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  • 1. K.E.S’s SHROFF COLLEGE OF ARTS & COMMERCE SUBJECT: Banking in Financial Systems
  • 2. Class : S.Y.B.F.M. rd Semester: 3 PRESENTATION ON : American crises in 2007 Submitted to : Vaibhav sir Academic year : 2011-12
  • 4. GENERAL INTRODUCTION ABOUT THE SECTOR : The Indian economy is emerging as one of the strongest economy of the world with the GDP growth of more than 8% every year. This has given a great support for the development of banking industry in the country. Due to globalization, competition among the banks has drastically been increased. As India has a substantial upper and middle class income hence the banks have immense opportunities to increase their market shares. The consumer being on the receiving end is in the comfortable position but the banks trying to increase their market share have to continuously add value for consumers in order to increase market share and sustain their growth. BANKING SECTOR of America : The banking sector is the most dominant sector of the financial system in India. Significant progress has been made with respect to the banking sector in the post liberalization period. The financial health of the commercial banks has improved manifolds with respect to capital adequacy. Though the U.S. banking sector was in recovery mode in 2010, it still managed to reach some highs and lows. There were 157 bank failures in the country last year, the most since 1992, according to the Federal Deposit Insurance Corporation (FDIC). And the number of new bank charters was at an historic low -- 11, compared with 181 three years earlier. With so many banks leaving the sector and so few entering it, a long-anticipated consolidation process is now under way. The U.S. is expected to end up with no less than 6,529 commercial banks and 1,128 savings institutions by the end of this year.
  • 5. INTRODUCTION of American crisis : Since 2007, the world has experienced a period of severe financial stress, not seen since the time of the Great Depression. This crisis started with the collapse of the subprime residential mortgage market in the United States and spread to the rest of the world through exposure to U.S. real estate assets, often in the form of complex financial derivatives, and a collapse in global trade. Many countries were significantly affected by these adverse shocks, causing systemic banking crises in a number of countries, despite extraordinary policy interventions.Systemic banking crises are disruptive events not only to financial systems but to the economy as a whole. Such crises are not specific to the recent past or specific countries almost no country has avoided the experience and some have had multiple banking crises. While the banking crises of the past have differed in terms of underlying causes, triggers, and economic impact, they share many commonalities. Banking crises are often preceded by prolonged periods of high credit growth and are often associated with large imbalances in the balance sheets of the private sector, such as maturity mismatches or exchange rate risk, that ultimately translate into credit risk for the banking sector. Global financial stability has been shaken and America is facing a growing economic crisis that could make the 1930s look like “good times.” The U.S. banking system is on the verge of disaster, as banks have recorded over $100 billion in losses, with hundreds of billions more forecasted. What Is Sub-Prime Crisis ?
  • 6. Subprime is the cause of USA Economymelt down. It is the very popular news among everyone and it is become very serious then expected. It caused more damage to all the industries. Subprime crisis caused big loss to the banks and now it is affecting the other industries like AutoMobile companies (GM, Ford, etc.). In this blog I will write about what exactly is the Subprime crisis and why USA banks created such a big mistake in their era. Some experts comparing this disaster with the 1930 Economy slow down in USA.  The subprime mortgages are subprime. In simple words, the principle allows a person to purchase a property for a fixed interest rate particularly low the first 2 years (e.g. 1.45%) and then switch to a floating rate contains a risk premium (e.g. 8%). In return, the property is mortgaged.  The latter sold their property with a capital gain (the U.S. housing market growing 10% per year) enabling them to repay the loan and interest. In 2007, Beneficiaries wishing to sell their subprime real estate at the end of second year was leading a face down in the U.S. housing market. EFFECTS OF AMERICAN PUBLIC Crisis Strikes The crisis started in the summer of 2007. Due to the surplus of homes on the market, housing prices fell moderately—tipping the scales. Also around this time, the first batch of interest rate resets came due. Faced with exploding monthly payments, falling house prices, and an inability to refinance their mortgages, many customers defaulted on their loans. Lenders call it “jingle mail,” as so many homeowners are just turning in their keys.
