Introduction

USA’s slowdown is a topic that is hotly debated and dominates the headlines everyday of the week.

Today the scenario is so big that it is not just US that is grappling on how to resolve the issue but the entire world is mooting about it. We have read with growing confusion and concern about the contradictory information about slowdown - subprime crisis and its impact in India. For a while now Indian companies and policy makers have denied that subprime crisis will impact the Indian economy. For instance, I read a news items that writes Infosys thinks the mortgage crisis will not impact them, and I have also read another news article where Infosys says the mortgage crisis will impact them. And here is another news item where India’s central bank, the Reserve Bank of India, has expressed concern about the subprime crisis impacting the Indian economy.

Hence to analyze the situation and have a better look of the topic the research paper deals with the issue of US slowdown and its Impact on the world.

How it all started?

The scenario of the US economy in March 2006 (US):

It was observed that till the third quarter of 2005, the US economy had shown a stable robust pace of growth since last three years. Gross domestic product (GDP) grew at a real annualized rate of at least 3.3 percent in every quarter between March 2003 and September 2005. However by the fourth quarter it fell down to the rate of 1.6 percent. On the contrary, FDIC, an independent agency created by the Congress that maintains the stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions, and managing receiverships, turned in a fifth-consecutive year of record earnings in 2005, posting net income of $134.2 billion.

Existence of these two extreme situations at the same time, led to the obvious question: “How long can these good times last? Experience teaches us that economic expansions do not last forever and that some types of economic disruptions can be associated with financial distress for banking organizations”. With this in mind, the Federal Deposit Insurance Corporation then hosted a panel discussion to gain insights into scenarios for the next recession. The event was convened by FDIC Chief Economist Richard Brown, Kathleen Camilli - Chief Economist and Director of Camilli Economics; Arthur McMahon - Director of Economic Outlook and Bank Condition for the Office of the Comptroller of the Currency (OCC); and Meredith Whitney - Executive Director for CIBC World Markets, a subsidiary of the Canadian Imperial Bank of Commerce in New York. The panel discussed the economic trends and potential areas of weakness that could pose problems for banks in the next recession. The issue also looked at the historical performance of the banking industry across business cycles and how well the industry is positioned to effectively manage the risks and challenges that may be associated with the next recession. Miss Camilli Econom introduced the notion that the U.S. economy might have experienced a mid-cycle growth slowdown in late 2005. These slowdowns have a precedent, as they have occurred during expansions in both the 1980s and 1990s (see Chart 1). Ms. Camilli also noted that the recent historical pattern of real GDP growth points to recessions occurring near the start of every decade.

The Key Factors:

The recession in question today can be accounted to the following factors which at that time were considered to be the major concerns that could pose risks to the economy going forward:

a spike in energy prices
a decline in home prices
a retrenchment in consumer spending arising from record consumer indebtedness.

It should be noted that in addition to the above factors, financial market panics, natural disasters, terrorism, war, and even changes to policy are among many other sources of disruption to the benign economic and banking environment.

Energy Shocks

Because global excess crude oil production and refining capacity are limited, the risk of supply-side energy shocks has always remained high. Strong global growth in energy demand in recent years, coupled with decades of limited new international investment in energy production capacity, have left the United States and the world exposed to increased energy risks. Although the U.S. economy has become less reliant on energy than in the 1970s, it still suffers from energy supply disruptions that result in spiking oil, gas, and gasoline prices.

With time the economy should be able to adjust to higher energy prices, but in the short run, any supply-disrupting events, including labor strikes, severe weather, or terrorism, may cause energy prices to jump. By varying degrees, these spikes would weigh on overall economic growth while adding volatility to the outlook. Moreover, this risk is likely to stay in play for several more years, given the long lags required to add new energy production capacity and expectations for continued global growth in energy demand.

Housing

The housing slowdown is another area of concern. The housing boom of 2005 has been unprecedented in modern U.S. history. It has been suggested by many analysts that the housing boom has been a significant contributor to gains in consumer spending. It was brought to light by a number of the FDIC roundtable panelists that, the apparent connection between rising real estate wealth during the past four years and the sustained strength in consumer spending during that period. Because consumer spending accounts for over two-thirds of U.S. economic activity, any shock to consumer spending, such as that might be caused by a housing slowdown, is a concern to overall economic growth.

