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EFFECT OF SUBPRIME

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					                         EFFECT OF SUBPRIME


               Subprime Introduction
      Subprime lending (near-prime, non-prime, or second chance lending) is a
financial term that was popularized by the media during the "credit crunch" of
2007 and involves financial institutions providing credit to borrowers who do
not meet prime underwriting guidelines. Subprime borrowers have a
heightened perceived risk of default, such as those who have a history of loan
delinquency or default, those with a recorded bankruptcy, or those with
limited debt experience.

      Although there is no standardized definition, in the US subprime loans
are usually classified as those where the borrower has a FICO score below 680.
Subprime lending encompasses a variety of credit types, including mortgages,
auto loans, and credit cards.

      Subprime could also refer to a security for which a return above the
"prime" rate is adhered, also known as C-paper. The term subprime often
correlates with non-conforming loans, or those that do not meet Fannie Mae
or Freddie Mac guidelines. Those guidelines may be the size of the loan, a high
debt-to-income ratio or lack of income documentation provided.

       The Wall Street Journal reported in 2006 that 61 percent of all
borrowers receiving subprime loans had credit scores high enough to qualify
for prime conventional loans.

       Proponents of subprime lending maintain that the practice extends
credit to people who would otherwise not have access to the credit market




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                          EFFECT OF SUBPRIME

Background
       Subprime lending evolved with the realization of a demand in the
marketplace for loans to high-risk borrowers with imperfect credit. The first
subprime was initiated in 1993. Many companies entered the market when the
prime interest rate was low, and real interest became negative allowing
modest subprime rates to flourish; negative interest rates are hand-outs, the
more you borrow the more you earn.[citation needed] Others entered with the
relaxation of usury laws. Traditional lenders were more cautious and
historically turned away potential borrowers with impaired or limited credit
histories. Statistically, approximately 25% of the population of the United
States falls into this category. Citation needed] In 1998, the Federal Trade
Commission estimated that 10% of new-car financing in the U.S. was provided
by subprime loans, and that $125 billion of $859 billion total mortgage dollars
were subprime.

      In the third quarter of 2007, subprime ARMs only represented 6.8% of
the mortgages outstanding in the US, yet they represented 43.0% of the
foreclosures started. Subprime fixed mortgages represented 6.3% of
outstanding loans and 12.0% of the foreclosures started in the same period.


Subprime lenders
       To access this increasing market, lenders often take on risks associated
with lending to people with poor credit ratings or limited credit histories. For
example, they would lend money to consumers that have bad credit. The FICO
score indicates to the lender the rate of default. Those with credit scores
below 620 have a much higher default rate than those with credit score above
720. However, if a borrower has sufficient income then he or she may qualify
for a subprime mortgage product. Subprime loans are considered to carry a far
greater risk for the lender due to the aforementioned credit risk characteristics
of the typical subprime borrower. Lenders use a variety of methods to offset
these risks. In the case of many subprime loans, this risk is offset with a higher
interest rate. In the case of subprime credit cards, a subprime customer may
be charged higher late fees, higher over-the-limit fees, yearly fees, or up-front
fees for the card. Late fees are charged to the account, which may drive the
customer over their credit limit, resulting in over-the-limit fees. These higher

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fees compensate the lender for the increased costs associated with servicing
and collecting such accounts, as well as for the higher default rate.


Borrower profiles
       Subprime loans can offer an opportunity for borrowers with a less-than-
ideal credit record to become a home owner. Borrowers may use this credit to
purchase homes, or in the case of a cash-out refinance, finance other forms of
spending such as purchasing a car, paying for living expenses, remodeling a
home, or even paying down on a high-interest credit card. However, due to the
risk profile of the subprime borrower, this access to credit comes at the price
of higher interest rates, increased fees and other increased costs. Subprime
lending (and mortgages in particular) provides a method of "credit repair"; if
borrowers maintain a good payment record, they should be able to refinance
into mainstream rates after two to three years. In the United Kingdom, most
subprime mortgages have a two or three-year tie-in, and borrowers may face
additional charges for replacing their mortgages before the tie-in has expired.

Generally, the credit profile keeping a borrower out of a prime loan may
include one or more of the following:

Two or more loan payments paid past 30 days due in the last 12 months, or
one or more loan payments paid past 90 days due the last 36 months;

Judgment, foreclosure, repossession, or non-payment of a loan in the past;

Bankruptcy in the last 5 years;

Relatively high default probability as evidenced by the credit score.

Accuracy of the credit line data obtained by the underwriter.




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                          EFFECT OF SUBPRIME

Private label credit
        In the USA, this group of credit companies includes major banks such as
Wells Fargo, CitiBank, GE Credit, Household Finance, and more. While it is not
certain what percentage of subprime lending involves the private label
branding of the retail chains (i.e. The Gap, Victoria's Secret, Old Navy, and most
furniture and appliance retailers), most national retail chains use some form of
subprime lending as a marketing strategy. Deferred interest programming may
result in high default rates that must be offset by aggressive lending practices.
It is common for a $200,000,000 furniture retailer to have 50% of their long-
term business be derived from the direct result of private label credit
promotions.


Origination, securitization and servicing
      Some subprime originators (mortgage companies or brokers) formerly
promoted residential loans with features that could trap low income
borrowers into loans with increasing yield terms that eventually exceed
borrower’s capability to make the payments. Most of these loans were
originated for the purpose of selling them into securitization conduits, which
are special purpose entities (REMICs) that issue Residential Mortgage Backed
Securities (RMBS), bonds, securities and other investment vehicles for resale to
pension funds and other fixed income investors. The same process takes place
for some commercial mortgages (CMBS).

       Some of these mortgage originators are owned or controlled by major
financial institutions which provide a "Warehouse" line for their lending. For
example, First Franklin was owned by Merrill Lynch and WMC was owned by
GE. These financial institutions then remain in control of these loans as
"Trustee", "Servicers" and "Controlling Class" of the REMIC trusts in hopes of
deriving significant fees and other income from management of Taxes,
Insurance and Repair Reserve Funds required by the terms of these mortgages.

      In most cases, should these loans default, the servicing is passed to
"Special Servicers" who derive "Workout", "Foreclosures" and Real estate
owned (REO) management fees. The Special Servicers are directed by
"Directing Class" or "Controlling Class" which comprise of majority holders of


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the lowest class of REMIC Trust securities also referred to as "First Loss" or "B-
Piece" holders.

       The shortfall of loan repayment is usually repaid as a result of
"Repurchase Demand" by Special Servicer on GSE or loan seller to REMIC Trust
also called "Loan Depositor." The purchased collateral at auctions by Special
Servicers is referred to as REO properties which then can be marketed and sold
for market value. Special Servicers usually keep the "Upside" or difference
between auction price and market sale of the collateral. These foreclosure fees
and REO income form a major incentive for Servicers to purchase the
"Servicing Rights" of the REMIC trusts from Trustees who, depending on the
terms of the Pooling and Servicing Agreement (PSA), have the authority to
replace Servicers. It is not uncommon for a predatory Servicer to pay millions
of dollars to procure the "Servicing Rights" of the REMIC trusts in hopes of
successful foreclosures and equity stripping from Borrowers, Guarantors, Loan
Sellers and Investor.

       REMIC Trusts are "Passive" or "Pass-Through" Entities under the IRS
code and are not taxed at trust level. However, the bond-holders are expected
to be taxpaying entities and are taxed on interest income distributed by the
REMIC trusts. REMIC trusts are forbidden from any other business activities
and are taxed 100% on any other income they may generate which is referred
to as "Prohibited Income" under IRC 860 Code.




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                          EFFECT OF SUBPRIME

Types
Subprime mortgages
       Like other subprime loans, subprime mortgages are defined by the
financial and credit profile of the consumers to which they are marketed.
According to the U.S. Department of Treasury guidelines issued in 2001,
"Subprime borrowers typically have weakened credit histories that include
payment delinquencies and possibly more severe problems such as charge-
offs, judgments, and bankruptcies. They may also display reduced repayment
capacity as measured by credit scores, debt-to-income ratios, or other criteria
that may encompass borrowers with incomplete credit histories."

       Unlike other nations, the US Tax Code allows 100% tax deductibility of all
interest payments and part of principal payments on loans for housing. This
means a tax break of 30% to 50%, not only of the real interest but also of the
inflation part of nominal interest rates. This tax break is what fuelled second
and third mortgages, used to buy cars and other consumer goods. Interest
rates on car purchases are not deductible, but second mortgages are. This tax
give away is what makes America become the most personally indebted nation
in the world. Countries like Brazil that do not use nominal interest rates in
housing loans, and do not give such tax breaks do not have a prime or a sub-
prime housing problem.

       Subprime mortgage loans are riskier loans in that they are made to
borrowers unable to qualify under traditional, more stringent criteria due to a
limited or blemished credit history. Subprime borrowers are generally defined
as individuals with limited income or having FICO credit scores below 620 on a
scale that ranges from 300 to 850. Subprime mortgage loans have a much
higher rate of default than prime mortgage loans and are priced based on the
risk assumed by the lender.

       Although most home loans do not fall into this category, subprime
mortgages proliferated in the early part of the 21st Century. About 21 percent
of all mortgage originations from 2004 through 2006 were subprime, up from 9
percent from 1996 through 2004, says John Lon ski, chief economist for

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                          EFFECT OF SUBPRIME

Moody's Investors Service. Subprime mortgages totaled $600 billion in 2006,
accounting for about one-fifth of the U.S. home loan market citation needed]

      As with other types of mortgage, various special loan features are
available with subprime mortgages, including:

Interest-only payments, which allow borrowers to pay only interest for a
period of time (typically 5–10 years);

"Pay option" loans, usually with adjustable rates, for which borrowers choose
their monthly payment (full payment, interest only, or a minimum payment
which may be lower than the payment required to reduce the balance of the
loan);

And so-called "hybrid" mortgages with initial fixed rates that sooner or later
convert to adjustable rates.

      This last class of mortgages has grown particularly popular among
subprime lenders since the 1990s. Common subprime hybrids include the "2-
28 loan", which offers a low initial interest rate that stays fixed for two years
after which the loan resets to a higher adjustable rate for the remaining life of
the loan, in this case 28 years. The new interest rate is typically set at some
margin over an index, for example, 5% over a 12-month LIBOR. Variations on
the "2-28" include the "3-27" and the "5-25".


Subprime credit cards
       Credit card companies in the United States began offering subprime
credit cards to borrowers with low credit scores and a history of defaults or
bankruptcy in the 1990s when usury laws were relaxed. These cards usually
begin with low credit limits and usually carry extremely high fees and interest
rates as high as 30% or more. In 2002, as economic growth in the United States
slowed, the default rates for subprime credit card holders increased
dramatically, and many subprime credit card issuers were forced to scale back
or cease operations.

      In 2007, many new subprime credit cards began to sprout forth in the
market. As more vendors emerged, the market became more competitive,
forcing issuers to make the cards more attractive to consumers. Interest rates
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on subprime cards now start at 9.9% but in some cases still range up to 24%
APR.

       In some situations, subprime credit cards may help a consumer improve
poor credit scores. Most subprime cards report to major credit reporting
agencies such as Transition and Equifax, but in the case of "secured" cards,
credit scoring often reflects the nature of the card being reported and may or
may not consider it. Issuers of these cards claim that consumers who pay their
bills on time should see positive reporting to these agencies within 90 days.


Proponents
       Individuals who have experienced severe financial problems are usually
labeled as higher risk and therefore have greater difficulty obtaining credit,
especially for large purchases such as automobiles or real estate. These
individuals may have had job loss, previous debt or marital problems, or
unexpected medical issues, usually unforeseen and causing major financial
setbacks. As a result, late payments, charge-offs, repossessions and even
bankruptcy or foreclosures may result.

       Due to these previous credit problems, these individuals may also be
precluded from obtaining any type of conventional loan. To meet this demand,
lenders have seen that a tiered pricing arrangement, one which allows these
individuals to receive loans but pay a higher interest rate and higher fees, may
allow loans which otherwise would not occur. In 1999, under pressure from
the Clinton administration, Fannie Mae, the nation's largest home mortgage
underwriter, relaxed credit requirements on the loans it would purchase from
other banks and lenders, hoping that easing these restrictions would result in
increased loan availability for minority and low-income buyers. Putting
pressure on the GSE's (Government Sponsored Enterprise) Fannie Mae and
Freddie Mac, the Clinton administration looked to increase their sub-prime
portfolios, including the Department of Housing and Urban Development
expressing its interest in the GSE's maintaining a 50% portion of their portfolios
in loans to low and moderate-income borrowers.

      From a servicing standpoint, these loans have a statistically higher rate
of default and are more likely to experience repossessions and charge offs.

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                          EFFECT OF SUBPRIME

Lenders use the higher interest rate and fees to offset these anticipated higher
costs.

       Provided that a consumer enters into this arrangement with the
understanding that they are higher risk, and must make diligent efforts to pay,
these loans do indeed serve those who would otherwise be underserved.
Continuing the example of an auto loan, the consumer must purchase an
automobile which is well within their means, and carries a payment well within
their budgets


Criticism
       Capital markets operate on the basic premise of risk versus reward.
Investors taking a risk on stocks expect a higher rate of return than do
investors in risk-free Treasury bills, Guaranteed Investment Certificates, etc.
which are backed by the full faith and credit of the issuing country or
institution. The same goes for loans. Allegedly less creditworthy subprime
borrowers represent a riskier investment, so lenders will charge them a higher
interest rate than they would charge a prime borrower for the same loan.

       To avoid high initial mortgage payments, many subprime borrowers took
out adjustable-rate mortgages (or ARMs) that give them a lower initial interest
rate. But with potential annual adjustments of 2% or more per year, these
loans can end up costing much more. So a $500,000 loan at a 4% interest rate
for 30 years equates to a payment of about $2,400 a month. But the same loan
at 10% for 27 years (after the adjustable period ends) equates to a payment of
$4,220. A 6-percentage-point increase in the rate caused slightly more than a
75% increase in the payment. This is even more apparent when the lifetime
cost of the loan is considered (though most people will want to refinance their
loans periodically). The total cost of the above loan at 4% is $864,000, while
the higher rate of 10% would incur a lifetime cost of $1,367,280.

      On the other hand, interest rates on ARMs can also go down - in the US,
some interest rates are tied to federal government-controlled interest rates, so
when the Fed cuts rates, ARM rates go down, too. Most subprime ARM loans
are tied to LIBOR (London Interbank Offered Rate - a rate trading system
originating in Britain). ARM interest rates usually adjust once a year or per

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quarter, and the rate is based on a calculation specified in the loan documents.
Also, most ARMs limit the amount of change in a rate.


Mortgage discrimination
       Some subprime lending practices have raised concerns about mortgage
discrimination on the basis of race. The NAACP filed a lawsuit in federal court
in Los Angeles against 12 mortgage lenders. The lawsuit accuses the companies
of steering black borrowers into subprime loans. Black and other minorities
disproportionately fall into the category of "subprime borrowers", even when
median income levels were comparable, home buyers in minority
neighborhoods were more likely to get a loan from a subprime lender. Interest
rates and the availability of credit are often tied to credit scores, and the
results of a 2004 Texas Department of Insurance study found that of the 2
million Texans surveyed, "black policyholders had average credit scores that
were 10% to 35% worse than those of white policyholders. Hispanics' average
scores were 5% to 25% worse, while Asians' scores were roughly the same as
whites.




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                          EFFECT OF SUBPRIME

Subprime mortgage crisis
      The subprime mortgage crisis is an ongoing financial crisis triggered by a
dramatic rise in mortgage delinquencies and foreclosures in the United States,
with major adverse consequences for banks and financial markets around the
globe. The crisis, which has its roots in the closing years of the 20th century,
became apparent in 2007 and has exposed pervasive weaknesses in financial
industry regulation and the global financial system.

      Many USA mortgages issued in recent years were made to subprime
borrowers, defined as those with lesser ability to repay the loan based on
various criteria. When USA house prices began to decline in 2006-07, mortgage
delinquencies soared, and securities backed with subprime mortgages, widely
held by financial firms, lost most of their value. The result has been a large
decline in the capital of many banks and USA government sponsored
enterprises, tightening credit around the world.


Background
       The crisis began with the bursting of the United States housing bubble
and high default rates on "subprime" and adjustable rate mortgages (ARM),
beginning in approximately 2005–2006. Government policies and competitive
pressures for several years prior to the crisis encouraged higher risk lending
practices. Further, an increase in loan incentives such as easy initial terms and
a long-term trend of rising housing prices had encouraged borrowers to
assume difficult mortgages in the belief they would be able to quickly
refinance at more favorable terms. However, once interest rates began to rise
and housing prices started to drop moderately in 2006–2007 in many parts of
the U.S., refinancing became more difficult. Defaults and foreclosure activity
increased dramatically as easy initial terms expired, home prices failed to go up
as anticipated, and ARM interest rates reset higher. Foreclosures accelerated
in the United States in late 2006 and triggered a global financial crisis through
2007 and 2008. During 2007, nearly 1.3 million U.S. housing properties were
subject to foreclosure activity, up 79% from 2006.



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       Financial products called mortgage-backed securities (MBS), which
derive their value from mortgage payments and housing prices, had enabled
financial institutions and investors around the world to invest in the U.S.
housing market. Major Banks and financial institutions had borrowed and
invested heavily in MBS and reported losses of approximately US$435 billion as
of 17 July 2008. The liquidity and solvency concerns regarding key financial
institutions drove central banks to take action to provide funds to banks to
encourage lending to worthy borrowers and to restore faith in the commercial
paper markets, which are integral to funding business operations.
Governments also bailed out key financial institutions, assuming significant
additional financial commitments.

      The risks to the broader economy created by the housing market
downturn and subsequent financial market crisis were primary factors in
several decisions by central banks around the world to cut interest rates and

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                           EFFECT OF SUBPRIME

governments to implement economic stimulus packages. These actions were
designed to stimulate economic growth and inspire confidence in the financial
markets. Effects on global stock markets due to the crisis have been dramatic.
Between 1 January and 11 October 2008, owners of stocks in U.S. corporations
had suffered about $8 trillion in losses, as their holdings declined in value from
$20 trillion to $12 trillion. Losses in other countries have averaged about 40%.
Losses in the stock markets and housing value declines place further
downward pressure on consumer spending, a key economic engine. Leaders of
the larger developed and emerging nations met in November 2008 to
formulate         strategies          for       addressing        the        crisis.




