for loan by borrower

4. Originator transfers the loan to the subsidiary of an investment banking firm ( Seller)5. Seller(Investment bank) collects a pool of loans and call it as SPE/SIV/SPV. Off balance sheet instrument6. SPV can be a corporation, partnership or limited liability company. Most often a Trust. It has nothing else except mortgage loans7. Underwriter purchases all the securities (derivative income streams) 8. In designing SPV and its tranches underwriter works with credit rating agencies

9. Underwriter then sells the securities to the investors10. High rated tranches might be guaranteedby a 3rd party insurance company11. Seller also arranges to sell the rights to service the loan pool to a company or sometimes Originator takes these rights

12. MERS – document custodian. Company to keep track of mountains of paper work on loans in the pool. At National level. Source : Subprime Mortgage Market Turmoil , testimony by Christopher L. Peterson

Terminology 46

Complexity of Financial Products & Models

Mark to Market / Model

Blame the models

The fragility of models

Four Major Implications

VaR

Market risk model

CRA’s: SIV & Sub-prime

Unrealistic demands

Use models but…

Terminology 47

Mark to Market / Model

Last year, Banta bought an apartment in Gurgaon. He spent Rs 1 Cr. His Real Estate agent says it’s worth Rs 60 Lac today.

Banks are not lending, so no one is offering to buy Banta’s apartment. A drunk guy , Santa, met at the bar said he would pay Banta Rs. 5 Lac

Rs 60 Lac is the Mark to Model.

Rs 5 Lac is the Mark to Market.

How much is Banta’s apartment worth?

If he used it as collateral for a loan, how much would you lend him?

A mark to model is less reliable

Assumptions

May assign a liquidity which is not present.

complex financial instruments

no ready market => mark to model

Source :http://innovationcreators.com/wp/?p=464

http://innovationcreators.com/wp/?p=464

Terminology 48

Blame the models

Quality of Statistical Risk Models was much lower

Ignored Black Swans ( the highly improbable and unpredictable events that

have massive impact. ) - Fractals Theory & Chaos Theoryno one managed to prove that the use of a model that does not work is neutral,

volatility as an indicator of stability has fooled the banking system.

Identification of fourth quadrant (danger zone) is important

Ignored liquidity

Ignored increase in correlation during downturn

Ignored leverage ratios

Ignored the fact that events are correlated and risks are auto correlated.

Trading in OTCEI further made value & risk assessment difficult

No standard contracts

No information on holdings and pairings

Sources: Blame the Models by Jon Daniielson , London School of Economics

Ian Stewart, Does God Play Dice? The Mathematics of Chaos

Terminology 49

The fragility of Models

Finance is not physics; it is more complex. Endogenous risk:

Statistical properties change under observation since market participants react to

information

We can only model aggregate behavior.

Financial modeling changes the statistical laws in real-time,

we can ignore endogenous risk in calm. In a crisis, we cannot. And that is when

the models fail.

Quality of assumptions

Modelers tend to ignore what is difficult, not what is important.

liquidity had generally been ignored in model design

Data quality

Financial data have the annoying habit of being of short duration.

The statistical properties of financial data change over time

Source: Blame the Models by Jon Daniielson , London School of Economics

Terminology 50

Four Main Implications

1. SF Pool Losses Don’t Recover2. SF Pool Losses are Skewed3. SF Pool Losses are Moving Target4. SF Pool Loss Distribution Narrows Over Time

Source: Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions, Joseph R. Mason, Associate Professor of Finance, Drexel University & Joshua Rosner, Managing Director, Graham Fisher & Co.

Terminology 51

VaR (Value at Risk)

What is my worst case scenario (compare volatility)

Three components: a time period, a confidence level (relatively high) and a loss amount (or loss percentage).

What is the most I can - with a 95% or 99% level of confidence - expect to lose in dollars over the next month?

3 MethodsHistorical Method – actual historical distribution

Variance-covariance Method – assumes normal distribution

VaR = Value * Z * σdaily * (horizon Period)1/2

1% VaR of $400m with σdaily = .75% for 10 day period

= $400m * .0075 * 2.326 * 10 = $22.07m

Basel (rule based) : 8% of $400m = $32m

Monte Carlo Simulation – any method of randomly generated trials

Source :http://www.investopedia.com/articles/04/092904.asp

http://www.investopedia.com/articles/04/092904.asp

Terminology 52

Market Risk Model

Daily 99% VaR estimates for a $1000 portfolio of IBM for May 1, 2008Sample size 1 year 4 years 10 years

Estimation method

Historical simulation $22.8 $17.7 $29.9

Moving window $24.7 $18.8 $32.6

Exponentially moving average $21.3 $21.3 $21.3

Normal GARCH $25.5 $23.4 $24.0

Fat tail GARCH $27.6 $20.6 $22.9


No easy way to pick the best method.

The model risk increases as we increase the number of assets.

Aggregation Method & its associated assumptions ?

Assets traded on different exchanges, time zones and opening hours,dates of holidays

, asset categories

Terminology 53

CRA’s : SIV & Sub-prime

Modeling process is much more complicated and harder to verify,which increases the risk of mistakes.

Aggregation problem

the short data sets mean that we can not obtain the default probabilities => need to model default probabilities.

The rating agencies like Moody’suse historical credit data and ignore the actual loan applications

Underestimated the importance of the business cycle and the presence of a speculative bubble in housing markets.

default correlations and low rates of defaults of mortgages initially

mortgage defaults become highly correlated in downturns

Data samples used to rate SIV’s often were not long enough to include a recession

Didn’t include key data fields like debt-to-income,appraisal type,originating lender & rate,resets


Moody’s Fiasco

Terminology 54

Unrealistic demands

A high quality modeling process is harmonization between probability levels, sample sizes, and testing.

Can’t use same models in all situations (95%,99%)

Models which can’t be backtested , 99.9% model (risk of loss in every 1000 years), fat tail VaR model

Exceptions are copulas etc. which are still at experimental level

Dependence on Basel II Accord (based on regulation by models) could be problematic since model risk could go out of sync


Terminology 55

Use models but …

The financial institutions that are surviving this crisis best are those with

the best management, not those who relied on models to do the

management’s job.

