A Project Report on Complete Assessment of the Impact of Subprime Crisis on World Market and Economies

A DISSERTION SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENT FOR THE AWARD OF MBA DEGREE OF BANGALORE UNIVERSITY

by Mr. Prateek Srivastava

Reg No: 07XQCM6066

Under the guidance and supervision of Dr.N.S. Malavalli

M P BIRLA INSTITUTE OF MANAGEMENT (Associate Bharatiya Vidya Bhavan) 43, Race Course, BANGALORE MAY 2009
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DECLARATION
I hereby declare that this dissertation entitled Complete Assessment of Impact of subprime Crisis on World Market and Economies is the result of my own research work carried out under the guidance and supervision of Dr. N.S.Malavalli, MPBIM Bangalore.

I also declare that this dissertation has not been submitted earlier to any Institute/Organization for the award of any degree or diploma.

Place: Bangalore Date: 06- 05- 2009

Name: Prateek Srivastava Reg No: 07XQCM6066

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PRINCIPALS CERTIFICATE

I hereby certify that this dissertation entitled Complete assessment of Impact of Subprime Crisis on World Market and Economies has been prepared by Prateek Srivastava under the guidance and supervision of Dr.N.S.Malavalli, Principal, M.P.Birla Institute of Management, Bangalore.

Place: Bangalore Date: 06-05-2009 (Dr. Nagesh S Malavalli) Principal

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GUIDES CERTIFICATE

I hereby certify that this dissertation entitled Complete assessment of Impact of subprime crisis on World markets and economies is the result of research work carried out by Prateek Srivastava under my guidance and supervision.

Place: Bangalore Date: 06-05-2009

Dr. N.S. Malavalli

(Faculty)

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ACKNOWLEDGEMENT

I am extremely thankful to all those who have shared their views, opinions, ideas and experiences with me in carrying out this research work. I am particularly indebted to Dr. N.S. Malavalli, Professor, M P Birla Institute of Management, Bangalore for his guidance and the necessary academic support.

Name: Prateek Srivastava Reg no: 07XQCM6066

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CONTENTS

SL.NO.

PARTICULARS

PAGE NO.

1 2 3 4 5 6 7 8

Executive Summary Introduction Research Analysis Findings Recommendations Conclusions Bibliography

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EXECUTIVE SUMMARY
The collapse of the subprime mortgage market in late 2007 set in motion a chain reaction of economic and financial adversity that has spread to global financial markets, created depression-like conditions in the housing market, and pushed the U.S. economy, along with the entire world economy, to the brink of recession. In response, many governments and the central banks across the world have proposed new spending and credit programs that would greatly expand the role of government in the economy but do little to alleviate the distress caused by the financial crisis that has spread rapidly to nearly all sectors of the economy.

The report has been drawn up with the objective of identifying and analyzing the various factors that led to subprime crisis and its affect on different countries and different sectors across the world. Five countries and five sectors were chosen for this purpose.

The study starts with a brief insight into those conditions responsible for the subprime, how they evolved over time and the financial structure and its final collapse.

The countries and sectors chosen for this purpose are those which were hugely impacted by the subprime crisis or those which were growing very rapidly before the subprime crisis but came to a sudden halt due to subprime.

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INTRODUCTION
Subprime means being of less than top quality or below a prime rate. Subprime lending involves financial institutions lending to borrowers who do not meet underwriting guidelines. Subprime lending evolved with the realization of demand in the marketplace for loans to high risk borrowers with imperfect credit. These borrowers are more likely not to pay the money back, depending on their payment history and income levels i.e. lending to those people who have bad credit.

The first subprime was initiated in 1993. Many companies entered the market when the prime interest rate was low and real interest became negative. 25% of the population of U.S. falls into the category of limited or impaired credit history. Traditional lenders turned away potential borrowers with such impaired credit histories. In 1998, it is estimated that 10% of new car financing in the U.S. was provided by Subprime loans.

The Subprime Crisis began with the bursting of the United States housing bubble. High default rates on subprime and Adjustable Rate Mortgages (ARM) began to increase after that at a much faster pace. Lax regulation, deregulation of government policies and investment from the private sector had greatly increased higher-risk lending. Subprime mortgages increased 292% between the period 2003 to 2007.An increase in loan incentives such as easy initial terms and a long term trend of rising housing prices encouraged borrowers to assume difficult mortgages in the belief that they would be able to quickly refinance at a more favorable terms. But once interest rates began to rise and housing prices started to drop moderately in the year 2006-2007 in many parts of the United States, refinancing became more difficult. Home prices failed to go up as expected and ARM interest rates reset higher. This triggered a global financial crisis through 2007 and 2008. In the year 2007, nearly 1.3 million U.S. housing properties were subjected to foreclosures which was 79% more than that in 2006. Therefore, Subprime crisis refers to the crisis when the borrowers to whom loans are issued, fail to repay them. It started in U.S. market when loans were given to borrowers at very low interest rates. The borrowers took loans more than their capacity and later failed to pay back the debt. This caused severe liquidity crisis in the world markets and eventually led to recession in many countries.
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Subprime Lenders

To access the increasing market of Adjustable Rate Mortgage (ARM), lenders often take risks by lending to people with poor credit ratings or limited credit histories. i.e. They would lend money to consumers that have bad credit. If a borrower has sufficient income, then he or she may qualify for a subprime mortgage product. These types of loans are considered to carry a far greater risk for the lender due to the credit risk of the subprime borrower. Various methods are used by the lenders to offset these risks. In case of subprime loans, this risk is offset with a higher interest rate. In case of Subprime Credit Cards, a subprime customer may be charged higher late fees , yearly fees or higher upfront fees for the card. In this case, late fees are charged to the account which drives the customer over their credit limit. This higher fees compensates the lender for the increased cost.

Subprime Borrowers

Subprime loans provide an opportunity to borrowers with less than ideal credit record to become a home owner. They may use this credit to purchase homes , finance other forms of spending such as paying for living expenses, purchasing a car or even paying down on a high interest credit card. But due to the risk profile of the subprime borrower, the credit comes at a very high interest rate. But if borrowers maintain a good payment record, they are able to refinance into mainstream rates after 2-3 years. In general, the credit profile keeping a borrower out of a prime loan may include one or more of the following :

Bankruptcy in the last 5 years. Relatively high default probability based on the credit score. Accuracy of the credit line data obtained by the underwriter. Non-payment , repossession or foreclosure of a loan in the past. Two or more loan payments paid past thirty days due in the last twelve months

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Type of Subprime Lending

There are fundamentally two types of subprime lending. They are :

a ) Subprime Mortgages :

Subprime Mortgages are defined by the financial and credit profiles of the consumers to which they are marketed. These borrowers have very poor credit histories that includes payment defaults or payment delays, charge offs and bankruptcies. They also display reduced payment capacity as measured by credit scores. In U.S.A. the government allows a tax break of 30% to 50% not only on the real interest but also on the inflation part of nominal interest rates. This tax break is then used to buy cars and other consumer goods. This tax has made USA the most personally indebted nation in the world. Other countries in the world like Brazil that do not use nominal interest rates in housing loans and do not give such tax breaks do not have a subprime housing problem.

Subprime mortgage loans are much riskier loans because they are given to those borrowers who are unable to qualify under strict criteria due to a poor credit history. These individuals have credit scores below 620 on a scale of 300 to 850. Such loans have a much higher rate of default than prime mortgage loans and are priced based on the risk assumed by the lender. 21% of all mortgage loans from 2004 to 2006 were subprime , which totaled $600 billion in 2006.

Various special loan features are available with subprime crisis. They are :-

Interest only payments, which allow borrowers to pay only interest for a period of time, say 5-10 years. Pay option loans, for which borrowers choose their monthly payment Hybrid mortgages with initial fixed rates that sooner or later can be converted to adjustable rates. Common subprime hybrids include the 2-28 loan which offers a
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low initial interest rate that stays fixed for two years after which loan is rest to a higher adjustable rate

b ) Subprime Credit Cards :

Credit Card companies in the U.S. began offering subprime credit cards to borrowers with low credit scores and a history of defaults in the 1990s when the laws were relaxed. These cards had low credit limits but the fees was extremely high and interest rates as high as 30% per annum or more. In the year 2002, as economic growth in the United States slowed, the default rates for subprime credit card holders increased exponentially and many subprime credit card issuers were forced to scale back or cease operations.

In 2007, many new subprime credit cards began to flourish in the market. With more credit card providers, the credit card market became more competitive, forcing the issuers to make the cards more attractive to the customers. Interest rate on subprime credit cards is still at 9.9% per annum and in some cases, reaches as high as 24% per annum.

Subprime credit cards may help a customer improve poor credit scores. Most subprime cards report to major credit reporting agencies such as Transunion but in the case of secured cards, credit scoring often reflects the nature of the card being reported. Issuers of these cards claim that customers who pay their bills on time should see positive reporting to these agencies within ninety days.

Customers who have experienced severe financial crisis carry much higher risk and therefore have much difficulty obtaining credit, especially for large purchases such as automobiles or real estates. This could be possible because of the following reasonsunforeseen major financial setbacks, unexpected medical issues, job loss or previous debt problems. This may lead to late payments, repossessions and even bankruptcy. Due to these credit problems, these individuals may not be able to get any type of conventional loan. To meet this demand, lenders allow these individuals to receive
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loans by paying a higher interest rate and higher fees. In the year 1999, Fannie Mae, the then U.S. largest home mortgage underwriter, relaxed credit requirements on the loans it would purchase from other banks and lenders, thinking that easing of the restrictions would result in increased loan availability for the nations low income buyers.

These loans had statistically higher rate of default and are more likely to experience repossessions and charge offs. Lenders use the higher interest rates and fees to offset these anticipated higher costs.

