The Current Turmoil Cause and Effect

1
The Current TurmoilCause and Effect
Dr. B. Yerram Raju, Regional Director, PRMIA,
Hyderabad Chapter At the Seminar on Financial
Risk Management, Gitam University, Visakhapatnam
(November 14, 2008) Picture Courtesy-Economist
2
Feet in the frying pan no where else to jump
except fire.
Economist, London.
3
Current Risk Environment

• Foreign Capital fled
• Confidence evaporated
• Stock Markets plunged
• Global Market meltdown
• Currencies tumbled
• Asset flight to safety
• FIs blowing cold on credit
• Government Interventions
• Political environment
• Severe drought of credit and confidence lead
  recession.

4
Hey days

• Large inflow of assets
• MAs drive business growth
• Opportunities even in volatile markets seized
  without winking the eye
• Basel II compliance targets moved forward

5
Before the downturn The Housing Boom

• The introduction of exotic loans, adjustable rate
  mortgages, and relaxed standards allowed for an
  increase in sub-prime mortgage lending.
• Low interest rates encouraged Wall Street
  investors to back sub-prime loans in greater
  quantities.
• Hedge funds worldwide borrowed money to invest
  heavily in sub-prime mortgages.

6
D-days

• Unprecedented outflow of funds
• De-leveraging
• Government investment/increased scrutiny
• Extreme volatile share prices
• Recession fears
• Nervous investors
• Business uncertainty

7
Features of Housing Finance Crisis

• No-recourse Home Loans if a borrower defaults,
  bank can claim back the property used as
  collateral, but nothing more. Borrower in order
  to escape negative equity in the event of
  property value becoming less than mortgage value
  defaults on credit
• Abandoned houses fall into disrepair and loose
  further value in the hands of lender.

8
Securitization

• Loans are bundled into packages sold to outside
  investor
• Monthly payments of home owners collected by
  service agents and passed through to investors as
  interest payments on their bonds.
• Eventually gave rise to Collateralized debt
  obligations (CDS) sophisticated instruments
  that bundled together packages of different bonds
  and then sliced them into tranches according to
  investors appetite for risk. (Economist 18.10.08
  p.73)

9

• BANKS HAVE ALWAYS BEEN A WEAK LINK IN THE
  FINANCIAL SYSTEM BECAUSE OF A MISMATCH BETWEEN
  THEIR ASSETS AND LIABILITIES.

10
Originator Crisis Caused By Repurchase Wave

• The sudden performance deterioration caused a
  spike in first payment defaults (FPDs) and early
  payment defaults (EPDs)
• Loan buyers exercised their rights to put first
  payment defaults back to originators
• Large outlays for repurchase put substantial
  strain on smaller, poorly capitalized companies
• Early payment defaults in warehouse lines caused
  lenders to tighten
• The need to change product mix further
  constrained lenders as they saw
  volume/profitability fall
• High repurchase obligations and lack of financing
  drives marginal players into bankruptcy (Ownit,
  ResMae, MLN, Peoples Choice)
• Larger players also under severe stress (Fremont,
  New Century, Accredited)
• Discount loan pricing continues to weigh on
  originators
• Well-capitalized entities can weather the storm,
  and opportunistic buyers are active

11
The downturn begins

• Interest rates rise and housing prices fall.
  Monthly mortgage rates for subprime borrowers
  skyrocket, but the post-2005 housing slump means
  they do not have enough equity to refinance or
  sell.
• Lenders, rating agencies, and investors
  underestimated the number of loans that would
  default. Relaxed standards lured borrowers into
  taking out loans they couldnt afford once
  initial interest rates expired.
• This leads to a 113 increase in foreclosures
  from July 2006 to July 2007.

12
Banks pull back

• Banks re-evaluate high-risk loans in the face of
  potential losses on loans to hedge funds.
• As a result, credit is tightened for borrowers
  across the board, affecting commercial real
  estate, leveraged buyouts, venture capital
  lending, mergers and acquisitions, etc.

13
Who is to Blame?

• Lenders for their predatory lending practices
  focused on subprime mortgage candidates
• Rating Agencies Overrate the MBS and other
  derivatives with underlying securities of little
  value with full knowledge.
• Mortgage brokers for steering borrowers to
  unaffordable loans
• Appraisers for inflating housing values
• Wall Street investors for backing subprime
  mortgage loans without first verifying the
  security of the portfolio
• Borrowers for overstating income levels on loan
  applications and entering into loan agreements
  they could not afford
• Government for lack of oversight

14
Ongoing Effects

• Subprime mortgage industry collapses, thousands
  of jobs are lost
• Surge of foreclosure activity
• Housing prices and sales are both down
• Interest rates rise across the board as the
  effects of the collapse of the subprime mortgage
  industry seep into the near-prime and prime
  mortgage markets
• Investors lost billions of dollars in securities
  tied to the subprime mortgage industry, resulting
  in upheavals throughout the global financial
  market

15
Deterioration not by day but by hours

• Fed Reserve allowed certain firms to liquidate
  and certain others bail-outs
• Treasury Secretary proposed a bail-out package of
  700bn whereas the loss involved crosses trillion
  dollars
• The fire engulfed Great Britain and Europe
• Japanese markets also tumbled
• All Central Banks came out with bail-out packages
  and nationalization of banks in the troubled zone.

