Sub Prime Crisis &Euro Zone Crisis

A Presentation by-

Siddhant Agarwal

Sub Prime Crisis…

… and its rippling effects on the global economy

Contents

$ About the Crisis

$ Impact on USA

$ Impact on the World

$ Impact on India

$ Conclusion: Is there light at the end of the tunnel?

About the crisis

$ Post 2001, the US government had encouraged US banks to lend money to people, to encourage spending & investing mainly for the purpose of buying houses

$ These banks granted loans to large number of borrowers despite having lower income levels, unsure employment status, unscrupulous credit history, etc.

$ Huge number of borrowers availed of bank credit without evaluating their repayment capacities. The economy was flush with liquidity & stock markets were booming

The Bubble Burst$ A silent storm brewed in international financial

markets with origins in the US housing market, which witnessed an unprecedented boom since 2001

$ The boom was led by rising housing prices, low interest rates & aggravated by financial innovation viz. MBS, CDO and CDS

$ Housing prices in USA began to drop in 2006. Rising interest rates & falling housing prices led to rise in sub prime mortgage delinquencies & resultant foreclosure

$ Result: The housing bubble burst in Aug 2006

Sequence of events

Impact of Sub Prime Crisis in USA

The chart above brings out the irony and shows that underlying sub prime houses are only a small percentage of the total housing market and it was the bubble formed due to financial instruments viz. MBS, CDO and CDS, that caused the real problem

Impact of Sub Prime Crisis in USA$ Initial impact was felt in March 2008, when

investment bank, Bear Stearns was acquired by J.P. Morgan Chase, a commercial bank, for US$1.2 billion

$ September 2008, witnessed major shakeouts in the US financial sector. The drama began with Lehman Brothers declaring bankruptcy on 15 September 2008, facing a refusal by the federal government to bail it out

$ Washington Mutual is closed by the US government in the largest failure of a US bank. Its banking assets are sold to J.P. Morgan Chase for US$1.9 billion

The problem with investment bank balance sheets was that on the left side nothing was right and on the right side nothing was left!

Impact of Sub Prime Crisis in USA$ US Federal Reserve provided an emergency loan

of US$85 billion to insurance major, American International Group (AIG), which will be repaid by selling off assets of AIG

$ Investment bank, Merill Lynch was acquired by Bank of America in September 2008 for $50 billion

$ US Federal Reserve granted approval to investment banks, Goldman Sachs and Morgan Stanley to convert themselves into commercial banks

$ US Treasury Department confirmed that both Fannie Mae and Freddie Mac, would be placed into conservatorship with the government taking over their management

Impact of Sub Prime Crisis in USA$ Wachovia Corp agrees to sell most of its assets

to Citigroup Inc in a deal brokered by regulators. However, Wells Fargo, a commercial bank, drafted an agreement to acquire assets of Wachovia for US$15.1 blln

$ The deal forced Wachovia to backtrack from the Citigroup deal worth US$2.2 billion which was backed by the US Government

$ US Government releases a US$700 billion bailout package for its financial industry

$ Dow Jones posts its largest point decline ever while the S&P 500 had its worst day since 1987 with an 8.8% drop

What's the difference between a guy who just lost everything in Las Vegas and an Investment Banker? A tie!

Domino Effect across the World$ Northern Rock Bank had difficulty

finding finance to keep the business going and was nationalised in February 2008

$ British bank Lloyds TSB Group Plc agrees to buy rival HBOS Plc, (UK’s largest mortgage lender) scooping up Britain's biggest home loan lender in an all-share deal which values HBOS at over £12 billion (US$22.3 billion)

$ In September 2008, British bank Bradford & Bingley was nationalised by the UK government, which will take control of the bank's £50bn mortgages and loans, while its savings operations and branches are to be sold to Spain's Santander

$ The Dutch operations of Fortis, Europe's largest victim of the credit crisis, have been nationalised in a €16.8 billion (£13 billion) deal aimed to calm investors in the troubled banking and insurance group

$ Germany struggled to rescue lender Hypo Real Estate (Mortgage Giant), underlining the challenge facing European leaders, who vowed to restore stability in a banking system hit by the worst crisis since the 1930s

$ In October 2008, the Australian government announced that AU$4 billion was to be raised to fund non-bank lenders that are unable to obtain funding to finance new loans. After industry feedback this was increased to AU$8 billion

$ Japanese financial powerhouse, Nomura Holdings Inc. bought over Lehman's franchise in Europe and Asia Pacific, including Japan and Australia

Domino Effect across the World

$ Credit got tighter - banks became extremely careful parting with their capital and decreased lending activities either to business houses, retail customers and even to each other.

