Subprime Meltdown

Submission for

Crisil Young Thought Leader Series 2007

“Lessons from sub-prime meltdown”

Submitted by:

Neeraj Parashar

MBA Full Time Student 2006-07

Second Year

Institute of Management Studies, Indore

Email Address:

neeraj.parashar@hotmail.com

5th October, 2007

ACKNOWLEDGEMENTS

I would like to thank the following for sharing their views on the subject and providing support in giving this dissertation an organized look;

1. Ms. Mahak Jain, First Year, MBA, Institute of Management Studies, Indore

2. Ms. Ruhi Agrawal, First Year, MBA, Institute of Management Studies, Indore

3. Mrs. Neetika Khoda, First Year, MBA, Institute of Management Studies, Indore

Neeraj Parashar

Executive Summary

Wealth without Work, Pleasure without Conscience, Knowledge without Character, Commerce (Business) without Morality (Ethics), Science without Humanity, Religion without Sacrifice, Politics without Principle are the seven deadly sins that are quoted by Gandhiji along with the popular principle of sacred means for sacred goals. In the story of subprime meltdown the shortcomings of US government, their materialistic society and the prevailing practices of industry got exposed. Subprime meltdown is not an overnight story of financial shock but a prevailing tendency of American culture of achieving more beyond their affordability; creation of wealth (subprime mortgaged backed loans) without work (passing of buck of CDOs); irrational investments and financial planning on the part of individuals and organizations; technology facilitated credit history of borrowers being ignored; are only the few manifestations of Gandhian thoughts. A society built on human esteem, dignity and financially disciplined life actually shapes the society concretely on solid values.

The subprime meltdown is also a manifestation of changing world economic order, where the oil prices are rising and dollar is losing its value. The new engines of economic growth (BRIC) are gaining more crucial role in the trade and manufacturing scenario of the world economy. The long term implications of subprime meltdown essentially reveals the fundamental weaknesses in US economy i.e. $ 800bn fiscal deficit and its dependency on third worlds’ savings invested in US gilt edged securities($23 tn). As per the IMF Global Financial and Stability Report the worst effects of this crisis will be visible in 2008 when collateralized debt obligations holders will find the status of their investments.

Considering the integrity of global economy with US economy, this crisis would prove to be a big lesson for Indian banking sector before fully adopting BASEL II norms. Micro financing also seeks a special mention considering its role in addressing the housing requirements of those people who cannot offer any collateral. Regulation of NBFCs and hedge funds is also essential for maintaining financial discipline in the economy. Though, the affected banks are getting bailout packages from their central banks, in order to avoid worsening global liquidity crunch, still, investments of the foreign currency based rapidly growing economies may feel the shudders. In the changing global scenario, value creation at all levels is what going to survive against international shocks and challenges of nation building.

There are also hidden opportunities for India owing to downsizing pressures in US and good returns offered by Indian economy.

Lessons of Subprime Meltdown

Since, subprime refers to a portion of the mortgage business or available mortgage solutions dedicated to borrowers with less than perfect or "tough" credit. These solutions have traditionally come with higher interest rates, and in many cases, prepayment penalties.

A prepayment penalty may be expressed as a percentage of the loan, or specific dollar amount, and typically based on a specific number of months or years for paying off the loan prematurely. Typical prepayment penalties range from six months of interest to two to three percent of the loan amount.

Seeds of the Crisis

1. Predatory lending: It is the practice of a lender deceptively convincing borrowers to agree to unfair and abusive loan terms. This could be done either through outright deception or through aggressive sales tactics, taking advantage of borrowers' lack of understanding of extremely complicated transactions. Predatory loans, as subprime mortgage backed loans, could lead to foreclosure. Even though these loans have been losing value for years, it wasn't until June 2007 that any of this mattered. That's because of what is known in the trade as the "marks," the value of a stock or bond as it’s "marked" by a firm. Many of these mortgage bonds were priced way too high because nobody thought