It is very likely that housing wealth has been a significant factor behind growth in consumer spending. Through the use of cash-out refinancing, increased mortgage balances, and greater use of home equity lines of credit, as well as through owners selling homes outright and cashing in on their accumulated equity, it is estimated that anywhere from $444 billion to $600 billion was liquidated from housing wealth during 2005. Whichever estimate one uses, the total almost surely eclipses the $375 billion gain in after-tax income for the year. While probably not all of the home equity liquidated during 2005 fed consumption spending (much of it was invested into other assets, including second or vacation homes), these statistics illustrate how important home equity had been as a source of household liquidity.

However, there was a significant change in the structure of mortgage lending and that possessed new risks to housing. These changes were most evident in the rising popularity of interest-only and payment-option mortgages, which allow borrowers to afford more expensive homes relative to their income, but which also, increase variability in borrower payments and loan balances. To the extent that some borrowers with these innovative mortgages may not fully understand the potential variability in their payments over time, the credit risk associated with these instruments could be difficult to evaluate. In addition, the degree of effective leverage in home-purchase loans has risen in recent years with the advent of so-called “piggy-back” mortgage structures that substitute a second-lien mortgage for some or all of the traditional down payment. The use of revolving home equity lines of credit in lieu of down payments has enabled an increasing number of first-time buyers to qualify for homes that they otherwise could not afford.

The research conducted by Ms. Whitney in 2005 suggested that a group that includes approximately 10 percent of U.S. households may be at heightened risk of credit problems in the then prevailing environment. This group mainly includes households that gained access to mortgage credit for the first time during the recent expansion of subprime and innovative mortgage loan programs. Not only do many borrowers in the group have pre-existing credit problems, they may also be more vulnerable than other groups to rising interest rates because of their reliance on interest-only and payment-option mortgages.

And as predicted these types of mortgages brought the significant payment shock that occurred due to the low introductory interest rates expiry, when index rates rose, and when these loans eventually began to require regular amortization of principal including any deferred interest that has accrued.

Chart 2 below shows how the rate of House Ownership increased drastically in 2005, due to these changes.

Mortgage lending to bank and thrift earnings, brought large-scale changes in this sector and it had clear implications for the banking outlook. Bank exposure to mortgage and home equity lending were at peak levels. As reported in the FDIC’s Quarterly Banking Profile 2006, 1-4 family residential mortgages and home equity lines of credit accounted for a combined 38 percent of total loans and leases in fourth quarter 2005, well above the roughly one-third share maintained at the beginning of the decade.

These points of change in monetary structure rather than being a sign of modernization in housing activity was a harbinger to a significant correction in the Realty. Inventories of unsold homes and sales volumes are among the indicators pointing to a housing slowdown. Later in 2005 even the pace of existing home sales started showing negative growth. And finally the crisis began with the bursting of the housing bubble in the US and high default rates on "subprime" and other adjustable rate mortgages (ARM). During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% versus 2006.

Subprime Lending: Background

Subprime lending is a general term that refers to the practice of making loans to borrowers who do not qualify for market interest rates because of problems with their credit history or the inability to prove that they have enough income to support the monthly payment on the loan for which they are applying. The word Subprime refers to the credit-worthiness of the borrower (being less than ideal) and does not refer to the interest rate of the loan. Subprime loans or mortgages are risky for both creditors and debtors because of the combination of high interest rates, bad credit history, and murky personal financial situations often associated with subprime applicants. A subprime loan is one that is offered at an interest rate higher than A-paper loans due to the increased risk.

The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007, with over 7.5 million first-lien subprime mortgages outstanding. Approximately 16% of subprime loans with adjustable rate mortgages (ARM) were 90-days delinquent or in foreclosure proceedings as of October 2007, roughly triple the rate of 2005. By January of 2008, the delinquency rate had risen to 21%.

Subprime ARMs only represent 6.8% of the loans outstanding in the US, yet they represent 43.0% of the foreclosures started during the third quarter of 2007. A total of nearly 446,726 U.S. household properties were subject to some sort of foreclosure action from July to September 2007, including those with prime, alt-A and subprime loans. This is double the 223,000 properties in the year-ago period and 34% higher than the 333,627 in the prior quarter. This increased to 527,740 during the fourth quarter of 2007, an 18% increase versus the prior quarter. For all of 2007, nearly 1.3 million properties were subject to 2.2 million foreclosure filings, up 79% and 75% respectively versus 2006. Foreclosure filings including default notices, auction sale notices and bank repossessions can include multiple notices on the same property.

