'Sub-Prime Crisis: After Effects' for Dummies

History:

1930s Great Depression

Collapse of the national housing market discourages private lenders from from investing in home loans.

1938 US Housing Bill signed

Fannie Mae, nickname for Federal National Mortgage Association established as an US Government organization in 1938 as part of Roosevelt's US Housing Bill to buy up mortgages and sell them on to investors. The idea was to raise levels of home ownership and the availability of affordable housing. Thus building a secondary mortgage market. 

1968  Private company with a direct credit line from the US Treasury

Under pressures created by the Vietnam War, Lyndon B Johnson privatizes the lender to remove it from its accounts. Fannie starts operating as a Government Sponsored Enterprise (GSE) thus generating profit for its stockholders with a special claim for government assistance in case of any financial trouble. Being a GSE, ensures that Fannie Mae has a direct credit line from the US Treasury, exemption from State and Local Taxes and SEC oversight.    

1970 Monopoly to Duopoly 

To end the monopoly of the Fannie Mae, Federal Home Loan Mortgage Corporation - Freddie Mac was set up as a competitor. Another GSE.

2003 Financial Accounting Scandal

Investigations by Justice Department and SEC into Freddie Mac's accounting practices reveals errors of $4.5 billion. 3 top executives forced to quit.

2007 Sub Prime Mortgage Crisis

Hits the US Housing market.

2008 US Government Bailouts

Loses 74% shareholder value of investments on escalating concern that Fannie and Freddie do not have enough capital to weather the subprime debacle. 

Stats:

• Fannie Mae and Freddie Mac control 90% of US secondary mortgage market.
• Combined current assets is 45 % greater than that of US's largest private bank (Citigroup)
• Combined current debt is 46% of current US national debt. 
• $3+ trillion of debt and guarantees
• $800 billion of junky mortgages  
• China holds $376 billion of long term US agency debt and most of it is in Fannie and Freddie asset. 

The Economic Cycle - Vicious or Virtuous ? 

Virtuous Cycle?

• Local bank disburses loans with low down payment and fixed interest rate. 
• Freddie and Fannie buys mortgages from local banks, securitizes them and sells them as bonds to investors.
• Freddie & Fannie as GSEs operate as private enterprises with US government guarantee of backing in case of financial trouble. Thus their securities are as good as US government securities.
• Being least risky of securities due to US government backing, these securities have high liquidity.  This allows them to have low yield.
• Freddie and Fannie makes profit from the difference in the interest rates charged to borrower and interest rates serviced to the investor to their securities. 
• Due to the direct line of credit from the US Treasury a major buyer of their securities are foreign governments and central banks to hold their foreign reserves. 

 Vicious Cycle?

• Post the the subprime debacle, there is a growing concern amongst investors ( Foreign central banks) about Freddie and Fannie's ability to service their securities.
• Liquidity of these securities decreases resulting in increased risk thus raising the interest rate of borrowing of these securities.
• Interest rate of mortgages increased subsequently.
• US Housing market busts.
• Bad debts for such mortgages run into $800 billion.
• Concern amongst invertors continue to escalate and the vicious cycle of bad debt continues.

To break out out this vicious cycle US government bails out these secondary mortgage company as a measure of reassurance to the investors .

An article on the Sub Prime Crisis in ET, Bangalore

http://epaper.timesofindia.com/Daily/skins/ET/navigator.asp?Daily=ETM&login=default&AW=1197607670859

Appreciating Rupee -Subprime Crisis Co-relation for Dummies

Being in an export oriented sector, with revenues from US of most IT services companies touching 30-5o%, Sub Prime Loan Crisis has entered the popular pshcye of everyone and anyone involved. Nowadays almost every cost cutting measure is blamed on it - starting from the smaller sugar packs in the pantry to the employee travel freeze to the top honchos talking of de-risking the existing business models. ET yesterday carried an article of Satyam looking at Malaysia as an alternate location for offshoring services because the Malay Ringgit does not appreciate as much as the Indian Rupee (INR) in relation to the US Dollar (USD)

So what is the mystery of the INR appreciating compared to the USD? We would probably need to go back 7 years to unfold the entire story.

2001-2005 -> Real Estate Boom in the US results in the loan interest rates going down, because the risk of repayment reduces as a direct co-relation. So the average American finds it that much easier to take loans from financial institutions. Thus higher value-loans were given out to subprime borrowers; people whose credit-worthiness in low to catch on to the wave. The lenders' confidence in the real estate boom made them convert these subprime loans into bonds - this is what is know as securitization. These bonds were sold to banks, insurance companies etc. These bonds were also sold to hedge funds which invest in global markets.

2006-2007-> The real-estate scenario takes a complete U-turn and the risk in returning or rather in the repayment the loan increases significantly. Interest rate triples in the United States and it becomes difficult for the subprime borrowers to return their loans forming a vicious cycle of cause and effect. Borrowers prefer defaulting on their repayments and cuases the real estate prices to nose dive. In the meantime the Bonds turn into bad debt and the real estate prices fall further. The hedge funds to recover their money reduce their holding in other fast developing and rising global markets, namely the Indian Stock Market .

Result -> The market for Rupee increases – this reduces the value of dollar in comparison.

Summary -> Interest Rate Parity and Exchange Rate parity is relative in comparison with two countries.