….
A
Paper on
Submitted by
Ritesh T. [email protected]
9970561723
(MIT School of Management, kothrud, Pune)www.mitpune.com
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The U.S. Sub-prime crisis & its effect on the Indian Stock Market
Aspire’08
Contents:Chapter Page no.
Synopsis
1. Introduction 01
Financial instability
Impact on India
2. Overview of sub-prime mortgage industry 06
Mortgage
Sub-prime Mortgage
Some of the sub-prime mortgages include
3. The current sub-prime mortgage crisis in US 07
4. Bad effects on Financial Institutions of U.S. due to sub-prime
mortgage industry 07
5. Schematics for better understanding sub-prime crisis 08
Fig.2 & Fig.3
6. Factors Which Drive Stock Market 09
7. Can India withstand US economic shock? 10
8. How the US sub-prime crisis does influence the Indian Stock
market?
9. These could be possible solutions 11
10.Conclusion 13
11.Acknowledgement 14
12.Bibliography 15
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The U.S. Sub-prime crisis & its effect on the Indian Stock Market
Aspire’08
Synopsis:The marketing scenario changes and so does the economies of the world. It is
needless to say that even the strongest of strong economies can be vibrant influencing
the global financial structure. The U.S. economy & its measuring unit $ has always
been an influential factor for the emerging economies like India.
The interlinking effect is the residue of the changing trends that ignited way
back in 1981. In 1981, when Fed rate was 20 per cent, some 5.7 per cent US
households had held stocks. When, in the year 2001, Fed rates were 1 per cent, some
52 per cent of the US households became obsessed with Wall Street, a ten-fold
increase in 20 years. When the stocks that the households held appreciated in the
market, they began spending more by borrowing against the unrealized and illusory
stock values. This unrealized asset-based lending and spending yet another topic in
itself, is another reason for spending beyond current income. The appreciation in
house values, like appreciation in stock values, also encouraged the households to
borrow and spend. This has led to the sub-prime crisis in US.
The US dollar is faced with the prospect of losing its pre-eminence as the
dominant reserve asset as it weakens under the weight of its galloping current account
deficit and the spreading contagion of sub-prime woes and with this Dalal Street
replaces Wall Street, more dollars are pouring into the Indian stock market through
FIIs/FIs. But other face of coin has stroked severely on 21/01/08 when Sensex fell by
4000 pts this is because any crisis is not good for Share market.
The RBI along with SEBI will have to take extra care to further tighten
monetary expansion to mitigate the effect of Sub-prime crisis & thereby melting
dollars on turbulence of Indian stock market & ultimately on our economy, for this
purpose RBI can use instruments like issue of dollar/euro bonds.
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The U.S. Sub-prime crisis & its effect on the Indian Stock Market
Aspire’08
Introduction:
Of late, we see many articles related to US sub-prime mortgage crisis in
business magazines, web sites etc. Here through this paper we attempt to discover the
background of this crisis and its effect on Indian stock markets.
The sub-prime mortgage market, which resulted in high credit risk and
counter-party risk in the US, is still facing uncertainties and financial instability — an
offshoot of imprudent policies of US banks and other financial institutions operating
there. In fact, financial markets across the world have been turbulent.
The US institutions — in particular, Freddie Mc, Boston Financial, Northern
Rock, Merrill Lynch and Citi Group — face mortgage losses and massive
accumulation of dead assets due to sub-prime financing of borrowers with poor credit
history and weak documentation of income. Truly speaking, they committed selection
blunders to earn high fees on mortgage deals and sidetracked income recognition
norms.
Financial instability
A large number of borrowers were lured by low interest rates and monthly
income schemes. Banks, in particular, did not observe transparency and concealed
from customers the fact that after two years, interest rates would become variable. As
a result of the interest burden, the repaying capacity of borrowers sank to the level of
bankruptcy and heavy dead assets, swallowing the bank’s financial viability and net
worth.
This viral crept into European Banks too. Since a large number of US banks
and other financial institutions are entering the Asian (especially Chinese and East-
Asian) and West Asian markets to mobilize funds to rescue themselves from
bankruptcy, there is the danger that financial instability may creep into Asia as well.
An unexpected consequence may be a slowdown in the flow of funds from
some of these East-Asian countries to the Indian financial markets. There are
indications that markets in Hong Kong, China, South Korea, New Zealand, and so on
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The U.S. Sub-prime crisis & its effect on the Indian Stock Market
Aspire’08
are already becoming uneasy with stock prices falling. On the international front,
another visible and emerging source of financial instability is the reckless creation of
massive liquidity at lower cost by the Fed to provide cash to the US financial
institutions, which may hasten further depreciation of the dollar and the appreciation
of other currencies, resulting in greater pressure in international trade relations.