The customer enters into this agreement with the understanding that they are at higher risk, and must make genuine efforts to pay. These loans do indeed serve those who would otherwise be underserved. For example, in case of an auto loan, the customer must purchase an automobile which is well within their means and carries a payment within their budgets.

Mortgage Market
Subprime lending is the practice of lending, in the form of mortgages for the purchase of homes. The usual criteria was borrowing at the lowest prevailing market interest rates. But in this case, the criteria pertained to higher risk structure of the loans, poor loan documentation, low levels of collateral, the borrowers credit score and other factors like credit history. When real estate prices fell, the value of the collateral securing the mortgage dropped and the risk of loss to the lender increased significantly. If a borrower fails to make timely mortgage payments to the loan servicer, the lender may be forced to take possession of the property. This process is called foreclosure.

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The value of U.S.A. subprime mortgages was estimated at $1.3 trillion as on March 2007. Between the years 2004-2006, the share of subprime mortgages relative to total mortgages was between 18% to 21% compared to just 10% in 2001-2003. This rose to 21% in January 2008 and to 25% in May 2008. The value of all outstanding residential mortgages owned by USA households to purchase residences houses was US$ 9.9 trillions by the end of 2006 and US$ 10.6 trillion as of midyear 2008.The lenders who gave loans to the borrowers, began the process of foreclosures on nearly 1.3 million properties which was 79% more compared to that in the year 2006.This increased to 2.3 million in 2008. Between august 2007 and October 2008, almost one million residences had to face foreclosures.

Credit Risk :
Credit risk arises when a borrower defaults on the loan he/she owns to the banks or any other financial institutions. In these cases, it is the lenders who bore the credit risk on the mortgages they issued. During the last sixty years, a variety of financial innovations have made it possible for lenders to sell the right to receive the payments on the mortgages they issue. This process is called securitization. The resulting securities are called mortgage backed securities (MBS) and collateralized Debt obligations(CDO). The investors holding MBS and CDOs also bear several types of risks which can lead to disastrous consequences. In general, there are five primary types of risks

Credit Risk

: The risk that the borrower of the loan is either unwilling or

unable to pay back the loan. Asset Price Risk : The risk that the assets (mortgage backed securities) will

depreciate in value, resulting in financial losses Liquidity Risk : The risk that a business entity will be unable to obtain cash

to fund its operations soon enough to prevent an unusual loss.

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Counterparty Risk : The risk that a party to a contract is unable or unwilling to uphold their obligations. Systemic Risk : The net effect of these and other risks is called systemic

risk. This happens when formerly uncorrelated risks become highly correlated and damage the entire financial system. When home owners defaulted, the payments received by MBO and CDO investors declined and the credit risk rose sharply. This had a significant adverse effect on investors and the entire mortgage industry. The risks associated with American mortgage lending have global impacts because of the close integration of USA housing and mortgage markets with global financial markets. Investors in MBS and CDOs can insure against credit risk by buying Credit Default Swaps (CDS). As mortgage defaults rose, the probability that the issuers of CDS would have to pay their counterparties increased. This caused a lot of uncertainty across the system, as investors wondered if CDS issuers would honor their commitments.

Mortgage backed securities :

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 loans. Not all securities backed by mortgages are considered mortgage backed securities. For example, housing bonds are backed by the mortgages which they fund but are not called mortgage backed security. Residential mortgages in the United States have the option to pay more than the required monthly payment or to pay off the loan in its entirety (prepayment). This affects the remaining loan principal and the monthly cash flow of an MBS in not known in advance. This also presents an additional risk to the MBS investors.
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Commercial Mortgage backed Securities (CMBS) are those securities which are secured by commercial properties such as apartment buildings, office properties, industrial properties and other commercial sites. The properties of these loans vary with longer term loans often fixed at fixed interest rates and having restrictions on repayment while short term loans are at variable rates and freely prepayable.

The various uses of mortgage backed securities are Transform relatively illiquid individual financial assets into liquid and tradable capital markets instruments. More efficient and lower cost source of financing in comparison with other bank and capital markets financing alternatives. Allow issuers to diversify their financing sources, by offering alternatives to more traditional forms of debts and equity financing. Allow mortgage originators to replenish their funds which can then be used for additional origination activities.

Credit Default Swap

A Credit default swap (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller and in turn receives a payoff if an underlying financial instrument defaults. This is different from an insurance in the following manner The seller need not be a regulated entity. The seller is not required to maintain any reserves to pay off buyers although all major CDS dealers are subject to banking capital requirements.
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The buyer of a CDS does not need to own the underlying security or other form of credit exposure.

Like most financial derivatives, credit default swaps can be used by investors for speculation, hedging and arbitrage. By the end of 2007, the CDS market had a notional value of $45 trillion. As the market grew and matured, CDs were used by investors wishing to bet for or against the likelihood that particular companies or portfolios would suffer financial difficulties rather than to insure against bad debts. By late 2007, it was approximately ten times as large as it had been four years ago. The market for credit default swaps attracted considerable concern from regulators in 2008, starting with the collapse of Bear Stearns. Before the collapse of Bear Stearns, the banks CDS spread widened hugely, indicating a surge of buyers taking out protection on the bank. This means that investors saw that bear stearns was in trouble and sought to hedge any exposure to the bank or speculate on its exposure. In the month of September, the bankruptcy of lehman brothers, caused a total of $ 400 billion to become payable to the buyers of CDS protection referenced against the insolvent bank. American International group (AIG) required a federal bailout because it had been excessively selling CDS protection without hedging against the possibility that the reference entities might decline in value which exposed the insurance giant to potential losses of over $100 billion.

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Subprime Mortgage Crisis

The Subprime Mortgage crisis was a financial crisis started by a dramatic rise in mortgage meltdown and foreclosures in the United States with major adverse

consequences for banks and financial markets around the globe. This crisis has exposed weaknesses in financial industry regulation and the global financial system. Approximately 80% of U.S. mortgages issued in recent years to subprime borrowers were adjustable rate mortgages. When U.S. house prices began to decline in 2006-2007, refinancing became more difficult and adjustable rate mortgages began to reset at higher rates.

The crisis began with the bursting of the U.S. housing bubble in 2005-2006. High default rates on subprime and adjustable rate mortgages began to rise very quickly after that. Lax regulation, deregulation of government policies and investment from the private sector had increased high risk lending. Subprime mortgages increased 292% from 2003 to 2007. The risk to the broader economy created by the housing market downturn and financial market crisis were prime factors in several decisions by central banks around the world to cut interest rates and the governments to implement economic stimulus package. These actions were taken to stimulate economic growth and inspire confidence in the financial markets. Between the period of January 1, 2008 and October 11, 2008, shareholders of the U.S. companies had suffered about $8 trillion in losses as their holdings declined in value from $20 trillion to $12 trillion. Losses in the stock markets and housing value placed further downward pressure on consumer spending. A steep rise in the rate of subprime mortgage defaults and foreclosures had caused more than 100 subprime mortgage lenders to fail or file for bankruptcy. The failure of these
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companies caused prices in the $6.5 trillion mortgage backed securities to collapse and had a devastating impact on the U.S. housing market and economy as a whole. But the impact of this crisis was not limited to U.S. only, it had its effect on the entire world economy. Subprime debts were repackaged by banks into attractive looking investment vehicles and securities that were snapped up by banks , traders and hedge funds on the US, European and Asian markets. After the subprime crisis hit the subprime mortgage industry, the investors found their investments almost valueless. With the crisis getting severe, banks started controlling their lending to each other which lead to a dramatic increase in interest rates and difficulty in maintaining credit lines. This affected healthy businesses also across the world who did not have any direct connection with the subprime crisis due to banks unwillingness to budge on credit lines. Borrowers were criticized for entering into loan agreements they could not meet. As housing prices rose from 2000 to 2005, borrowers who faced difficulty in making their payments, were still making lots of money in equity thus making it easier for them to refinance or sell their homes. But if US home prices continued to fall, the subprime mortgage defaults could have caused more problems for the local economy. These concerns about the subprime mortgage lending industry caused a sharp drop in stocks across the U.S. which affected all the other stock markets worldwide. Across the Asia and Europe, markets just crashed. But the markets recovered in next two days only. The recovery was temporary as the markets were again touching their lowest levels in spite of the Fed cutting interest rates by half basis point i.e. 0.50%. and again by a quarter point i.e. 0.25%. In December 2007, the U.S. government announced a plan to temporarily freeze the mortgages of a limited number of mortgage debtors holding. But still, the default rate on securitized subprime loans hit 25.2% in the same month.

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CAUSES OF SUBPRIME CRISIS

There are many factors which led to the subprime crisis in both housing and credit markets, which emerged over a number of years. These causes include the inability of the home owners to make their mortgage payments, borrowers over extending , predatory lending, speculation and over building during the boom period, high personal and corporate debt, financial products that concealed the risk of mortgage default, monetary policy and government regulation. Two things that further speeded up subprime crisis were the influx of money from the private sector banks entering into the mortgage bond market and the predatory lending practices of mortgage brokers.

During the period of strong global growth , the various market participants were expecting higher yields, though it increased the risk, and failed to exercise proper due diligence. Also, unsound risk management practices and complex and opaque financial products made the whole financial system much more vulnerable. Policy makers, regulators and supervisors across the world did not addressed the risks that was building up in the financial markets.

Housing Market boom and the bust :

One of the main reasons for subprime crisis was the initial boom and later on, the bust in the housing markets. The boom in the housing market was fuelled by low interest rates and large inflow of foreign funds which created easy credit conditions for a number of years prior to the crisis. Due to this, home ownership in US increased from 64% in 1994 to an all time high of 69.2% in 2004. This was also the reason for the increase in home prices in U.S. and encouraged debt-financed consumption. The increase in US home prices between 1997 and 2006 was 124%. This housing bubble forced many home
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owners to refinance their homes at lower interest rates or financing consumer spending by taking out second mortgages secured by the price appreciation. At the end of 2007, the debt ratio of US households as a percentage of annual disposable personal income was 127% compared to just 77% in 1990.