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                       EFFECT OF SUBPRIME



Mortgage market
      Subprime lending is the practice of lending, mainly in the form
of mortgages for the purchase of residences, to borrowers who do
not meet the usual criteria for borrowing at the lowest prevailing
market interest rate. These criteria pertain to the borrower's credit
score, credit history and other factors. If a borrower is delinquent in
making timely mortgage payments to the loan servicer (a bank or
other financial firm), the lender can take possession of the residence
acquired using the proceeds from the mortgage, in a process called
foreclosure.

       The value of USA subprime mortgages was estimated at $1.3
trillion as of March 2007, with over 7.5 million first-lien subprime
mortgages outstanding. Between 2004-2006 the share of subprime
mortgages relative to total originations ranged from 18%-21%,
versus less than 10% in 2001-2003 and during 2007. In the third
quarter of 2007, subprime ARMs making up only 6.8% of USA
mortgages outstanding also accounted for 43% of the foreclosures
which began during that quarter. By October 2007, approximately
16% of subprime adjustable rate mortgages (ARM) were either 90-
days delinquent or the lender had begun foreclosure proceedings,
roughly triple the rate of 2005. By January 2008, the delinquency
rate had risen to 21%. And by May 2008 it was 25%.

      The value of all outstanding residential mortgages, owed by
USA households to purchase residences housing at most four
families, was US$9.9 trillion as of year-end 2006, and US$10.6 trillion
as of midyear 2008. During 2007, lenders had begun foreclosure
proceedings on nearly 1.3 million properties, a 79% increase over
2006. This increased to 2.3 million in 2008, an 81% increase vs. 2007.

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                          EFFECT OF SUBPRIME

As of August 2008, 9.2% of all mortgages outstanding were either
delinquent or in foreclosure. Between August 2007 and October
2008,       936,439        USA       residences       completed
foreclosure




Credit risk
       Credit risk arises because a borrower has the option of defaulting on the
loan he/she owes. Traditionally, lenders (who were primarily thrifts) bore the
credit risk on the mortgages they issued. Over the past 60 years, a variety of
financial innovations have gradually made it possible for lenders to sell the
right to receive the payments on the mortgages they issue, through a process
called securitization. The resulting securities are called mortgage backed
securities (MBS) and collateralized debt obligations (CDO). Most American
mortgages are now held by mortgage pools, the generic term for MBS and
CDOs. Of the $10.6 trillion of USA residential mortgages outstanding as of
midyear 2008, $6.6 trillion were held by mortgage pools and $3.4 trillion by
traditional depository institutions.

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                         EFFECT OF SUBPRIME

This "originate to distribute" model means that investors holding MBS and
CDOs also bear several types of risks, and this has a variety of consequences.
There are four primary types of risk:




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                          EFFECT OF SUBPRIME

Name                                      Description
Credit Risk     the risk that the homeowner or borrower will be unable or
                unwilling to pay back the loan
Asset price the risk that assets (MBS in this case) will depreciate in value,
risk            resulting in financial losses, markdowns and possibly margin
                calls
Liquidity risk the risk that a business entity will be unable to obtain financing,
                such as from the commercial paper market
Counterparty The risk that a party to a contract will be unable or unwilling to
risk            uphold their obligations.
                The aggregate effect of these and other risks has recently been
                called systemic risk, which refers to when formerly
                uncorrelated risks shift and become highly correlated,
                damaging the entire financial system
       When homeowners default, the payments received by MBS and CDO
investors decline and the perceived credit risk rises. This has had a significant
adverse effect on investors and the entire mortgage industry. The effect is
magnified by the high debt levels (financial leverage) households and
businesses have incurred in recent years. Finally, the risks associated with
American mortgage lending have global impacts, because a major
consequence of MBS and CDOs is a closer integration of the USA housing and
mortgage markets with global financial markets.

      Investors in MBS and CDOs can insure against credit risk by buying credit
defaults swaps (CDS). As mortgage defaults rose, the likelihood that the issuers
of CDS would have to pay their counterparties increased. This created
uncertainty across the system, as investors wondered if CDS issuers would
honor their commitment


Causes
       He reasons proposed for this crisis is varied and complex. The crisis can
be attributed to a number of factors pervasive in both housing and credit
markets, factors which emerged over a number of years. Causes proposed
include the inability of homeowners to make their mortgage payments, poor
judgment by borrowers and/or lenders, speculation and overbuilding during
the boom period, risky mortgage products, high personal and corporate debt
levels, financial products that distributed and perhaps concealed the risk of

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                          EFFECT OF SUBPRIME

mortgage default, monetary policy, international trade imbalances, and
government regulation (or the lack thereof).Ultimately, though, moral hazard
lay at the core of many of the causes

      In its "Declaration of the Summit on Financial Markets and the World
Economy," dated 15 November 2008, leaders of the Group of 20 cited the
following causes

       During a period of strong global growth, growing capital flows, and
prolonged stability earlier this decade, market participants sought higher yields
without an adequate appreciation of the risks and failed to exercise proper due
diligence. At the same time, weak underwriting standards, unsound risk
management practices, increasingly complex and opaque financial products,
and consequent excessive leverage combined to create vulnerabilities in the
system. Policy-makers, regulators and supervisors, in some advanced
countries, did not adequately appreciate and address the risks building up in
financial markets, keep pace with financial innovation, or take into account the
systemic ramifications of domestic regulatory actions.


Boom and bust in the housing market
       Low interest rates and large inflows of foreign funds created easy credit
conditions for a number of years prior to the crisis, fueling a housing market
boom and encouraging debt-financed consumption. The USA home ownership
rate increased from 64% in 1994 (about where it had been since 1980) to an
all-time high of 69.2% in 2004. Subprime lending was a major contributor to
this increase in home ownership rates and in the overall demand for housing,
which drove prices higher.

       Between 1997 and 2006, the price of the typical American house
increased by 124%. During the two decades ending in 2001, the national
median home price ranged from 2.9 to 3.1 times median household income.
This ratio rose to 4.0 in 2004 and 4.6 in 2006. This housing bubble resulted in
quite a few homeowners refinancing their homes at lower interest rates, or
financing consumer spending by taking out second mortgages secured by the
price appreciation. USA household debt as a percentage of annual disposable
personal income was 127% at the end of 2007, versus 77% in 1990

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                          EFFECT OF SUBPRIME




      While housing prices were increasing, consumers were saving less and
both borrowing and spending more. A culture of consumerism is a factor "in an
economy based on immediate gratification." Starting in 2005, American
households have spent more than 99.5% of their disposable personal income
on consumption or interest payments. If imputations mostly pertaining to
owner-occupied housing are removed from these calculations, American
households have spent more than their disposable personal income in every
year starting in 1999. Household debt grew from $705 billion at year-end 1974,
60% of disposable personal income, to $7.4 trillion at yearend 2000, and finally
to $14.5 trillion in midyear 2008, 134% of disposable personal income. During
2008, the typical USA household owned 13 credit cards, with 40% of
households carrying a balance, up from 6% in 1970




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                          EFFECT OF SUBPRIME




       This credit and house price explosion led to a building boom and
eventually to a surplus of unsold homes, which caused U.S. housing prices to
peak and begin declining in mid-2006. Easy credit, and a belief that house
prices would continue to appreciate, had encouraged many subprime
borrowers to obtain adjustable-rate mortgages. These mortgages enticed
borrowers with a below market interest rate for some predetermined period,
followed by market interest rates for the remainder of the mortgage's term.
Borrowers who could not make the higher payments once the initial grace
period ended would try to refinance their mortgages. Refinancing became
more difficult, once house prices began to decline in many parts of the USA.
Borrowers who found themselves unable to escape higher monthly payments
by refinancing began to default.

       As more borrowers stop paying their mortgage payments, foreclosures
and the supply of homes for sale increase. This places downward pressure on
housing prices, which further lowers homeowners' equity. The decline in
mortgage payments also reduces the value of mortgage-backed securities,
which erodes the net worth and financial health of banks. This vicious cycle is
at the heart of the crisis.


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                       EFFECT OF SUBPRIME




      By September 2008, average U.S. housing prices had declined by over
20% from their mid-2006 peak. This major and unexpected decline in house
prices means that many borrowers have zero or negative equity in their

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                          EFFECT OF SUBPRIME

homes, meaning their homes were worth less than their mortgages. As of
March 2008, an estimated 8.8 million borrowers — 10.8% of all homeowners
— had negative equity in their homes, a number that is believed to have risen
to 12 million by November 2008. Borrowers in this situation have an incentive
to "walk away" from their mortgages and abandon their homes, even though
doing so will damage their credit rating for a number of years.

       Increasing foreclosure rates increases the inventory of houses offered
for sale. The number of new homes sold in 2007 was 26.4% less than in the
preceding year. By January 2008, the inventory of unsold new homes was 9.8
times the December 2007 sales volume, the highest value of this ratio since
1981. Furthermore, nearly four million existing homes were for sale, of which
almost 2.9 million were vacant. This overhang of unsold homes lowered house
prices. As prices declined, more homeowners were at risk of default or
foreclosure. House prices are expected to continue declining until this
inventory of unsold homes (an instance of excess supply) declines to normal
levels. [Citation needed]

       Economist Muriel Routine wrote in January 2009 that subprime
mortgage defaults triggered the broader global credit crisis, but were just one
symptom of multiple debt bubble collapses: "This crisis is not merely the result
of the U.S. housing bubble’s bursting or the collapse of the United States’
subprime mortgage sector. The credit excesses that created this disaster were
global. There were many bubbles, and they extended beyond housing in many
countries to commercial real estate mortgages and loans, to credit cards, auto
loans, and student loans. There were bubbles for the securitized products that
converted these loans and mortgages into complex, toxic, and destructive
financial instruments. And there were still more bubbles for local government
borrowing, leveraged buyouts, hedge funds, commercial and industrial loans,
corporate bonds, commodities, and credit-default swaps..." It is the bursting of
the many bubbles that he believes are causing this crisis to spread globally and
magnify its impact




    22
                          EFFECT OF SUBPRIME

Speculation
       Speculation in residential real estate has been a contributing factor.
During 2006, 22% of homes purchased (1.65 million units) were for investment
purposes, with an additional 14% (1.07 million units) purchased as vacation
homes. During 2005, these figures were 28% and 12%, respectively. In other
words, a record level of nearly 40% of homes purchases were not intended as
primary residences. David Leech, NAR's chief economist at the time, stated
that the 2006 decline in investment buying was expected: "Speculators left the
market in 2006, which caused investment sales to fall much faster than the
primary market.

       Housing prices nearly doubled between 2000 and 2006, a vastly
different trend from the historical appreciation at roughly the rate of inflation.
While homes had not traditionally been treated as investments subject to
speculation, this behavior changed during the housing boom. For example, one
company estimated that as many as 85% of condominium properties
purchased in Miami were for investment purposes. Media widely reported
condominiums being purchased while under construction, then being "flipped"
(sold) for a profit without the seller ever having lived in them. Some mortgage
companies identified risks inherent in this activity as early as 2005, after
identifying investors assuming highly leveraged positions in multiple
properties.

       Nicole Galina’s of the Manhattan Institute described the consequences
of failing to respond to the shifting treatment of a home from conservative
inflation hedge to speculative investment. For example, individuals investing in
equities have margin (borrowing) restrictions and receive warnings regarding
the risk to principal; there are no such requirements for home buyers. While
stock brokers are prohibited from telling an investor that a stock or bond
investment cannot lose money, it was not illegal for mortgage brokers to do so.
Equity investors are well-aware of the need to diversify their financial holdings,
but for many homeowners the home represented both a leveraged and
concentrated risk. Further, in the U.S. capital gains on stocks are taxed more
aggressively than housing appreciation, which has large exemptions. These
factors all enabled speculative behavior.


    23
                          EFFECT OF SUBPRIME

      Economist Robert Sheller argues that speculative bubbles are fueled by
"contagious optimism, seemingly impervious to facts, that often takes hold
when prices are rising. Bubbles are primarily social phenomena; until we
understand and address the psychology that fuels them, they're going to keep
forming." Keynesian economist Hyman Minsk described three types of
speculative borrowing that contribute to rising debt and an eventual collapse
of asset values.

The "hedge borrower," who expects to make debt payments from cash flows
from other investments;

The "speculative borrower," who borrows believing that he can service the
interest on his loan, but who must continually roll over the principal into new
investments;

The "Penza borrower," who relies on the appreciation of the value of his assets
to refinance or pay off his debt, while being unable to repay the original loan.


High-risk mortgage loans and lending/borrowing practices
       Lenders began to offer more and more loans to higher-risk borrowers,
including illegal immigrants. Subprime mortgages amounted to $35 billion (5%
of total originations) in 1994, 9% in 1996, $160 billion (13%) in 1999, [66] and
$600 billion (20%) in 2006. A study by the Federal Reserve found that the
average difference between subprime and prime mortgage interest rates (the
"subprime markup") declined from 280 basis points in 2001, to 130 basis
points in 2007. In other words, the risk premium required by lenders to offer a
subprime loan declined. This occurred even though the credit ratings of
subprime borrowers, and the characteristics of subprime loans, both declined
during the 2001–2006 period, which should have had the opposite effect. The
combination of declining risk premier and credit standards is common to
classic boom and bust credit cycles.

      In addition to considering higher-risk borrowers, lenders have offered
increasingly risky loan options and borrowing incentives. In 2005, the median
down payment for first-time home buyers was 2%, with 43% of those buyers
making no down payment whatsoever. By comparison, China has down


    24
                         EFFECT OF SUBPRIME

payment requirements that exceed 20%, with higher amounts for non-primary
residences.

      Growth in mortgage loan fraud based upon US Department of the
Treasury Suspicious Activity Report Analysis.

      One high-risk option was the "No Income, No Job and no Assets" loans,
sometimes referred to as Ninja loans. Another example is the interest-only
adjustable-rate mortgage (ARM), which allows the homeowner to pay just the
interest (not principal) during an initial period. Still another is a "payment
option" loan, in which the homeowner can pay a variable amount, but any
interest not paid is added to the principal. An estimated one-third of ARMs
originated between 2004 and 2006 had "teaser" rates below 4%, which then
increased significantly after some initial period, as much as doubling the
monthly
payment




      Mortgage underwriting practices have also been criticized, including
automated loan approvals that critics argued were not subjected to
appropriate review and documentation. In 2007, 40% of all subprime loans
resulted from automated underwriting. The chairman of the Mortgage Bankers

    25
                          EFFECT OF SUBPRIME

Association claimed that mortgage brokers, while profiting from the home loan
boom, did not do enough to examine whether borrowers could repay.
Mortgage fraud by borrowers increased.


Securitization practices
      Securitization, a form of structured finance, involves the pooling of
financial assets, especially those for which there is no ready secondary market,
such as mortgages, credit card receivables, student loans. The pooled assets
serve as collateral for new financial assets issued by the entity (mostly GSEs
and investment banks) owning the underlying assets. The diagram at left
shows how there are many parties involved.

        Securitization, combined with investor appetite for mortgage-backed
securities (MBS), and the high ratings formerly granted to MBSs by rating
agencies, meant that mortgages with a high risk of default could be originated
almost at will, with the risk shifted from the mortgage issuer to investors at
large. Securitization meant that issuers could repeatedly relend a given sum,
greatly increasing their fee income. Since issuers no longer carried any default
risk, they had every incentive to lower their underwriting standards to increase
their loan volume and total profit.

       The traditional mortgage model involved a bank originating a loan to the
borrower/homeowner and retaining the credit (default) risk. With the advent
of securitization, the traditional model has given way to the "originate to
distribute" model, in which the credit risk is transferred (distributed) to
investors through MBS and CDOs. Securitization created a secondary market
for mortgages, and meant that those issuing mortgages were no longer
required to hold them to maturity. Asset securitization began with the creation
of private mortgage pools in the 1970s. Securitization accelerated in the mid-
1990s. The total amount of mortgage-backed securities issued almost tripled
between 1996 and 2007, to $7.3 trillion. The securitized share of subprime
mortgages (i.e., those passed to third-party investors via MBS) increased from
54% in 2001, to 75% in 2006. Alan Greenspan has stated that the current
global credit crisis cannot be blamed on mortgages being issued to households



    26
                         EFFECT OF SUBPRIME

with poor credit, but rather on the securitization of such mortgages.




        American homeowners, consumers, and corporations owed roughly $25
trillion during 2008. American banks retained about $8 trillion of that total
directly as traditional mortgage loans. Bondholders and other traditional
lenders provided another $7 trillion. The remaining $10 trillion came from the
securitization markets. The securitization markets started to close down in the
spring of 2007 and nearly shut-down in the fall of 2008. More than a third of
the private credit markets thus became unavailable as a source of funds.

       Investment banks sometimes placed the MBS they originated or
purchased into off-balance sheet entities called structured investment vehicles
or special purpose entities. Moving the debt "off the books" enabled large
financial institutions to circumvent capital requirements, thereby increasing
profits but augmenting risk. Investment banks and off-balance sheet financing
vehicles are sometimes referred to as the shadow banking system and are not

    27
                           EFFECT OF SUBPRIME

subject to the same capital requirements and central bank support as
depository banks.

       Some believe that mortgage standards became lax because
securitization gave rise to a form of moral hazard, whereby each link in the
mortgage chain made a profit while passing any associated credit risk to the
next link in the chain. At the same time, some financial firms retained
significant amounts of the MBS they originated; thereby retaining significant
amounts of credit risk and so were less guilty of moral hazard. Some argue this
was not a flaw in the securitization concept per se, but in its implementation.