  • 7. Confronted with higher monthly payments on mortgages that are greater than the value of their homes, homeowners are abandoning their mortgages. Many feel no moral obligation to fulfill what they promised to repay, believing it is better to walk away from their homes. They feel that while this hurts their credit rating, in the short-term it hurts less than the downward spiral toward bankruptcy. Crisis Spreads As the crisis intensifies, mortgage defaults are multiplying. And everyone is on the hook. “Monoline” insurance companies have suddenly become liable for multiple billions of dollars of debt. Investors have been left holding bonds that may never be repaid. Banks are finding it difficult to sell additional bonds as investors have backed out of the market, leery of poor investments. Thus, the banks’ fee income has dried up—leaving them with massive deficiencies in capital. As credit problems mount, banks have sharply reduced lending to each other and the public, fearful the loans will not be repaid (the “credit crunch”) as liquidity dries up and less money is available to finance commercial loans. Recently, a group of bankers were unable to back $14 billion of debt to finance an entertainment company. Other major deals in the tens of billions are now in jeopardy. The credit crunch has pushed beyond retail banking; it is now affecting major business deals and even commercial real estate. And municipal bonds (used to fund cities, colleges and hospitals), which were once considered safe investments, can no longer readily find buyers. Kings Become Beggars Increasingly, America’s banks have been forced to look to other nations for capital. Recently, U.S. banks received massive infusions of capital from Asian and Middle Eastern sources that are purchasing larger stakes in America’s largest bank institutions. During the G7 meeting mentioned earlier, Toshihiko Fukui, governor of the Bank of Japan, made a statement that could have serious ramifications, as the banking crisis further deteriorates: “If everyone
  • 8. does the same thing it won’t be any more effective. Each country needs to do what is best for its own particular situation.” In the near future, will countries that have so often supported America financially stop doing so, causing the crisis to spiral out of control? A Culture of Greed In many cases, mortgage brokers misrepresented terms and conditions to eager customers who provided them with fraudulent information. Sometimes banks did not even bother to check the information provided. Banks sold risky bonds as safe investments to unsuspecting investors. Rating agencies, paid by the banks, rated risky bonds (those with subprime components) as safe—even giving them the highest rating.With substantial increases in real estate prices occurring every year, builders went on a building spree around the nation. Reckless Lending In their quest for higher profits, banks no longer felt the need to carefully screen loan applicants, as they once did. Customers who did not qualify for loans under the banks’ standard lending procedures (i.e., “subprime” customers) were now targeted as a lucrative source of income, and marketed aggressively to. Loans were provided to people with no income, no job and no assets (so-called NINJA loans). The 2008-2009 Financial Crisis – Causes and Effects Market instability The recent market instability was caused by many factors, chief among them a dramatic change in the ability to create new lines of credit, which dried up the flow of money and slowed new economic growth and the buying and selling of assets. This hurt individuals, businesses, and financial institutions hard, and many financial institutions were left
  • 9. holding mortgage backed assets that had dropped precipitously in value and weren’t bringing in the amount of money needed to pay for the loans. This dried up their reserve cash and restricted their credit and ability to make new loans. There were other factors as well, including the cheap credit which made it too easy for people to buy houses or make other investments based on pure speculation. Cheap credit created more money in the system and people wanted to spend that money. Unfortunately, people wanted to buy the same thing, which increased demand and caused inflation. Private equity firms leveraged billions of dollars of debt to purchase companies and created hundreds of billions of dollars in wealth by simply shuffling paper, but not creating anything of value. In more recent months speculation on oil prices and higher unemployment further increased inflation. How did it go so bad? The American economy is built on credit. Credit is a great tool when used wisely. For instance, credit can be used to start or expand a business, which can create jobs. It can also be used to purchase large ticket items such as houses or cars. Again, more jobs are created and people’s needs are satisfied. But in the last decade, credit went unchecked in our country, and it got out of control. Mortgage brokers, acting only as middle men, determined who got loans, then passed on the responsibility for those loans on to others in the form of mortgage backed assets (after taking a fee for themselves originating the loan). Exotic and risky mortgages became commonplace and the brokers who approved these loans absolved themselves of responsibility by packaging these bad mortgages with other mortgages and reselling them as “investments.” Thousands of people took out loans larger than they could afford in the hopes that they could either flip the house for profit or refinance later at a lower rate and with more equity in their home – which they would then leverage to purchase another “investment” house.