16
Government Action

• To avoid complete market failure and to allow
  banks to borrow money cheaply, the Federal
  Reserve, European Central Bank, and their
  counterparts flood the market with billions of
  dollars, euros, and yen from August 2008.
• The injected government funds were designed to
  encourage banks to continue making loans rather
  than conserving cash and making the credit crunch
  worse.
• Government action led to inflation and an
  international credit crunch that slowed economic
  growth worldwide.
• BAIL OUT ENCOURAGES RISKY BEHAVIOUR

17
Lessons in the process being learnt

• Development of speculative real estate markets
  and lax standards of credit appraisal are the
  surest routes to economic disaster
• Rating instrumentality is no substitute to
  independent due diligence
• Higher capital allocation with or without Basel
  II or prospective Basel III is no insurance for
  bank failures triggered by systemic, people and
  process failures
• Sophisticated mathematical models,
  notwithstanding back testing, stress testing and
  the like hardly forebode collapses. Better that
  the model-driven soothsayers exit the market.
• GAAP is not enough
• Macro prudential analysis (MPA) requires revisit
• High degree of flexibility is required in the
  choice of benchmarks
• Appetite for mergers and acquisitions move in a
  new direction
• Injecting liquidity through equity is a better
  route than a bail-out package
• Regulators to keep watch on leverage ratios more
  than the capital.

18
Indian Context

• In India, the closeted financial system is not
  heavily exposed to the financial crisis.
• PM None can be immune from a global melt down.
• In politics, economic reason always does not
  prevail (e.g. Farm Loan Waivers)

19
Indias Position

• Government asserts that the impact of the
  sub-prime crisis is moderate (FM RBI)
• Caught in the grip of inflation touching the
  highest double digit in the post-reform era.
• But there was a free fall of the stock markets
  pushing down Sensex by 57 percent from its level
  9months ago (24-X-08)-lt9000
• Markets continue to be volatile despite several
  blue chip companies and Banks reporting
  encouraging results for Q2.
• Reason Several FIIs continue to pull back their
  investments sheerly for their own survival with
  credit and home loan markets, inter-bank lending
  choking up.
• Despite low agriculture growth (2), Indian
  economy estimated to grow 7.7-8 percent as per
  the RBI Policy announcement. Hence markets have
  a chance to bounce back. But Indian investments
  are sluggish. Foreign investments distant.

20
Political Environment

• Elections in six States round the corner
  December 2008
• General Elections likely to take place in Feb2009
• UPA Government is treading on wafer thin majority
• Terrorism threatening security and life
• Relations with the US and Far East as also Europe
  significantly improved.

21
Knee-jerk Action

• Sep 16-08 RBI allows Banks to participate in
  Forex market FCNR and NRE deposit rates
  increased
• Sept 22 Finance Ministry raised the overseas
  borrowing caps for infrastructure companies from
  100mn to 500mn with average maturity of 7 years
  to boost capital flows.
• Oct 22 RBI also announced confirmatory
  statement.
• Oct 7Infrastructure to include Mining,
  Exploration and Refining Companies, for ECB
  purposes. Borrowing cap raised ten times from
  50mn to 500mn.
• SEBI said it would effectively monitor FIIs for
  preventing short-selling.
• Oct6 SEBI lifted restrictions on issue of
  Participatory Notes by FIIs to arrest outflow of
  FII funds FIIs allowed to issue PNs against
  securities including derivatives as underlying
  assets. Limit of 40 of FIIS total assets to
  issue PNs done away with.

22
Credit Policy announcements by the RBI

• Cut in CRR by 50 basis points effective Oct
  11.(9to 8.5)
• Further cut announced on Oct 10 by 100basis
  points.(7.5)
• Oct 15 Further cut in CRR by 100basis points
  (6.5)
• Oct 14 Infused Rs.20000cr liquidity thru special
  lending route for MFs Banks allowed to borrow
  for 14days at 9p.a.
• Oct 20 4days ahead of Credit Policy
  announcement, RBI cut REPO rate by 100basis
  points to 8 the first REPO cut since 2004
• November1 Further CRR cut in two tranches
  retrospective October 25 fifty basis points Nov
  8-another 50 basis points. (Effective 5.5)
• Repo Rate cut by 50 basis points.(Effective 8)
• Buy back of Market Stabilisation Scheme (MSS)
  dated securities
• Special Refinance window 1 of net of demand
  and time liabilities of Banks
• Signaled Rate cut from commercial banks easing
  the credit flow.
• Liquidity improves
• Markets reacted favourably al bait temporarily.
• This is in tune with the global trends.
• All the perfumes of Arabia will not sweeten this
  little hand.

23
Source Economist, London Oct 25-31, 2008
24
Measures taken by G-8 other than India
Source Amrita Narlikar, University of Cambridge
Financial Express dated 01.11.2008
25
Regulators Government all Alert

• US Fed cut rates to 2 the lowest in 50 years
  also indicated further rate cut
• UK closing in for zero interest rate
• All other countries in Europe and Pacific follow
  the same route.
• Avoid am-Bush on November 15, 2008 at the G-20
  Summit

26
Risk Management Process Can it come to rescue?
Treat Risks
Collaborative Risk
Risk Analytics
Policy Management
Monitor Review
Key Risk Indicators
27

• Thank You
• for the
• patience
• yerramr_at_gmail.com
  Hyderabad_at_prmia.org