       According to Nobel laureate Dr. A. Michael Spence, "systemic risk
escalates in the financial system when formerly uncorrelated risks shift and
become highly correlated. When that happens, then insurance and
diversification models fail. There are two striking aspects of the current crisis
and its origins. One is that systemic risk built steadily in the system. The second
is that this buildup went either unnoticed or was not acted upon. That means
that it was not perceived by the majority of participants until it was too late.
Financial innovation, intended to redistribute and reduce risk, appears mainly
to have hidden it from view. An important challenge going forward is to better
understand these dynamics as the analytical underpinning of an early warning
system with respect to financial instability


Inaccurate credit ratings
       Credit rating agencies are now under scrutiny for having given
investment-grade ratings to CDOs and MBSs based on subprime mortgage
loans. These high ratings were believed justified because of risk reducing
practices, including over-collateralization (pledging collateral in excess of debt
issued), credit default insurance, and equity investors willing to bear the first
losses. However, there are also indications that some involved in rating
subprime-related securities knew at the time that the rating process was
faulty. Emails exchanged between employees of rating agencies, dated before
credit markets deteriorated and put in the public domain by USA Congressional
investigators, suggest that some rating agency employees suspected that lax
standards for rating structured credit products would result in major problems.
For example, one 2006 internal Email from Standard & Poor's stated that

    28
                          EFFECT OF SUBPRIME

"Rating agencies continue to create and [sic] even bigger monster—the CDO
market. Let's hope we are all wealthy and retired by the time this house of
cards
falters




       High ratings encouraged investors to buy securities backed by subprime
mortgages, helping finance the housing boom. The reliance on agency ratings
and the way ratings were used to justify investments led many investors to
treat securitized products — some based on subprime mortgages — as
equivalent to higher quality securities. This was exacerbated by the SEC's
removal of regulatory barriers and its reduction of disclosure requirements, all
in the wake of the Enron scandal.


    29
                           EFFECT OF SUBPRIME

       Critics allege that the rating agencies suffered from conflicts of interest,
as they were paid by investment banks and other firms that organize and sell
structured securities to investors. On 11 June 2008, the SEC proposed rules
designed to mitigate perceived conflicts of interest between rating agencies
and issuers of structured securities. On 3 December 2008, the SEC approved
measures to strengthen oversight of credit rating agencies, following a ten-
month investigation that found "significant weaknesses in ratings practices,"
including conflicts of interest.

      Between Q3 2007 and Q2 2008, rating agencies lowered the credit
ratings on $1.9 trillion in mortgage backed securities. Financial institutions felt
they had to lower the value of their MBS and acquire additional capital so as to
maintain capital ratios. If this involved the sale of new shares of stock, the
value of the existing shares was reduced. Thus ratings downgrades lowered the
stock prices of many financial firms.

       In December 2008 economist Arnold Kling testified at congressional
hearings on the collapse of Freddie Mac and Fannie Mae. Kling said that a high-
risk loan could be “laundered” by Wall Street and return to the banking system
as a highly rated security for sale to investors, obscuring its true risks and
avoiding capital reserve requirements.


Government policies
      Both government action and inaction has contributed to the crisis. Some
are of the opinion that the current American regulatory framework is
outdated. Then President George W. Bush stated in September 2008:

       "Once this crisis is resolved, there will be time to update our financial
regulatory structures. Our 21st century global economy remains regulated
largely by outdated 20th century laws. The Securities and Exchange
Commission (SEC) has conceded that self-regulation of investment banks
contributed to the crisis.

      Increasing home ownership was a goal of the Clinton and Bush
administrations. There is evidence that the Federal government leaned on the
mortgage industry, including Fannie Mae and Freddie Mac (the GSE), to lower
lending standards. Also, the U.S. Department of Housing and Urban

    30
                          EFFECT OF SUBPRIME

Development's (HUD) mortgage policies fueled the trend towards issuing risky
loans.

       In 1995, the GSEs began receiving government incentive payments for
purchasing mortgage backed securities which included loans to low income
borrowers. Thus began the involvement of the GSE with the subprime market.[
Subprime mortgage originations rose by 25% per year between 1994 and 2003,
resulting in a nearly ten-fold increase in the volume of subprime mortgages in
just nine years. The relatively high yields on these securities, in a time of low
interest rates, were very attractive to Wall Street, and while Fannie and
Freddie generally bought only the least risky subprime mortgages, these
purchases encouraged the entire subprime market. In 1996, HUD directed the
GSE that at least 42% of the mortgages they purchased should have been
issued to borrowers whose household income was below the median in their
area. This target was increased to 50% in 2000 and 52% in 2005. From 2002 to
2006 Fannie Mae and Freddie Mac combined purchases of subprime securities
rose from $38 billion to around $175 billion per year before dropping to $90
billion, thus fulfilling their government mandate to help make home buying
more affordable. During this time, the total market for subprime securities
rose from $172 billion to nearly $500 billion only to fall back down to $450
billion.

       By 2008, the GSE owned, either directly or through mortgage pools they
sponsored, $5.1 trillion in residential mortgages, about half the amount
outstanding. The GSE have always been highly leveraged, their net worth as of
30 June 2008 being a mere US$114 billion. When concerns arose in September
2008 regarding the ability of the GSE to make good on their guarantees, the
Federal government was forced to place the companies into a conservatorship,
effectively nationalizing them at the taxpayers' expense.

      Liberal economist Robert Suttner has suggested that the repeal of the
Glass-Seagull Act by the Gramm-Leach-Bliley Act of 1999 may have contributed
to the subprime meltdown, but this is controversial. The Federal government
bailout of thrifts during the savings and loan crisis of the late 1980s may have
encouraged other lenders to make risky loans, and thus given rise to moral
hazard.


    31
                         EFFECT OF SUBPRIME

      Economists have also debated the possible effects of the Community
Reinvestment Act (CRA), with detractors claiming that the Act encouraged
lending to uncreditworthy borrowers. and defenders claiming a thirty year
history of lending without increased risk. Detractors also claim that
amendments to the CRA in the mid-1990s, raised the amount of mortgages
issued to otherwise unqualified low-income borrowers, and allowed the
securitization of CRA-regulated mortgages, even though a fair number of them
were subprime.

       Federal Reserve Governor Randall Kroszner, says the CRA isn't to blame
for the subprime mess:

      "First, only a small portion of subprime mortgage originations are
related to the CRA. Second, CRA-related loans appear to perform comparably
to other types of subprime loans. Taken together… we believe that the
available evidence runs counter to the contention that the CRA contributed in
any substantive way to the current mortgage crisis."

Kroszner added:

      "Only 6% of all the higher-priced loans were extended by CRA-covered
lenders to lower-income borrowers or neighborhoods in their CRA assessment
areas, the local geographies that are the primary focus for CRA evaluation
purposes.

FDIC Chairman Sheila Bair also disputes that the CRA was a problem:

"Let me ask you: where in the CRA does it say: make loans to people who can't
afford to repay? Nowhere! And the fact is, the lending practices that are
causing problems today were driven by a desire for market share and revenue
growth ... pure and simple.


Policies of central banks
       Central banks manage monetary policy and may target the rate of
inflation. They have some authority over commercial banks and possibly other
financial institutions. They are less concerned with avoiding asset price
bubbles, such as the housing bubble and dot-com bubble. Central banks have
generally chosen to react after such bubbles burst so as to minimize collateral

    32
                          EFFECT OF SUBPRIME

damage to the economy, rather than trying to prevent or stop the bubble
itself. This is because identifying an asset bubble and determining the proper
monetary policy to deflate it are matters of debate among economists.

        Some market observers have been concerned that Federal Reserve
actions could give rise to moral hazard. A Government Accountability Office
critic said that the Federal Reserve Bank of New York's rescue of Long-Term
Capital Management in 1998 would encourage large financial institutions to
believe that the Federal Reserve would intervene on their behalf if risky loans
went sour because they were “too big to fail.

       A contributing factor to the rise in house prices was the Federal
Reserve's lowering of interest rates early in the decade. From 2000 to 2003,
the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%.
This was done to soften the effects of the collapse of the dot-com bubble and
of the September 2001 terrorist attacks, and to combat the perceived risk of
deflation. The Fed believed that interest rates could be lowered safely
primarily because the rate of inflation was low; it disregarded other important
factors. Richard W. Fisher, President and CEO of the Federal Reserve Bank of
Dallas, said that the Fed's interest rate policy during the early 2000s was
misguided, because measured inflation in those years was below true inflation,
which led to a monetary policy that contributed to the housing bubble.


Financial institution debt levels and incentives
       Many financial institutions, investment banks in particular, issued large
amounts of debt during 2004–2007, and invested the proceeds in mortgage-
backed securities (MBS), essentially betting that house prices would continue
to rise, and that households would continue to make their mortgage
payments. Borrowing at a lower interest rate and investing the proceeds at a
higher interest rate is a form of financial leverage. This is analogous to an
individual taking out a second mortgage on his residence to invest in the stock
market. This strategy proved profitable during the housing boom, but resulted
in large losses when house prices began to decline and mortgages began to
default. Beginning in 2007, financial institutions and individual investors
holding MBS also suffered significant losses from mortgage payment defaults


    33
                             EFFECT OF SUBPRIME

and        the   resulting     decline     in    the      value     of     MBS.




      A 2004 SEC ruling allowed USA investment banks to issue substantially
more debt, which was then used to purchase MBS. Over 2004-07, the top five
US investment banks each significantly increased their financial leverage (see
diagram), which increased their vulnerability to the declining value of MBSs.
These five institutions reported over $4.1 trillion in debt for fiscal year 2007,
about 30% of USA nominal GDP for 2007. Further, the percentage of subprime
mortgages originated to total originations increased from below 10% in 2001-
2003 to between 18-20% from 2004-2006, due in-part to financing from
investment banks.

Three investment banks either went bankrupt (Lehman Brothers) or were sold
at fire sale prices to other banks (Bear Stearns and Merrill Lynch) during
September 2008. The failure of 3 of the 5 large USA investment banks
augmented the instability in the global financial system. The remaining two
investment banks, Morgan Stanley and Goldman Sachs, opted to become
commercial banks, thereby subjecting themselves to more stringent
regulation.
      34
                          EFFECT OF SUBPRIME

      The New York State Comptroller's Office has said that in 2006, Wall
Street executives took home bonuses totaling $23.9 billion. "Wall Street
traders were thinking of the bonus at the end of the year, not the long-term
health of their firm. The whole system—from mortgage brokers to Wall Street
risk managers—seemed tilted toward taking short-term risks while ignoring
long-term obligations. The most damning evidence is that most of the people
at the top of the banks didn't really understand how those [investments]
worked.

      Investment banker incentive compensation was focused on fees
generated from assembling financial products, rather than the performance of
those products and profits generated over time. Their bonuses were heavily
skewed towards cash rather than stock and not subject to "claw-back"
(recovery of the bonus from the employee by the firm) in the event the MBS or
CDO created did not perform. In addition, the increased risk (in the form of
financial leverage) taken by the major investment banks was not adequately
factored into the compensation of senior executives.


Credit default swaps
      Credit defaults swaps (CDS) are financial instruments used as a hedge
and protection for debt holders, in particular MBS investors, from the risk of
default. As the net worth of banks and other financial institutions deteriorated
because of losses related to subprime mortgages, the likelihood increased that
those providing the insurance would have to pay their counterparties. This
created uncertainty across the system, as investors wondered which
companies would be required to pay to cover mortgage defaults.

       Like all swaps and other financial derivatives, CDS may either be used to
hedge risks (specifically, to insure creditors against default) or to profit from
speculation. The volume of CDS outstanding increased 100-fold from 1998 to
2008, with estimates of the debt covered by CDS contracts, as of November
2008, ranging from US$33 to $47 trillion. CDS are lightly regulated. As of 2008,
there was no central clearinghouse to honor CDS in the event a party to a CDS
proved unable to perform his obligations under the CDS contract. Required
disclosure of CDS-related obligations has been criticized as inadequate.
Insurance companies such as American International Group (AIG), MBIA, and

    35
                           EFFECT OF SUBPRIME

Ambac faced ratings downgrades because widespread mortgage defaults
increased their potential exposure to CDS losses. These firms had to obtain
additional funds (capital) to offset this exposure. AIG's having CDSs insuring
$440 billion of MBS resulted in its seeking and obtaining a Federal government
bailout.

       Like all swaps and other pure wagers, what one party loses under a CDS,
the other party gains; CDSs merely reallocate existing wealth. Hence the
question is which side of the CDS will have to pay and will it be able to do so.
When investment bank Lehman Brothers went bankrupt in September 2008,
there was much uncertainty as to which financial firms would be required to
honor the CDS contracts on its $600 billion of bonds outstanding. Merrill
Lynch's large losses in 2008 were attributed in part to the drop in value of its
unhedged portfolio of collateralized debt obligations (CDOs) after AIG ceased
offering CDS on Merrill's CDOs. The loss of confidence of trading partners in
Merrill Lynch's solvency and its ability to refinance its short-term debt led to its
acquisition by the Bank of America.

Economist Joseph Stieglitz summarized how credit default swaps contributed
to the systemic meltdown: "With this complicated intertwining of bets of great
magnitude, no one could be sure of the financial position of anyone else-or
even of one's own position. Not surprisingly, the credit markets froze.


Inflow of funds due to trade deficits
       In 2005, Ben Bernanke addressed the implications of the USA's high and
rising current account (trade) deficit, resulting from USA imports exceeding its
exports. Between 1996 and 2004, the USA current account deficit increased by
$650 billion, from 1.5% to 5.8% of GDP. Financing these deficits required the
USA to borrow large sums from abroad, much of it from countries running
trade surpluses, mainly the emerging economies in Asia and oil-exporting
nations. The balance of payments identity requires that a country (such as the
USA) running a current account deficit also have a capital account (investment)
surplus of the same amount. Hence large and growing amounts of foreign
funds (capital) flowed into the USA to finance its imports. Foreign investors
had these funds to lend, either because they had very high personal savings
rates (as high as 40% in China), or because of high oil prices. Bernanke referred

    36
                         EFFECT OF SUBPRIME

to this as a "savings glut" that may have pushed capital into the USA, a view
differing from that of mainstream economists, who view such capital as having
been pulled into the USA by its high consumption levels. In other words, a
nation cannot consume more than its income unless it sells assets to
foreigners, or foreigners are willing to lend to it.

       Regardless of the push or pull view, a "flood" of funds (capital or
liquidity) reached the USA financial markets. Foreign governments supplied
funds by purchasing USA Treasury bonds and thus avoided much of the direct
impact of the crisis. USA households, on the other hand, used funds borrowed
from foreigners to finance consumption or to bid up the prices of housing and
financial assets. Financial institutions invested foreign funds in mortgage-
backed securities. USA housing and financial assets dramatically declined in
value after the housing bubble burst




    37
                          EFFECT OF SUBPRIME

Impact
Financial market impacts, 2007
      The crisis began to affect the financial sector in February 2007, when
HSBC, the world's largest (2008) bank, wrote down its holdings of subprime-
related MBS by $10.5 billion, the first major subprime related loss to be
reported. During 2007, at least 100 mortgage companies either shut down,
suspended operations or were sold. Top management has not escaped
unscathed, as the CEOs of Merrill Lynch and Citigroup resigned within a week
of each other in late 2007. As the crisis deepened, more and more financial
firms either merged, or announced that they were negotiating seeking merger
During 2007, the crisis caused panic in financial markets and encouraged
investors to take their money out of risky mortgage bonds and shaky equities
and put it into commodities as "stores of value".

        Financial speculation in commodity futures following the collapse of the
financial derivatives markets has contributed to the world food price crisis and
oil price increases due to a "commodities super-cycle.Financial speculators
seeking quick returns have removed trillions of dollars from equities and
mortgage bonds, some of which has been invested into food and raw Partners

       Mortgage defaults and provisions for future defaults caused profits at
the 8533 USA depository institutions insured by the FDIC to decline from $35.2
billion in 2006 Q4 billion to $646 million in the same quarter a year later, a
decline of 98%. 2007 Q4 saw the worst bank and thrift quarterly performance
since 1990. In all of 2007, insured depository institutions earned approximately
$100 billion, down 31% from a record profit of $145 billion in 2006. Profits
declined from $35.6 billion in 2007 Q1 to $19.3 billion in 2008 Q1, a decline of
46%.


Financial market impacts, 2008
      As of August 2008, financial firms around the globe have written down
their holdings of subprime related securities by US$501 billion. The IMF
estimates that financial institutions around the globe will eventually have to
write off $1.5 trillion of their holdings of subprime MBSs. About $750 billion in

    38
                          EFFECT OF SUBPRIME

such losses had been recognized as of November 2008. These losses have
wiped out much of the capital of the world banking system. Banks
headquartered in nations that have signed the Basel Accords must have so
many cents of capital for every dollar of credit extended to consumers and
businesses. Thus the massive reduction in bank capital just described has
reduced the credit available to businesses and households.




      When Lehman Brothers and other important financial institutions failed
in September 2008, the crisis hit a key point. During a two day period in
September 2008, $150 billion were withdrawn from USA money market funds.
The average two day outflow had been $5 billion. In effect, the money market
was subject to a bank run. The money market had been a key source of credit
for banks (CDs) and nonfinancial firms (commercial paper). The TED spread
(see graph above), a measure of the risk of interbank lending, quadrupled
shortly after the Lehman failure. This credit freeze brought the global financial
system to the brink of collapse. The response of the USA Federal Reserve, the
European Central Bank, and other central banks was immediate and dramatic.
During the last quarter of 2008, these central banks purchased US$2.5 trillion

    39
                          EFFECT OF SUBPRIME

of government debt and troubled private assets from banks. This was the
largest liquidity injection into the credit market, and the largest monetary
policy action, in world history. The governments of European nations and the
USA also raised the capital of their national banking systems by $1.5 trillion, by
purchasing newly issued preferred stock in their major banks


Indirect economic effects
       The subprime crisis has had a number of adverse effects on the overall
American economic situation. USA GDP was expected to contract at a 5.5%
annual rate during Q4 2008. USA employers slashed 2.6 million jobs during
2008, the most since 1945. There have been significant job losses in the
financial sector, with over 65,400 jobs lost in the USA as of September 2008.
The unemployment rate climbed to 7.2% in December 2008, the highest level
in 16 years.

       Declining house prices have reduced household wealth and the
collateral for home equity loans, which is placing downward pressure on
consumption. The tightening of credit has caused a major decline in the sale of
motor vehicles. Between October 2007 and October 2008, Ford sales were
down 33.8%, General Motors sales were down 15.6%, and Toyota sales had
declined 32.3%. There is an ongoing global automobile industry crisis, and calls
for some form of government intervention.