The estimated value of subprime adjustable-rate mortages (ARM) resetting at higher interest rates is U.S. $400 billion for 2007 and $500 billion for 2008. Reset activity is expected to increase to a monthly peak in March 2008 of nearly $100 billion, before declining. An average of 450,000 subprime ARM are scheduled to undergo their first rate increase each quarter in 2008.

Consumer Debt and Lack of Saving

The housing boom of recent years, till 2005, resulted in a surge in new consumer debt, most of it in the form of mortgages. Historically, recessions have provided an opportunity for households and businesses to retrench and rebuild balance sheets that might have become strained late in the previous expansion. The response of businesses during the 2001 recession provides a classic example in this regard as investment, spending, and hiring activities were curtailed sharply from their heady, late-1990s pace. In part because of the wealth-offset provided by housing, however, the long “jobless recovery” following the 2001 recession did not weigh heavily on the consumer sector. Consumers did slow their pace of spending growth in 2001 and 2002, but spending growth never fell below a 1 percent annual pace in any quarter—and in no quarter did it actually decline. By contrast, during the early 1990s recession, consumer spending declined for two straight quarters. At this point in time, however, the consumer sector has not experienced a real recession in 15 years. And a report says that even in October – November 2007, there was an increase in growth by marginal 0.6 point basis.

In some sense, this long recession hiatus itself raises concerns. Consumers in US have gradually become more indebted over time—so much so that they are now spending more in aggregate than they earn, resulting in the much-lamented negative personal savings rate. The personal savings rate always turns out to be a bit of a statistical anachronism in an economy where so much spending is driven by the accumulation of wealth rather than current income. And at such point even a slight moderation in home-price growth could reduce the amount of new home equity added to the economy each year. This slower accumulation of wealth, coupled with rising interest rates that increase the cost of tapping that wealth, began to curtail the pace of U.S. consumer spending growth. Just as there has been a positive wealth effect from soaring home prices before 2005, an end to the housing boom resulted in a slowdown in consumer spending growth.

How it affects World Economy?

The US Subprime Crisis Goes Global

The subprime mortgage crisis was a sharp rise in home foreclosures which started in the United States in late 2006 and became a global financial crisis during 2007 and 2008.

The mortgage lenders that retained credit risk (the risk of payment default) were the first to be affected, as borrowers became unable or unwilling to make payments. Major Banks and other financial institutions around the world have reported losses of approximately U.S. $170 billion as of February 2008. In the United States, 84 mortgage lenders went bankrupt or partially ceased their activity between the beginning of the year and 17 August 2007, as opposed to only 17 for the whole of 2006. In Germany, the IKB bank and the public institute SachsenLB, both of whom had invested heavily in the US mortgage market, suffered immediate effects.

Due to a form of financial engineering called securitization, many mortgage lenders had passed the rights to the mortgage payments and related credit/default risk to third-party investors via mortgage-backed securities (MBS) and collateralized debt obligations (CDO). Corporate, individual and institutional investors holding MBS or CDO faced significant losses, as the value of the underlying mortgage assets declined. Stock markets in many countries declined significantly.

The widespread dispersion of credit risk and the unclear impact on financial institutions caused lenders to reduce lending activity or to make loans at higher interest rates. Similarly, the ability of corporations to obtain funds through the issuance of commercial paper was impacted. This aspect of the crisis is consistent with a credit crunch. The liquidity concerns drove central banks around the world to take action to provide funds to member banks to encourage the lending of funds to worthy borrowers and to re-invigorate the commercial paper markets.

But the domino effect does not stop there: the banks that bought up mortgages did so by setting up largely off-balance sheet operating companies called Structured Investment Vehicles (SIV). These SIVs finance the purchase of mortgage loans by selling commercial papers to other investors. Their profit comes from the difference between the remuneration paid to buyers of their commercial papers and the money gained from high-yield mortgage loans converted into bonds (CDO Collateralized Debt Obligations).

Of course all these complex debt and loan packages do not create real wealth (whereas there is real wealth in the construction industry and its suppliers): they are largely speculative financial operations. The crisis in this shaky "paper" market, however, leads to the destruction of wealth and human lives (failed construction companies, financial ruin and even suicide, loss of employment, and repossession of properties).