On one hand, the housing prices in U.S. were increasing and on the other hand, the consumers were saving less and borrowing and spending more. Since 2005, consumers in the U.S. have spent more than 99.5% of their personal disposable income on just consumption or payment of interests. In midyear 2008, the household debt was at $14.5 trillion which was 134% of the disposable personal income. Customers, on an average, were having 13 credit cards with 40% of households carrying a balance.

The excess credit in the financial system and house price explosion led to real estate boom initially and eventually to a surplus of unsold homes. So, in the beginning, U.S. home prices reached their peak and then began to decline at a rapid pace. Availability of easy credit and a belief that the home prices would continue to increase in the future also, encouraged many borrowers to obtain adjustable rate mortgages. These kind of mortgages attracted borrowers with a below market interest rate for some pre determined rate. In case the borrowers failed to make the payments after the initial grace period, they would try to refinance their mortgages. But this became difficult once the house prices began to fall. Those home borrowers who found even refinancing their mortgages difficult, began to default on their monthly payments. This resulted in increase of homes for sale which further reduced the home prices and lowered home owners equity. The decline in mortgage payments also reduced the value of mortgage backed securities which eroded the net worth and financial health of the banks. Between mid 2006 and September 2008, US prices had declined by almost 20%. This means that the value of home owners homes were less than their mortgages.

Due to the declining home prices, inventory of houses offered for sale increased. In January 2008, nearly four million homes were for sale. Number of new homes sold in
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2008 declined by more than 26% compared to 2007. This large number of unsold homes further lowered home prices.

Speculation :
Speculation in residential real estate has also been a contributing factor. During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12% respectively. In other words, a record level of nearly 40% of homes purchases were not intended as primary residences. Housing prices doubled between 2000 and 2006, a different trend from the historical appreciation at roughly the rate of inflation. While homes had not traditionally been treated as investments subject to speculation, this behavior changed during the housing boom. For example, one company estimated that as many as 85% of condominium properties purchased in Miami were for investment purposes. Media widely reported condominiums being purchased while under construction, then being sold for a profit without the seller ever having lived in them. Some mortgage companies identified risks hidden in this activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple properties. While stock brokers are prohibited from telling an investor that a stock or bond investment cannot lose money, it was not illegal for mortgage brokers to do so. Equity investors are well-aware of the need to diversify their financial holdings, but for many homeowners the home represented both a leveraged and concentrated risk. Further, in the U.S., capital gains on stocks are taxed more aggressively than housing appreciation, which has large exemptions. Keynesian economist Hyman Minsky described three types of speculative borrowing that contribute to rising debt and an eventual collapse of asset values:

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The "hedge borrower," who expects to make debt payments from cash flows from other investments; The "speculative borrower," who borrows believing that he can service the interest on his loan, but who must continually roll over the principal into new investments; The "Ponzi borrower who relies on the appreciation of the value of his assets to refinance or pay off his debt, while being unable to repay the original loan. Speculative borrowing has been cited as a contributing factor to the subprime mortgage crisis.

Lending and borrowing

Lenders began to offer more and more loans to higher-risk borrowers. Subprime mortgages amounted to $600 billion, which was approximately 20% in 2006. The average difference between subprime and prime mortgage interest rates (the "subprime markup") declined from 280 basis points in 2001 to 130 basis points in 2007. In other words, the risk premium required by lenders to offer a subprime loan declined. This occurred even though the credit ratings of subprime borrowers, and the characteristics of subprime loans, both declined during the 20012006 period, which should have had the opposite effect. In addition to considering higher-risk borrowers, lenders offered increasingly risky loan options and borrowing incentives. In 2005, the median down payment for first-time home buyers was 2%, with 43% of those buyers making no down payment whatsoever. By comparison, China has down payment requirements that exceed 20%, with higher amounts for non-primary residences. One high-risk option was the "No Income, No Job and no Assets" loans, sometimes referred to as Ninja loans. Another example is the interest-only adjustable-rate mortgage (ARM), which allows the homeowner to pay just the interest (not principal) during an initial period. Still another is a "payment option" loan, in which the homeowner
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can pay a variable amount, but any interest not paid is added to the principal. An estimated one-third of ARMs originated between 2004 and 2006 had "teaser" rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment. The proportion of subprime ARM loans made to people with credit scores high enough to qualify for conventional mortgages with better terms increased from 41% in 2000 to 61% by 2006. However, there were many factors other than credit score that affect lending. In addition to this, mortgage brokers in some cases received incentives from lenders to offer subprime ARM's even to those with credit ratings that merited a non-subprime loan. For example, brokers for one lender could earn a "yield spread premium" equal to 2% of the loan amount -- or $8,000 on a $400,000 loan -- if a borrower's interest rate was an extra 1.25 percentage points higher than the lender's prime rates. On average, U.S. mortgage brokers collected 1.88% of the loan amount for originating a subprime loan, compared with 1.48% for conforming loans. Payouts for subprime loans have traditionally been higher, in part because these loans sometimes took more work and the approval rate could be lower. Mortgage underwriting practices, which were not subjected to appropriate review and documentation were also criticized .This also included automated loan approvals. Mortgage brokers made no effort to verify whether borrowers could even repay the amount.

Concept of Securitization :

Securitization is a form of structured finance, which involves the pooling of financial assets, especially those for which there is no ready secondary market, such as mortgages, credit card receivables, and student loans. The pooled assets are then transferred to

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a special purpose entity and served as collateral for new financial assets issued by the entity. It is combined with investor appetite for mortgage backed securities, and the high ratings formerly granted to MBSs by rating agencies, meant that mortgages with a high risk of default could be sold easily to warehouses with the risk shifted from the mortgage originator to investors. Securitization allows issuers to easily generate capital for new loans. The traditional mortgage model involved a bank originating a loan to the borrower and retaining the credit risk. With the advent of securitization, the traditional model has given way to the "originate to distribute" model, in which the credit risk is transferred to investors through MBS and CDOs. Securitization created a secondary market for mortgages, and meant that those issuing mortgages were no longer required to hold them to maturity. Asset securitization began with the creation of private mortgage pools in the 1970s. Securitization accelerated in the mid-1990s. The total amount of mortgage-backed securities issued almost tripled between 1996 and 2007, to $7.3 trillion. The securitized share of subprime mortgages increased from 54% in 2001, to 75% in 2006. The securitization markets started to close down in 2007 and nearly shut-down in 2008. More than a third of the private credit markets thus became unavailable as a source of funds. Securitization involves the transfer of mortgage loans into off-balance sheet entities called structured investment vehicles. However, the institution effecting the securitization transaction often retains a subordinated interest in the assets, which can concentrate credit risk within the originating institution. Mortgage standards became lax because securitization gave rise to a form of moral hazard whereby each link in the mortgage chain made a profit while passing any associated credit risk to the next link in the chain. At the same time, some financial firms retained significant amounts of the MBS they originated, thereby retaining significant amounts of credit risk and so were less guilty of moral hazard.
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The model used to correlate the risks among different loans in securitization pool is often criticized. Correlation modeling is used to determine how the default risk of one loan in a pool is statistically related to the default risk for other loans. This technique is widely adopted as a means of evaluating the risk associated with securitization transactions. But, the flaws in this technique did not become apparent to market participants until after many hundreds of billions of dollars of ABS and CDOs backed by subprime loans had been rated and sold. When the investors stopped buying subprime-backed securities, which halted the ability of mortgage originators to extend subprime loans, the effects of the crisis were already beginning to emerge.

There are two striking aspects of the current crisis and its origins. One is that systemic risk built steadily in the system. The second is that this buildup went either unnoticed or was not acted upon. That means that it was not perceived by the majority of participants until it was too late. An important challenge going forward is to better understand these dynamics as the analytical underpinning of an early warning system with respect to financial instability.

Inaccurate and Unreliable credit ratings :

After the subprime crisis, the role of credit rating agencies was also under scanner. They are now under scrutiny for having given investment-grade ratings to CDOs and MBS based on subprime mortgage loans. These high ratings were believed justified because of risk reducing practices, including over-collateralization , credit default insurance and equity investors willing to bear the first losses. However, there were also indications that some involved in rating subprime-related securities knew at
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that time that the rating process was faulty. Some rating agency employees suspected that lax standards for rating structured credit products would result in major problems. High ratings encouraged investors to buy securities backed by subprime mortgages, helping finance the housing boom. The reliance on agency ratings and the way ratings were used to justify investments led many investors to treat securitized products, some based on subprime mortgages, as equivalent to higher quality securities. The Credit rating agencies suffered from conflicts of interest, as they were paid by investment banks and other firms that organized and sold structured securities to investors. Between 2007 and 2008, rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities. Financial institutions felt they had to lower the value of their MBS and acquire additional capital so as to maintain capital ratios. If this involved the sale of new shares of stock, the value of the existing shares would reduced. Thus ratings downgrades lowered the stock prices of many financial firms.

Government Policies :
The various policies of the U.S. government also contributed to the crisis. Some believed that the current American regulatory framework was outdated. The Securities and Exchange Commission also failed to regulate the rating agencies on Wall Street. These agencies incorrectly rated 3.2 trillion dollars of subprime mortgage-backed securities as AAA securities. The toxic securities were subsequently sold to government sponsored enterprises like Fannie Mae and other private investors worldwide. Among the new mortgage loan types were adjustable-rate, option adjustable-rate, balloon-payment and interest-only mortgages. Congress failed to enact regulations that would have prevented exploitations by these loan types. Subsequent widespread abuses of predatory lending occurred with the use of adjustable-rate mortgages. 80% of subprime mortgages were adjustable-rate mortgages.