        Members of USA minority groups received a disproportionate number of
subprime mortgages, and so have experienced a disproportionate level of the
resulting foreclosures. Minorities have also born the brunt of the dramatic
reduction in subprime lending. House-related crimes such as arson have
increased. Many renters became innocent victims, by being evicted from their
residences without notice, because their landlords' property has been
foreclosed. In October 2008, Tom Dart, the elected Sheriff of Cook County,
Illinois, criticized mortgage lenders for the adverse consequences their actions
had on tenants, and announced that he was suspending all foreclosure
evictions




    40
                         EFFECT OF SUBPRIME



Responses
      Various actions have been taken since the crisis became apparent in
August 2007. In September 2008, major instability in world financial markets
increased awareness and attention to the crisis. Various agencies and
regulators, as well as political officials, began to take additional, more
comprehensive steps to handle the crisis.

       To date, various government agencies have committed or spent trillions
of dollars in loans, asset purchases, guarantees’, and direct spending


Legislative and regulatory responses


Federal Reserve Bank
       The central bank of the USA, the Federal Reserve, in partnership with
central banks around the world, has taken several steps to address the crisis.
Federal Reserve Chairman Ben Bernanke stated in early 2008: "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. The Fed has:

Lowered the target for the Federal funds rate from 5.25% to 2%, and the
discount rate from 5.75% to 2.25%. This took place in six steps occurring
between 18 September 2007 and 30 April 2008;

Undertaken, along with other central banks, open market operations to ensure
member banks remain liquid. These are effectively short-term loans to
member banks collateralized by government securities. Central banks have
also lowered the interest rates (called the discount rate in the USA) they
charge member banks for short-term loans;

       Used the Term Auction Facility (TAF) to provide short-term loans
(liquidity) to banks. The Fed increased the monthly amount of these auctions
throughout the crisis, raising it to $300 billion by November 2008, up from $20


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                          EFFECT OF SUBPRIME

billion at inception. A total of $1.6 trillion in loans to banks were made for
various types of collateral by November 2008.

Finalized, in July 2008, new rules for mortgage lenders;

In October 2008, the Fed expanded the collateral it will lend against to include
commercial paper, to help address continued liquidity concerns. By November
2008, the Fed had purchased $271 billion of such paper, out of a program limit
of $1.4 trillion.

In November 2008, the Fed announced the $200 billion Term Asset-Backed
Securities Loan Facility (TALF). This program supported the issuance of asset-
backed securities (ABS) collateralized by loans related to autos, credit cards,
education, and small businesses. This step was taken to offset liquidity
concerns.

In November 2008, the Fed announced a $600 billion program to purchase the
MBS of the GSE, to help lower mortgage rates


Regulation
       Regulators and legislators have contemplated taking action with respect
to lending practices, bankruptcy protection, tax policies, affordable housing,
credit counseling, education, and the licensing and qualifications of lenders.
Regulations or guidelines can influence the transparency and reporting
required of lenders and the types of loans they choose to issue. Congressional
committees are also conducting hearings to help identify solutions and apply
pressure to the various parties involved.

       On 31 March 2008, a sweeping expansion of the Fed's regulatory powers
was proposed, that would expand its jurisdiction over nonbank financial
institutions, and its authority to intervene in market crises.

Responding to concerns that lending was not properly regulated, the House
and Senate are both considering bills to further regulate lending practices.

Countrywide's VIP program has led ethics experts and key senators to
recommend that members of Congress be required to disclose information
about the mortgages they take out.

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                         EFFECT OF SUBPRIME

No depository banks (e.g., investment banks and mortgage companies) are not
subject to the same capital requirements as depository banks. Many
investment banks had limited capital to offset declines in their holdings of
MBSs, or to support their side of credit default insurance contracts.

Nobel prize winner Joseph Stieglitz has recommended that the USA adopt
regulations restricting leverage, and preventing companies from becoming
"too big to fail.

British Prime Minister Gordon Brown and Nobel laureate A. Michael Spence
have argued for an "early warning system" to help detect a confluence of
events leading to systemic risk. Dr. Ram Charan has also argued for risk
management early warning systems at the corporate board level.

On 18 September 2008, UK regulators announced a temporary ban on short-
selling the stock of financial firms.

The Australian government will invest AU$4 billion in mortgage backed
securities issued by nonbank lenders, in an attempt to maintain competition in
the mortgage market. However this is considered a drop in the ocean in
regards to total lending.

Fed Chairman Ben Bernanke stated there is a need for "well-defined
procedures and authorities for dealing with the potential failure of a
systemically important non-bank financial institution.

Alan Greenspan has called for banks to have a 14% capital ratio, rather than
the historical 8-10%. Major U.S. banks had capital ratios of around 12% in
December 2008 after the initial round of bailout funds. The minimum capital
ratio is regulated.

Economists Nouriel Roubini and Lasse Pederson recommended in January 2009
that capital requirements for financial institutions be proportional to the
systemic risk they pose based on an assessment by regulators. Further, each
financial institution would pay an insurance premium to the government based
on its systemic risk




    43
                         EFFECT OF SUBPRIME

Economic Stimulus Act of 2008
       On 13 February 2008, President Bush signed into law an economic
stimulus package costing $168 billion, mainly taking the form of income tax
rebate checks mailed directly to taxpayers.Checks were mailed starting the
week of 28 April 2008. However, this rebate coincided with an unexpected
jump in gasoline and food prices. This coincidence led some to wonder
whether the stimulus package would have the intended effect, or whether
consumers would simply spend their rebates to cover higher food and fuel
prices. Some Congressmen even contemplated a second round of tax rebates
to ensure that the American economy would indeed be stimulated. Secretary
of the Treasury Henry Paulson strongly opposed such initiative.


Housing and Economic Recovery Act of 2008
      The Housing and Economic Recovery Act of 2008 included six separate
major acts intended to restore confidence in the American mortgage industry.
The Act

     Insures $300 billion in mortgages, that will assist an estimated 400,000
borrowers;

       Creates a new Federal regulator to ensure the safe and sound operation
of the GSEs (Fannie Mae and Freddie Mac) and Federal Home Loan Banks;

     Raises the ceiling on the dollar value of the mortgages the government
sponsored enterprises (GSEs) may purchase;

      Lends money to mortgage bankers to help them refinance the
mortgages of owner-occupants at risk of foreclosure. The lender reduces the
amount of the mortgage (typically taking a significant loss), in exchange for
sharing in any future appreciation in the selling price of the house via the
Federal Housing Administration. The refinancing must have fixed payments for
a term of 30 years;

       Requires that lenders disclose more information about the products they
offer and the deals they close;




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                          EFFECT OF SUBPRIME

Failures and government bailouts of financial firms
      Northern Rock, encountering difficulty obtaining the credit it required to
remain in business, was nationalized on 17 February 2008. As of 8 October 8
2008, United Kingdom taxpayer liability arising from this takeover had risen to
£87 billion ($150 billion).

       Bear Stearns was acquired by J.P. Morgan Chase in March 2008 for $1.2
billion. The sale was conditional on the Fed's lending Bear Sterns US$29 billion
on a nonrecourse basis.

      IndyMac Bank, America's leading Alt-A originator in 2006 with
approximately $32 billion in deposits was placed into conservatorship by the
FDIC on July 11, 2008, citing liquidity concerns. A bridge bank, IndyMac Federal
Bank, FSB, was established under the control of the FDIC.

      The GSEs Fannie Mae and Freddie Mac were both placed in
conservatorship in September 2008.The two GSE's guarantee or hold mortgage
backed securities(MBS), mortgages and other debt with a Notional value of
more than $5 trillion.

Merrill Lynch was acquired by Bank of America in September 2008 for $50
billion.

      Scottish banking group HBOS agreed on 17 September 2008 to an
emergency acquisition by its UK rival Lloyds TSB, after a major decline in
HBOS's share price stemming from growing fears about its exposure to British
and American MBSs. The UK government made this takeover possible by
agreeing to waive its competition rules.

      Lehman Brothers declared bankruptcy on 15 September 2008, after the
Secretary of the Treasury Henry Paulson, citing moral hazard, refused to bail it
out.

      AIG received an $85 billion emergency loan in September 2008 from the
Federal Reserve. Which AIG is expected to repay by gradually selling off its
assets. In exchange, the Federal government acquired a 79.9% equity stake in
AIG.



    45
                          EFFECT OF SUBPRIME

      Washington Mutual (WaMu) was seized in September 2008 by the USA
Office of Thrift Supervision (OTS). Most of WaMu's untroubled assets were to
be sold to J.P. Morgan Chase.

       British bank Bradford & Bingley was nationalized on 29 September 2008
by the UK government. The government assumed control of the bank's £50
billion mortgage and loan portfolio, while its deposit and branch network are
to be sold to Spain's Group Santander.

       In October 2008, the Australian government announced that it would
make AU$4 billion available to nonbank lenders unable to issue new loans.
After discussion with the industry, this amount was increased to AU$8 billion.

      In November 2008, the U.S. government announced it was purchasing
$27 billion of preferred stock in Citigroup, a USA bank with over $2 trillion in
assets, and warrants on 4.5% of its common stock. The preferred stock carries
an 8% dividend. This purchase follows an earlier purchase of $25 billion of the
same preferred stock using TARP funds.


Emergency Economic Stabilization Act of 2008
       As of June 30, 2008, residential mortgages owed by USA households
totaled US$10.6 trillion. As of August 2008, 9.2% of these mortgages were
either seriously delinquent or in foreclosure.

       On 19 September 2008, the U.S. Federal government announced a plan,
requiring Congressional approval, to purchase from financial institutions large
amounts of mortgage backed securities (MBSs) and collateralized debt
obligation (CDOs) backed by subprime mortgages. The estimated cost of this
plan was at least $700 billion. The plan also banned short-selling the stocks of
financial firms. On 29 September 2008, the House of Representatives rejected
a revised version of the plan. On 1 October 2008, the U.S. Senate approved an
amended version of the plan, which was ratified by the House on October 3
and immediately signed into law by President Bush. After the law was passed,
the the U.S. Treasury instead primarily used the first $350 billion of bailout
funds to buy preferred stock in banks instead of troubled mortgage assets.



    46
                         EFFECT OF SUBPRIME

       A Congressional Oversight Panel (COP) chaired by Harvard Professor
Elizabeth Warren was created to monitor the implementation of the law. COP
issued its first report on 10 December 2008, which was primarily a series of
questions and answers. In an interview, Warren stated that banks cannot be
stabilized unless foreclosures are addressed.

      For a summary of U.S. government financial commitments and
investments related to the crisis, see CNN - Bailout Scorecard


Lending industry action
      Both lenders and borrowers may benefit from avoiding foreclosure,
which is a costly and lengthy process. Some lenders have offered troubled
borrowers more favorable mortgage terms (i.e., refinancing, loan modification
or loss mitigation). Borrowers have also been encouraged to contact their
lenders to discuss alternatives.

       Corporations, trade groups, and consumer advocates have begun to cite
data on the numbers and types of borrowers assisted by loan modification
programs. There is some disagreement regarding the data, and the adequacy
of measures taken to date. A report January 2008 report stated 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 foreclosures were
initiated. Consumer groups claimed these modifications affected less than 1%
of the 3 million ARM subprime mortgages outstanding as of the third quarter.

       The State Foreclosure Prevention Working Group, a coalition of state
attorney generals and bank regulators from 11 states, reported in April 2008
that loan servicers could not keep up with the rising number of foreclosures.
70% of subprime mortgage holders are not getting the help they need. Nearly
two-thirds of loan workouts require more than six weeks to complete under
the current "case-by-case" method of review. In order to slow the growth of
foreclosures, the Group has recommended a more automated method of loan
modification that can be applied to large blocks of struggling borrowers.

     In December 2008, the U.S. FDIC reported that more than half of
mortgages modified during the first half of 2008 were delinquent again, in
many cases because payments were not reduced or mortgage debt was not

    47
                         EFFECT OF SUBPRIME

forgiven. This is further evidence that case-by-case loan modification is not
effective as a policy tool.

      On October 5, 2008, the Bank of America, following on a legal
settlement with several states, announced a more aggressive and systematic
program intended to help an estimated 400,000 borrowers keep their homes.
The program will limit payments as a fraction of household income, and reduce
mortgage balances.

      In November 2008, Fannie Mae, Freddie Mac and their network of
mortgage service providers announced a streamlined loan modification
program and foreclosure suspension, designed to help keep borrowers in their
homes.

      Several Australian lenders have amended their policies for higher risk
mortgage types. These changes have been relatively minor, with the exception
of those nonconforming lenders that lend to credit impaired and subprime
borrowers. It remains to be seen if this trend will continue, or if Australian
lenders will eventually stop offering riskier loan products


Hope Now Alliance
      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. These
actions are part of the Hope Now Alliance, an ongoing collaborative effort
between the US Government and private industry to help certain subprime
borrowers. In February 2008, the Alliance reported that during the second half
of 2007, it had helped 545,000 subprime borrowers with shaky credit, or 7.7%
of 7.1 million subprime loans outstanding as of September 2007. A
spokesperson for the Alliance acknowledged that much more must be done.

       During February 2008, a program called "Project Lifeline" was
announced. Six of the largest USA lenders, in partnership with the Hope Now
Alliance, agreed to defer foreclosure actions for 30 days for borrowers 90 or
more days delinquent on their mortgage payments. The intent of the program
was to reduce foreclosures by encouraging loan adjustments.


    48
                           EFFECT OF SUBPRIME

Bank capital replenishment from private sources
       As of May 2008, major financial institutions had obtained over $260
billion in new capital, taking the form of bonds or preferred stock sold to
private investors in exchange for cash. This new capital has helped banks
maintain required capital ratios (an important measure of financial health),
which have declined significantly due to losses on subprime loans or CDO
investments. Raising additional capital has been advocated by the leadership
of the U.S. Federal Reserve and the Treasury Department. Well-capitalized
banks are in a better position to lend at favorable interest rates, and to offset
the falling liquidity and rising uncertainty in credit markets. Banks have
obtained some of their new capital from the sovereign wealth funds of
developing countries, which may have political implications.

       Certain major banks have also reduced their dividend payouts to
stabilize their financial position. Of the 3776 FDIC insured institutions that paid
a dividend on their common stock in the first quarter of 2007, almost half
(48%) paid a lower dividend in the first quarter of 2008, and 666 institutions
reduced their dividend to zero. Insured institutions paid $14.0 billion in total
dividends in the first quarter of 2008, down $12.2 billion (46.5%) from the first
quarter of 2007.

      Steven Pearlstein has advocated government guarantees for new
preferred stock, to encourage investors to provide private capital to the banks


Litigation
      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
was not quantified but is also believed to be significant. The study found that
43% 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. Former Bear

    49
                         EFFECT OF SUBPRIME

Stearns managers were named in civil lawsuits brought in 2007 by investors,
including Barclays Bank PLC, who claimed they had been misled.

       An important issue related to the restructuring of mortgage loans
involves the contractual rights of investors who purchased related MBS.
Investor permission is often required to modify the underlying mortgages,
resulting in a "case-by-case" loan modification regime. This presents a
challenge for banks and governments who are attempting to limit foreclosures
by helping large groups of homeowners re-negotiate the terms of their
mortgages efficiently. A class-action lawsuit was filed in December 2008 that
may have significant implications


Law enforcement
      The number of Federal Bureau of Investigation (FBI) agents assigned to
mortgage-related crimes increased by 50% between 2007 and 2008. In June
2008, the FBI stated that its mortgage fraud caseload has doubled in the past
three years to more than 1,400 pending cases. Between 1 March and 18 June
2008, 406 people were arrested for mortgage fraud in an FBI sting across the
country. People arrested include buyers, sellers and others across the wide-
ranging mortgage industry.

      On 8 March 2008, the FBI began a probe of Countrywide for possible
fraudulent lending practices, securities fraud.

       On 19 June 2008, two former Bear Stearns managers were arrested by
the FBI, and were the first Wall Street executives arrested related to the
subprime lending crisis. They were suspected of misleading investors about the
risky subprime mortgage market.

       On July 16, 2008, an unnamed US Government official said that the FBI is
investigating Indy Mac for possible fraud. It is not clear if the investigation
began before the bank was taken over by the FDIC upon its $32 billion collapse.

       On 23 September 2008, in response to concerns about the bailouts of so
many firms, two government officials stated that the Federal Bureau of
Investigation was looking into the possibility of fraud by mortgage financing
companies Fannie Mae and Freddie Mac, Lehman Brothers, and insurer

    50
                          EFFECT OF SUBPRIME

American International Group, bringing to 26 the number of corporate lenders
under investigation.


Ethics investigation
       On 18 June 2008, a Congressional ethics panel started examining
allegations that Democrat Senators Christopher Dodd of Connecticut (the
sponsor of a major $300 billion housing rescue bill) and Kent Conrad of North
Dakota received preferential loans by troubled mortgage lender Countrywide
Financial Corp.


Executive compensation reform
      Banks and executives are under pressure to reduce bonuses, as much of
the profits recognized by major banks were wiped out by subsequent losses
during the crisis. The extent of risk taken was not properly factored into bonus
computations. Several executives have foregone bonuses in light of what
turned out to be poor performance. However, few firms had "claw back"
provisions to recapture the bonuses, which were based on short-term profits
rather than long-term value creation. Credit Suisse bank announced it will
begin paying bonuses out of a fund containing troubled assets on its books, in
place of cash. Gains or losses on the fund will affect employee bonuses. This
approach was praised as "monstrously clever" by one analyst


Effect on the financial condition of USA governmental units
       The Federal government's efforts to support the global financial system
have resulted in significant new financial commitments, totaling $7 trillion by
November, 2008. These commitments can be characterized as investments,
loans, and loan guarantees, rather than direct expenditures. In many cases, the
government purchased financial assets such as commercial paper, mortgage-
backed securities, or other types of asset-backed paper, to enhance liquidity in
frozen markets.As the crisis has progressed, the Fed has expanded the
collateral against which it is willing to lend to include higher-risk assets




    51
                         EFFECT OF SUBPRIME




The extent to which the Federal government is at risk because of these
investments and guarantees remains to be seen. The upshot has been a US$1
trillion increase in the national debt of the USA during FY 2008, compared to
an average increase of US$550 billion during the previous five years. The total
debt reached $10 trillion in September 2008

In addition, state and local government property tax collections are expected
to decline because of an estimated $1.2 trillion reduction in housing prices,
and a slowing of the overall American economy. This expectation is affecting
the ability of state governments to finance their operations through bond
sales. Finding themselves unable to borrow, the states of California and
Massachusetts have requested that the Fed lend them the amounts they
would have borrowed elsewhere under normal conditions.