When the crisis erupted in August 2007, the investors who habitually bought commercial papers issued by the SIVs stopped buying them because they no longer had confidence in the health and credibility of the SIVs. Consequently the SIVs lacked liquidity for buying mortgage bonds and the crisis worsened. The big banks that had created these SIVs had to honour SIV commitments to avoid them going bankrupt. While SIV operations had until then been below-the-line items (which allowed them to conceal the risks they were taking), big US and European banks were now obliged to show SIV debts on their balance sheets. Among these were Bank of America, Citigroup (the leading worldwide banking group), Wachovia, Morgan Stanley and Merrill Lynch, Deutsche Bank and UBS (Union des Banques Suisses). Between August and October 2007, US banks alone took on at least 280 billion dollars of SIV debts , with serious bottom-line consequences. Several major banks such as Citigroup and Merrill Lynch at first tried to minimize their level of risk exposure, but their losses were so considerable that they could not conceal them for long. Chairmen were ejected, but not without a golden parachute. Merrill Lynch's chairman Stan O'Neal received 160 million dollars as compensation for his untimely departure! On the contrary, the CEO of the bank Goldman Sachs, Lloyd Blankfein, established the record for the highest bonus in 2007: 68 million dollars, for record benefits and for the knack of having bought products that derived from the exploitation of the subprime crisis (which contributed to exacerbate the latter, according to some sources). Effectively, these scandalous sums reward anti-social, if not criminal, behaviours.

The August 2007 crisis had spectacular effects both in the United States and in Europe. "On Friday 10 August, in Europe and in the United States, an incredible thing happened: in 24 hours banks became too mistrustful of each other to do any mutual lending, forcing the central banks to step in massively. In 4 days, up to 14 August 2007, the ECB [European Central Bank] pumped nearly 230 billion euros of liquidities into the market." The US Federal Reserve acted likewise. The dynamic response of the US and European monetary authorities thus prevented multiple bankruptcies. From the 13 December 2007, in a joint action, on a scale never witnessed before, the ECB, the Federal Reserve, the Bank of England, the Bank of Canada and the Swiss National Bank (supported by the Bank of Japan) again pumped enormous liquidities into the interbank market, a sign that the crisis is not over yet.

The response of the US and European political and financial authorities to the liquidity crisis which began in August 2007 is a far cry from the response imposed on the Indonesian authorities by the IMF, supported by these same governments, at the time of the Asian crisis of 1997-1998. In the first case, the US and European authorities saved the banks by placing liquidities at their disposal, whereas in Indonesia, the IMF enforced bankruptcy on dozens of banks by refusing to let either the Indonesian Central Bank or the IMF itself lend them liquidities. This ended in a social disaster and a huge increase in the internal public debt because the debts of the failed private banks were transferred to the Indonesian State. Another glaring difference: to stem the crisis, the US monetary authorities have since August 2007 lowered interest rates (as they did between 2001 and May 2004), whereas the IMF demanded that the Indonesian government increase interest rates, a factor which considerably aggravated the crisis. Double standards for the North and South

Europe in Slowdown too!

The downturn that began in the US is spreading inexorably to Europe, where housing sales and prices are falling in most Euro Zone countries and the United Kingdom, and service industries grew last month at the slowest rate in four years.

The department store giant Macy’s reported a 7.1 percent fall in same-store sales for January and announced it was cutting 2,300 jobs as part of a consolidation of its management structure.

A report issued by Thomson Financial said US chain stores’ total same-store sales rose by just 0.3 percent in January, far lower than the already minimal 1 percent rise predicted by analysts. The International Council of Shopping Centers has also reported its weakest January performance in four decades.

On the housing front, the National Association of Realtors (NAR) reported Thursday that pending previously-owned home sales fell 1.5 percent in December. The NAR’s pending home sales index was down 24.2 percent from the prior year’s period. The realtors’ organization predicted further declines in home prices into 2009.

This followed the report released January 28, 2008 showing that sales of new single-family homes had plummeted by a record 26 percent in 2007 and builders had slashed prices by the most since 1970.

The collapse of the US housing market remains the biggest factor contributing to the crisis in credit markets in the US and around the world, which has produced tens of billions in losses by major US and European banks and a sharp contraction in credit.

Responding to the growth of recessionary currents in Europe, the Bank of England on Thursday cut interest rates by a quarter percentage point to 5.25 percent. The move was a reaction to “slower consumer spending and a weakening housing market,” said Wachovia Corp. analyst Jill Trainor.