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In 1995, the GSE's like Fannie Mae began receiving government tax incentives for purchasing mortgage backed securities which included loans to low income borrowers. Thus began the involvement of the Fannie Mae and Freddie Mac with the subprime market. In 1996, U.S. Housing and Urban development set a goal for Fannie Mae and Freddie Mac that at least 42% of the mortgages they purchase should be issued to borrowers whose household income was below the median in their area. This target was increased to 50% in 2000 and 52% in 2005. From 2002 to 2006, as the U.S. subprime market grew 292% over previous years, Fannie Mae and Freddie Mac combined purchases of subprime securities rose from $38 billion to around $175 billion per year before dropping to $90 billion per year, which included 350 billion of Alt-A securities. Fanny Mae had stopped buying Alt-A products in the early 1990's because of the high risk of default. By 2008, the Fannie Mae and Freddie Mac owned, $5.1 trillion in residential mortgages, about half the total U.S. mortgage market. The GSE have always been highly leveraged, their net worth as of 30 June 2008 being a mere US$114 billion. When concerns arose in September 2008 regarding the ability of the GSE to make good on their guarantees, the Federal government was forced to effectively nationalize them at the taxpayers' expense.

Central Banks Policies :

Few of the policies of the central banks can also be held responsible for the subprime crisis. Central banks manage monetary policy. They have some authority

over commercial banks and possibly over other financial institutions. They are less concerned with avoiding asset price bubbles such as the housing bubble. Central banks have generally chosen to react after such bubbles burst so as to minimize collateral damage to the economy, rather than trying to prevent or stop the bubble itself. This is because identifying an asset bubble and determining the proper monetary policy to deflate it are still difficult. A contributing factor to the rise in house prices was the Federal Reserve's lowering of interest rates early in the decade. From 2000 to 2003, the Federal Reserve lowered
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the federal funds rate target from 6.5% to 1.0%. This was done to soften the effects of the collapse of the dotcom bubble, the 9/11 terrorists attacks in U.S. and to combat the perceived risk of deflation. The Fed believed that interest rates could be lowered safely because the rate of inflation was low at that time. The Fed raised the Fed funds rate significantly between July 2004 and July 2006. This contributed to an increase in 1-year and 5-year ARM rates, making ARM interest rate more expensive for homeowners. This may have also contributed to the deflating of the housing bubble, as asset prices generally move inversely to interest rates and it became riskier to speculate in housing.

Debt level of Financial Institutions :

As mentioned earlier, many financial institutions, investment banks issued large amounts of debt during 20042007, and invested the proceeds in mortgage backed securities, thinking that house prices would continue to rise, and that households would continue to make their mortgage payments. Borrowing at a lower interest rate and investing the proceeds at a higher interest rate is a form of financial leverage. This strategy proved profitable during the housing boom, but resulted in large losses when house prices began to decline and mortgages began to default. Beginning in 2007, financial institutions and individual investors holding MBS also suffered significant losses from mortgage payment defaults and the resulting decline in the value of MBS.

In September 2008, three of the largest U.S. investment banks-Lehman Brothers, Bear Stearns and Merrill Lynch, either went bankrupt or were sold at fire sale prices to other banks. These failures caused major havoc in the global financial system. The remaining two investment banks, Morgan Stanley and Goldman Sachs, opted to become commercial banks, thereby subjecting themselves to more stringent regulation by the U.S. government.

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Investment banker incentive compensation was focused on fees generated from assembling financial products rather than the performance of those products and profits generated over time. Their bonuses were heavily skewed towards cash rather than stock. In addition, the increased risk, in the form of financial leverage, taken by the major investment banks was not adequately factored into the compensation of senior executives.

Inflow of funds due to trade deficits :

Between 1996 and 2004, the USA current account deficit increased by $650 billion, from 1.5% to 5.8% of GDP. Financing these deficits required the USA to borrow large sums from abroad, from the countries running trade surpluses, mainly the emerging economies in Asia and oil-exporting nations. The balance of payment identity requires that a country running a current account deficit also have a capital account surplus of the same amount. Hence large and growing amounts of foreign funds flowed into the USA to finance its imports. Foreign investors had these funds to lend, because they had very high personal savings rates, as high as 40% in China or because of high oil prices. This was referred to as a "savings glut" that may have pushed capital into the USA. A nation cannot consume more than its income unless it sells assets to foreigners, or foreigners are willing to lend to it. Therefore, a flood of funds reached the USA financial markets. Foreign governments supplied funds by purchasing USA treasury bonds and thus avoided much of the direct impact of the crisis. USA households, on the other hand, used funds borrowed from foreigners to finance consumption or to bid up the prices of housing and financial assets. Financial institutions invested foreign funds in mortgage backed securities. USA housing and financial assets dramatically declined in value after the housing bubble burst.

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Boom and collapse of the banking system :

Banking system entities became critical to the credit markets, supporting the financial system from the bottom , but were not subject to the same regulatory controls. Further, these entities were vulnerable because they borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets. This meant that disruptions in credit markets would make them subject to rapid deleveraging, selling their long-term assets at depressed prices.

The combined balance sheets of the then five major investment banks totaled $4 trillion. In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion.

Nobel laureate Paul Krugman described the run on the shadow banking system as the "core of what happened" to cause the crisis. As the shadow banking system expanded to rival or even surpassed conventional banking in importance, politicians and government officials realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible and responded by extending regulations and the financial safety net to cover these new institutions.

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IMPACT of Subprime Crisis on Major World Economies

IMPACT ON U.S.A.:
The subprime crisis had its devastating effect on the economy of the United States. This led to it recession in 2009. Between 2007 and 2009, average individual U.S. household lost more than a quarter of their net worth. Its stock index, the S&P 500, crashed by more than 45% from its 2007 peak. Total retirement assets dropped by 22%. Savings and investment assets lost $1.2 trillion. The first major subprime related loss was reported when Hongkong and Shanghai Banking Corporation (HSBC), the worlds largest bank, wrote down its holdings of subprime related mortgage backed securities by $10.5 billion in the year 2007. During the same year, more than 100 mortgage companies were either shut down, suspended their operations or were sold out. With the deepening of the crisis, more and more financial firms were forced to merge with each other or were seeking mergers. The CEOs of Merrill Lynch and Citigroup resigned within a week of each other.

The common investors started taking their money out of mortgage bonds and equities and put it into commodities. Following the collapse of the financial derivatives, financial speculation in commodity futures contributed to world food price crisis and oil price increases, which reached a peak of $148 per barrel. Thus, trillions of dollars were withdrawn from equities and mortgage bonds and invested in food and raw materials.

By august 2008, financial firms around the world, wrote down their holdings of subprime related securities by a whopping $501 billion where as the International Monetary Fund (IMF) estimated that this figure will eventually reach $1.5 trillion. These losses wiped out much of the capital of the world banking system. This further reduced the credit available to businesses and households.
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The crisis reached its peak on 15th September 2008. This day saw the collapse of Lehman Brothers, which in its 158 years of history, never witnessed even a single quarter of loss. On September 16, the large insurer American International group (AIG), a significant participant in the credit default swaps market, suffered a liquidity crisis following the downgrade of its credit rating Within two days of the collapse of lehman brothers, $150 billion were withdrawn from the USA money funds. This money market had always been a key source of credit for banks and other non financial firms. On September 21, two U.S. investment banks, Goldman Sachs and Morgan Stanley converted to bank holding companies. On September 25, Washington Mutual, the largest savings bank holding company, was seized by Federal Deposit Insurance Corporation and most of its assets were transferred to JP Morgan Chase. On September 29, it was announced that Wachovia, the fourth largest bank in the U.S. would be acquired by Citigroup.

U.S. stock market suffered steep declines. Dow Jones and Nasdaq crashed within minutes of opening of the trade. At the end of the day, Dow Jones suffered the largest drop in the history of the index. The S&P 500 banking index fell 14% on September 29,2008 with the sharp drop in the value of stock prices of banks like Northern Trust, State Street and Bank of New York Mellon. After few days, the stock market rebounded but there was still a crisis in the credit market with the LIBOR rate rising to 6.88%, a rise of 4.7%.

The TED spread, the difference between the interest rates on interbank loans and short term U.S. government debts, a measure of the risk of interbank lending increased by 400% short after the collapse of the Lehman brothers. This credit freeze brought the global financial system to its almost collapse. The USA federal reserve and the European Central Bank responded immediately by purchasing $2.5 trillion of government bonds. This was the largest liquidity injection into the credit market and the largest monetary action in the world history. They also raised the capital of their national banking systems by $1.5 trillion by purchasing newly issued preferred stock in their major banks.
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Before the crisis, banks would lend to customers for mortgages, credit cards or auto loans, then sell the related assets to investors through the securitization markets. They allowed banks to replenish their cash so they could lend again, generating fees with each transaction. The securitization markets started to close down in 2007 and nearly shutdown in 2008. More than a third of the private credit markets thus became unavailable as a source of funds.

Banks actually increased their extension of credit by six percent since September, but they were having a hard time securitizing those loans in the capital markets. That means that they were no longer able to use the proceeds to make further loans, which would allow them to use the initial dollar over and over again. By mid-December 2008, pure panic had pushed the value of AAA-rated commercial-mortgage-backed securities down to 68 percent of their face value, despite a commercial-mortgage delinquency rate of only one percent. As a result of this, all investors holding CMBS have had to write down their holdings by 32 percent, even if the underlying mortgages were being paid on time. That, in turn, led prices to decline even more and investors to write off more capital, further tightening the credit crunch.