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                          EFFECT OF SUBPRIME

Expectations and forecasts
        We have been concerned for some time about the risks in asset-backed
bonds, particularly bonds that are backed by home equity loans, automobile
loans or credit card debt (we own no asset-backed bonds). It seems to us that
securitization (or the creation of these asset-backed bonds) eliminates the
incentive for the originator of the loan to be credit sensitive... With
securitization, the dealer (almost) does not care as these loans can be laid off
through securitization. Thus, the loss experienced on these loans after
securitization will no longer be comparable to that experienced prior to
securitization (called a moral hazard)... This is not a small problem. There is
$1.0 trillion in asset-backed bonds outstanding as of December 31, 2003 in the
U.S.... Who is buying these bonds? Insurance companies, money managers and
banks – in the main – all reaching for yield given the excellent ratings for these
bonds. What happens if we hit an air pocket?

       Stifel Nicolaus, writing in MarketWatch, has claimed that the problem
mortgages are not confined to the subprime niche: "the rapidly increasing
scope and depth of the problems in the mortgage market suggest that the
entire sector has plunged into a downward spiral similar to the subprime woes
whereby each negative development feeds further deterioration," calling it a
"vicious cycle" and adding that lenders "continue to believe conditions will get
worse".

     On 19 May, 2008, Nouriel Roubini, a professor at New York University
and head of Roubini Global Economics, was quoted as saying that if the
economy slips into recession "then you have a systemic banking crisis like we
haven't had since the 1930s".

      Because debt instruments backed by subprime mortgages were
purchased worldwide, the International Monetary Fund (IMF) "says that
worldwide losses stemming from the USA subprime mortgage crisis could run
to $945 billion.

     As of February 2009, analysts were predicting that Alt-A loans, offered to
those with good credit but less steady income than prime borrowers,

    53
                          EFFECT OF SUBPRIME

represent the next wave of delinquencies and foreclosures. Rating agency
Moody's expects the delinquency rate to increase to over 20%, compared with
the historical average of below 1%. Analysts at Goldman Sachs estimate write-
downs on the $1.3 trillion of total Alt-A debt at $600 billion, almost as much as
expected subprime losses. Add in option ARMs, many of which are essentially
the same as Alt-A, and the potential impact climbs towards $1 trillion.

      Francis Fukuyama has argued that the crisis represents the end of
Reaganism in the financial sector, which was characterized by lighter
regulation, pared-back government, and lower taxes. Significant financial
sector regulatory changes are expected as a result of the crisis.

       Fareed Zakaria believes that the crisis may force Americans and their
government to live within their means. Further, some of the best minds may
be redeployed from financial engineering to more valuable business activities,
or to science and technology.

      Roger Altman wrote that "the crash of 2008 has inflicted profound
damage on [the U.S.] financial system, its economy, and its standing in the
world; the crisis is an important geopolitical setback...the crisis has coincided
with historical forces that were already shifting the world's focus away from
the United States. Over the medium term, the United States will have to
operate from a smaller global platform -- while others, especially China, will
have a chance to rise faster.

       The crisis has cast doubt on the legacy of Alan Greenspan, the Chairman
of the Federal Reserve System from 1986 to January 2006. Senator Chris Dodd
claimed that Greenspan created the "perfect storm". Greenspan has remarked
that there is a one-in-three chance of recession from the fallout. When asked
to comment on the crisis, Greenspan spoke as follows

       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


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                           EFFECT OF SUBPRIME

Mortgage loan
       A mortgage loan is a loan secured by real property through the use of a
note which evidences the existence of the loan and the encumbrance of that
realty through the granting of a mortgage which secures the loan. However,
the word mortgage alone, in everyday usage, is most often used to mean
mortgage loan.

       A home buyer or builder can obtain financing (a loan) either to purchase
or secure against the property from a financial institution, such as a bank,
either directly or indirectly through intermediaries. Features of mortgage loans
such as the size of the loan, maturity of the loan, interest rate, method of
paying off the loan, and other characteristics can vary considerably.


Mortgage loan basics

Basic concepts and legal regulation
       According to Anglo-American property law, a mortgage occurs when an
owner (usually of a fee simple interest in realty) pledges his interest as security
or collateral for a loan. Therefore, a mortgage is an encumbrance on property
just as an easement would be, but because most mortgages occur as a
condition for new loan money, the word mortgage has become the generic
term for a loan secured by such real property.

      As with other types of loans, mortgages have an interest rate and are
scheduled to amortize over a set period of time; typically 30 years. All types of
real property can, and usually are, secured with a mortgage and bear an
interest rate that is supposed to reflect the lender's risk.

      Mortgage lending is the primary mechanism used in many countries to
finance private ownership of residential property. For commercial mortgages
see the separate article. Although the terminology and precise forms will differ
from country to country, the basic components tend to be similar:




    55
                           EFFECT OF SUBPRIME

Property: the physical residence being financed. The exact form of ownership
will vary from country to country, and may restrict the types of lending that are
possible.

      Mortgage: the security created on the property by the lender, which will
usually include certain restrictions on the use or disposal of the property (such
as paying any outstanding debt before selling the property).

Borrower: the person borrowing who either has or is creating an ownership
interest in the property.

Lender: any lender, but usually a bank or other financial institution.

Principal: the original size of the loan, which may or may not include certain
other costs; as any principal is repaid, the principal will go down in size.

Interest: a financial charge for use of the lender's money.

Foreclosure or repossession: the possibility that the lender has to foreclose,
repossess or seize the property under certain circumstances is essential to a
mortgage loan; without this aspect, the loan is arguably no different from any
other type of loan.

       Many other specific characteristics are common to many markets, but
the above are the essential features. Governments usually regulate many
aspects of mortgage lending, either directly (through legal requirements, for
example) or indirectly (through regulation of the participants or the financial
markets, such as the banking industry), and often through state intervention
(direct lending by the government, by state-owned banks, or sponsorship of
various entities). Other aspects that define a specific mortgage market may be
regional, historical, or driven by specific characteristics of the legal or financial
system.

      Mortgage loans are generally structured as long-term loans, the periodic
payments for which are similar to an annuity and calculated according to the
time value of money formulae. The most basic arrangement would require a
fixed monthly payment over a period of ten to thirty years, depending on local
conditions. Over this period the principal component of the loan (the original


    56
                           EFFECT OF SUBPRIME

loan) would be slowly paid down through amortization. In practice, many
variants are possible and common worldwide and within each country.

       Lenders provide funds against property to earn interest income, and
generally borrow these funds themselves (for example, by taking deposits or
issuing bonds). The price at which the lenders borrow money therefore affects
the cost of borrowing. Lenders may also, in many countries, sell the mortgage
loan to other parties who are interested in receiving the stream of cash
payments from the borrower, often in the form of a security (by means of a
securitization). In the United States, the largest firms securitizing loans are
Fannie Mae and Freddie Mac, which are government sponsored enterprises.

      Mortgage lending will also take into account the (perceived) riskiness of
the mortgage loan, that is, the likelihood that the funds will be repaid (usually
considered a function of the creditworthiness of the borrower); that if they are
not repaid, the lender will be able to foreclose and recoup some or all of its
original capital; and the financial, interest rate risk and time delays that may be
involved in certain circumstances.


Mortgage loan types
       There are many types of mortgages used worldwide, but several factors
broadly define the characteristics of the mortgage. All of these may be subject
to local regulation and legal requirements.

   1) Interest: interest may be fixed for the life of the loan or variable, and
      change at certain pre-defined periods; the interest rate can also, of
      course, be higher or lowe
   2) Term: mortgage loans generally have a maximum term, that is, the
      number of years after which an amortizing loan will be repaid. Some
      mortgage loans may have no amortization, or require full repayment of
      any remaining balance at a certain date, or even negative amortization.
   3) Payment amount and frequency: the amount paid per period and the
      frequency of payments; in some cases, the amount paid per period may
      change or the borrower may have the option to increase or decrease the
      amount paid.



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                          EFFECT OF SUBPRIME

   4) Prepayment: some types of mortgages may limit or restrict prepayment
      of all or a portion of the loan, or require payment of a penalty to the
      lender for prepayment

   The two basic types of amortized loans are the fixed rate mortgage (FRM)
and adjustable rate mortgage (ARM) (also known as a floating rate or variable
rate mortgage). In many countries, floating rate mortgages are the norm and
will simply be referred to as mortgages; in the United States, fixed rate
mortgages are typically considered "standard." Combinations of fixed and
floating rate are also common, whereby a mortgage loan will have a fixed rate
for some period, and vary after the end of that period.

   In a fixed rate mortgage, the interest rate, and hence periodic payment,
remains fixed for the life (or term) of the loan. In the U.S., the term is usually
up to 30 years (15 and 30 being the most common), although longer terms
may be offered in certain circumstances. For a fixed rate mortgage, payments
for principal and interest should not change over the life of the loan, although
ancillary costs (such as property taxes and insurance) can and do change.

   In an adjustable rate mortgage, the interest rate is generally fixed for a
period of time, after which it will periodically (for example, annually or
monthly) adjust up or down to some market index. Common indices in the U.S.
include the Prime Rate, the London Interbank Offered Rate (LIBOR), and the
Treasury Index ("T-Bill"); other indices are in use but are less popular.




    58
                          EFFECT OF SUBPRIME

       Adjustable rates transfer part of the interest rate risk from the lender to
the borrower, and thus are widely used where fixed rate funding is difficult to
obtain or prohibitively expensive. Since the risk is transferred to the borrower,
the initial interest rate may be from 0.5% to 2% lower than the average 30-
year fixed rate; the size of the price differential will be related to debt market
conditions, including the yield curve.

       Additionally, lenders in many markets rely on credit reports and credit
scores derived from them. The higher the score, the more creditworthy the
borrower is assumed to be. Favorable interest rates are offered to buyers with
high scores. Lower scores indicate higher risk for the lender, and higher rates
will generally be charged to reflect the (expected) higher default rates.

       A partial amortization or balloon loan is one where the amount of
monthly payments due are calculated (amortized) over a certain term, but the
outstanding principal balance is due at some point short of that term. This
payment is sometimes referred to as a "balloon payment" or bullet payment.
The interest rate for a balloon loan can be either fixed or floating. The most
common way of describing a balloon loan uses the terminology X due in Y,
where X is the number of years over which the loan is amortized, and Y is the
year in which the principal balance is due.

Other loan types:
   1) Assumed mortgage
   2) Balloon mortgage
   3) Blanket loan
   4) Bridge loan
   5) Budget loan
   6) Buydown mortgage
   7) Commercial loan
   8) Endowment mortgage
   9) Equity loan
   10)      Flexible mortgage
   11)      Foreign National mortgage
   12)      Graduated payment mortgage loan
   13)      Hard money loan

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                          EFFECT OF SUBPRIME

   14)      Jumbo mortgages
   15)      Offset mortgage
   16)      Package loan
   17)      Participation mortgage
   18)      Reverse mortgage
   19)      Repayment mortgage
   20)      Seasoned mortgage
   21)      Term loan or Interest-only loan
   22)      Wraparound mortgage
   23)      Negative amortization loan
   24)      Non-conforming mortgage


Loan to value and downpayments
      Upon making a mortgage loan for purchase of a property, lenders
usually require that the borrower make a downpayment, that is, contribute a
portion of the cost of the property. This downpayment may be expressed as a
portion of the value of the property (see below for a definition of this term).
The loan to value ratio (or LTV) is the size of the loan against the value of the
property. Therefore, a mortgage loan where the purchaser has made a
downpayment of 20% has a loan to value ratio of 80%. For loans made against
properties that the borrower already owns, the loan to value ratio will be
imputed against the estimated value of the property.

       The loan to value ratio is considered an important indicator of the
riskiness of a mortgage loan: the higher the LTV, the higher the risk that the
value of the property (in case of foreclosure) will be insufficient to cover the
remaining principal of the loan.


Value: appraised, estimated, and actual
       Since the value of the property is an important factor in understanding
the risk of the loan, determining the value is a key factor in mortgage lending.
The value may be determined in various ways, but the most common are:

      Actual or transaction value: this is usually taken to be the purchase price
of the property. If the property is not being purchased at the time of
borrowing, this information may not be available.
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      Appraised or surveyed value: in most jurisdictions, some form of
appraisal of the value by a licensed professional is common. There is often a
requirement for the lender to obtain an official appraisal.

       Estimated value: lenders or other parties may use their own internal
estimates, particularly in jurisdictions where no official appraisal procedure
exists, but also in some other circumstances.


Equity or homeowner's equity
      The concept of equity in a property refers to the value of the property
minus the outstanding debt, subject to the definition of the value of the
property. Therefore, a borrower who owns a property whose estimated value
is $400,000 but with outstanding mortgage loans of $300,000 is said to have
homeowner's equity of $100,000.


Payment and debt ratios
       In most countries, a number of more or less standard measures of
creditworthiness may be used. Common measures include payment to income
(mortgage payments as a percentage of gross or net income); debt to income
(all debt payments, including mortgage payments, as a percentage of income);
and various net worth measures. In many countries, credit scores are used in
lieu of or to supplement these measures. There will also be requirements for
documentation of the creditworthiness, such as income tax returns, pay stubs,
etc; the specifics will vary from location to location. Many countries have lower
requirements for certain borrowers, or "no-doc" / "low-doc" lending standards
that may be acceptable in certain circumstances.


Standard or conforming mortgages
      Many countries have a notion of standard or conforming mortgages that
define a perceived acceptable level of risk, which may be formal or informal,
and may be reinforced by laws, government intervention, or market practice.
For example, a standard mortgage may be considered to be one with no more
than 70-80% LTV and no more than one-third of gross income going to
mortgage debt.


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       A standard or conforming mortgage is a key concept as it often defines
whether or not the mortgage can be easily sold or securitized, or, if non-
standard, may affect the price at which it may be sold. In the United States, a
conforming mortgage is one which meets the established rules and procedures
of the two major government-sponsored entities in the housing finance market
(including some legal requirements). In contrast, lenders who decide to make
nonconforming loans are exercising a higher risk tolerance and do so knowing
that they face more challenge in reselling the loan. Many countries have
similar concepts or agencies that define what are "standard" mortgages.
Regulated lenders (such as banks) may be subject to limits or higher risk
weightings for non-standard mortgages. For example, banks in Canada face
restrictions on lending more than 75% of the property value; beyond this level,
mortgage insurance is generally required (as of April 2007, there is a proposal
to raise this limit to 80%).




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                          EFFECT OF SUBPRIME

Repaying the capital
There are various ways to repay a mortgage loan; repayment depends on
locality, tax laws and prevailing culture


Capital and interest
      The most common way to repay a loan is to make regular payments of
the capital (also called principal) and interest over a set term. This is commonly
referred to as (self) amortization in the U.S. and as a repayment mortgage in
the UK. A mortgage is a form of annuity (from the perspective of the lender),
and the calculation of the periodic payments is based on the time value of
money formulas. Certain details may be specific to different locations: interest
may be calculated on the basis of a 360-day year, for example; interest may be
compounded daily, yearly, or semi-annually; prepayment penalties may apply;
and other factors. There may be legal restrictions on certain matters, and
consumer protection laws may specify or prohibit certain practices.

       Depending on the size of the loan and the prevailing practice in the
country the term may be short (10 years) or long (50 years plus). In the UK and
U.S., 25 to 30 years is the usual maximum term (although shorter periods, such
as 15-year mortgage loans, are common). Mortgage payments, which are
typically made monthly, contain a capital (repayment of the principal) and an
interest element. The amount of capital included in each payment varies
throughout the term of the mortgage. In the early years the repayments are
largely interest and a small part capital. Towards the end of the mortgage the
payments are mostly capital and a smaller portion interest. In this way the
payment amount determined at outset is calculated to ensure the loan is
repaid at a specified date in the future. This gives borrowers assurance that by
maintaining repayment the loan will be cleared at a specified date, if the
interest rate does not change.




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                          EFFECT OF SUBPRIME

Interest only
       The main alternative to capital and interest mortgage is an interest only
mortgage, where the capital is not repaid throughout the term. This type of
mortgage is common in the UK, especially when associated with a regular
investment plan. With this arrangement regular contributions are made to a
separate investment plan designed to build up a lump sum to repay the
mortgage at maturity. This type of arrangement is called an investment-backed
mortgage or is often related to the type of plan used: endowment mortgage if
an endowment policy is used, similarly a Personal Equity Plan (PEP) mortgage,
Individual Savings Account (ISA) mortgage or pension mortgage. Historically,
investment-backed mortgages offered various tax advantages over repayment
mortgages, although this is no longer the case in the UK. Investment-backed
mortgages are seen as higher risk as they are dependent on the investment
making sufficient return to clear the debt.

       Until recently it was not uncommon for interest only mortgages to be
arranged without a repayment vehicle, with the borrower gambling that the
property market will rise sufficiently for the loan to be repaid by trading down
at retirement (or when rent on the property and inflation combine to surpass
the interest rate).


No capital or interest
      For older borrowers (typically in retirement), it may be possible to
arrange a mortgage where neither the capital nor interest is repaid. The
interest is rolled up with the capital, increasing the debt each year.

      These arrangements are variously called reverse mortgages, lifetime
mortgages or equity release mortgages, depending on the country. The loans
are typically not repaid until the borrowers die, hence the age restriction. For
further details, see equity release.


Interest and partial capital
      In the U.S. a partial amortization or balloon loan is one where the
amount of monthly payments due are calculated (amortized) over a certain
term, but the outstanding capital balance is due at some point short of that
term. In the UK, a part repayment mortgage is quite common, especially where
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the original mortgage was investment-backed and on moving house further
borrowing is arranged on a capital and interest (repayment) basis.