The solution to a problem like the sub-prime crisis is not Basel II but to

understand the products ,interaction with institutions and risks involved

Taleb’s Thumb rulesLearn to love redundancy

Beware presentations of risk numbers

Absence of Volatility is not absence of risk ……


Terminology 56

Faults in the model and aftermath…

Financial Turbulence

Sources of Market Failure

Regulatory Shortcomings

Reasons for forming of sub-

prime mess

Big Assumptions and

misaligned incentives

Terminology 57

Financial Turbulence

Crisis precipitated by failure of America’s financial

sector toManage Risk

Allocate Capital

Financial sector made Bad Loans & engaged in multi

billion dollar gamble through derivatives & Credit

default Swaps.


Terminology 58

Sources of Market Failure

Poor Credit appraisal standards – Loans for NINJAS

New dimension to bank liquidity

Faulty Risk Management Tools & Models

Role of Credit Rating Agencies – Understatement of Risk

Weak Public disclosures of Risk & Exposures


Terminology 59

Regulatory Shortcomings

Lax regulations which did not keep pace with the

innovations happening in financial engineering

Limited regulation on investment Banking

Failure of regulators – overestimation of strength &

resilience of financial system


Terminology 60

Leading to . . .

Inadequate capital

growth of unregulated exposures

excessive risk-taking

weak liquidity risk management.

For eg : Hedge funds leverage ratio of the order of 500%

Shortcomings associated with the valuation and financial

reporting of structured products

CDOs and credit derivatives trade on OTCEI


Terminology 61

Reasons for forming of Sub-prime mess

Giant pool of money available for investment through

savings of Oil exporters , economic development in BRIC

countries.

US kept interest rates too low for too long in post dotcom

bust period

Building up of the housing bubble

Terminology 62

Reasons for forming of Sub-prime mess

Private share in mortgage market growth in large part

through origination and securitization of high risk sub-prime

and Alt-A mortgages.

To sum up in 3 words as noted by Harvard dean:

Leverage(high), Transparency (low) and Liquidity

(abundant)

Terminology 63

Big assumptions & Misaligned incentives

Banks kept on lowering lending standards, since they assumed they could sell the risk on.

A widespread assumption that the process of “slicing and dicing” debt had made the financial system more stable.

Investors barely understood these complex products and believed the credit rating agencies.

Source :http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

Terminology 64

Big assumptions Cont..

“Churning” of capital “allows even an institution without a

great amount of fixed capital to make a huge amount of

loans, lending in a year much more money than it has

Securitization conduit divides various lending tasks into Multiple corporate entities—a broker, an originator, a

servicer, a document custodian, etc.

Prevents the accumulation of a large enough pool of at risk

assets.

Source :http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html


Terminology 65

Good days don’t last forever.

Financial innovations like ARM (adjustable rate mortgage) mechanism led to

complacency. By mid 2006, time to pay bigger amounts comes :--

Household income did not increase in same proportion as house prices

Subprime mortgage owners start defaulting

Rating agencies revise ratings of MBS/CDO as expected number of

defaults turn out higher. Many ratings are lowered

Bewildered investors lost faith in ratings, many stop buying MBS/CDO

altogether.

Terminology 66

Crisis at the door (mid 2006 onwards):

Banks find themselves in non-comfortable position , stop making loans

Housing prices plummet owing to increase in foreclosure, delinquency

and stoppage of loans – prices fall exponentially in vicious cycle

Perfectly good borrowers – Prime/A category – see the value of their

houses also fall. This feeling of loss of wealth makes them spend less,

putting the economy in to a further downturn due to lack of demand.

=> SUBPRIME CRISIS

Terminology 67

Oh ! what a mess….

More frenzy -> more defaults -> again revised ratings -> further

stoppage of funding & loans -> further fall in house prices as demand

and supply mismatch....problem feeding itself in circular fashion. =>

SUBPRIME CRISIS

Most of the player in the market, mortgage brokers, investment banks

were running in debts caught unaware and are in insolvency and start

tumbling down

Central government start pumping in money as last resort but one

thing is surely not returning soon and which is very vital in financial

industry -FAITH.

Terminology 68

CDS

CDS were used to profit from speculation.

The volume of CDS outstanding increased 100-fold from 1998 to

2008.CDS market stated to be $62 trillion.

Market is completely lacking in transparency and unregulated.

Reasons for expansion of CDS market

- Limited capital requirement for CDS

- No need for funds to take risk through CDS

Thus Hedge funds were active participants in CDS

Terminology 69

CDS

Defaults increased the likelihood of “protection sellers” having to pay

counter parties.Thus Insurance Companies ratings downgraded.

“Counter party risk.” loomed large -party providing the insurance

protection does not have the money to pay the insured buyer when

default occurred.

CDS transactions also one of the reasons for the crisis spreading to

the insurance sector, the main victim being AIG.

Terminology 70

In Short

When homeowners default, the

amount of cash flowing into

MBS declines and becomes

uncertain.

Investors and businesses

holding MBS have been

significantly affected.

The effect is magnified by the

high debt levels maintained by

individuals and corporations, ie

financial leverage.

Source :http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,


Terminology 71

Crisis Toll

“The Most serious financial crisis since the Great Depression of the

1930”

““Real estate prices collapsed, creditReal estate prices collapsed, creditdried up, house building stopped ...dried up, house building stopped ...

Terminology 72

The Genesis .. . US Mortgage Market

Home Prices were expected to rise forever . . . . .

Home ownership rate reaches an all time high of 65 %

Home mortgage debts as % of PDI rises to 75 %

Overall Household leverage rises over 100%

Weak link in chain : Subprime borrower

Default starts in subprime market

Sales fallExisting home sales nationwide fell 29%

Terminology 73… NOT any more!… NOT any more!

“Any real-estate investmentis a good investment … ”

But Home Prices starts to fall..

Forty-six States Had Falling Prices in the Fourth Quarter 2007

Terminology 74

The Mess . . . .

Surge in Mortgage Loan Fraud leading to record Dollar losses

Leading financial Institution & Investment Bank going bankrupt

All Leading too …

Bear Stearns goes belly up … American International Group (AIG) 85B. bailout

Record delinquencyForeclosure rises

Rising Inventory on books

IndyMac is seized by the FDIC

Terminology 75

Spillover to the Rest of the World

ECB Primary Reaction Function

Federal Reserve Primary Reaction Function

Appreciation of

EuroDecline in Euro-Area Economic

Activity

Deterioration in U.S.