Impact on India
This could have a number of side effects, especially on the financial markets
in India. For instance, Indian banks with branches in the US and the UK may lend to
banks affected by the sub-prime debt crisis. This would weaken their balance sheet in
future.
It is interesting to look at branches of foreign banks operating in India. They
accept large deposits from Indian depositors. If they do not get out of the financial
turbulence in their respective domestic markets, their dead assets in foreign markets
may impair their liquidity in India, resulting in the funds of Indian residents being
locked up.
Solutions are many but while selecting we need to be very cautious, since our
primary economy sector i.e. agriculture is not the main contributor behind our recent
economic boom and our booming sector i.e. service is mainly depend upon global
market. So, it is likely the global cues have its effect on our financial market &
ultimately on our economy.
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The U.S. Sub-prime crisis & its effect on the Indian Stock Market
Aspire’08
Overview of sub-prime mortgage industry:Before we understand the crisis, let us first define what is mortgage and sub-
prime mortgage.
Mortgage: In simple terms, it is a “conditional” conveyance of property as security for
the repayment of a loan.
Sub-prime Mortgage:It means offering loans to borrowers who do not qualify for them at market
interest rates due to their deficient or poor credit history. Since this involves risk of
non-payment by the client, it is usually offered at a higher interest rate.
Sub-prime lending may be utilized for sub-prime
mortgages (few home loans), sub-prime car loans, sub-prime
credit cards etc. Sub-prime mortgages totaled $600 billion in
2006, accounting for about one-fifth of the US home loan
(Fig.1) market.
Some of the sub-prime mortgages include:• Interest-only mortgages, which allow borrowers to pay only interest for a
period of time
• “Pick a payment” loans, for which borrowers choose their monthly payment
• Initial fixed rate mortgages that can be converted to variable rates
Potential sub-prime borrowers may comprise of financially troubled people
i.e. those who lost jobs, those with a history of previous debts, those who have had
marital problems or those who had unexpected medical conditions. Sub-prime lenders
take a higher degree of risk; by increasing the interest rates they manage to offset the
risk to an extent.
The current sub-prime mortgage crisis in US:The US real estate industry had a boom between 2001 and 2005 as property
prices reached historic highs on account of low interest rates, price-to-rent ratios and
other factors. When property prices began to fall due to saturation or lack of demand,
the owners had to face mortgage loan, which was higher compared to property value.
The collapse of the US market had a direct impact on housing values, mortgage
industry, real estate companies, hedge funds etc. (A hedge fund is an investment fund
charging a performance fee and typically open to only a limited range of investors;
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The U.S. Sub-prime crisis & its effect on the Indian Stock Market
Aspire’08
unlike mutual funds and pension funds, hedge funds are not usually regulated by
Securities Exchange Commission.)
In late 2006, several US sub-prime mortgage companies had to close down
due to losses. New Century Financial Corporation had to file for bankruptcy. Some
companies were accused for actively encouraging fraudulent income inflation on loan
applications. This led to collapse of stock prices for many companies in sub-prime
mortgage industry, notably for some large lenders like Countrywide Financial and
Washington Mutual.
Bad effects on Financial Institutions of U.S. due to sub-prime mortgage
industry:• Merrill Lynch seized $800 million in assets from two Bear Stearns hedge
funds that were involved in securities backed by sub-prime loans. The two funds are
now reported to be essentially worthless
• American Home Mortgage Investment Corporation filed Chapter 11
bankruptcy
• Mortgage Guaranty Insurance Corporation announced it would discontinue
its purchase of Radian Group after suffering a $ 1 billion loss of its investment in
Credit-Based Asset Servicing and Securitization. C-BASS is seeking to restructure its
financing. The MGIC-Radian transaction would have been a $4.9 billion deal.
• French bank BNP Paribas stopped valuing three of its funds and suspended
all withdrawals by investors after United States sub-prime mortgage woes had caused
"a complete evaporation of liquidity”
• Goldman Sachs' $8 billion Global Alpha hedge fund, its largest, reportedly
lost 26% in 2007
• Citigroup has reported taking $700 million in losses in its credit business
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The U.S. Sub-prime crisis & its effect on the Indian Stock Market
Aspire’08
Schematics for better understanding sub-prime crisis:
(Fig. 2)
(Fig. 3)
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The U.S. Sub-prime crisis & its effect on the Indian Stock Market
Aspire’08
Factors Which Drive Stock Market:1. Three Es i.e. Economy (both global as well as domestic), Earning
& Emotions:When we talk about economy as a factor then it is well known fact that
growth in economy should be at pace to encourage common man to invest
more by creating faith on account of transparent financial system. This is
applicable to both global as well as domestic economy. There should be
overall growth of all three sectors of economy i.e. Primary, Secondary, &
Tertiary.