The subprime crisis has had a number of adverse effects on the overall American economic situation. U.S. GDP contracted at a 6.2% annual rate in 2008. On December 1, 2008, the National Bureau of Economic research declared that the U.S. economy had entered recession in December 2007. In the 12 month period ending in February 2009, the number of unemployed persons in the U.S. increased by approximately five million. There have been significant job losses in the financial sector, with over 65,400 jobs lost in the USA as of September 2008. The U.S. unemployment rate climbed to 8.1% in February 2009, the highest level in 26 years.

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Declining house prices have reduced household wealth which has placed downward pressure on consumption. The tightening of credit has caused a major decline in the sale of motor vehicles. Between October 2007 and October 2008, Ford sales were down 33.8%, General Motors sales were down 15.6%, and Toyota sales had declined 32.3%. There is an ongoing global automobile industry crisis and calls for some form of government intervention.

House-related crimes such as arson have increased. Many renters became innocent victims, by being evicted from their residences without notice, because their landlords' property had been foreclosed. Nationwide, up to 40% of all people at risk of eviction due to foreclosure are renters.

IMPACT ON AUSTRALIA :
The impact of subprime crisis was not limited in the U.S. only but was felt all over the world. The spread between three month bank bill swap rates and cash, for example, increased almost immediately, revealing that Australian banks had become as eager to increase their liquidity and as reluctant to part with it as banks in the US, Europe and the UK. The spread did not increase as much as elsewhere, but it signaled that the Australian financial system would not be immune to the subprime crisis. The Australian equity market began to be more influenced by movements in the US and Europe. The reduction in value of the corporate bond market encouraged many business borrowers to look to banks as an alternative source of funding.

Australias major banks were not as dependent on the residential mortgage backed securities market as many institutions in other parts of the world but securitisation had become very much more important in recent years. The major banks in Australia RMBS market to secure term funding, the smaller players in the home mortgage market depended on securitisation as a relatively cheap source of funds. But when this market
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closed down in November, it was a shock to the funding of Australian household demand for mortgages. Late last year, there were three additional sources of demand for bank lending Households which used smaller lenders which funded their lending by securitisation Bigger businesses denied access to the bond market, and The banks own assumption of assets.

Australian banks raised most of their liabilities onshore but they accustomed to rely upon the capital markets of Europe, U.S. and Japan to supply most of their term funding. In the second half of 2008, the global market for bank paper became extremely expensive and difficult to access. This was because lenders were unsure about the extent of losses in all banks and were worried about the value of their existing portfolios of term bank paper which was declining rapidly. Australian banks were willing to pay a higher spread for short term funding but were reluctant to pay unusually high spreads to borrow term. With the RMBS and other asset backed paper markets closed or trading only thinly, the offshore market for Australian bank term paper suddenly difficult to access, the onshore market for short term funding became unusually expensive. All this happened at a time when the Australian banks demand for liabilities was rising, to match the increased supply of assets being offered to the banking system.

These sudden pressures on the both the asset and liability sides of banks balance sheets occurred without any change in the default rate in Australian bank assets or those in the financial system, without any increase in the provision for bad and doubtful debts, without any flaw in Australian financial institutions. It occurred despite the fact that Australian financial institutions owned only insignificant amounts of US sub-prime mortgage paper, and had relatively little exposure to any of the major classes of financial assets where default occurred.
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There were major cyclical differences between Australia and other comparable economies. The big Australian boom in house prices and sales of established houses, which was quite as formidable as the boom in the US and the UK, ended in 2003. Mortgage loan growth through 2006 and into 2007 was not much less than half the rate evident during the boom. House price growth had only just resumed, after several years of sluggish movement in median house prices. After a period of sharp decline associated with the housing boom, household savings as a share of GDP rose through 2006 and into 2007. The credit crisis hit Australia after a period of household balance sheet consolidation. Much the same is true of the home construction industry. House construction was also quite weak through 2006 and into 2007, with the beginnings of a recovery only becoming evident after a sharp downturn in 2004 and 2005. By the middle of 2007 the Australian housing boom was on its peak.

One of the causes of the housing slowdown was the gradual tightening of the Australian cash rate since 2002. By the middle of 2007 the variable mortgage lending rate was 200 basis points higher than it had been in 2002. Unlike the US market, Australian mortgages are typically variable rate. The Australian market does feature introductory rates, but the gap between the introductory rate and the standard rate is much narrower than was usual in the US. The predominance of variable rates and the upward trend in the cash rate, together with the evident slow growth in national median house prices, meant that by 2007 borrowers had already been discouraged from taking on loans they would not over time be able to service. By the middle of 2007, when the crisis struck, Australia had been experiencing for several years a boom in business investment. Some of this was related to markedly higher prices for energy, metals and minerals, but much arose from the fact that by the middle of 2007 Australia was close the beginning the seventeenth year of an uninterrupted economic expansion which had seen profits increase as a share of income. It was one of

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the components of growth least likely to be discouraged by even a substantial increase in borrowing costs.

The sharpest financial market impact had turned out to be in the equity market, which in the first few months of the last year fell more sharply than the US equity market. This was because the Australian market had increased markedly faster than the US market in recent years. Financial, mining and property stocks are relatively more important in the Australian market than the US market, and all three sectors were hit by concerns arising from the credit crisis. Highly leveraged businesses with solid but illiquid assets were also hit hard, particularly where dividend growth depended on borrowing against revalued assets.

IMPACT ON EUROPE:
Europe was the second most worst affected market after the US.A. due to subprime crisis. This crisis made European banks, involved in securities backed by subprime mortgage loans, felt the credit crunch. This crisis spread throughout the market for mortgage backed securities traded by financial institutions, particularly favored by prominent European banks such as UBS, Deutsche bank and many others. The collapse of mortgage-backed security markets led banks to lose confidence in their ability to provide credit. This precipitated a loss of liquidity as banks started to cut back on interbank loans, which allowed banks to borrow money quickly among themselves at the end of the business day to cover their accounts. Banks, both U.S. and European, became wary of lending to each other. May be the credit squeeze could develop into a full-blown credit crisis, European banks started to raise capital. One way was to obtain the money from sovereign wealth funds; another was to lower operating costs and dividends.

The adoption of the euro brought many benefits to individual countries. With the euro, came stability and decreased interest rates for consumers. In particular, low interest rates
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and strong economic growth made mortgage lending a much more viable option for many consumers in countries such as Ireland, Spain and Italy who previously would not have been able to afford it due to locally imposed high interest rates. In last few years, Europes smaller economies set interest rates on the backs of their own financial systems, meaning that mortgage interest rates had to be high. With the adoption of the euro, suddenly even the small economies could enjoy low interest rates. Combined with relatively lax lending policies, this created a pool of mortgages in a number of European countries, particularly in Spain and Ireland. Spanish banks were more liberal in lending to young immigrants from Latin America with no credit history. 98 percent of new mortgages in Spain were variable rates, which meant that after the first five years of low interest, the rates shoot up. In Ireland, lenders were willing to advance borrowers up to 125 percent of the total loan. Only German banks were having truly stringent lending policies; as a result, only 43 percent of the total home stock in Germany were actually owned by residents, with the rest being owned by landlords.

With the slowing European economy, tighter mortgage lending rules and high interest rates imposed by the ECB to protect the euro, the number of foreclosures in Europe increased. European borrowers who had been lured by variable rate saw their interest rates spike, increasing the overall number of foreclosures and thus flooding the housing market with available homes. At the same time the banks tightened lending rules to prevent future foreclosures, pricing out customers with poor or no credit that would otherwise keep the demand for homes high. The twin effect of a rising supply of homes and falling demand due to the shrinking pool of consumers had a devastating effect on the already-inflated house prices. This collapse of the housing market adversely affected even the construction industry and the consumer confidence.

Following a major banking crisis in Western Europe, Central Europe and the Balkans were the ones most affected. Since the beginning of the decade, Central Europe had
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outgrown Western Europe, with 5.8 percent gross domestic product growth in 2007 compared to 2.6 percent for the euro area. But the capital that made that growth possible had come from Western Europe. Essentially, Central Europe offered greater return for investment throughout the current decade. While foreign direct investment in east-central Europe made up 40 percent of the net inflow in 2007, the rest came from the now-volatile Western European banks, which sunk more than $1 trillion in assets into Eastern European markets. Central Europe and the Balkans were also hit by severe crisis because foreign banks had loaned a lot of money to domestic banks. In many cases, a countrys entire banking system, such as Serbias, was actually foreign-owned. Western banks involved directly in emerging Europe were not involved in the U.S. subprime crisis, but they were vulnerable when the rest of the major Western banks decide to pull back their capital to shore up reserves or investments closer to home, thus affecting the total cost of credit. The normal effect of a financial crisis is a re-evaluation of risk in investment portfolios. This led to painful economic crises as credit became more expensive. This would force big banks in Europe to rethink the loans they made to Central Europe, the Balkans and their own mortgage customers, which, unlike in the United States, include large corporations. The financial crisis needed to be addressed separately by individual countries. Unlike the U.S. Federal Reserve, the ECB was almost concerned with the stability of the euro and keeping inflation down. It did not have the authority to intervene directly in the banking system of an EU member state. But even if the ECB had the authority to intervene on a country-by-country basis, the financial crisis would not be the same throughout the continent. Therefore, individual European countries were on their own when it came to be decided on whether to bail out struggling financial institutions or just let them collapse.