  • 10. A lot of people got rich quickly and people wanted more. Before long, all you needed to buy a house was a pulse and your word that you could afford the mortgage. Brokers had no reason not to sell you a home. They made a cut on the sale, then packaged the mortgage with a group of other mortgages and erased all personal responsibility of the loan. But many of these mortgage backed assets were ticking time bombs. And they just went off. The housing market declined The housing slump set off a chain reaction in our economy. Individuals and investors could no longer flip their homes for a quick profit, adjustable rates mortgages adjusted skyward and mortgages no longer became affordable for many homeowners, and thousands of mortgages defaulted, leaving investors and financial institutions holding the bag. This caused massive losses in mortgage backed securities and many banks and investment firms began bleeding money. This also caused a glut of homes on the market which depressed housing prices and slowed the growth of new home building, putting thousands of home builders and laborers out of business. Depressed housing prices caused further complications as it made many homes worth much less than the mortgage value and some owners chose to simply walk away instead of pay their mortgage. The credit will dried up These massive losses caused many banks to tighten their lending requirements, but it was already too late for many of them… the damage had already been done. Several banks and financial institutions merged with other institutions or were simply bought out. Others were lucky enough to receive a government bailout and are still functioning. The worst of the lot or the unlucky ones crashed. The economic bailout is desiged to increase the flow of credit.
  • 11. Many financial institutions that are saddled with risky mortgage backed securities can no longer afford to extend new credit. Unfortunately, making loans is how banks stay in business. If their current loans are not bringing in a positive cash flow and they cannot loan new money to individuals and businesses, that financial institution is not long for this world – as we have recently seen with the fall of Washington Mutual and other financial institutions. The idea behind the economic bailout is to buy these risky mortgage backed securities from financial institutions, giving these banks the opportunity to lend more money to individuals and businesses, hopefully spurring on the economy. HOW COSTLY ARE THE 2007-2009 SYSTEMIC BANKING CRISES? We estimate the cost of each crisis using three metrics: direct fiscal costs, output losses, andthe increase in public sector debt relative to GDP. Direct fiscal costs include fiscal outlayscommitted to the financial sector from the start of the crisis up to end and capture the direct fiscal implications ofintervention in the financial sector.20 Output losses are computed as deviations of actual GDP from its trend, and the increase in public debt is measured as the change in the public debt-to-GDP ratio over the four-year period beginning with the crisis year.21 Output losses and theincrease in public debt capture the overall real and fiscal implications of the crisis. New crises (2007-2009) DIRECT FIXED INCREASE PUBLIC OUTPUT LOSSES COST DEBTS Advanced economies 5.9 25.1 24.8 Other economies 4.8 23.9 4.7 All 4.9 23.9 24.5 Note: New crises include Austria, Belgium, Denmark, Germany, Iceland, Ireland, Latvia, Luxembourg,Mongolia, Netherlands, Ukraine, United Kingdom, and United State.