$ Effect on jobs – Many employees lost their jobs, especially in the financial sector.

Domino Effect across the World$ Stock markets tanked - Crisis caused panic in the

financial markets and investors sold out and withdrew their money, resulting in sharp drop in stock prices.

$ Many banks, mortgage lenders, real estate investment trusts & hedge funds suffered significant losses.

Domino Effect across the WorldThe world market capitalisation has fallen by 20% since March 2007 and by 31% since December 2007. Year to date, the Indian and Chinese markets have been the worst performers amongst the larger indices

Domino Effect in India

$ FII investments increased in most of 2007 in a booming Indian economy, as the Sensex was on its way to a historic peak of over 20,000 points

$ Since the inflow of dollars in the Indian economy increased, the dollar exchange rate decreased

$ In 2008, however, due to the effect of the sub prime crisis, FIIs liquidated their equity investments in a big way – leading to a crash in the stock markets

$ Simultaneously commodity prices, including oil prices, were on a rise due increasing demand for these commodities

$ The combined effect resulted in an increase in the dollar exchange rate

Is there light at the end of the tunnel?$ There are factors that indicate that there may be more trouble left in American

equity markets viz. USA has a low private savings rate and a negative household savings rate, in addition to a large current account deficit and a currency that needs to depreciate further to reduce this gap

$ There is also a severe financial crisis affecting all sectors of the economy. It does not seem likely the trouble has ended just yet

$ However, Warren Buffett may have started to see some light and has invested $5bn in thepreference shares (attached with equity warrants) of Goldman Sachs and $3bn in the preference shares of General Electric

$ Commodity prices (and hence inflation) are falling sharply and this will bring relief to the world and make a stronger case for lower interest rates. This also mitigates the impact of higher interest rates warranted by rising fiscal deficits of the governments being created to bail out/ takeover financial institutions

Is there light at the end of the tunnel?$ After an extended debate the US legislators have thought it fit, probably even

profitable, to create a bailout fund of US$700bn. This has been widely endorsed by most while some still feel the amount to be grossly inadequate

$ Central Banks around the world are putting up a concerted effort to provide liquidity to the globe by extending lines and cutting rates. This cannot but have a stemming effect

$ The world’s Wealth is estimated at US$150 trillion, a lot of which was built in the last 3 years. Some of the current losses in stocks and wealth is of course very painful but in the long term may prove to be just a bad dream that led to some much needed reform and changes in global leadership, a nightmare which looks like it shall last a while

$ Never before have housing, banks, hedge funds, insurance companies, commodities and currencies got so badly intertwined. Untangling them will take sometime. When done, this will create a new world order

Some quotes on the crisis“We were at the brink of something that would have made anything that's happened in financial history look pale. We were very, very close to a system that was totally dysfunctional and would have not only gummed up the financial markets but gummed up the economy in a way that would take us years and years to repair” – Warren Buffet

“There could be a lot more bank closures in the coming months which could create significant investment opportunities. As many as thousand banks could go belly up” – Wilbur Ross

“It is quite likely that the current synchronized global economic boom and the universal, all encompassing asset bubble will lead to a colossal bust” – Dr. Marc Faber

“The money markets have completely broken down, with no trading taking place at all. There is no market any more. Central banks are the only providers of cash to the market, no one else is lending” – Christopher Reiger (Dresdner Kleinwort)

Eurozone Debt Crisis

CAUSES, TIMELINE, EXTENT OF THE CRISIS, HOW IT IS BEING ADDRESSED AND

HOW IT’LL AFFECT US

How the crisis unfolded?

• Euro was born when European Union became a single economic zone.

• EU comprised of strong (Germany, France) as well as weak (Greece, Portugal) economies.

• Euro being the single currency in the union, there was no fear of local inflation, so banks lent indiscriminately.

• World economy was in good shape, so direct correlation between economic and repayment strength was not evident.

• Weaker economies of EU (PIIGS) overspent using borrowed money.

• Now they are unable to pay back their debt

• Ireland underwent a massive real estate bubble, and its banks sustained

giant losses. The Irish government wound up rescuing its banks, and now

the country is burdened under a huge debt load.