Financial Conditions

Deterioration in Euro-Area

Financial Conditions

Decline in U.S.

Economic Activity

Increase in U.S. Headline

Inflation

Increase in Euro-Area Headline Inflation

Financial Shock

Food and Energy Price

Shock

Federal Reserve

Cuts Its Policy

RateECB

Raises Its Policy

Rate

1

2

3

4

5

FIRE

ICE

Terminology 76

Financial Crises:- A Comparison …

Banking Losses in Constant US$ Terms (and as a Percentage of GDP)

0

200

400

600

800

1000

1200

1400

1600

U.S. S&L Crisis (1986-95)

Japan Banking Crisis(1990-99)

Asia Banking Crisis(1998-99)

US Subprime Crisis(2007-08)

Banking Losses Other Financial Losses

In 2007 U.S. Dollar Terms (US$ bn.)

2.5% of GDP

15% of GDP

10% of GDP

35% of GDP

Losses of over 1.4 trillion USDSource: IMF Global Financial Stability Report, October 2008, Chapter 1, p. 16.

Terminology 77

Impact on US Credit Market

Market for Liquidity FreezesSupply of credit decreased dramatically

Lenders refusing to lend to other banks

Lenders buy only government bonds – the “flight to quality”

Firms, individuals holding money as cash, not loans – the “liquidity trap”

Lenders are afraid of all loan types – subprime bonds, then student loans, then home equity loans, then commercial paper (business, consumer loans), etc.

Terminology 78

Impact on US Credit Market Cont..

Widening Spreads over 10 years treasury bonds:Municipal Bonds rises to a historic high of over 100 basis pts.

Mortgage-Backed & High-yield Bonds rises to a historic high of over 1000 basis pts.

Corporate Yield Spreads rises to over 500 basis pts.

Money Market Spreads Blow up to over 360 basis points ( US LIBOR / OIS) against a normal of 20 basis pts.

Terminology 79

Impact on Markets …

U.S. Equity Market Falls Back to 2003 Levels

Unprecedented rise in Equity market volatility

Financial Stocks Take Big Hits in Subprime Crisis

Financial Conditions Index falls to historic low

Major losses for banks worldwide

Commodity Prices : CRB Index Falls to 2003 Levels

Terminology 80

Impact on Foreign Exchange Market

Till end-July 2008, USD depreciated against major currencies on account of :

Weaker equity markets

Slowing manufacturing productivity growth

Higher unemployment with downward non- farm payroll employment, &

Low housing sales

Lowering consumer confidence

Terminology 81

Deleveraging Starts…..

From early-August 2008, USD’s strength reflected

Liquidation of positions in the overseas equity and bond markets by US investors

Repatriation of the money back to US due to slowing growth in the Euro area

Appreciation (+) / Depreciation (-) of USD vis-à-vis other currencies

Terminology 82

Financial restructuring starts …

Wachovia, the 6th largest bank, taken over by Wells Fargo Bank

Top Investment Bank : Lehman Brothers, Bears Stearns & Merrill

Lynch cease to exist

Goldman Sachs & Morgan Stanley were converted into Bank

Holding Companies

15 Banks declared bankruptcy:- Washington Mutual filed for biggest

ever bankruptcy.

Majors write down were made by Financial Institutions

Terminology 83

Recapitalization of financial system

Economic Stabilization Act was passed on Oct 3,2008

Troubled Assets Relief program, to purchase troubled assets of

USD 700 Billion was passed.

Limit on Deposit insurance was increased from USD 100000 to USD

250,000 per account

Eligible collaterals and the eligible counterparties were expanded

Foreign Exchange Swaps were created with major central banks for

infusing Dollar liquidity ( Made unlimited on October 13 , 2008 )

Terminology 84

Impact on World Markets: Equities

Financial stress sweeps through global markets….

Source: Bloomberg

• MSCI Emerging Market Index is down by over 66 % from their peak

• MSCI US and Euro Index are down by over 50 % from their peak

Terminology 85

Impact on World Markets : Government Bonds

Government bond yields

declines in major advanced economies

•Worsening Growth Expectation

• Falling Inflation Outlook

Terminology 86

Impact on World Markets : Short Term Int. Rate

Short Term Interest showed a mixed trend in major advanced economies reflecting

• Local Liquidity conditions

• Policy Rates

3- Months money market rates

Terminology 87

Macroeconomic risks continue to rise..

Continuous fall in Global Economic Activity

Considerable deteriotion from April 2008 situation

•Credit deterioration broadens

• Market & Liquidity Risk

•Fall in Risk Appetite

•Tighter Monetary & Financial conditions

Terminology 88

Risk of Systemic Default on the rise ..

Terminology 89

Impact of Financial Crisis on Europe . . .

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Payment incident index (*) 12 months moving rate

Scale of sector risk in Western Europe

* Payment incident index 100: World 1995-2000 basis

Terminology 90

United Kingdom Spain

United Kingdom, Spain, Ireland on negative watchPayment incident index (*)

12 months moving rate

3,2% 3,2% 3,0%

3,9%

2,3% 2,1%2,7%

3,3%

1,9%

2,8%3,1%

1,9%

0%

1%

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4%

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6%

7%

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(f)

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(f)

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3,9%4,5% 4,7%

4,4%

2,8% 2,7%3,0% 3,2%

3,5%3,9% 3,8%

2,3%

0%

1%

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(f)

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(f)

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Economic growth Payment incident index

Impact on Europe Cont..

*Payment incident index 100: World 1995-2000 basis

Terminology 91

US Economic Indicator : Snapshot !

GDP falls to less than 1% (YOY) in real termsExpectation 2009 : -1.30 % (YOY)

Inflation : Less than ZERO % in 2008 = Worst in 17 years

Unemployment: Rises to over 7.0 %

Interest Rate: Falls to 0.250 %

Unprecedented fall in economic activity

Terminology 92

Current Status of World Economy

World economy entering a major downturnOECD countries in recession

Enormous financial sector dislocation

Unknown fiscal costs of bailouts

Severe real economy dislocations

Stagflation potential

Developing countries growth rates ex China & India

reduced by half

Terminology 93

Current Status of World Economy Cont..