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IMPACT ON INDIA :
Subprime crisis had its effect on the developing countries of Asia also, including India. The initial impact of the subprime crisis on the Indian economy was temporary. Indian banks with branches in the U.S. or U.K. had lend to banks affected by the subprime debt crisis. This weakened their balance sheets after the exposure of the subprime crisis. Also, foreign banks with branches in India, accepted large deposits from Indian depositors but since they had turbulence in their respective domestic markets, their non performing assets in foreign markets impaired their liquidity in India. After the U.S. Fed cut rates in August 2007, the net capital inflows in India increased substantially. This led the Reserve Bank to cut cash reserve ratio. The direct effect of the subprime crisis on Indian banks and financial sector was almost negligible because of prudential policies put in place by the Reserve Bank. The lower presence of foreign banks in the Indian banking sector also minimized the direct impact on the domestic economy. The larger presence of foreign banks could increase the vulnerability of the domestic economy to foreign shocks, as happened in European countries. In view of liquidity and capital shocks to the parent foreign bank, their subsidiaries in India could have been forced to scale down its operations in the domestic economy, even as the fundamentals of the domestic economy remain robust. There was also no direct impact of the Lehman failure on the domestic financial sector in view of the limited exposure of the Indian banks. However, following the Lehman failure, there was a sudden change in the external environment. But there was a sell-off in domestic equity markets by portfolio investors. Consequently, there were large capital outflows by portfolio investors during September-October 2008, with accompanying pressures in the foreign exchange market. The contraction of capital flows and the sell-off in the domestic market adversely affected both external and domestic financing for the corporate sector. The sharp slowdown in demand in the major advanced economies also had an adverse impact on
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our exports and industrial performance. On the positive side, the significant correction in international oil and other commodity prices alleviated inflationary pressures as measured by wholesale price index. However, various measures of consumer prices remain at elevated levels on the back of continuing high inflation in food prices. Government finances, which had exhibited a noteworthy correction starting 2002-03, came under renewed pressure in 2008-09 on account of higher expenditure outgoes due to Higher international crude oil prices (up to September 2008) Higher fertilizer prices and associated increase in fertilizer prices The Sixth Pay Commission award Debt waiver scheme. The fiscal stimulus packages involving additional expenditures and tax cuts had put further stress on the fiscal balances. Reflecting these factors, the Central Governments fiscal deficit more than doubled from 2.7 per cent of GDP in 2007-08 to 6.0 per cent in 2008-09, reaching again the levels seen around the end of the 1990s. The revenue deficit at 4.4 per cent of GDP will be at its previous peak touched during 2001-02 and 2002-03. Primary balance again turned into deficit in 2008-09, after recording surpluses during the preceding two years. Net market borrowings during 2008-09 almost trebled from the budgeted Rs.1,13,000 crore to Rs.3,29,649 in the revised estimates and were budgeted at Rs.3,08,647 crores (gross borrowings at Rs. 3,98,552 crore) in 2009-10.

In view of the renewed fiscal deterioration, the credit rating agency Standard and Poors changed its outlook on long-term sovereign credit rating from stable to negative. Moreover, in order to boost domestic demand, the Government announced additional tax sops. Thus, while the slowdown in the domestic economy may call for fiscal stimulus, fiscal movement is limited. Reflecting the slowdown in external demand, and the consequences of reversal of capital flows, growth in industrial production decelerated to 2.8 per cent in 2008-09 (AprilFebruary) from 8.8 per cent in the corresponding period of 2007-08. On the other hand,
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services sector activity held up relatively well in 2008-09 (April-December) with growth of 9.7 per cent. Services sector activity was buoyed up by acceleration in community, social and personal services on the back of higher government expenditure. Overall, real GDP growth slowed to 6.9 per cent in the first three quarters of 2008-09 from 9.0 per cent in the corresponding period of 2007-08. On the expenditure side, growth of private final consumption expenditure decelerated to 6.6 per cent from 8.3 per cent. On the other hand, reflecting the fiscal stimuli and other expenditure measures, growth in government final consumption expenditure accelerated to 13.3 per cent from 2.7 per cent. It is now quite clear that the Indian banks and financial system had only negligible direct exposure to the western banks toxic assets. Indian banks credit quality remains of high quality. Bank credit growth was high at around 30% during the period 2004-07, but there was no relaxation of lending standards. Banks loans to individuals for housing were backed by loan to value ratios. In view of the rapid credit growth to certain sectors, the Reserve Bank tightened prudential norms for these sectors in order to safeguard financial stability. Therefore, unlike the banking system in the western world, domestic banks in India did not record any major losses and there was no need of any government bailout. Growth in bank credit remained strong up to October 2008 but is coming down since that period. There was no need of any government guarantee for bank deposits. Interbank money market had been working normally. Earlier, there was some volatility in the call money rate, but this was because of the reversal in capital flows and the tightening of liquidity in the September-October 2008 period. The only main impact on Indian markets following the collapse of Lehman Brothers was significant correction in stock market because of major sell off in the equity market by Foreign Institutional Investors (FIIs). This made lot of pressure on the domestic mutual fund industry and reduced foreign funding. Since, alternative sources of funding dried up so there was lot of redemption pressure on mutual funds. Drying up of mutual funds, who

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provide funds to other sectors, further reduced the flow of fund for those sectors. Thus, the only hope for lending was with Public Sector Units ( PSUs).

IMPACT ON JAPAN :
Like other global economies, Japan felt some impact due to subprime crisis in the U.S. But the impact was much less than in other markets. After a long boom, the Japanese economy was jolted by a plunge in the real estate market. In Tokyo, the government and bankers were slow to recognize the size of the problem. Bad loans piled up. The financial troubles rippled through the economy as consumer spending and job growth fell. Previously, Japanese financial institutions were believed to be immune from the meltdown in the U.S. subprime mortgage market due to their relatively limited exposure to subprime-linked securitized products. But the global financial market turmoil induced by the subprime crisis led to plunges in the prices of stocks and securitized products that were not directly linked to the subprime loans, pressing the financial institutions to incur massive investment losses. According to report by Japans Ministry of Land, Infrastructure and Transport, the seasonally adjusted annualized housing starts were pushed down to a record-low of 720,000. Housing starts showed steep year-on-year declines each month, with a 23.4 per cent drop in July followed by a 43.3 per cent plunge in August. Construction starts for owner-occupied homes dropped 21.6 per cent, while those for rental homes came down 51.3 per cent. Building starts for homes for sale fell 55.6 per cent, with condominiums falling 74.8 per cent. In the third-quarter GDP estimates of 2008, there was an average 9 per cent decline in housing investment, the largest drop since the 11.1 per cent slide in the April-June quarter of 1997, when the consumption tax was raised. A 9 per cent decrease in housing investment translates into a 0.3 per cent drop in quarterly GDP. Japanese share prices have tumbled more than 10% since July, and credit market spreads widened with those in the U.S. and Europe. This trend had been striking in the credit
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default swap (CDS) markets, where overseas investors are the main players. On the other hand, the widening in Japanese cash bond spreads had been limited, with each sector driven by its own particular factors. The spread widening in blue chips, which are highly sensitive to interest rates, was primarily due to expectations around July of a rate hike by the Bank of Japan, while triple-B bond spreads widened on the deteriorating creditworthiness of consumer loan companies. Also, there had been no great impact at this time on CDOs that are backed by domestic assets. Spreads on Japanese bank capital in the Yankee and euro markets (banks subordinated debt bonds, preferred securities) widened greatly along with U.S. and European bank spreads. As a result, banks saw a sharp expansion in their CDS premiums due to the hedging needs of overseas investors and securities firms. To date, this is the movement that has most directly reflected the subprime-related widening in global market spreads. At the same time, domestic Japanese bond markets remain buoyant, and new issues continued to be absorbed smoothly at low spreads, differing starkly from their dollardenominated bond counterparts.

Japanese financial institutions and investors also did not have great exposure to subprime loans or ABS and CDOs in the first place, the leading banks have an average exposure of a less than one percent of total assets so the chances of any change in credit risk are negligible. Banks have firmed up their balance sheets and claim ample deposit-loan ratios, leaving little risk of a liquidity crunch similar to that in the U.S. and Europe

The Japanese slump proved long-lived. It was a humbling setback for a nation once feared and admired as a model of economic dynamism. The shadow of Japan hangs over the US economy these days. The nation was sliding into a housing-driven downturn, just as it also appeared to be losing its global edge from the productivity-enhancing gains driven by technology investments of recent decades.

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IMPACT of Subprime Crisis on Major Sectors

IMPACT ON REAL ESTATE

When started, subprime loans were a niche market, appealing to people with bad or no credit, and allowed these people who had previously been shut out of the American Dream, to take part in it, and to become homeowners. Subprime loans made up roughly 25% of all housing loans. Greed and gaming of the system facilitated the current crisis. By placing their clients in adjustable rate loans, many companies have profited briefly, only to finally see the property go into foreclosure. Foreclosure has a far-reaching impact, not only economically, but socially as well. As far as the real estate market is concerned, has seen its share of increases in foreclosures. Over the past two years, foreclosures were up 15%. The beginning months of 2007 had seen some interesting moves in the stock market and in the housing sector. In late February, the stock market plunged around 500 points in a day, the biggest drop in about five years, led by news of a decline in home prices and jitters about the subprime lenders and foreclosures. Many of these lenders saw their shares value dramatically decreased, while others were delisted from the New York Stock Exchange and some filed for bankruptcy. According to The Center for Responsible Lending forecasts, out of all subprime mortgages originating between the years 1998 and 2008, one out of every five (19.4%) resulted in foreclosure. In other terms, that effectively means that 2.2 million households lost their houses, at a cost of $164 billion to the economy. Data shows that in USA, states such as California, New York, New Jersey, Nevada, and Washington D.C. were the hardest hit. Those states hardest hit were the ones that had
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seen a rapid appreciation in housing prices over the past few years. In the Asia-Pacific region, subprime crisis had a negative effect leading to an overall decline in investments. Fallout from the sub-prime crisis, which started in the US, has been most evident during the first quarter of 2008 in more mature markets in the Asia-Pacific, such as Tokyo, Singapore, Sydney and Melbourne, where office capital values appeared to have peaked, while there has been a slowing in price growth in Hong Kong.

In the office sector, a sharp slowing in rental growth is occurring in Tokyo. But on the other end of the spectrum, the Manila office market has seen strong growth in business process outsourcing due to the increased emphasis by multinational corporations (MNCs) on lowering operational costs.