  • 12. What Caused the Current Financial Crisis? As you are all probably aware, the US is currently experiencing the biggest financial crisis after the Great Depression. And just like this past worldwide economic downturn, marked with massive bank failures and the stock market crash. Preceding Factors Contributing to the Financial Crisis When examining the causes for the financial crisis most people start directly with the real estate market (the place where the crisis really began) focusing on the subprime mortgages and unscrupulous lenders and casting the blame on the unsustainable real estate bubble which began to collapse in 2006. Whereas this is true, it is not the whole story. The whole real estate bubble originated mainly as a response to the huge demand of financial assets. And since not many places can actually provide such assets, naturally in such situations speculative bubbles come on the stage and become part of the supply response of financial assets to the demand of such assets. The Problem with Securitization of Mortgages Basically, securitization is a wonderful financial vehicle. Mortgages are pooled together as securities and sold to investors. Of course, as securities, they can also be resold. Securitization creates diversification and liquidity. It also "smoothes out" the idiosyncratic risk of defaulting or going bankrupt. Despite the existing lack of clarity and transparency (investors did not fully understand these vehicles and after all, it was hard to get information which houses are included in the pool) regular conforming mortgage backed securities were considered very low risk and were sold to investors not only in the US but also around the world.
  • 13. And then, the idea of generating higher returns originated. Mortgages were now offered to high risk borrowers too, at the cost of significantly higher mortgage rates. Those subprime mortgages were put in big pools of assets from which the so called "Mortgage Backed Securities" were created. Often, the mortgages were actually broken into pieces and grouped and packaged with other mortgage pieces of the same type. Thus, financial instruments and vehicles like SIV, CMO, CDO, MBS and etc. seemed like a great solution to the great demand of assets and the idea was that the yields on such securitized subprime mortgages would also be higher. However, the problem with securitization stems from the fact that it does not provide protection against systematic risk. And unfortunately, such a systematic risk was also not priced into the subprime mortgage pools... not until things went wrong and subprime borrowers started defaulting on their mortgages. Reasons behind the Large Scale of the Crisis As we already noted, credit rating agencies didn't take into account the possible systematic risk and blessed the apparently low risk securities with AAA rating. Pension funds, mutual funds, some money market funds, banks and investors from all over the world purchased such securities thinking that they are safe. And as for the riskier securities, they also had their clientele - the hedge funds. Thus, the markets absorbed enormous amounts of these securities. Additionally, because investors considered such securities low risk, they leveraged them. In other words they invested more than they actually had capital for. This liquidity and the fact that these instruments became so widely spread among investors of all types and sizes now stand behind the great scale of this financial crisis.
  • 14. The Shock The subprime lending increased the homeownership rate in the United States significantly and about 5 million people went from tenants to homeowners. As a result, rents went down and house prices went up till they reached unsustainable heights relative to rents. Thus, when the rise in housing prices stopped in 2006, inevitably many subprime borrowers had difficulty making their mortgage payments. The housing bubble and particularly the excesses of the subprime mortgage market became even more evident when many subprime mortgage lenders began declaring bankruptcy around March 2007. This problem started to gain crisis proportions and yet, the financial authorities and the Federal Reserve believed that it was an isolated phenomenon. Well, they were wrong. Instead, in mid-2007, the losses in the subprime mortgage markets triggered surprising turmoil throughout the international financial system, given the presumed small size of the US subprime market compared to the global financial markets. The crisis spread with amazing speed to other markets and even to financial institutions that had no direct exposure to the subprime mortgage market. CONCLUDING REMARKS
  • 15. First, the recent crisis was concentrated in advanced economies, in particular those with large and integrated financial systems, unlike many of the boom-bust in the past that centered on emerging market economies. Liquidity shortages at systemically important, globally interconnected financial institutions in these advanced economies prompted large-scale government interventions. Second, while the intensity of policy interventions has been comparable to past crisis episodes, the speed of intervention and implementation of resolution policies was faster this time. This in part reflects that most of the crisis-affected countries are high income countries with strong legal, political, and economic institutions that create an enabling environment for an effective and speedy crisis resolution. Recapitalization contributing to lower direct fiscal outlays. Third, countries used a much broader range of policy measures compared to past episodes, including unconventional monetary policy measures, asset purchases and guarantees, and significant fiscal stimulus packages. These large scale public interventions were possible in part because most of the crisis-affected countries are high-income countries with relatively greater institutional quality and credibility of policy actions. Fourth, preliminary estimates indicate that the overall economic costs of the recent crises are higher in terms of output losses and increases in public debt compared to past crises, though fiscal costs associated with financial sector interventions are lower this time.