Weakening global trade - world trade likely to decrease in 2009 for the first time since the 1982 recession, remittances dropping Emerging markets witnessing international reserves declining, volatile equity and foreign exchange marketsVolatile commodity prices pose risks for importers & exportersGlobal Inflation Risk Moderated but Volatile

OECD Leading Economic Indicator Points to a Significant Slowdown

Terminology 94

Impact of Financial Crisis on Domestic Financial Markets

Economic Indicator: Snapshot

Impact on financial markets

Impact analysis on key sectors

Terminology 95

Economic Indicator : Snapshot !

GDP for 2008-09 8.0-8.5% (YOY)

Expectation 2009-10 : Less than 7 %

Index of Industrial production fell to less than 1 % in Aug.

Fiscal Deficit expected to touch over 5 % of GDP

Inflation : Over 8.5% in 2008-09

Interest Rate: 10 years G-Sec yield is at less than 5 %

Equities Market down by over 60 % from their peak

Terminology 96

Inflation – Number 1 concern now

Inflation numbers : Rate in May/June 08 vs. (2007)•Japan - 7.1% 27 year record high

•China - 7.7% (4.8%)

•India - 7.8% (4.4%)

•Malaysia - 7.7%, (2.0%)

•Vietnam - 25.2% (8.3%)

•Singapore - 7.5% worst in 26 years

Terminology 97

2009 = slowdown + uneasy financing for companies

An expected slowdown of the World Economy, especially felt in industrialized countries

A more difficult access to financing for Companies because of tougher credit conditions

Terminology 98

Impact on Equity Markets

Global equities market more tightly linkedFall in Asian equities markets even more severe than in the U.S. Equity markets decline (Q3-2008):

Japan - 34% China - 50%India - 45% Singapore - 30%Malaysia - 27%

Reasons Withdrawal of foreign equity funds from Asia to cover losses in U.S

Negative news about the health of financial institutionsChina and India markets over-heatedExtension of credit lossesHigh inflationFears over decline in corporate earnings

Terminology 99

Impact on Financial Markets

In India, Short term Int. rate rose initially and then fell

• Local Liquidity conditions (Initial Rise)

•Policy Measures (Fell)

Terminology 100

Impact on Foreign Exchange Market

Till end-July 2008, USD depreciated against major currencies on account of :lowering consumer confidenceweaker equity markets slowing manufacturing productivity growth higher unemployment with downward non-farm payroll employment, and low housing salesFrom early-August 2008, USD’s strength reflectedliquidation of positions in the overseas equity and bond markets by US investorsrepatriation of the money back to USdue to slowing growth in the Euro area

Appreciation (+) / Depreciation (-) of USD vis-à-vis other currencies

Terminology 101

Impact of Financial Crisis on Japan

Japanese companies suffered from disappointing growth prospects

Payment incident index (*) 12 months moving rate Scale of sectoral risk

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WORLD

Japan


Terminology 102

Impact of Financial Crisis on Developing Countries

Massive capital outflows, drastic drop off from previous record highs (from $1 trillion to nearly $500b, from 7.6 to 3 percent of GDP)Many hard hit developing countries already had:– Fiscally precarious positions– High levels of initial poverty and malnutrition– Limited capacity to implement targeted policy response

Impact– Affects wages and employment as inflation passes through

(inflation up 5% in most, >10% in more than half)– Sharp drop in investment, which has been driver of growth– Falling remittances – Long term cost of coping mechanisms, loss of fiscal cushions

Terminology 103

Impact of Financial Crisis on Developing Countries

Financial flows are likely to drop precipitously ……

Net private capital flows to developing countriesNet private capital flows to developing countries

$ billions

0

200

400

600

800

1000

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

e20

08P

2009

P

Possible Possible

20082008--0909

$998 billion in 2007

East Asia CrisisEast Asia Crisis

Source: World Bank staff estimates

Terminology 104

Impact of Financial Crisis on India

Liquidity conditions in Q2-2008 were eased on account of significant reduction in the cash balances of Central Govt. In Q3, liquidity conditions mostly remained in a deficit modeIndian financial markets in Q3 witnessed heightened volatility reflecting uncertain global situation

Interest rates in money market moved in accordance with evolving liquidity conditionsDaily avg. call rate continued to remain above the repo rate reflecting the impact of hikes in CRR and repo rate Indian rupee depreciated against major currencies In credit markets, lending rates of scheduled banks hardened

Liquidity Adjustment Facility and the Call RateYields in govt. securities market decreasedIndian equity markets declined in tandem with trends in major international equity markets as well as edging up of domestic inflation

Terminology 105


Foreign Exchange MarketDuring FY2008-09, Indian rupee generally depreciated (from Rs 39.89 to Rs 48.84 per USD ~ depreciated by 18%)Due to FII outflows, bearish stock market conditions, high inflation and higher crude oil prices reflecting higher demand for USD

Movement of Rupee vis-à-vis Major Currencies

5.5%

3.6%

18%

Credit MarketScheduled commercial banks increased their deposit rates for various maturities by 25-150 basis pts (8.25-9.5% in Jun’08 to 8.75-10.25% in Sep’08)Benchmark lending rates of PSBsincreased by 75-125 basis pts from 12.5-14% in Jun’08 to 13.75-14.75% by Sep’08

Deposit & Lending Rates-PSB

Terminology 106


Govt. Securities MarketHeightened inflationary expectations emanating from sharp increase in global commodity and crude oil prices led to hardening of yield in Q1-Q2Since Q3, yields have eased due to CRR reduction to 250 basis pts and softening of crude oil prices

Yields on Govt. Securities

Equity Market - Primary MarketWitnessed slackness in resource mobilizationduring Q2-Q3Cumulatively, resources raised through public issues declined sharply to Rs 12,361 crores during Q2 from Rs 31,850 crores during corresponding Q2 of 2007No. of issues declined from 60 to 32 (19 IPOs from Pvt. sector cos. constituting 16% of total resource mobilization)Avg. size of Public issue declined to Rs 386 crfrom Rs 531

Mobilization of Resources – Primary Market

Terminology 107


Stock MarketFour distinct Phase- Phase I (Apr 1 & May 21’08) – Mkts staged recovery due to better results of Q4-2007

declared by IT majors, net purchases by FIIs in Indian equity mkt and some easing of international crude oil prices

- Phase II (May 22 & July 16’08) – Mkt sentiment turned cautious on account of increase in in’tl crude oil prices , hike in retail fuel oil prices, rise in domestic inflation rate, rising trade deficit and depreciation of rupee, domestic political uncertainties, downward trend in in’tlequity mkts, etc