Another trend noted was that of MNCs moving their offices from central business locations to cheaper peripheral sites. Singapore, for example, is seeing strong enquiry levels for built-to-suit options in business park locations, driving up rental levels in these districts.

IMPACT ON BANKING SECTOR :

The turbulence triggered by the US mortgage market led to the re-pricing of risks, which in turn has resulted in significant losses for the financial sector, and temporary impairment of certain market segments. In addition to the direct losses suffered by US and European banks, these institutions also had to face increasing cost of funds and shrinking funding. Even though the banking sector had no direct exposure to the

products involved in the US mortgage market, the global growth of risk premiums has caused increasing funding costs and shortening maturities of foreign funds. The direct losses of Chinese banks from the U.S. subprime crisis were not especially large in the amount. The ICBC, China's largest commercial lender, suffered a loss of1.2 billion
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crisis.
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Bank of China was the largest holder of subprime-related assets in the country, and its investment in subprime asset-backed securities was 4.99 billion U.S. dollars in 2007. It had set aside 1.295 billion U.S. dollars in provisions to cover a possible decrease in value of subprime securities. China Construction Bank, the country's major property lender, had made provisions of 630 million U.S. dollars for possible losses in its 980 million dollar U.S. subprime investments.

Even Africa has not escaped the impact of the sub-prime crisis entirely. Although the crisis origins lie in the USA, it spread rapidly across the globe, hurting European and then Asian companies along the way. First, and most crucially, GDP growth is declining. Foreign banks had become far more risk averse then they were 18 months ago, and were not keenly providing funds for riskier emerging market countries. Infrastructure projects which were viable with high and rising commodity prices were no longer attractive, either for lack of funding, or due to the reduced economic rationale. . In South Africa, for example, credit growth between January 2008 and 2009 slowed from 28% to 13.2%. Bad debts continued to grow in the 1st quarter, and growing unemployment proved to keep the trend of impaired debts to total advances growing for the foreseeable future. African banks were by no means as badly off as what their global peers were. Most major global banks reported hefty losses since the middle of July 2008. African banks, by contrast, were reporting lower profits than they were prior to the sub-prime crisis breaking, but profits remained positive. However, rumors surfaced in Nigeria about some of the large banks facing liquidity concerns, raising questions about their sustainability, and prompting attempted takeovers. These rumors stem from the Nigerian banking sector taking on large debt exposure in the petroleum import sector, which was unable to repay its debts in the current environment.
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In addition, Nigerian banks also had exposure to Nigerian stocks, to the tune of N800bn. debts, in a manner not dissimilar to US and European precedents. In Kenya, liquidity was kept alive by allowing banks to borrow from other banks, using government securities as collateral. This was the first time such trades have occurred in the country, and this has provided liquidity that would otherwise not have been available. Undoubtedly African banks were facing tougher trading conditions than they were last year this time, despite the recent interest rate relief. This was clearly seen in the pace at which market capitalization had fallen. But African banks were not faced with such sharp equity valuation downgrades as what some of their global peers were. In the worst case scenario in South Africa, one banks market capitalization fell 39%. Nigerias largest bank by market capitalization, Diamond Bank, had a more dramatic 57% loss in value, but had since recovered from its lowest point. To some extent local economic circumstances around the world played a crucial role in financial services market capitalizations falling : high interest rates and consumer price inflation had squeezed disposable income, thereby pushing up bad debts in the case of the banking sector, and causing increased policy lapses in the case of insurers.

IMPACT ON AIRLINES :
While the going was good for the aviation sector in 2007, hopes were high that 2008 would be even better, especially for the airline industry in the United States that were having a hard time for long. The reason was fuel prices continued to climb and the fallout from the US sub-prime crisis. Following favorable conditions in 2006, the aviation sector in the Asia-Pacific region had made huge earnings in 2007, leading, in many cases, to record profits for many
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airlines. However, subprime

aviation sector

entered a period of economic uncertainty after crisis

It was for the first time that the airlines are facing adverse economic conditions even as the world has at its disposal a number of low cost or low fare airline options.

During the so-called Asian Financial Crisis that took place a decade ago, the number of people flying had gone down sharply, leading to the airlines losing in a big way. But, this time around, things were very different. There was a new aviation environment, with new, private airlines, mostly well-positioned to survive in difficult conditions. The worlds major network airlines had also restructured effectively to allow them to be competitive when times get tough.

There was significant imminent slowing in air travel. Load factors started to ease as fresh capacity entered the market. Passenger and freight volumes in the airline industry

declined on an average of 22%. International freight volume showed a reduction of 20% in the year ended 2008. Even the African airlines experienced the worst performance in the cargo sector, recording a more than 31% drop in international freight traffic. Aviation industrys losses were estimated to be $2.5 billion in 2008. The Asian region was the worst hit with $1.7 billion losses for 2008. European airlines suffered losses of about $1 billion. While Latin American and African airlines made a combined loss of $1.2 billion. Due to the huge losses, even the banks were unwilling to provide any help to the aviation industry.

The global airline industry faced losses of $4 billion in the first three quarters of 2008, due to which share prices of major airlines across the world crashed. Recession had hit the airlines industry very hard. Though jet fuel prices hit a four year low of $35/barrel, most airlines could not take its advantage because of hedging. Due to

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mounting losses quarter on quarter, airlines started reducing staff and started leasing aircrafts instead of buying them.

IMPACT ON TOURISM :
As a result of extremely volatile world economy and financial crisis, tourism demand slowed down significantly throughout 2008. In the last six months of 2008, international tourists arrival showed negative growth. In Europe and Asia, it came down by 3%. Indias travel and tourism sector had also been badly hit by the global credit crisis. Of the tourist visiting India, corporate travelers accounted for the majority chunk. This segment was already getting affected since the start of the year on account of the global credit and subprime crisis. With companies cutting down travel budgets, this segment exercised caution. Hotels in the metros which largely catered to corporate tourists witnessed a sharp dip in occupancy rates in the past few months, in some cases as much as 25% to 30%. Almost all the top six hotel markets i.e. Delhi, Mumbai, Chennai, Hyderabad, Bangalore and Jaipur were impacted. Hotels were selling corporate travel packages at huge discounts to maintain occupancy. The outbound tourist traffic was affected by the economic crisis, coupled with higher air fares and depreciating rupee-dollar exchange rate. While the medium term effect on this segment was relatively less, an economic slowdown lead to deferment of future travel plans or travelers instead chose to visit domestic destinations. More than 1 million inbound tourists visited India last in 2008, which was much less compared to last 2007. Mostly for leisure, these tourists visited places across the country. Hence destinations like Mumbai, Delhi, Agra, Jaipur, Goa and Kerala among others faced tough times, which were very popular among the tourists. Inbound tourism from US was already adversely affected and by FY09, its adverse impact in terms of percentage was in the range of 10% to 15% .

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Since, the Indian tourism industry, valued at Rs 333.5 billion, earns most of its foreign exchange revenues from the US, UK and European visitors, on account of recent crisis, the sector lost as much as 40% of annual revenues. Even as per the estimates of the Tourism Committee of The ASSOCHAM, on account of the global slowdown, the growth in tourism sector is likely to fall by a minimum of 10% and stay at around 5% year on year for financial year 2009.

IMPACT ON AUTOMOBILE INDUSTRY :

The deepening and widening U.S. financial crisis seriously eroded global real economy including the global automobile industry. The increase in oil price and the financial crisis had been great shock to the American automobile industry. In the past few years, crude oil prices kept on increasing and hit a record high of $147 per barrel. Due to the high price, consumers became less interested in the American made high oil consuming autos. As a result, Japanese made and Korean made low oil consuming autos became big challengers to the American auto industry. With many customers preferring to maintain old cars rather than buying new ones, the demand in the U.S. after sales service market remained at 5%. Sales fell further as consumer credit tightened and it became much harder for people with poor credit to obtain a bank loan to buy a car. The subprime crisis turned into full scale financial crisis in mid of September 2008 and hit the American auto industry, almost devastating it. The falling of house prices, the credit crunch, increase in unemployment resulted in less demand for the automobiles. In the third quarter of 2008, General Motors sales were down by 21%. The three major American automakers General Motors, Ford and Chrysler, the symbols of American Auto industry, are now facing bankruptcy. All the three pleaded for a $25 billion bailout from the U.S. government to help them go through this crisis and avoid being bankrupt.

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During this auto plight, there were great debates whether or not to give the auto companies the bailout. The U.S. Congress decided to vote on November 20th, 2008, but the meeting was cancelled as the Big Three were required to hand in a detailed plan about how would the bailout money be used, if given to them. As early as by April, the U.S. government was pressurizing Chrysler to merge its operations with Fiat, so as to get the bailout money from the government. But on May 1st 2009, it was reported that Chrysler would finally file for bankruptcy after talks to restructure its debt with lenders failed. This would send shock waves through the entire automobile industry worldwide including suppliers, dealers and millions worldwide who relied on industry for their livelihoods. The U.S. financial crisis also affected the Chinese Automobile industry and its exports. Chinas auto export declined by 22.18% in the month of October 2008. The total auto export value declined by 1.53% month on month and reached $4.7 billion. The export of Chinas largest Sports Utility Vehicle(SUV) maker, Great Wall Motor, was down by 30% . Even the manufacturers of automobiles spare parts faced huge challenges due to the subprime crisis. For local auto parts makers, the impact on exports by the demand slowdown of the global market triggered by financial crisis was less than the local currencys appreciation. French car maker, Renault, reduced its worldwide production by 25% in the last quarter of 2008. Another German car manufacturer, Opel, requested loan guarantees from the local government. In February 2009, the State Bank of India, reduced interest rates on loans related to new automobile purchases. The downturn in automobile production compared to 2008 contributed to the bank's decision to lower interest rates. In Japan also, Toyota faced double digit decline in sales in June 2008 due to slowing of the American economy. By the end of the year, Toyota announced its first quarterly loss in its seventy years of
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business. Sales of Toyota cars dropped by 34% and that of Honda Motors by 32%. Nissan, another Japanese car manufacturer, announced to cut its production by eighty thousand vehicles in the beginning of 2009. Suzuki Motor Corporation, Japans second biggest car manufacturer, also slashed its production by thirty thousand units because of fall in demand. South Korean automakers were also affected by the automotive crisis. Hyundai Motor Company had to reduce its production in U.S. , India and China. It had to also shorten its factory operations for the workers to reduce costs. In the U.K., Jaguar Land Rover which is now owned by TATA Motors, asked the government for $1.5 billion loan to meet the financial needs.