The European Central Bank held its key rate steady at 4 percent, but ECB President Jean-Claude Trichet reversed his previous position and told a news conference he was open to rate cuts down the road because of weakening economic growth in Europe.

III

Global Slowdown & India

As the cliché goes, whenever the US sneezes, the world catches a cold. This is evident from the way the Indian markets crashed taking a cue from a probable recession in the US and a global economic slowdown.

Weakening of the American economy is bad news for the world and India is no exception.

Impact of a US recession on India

Indian companies have major outsourcing deals from the US. India's exports to the US have also grown substantially over the years. The India economy is likely to lose between 1 to 2 percentage points in GDP growth in the next fiscal year. Indian companies with big tickets deals in the US would see their profit margins shrinking.

The worries for exporters will grow as rupee strengthens further against the dollar. But experts note that the long-term prospects for India are stable. A weak dollar could bring more foreign money to Indian markets.

India’s apparel exporters are facing cancelled orders and dried up pipelines, a result of a weakening US economy and a strengthening Indian Rupee against the US Dollar.

The merchandizing head of one of the leading Indian apparel chain mentioned that top Indian exporters, who were operating at full capacity till a few months ago and had little interest in smaller Indian orders, are now queuing up outside her office to produce her private labels. Apparently, weak consumer spending forecasts have led several US retail and apparel majors to reduce their purchases. And a stronger Indian Rupee has made countries like Vietnam and Bangladesh more attractive than India.

There are other area of concerns to: large-scale unemployment and a depressed business environment. A weak US economy will affect India’s income, thereby adversely affecting Indian consumer spending and overall business.

Several small and medium scale exporters are folding up, and large exporters are desperately trying to keep their businesses afloat. The ‘garment export city’ of Tirupur in South India has already seen 15,000 layoffs with more expected in the following months. In Bangalore 30,000 garment factory workers – mostly women – have lost their jobs in the last few weeks.

The Indian technology industry appears more optimistic, at least publicly. Despite the rising Rupee adversely affecting their revenues, business projections announced by top outsourcing companies remain encouraging. But inside news from several top technology companies tell a completely different story. Recruitment divisions are being asked to go slow on hiring. Till last quarter these companies were hiring in hordes, building strong bench strengths to nullify attrition. Now, hiring is being directed strictly on project and requirement basis. Infosys has reported a higher utilization rate, which shows a leaner bench. And major newspapers are showing declining employment advertisements. Worse, this year’s IT recruitment is projected to be the lowest in the last 3 years.

In Indian Stock Exchange January 21 and 22 saw a meltdown with a mind-boggling US$450 billion in market capitalization being vaporized just because of the rumour of confirmed Recession. An unprecedented interest cut by the Fed led to a bounce-back on January the benchmark index (BSE) has gained 2.5%, almost in line with Hang-Seng, Nikkei, and Kospi.

History might hold a clue here. The last time the bubble burst (2001–2002), the Dow Jones Industrial Area went down by 23%, while the Indian Index fell by 15%.

On the Other Hand:

Inspite of all these facts and figures, there exists a total different theory that says that this Global slowdown may indeed help India. The analysts and government in India are hopeful for double digit growth figures. The following claims are put forward in support:

The Indian economy has shown a robust and consistent growth trajectory and the projection for 2008 is 9%. Indian exports to the United States account for just over 3% of GDP. India has a healthy trade surplus with the United States.

In other words, the effects of this recession on India may be quite distinct from those of the past.

India Shinning: In this global slowdown there are few opportunities for India, which utilized in the best form could help sustain growth and robustness. Here are some areas worth following:

1. A credit crisis in the United States might lead to a restructuring of asset allocation at pension funds. It has been suggested that CalPERS is likely to shift an additional US$24 billion to its international portfolio. A large portion of this is likely to flow into India and China. If other funds follow suit, a cascading effect can be expected. Along with the already significant dollar funds available, the additional funds could be deployed to create infrastructure—roads, airports, and seaports—and be ready for a rapid takeoff when normalcy is restored.

2. In terms of specific sectors, the IT Enabled Services sector may be hit since a majority of Indian IT firms derive 75% or more of their revenues from the United States—a classic case of having put all eggs in one basket. If Fortune 500 companies slash their IT budgets, Indian firms could be adversely affected. Instead of looking at the scenario as a threat, the sector would do well to focus on product innovation (as opposed to merely providing services). If this is done, India can emerge as a major player in the IT products category as well.