- Phase III (Jul 17 & 7 Sep’08) – Mkt recovered on account of restoration of domestic political stability and decline in crude oil prices

Indian Stock Market- Phase IV (7 Sep’08 onwards) – Mkt turned volatile due to decline in international stock mkts triggered by bankruptcy/sell-out/restructuring of some of world’s largest financial inst., heavy net sales by FIIs, sharp fall in value of rupee & slowdown in industrial growthSectoral indices also witnesses downward trendP/E ratios of 30 scrips in BSE Sensexdeclined from 20.1 (end-Mar’08) to 16.2 (at end-Sep’08)

I II III IV

Terminology 108

Impact on India – The Good, Bad and Ugly

Indian companies with big tickets deals in the international market are seeing their profit margins shrinkingTrade finance is drying up and is dragging down exports

Terminology 109


Indian Financial ServicesIndian Financial ServicesIndian Financial Services Most ImpactedMost Impacted

The US sub-prime market crisis, which so far caused losses worth $181 billion to the world’s top 45 banks by the end of FY08, has started hitting Indian banks also

India’s largest private sector bank ICICI Bank was the first bank to announce a loss of about Rs. 1,056 crores owing to the sub prime crisis of US in the FY08 results

The public sector banks have had a limited position in the structured products and therefore impact is expected to be minimal. However negative sentiments will hit harder

Punjab national Bank, Bank of India, State Bank of India, Bank of Baroda were major banks having an exposure to the instruments issued by Lehman and Merrill Lynch

However the banking sector in general will have to face tight liquidity conditions apart from further mark-to-market losses. The net non performing assets of entire banking sector is less than 2% and it is well capitalized. The capital adequacy ratio is around 13% as against the statutory requirement of 8 to 9%.

Terminology 110


Indian Financial Services Chakra-view…..Exposed??Indian Financial Services ChakraIndian Financial Services Chakra--viewview……..Exposed??..Exposed??

Terminology 111


With the sudden collapse of world leading financial houses, the Indian real estate players who were already facing the problem of lack of funds due to economic slowdown & correction in prices are finding difficult in raising further funds

Among the US Financial Houses --- Lehman Brothers was very bullish on Indian Reality Sector and had an investment in excess of US$ 700 mn (maximum amongst peers)

Lehman’s real estate investments at project levels (including the big ones like DLF, Unitech & Future Capital) have been disbursed & it will not affect the ongoing projects

RBI’s directive not to remit investments made by US financial houses in India without permission is also a step in positive direction and would restrict flight of capital

However, stocks of companies in which sunked financial institutions have a direct exposure (as FII investments especially Lehman) would see selling pressure

Real EstateReal EstateReal Estate Most ImpactedMost Impacted

Terminology 112


AutomobilesAutomobilesAutomobiles Mildly ImpactedMildly Impacted

Auto companies have been seeing sluggish sales for the past few months due to higher interest rates and higher fuel prices

Two wheelers have shown decent sales growth in the last 2 months, more due to the low base effect

It would get tougher for passenger and commercial vehicles and it might start impacting two wheeler vehicle sales negatively

Exports of auto companies might take some hit, however, the impact on exports might not have significant impact on the top-line of auto companies, as the percentage sales contribution from exports is less for Indian auto companies; but this might cause the auto companies to cut their export targets for the next two or three years

Sales Growth

Description Jul'08 Aug'08

Passenger Vehicles ‐1.40% ‐4.35%

Commercial Vehicles 2.00% ‐6.33%

Three‐wheelers 1.50% ‐3.19%

Two‐wheelers 19.50% 14.24%

Terminology 113


Hospitality , Travel and TourismHospitality , Travel and TourismHospitality , Travel and Tourism Mildly ImpactedMildly Impacted

Slowdown in travel demand: Travel budgets of companies have fallen by approx. 40% and a further fall of 10-15% is expected in the next 2 quarters

Hotels face difficulty in maintaining occupancies - falling from the current 75% to 68-70%

Growth in average rooms rates is expected to slowdown from 16-21% to 5-9%

With increasing competition and room tariff wars, hotels facing pressure on their profit margins

Lack of investments in properties will limit the hotels from expansion plans

AIG bailout is likely to impact Indian Aviation as its subsidiary is among the world’s largest aircraft leasers to Indian companies

Terminology 114

Learning & change of the model

What has the crisis been about?

India’s long term growth story

remains intact

Strong long term growth prospects

Lessons from sub-prime crisis

Controlling the crisis

Terminology 115

What has the crisis been about

This crisis is about three things:

Too much liquidity.

Fundamental structural problems in the credit industry, including the almost-total

lack of regulation.

Lack of transparency of complex financial instruments for which there is no public

market, making them tough to value and nearly impossible to trade.

There is fair distance to travelBanks have recognized only a fraction of the overall potential losses –

approximately $50 billion to $75 billion so far on sub-prime debt alone.Total

bailout cost is around $1 trillion (IMF estimate)

Source: Three Ways to Know When the Credit Crisis Hits Bottom, Keith Fitz-Gerald,Investment Director,Money Morning/The Money Map Report

Terminology 116

India’s long term growth story remain intact

India’s GDP growth is expected to continue as 85% comes from

domestic marketIndia a country of savers – low credit dependenceStrong base of trained manpower

Terminology 117

Strong long term growth prospects

Growing insurable population in 20-60 years bracket

Increasing disposable income

Terminology 118


Importance of observing prudent underwriting standards, verification of

documents, and an ongoing monitoring of the borrowers affairs

Liquidity Risk - Close link between market liquidity and an individual bank’s

funding liquidity

Importance of reliable valuations and transparency of risk exposures.

Inappropriately optimistic valuation and modeling methodologies

Technology does not obviate the need to assess a borrower carefully.

Insufficient recognition of residual risks in the structured products

Lack of transparency due to insufficient disclosure.

Compensation systems rewarded very short-term employee performance.

Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html


Terminology 119


Conflict of interest in the role of rating agencies

Rating agencies are paid for their rating exercise by the issuers of

securities and not by the investors in those securities.