Foreclosure and non-recourse lending
      In most jurisdictions, a lender may foreclose the mortgaged property if
certain conditions - principally, non-payment of the mortgage loan - obtain.
Subject to local legal requirements, the property may then be sold. Any
amounts received from the sale (net of costs) are applied to the original debt.
In some jurisdictions, mortgage loans are non-recourse loans: if the funds
recouped from sale of the mortgaged property are insufficient to cover the
outstanding debt, the lender may not have recourse to the borrower after
foreclosure. In other jurisdictions, the borrower remains responsible for any
remaining debt. In virtually all jurisdictions, specific procedures for foreclosure
and sale of the mortgaged property apply, and may be tightly regulated by the
relevant government; in some jurisdictions, foreclosure and sale can occur
quite rapidly, while in others, foreclosure may take many months or even
years. In many countries, the ability of lenders to foreclose is extremely
limited, and mortgage market development has been notably slower.




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                           EFFECT OF SUBPRIME

Credit card
       A credit card is part of a system of payments named after the small
plastic card issued to users of the system. It is a card entitling its holder to buy
goods and services based on the holders promise to pay for these goods and
services. The issuer of the card grants a line of credit to the consumer (or the
user) from which the user can borrow money for payment to a merchant or as
a cash advance to the user. A credit card is different from a charge card, where
a charge card requires the balance to be paid in full each month. In contrast,
credit cards allow the consumers to 'revolve' their balance, at the cost of
having interest charged. Most credit cards are issued by local banks or credit
unions, and are the same shape and size as specified by the ISO 7810 standard.


How credit cards work
      Credit cards are issued after an account has been approved by the credit
provider, after which cardholders can use it to make purchases at merchants
accepting that card.

       When a purchase is made, the credit card user agrees to pay the card
issuer. The cardholder indicates his/her consent to pay, by signing a receipt
with a record of the card details and indicating the amount to be paid or by
entering a Personal identification number (PIN). Also, many merchants now
accept verbal authorizations via telephone and electronic authorization using
the Internet, known as a 'Card/Cardholder Not Present' (CNP) transaction.

       Electronic verification systems allow merchants to verify that the card is
valid and the credit card customer has sufficient credit to cover the purchase in
a few seconds, allowing the verification to happen at time of purchase. The
verification is performed using a credit card payment terminal or Point of Sale
(POS) system with a communications link to the merchant's acquiring bank.
Data from the card is obtained from a magnetic stripe or chip on the card; the
latter system is in the United Kingdom and Ireland commonly known as Chip
and PIN, but is more technically an EMV card.

     Other variations of verification systems are used by ecommerce
merchants to determine if the user's account is valid and able to accept the

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charge. These will typically involve the cardholder providing additional
information, such as the security code printed on the back of the card, or the
address of the cardholder.

       Each month, the credit card user is sent a statement indicating the
purchases undertaken with the card, any outstanding fees, and the total
amount owed. After receiving the statement, the cardholder may dispute any
charges that he or she thinks are incorrect (see Fair Credit Billing Act for details
of the US regulations). Otherwise, the cardholder must pay a defined minimum
proportion of the bill by a due date, or may choose to pay a higher amount up
to the entire amount owed. The credit provider charges interest on the
amount owed if the balance is not paid in full (typically at a much higher rate
than most other forms of debt). Some financial institutions can arrange for
automatic payments to be deducted from the user's bank accounts, thus
avoiding late payment altogether as long as the cardholder has sufficient
funds.




Interest charges
       Credit card issuers usually waive interest charges if the balance is paid in
full each month, but typically will charge full interest on the entire outstanding
balance from the date of each purchase if the total balance is not paid.

      For example, if a user had a $1,000 transaction and repaid it in full
within this grace period, there would be no interest charged. If, however, even
$1.00 of the total amount remained unpaid, interest would be charged on the
$1,000 from the date of purchase until the payment is received. The precise
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manner in which interest is charged is usually detailed in a cardholder
agreement which may be summarized on the back of the monthly statement.
The general calculation formula most financial institutions use to determine
the amount of interest to be charged is APR/100 x ADB/365 x number of days
revolved. Take the Annual percentage rate (APR) and divide by 100 then
multiply to the amount of the average daily balance (ADB) divided by 365 and
then take this total and multiply by the total number of days the amount
revolved before payment was made on the account. Financial institutions refer
to interest charged back to the original time of the transaction and up to the
time a payment was made, if not in full, as RRFC or residual retail finance
charge. Thus after an amount has revolved and a payment has been made, the
user of the card will still receive interest charges on their statement after
paying the next statement in full (in fact the statement may only have a charge
for interest that collected up until the date the full balance was paid...i.e. when
the balance stopped revolving).

       The credit card may simply serve as a form of revolving credit, or it may
become a complicated financial instrument with multiple balance segments
each at a different interest rate, possibly with a single umbrella credit limit, or
with separate credit limits applicable to the various balance segments. Usually
this compartmentalization is the result of special incentive offers from the
issuing bank, to encourage balance transfers from cards of other issuers. In the
event that several interest rates apply to various balance segments, payment
allocation is generally at the discretion of the issuing bank, and payments will
therefore usually be allocated towards the lowest rate balances until paid in
full before any money is paid towards higher rate balances. Interest rates can
vary considerably from card to card, and the interest rate on a particular card
may jump dramatically if the card user is late with a payment on that card or
any other credit instrument, or even if the issuing bank decides to raise its
revenue.




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                          EFFECT OF SUBPRIME

Benefits to customers
       Because of intense competition in the credit card industry, credit card
providers often offer incentives such as frequent flyer points, gift certificates,
or cash back (typically up to 1 percent based on total purchases) to try to
attract customers to their programs.

      Low interest credit cards or even 0% interest credit cards are available.
However, services are available which alert credit card holders when their low
interest period is due to expire. Most such services charge a monthly or annual
fee.


Detriments to customers
       Credit cards with low introductory rates are limited to a fixed term,
usually between 6 and 12 months after which a higher rate is charged. As all
credit cards assess fees and interest, some customers become so encumbered
with their credit debt service that they are driven to bankruptcy.


Grace period
       A credit card's grace period is the time the customer has to pay the
balance before interest is charged to the balance. Grace periods vary, but
usually range from 20 to 40 days depending on the type of credit card and the
issuing bank. Some policies allow for reinstatement after certain conditions are
met.

       Usually, if a customer is late paying the balance, finance charges will be
calculated and the grace period does not apply. Finance charges incurred
depend on the grace period and balance; with most credit cards there is no
grace period if there is any outstanding balance from the previous billing cycle
or statement (i.e. interest is applied on both the previous balance and new
transactions). However, there are some credit cards that will only apply finance
charge on the previous or old balance, excluding new transactions.




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                          EFFECT OF SUBPRIME

Benefits to merchants
      For merchants, a credit card transaction is often more secure than other
forms of payment, such as checks, because the issuing bank commits to pay
the merchant the moment the transaction is authorized, regardless of whether
the consumer defaults on the credit card payment (except for legitimate
disputes, which are discussed below, and can result in charges back to the
merchant). In most cases, cards are even more secure than cash, because they
discourage theft by the merchant's employees and reduce the amount of cash
on the premises. Prior to credit cards, each merchant had to evaluate each
customer's credit history before extending credit. That task is now performed
by the banks which assume the credit risk.

       For each purchase, the bank charges the merchant a commission
(discount fee) for this service and there may be a certain delay before the
agreed payment is received by the merchant. The commission is often a
percentage of the transaction amount, plus a fixed fee. In addition, a merchant
may be penalized or have their ability to receive payment using that credit card
restricted if there are too many cancellations or reversals of charges as a result
of disputes. Some small merchants require credit purchases to have a
minimum amount (usually between $5 and $10) to compensate for the
transaction costs, though this is strictly prohibited by credit card companies
and must be reported to the consumer's credit card issuer.

       In some countries, for example the Nordic countries, banks guarantee
payment on stolen cards only if an ID card is checked and the ID card
number/civic registration number is written down on the receipt together with
the signature. In these countries merchants therefore usually ask for ID. Non-
Nordic citizens, who are unlikely to possess a Nordic ID card or driving license,
will instead have to show their passport, and the passport number will be
written down on the receipt, sometimes together with other information.
Some shops use the card's PIN for identification, and in that case showing an ID
card is not necessary.




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Detriments to merchants
Merchants are charged many fees for the privilege of accepting credit cards.
The merchant may be charged a discount rate of 1%-3%+ of each transaction
obtained through a credit card. Usually, the merchant will also pay a flat per-
item charge of $0.05 - $0.50 for each transaction. Thus in some instances of
very low value transactions, use of credit cards may actually cause the
merchant to lose money on the transaction


Parties involved
      Cardholder: The holder of the card used to make a purchase; the
consumer.

      Card-issuing bank: The financial institution or other organization that
issued the credit card to the cardholder. This bank bills the consumer for
repayment and bears the risk that the card is used fraudulently. American
Express and Discover were previously the only card-issuing banks for their
respective brands, but as of 2007, this is no longer the case.



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     Merchant: The individual or business accepting credit card payments for
products or services sold to the cardholder

Acquiring bank: The financial institution accepting payment for the products or
services on behalf of the merchant.

Independent sales organization: Resellers (to merchants) of the services of the
acquiring bank.

Merchant account: This could refer to the acquiring bank or the independent
sales organization, but in general is the organization that the merchant deals
with.

Credit Card association: An association of card-issuing banks such as Visa,
MasterCard, Discover, American express, etc. that set transaction terms for
merchants, card-issuing banks, and acquiring banks.

Transaction network: The system that implements the mechanics of the
electronic transactions. May be operated by an independent company, and
one company may operate multiple networks. Transaction processing
networks include: Carnet, Nabisco, Omaha, Paymentech, NDC Atlanta, Nova,
TSYS, Concord EFSnet, and VisaNet.

       Affinity partner: Some institutions lend their names to an issuer to
attract customers that have a strong relationship with that institution, and get
paid a fee or a percentage of the balance for each card issued using their
name. Examples of typical affinity partners are sports teams, universities,
charities, professional organizations, and major retailers.

The flow of information and money between these parties — always through
the card associations — is known as the interchange, and it consists of a few
steps.




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Transaction steps
      Authorization: The cardholder pays for the purchase and the merchant
submits the transaction to the acquirer (acquiring bank). The acquirer verifies
the credit card number, the transaction type and the amount with the issuer
(Card-issuing bank) and reserves that amount of the cardholder's credit limit
for the merchant. An authorization will generate an approval code, which the
merchant stores with the transaction.

        Batching: Authorized transactions are stored in "batches", which are
sent to the acquirer. Batches are typically submitted once per day at the end of
the business day. If a transaction is not submitted in the batch, the
authorization will stay valid for a period determined by the issuer, after which
the held amount will be returned back to the cardholder's available credit (see
authorization hold). Some transactions may be submitted in the batch without
prior authorizations; these are either transactions falling under the merchant's
floor limit or ones where the authorization was unsuccessful but the merchant
still attempts to force the transaction through. (Such may be the case when
the cardholder is not present but owes the merchant additional money, such
as extending a hotel stay or car rental.)

       Clearing and Settlement: The acquirer sends the batch transactions
through the credit card association, which debits the issuers for payment and
credits the acquirer. Essentially, the issuer pays the acquirer for the
transaction.

      Funding: Once the acquirer has been paid, the acquirer pays the
merchant. The merchant receives the amount totaling the funds in the batch
minus the "discount rate," which is the fee the merchant pays the acquirer for
processing the transactions.

       Chargebacks: A chargeback is an event in which money in a merchant
account is held due to a dispute relating to the transaction. Chargebacks are
typically initiated by the cardholder. In the event of a chargeback, the issuer
returns the transaction to the acquirer for resolution. The acquirer then
forwards the chargeback to the merchant, who must either accept the
chargeback or contest it.


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                           EFFECT OF SUBPRIME

Secured credit cards
       A secured credit card is a type of credit card secured by a deposit
account owned by the cardholder. Typically, the cardholder must deposit
between 100% and 200% of the total amount of credit desired. Thus if the
cardholder puts down $1000, they will be given credit in the range of $500–
$1000. In some cases, credit card issuers will offer incentives even on their
secured card portfolios. In these cases, the deposit required may be
significantly less than the required credit limit, and can be as low as 10% of the
desired credit limit. This deposit is held in a special savings account. Credit card
issuers offer this because they have noticed that delinquencies were notably
reduced when the customer perceives something to lose if the balance is not
repaid.

       The cardholder of a secured credit card is still expected to make regular
payments, as with a regular credit card, but should they default on a payment,
the card issuer has the option of recovering the cost of the purchases paid to
the merchants out of the deposit. The advantage of the secured card for an
individual with negative or no credit history is that most companies report
regularly to the major credit bureaus. This allows for building of positive credit
history.

       Although the deposit is in the hands of the credit card issuer as security
in the event of default by the consumer, the deposit will not be debited simply
for missing one or two payments. Usually the deposit is only used as an offset
when the account is closed, either at the request of the customer or due to
severe delinquency (150 to 180 days). This means that an account which is less
than 150 days delinquent will continue to accrue interest and fees, and could
result in a balance which is much higher than the actual credit limit on the
card. In these cases the total debt may far exceed the original deposit and the
cardholder not only forfeits their deposit but is left with an additional debt.

     Most of these conditions are usually described in a cardholder
agreement which the cardholder signs when their account is opened.

      Secured credit cards are an option to allow a person with a poor credit
history or no credit history to have a credit card which might not otherwise be
available. They are often offered as a means of rebuilding one's credit. Secured

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credit cards are available with both Visa and MasterCard logos on them. Fees
and service charges for secured credit cards often exceed those charged for
ordinary non-secured credit cards, however, for people in certain situations,
(for example, after charging off on other credit cards, or people with a long
history of delinquency on various forms of debt), secured cards can often be
less expensive in total cost than unsecured credit cards, even including the
security deposit.

     Sometimes a credit card will be secured by the equity in the borrower's
home. This is called a home equity line of credit (HELOC).


Prepaid "credit" cards
       A prepaid credit card is not a credit card,since no credit is offered by the
card issuer: the card-holder spends money which has been "stored" via a prior
deposit by the card-holder or someone else, such as a parent or employer.
However, it carries a credit-card brand (Visa, MasterCard, American Express or
Discover) and can be used in similar ways just as though it were a regular credit
card.

       After purchasing the card, the cardholder loads the account with any
amount of money, up to the predetermined card limit and then uses the card
to make purchases the same way as a typical credit card. Prepaid cards can be
issued to minors (above 13) since there is no credit line involved. The main
advantage over secured credit cards (see above section) is that you are not
required to come up with $500 or more to open an account. With prepaid
credit cards you are not charged any interest but you are often charged a
purchasing fee plus monthly fees after an arbitrary time period. Many other
fees also usually apply to a prepaid card.

Prepaid credit cards are sometimes marketed to teenagers for shopping online
without having their parents complete the transaction.

       Because of the many fees that apply to obtaining and using credit-card-
branded prepaid cards, the Financial Consumer Agency of Canada describes
them as "an expensive way to spend your own money". The agency publishes a
booklet, "Pre-paid cards", which explains the advantages and disadvantages of
this type of prepaid card.

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                          EFFECT OF SUBPRIME

Credit Card Security
       Credit card security relies on the physical security of the plastic card as
well as the privacy of the credit card number. Therefore, whenever a person
other than the card owner has access to the card or its number, security is
potentially compromised. Merchants often accept credit card numbers without
additional verification for mail order purchases. They however record the
delivery address as a security measure to minimise fraudulent purchases.
Some merchants will accept a credit card number for in-store purchases,
whereupon access to the number allows easy fraud, but many require the card
itself to be present, and require a signature. Thus, a stolen card can be
cancelled, and if this is done quickly, will greatly limit the fraud that can take
place in this way. For internet purchases, there is sometimes the same level of
security as for mail order (number only) hence requiring only that the fraudster
take care about collecting the goods, but often there are additional measures.
The main one is to require a security PIN with the card, which requires that the
thief have access to the card, as well as the PIN.

      The PCI DSS is the security standard issued by The PCI SSC (Payment
Card Industry Security Standards Council). This data security standard is used
by acquiring banks to impose cardholder data security measures upon their
merchants.


Problems
His low security of the credit card system presents countless opportunities for
fraud. This opportunity has created a huge black market in stolen credit card
numbers, which are generally used quickly before the cards are reported
stolen.

The goal of the credit card companies is not to eliminate fraud, but to "reduce
it to manageable levels". This implies that high-cost low-return fraud
prevention measures will not be used if their cost exceeds the potential gains
from fraud reduction.

Most internet fraud is done through the use of stolen credit card information
which is obtained in many ways, the simplest being copying information from

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retailers, either online or offline. Despite efforts to improve security for
remote purchases using credit cards, systems with security holes are usually
the result of poor implementations of card acquisition by merchants. For
example, a website that uses SSL to encrypt card numbers from a client may
simply email the number from the webserver to someone who manually
processes the card details at a card terminal. Naturally, anywhere card details
become human-readable before being processed at the acquiring bank, a
security risk is created. However, many banks offer systems where encrypted
card details captured on a merchant's webserver can be sent directly to the
payment processor.

Controlled Payment Numbers which are used by various banks such as Citibank
(Virtual Account Numbers), Discover (Secure Online Account Numbers, Bank of
America (ShopSafe), 5 banks using eCarte Bleue and CMB's Virtualis in France,
and Swedbank of Sweden's eKort product are another option for protecting
one's credit card number. These are generally one-time use numbers that front
one's actual account (debit/credit) number, and are generated as one shop on-
line. They can be valid for a relatively short time, for the actual amount of the
purchase, or for a price limit set by the user. Their use can be limited to one
merchant if one chooses. The effect of this is the user’s real account details are
not exposed to the merchant and its employees. If the number the merchant
has on their database is compromised, it would be useless to a thief after the
first transaction and will be rejected if an attempt is made to use it again.