3. The manufacturing sector has to ramp up scale economies, and improve productivity and operational efficiency, thus lowering prices, if it wishes to offset the loss of revenue from a possible US recession. The demand for appliances, consumer electronics, apparel, and a host of products is huge and can be exploited to advantage by adopting appropriate pricing strategies. Although unlikely, a prolonged recession might see the emergence of new regional groupings—India, China, and Korea?

4. The tourism sector could be affected. Now is the time to aggressively promote health tourism. Given the availability of talented professionals, and with a distinct cost advantage, India can be the destination of choice for health tourism.

5. A recession in the United States may see the loss of some jobs in India. The concept of Social Security, that has been absent until now, may gain momentum.

6. The Indian Rupee has appreciated in relation to the US dollar. Exporters are pushing for government intervention and rate cuts. What is conveniently forgotten in this debate is that a stronger Rupee would reduce the import bill, and narrow the overall trade deficit. The Indian central bank (Reserve Bank of India) can intervene anytime and cut interest rates, increasing liquidity in the economy, and catalyzing domestic demand. A strong domestic demand would also help in competing globally when the recession is over.

Conclusion

In summary, at the macro-level, a recession in the US may bring down GDP growth, but not by much. At the micro-level, specific sectors could be affected. Innovation now may prove to be the engine for growth when the next boom occurs.

For US firms, who have long looked at China as a better investment destination, this may be a good time to look at India as well. After all, 350 million people with purchasing power cannot be ignored.

Actions to manage the crisis

Lenders and homeowners both may benefit from avoiding foreclosure, which is a costly and lengthy process. Some lenders have taken action to reach out to homeowners to provide more favorable mortgage terms (i.e., loan modification or refinancing). Homeowners have also been encouraged to contact their lenders to discuss alternatives. Corporations, trade groups, and consumer advocates have begun to cite statistics on the numbers and types of homeowners assisted by loan modification programs. There is some dispute regarding the appropriate measures, sources of data, and adequacy of progress. A report issued in January 2008 showed that mortgage lenders modified 54,000 loans and established 183,000 repayment plans in the third quarter of 2007, a period in which there were 384,000 new foreclosures. Consumer groups claimed the modifications affected less than 1 percent of the 3 million subprime loans with adjustable rates that were outstanding in the third quarter.

Credit rating agencies help evaluate and report on the risk involved with various investment alternatives. The rating processes can be re-examined and improved to encourage greater transparency to the risks involved with complex mortgage-backed securities and the entities that provide them. Rating agencies have recently begun to aggressively downgrade large amounts of mortgage-backed debt.

Regulators and legislators can take action regarding lending practices, bankruptcy protection, tax policies, affordable housing, credit counselling, education, and the licensing and qualifications of lenders. Regulations or guidelines can also influence the nature, transparency and regulatory reporting required for the complex legal entities and securities involved in these transactions. Congress also is conducting hearings help identify solutions and apply pressure to the various parties involved.

The media can help educate the public and parties involved. It can also ensure the top subject material experts are engaged and have a voice to ensure a reasoned debate about the pros and cons of various solutions.

Banks have sought and received additional capital (i.e., cash investments) from sovereign wealth funds, which are entities that control the surplus savings of developing countries. An estimated U.S. $69 billion has been invested by these entities in large financial institutions over the past year. On January 15, 2008, sovereign wealth funds provided a total of $21 billion to two major U.S. financial institutions. Such capital is used to help banks maintain required capital ratios (an important measure of financial health), which have declined significantly due to subprime loan or CDO losses. Sovereign wealth funds are estimated to control nearly $2.9 trillion. Much of this wealth is oil and gas related. As they represent the surplus funds of governments, these entities carry at least the perception that their investments have underlying political motives.

Litigation related to the subprime crisis is underway. A study released in February 2008 indicated that 278 civil lawsuits were filed in federal courts during 2007 related to the subprime crisis. The number of filings in state courts were not quantified but are also believed to be significant. The study found that 43 percent of the cases were class actions brought by borrowers, such as those that contended they were victims of discriminatory lending practices. Other cases include securities lawsuits filed by investors, commercial contract disputes, employment class actions, and bankruptcy-related cases. Defendants included mortgage bankers, brokers, lenders, appraisers, title companies, home builders, servicers, issuers, underwriters, bond insurers, money managers, public accounting firms, and company boards and officers.