Appropriate mechanisms should be evolved to ensure that the

information received by the rating agencies is reliable;

Closer attention to the liquidity risks faced by the rated entity / product

should be mandated for the rating agencies in their rating process;

Road map for the rating agency reforms, should be evolved to address

the weaknesses revealed as also to promote competition in the rating

industrySource s , : Financial Time http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html


Terminology 120

Controlling the crisis- better warning signals in future

Strengthened Prudential oversight of capital, liquidity risk management

Phased implementation of the Basel II norms

Minimum capital requirement prescribed at higher levels of 9% .

Banks exposure to sensitive sectors and their liquidity position monitored on a

regular basis

Broad guidelines for asset – liability management have been put in place and

banks develop risk management policies under broad guidelines

Overnight unsecured market for funds has been restricted only to banks and

primary dealers



Terminology 121


Enhancing transparency and valuation

Strengthened the valuation norms and market discipline in respect of

complex financial products including issuance of guidelines on valuation

of various instruments

Comprehensive guidelines on derivatives incorporating risk

management and corporate governance aspects, suitability and

appropriateness policy.

Set of disclosure requirements developed to enable assessment on

capital adequacy, risk exposure, risk assessment processes and key

business parameters



Terminology 122


Changes in the role and uses of credit ratings

Norms developed to ensure consistency in credit rating agencies by banks

disallowing banks to cherry pick the assessments provided by different credit

rating agencies

Strengthening the authorities responsiveness to risks:

A working group has been constituted to lay down a road map for adoption of a

suitable frame work for cross border supervision and supervisory cooperation

Robust arrangements for dealing with stress in the financial system

Institutional arrangements have been put in place for liquidity management

facilities, and open market operations, and market stabilisation schemes

RBI has been empowered under existing legal framework to deal with the

resolution for the weak and failing banks



Terminology 123

Conclusion

Risk of sub-prime Housing loan transferred : commercial bank ->

investment bank -> investors through securitization

Mortgagor defaults created havoc in real estate and in turn financial markets

and leveraged financial institutions

Models were too fragile to value complex financial instruments since they

ignored vital variables like Black Swans , liquidity,leverage & correlated

risks etc.

Crisis is GLOBAL (geographically market-wise , sector-wise , etc.)

In India: Banks,financial Services,IT,real estate & infrastructure are worst

affected whereas pharma , FMCG , Media & Entertainment least affected

Strengthening capital & liquidity risk management, Enhancing transparency

and valuation , CRA’s overhaul & legal framework is important to avert

these kind of crises

Terminology 124

References

1. Financial Crisis 2008 - Parshwadeep Lahane2. Annual Policy Review, RBI monthly bulletin November

20093. Where Did the Risk Go? How Misapplied Bond Ratings

Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions, Mason & Rosner, Drexel University

4. Three Ways to Know When the Credit Crisis Hits Bottom, Keith Fitz-Gerald,Investment Director,Money Morning/The Money Map Report

5. The Black Swan, Nassim Nicholas Taleb6. Fooled by Randomness, Nassim Nicholas Taleb7. Global Financial Stability Report, Oct 20088. World Economic Outlook

Terminology 125

Thanks

Questions

Terminology 126

Hyperlink Slides

Terminology 127

A Longer-Term Perspective on Home Prices

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1980’sBoom

CurrentBoom

60

80

100

120

140

160

180

200

220

1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

100

120

140

160

180

200

220

WorldWar I

GreatDepression

WorldWar II

1970’sBoom

1980’sBoom

CurrentBoom

1890=100

60

80

100

120

140

160

180

200

220

1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

100

120

140

160

180

200

220

WorldWar I

GreatDepression

WorldWar II

1970’sBoom

1980’sBoom

CurrentBoom

60

80

100

120

140

160

180

200

220

1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

100

120

140

160

180

200

220

WorldWar I

GreatDepression

WorldWar II

1970’sBoom

1980’sBoom

CurrentBoom

1890=100

80

60

Source: Robert J. Shiller, 2006.

Terminology 128

Homeownership Rate Reaches Historic High in 2004

62

63

64

65

66

67

68

69

70

1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005

Percent 69.2% in September 2004

67.8% in March 2008

2008

Source: U.S. Census Bureau.

Terminology 129

Home Mortgage Share of Household Liabilities : New High in 2007

55

60

65

70

75

1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007

Percent

Source: Federal Reserve.

Terminology 130

Ratio of Median Home Price to Median Household Income Surges

2.5

3.0

3.5

4.0

4.5

5.0

'68 '70 '72 '74 '76 '78 '80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06

Median Home Price/Median Household Income

Terminology 131

Median Existing Single-family Home Price:Too Good to Last

20082007200620052004200320022001200019991998

20

15

10

5

0

-5

-10

-15

Percent change, year ago

Sources: National Association of Realtors, Moody’s Economy.com.

Terminology 132

History Repeats Itself: Home Prices Don’t Just Go Up

Change in Home Prices in 100 plus years

-20%

-10%

0%

10%

20%

30%

40%

1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

WorldWar I

GreatDepression

WorldWar II

1970’sBoom

1980’sBoom

CurrentBoom

Percentage change, year ago

Source: Robert J. Shiller, 2006.

Terminology 133

Existing Home Sales Are Down Everywhere Over the Past Two Years

Percent change in existing home sales Fourth-quarter 2005 through fourth-quarter 2007

Existing home sales nationwide down 29%Source: Freddie Mac.

Terminology 134

Forty-six States Had Falling Prices in the Fourth Quarter 2007

United States: - 9.3% (fourth-quarter annualized growth)

Source: Freddie Mac.

Terminology 135

OECD Leading Economic Indicator Points to a Significant Slowdown

2001-02 Worldwide Recession

2007-08 Financial Crisis

Terminology 136

Impact of Financial Crisis on United States

Payment incident index (*) 12 months moving rate Scale of sector risk

0

50

100

150

200

250

300

june

93

dec-

93ju

ne 9

4de

c-94

june

95

dec-

95ju

ne 9

6de

c-96

june

97

dec-

97ju

ne 9

8de

c-98

june

99

dec-

99ju

ne 0

0de

c-00

june

01

dec-

01ju

ne 0

2de

c-02

june

03

dec-

03ju

ne 0

4de

c-04

june

05

dec-

05ju

ne 0

6de

c-06

june

-07

déc-

07

WORLD

United States


Terminology 137

Inflation Expectations Are Trending Downward

TIPS/10-Year Implied Breakeven Inflation Rate

Terminology 138

Unemployment Expectation

4.4 % Oct. 2006

6.1 % Oct. 2008

7%-8%2009

Forecasts

Terminology 139

Commodity Prices

CRB Commodity Price Index

Terminology 140

Baltic Dry Index

Terminology 141

Mortgage Loan Fraud Surges

Source: Financial Crimes Enforcement Network.