Second ‘E’ is depending on first ‘E’ as accelerated economy always
reaps more fruits to people.
Third is also on much extent is depend on above two, since healthy
economy brings more wealth to investors which in turns increase one’s
morale.
2. Domestic factors:Domestic political scenario, for building & marinating growth friendly
atmosphere political situations play an important role in that respect. Stable
political scenario always gives boost to economy.
Domestic business scenario, certainly if global business is under peril
then it will affect our stock market, but that effect will be nuance if our
domestic business houses are performing well.
Inflation, here a bit increase in it, reflects on stock. Since under a high
inflation now people need more money to fulfill their basic needs, then to save
& remaining to invest.
3. Natural and artificial calamities:Natural calamities like Tsunami, Flood, Draught, Earthquake has
tremendous impact on stock market. On the same line artificial irregularities
like Wars, Riots, over manipulation in economy leads to catastrophic effect.
4. Supply & Demand:These are the mega driver of share market; whatever happens in the
stock market is mainly due to Matching or Mismatching of demand &
supply.
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The U.S. Sub-prime crisis & its effect on the Indian Stock Market
Aspire’08
Can India withstand US economic shock?The fundamentals of Indian economy are sound. As of now, we are convinced
that notwithstanding what is happening elsewhere in the world, we can sustain the
growth momentum of the country at 9-9.5 percent per annum. India will do
everything possible to not only lift economic growth but also keep inflation low.
Please remember that the other side of the economy is just as important to a
developing country. Inflation must be kept low. Between inflation and growth what
hurts the poor most is inflation. Therefore India must keep inflation low and aim for a
reasonably high rate of growth. Since the world was becoming increasingly
interdependent, an international financial crisis could impact on the growth of
emerging countries, including India.
As far as the Indian economy is concerned, we are not affected in the sense
our banks don't have lending of that sort, which has led to the crisis, which had cause
the turmoil in the US due to indiscriminate lending. The country might be affected by
the current global crisis if it spread to the European market and led to a decline in
India's exports. But if there's a slowdown not only in the US but also in Europe and
other parts of the world, it will affect our exports; India would be affected less than
China, since 'As long as we can ensure that investment is buoyant and consumption
rises steadily we can moderate the impact of a US slowdown.'
How the US sub-prime crisis does influence the Indian Stockmarket?
In theory, it shouldn't really affect the Indian market much at all. Unless a lot
of Indian companies have invested in some of the US SIVs that have lot of that sub-
prime debt in them, financially they should be just fine. But as I mentioned
“Theoretically”, let’s analyze practical case of recent fall down of Indian stock market
where BSE fell by 1408.35 on Monday and then further on Tuesday same happen
with S&P CNX NIFTY it fell from 6287.85 on 8/01/08 to 5208.80 on 21/01/08 in line
with global cues.ffffffffffffffffffff
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The U.S. Sub-prime crisis & its effect on the Indian Stock Market
Aspire’08
Some Reasons:
First, several foreign institutional investors (FIIs) are reeling under the impact
of non-performing or bad loans originating in the US sub-prime market. It is likely to
slowdown, or even reverses, the flow of foreign direct investments in the Indian
economy. This, as you know, will affect the long-term growth prospects of our
economy.
Second, several aspects in the Indian housing sector resemble the
fundamentals of the US sub-prime mortgage crisis. Property prices here have grown
tremendously; borrowing and lending rates have seen gradual increases; banks and
other lending institutions have recorded an increase in their non-performing assets.
Third, due to the huge losses in banking business in U.S., many giant banks
facing problem of heavy dead asset & ultimately less liquidity, So now to rescue
themselves from bankruptcy they are entering in to the Asian markets to mobilize
funds. Because of this unexpected entrance by U.S. banks, flow of funds from Asian
market going to west & there is slowdown of funds flowing to India from this East
Asian market.
Fourth, many foreign banks have converted their risky mortgage loan in to
Wall street investment and many Indian financial institutions have invested there in
huge amount, So certainly whatever happen at Wall street it will affect Dallal street.
Fifth, crude oil prices are continuously increasing which in turn require more
dollar to buy it create a more demand for dollar & thus many FIIs are withdrawing
their funds from stock market.
