Subprime Tsunami

The mortgage securities market in US is at 50% of its GDP at $6.5 trillion. The financial stability of Bear Sterns was invariably linked to repayment of loans that it had underwritten. Just a few days prior to the collapse of the investment bank , Carlyle Capital (PE), one of the oldest private equity funds the world had known, went bust after its mortage losses wiped out its entire equity. Carlyle capital was leveraged to the extent of 32 times its book value. Though Carlyle had not taken any exposure to subprime assets and was holding only AAA rated mortgage bonds of Freddie Mac and Fannie Mae, many hedge funds had sold these bonds on the fear of a credit crisis prevailing in these two government guaranteed institutions resulting in excess supply of these bonds in the market. As a consequence, excess supply resulted in bonds prices falling and margins calls getting triggered for more collateral from Carlyle. The fact that most of the lenders of Carlyle were investment banks like Bear Sterns who dint want to extend any lenity was an indication of the problems they themselves faced internally.
Subprime mortgages were sold to homeless borrowers with lax credit standards on the pretext that they could refinance their homes to pay up later. But what was not explained to them was the interest rate clause would be reset every two years. As long as the interest rates were low, there was huge demand for housing and there was a construction boom that was witnessed all across the US which eventually resulted in excess supply of real estate. The situation was almost surreal with houses getting refinanced for a second mortgage just to fund consumption in the US. A consumption boom was also necessary to finance the US war in Afghanistan and Iraq. Government agencies operated in full swing bringing out ads to fuel consumption in US. As inflation spiralled out of control and interest rates began to spike up, these loan reste clauses came into effect. The subprime borrowers began to default unable to meet their liabilities. Most of these subprime borrowers had no source of income whatsover or had falsified the records while submitting the loan applications. Once they started to default, there were only two options, either to sell the house and meet the committment or subject the property to foreclosure. But with property rates having fallen under high interest rates and excess supply of real estate, they could neither refinance their house nor dispose them at falling prices. Most subprime borrowers have foreclosed their accounts by surrendering the plot resulting in the mortgage companies being left with houses whose value/collateral was way below the Loan value. The subprime contagion had begun and had a chain reaction throughout the economy. Today, the monster has resulted in losses close to $ 1 trillion in the US economy, almost the size of the Indian economy.The losses faced by mortgage companies resulted in many of them filing for bankruptcy and all the bonds securitised by them in the form of pass through certificates after a due diligence rating from the S&P's and Moody's of the World were reduced to nullity in terms of value. This resulted in huge write off's in the balance sheet of hedge funds and investment banks who had to mark to market assets held by them.
Similar was the case with Bear Sterns, the second largest underwriter of mortgage bonds in the US. The exposure to exotic derivatives at Bear sterns was almost the size of the US economy at $13 trillion. As has been proved over the last one year, these derivatives have indeed become weapons of mass destruction. The collateralised debt obligations and its liabilities on Credit defualt swaps underwritten had led to the collpase of two hedge funds owned by it. Post Carlyle's collapse and the FED's surprise interest rate cut by 75 basis points, credit spreads began to widen, there was panic among the market participants that there are more skeletons waiting in the closet. Rumours started doing the rounds that Bear Sterns was in trouble. Bear Sterns also handled the largest volume of trading transactions on the bourses and hence had huge deposits of collaterals and margin money from clients. These clients started withdrawing cash from the company and the latter was put into a liquidity crisis. Margin calls coudnt be met on mortgage bonds and CDO's. The firm sold its holdings in equities all across global markets held through its investing arm BSMA triggering off a fire sale of equities in most EM's. Bear Sterns was set for bankruptcy before the FED stepped in and aided JP morgan Chase to buyout Bear Sterns at $2 per share. The share price had collapsed from a high of 170$ before the subprime crisis broke out to $30 when the crisis was as its peak, almost wiping out the lifetime savings of its employee base who had put their hard earned money into Bear Sterns equity.

Oil prices surged to a record high above $112 last week. The current crude prices are nearly 10 times the levels less than a decade ago. Crude oil prices behave much as any other commodity with wide price swings in times of shortage or oversupply. The crude oil price cycle may extend over several years responding to changes in demand as well as OPEC and non-OPEC supply. The impact of crude oil prices on growth in developing countries is thought to be significantly higher, because energy-intensive manufacturing generally accounts for a larger share of their GDP.

Since 2002, major oil producing countries have been investing in exploration and development. Furthermore, planned gross capacity additions from new projects in non-OPEC countries (including non-conventional sources) would add to supply.Oil-consuming countries have also started diversifying their fuel-mix by switching to alternative sources of energy like natural gas and renewables. The interplay of these forces can drive down the prices of crude oil from the current levels.

On the demand side, while consumption in the past has been driven by OECD countries, particularly the US, much of the current incremental demand is coming from emerging economies, particularly China and India, which contributed more than 40 per cent of the incremental global consumption during 2000-06. Global oil demand is expected to increase to 100 million barrels per day (mbpd) by 2015 as against 85.7 mbpd currently.While oil demand is projected to increase significantly, supply may struggle to keep pace. The production from the existing fields is declining by 4 per cent per annum which means that new capacity needs to be added every year just to offset the decline in existing production.

The depreciation of the US dollar and the worsening US economy are also held as major culprits for the price rise. The falling dollar coupled with the declining stock and credit markets also increases traders' interest in commodities such as oil,which further fuels price rise.Speculative investment by major hedge funds also seems to play a key role on oil price volatility.They are not liquidating their positions until clarity emerges on the dollar front.

While, one cannot rule out the possibility of the volatile crude prices from receding somewhat in the near future, driven maybe by a dip in global demand as a result of sustained economic downturn in the US, what does appear is that over the last few years, the equilibrium price of oil has shifted upwards and the volatility has increased significantly, leaving prices vulnerable to fluctuations even due to the slightest disruption in supplies (like the recent one of a cracked pipeline at Tennessee which cut supplies of more than 1 million barrels a day to the US) or changes in demand.

Random notes on subprime

The sub-prime mortgage crisis is the major financial crisis of the new millennium whose origin is in the United States (US) housing market. Subsequently, this spread to Europe and some other parts of the world. The gradual softening of international interest rates during the last few years, coupled with relatively easy liquidity conditions across the world, provided for increased risk appetite of investors leading to expansion in the sub-prime market. The word ‘sub-prime’ refers to borrowers (who are not rated as ‘prime’) and who do not have a sound track record of repayment of loans. The risks inherent in sub-prime loans were sliced into different components
and packaged into a host of securities, referred to as asset-backed securities and collateralised debt obligations (CDOs). Credit rating agencies had assigned risk ranks (e.g. AAA, BBB) to them to facilitate marketability. Because of the complex nature of such new products, intermediaries such as hedge funds, pension funds and banks, who held them in their portfolio or through SPVs, were not fully aware of the risks involved. When interest rates rose leading to defaults in the housing sector, the value of the underlying loans declined along with the price of these products. Institutions were saddled with illiquid and value-eroded instruments, leading to liquidity crunch; the crisis in the credit market subsequently spread to the money market as well. The policy response in the US and the Euro area has been to address the issue of enhancing liquidity as well as to restore the faith in the financial system. The sub-prime crisis has also impacted the emerging economies, depending on their exposure to the sub-prime and the related assets.
India has remained relatively insulated from this crisis. The banks and financial institutions in India do not have marked exposure to the sub-prime and related assets in matured markets. Further, India’s gradual approach to the financial sector reforms process, with the building of appropriate safe-guards to ensure stability, has played a positive role in keeping India immune from such shocks.