0

10

20

30

40

50

60

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Thousands

Terminology 142

S & P 500 Index

Terminology 143

Equity Market Volatility

S&P 500 Volatility

Terminology 144

Bloomberg’s Financial Conditions Index

Terminology 145

Market for Liquidity Freezes

Thirty-Day AA Rated Commercial Paper Rates

Nonfinancial Commercial

Paper

Financial Commercial

Paper

Asset-backed Commercial

Paper

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

May07

Jun07

Jul07

Aug07

Sep07

Oct07

Nov07

Dec07

Jan08

Feb08

Mar08

Apr08

May08

Percent

Source: Federal Reserve.

Terminology 146

Widening Spreads: Municipal Bonds

ML municipal master index yield spread

-80

-40

0

40

80

120

Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08

Basis point spread over 10-year treasury bond

ML municipal master index yield spread

-80

-40

0

40

80

120


Basis point spread over 10-year treasury bond

Source: Bloomberg.

Terminology 147

Widening Spreads :Mortgage-Backed & High-yield Bonds

Source: Bloomberg.

ML High-Yield Bond Index

ML BBB Mortgage-Backed Securities Index

0

200

400

600

800

1000

1200


Basis point spread above 10-year treasury bond

ML High-Yield Bond Index

ML BBB Mortgage-Backed Securities Index

0

200

400

600

800

1000

1200


Basis point spread above 10-year treasury bond

Terminology 148

Money Market Spreads : U.S. Libor/OIS Spread

U.S. Libor/OIS Spread

Terminology 149

Credit Spreads : Baa Corporate/ Treasury Spread

Terminology 150

The Dollar in 2007-08

January-August 2007From 1.30 to 1.35

Sept.-Nov. 2007From 1.35 to 1.45

Dec.Jan.Pause

Feb.-April 2008From 1.45 to 1.60

May-July2008.Pause

July.-Oct. 2008From 1.60 to 1.36

Terminology 151

Financial Stocks

-11%-17%

-18%-29%

-32%-40%

-52%-52%-53%

-56%-56%

-63%-77%

-87%-94%

-1 -0.8 -0.6 -0.4 -0.2 0

JP Morgan & ChaseGoldman SachsWells FargoBank of AmericaMorgan StanleyAIGLehman BrothersUBSWachoviaFannie MaeMerrill LynchFreddie MacWashington MutualCountrywideBear Stearns

Source: Bloomberg.

Percentage change in price, December 2006–March 2008

Terminology 152

Major losses for banks worldwide

Source: Bloomberg.

38.237.0

19.516.1

15.414.8

12.69.89.7

9.18.4

7.77.0

42.9CitigroupUBS

Merrill LynchHSBC

IKB Deutsche Royal Bank of Scotland

Bank of AmericaMorgan Stanley

JPMorgan ChaseCredit Suisse

Washington MutualCredit AgricoleDeutsche Bank

Wachovia

Losses/write-downs through May 27, 2008, US$ billions

Terminology 153293

225

429

1,014

813

946

0

200

400

600

800

1,000

1,200

2002 2003 2004 2005 2006 2007

US$ Millions

Dollar Losses in Reported Cases of Mortgage Fraud

Source: Federal Bureau of Investigation.

Terminology 154

Market share shifted from 2003 to mid 2006

76

43

24

57

0

20

40

60

80

100

2003 mid-2006

%

Year

Mortgage market % share

Government sponsered Private( Wall Street firms)

• Government share fell by 43%where as private share rose sharply by 138% over a period of 3 years

Between sub-prime and prime

• Subprime lending increased by massive 205% over 3 years

• Alternative–A similarly expanded by 384%

• Increase in Prime was mere 16.7%

Terminology 155

Global pool of money

Source:http://www.rbnz.govt.nz/speeches/2968727.html

• After 1997/98 financial crisis – Developing countries focus on export-driven growth and the associated accumulation of foreign exchange reserves• The strength of exports relative to domestic demand has seen saving outstrip investment in most of these economies

• Accordingly, we have the ironic situation whereby a range of developing countries are (in net terms) the providers of capital to some of the world’s most developed economies.

• This rapidly rising “savings glut” has been a principal source of increased global liquidity.

http://www.rbnz.govt.nz/speeches/2968727.html

Terminology 156

Rise of Global Liquidity (1998 onwards)

• The flow of increased global liquidity through markets has provided the impetus for many changes

• To generate a return on this liquidity has spurred massive growth in securitization of debt and the development of a vast array of derivatives. The propagation of these instruments can itself be seen as a source of liquidity growth. From a monetary policy perspective, this implies a very big increase in the liquidity that is not directly controlled by central banks. ••Bank for International Settlements, highlighted a number of important new features:

• the unbundling and re-pricing of risk through major advances in financial engineering, resulting in improved ability to lever lending via new markets such as for credit transfer products;• the emergence of new financial players such as hedge funds and private equity firms that have not been traditional intermediaries;• more reliance of financial firms on markets to handle growing complexity;• a reliance on market liquidity even in stress situations; and• a surge in volume and value of transactions.

Source:http://www.rbnz.govt.nz/speeches/2968727.html

http://www.rbnz.govt.nz/speeches/2968727.html

Terminology 157

FED interest rate

• To catch up with dot com bust FED kept interest rate low for too long

•This indirectly resulted in investors looking for other safe heavens

• They got attracted to housing market

Terminology 158

High Banks leverage ratio’s to fund MBS/CDO

Terminology 159

Building up of the housing bubble

Terminology 160

Housing prices and Income

• Housing prices were increasing

•Income slope was almost flat

Source: http://varbuzz.com/meltdown/

http://varbuzz.com/meltdown/

Terminology 161

Starting 2006 housing bubble busted

Terminology 162

LIBOR rate

Terminology 163

Credit rating of complex financial instruments

Source: IMF and WSJ

Terminology 164

Speedy Foreclosures

Terminology 165

Top 10 Bankruptcies

Terminology 166

The American way of debt

Source: http://www.nytimes.com/interactive/2008/07/20/business/20debt-trap.html?ei=5070

http://www.nytimes.com/interactive/2008/07/20/business/20debt-trap.html?ei=5070

Terminology 167

Average debt of American in 2004

Source: http://www.nytimes.com/interactive/2008/07/20/business/20debt-trap.html?ei=5070

http://www.nytimes.com/interactive/2008/07/20/business/20debt-trap.html?ei=5070

Terminology 168

VaR

With 95% confidence, we expect that our worst daily loss will not exceed 4%.