Sixth, due to the appreciation in rupee our export business’ balance sheet was
heated worst & hence lost their stock value.
Seven, recession in the U.S. will mean less imports by it from Asian
manufacturers like China & India thus loosing business & ultimately loosing stock
value.
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The U.S. Sub-prime crisis & its effect on the Indian Stock Market
Aspire’08
These could be possible solutions:1. SEBI along with RBI must take some concrete decision like P-
NOTES, so that investments through FFIs, FI, & foreign VCFs, will
have a minimum lock in period of one year, if the investment occurs
during preceding 12 months before the IPO date.
2. We should more focus on our primary & secondary economic sector
rather than tertiary as tertiary sector mainly depend on foreign markets
for business, so in this case it is not possible to preclude from global
volatility. And we can do this as here in India we have sufficient
consumer to accelerate our economy.
3. As of now we don’t have upper & lower circuit for derivative market
products i.e. Futures & Options, and this was the main reason for huge
fall down on 21st January. So SEBI should ponder in this regard.
4. RBI need to continuously monitor the currency situation, though RBI
presently have instruments like CRR, Liquidity Adjustment Facility
(LAF) & Market Stabilization System (MSS), the RBI will have to
discover additional instruments such as issue of dollar/euro bond to
mop up foreign ex-change inflows & control monetary expansion.
5. Decoupling, if possible since it would be then an ideal situation. But to
my view point it is possible in today’s era where we have accepted
liberalization & we have open our current account.
6. There could be also some measures which international regulator like
International Monetary Fund (IMF) & World Bank could practice i.e.
SDRs (Special Drawing Rights)
7. As an investor, we need not to be very panic. Before undergoing any
trade buying /selling think have I checked all fundamentals related to
particular scrip or am I doing since my neighbor is undergoing through
same trade. Because FIIs are big bulls they will not get affected if any
thing happens in the Indian market it is we Indian going to suffer.
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The U.S. Sub-prime crisis & its effect on the Indian Stock Market
Aspire’08
Conclusion:It may be noted that the stock market is still flush with liquidity and money
has not moved out of country. FIIs that entered the market to unload their position for
profit making will not do so now because foreign markets are not safe.
Moreover, there cannot be a stock market driven policy, but regular
intervention are necessary by regulatory bodies like SEBI & RBI. Money supply &
interested rate have to be determined by real variables such as economic growth and
their respective requirement for credit, and the inflation rate. In fact, growth in market
capitalization should be compared to investment growth in terms of production does
not happen; we should take a serious look at market capitalization. Market is still
bullish on the banking, power, media, and metals ferrous and mining sector and also
on the undervalued pharmaceutical sector.
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The U.S. Sub-prime crisis & its effect on the Indian Stock Market
Aspire’08
Acknowledgement:At the outset we acknowledge with our gratitude the guidance and direction
given to ous by Ms. Haridas, faculty of Economics MITSOM, PUNE to make our
paper so comprehensive and successful.
We are extremely grateful to Ms. Anjali Vamburkar for giving us a valuable
and comprehensive guidance, which make competent to digest difficult financial
jargon.
We consider ourselves very fortunate for having been selected by a very
reputed management institute to present ourselves in front of dignitaries & giving us
an opportunity to become more competent.
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The U.S. Sub-prime crisis & its effect on the Indian Stock Market
Aspire’08
Bibliography:1. Calvo Guillermo, November 12, 2007, FINANCIAL CRISES Lessons and
Prospects, Columbia University Journal, pp 225-265
2. Favaro Edgardo and Lahiri Ashok K., Book Fiscal Policies and sustainable
Growth in India, chapter no.4th, First edition Oxford Uni.press, pp 75-100
3. Giglitz Joseph E., September 2007, The Changing Global Economic
Landscape: Opportunities and Risks, Graz journal, pp 123-235
4. Khan M.Y. 28th January 2008, Turbulence in financial markets and the way
ahead, The Business Line, page no. 10
5. S. Gurumurthy, 21 december 2008, The $3.8 trillion pro-notes depreciating by
the hour, The Business Line, page no. 9
6. S. Venkitaramanan, 7th January 2008, Dollar decline and solutions, The
Business Line, page no. 10
7. V.Kandaswamy, 28th January 2008, Markets the day after, Capital Market
magazine, January-February issue, page no. 8
8. www.thehindubusinessline.com
9. www.wikipedia.com
10. www.thecapitalmarket.com
11. www.theeconomist.com
12. www.sebi.gov.in
13. www.rbi.org.in
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