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        The same system of controls can be used on standard real plastic as well.
For example if a consumer has a chip and pin (EMV) enabled card they can
limit that card so that it be used only at point of sale locations (i.e. restricted
from being used on-line) and only in a given territory (i.e. only for use in
Canada). There are many other controls too and these can be turned on and
off and varied by the credit card owner in real time as circumstances change
(i.e., they can change temporal, numerical, geographical and many other
parameters on their primary and subsidiary cards). Apart from the obvious
benefits of such controls: from a security perspective this means that a
customer can have a chip and pin card secured for the real world, and limited
for use in the home country assuming it is totally chip and pin. In this
eventuality a thief stealing the details will be prevented from using these
overseas in non chip and pin (EMV) countries). Similarly the real card can be
restricted from use on-line so that stolen details will be declined if this tried.
Then when the card user shops online they can use virtual account numbers. In
both circumstances an alert system can be built in notifying a user that a
fraudulent attempt has been made which breaches their parameters, and can
provide data on this in real time. This is the optimal method of security for
credit cards, as it provides very high levels of security, control and awareness
in the real and virtual world. Furthermore it requires no changes for merchants
at all and is attractive to users, merchants and banks, as it not only detects
fraud but prevents it.

       The Federal Bureau of Investigation and U.S. Postal Inspection Service
are responsible for prosecuting criminals who engage in credit card fraud in
the United States, but they do not have the resources to pursue all criminals. In
general, federal officials only prosecute cases exceeding US $5000 in value.
Three improvements to card security have been introduced to the more
common credit card networks but none has proven to help reduce credit card
fraud so far. First, the on-line verification system used by merchants is being
enhanced to require a 4 digit Personal Identification Number (PIN) known only
to the card holder. Second, the cards themselves are being replaced with
similar-looking tamper-resistant smart cards which are intended to make
forgery more difficult. The majority of smartcard (IC card) based credit cards
comply with the EMV (Europe MasterCard Visa) standard. Third, an additional


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3 or 4 digits Card Security Code (CSC) is now present on the back of most cards,
for use in "card not present" transactions. See CVV2 for more information.

       The way credit card owners pay off their balances has a tremendous
effect on their credit history. All the information is collected by credit bureaus.
The credit information stays on the credit report, depending on the jurisdiction
and the situation, for 1, 2, or even 10 years after the debt is repaid.




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                           EFFECT OF SUBPRIME

Credit Card Profits and losses
      In recent times, credit card portfolios have been very profitable for
banks, largely due to the booming economy of the late nineties. However, in
the case of credit cards, such high returns go hand in hand with risk, since the
business is essentially one of making unsecured (uncollateralized) loans, and
thus dependent on borrowers not to default in large numbers.


Costs
Credit card issuers (banks) have several types of costs:


Interest expenses
       Banks generally borrow the money they then lend to their customers. As
they receive very low-interest loans from other firms, they may borrow as
much as their customers require, while lending their capital to other borrowers
at higher rates. If the card issuer charges 15% on money lent to users, and it
costs 5% to borrow the money to lend, and the balance sits with the
cardholder for a year, the issuer earns 10% on the loan. This 5% difference is
the "interest expense" and the 10% is the "net interest spread"


Operating costs
       This is the cost of running the credit card portfolio, including everything
from paying the executives who run the company to printing the plastics, to
mailing the statements, to running the computers that keep track of every
cardholder's balance, to taking the many phone calls which cardholders place
to their issuer, to protecting the customers from fraud rings. Depending on the
issuer, marketing programs are also a significant portion of expenses.


Charge offs
       When a consumer becomes severely delinquent on a debt (often at the
point of six months without payment), the creditor may declare the debt to be
a charge-off. It will then be listed as such on the debtor's credit bureau reports
(Equifax, for instance, lists "R9" in the "status" column to denote a charge-off.)
The item will include relevant dates, and the amount of the bad debt. [18]

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      A charge-off is considered to be "written off as uncollectable." To banks,
bad debts and even fraud are simply part of the cost of doing business.

       However, the debt is still legally valid, and the creditor can attempt to
collect the full amount for the time periods permitted under state law, which is
usually 3 to 7 years. This includes contacts from internal collections staff, or
more likely, an outside collection agency. If the amount is large (generally over
$1500–$2000), there is the possibility of a lawsuit or arbitration.

       In the US, as the charge off number climbs or becomes erratic, officials
from the Federal Reserve take a close look at the finances of the bank and may
impose various operating strictures on the bank, and in the most extreme
cases, may close the bank entirely.


Rewards
       Many credit card customers receive rewards, such as frequent flier
points, gift certificates, or cash back as an incentive to use the card. Rewards
are generally tied to purchasing an item or service on the card, which may or
may not include balance transfers, cash advances, or other special uses.
Depending on the type of card, rewards will generally cost the issuer between
0.25% and 2.0% of the spread. Networks such as Visa or MasterCard have
increased their fees to allow issuers to fund their rewards system. Some issuers
discourage redemption by forcing the cardholder to call customer service for
rewards. On their servicing website, redeeming awards is usually a feature that
is very well hidden by the issuers. Others encourage redemption for lower cost
merchandise; instead of an airline ticket, which is very expensive to an issuer,
the cardholder may be encouraged to redeem for a gift certificate instead.
With a fractured and competitive environment, rewards points cut
dramatically into an issuer's bottom line, and rewards points and related
incentives must be carefully managed to ensure a profitable portfolio. Unlike
unused gift cards, in whose case the breakage in certain US states goes to the
state's treasury, unredeemed credit card points are retained by the issuer.


Fraud
     The cost of fraud is high; in the UK in 2004 it was over £500 million. [19]
When a car is stolen, or an unauthorized duplicate made, most card issuers will
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refund some or all of the charges that the customer has received for things
they did not buy. These refunds will, in some cases, be at the expense of the
merchant, especially in mail order cases where the merchant cannot claim
sight of the card. In several countries, merchants will lose the money if no ID
card was asked for, therefore merchants usually require ID card in these
countries. Credit card companies generally guarantee the merchant will be
paid on legitimate transactions regardless of whether the consumer pays their
credit card bill. Most of the banking services have their own credit card
services that handle fraud cases and monitoring any possible attempt of fraud.
Employees that are specialized in doing fraud monitoring and investigation are
often placed in Risk Management or Fraud and Authorization or Cards and
Unsecured Business. The fraud monitoring emphasize in minimizing fraud
losses while doing their best to track down fraudster from getting as much
illegal information and using the credit card as their can. The credit card fraud
is one of the major problems within white collar crimes that has been around
for many decades and even though the creation of chip based card (EMV) in
some countries was in place to prevent these fraud case, there are still many
cases reported and still around in these countries.


Interchange fee
In addition to fees paid by the card holder, merchants must also pay
interchange fees to the card-issuing bank and the card association. For a
typical credit card issuer, interchange fee revenues may represent about a
quarter of total revenues...

These fees are typically from 1 to 6 percent of each sale, but will vary not only
from merchant to merchant (large merchants can negotiate lower rates), but
also from card to card, with business cards and rewards cards generally costing
the merchants more to process. The interchange fee that applies to a
particular transaction is also affected by many other variables including the
type of merchant, the merchant's total card sales volume, the merchant's
average transaction amount, whether the cards are physically present, if the
card's magnetic stripe is read or if the transaction is hand-keyed or entered on
a website, the specific type of card, when the transaction is settled, and the
authorized and settled transaction amounts.

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Interchange fees may consume over 50 percent of profits from card sales for
some merchants (such as supermarkets) that operate on slim margins. In some
cases, merchants add a surcharge to the credit cards to cover the interchange
fee, encouraging their customers to instead use cash, debit cards, or even
cherubs.


Interest on outstanding balances
       Interest charges vary widely from card issuer to card issuer. Often, there
are "teaser" rates in effect for initial periods of time (as low as zero percent
for, say, six months), whereas regular rates can be as high as 40 percent. In the
U.S. there is no federal limit on the interest or late fees credit card issuers can
charge; the interest rates are set by the states, with some states such as South
Dakota, having no ceiling on interest rates and fees, inviting some banks to
establish their credit card operations there. Other states, for example
Delaware, have very weak usury laws. The teaser rate no longer applies if the
customer doesn't pay his bills on time, and is replaced by a penalty interest
rate (for example, 24.99%) that applies retroactively.


Fees charged to customers
The major fees are for:

Late payments or overdue payments

Charges that result in exceeding the credit limit on the card (whether done
deliberately or by mistake), called over limit fees

Returned cherub fees or payment processing fees (egg phone payment fee)

Cash advances and convenience cherubs (often 3% of the amount) .
Transactions in a foreign currency (as much as 3% of the amount). A few
financial institutions do not charge a fee for this.

Membership fees (annual or monthly), sometimes a percentage of the credit
limit.




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                          EFFECT OF SUBPRIME

Credit Card in India
       The Government of India maintains a database of the fees, features,
interest rates and reward programs of nearly 200 credit cards available in
India. This database is updated on a quarterly basis with information supplied
by the credit card issuing companies. Information in the database is published
every quarter on the website of the Financial Consumer Agency of India (FCAI).

Information in the database is published in two formats. It is available in PDF
comparison tables that break down the information according to type of credit
card, allowing the reader to compare the features of, for example, and all the
student credit cards in the database.


Collectible credit cards
        A growing field of numismatics (study of money), or more specifically
economic (study of money-like objects), credit card collectors seek to collect
various embodiments of credit from the now familiar plastic cards to older
paper merchant cards, and even metal tokens that were accepted as merchant
credit cards. Early credit cards were made of celluloid plastic, then metal and
fiber, then paper, and are now mostly plastic.


Controversy
       Credit card debt has soared, particularly among young people. Since the
late 1990s, lawmakers, consumer advocacy groups, college officials and other
higher education affiliates have become increasingly concerned about the
rising use of credit cards among college students. The major credit card
companies have been accused of targeting a younger audience, in particular
college students, many of whom are already in debt with college tuition fees
and college loans and who typically are less experienced at managing their
own finances.

     A 2006 documentary film titled Maxed Out: Hard Times, Easy Credit and
the Era of Predatory Lenders deals with this subject in detail. [28] The
nonprofit group Americans for Fairness in Lending works with Maxed Out to
educate Americans about credit card abuse.

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       Another controversial area is the universal default feature of many
North American credit card contracts. When a cardholder is late paying a
particular credit card issuer, that card's interest rate can be raised, often
considerably. With universal default, a customer's other credit cards, for which
the customer may be current on payments, May also have their rates and/or
credit limit changed. This universal default feature allows creditors to
periodically check cardholders' credit portfolios to view trade, allowing these
other institutions to decrease the credit limit and/or increase rates on
cardholders who may be late with another credit card issuer. Being late on one
credit card will potentially affect all the cardholder's credit cards. Citibank
voluntarily stopped this practice in March 2007 and Chase stopped the practice
in November 2007. [29] The fact that credit card companies can change the
interest rate on debts that were incurred when a different rate of interest was
in place is similar to adjustable rate mortgages where interest rates on current
debt may rise. However, in both cases this is agreed to in advance, and is a
trade off that allows a lower initial rate as well as the possibility of an even
lower rate (mortgages, if interest rates fall) or perpetually keeping a below-
market rate (credit cards, if the user makes his debt payments on time).

        Another controversial area is the trailing interest issue. Trailing interest
is the practice of charging interest on the entire bill no matter what percentage
of it is paid. U.S Senator Carl Levin raised the issue at a U.S Senate Hearing of
millions of Americans whom he said are slaves to hidden fees, compounding
interest and cryptic terms. Their woes were heard in a Senate Permanent
Subcommittee on Investigations hearing which was chaired by Senator Levin
who said that he intends to keep the spotlight on credit card companies and
that legislative action may be necessary to purge the industry.

       In the United States, some have called for Congress to enact additional
regulations on the industry; to expand the disclosure box clearly disclosing rate
hikes, use plain language, incorporate balance payoff disclosures, and also to
outlaw universal default. At a congress hearing around March 1, 2007, Citibank
announced it would no longer practice this, effective immediately. Opponents
of such regulation argue that customers must become more proactive and self-
responsible in evaluating and negotiating terms with credit providers. Some of


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the nation's influential top credit card issuers, who are among the top fifty
corporate contributors to political campaigns, successfully opposed it.


Hidden costs
       In the United Kingdom, merchants won the right through The Credit
Cards (Price Discrimination) Order 1990[31] to charge customers different
prices according to the payment method. As of 2007, the United Kingdom was
one of the world's most credit-card-intensive countries, with 2.4 credit cards
per consumer.

In the United States, until 1984 federal law prohibited surcharges on card
transactions. Although the federal Truth in Lending Act provisions that
prohibited surcharges expired that year, a number of states have since enacted
laws that continue to outlaw the practice; California, Colorado, Connecticut,
Florida, Kansas, Massachusetts, Maine, New York, Oklahoma, and Texas have
laws against surcharges. As of 2006, the United States probably had one of the
worlds if not the top ratio of credit cards per capita, with 984 million bank-
issued Visa and MasterCard credit card and debit card accounts alone for an
adult population of roughly 220 million people. The credit card per US capital
ratio was nearly 4:1 (as of 2003) and as high as 5:1 (as of 2006)


Redlining
       Credit Card redlining is a spatially discriminatory practice among credit
card issuers of providing different amounts of credit to different areas, based
on their ethnic-minority composition, rather than on economic criteria, such as
the potential profitability of operating in those areas.




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                          EFFECT OF SUBPRIME

Citibank
Following its merger with the First National Bank, the bank changed its name
to The First National City Bank of New York in 1935, and then shortened it to
First National City Bank in 1952.

The company organically entered the leasing and credit card sectors, and its
introduction of USD certificates of deposit in London marked the first new
negotiable instrument in market since 1888. Later to become part of
MasterCard, the bank introduced its First National City Charge Service credit
card - popularly known as the "Everything Card" - in 1967. [6]

During the mid-1970s, under the leadership of CEO Walter Wrist on, First
National City Bank (and its holding company First National City Corporation)
was renamed as Citibank, N.A. (and Citicorp, respectively). By that time, the
bank had created its own "one-bank holding company" and had become a
wholly owned subsidiary of that company, Citicorp (all shareholders of the
bank had become shareholders of the new corporation, which became the
bank's sole owner).

The name change also helped to avoid confusion in Ohio with Cleveland-based
National City Bank, though the two would never have any significant
overlapping areas except for City credit cards being issued in the latter
National City territory. (In addition, at the time of the name change to Citicorp,
National City of Ohio was mostly a Cleveland-area bank and had not gone on
its acquisition spree that it would later go on in the 1990's and 2000's.) Any
possible name confusion had City not changed its name from National City
eventually became completely moot when PNC Financial Services acquired the
National City of Ohio in 2008 as a result of the subprime mortgage crisis.


Automated banking card
      Shortly afterward, the bank launched the Citicorp, which allowed
customers to perform all transactions without a passbook. Branches also had
terminals with simple one line displays that allowed customers to get basic
account information without a bank teller. When automatic teller machines
were later introduced, customers could use their existing Citicorp.

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Credit card business
       In the 1960s the bank entered into the credit card business. In 1965,
First National City Bank bought Carte Blanche from Hilton Hotels. However
after three years, the bank (under pressure from the U.S. government) was
forced to sell this division. By 1968, the company created its own credit card.
The card, known as "The Everything Card," was promoted as a kind of East
Coast version of the BankAmerica. By 1969, First National City Bank decided
that the Everything Card was too costly to promote as an independent brand
and joined Master Charge (now MasterCard). Citibank unsuccessfully tried
again in 1977–1987 to create a separate credit card brand, the Choice Card.

      John S. Reed was elected CEO in 1984, and City became a founding
member of the CHAPS clearing house in London. Under his leadership, the next
14 years would see Citibank become the largest bank in the United States, the
largest issuer of credit cards and charge cards in the world, and expand its
global reach to over 90 countries. [6]

      As the bank's expansion continued, the Narre Warren-Caroline Springs
credit card company was purchased in 1981. In 1981, Citibank chartered a
South Dakota subsidiary to take advantage of new laws that raised the state's
maximum permissible interest rate on loans to 25 percent (then the highest in
the nation). In many other states, usury laws prevented banks from charging
interest that aligned with the extremely high costs of lending money in the late
1970s and early 1980s, making consumer lending unprofitable.


Recent losses and cost cutting measures
City is reportedly losing $8–11 billion, several days after Merrill Lynch
announced that it too has been losing billions from the subprime mortgage
crisis in the US.

On April 11, 2007, the parent City announced the following staff cuts and
relocations. [7]

On 4th November, 2007, Charles "Chuck" Prince quit as the chairman and chief
executive of Citigroup, following crisis meetings with the board in New York in
the wake of billions of dollars in losses related to subprime lending.


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                          EFFECT OF SUBPRIME

Former United States Secretary of the Treasury Robert Rubin has been asked
to replace ex-CEO Charles Prince to manage the losses City has amassed over
the years of being over-exposed to subprime lending during the 2002–2007
surge in the real estate industry.

In August 2008, after a three year investigation by California's Attorney
General Citibank was ordered to repay the $14 million (close to $18 million
including interest and penalties) that was removed from 53,000 customers
accounts over an eleven year period from 1992-2003. The money was taken
under a computerized "account sweeping program" where any positive
balances from over-payments or double payments were removed without
notice to the customers. [8]

On November 23, 2008, Citigroup was forced to seek federal financing to avoid
a collapse, in a way similar to its colleagues Bear Stearns and AIG. The US
government provided $25 billion and guarantees to risky assets to Citigroup in
exchange for stock. This was the latest bailout in a string of bailouts that began
with bear Stearns and peaked with the collapse of the GSE's, Lehman, AIG and
the start of TARP.

On January 16, 2009 Citigroup announced that it was splitting into two
companies. Citicorp will continue with the traditional banking business while
City Holdings Inc. will own the more risky investments, some of which will be
sold to strengthen the balance sheet of the core business; Citicorp.



Beleaguered Citigroup is upgrading its mile-high club with a brand-new $50
million corporate jet.




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Countrywide Financial
Countrywide Financial Corporation is a diversified financial marketing and
service holding company engaged primarily in residential mortgage banking
and related businesses. It is a wholly owned subsidiary of Bank of America.

Countrywide Financial is composed of:

Mortgage Banking, which originates purchases, securitizes, and services
mortgages. In 2006 Countrywide financed 20% of all mortgages in the United
States, at a value of about 3.5% of United States GDP, a proportion greater
than any other single mortgage lender.