Revival of the auto industry is very crucial for the global economies for the following reasons -: Auto manufacturing has a global turnover of around $2.6 trillion, more than the GDP of France but less than that of China, Germany, Japan, or the US. The auto sector contributes 3-4% of the total gross domestic product (GDP) of the United States, and over 6% of EU-15 GDP. Around 9 million jobs worldwide, or over 5% of the worlds

manufacturing workforce, are directly linked to making vehicles and parts. Each direct auto job supports at least another 5 jobs indirectly, with many more people employed in related service and manufacturing jobs, meaning more than 50 million people earn their livings from the industry.

RESPONSES TO THE CRISIS

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The Global response to financial crisis was rather immediate. In the U.S, The Federal Reserve, Securities and Exchange Commission took several steps on September 19th 2008, i.e. few days after Lehmans Brother bankruptcy, to intervene in the crisis. To save the money market mutual funds, the treasury announced a $50 billion program to insure the investments. The Securities and Exchange Commission also banned short selling for a short time. The government proposed a legislation to purchase up to $700 billion of troubled mortgage related assets from financial firms to improve confidence in the mortgage backed securities market. About half of the amount of the bailout money was then used to buy preferred stock in banks instead of troubled mortgage assets. In an effort to increase available funds for commercial banks and lower the Federal Funds Rate, on September 29 the U.S. Federal reserve announced plans to double its Term Auction Facility to $300 billion. Since, there appeared to be a shortage of U.S. dollars in Europe at that time, the Federal Reserve also announced it would increase its swap facilities with foreign central banks from $290 billion to $620 billion. As of December 24, 2008, the Federal Reserve had spend $1.2 trillion on purchasing various financial assets and making emergency loans to address the financial crisis, much beyond the $700 billion authorized by Congress from the federal budget. This included emergency loans to banks, credit card companies, and general businesses, the sale of Bear Stearns, and the bailouts of AIG, Fannie Mae and Freddie Mac and Citigroup.

The European Union also took immediate steps to counter the effects of subprime crisis. The European Central Bank injected $99.8 billion in a one-day money market auction. The Bank of England pumped in $36 billion. Central banks throughout the world added more than $200 billion from the September 15 to September 17.

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On September 29,2008 the Belgian, Luxembourg and Dutch authorities partially nationalized Fortis. On 8 October 2008 the British Government announced a rescue package of around 500 billion. The plan comprised of three parts. First, 200 billion would be made available to the banks in the Bank of England 's Special Liquidity scheme. Second, the Government would increase the banks' market capitalization, through the Bank Recapitalization Fund, with an initial 25 billion and another 25 billion to be provided if needed. Third, the Government would temporarily underwrite any eligible lending between British banks up to around 250 billion. On September 15th, 2008, China cut its interest rate for the first time in six years. Indonesia also reduced its repo rate, i.e. rate at which commercial banks can borrow funds from the central bank, to 10.25%. Australias Central bank, Reserve Bank of Australia, injected more than $1.5 billion into the banking system which was three times of the market requirement at that time. Reserve Bank of India also added $1.32 billion through a refinance operation. To stop the global financial crisis from hitting the worlds third largest economy, on November 9th2008, China announced a $586 billion stimulus package. This fund was to be invested in key areas of infrastructure and social welfare such as housing, rural infrastructure, transportation, health and education, environment, industry, tax cuts and finance till 2010. To promote economic expansion, impacted by the economic slowdown in U.S. and Europe, the government reduced interest rates three times in just two months. Tax rebates were also given on some labor intensive goods by the Ministry of Finance, China. Since China is the worlds third largest economy, so by helping its own economy to stabilize, it was actually helping to stabilize the global economy. In Taiwan, the central bank on September 16, 2008 cut its required reserve ratios for the first time in eight years. The central bank added $3.59 billion into the foreign-currency interbank market. Bank of Japan pumped $29.3 billion into the financial system on September 17, 2008 and the Reserve Bank of Australia added $3.45 billion.
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In India also, the Reserve Bank reduced the Cash Reserve Ratio (CRR) from 9% in September 2008 to as low as 5% in January 2009 thus injecting more than Rs. 1,60,000 crores liquidity in the system. In view of the adverse impact of the global slowdown on the domestic economy, policy rates were also cut, the reverse repo rate by 425 basis points from 9% to 4.75% and the reverse repo rate by 275 basis points from 6.00% to 3.25%. Other measures taken by the Reserve Bank in response to the global financial crisis included cut in the Statutory Liquidity Ratio (SLR), opening of new refinancing windows, refinance to SIDBI and EXIM Banks. The measures to improve foreign exchange liquidity included increase in interest rate ceilings on non-resident deposits, and easing of restrictions on external commercial borrowings and on short-term trade credits. The Central bank is the final source of money and credit creation and expansion in the economy. It was therefore important that the monetary base or reserved money continued to expand so as to meet the normal monetary requirements of the growing economy consistent with price stability. The reduction in CRR was expected to increase the money multiplier. The various monetary and liquidity measures, taken together, were able to release liquidity amounting to over Rs.4,90,000 crore since mid-September 2008 i.e. about 9 per cent of GDP. In Australia, the government took many timely measures to contain the effects of crisis though it was not as affected as others. In September the Government announced that the Australian Office of Financial Management would be authorized to purchase Australian residential mortgage-backed securities. This was done to strengthen the competition in Australias mortgage markets. It also announced the adoption of a Financial claims scheme. This scheme would ensure depositors and insurance policyholders with Authorized Deposit Taking Institutions to have quick access to their money up to a threshold limit. In September 2008, the council of Australian government created uniform national credit regulation so as to crack down on unscrupulous lending. In October, when the country started facing recession, an economic stimulus package worth $10.4 billion was
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announced. The grant to those buying homes for the first time was increased to $14,000 for existing homes and $21,000 for new homes. An even larger stimulus package of $47 billion was announced in February 2009 to boost the economy. This mainly included $14.7 billion for schools $6.6 billion for 20,000 new homes $3.9 billion to insulate 2.7 million homes $890 million for road repairs and infrastructure $2.7 billion in small business tax breaks $12.7 billion for cash bonuses

RECOMMENDATIONS

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There are many lessons that can be learnt from the Subprime Crisis. From poor lending to structured products , transparency and rating agencies, everything needs a review so that whatever has happened in the financial world, what bought the growing GDP world into a sudden recession, must not happen again. Some of the steps that can be taken by the governments and the financial institutions are

Asset Market Failure : Poor lending constituted the core of subprime crisis.
As for the role of the bank and financial institutions, it should try to choose its customers judiciously after proper screening followed by rigorous monitoring because till the time the borrower repays the interest along with the principal, the bank has to maintain this asset on its balance sheet. The need to monitor was given less importance because of securitization, thinking that in case the borrower fails to pay, collateral will be used to recover the money later. Subprime crisis showed that even if the asset was any real estate, it could not be relied upon. If the price of the collateral prevailing in the market comes down, when the asset is sold, then the seller will not be able to recover his dues even through selling. Thus, subprime crisis showed that market of asset does not provide any respite in case of failed lending.

New Model of bank is not sustainable : The unwillingness of the

mortgage banks to assess the risk profiles of the borrowers and lend on the basis of risk in times of low interest rates made the whole financial system very delicate. Many lenders deliberately relaxed their credit norms due to competition. Also, many lenders in U.S. try to generate as many loans as they can and then sell them quick. This clears the old model of banks which provides loans and keeps it on its books till the time it matures.
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Need for more transparency : It is said that sellers have more information
than buyers of what they are selling. But during the subprime, many investors did not know what they were buying and what the real worth of the security was. These complex securities do not trade at all and so their market prices are rarely available. To ensure more transparency, consistent valuation of such assets should be done by any regulator and the structured products must be standardized.

Regulate Rating Agencies : Investment banks pay the rating agencies to

rate the securities. They work closely in structuring the transactions. But they often collude to give a rating of their choice. Thus, the government must regulate the credit rating agencies also.

CONCLUSIONS
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The remodeled financial system made credit available to more people. This led to higher asset prices, increased value of collateral and loans. But the housing boom was more driven by speculation than by fundamentals. With the rise in the interest rates, the mortgage payments and the defaults rose. But the buyers of the mortgage property also came down due to increase in mortgage costs. Thus, a recession was developed in the U.S. housing market which quickly spread to entire U.S. economy and then to the whole world. The collapse of the U.S. housing bubble impacted home valuations, mortgage markets and home builders also. The recession in real estate sector has been created by instability in the financial sector. It is the failure of response of the financial sector in the form of financial innovation which failed to contain risks of lending.

Securitization was like a revolution that brought huge gains to the financial world. But the cost of securitization became apparent later. The challenge before the Federal Reserve and other Central Bankers is to control and regulate securitization without hurting its beneficial points like flexibility. The crisis has been a testing ground for central bankers of the world and will have a deep impact on the conduct of macroeconomic policy.

BIBLIOGRAPHY
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Business Today Business World Economic Times www.rbi.org.in www.incredibleindia.org

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