Bush Administration plan

President George W. Bush announced a plan to voluntarily and temporarily freeze the mortgages of a limited number of mortgage debtors holding ARMs. A refinancing facility called FHA-Secure was also created. This is part of an ongoing collaborative effort between the US Government and private industry to help some sub-prime borrowers called the Hope Now Alliance.

The Hope Now Alliance released a report in February, 2008 indicating it helped 545,000 subprime borrowers with shaky credit in the second half of 2007, or 7.7 percent of 7.1 million subprime loans outstanding in September 2007. A spokesperson acknowledged that much more must be done.

During February 2008, a program called "Project Lifeline" was announced. Six of the largest U.S. lenders, in partnership with the Hope Now Alliance, agreed to defer foreclosure actions for 30 days for homeowners 90 or more days delinquent on payments. The intent of the program was to encourage more loan adjustments, to avoid foreclosures.

The U.S. Treasury Department is working directly with major banks to develop a systematic means of modifying loans for a significant portion of borrowers facing ARM increases, rather than working through loans on a case-by-case basis.

President Bush also signed into law on February 13, 2008 an economic stimulus package of $168 billion, mainly in the form of income tax rebates, to help stimulate economic growth.

The Federal Reserve

Federal Reserve (Fed) Chairman Ben Bernanke signaled towards making interest rate cuts. In early 2008, Ben Bernanke said: "Broadly, the Federal Reserve’s response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary policy." Tougher regulatory standards are proposed. Additionally, a freeze of interest payments on certain sub-prime loans is announced. On January 22, 2008, the Fed also slashed a key interest rate (the federal funds rate) by 75 basis points to 3.5%, the biggest cut since 1984, followed by another cut of 50 basis points on January 30th.

The Fed and other central banks have conducted open market operations to ensure member banks have access to funds (i.e., liquidity). These are effectively short-term loans to member banks collateralized by government securities. Central banks have also lowered the interest rates charged to member banks (called the discount rate in the U.S.) for short-term loans. Both measures effectively lubricate the financial system, in two key ways. First, they help provide access to funds for those entities with illiquid mortgage-backed assets. This helps lenders, SPE, and SIV avoid selling mortgage-backed assets at a steep loss. Second, the available funds stimulate the commercial paper market and general economic activity. Specific responses by central banks are included in the subprime crisis impact timeline.

The Fed is utilizing the Term auction facility (TAF) to provide short-term loans (liquidity) to banks. The Fed increased the monthly amount of these auctions to $100 billion during March 2008, up from $60 billion in prior months. In addition, term repurchase agreements expected to cumulate to $100 billion were announced, which enhance the ability of financial institutions to sell mortgage-backed and other debt. The Fed indicated that both the TAF and repurchase agreement amounts will continue and be increased as necessary.

Fed Chairman Bernanke also delivered a speech March 4, 2008 titled "Reducing Preventable Mortgage Foreclosures." He advocated several solutions, including the reduction of loan principal amounts. This solution was highlighted to address a growing concern that an estimated 8.8 million U.S. homeowners (10%) with negative equity (homes worth less than the mortgage principal) will have a financial incentive to "walk away" from the property, further exacerbating the crisis.

Expectations and forecasts

As of November 22, 2007, analysts at a leading investment bank estimated losses on subprime CDO would be approximately U.S. $148 billion. As of December 22, 2007, a leading business periodical estimated subprime defaults between U.S. $200-300 billion. As of March 1, 2008 analysts from three large financial institutions estimated the impact would be between U.S. $350-600 billion.

Alan Greenspan, the former Chairman of the Federal Reserve, stated: "The current credit crisis will come to an end when the overhang of inventories of newly built homes is largely liquidated, and home price deflation comes to an end. That will stabilize the now-uncertain value of the home equity that acts as a buffer for all home mortgages, but most importantly for those held as collateral for residential mortgage-backed securities. Very large losses will, no doubt, be taken as a consequence of the crisis. But after a period of protracted adjustment, the U.S. economy, and the world economy more generally, will be able to get back to business."

Research Papers, Articles & Analysis

Tuesday, September 2, 2008

January Effect

Friday, August 15, 2008

US Slowdown. Its Effect In India & Elsewhere

The US Subprime Crisis Goes Global

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