• Spain also experienced a huge housing bubble. The country didn't indulge

in excessive borrowing, rather, it ended up with high deficits because it

couldn't collect enough tax revenue to cover its expenses.

• Greece not only borrowed beyond its means, but exacerbated the problem

with lots of overspending, little economic production to make up the

difference, and some creative bookkeeping to prevent euro zone

authorities from realizing the true extent of the situation.

• Italy and Portugal have huge debt to GDP ratios, high unemployment and

are struggling with a weak economy

What did the PIIGS do?

And now..

• Given the huge size of the PIIGS debt, investors are reluctant to buy bonds from European countries, since many are in huge debts and others may have to assume responsibility for the black sheep.

• We could be looking at depression for Europe and recession for rest of the world.

• Uncertainty prevails as

EU may break up

Some countries may pull out of the EU

Leading to a rash of ban failures

Timeline of the crisis

1999-2008 •Euro is introduced, more countries join in. •In Dec ‘08 EU leaders agree on a 200bn-euro stimulus plan to help boost European growth following the global financial crisis. •2009 •Slovakia joins EU, Estonia, Denmark and others make preparations to join.

•In April, the EU orders France, Spain, the Irish Republic and Greece to reduce their budget deficits •In December, Greece admits that its debts have reached 300bn Euros; 113% of GDP, nearly double the EU limit of 60

Timeline of the crisis (cont.)

2010 • Severe irregularities are found in Greece’s accounting

procedures. • Talks start over austerity measures, sparking riots and protests

• Euro continues to fall against Dollar and Pound. • In May, EU members and IMF agree on a 110 bn Euro bail-

out package for Greece. • Ireland, Portugal, Spain, Italy come under review. • In November, the EU and IMF agree to a bailout package to

the Irish Republic totaling 85bn Euros. • The Irish Republic soon passes the toughest budget in the

country's history.

Timeline of the crisis (cont.)

2011 • In February, eurozone finance ministers set up a permanent

bailout fund, called the European Stability Mechanism, worth about 500bn euros.

• In April, Portugal admits it cannot deal with its finances itself, leading to a 78bn-euro bailout.

• Greece approves fresh round of austerity measures, the EU approves the latest tranche of the Greek loan, worth 12bn euros.

• A second bailout of Greece is agreed upon, at 109 bn Euros

Timeline of the crisis (cont.)

2012 • S&P downgrades France and eight other euro zone

countries, blaming the failure of euro zone leaders to deal with the debt crisis.

• Euro zone service sector shrinks, unemployment rates hit all time high and European Commission predicts that the euro zone economy will contract by 0.3% in 2012.

• Attention shifts to Spain and Italy, as they struggle to avoid going the ‘Greece way’.

Extent of the Crisis: Debt as a % of GDP

Extent of the Crisis: Unemployment Rate

Extent of the Crisis: Projected GDP

Whose fault is it?

• “Irresponsible" countries who borrowed too much, taking advantage of the low interest rates available to all euro member nations.

• The euro as a single currency cant meet the needs of 17 different economies.

• Typically, a country's central bank can adjust a nation's money supply to encourage or inhibit growth as a way of dealing with economic turmoil. However, the nations yoked together under the euro frequently haven't had that option.

• If Spain and Germany hadn't both spent the last several years on the euro, for example, then they wouldn't have been able to borrow at the same low interest rates.

• If the PIIGS all still had their own individual currencies, they might be able to export their way out of the mess they're in -- selling goods on the international market until their respective situations were a little less dire

• The interconnectedness of the modern financial industry. Default by Italy or a departure of the eurozone by a fed-up Germany , could reverberate around the world.

What ‘s being done to avoid the crisis?

•Stronger economies are pushing for stringent spending control guidelines, where a country’s spending will be directly proportional to its economic strength. •Several options are being discussed, such as, issuance of Euro Bonds, backed by the entire EU. •Restructuring of debt, with strict austerity measures placed on countries at risk of default.

•Troubled eurozone countries are pledging to cut back government spending to show they can be trusted

How does it affect the world?

• Stock market volatility.

• Financial institutions exposed to the debt will write it down, affecting their bottom line.

• Borrowing will get costlier as interest rate will remain high.

• As a result, spending will be less leading to a longer recession.

• Weak consumption and spending in Europe spells trouble for the rest of the world economy, that is struggling to get out of the downturn.

Thank you!