The Current Turmoil Cause and Effect

1. The Current TurmoilCause and Effect Dr. B. Yerram Raju, Regional Director, PRMIA, Hyderabad Chapter At the Seminar on Financial Risk Management, Gitam University, Visakhapatnam (November 14, 2008) Picture: Courtesy-Economist yerramraju@prmia.org

2. Feet in the frying pan – no where else to jump except fire. Economist, London. yerramraju@prmia.org

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

4. Hey days • Large inflow of assets • M&As drive business growth • Opportunities even in volatile markets seized without winking the eye • Basel II compliance targets moved forward yerramraju@prmia.org

5. Before the downturn: The Housing Boom • The introduction of exotic loans, adjustable rate mortgages, and relaxed standards allowed for an increase in sub-prime mortgage lending. • Low interest rates encouraged Wall Street investors to back sub-prime loans in greater quantities. • Hedge funds worldwide borrowed money to invest heavily in sub-prime mortgages. yerramraju@prmia.org

6. D-days • Unprecedented outflow of funds • De-leveraging • Government investment/increased scrutiny • Extreme volatile share prices • Recession fears • Nervous investors • Business uncertainty yerramraju@prmia.org

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

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

9. BANKS HAVE ALWAYS BEEN A WEAK LINK IN THE FINANCIAL SYSTEM BECAUSE OF A MISMATCH BETWEEN THEIR ASSETS AND LIABILITIES. yerramraju@prmia.org

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

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

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

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

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

15. Deterioration not by day but by hours • Fed Reserve allowed certain firms to liquidate and certain others bail-outs • Treasury Secretary proposed a bail-out package of $700bn whereas the loss involved crosses trillion dollars • The fire engulfed Great Britain and Europe • Japanese markets also tumbled • All Central Banks came out with bail-out packages and nationalization of banks in the troubled zone. yerramraju@prmia.org

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

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

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

19. India’s Position • Government asserts that the impact of the sub-prime crisis is moderate (FM & RBI) • Caught in the grip of inflation – touching the highest double digit in the post-reform era. • But there was a free fall of the stock markets pushing down Sensex by 57 percent from its level 9months ago (24-X-08)-<9000 • Markets continue to be volatile despite several blue chip companies and Banks reporting encouraging results for Q2. • Reason: Several FIIs continue to pull back their investments sheerly for their own survival with credit and home loan markets, inter-bank lending choking up. • Despite low agriculture growth (2%), Indian economy estimated to grow 7.7-8 percent as per the RBI Policy announcement. Hence markets have a chance to bounce back. But Indian investments are sluggish. Foreign investments distant. yerramraju@prmia.org

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

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

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

23. Source: Economist, London Oct 25-31, 2008 yerramraju@prmia.org

24. Measures taken by G-8 other than India Source: Amrita Narlikar, University of Cambridge: Financial Express dated 01.11.2008 yerramraju@prmia.org

25. Regulators & Government all Alert • US Fed cut rates to 2% the lowest in 50 years – also indicated further rate cut • UK closing in for zero interest rate • All other countries in Europe and Pacific follow the same route. • Avoid am-Bush on November 15, 2008 at the G-20 Summit yerramraju@prmia.org

26. Risk Management Process – Can it come to rescue? Treat Risks Collaborative Risk Risk Analytics Policy Management Monitor & Review Key Risk Indicators yerramraju@prmia.org

27. Thank You for the patience yerramr@gmail.com; Hyderabad@prmia.org yerramraju@prmia.org