If we invest $100, we are 95% confident that our worst daily loss will not exceed $4 ($100 x -4%).

Source :http://www.investopedia.com/articles/04/092904.asp

http://www.investopedia.com/articles/04/092904.asp

Terminology 169

Effect of correlation

Financial MeltdownSource: Where Did the Risk Go by Mason & Rosner

∑∑ ∑== =

+=n

jijjiji

n

i

n

iiip rwww

11 1

22 σσσσ

Synthetics (e.g. ABX)

Property

Property

Property

Property

Property

Mortgage pool

AAA

AA

A

BBB

BB

Mortgage

$ for purchase or refiMortgage P&I Buy security

purchasedSecurity P&I

paid

Higher priority of

repayment

Lower priority of repayment

Lower yield

Higher yield

Mortgages are originated… And pooled together into a

trust

A series of securities (tranches) are created backed by the pool of

mortgages…

Which have different priorities in repayment, and thus different

levels of risk and yields

B

Unrated

Investors buy the individual securities

CDO Pool

Other RE and non-RE obligations

AAAAAA

BBBBBB

Unrated

Terminology 170

Black Swans

Classical metaphor: A Turkey is fed for a

1000 days—every days confirms to its

statistical department that the human

race cares about its welfare "with

increased statistical significance". On

the 1001st day, the turkey has a

surprise.

The fate of close to 1000 financial institutions (includes

busts such as FNMA, Bear Stearns, Northern Rock,

Lehman Brothers, etc.). The banking system

(betting AGAINST rare events) just lost > 1 Trillion

dollars (so far) on a single error, more than was

ever earned in the history of banking.

Turky Economics : we are in a new era of safety", and back-it up

with thorough and "rigorous" analysis and so package of sub-prime

loans (leveraged) gets sold on grounds that "30 years of history show

that the trade is safe

Source: The Black Swan, Nassim Nicholas Taleb

Terminology 171

Fourth Quadrant

passage from theory to the real world presents two distinct difficulties

• Inverse problem compounded by the small sample properties of rare events

• Many asymptotic properties do’nt work well pre-asymptotically

Source: The Black Swan, Nassim Nicholas Taleb

Terminology 172

Volatility as an indicator of stability

Random Walk—Characterized by volatility. You only find these in textbooks and in essays on probability by people who have never really taken decisions under uncertainty.

Random Jump process—It is not characterized by its volatility. Its exits the 80-120 range much less often, but its extremes are far more severe.

Fooled by Randomness: humans are hard-wired to demand an explanation for everything, even when there is none, leading us to be fooled into thinking that something is not random when it really is.

Sources: The Black Swan, Nassim Nicholas Taleb

Fooled by Randomness , Nassim Nicholas Taleb

Terminology 173

Fooled by Randomness

An evil investment advisor sends letters to a thousand or so prospective clients, telling half that a particular stock will go up and the other half that it will go down. The second month, repeat the same mailing to the half of the list where the prediction happened to be correct. Keep repeating each month and at the end of ten months he'll have a (short) list of peoplewho think he was correct for ten months in a row. Apply the same math to the world's pool of actual investment advisors and mutual fund managers and you'll find that the number of people with 10 year successful track records is about what you'd expect from pure chance!

Source: Fooled by Randomness , Nassim Nicholas Taleb

Terminology 174

Moody’s Fiasco

Moody’s discovered in February 2007 that the models used to

rate CDO’s had a mistake that provided ratings up to four

notches higher than they should have been.

Key problems in modeling of CDO’sIncorrect assessments of correlations between the individual assets

An AAA CDO tranche does not have the same risk characteristics as an

AAA corporate. The average probabilities of defaults may have been

similar, but the tails of the distribution are much fatter for CDOs.

Credit spreads on high-grade corporate obligations tend to narrow in a crisis

because of flight to quality. We see the opposite with CDOs.

Why would an AAA rated SIV earn 200 basis points above an AAA rated

corporate bond?


Terminology 175

SF Pool Losses don’t recover%

Los

s on

Ass

et P

ool

Time: zero to maturity

Cumulative Loss Level

Corporate Investments

Mortgage Pool

ExpectedActual


Terminology 176

SF Pool losses are Distributionallyskewed


Terminology 177

Moving,Increasing,Skewed SF Pool Loss distribution narrows over time

% L

oss

on A

sset

Poo

l

Cumulative Corporate Investment Performance



µ µ µ µ µ µ µ µ µ µ µ

% L

oss

on A

sset

Poo

l

Cumulative Mortgage Pool Performance



µ

µ

µµ µ µ µ

µµ

µ


Terminology 178

Investments devalued across the Globe

Source: BBC News, http://news.bbc.co.uk/2/hi/talking_point/7644574.stm

http://news.bbc.co.uk/2/hi/talking_point/7644574.stm

Terminology 179

Impact of Financial crisis-felt across the globe

Source: Reuters, http://www.reuters.com/news/globalcoverage/creditcrisis

http://www.reuters.com/news/globalcoverage/creditcrisis

Terminology 180

Mortgage Loan Fraud Surges

Source: Financial Crimes Enforcement Network.

0

10

20

30

40

50

60

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Thousands

Terminology 181

The Dollar in 2007-08

January-August 2007From 1.30 to 1.35

Sept.-Nov. 2007From 1.35 to 1.45

Dec.Jan.Pause

Feb.-April 2008From 1.45 to 1.60

May-July2008.Pause

July.-Oct. 2008From 1.60 to 1.36

Terminology 182

U.S. and Euro-Area Credit Default Swaps During the 2007-08 Financial Crisis

September 17, 2007 =100

U.S. CDS

Europe CDS

Terminology 183

U.S. and Euro-Area Swap Spreads During the 2007-08 Financial Crisis

September 17, 2007 =100

U.S. Swap Spreads

Europe Swap Spreads

the meltdown

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