Banking, which operates a federally chartered thrift that primarily invests in
mortgage loans and home equity lines of credit primarily sourced through its
mortgage banking operation.

Capital Markets, which operates as an institutional broker-dealer that primarily
specializes in trading and underwriting mortgage-backed securities.

Global Operations, which provides mortgage loan application processing and
loan servicing.

During the year ended December 31, 2005, for example, the Mortgage Banking
segment generated 59% of the Company's pre-tax earnings.

On January 11, 2008, Bank of America announced that it plans to purchase
Countrywide Financial for $4.1 billion in stock. On June 5, 2008, Bank of
America Corporation announced it had received approval from the Board of
Governors of the Federal Reserve System to purchase Countrywide Financial
Corporation. On June 25, 2008, Countrywide announced it had received the
approval of 69% of its shareholders to planned merger with Bank of America.
On July 1, 2008, Bank of America Corporation completed its purchase of
Countrywide Financial Corporation. In 1997 Countrywide spun off Countrywide
Mortgage Investment as an independent company called IndyMac Bank.[1]
Federal regulators seized IndyMac on July 11, 2008, after a week-long bank run




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Financials


2005
For year-ending Dec 31, 2005, amounts in thousands of dollars.

Total Assets: $235,085,370

Total Revenues: $13,016,708

Total Expenses: $5,868,942

Net Earnings: $2,528,090

Pre-tax Earnings by Segment:

Mortgage Banking: $2,434,525

Banking: $1,074,480

Capital Markets: $451,629

Insurance: $183,716

Global: $35,353

Other: $(31,937)


2006
For year-ending Dec 31, 2006, amounts in thousands of dollars.[6]

Total Assets: $85,946,230

Total Revenues: $5,417,128

Total Expenses: $5,082,993

Net Earnings: $1,674,846

Pre-tax Earnings by Segment:

Mortgage Banking: $2,062,399

Banking: $1,080,384


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                           EFFECT OF SUBPRIME

Capital Markets: $253,500

Insurance: $120,133

Global: $28,642

Other: $(10,923)

In its 2006 annual report to the SEC, CFC disclosed that 19% of its subprime
loans were delinquent


2007
For year-ending Dec 31, 2007, amounts in thousands of dollars.[8]

Total Assets: $211,730,061

Total Revenues: $6,061,437

Total Expenses: $6,764,975

Net Earnings: $(703,538)

Pre-tax Earnings by Segment:

Mortgage Banking: $(1,517,083)

Banking: $(268,752)

Capital Markets: $14,957

Insurance: $600,542




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                          EFFECT OF SUBPRIME

Businesses


Mortgage banking
The Mortgage Banking segment produces mortgage loans through a variety of
channels on a national scale. Nearly all of the mortgage loans the company
produces in this segment are sold into the secondary market, primarily in the
form of mortgage-backed securities. In 2006, 45% of those mortgages were
conventional non-conforming loans, loans too large to sell to Fannie Mae.[9]
The company generally performs the ongoing servicing functions related to the
mortgage loans that it produces. It also provides various loan closing services,
such as title, escrow and appraisal.

The Mortgage Banking segment consists of three distinct sectors: Loan
Production, Loan Servicing and Loan Closing Services.


Loan production
      The role of Loan Production is to originate and fund new loans, and to
acquire already-funded loans through purchases from other lenders. Loan
Production produces mortgage loans through four divisions of Countrywide
Home Loans: Consumer Markets, Full Spectrum Lending, Wholesale Lending
and Correspondent Lending.

      Consumer Markets and Full Spectrum Lending offer loans directly to
consumers. Loans produced by these two retail division are originated, funded,
and sold by Countrywide. Consumer Markets offers a wide variety of products,
whereas Full Spectrum Lending focuses primarily on products appropriate for
customers with less than prime-quality credit.

      Wholesale Lending offers loans to consumers whose loans are originated
by another mortgage broker. These loans are funded and sold by Countrywide,
but originated by other lenders.

Correspondent Lending purchases mortgage loans from other lenders, which
include mortgage bankers, commercial banks, savings and loan associations,
home builders and credit unions. These loans may be sold by Countrywide to
end-investors on the secondary market, but are originated and funded by
other lenders.
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                           EFFECT OF SUBPRIME

Loan servicing
       Loan Servicing services loans, i.e. collects payments from the borrower,
handles escrow accounts, tax and/or insurance payments (if applicable), then
remits "advances" to the investor's trustee as specified in the Pooling and
Servicing Agreement (PSA).

       Loan Servicing typically retains a fraction of the payment made (typically
25 - 45 basis points of the unpaid principal balance) as a "servicing fee".

       Loan Servicing also generates income in the form of interest on monies
received and held prior to paying scheduled advances to the trustee, fees
charged for late payments, force-placed insurance, document requests, legal
fees, payoff statements, etc.


Loan closing services
LandSafe and its subsidiaries offer loan closing services, including real estate
appraisal services, automated credit reporting products, flood determination
services and residential title services for the six major counties of Southern
California.


Banking
      The Banking segment consists of Countrywide Bank, FSB and
Countrywide Warehouse Lending. Formerly, the bank was known as
Countrywide Bank, N.A., a nationally chartered bank that was regulated jointly
by the Office of the Comptroller of the Currency and the Federal Reserve, but it
converted its charter to a federally chartered thrift that is regulated by the
Office of Thrift Supervision.[11][12] Countrywide Bank is the 3rd largest
Savings and Loan institution and is the fastest growing bank in United States
history. Assets from deposits are currently approaching $125 billion.

Countrywide Bank primarily originates and purchases mortgage loans and
home equity lines of credit for investment purposes. The majority of these
loans are sourced through its mortgage banking subsidiary, Countrywide Home
Loans. The Bank obtains retail deposits, primarily certificates of deposit,
through the Internet, call centers and more than 200 financial centers, many of



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                          EFFECT OF SUBPRIME

which are located in Countrywide Home Loans' retail branch offices as of April
1, 2007.

      Countrywide Warehouse Lending provides warehouse lines of credit to
mortgage bankers, who use these funds to originate loans. These mortgage
bankers are primarily customers of Countrywide Home Loans' Correspondent
Lending division and the Capital Markets divisions; the mortgage bankers use
warehouse lines of credit from Countrywide Warehouse Lending to help
originate loans, then sell those loans to Countrywide through Correspondent
Lending or Capital Markets.


Capital markets
      The Capital Markets segment primarily operates as a registered
securities broker dealer, a residential mortgage loan manager and a
commercial mortgage loan originator. CFC also operates broker dealers in
Japan and the United Kingdom, an introducing broker dealer of futures
contracts, an asset manager and a broker of mortgage servicing rights. With
the exception of its commercial mortgage activities, the company transacts
only with institutional customers, such as banks, other depository institutions,
insurance companies, asset managers, mutual funds, pension plans, other
broker dealers and governmental agencies. Customers of its commercial real
estate finance business are the owners or sponsors of commercial properties,
who can be individuals or institutions.

       Countrywide Asset Management Corporation manages the acquisition
and disposition of loans from third parties, as well as loans originated by
Countrywide Home Loans, on behalf of Countrywide Home Loans. These are
typically delinquent or otherwise illiquid residential mortgage loans, which
have primarily been originated under Federal Housing Administration (FHA)
and Veterans Administration (VA) programs. The Company attempts to
rehabilitate the loans, using the servicing operations of Countrywide Home
Loans, with the intent to securitize those loans that become eligible for
securitization. The remaining loans are serviced through foreclosure and
liquidation, which includes the collection of government insurance and
guarantee proceeds relating to defaulted FHA and VA program loans.


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                           EFFECT OF SUBPRIME

       Securities trading activities include the trading of debt securities in the
secondary market after the original issuance of the security. Underwriting
activities encompass the assumption of the risk of buying a new issue of
securities from the issuer and reselling the securities to investors, either
directly or through dealers. Capital Markets primarily underwrites mortgage-
related debt securities.


Insurance
      The Insurance segment activities include offering property, casualty, life
and credit insurance as an underwriter and as an insurance agency, and
providing reinsurance coverage to primary mortgage insurers, through two
business units: Balboa Life and Casualty Operations, and Balboa Reinsurance
Company.

       Balboa Life and Casualty Group underwrite property, casualty, life and
credit insurance in all 50 states through the Balboa Life and Casualty Group. Its
products include Lender-Placed Property and Auto, which includes lender-
placed auto insurance and lender-placed, real-property hazard insurance;
Voluntary Homeowners and Auto, which underwrites retail homeowners
insurance and home warranty plans for consumers, and Life and Credit, which
underwrites term life, credit life and credit disability insurance products.

        Balboa Reinsurance Company provides a mezzanine layer of reinsurance
coverage for losses between minimum and maximum specified amounts to the
insurance companies that provide private mortgage insurance (PMI) on loans
in its servicing portfolio. It provides this coverage with respect to substantially
all of the loans in the Company's portfolio that are covered by PMI, which
generally includes all conventional loans with an original loan amount in excess
of 80% of the property's appraised value. In return for providing this coverage,
it earns a portion of the PMI premiums.




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                          EFFECT OF SUBPRIME

Global operations
      The primary activities of the Global Operations segment was Global
Home Loans (GHL): a UK third party administrator (TPA) formed out of a joint
venture between Countrywide and Woolwich plc in 1998. Activities included
Loan Processing and Subservicing, providing mortgage loan application
processing and mortgage loan subservicing in the United Kingdom.

      Following the acquisition of Woolwich by Barclays plc, this relationship
developed further, with GHL acquiring the Barclays mortgage portfolio,
through a transfer of ownership of the Barclays mortgage operation in Leeds to
GHL in 2003.

       By 2005, GHL operation processed more than 11.3 billion pounds
sterling ($20.3 billion) in loans, all of which are subserviced for Barclays, PLC,
and the joint venture partner. As of December 31, 2005, Global's subservicing
portfolio was 59 billion pounds sterling ($102 billion).

      In November 2005, Barclays announced that it intended to terminate
the third party administration arrangement with GHL and bring the mortgage
originations and servicing operations back in-house. This resulted in
Countrywide buying out Barclays' remaining 30% stake in GHL. Barclays
brought the operation back in-house in February 2006.

      Since then Global's presence in the UK has been confined to providing
support to Barclays and Prudential Assurance, who continue to use the
proprietary originations, servicing and arrears processing systems developed
for GHL and Countrywide by Countrywide Technology Group (CWTG).

      A second venture in the UK, Valuation Services, provided one of the first
electronic residential property valuation services to third parties in the United
Kingdom through a majority-owned joint venture. This was sold to First
American in 2007.

      Offshore Services commenced operations in India in 2004. Set up to
exploit the strategic advantage of employing systems specialists based in the
sub-continent, it provides business process and technology services to the
Parent Company and its subsidiaries in both the United States and the United
Kingdom.

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                          EFFECT OF SUBPRIME

Controversies
Employee and contract labor issues
       In 2003, Countrywide was the subject of a class-action lawsuit alleging
overtime violations. Countrywide was charged with working employees 10-15
hours per day, 6 to 7 days per week without compensating them for overtime
wages.[13] The lawsuit was settled in May 2005, with the payment of $30
million in compensation to 400 account executives.[14] Additionally,
Countrywide is one of many companies that conducts in-depth background
searches of new employee applicants. The background search goes beyond
typical employment, education, and criminal history searches, and enables a
company to view the applicant's credit, and public record documents such as
lawsuits and divorce records. Although it must be authorized by the applicant,
Countrywide explicitly does not consider applicants who deny authorization for
a search. This policy has led to otherwise qualified applicant complaints and
dispute filings which claim this policy is discriminatory, invasive, and
compromises the applicant's privacy.

      Countrywide maintains a policy of not filing the legally required Internal
Revenue Service Form 1099 to independent brokers.[9] The validity of this is
questionable however.


Minority and subprime borrowers
Countrywide agreed to a settlement with New York state attorney general
Elliot Spitzer to compensate black and Hispanic borrowers improperly steered
by Countrywide salespeople to higher-cost loans. The company also agreed to
improve training and oversight of its loan officers and to pay New York state
$200,000 to cover costs of the investigation.

Countrywide subprime documents show a policy of lending to families with as
little as $1000 of disposal income, often compromising their ability to pay living
expenses. This guideline was not established by Countrywide, but rather the
investors to whom they sold their loans. However Countrywide had no qualms
in following through despite it knowing those families would likely fail to make
monthly payments: these loans would be sold to investors shortly after

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                          EFFECT OF SUBPRIME

anyway. Employees were given scripts as a sales aid when talking to customers
about taking out loans.

Economist Stan Liebowitz writes that the Fannie Mae Foundation singled out
Countrywide Financial as a "paragon" of a nondiscriminatory lender who works
with community activists, following "the most flexible underwriting criteria
permitted." The chief executive of Countrywide is said to have "bragged" that
in order to approve minority applications, "lenders have had to stretch the
rules a bit." Countrywide's commitment to low-income loans had grown to
$600 billion by early 2003


Hurricanes Katrina and Rita complaints
       Some customers have complained that after the devastating hurricanes
Katrina and Rita, Countrywide told loan customers in the affected areas that
they could take a break on payments without any late fees, and the payments
would be added back to the end of the loan. They now contend that
Countrywide forced the loan customers to pay the missed payments in a lump
sum, along with late fees they were told they didn't have to pay, within 30 days
or face foreclosure

"Friends of Angelo" VIP program

      In June 2008 Conde Nast Portfolio reported that numerous Washington,
DC politicians over recent years had received mortgage financing at
noncompetitive rates because the corporation considered the officeholders
"FOA's"—"Friends of Angelo". The politicians extended such favorable
financing included the chairman of the Senate Banking Committee, Democrat
Christopher Dodd, and the chairman of the Senate Budget Committee,
Democrat Kent Conrad. The article also noted Countrywide's political action
committee had made large donations to Dodd's campaign. Democrat Senator
Dodd proposed that the federal government buy up to $400 Billion in
defaulted mortgages. Citizens for Responsibility and Ethics in Washington
(CREW) has called for House and Senate to investigate Senators Conrad and
Dodd.

      It was reported that James Johnson, former CEO of Fannie Mae and an
adviser to Democratic presidential candidate Barack Obama, had received

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                           EFFECT OF SUBPRIME

loans under the "Friends of Angelo". Johnson announced he would step down
from the vice-presidential vetting position on June 11, 2008 in order to avoid
being a distraction to Obama's campaign.

      In June 2008 The Wall Street Journal reported that Franklin Raines, a
former CEO of Fannie Mae, received below market rates loans at Countrywide
Financial because the corporation considered the officeholders "FOA's"—
"Friends of Angelo" (Countrywide Chief Executive Angelo Mozilo). He received
loans for over $3 million while CEO of Fannie Mae. On July 16, 2008, The
Washington Post reported that Franklin Raines had "taken calls from Barack
Obama's presidential campaign seeking his advice on mortgage and housing
policy matters. Subsequent attempts to connect Obama's campaign with
Franklin Raines were characterized by The Washington Post as "a stretch"


State lawsuits
The office of Illinois Attorney General, Lisa Madigan, filed a civil lawsuit in Cook
County Circuit Court against Countrywide Financial Corporation on June 25,
2008. The lawsuit cites information gathered from documents obtained via a
subpoena in the fall of 2007. Madigan's office claims the "mortgage lender
engaged in "unfair and deceptive" practices to get homeowners to apply for
risky mortgages far beyond their means."

California Attorney General, Jerry Brown, followed suit by filing a similar
lawsuit on June 25, 2008, accusing the lender of breaking the state's laws
against false advertising and unfair business practices. The lawsuit also claims
the defendant mislead many consumers by misinforming them about the
workings of certain mortgages such adjustable-rate mortgages, interest-only
loans, low-documentation loans and home-equity loans while telling
borrowers they would be able to refinance before the interest rate on their
loans adjusted.

In August 2008, Connecticut Attorney General Richard Blumenthal also
brought suit against Countrywide, alleging that deceptive lending practices had
ripped off Connecticut homeowners.




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                          EFFECT OF SUBPRIME

Current events
Subprime Mortgage Crisis
Secondary market disruption
When Countrywide finances mortgage loans, they usually package them for
sale to large investors as mortgage-backed securities. Fannie Mae or Freddie
Mac can only buy loans which conform to the standards of government
sponsored enterprises. Non-conforming mortgages securities must be sold in
the private, secondary market to alternative investors. On August 3, 2007, this
secondary market essentially stopped trading most of the non-conforming
securities. Secondary mortgage market disruptions had happened previously,
but, the new disruption appeared more serious, both larger in range and likely
duration. Alt-A mortgages (loans given to apparently creditworthy borrowers
without much or any documentation) completely stopped at ratings lower than
AAA. Difficulties extended to much of AAA-rated mortgage-backed securities.
Only securities with conforming mortgages were trading. Countrywide
Financial issued a statement that its mortgage business has access to a nearly
$50 billion funding cushion.

After the collapse of American Home Mortgage on August 6, attention
returned to Countrywide Financial which at the time had issued about 17% of
all mortgages in the United States. Only days later Countrywide Financial
disclosed to the SEC that these disruptions in the secondary mortgage markets
could hurt it financially:

"Since the company is highly dependent on the availability of credit to finance
its operations, disruptions in the debt markets or a reduction in our credit
ratings could have an adverse impact on our earnings and financial condition,
particularly in the short term… Current conditions in the debt markets include
reduced liquidity and increased credit risk premiums for certain market
participants. These conditions, which increase the cost and reduce the
availability of debt, may continue or worsen in the future…. There can be no
assurance, however, that the Company will be successful in these efforts, that
such facilities will be adequate or that the cost of debt will allow us to operate
at profitable levels."
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This raised speculation that Countrywide was a potential bankruptcy risk. On
August 10, a run on the bank began as the secondary mortgage market shut
down, curtailing new mortgage funding.

The perceived risk of Countrywide bonds rose. Fitch, Moody's and Standard
and Poors credit ratings agencies downgraded Countrywide 1 or 2 grades,
some to near junk status. The cost of insuring its bonds rose 22% overnight.
This also limited its access to short-term debt called commercial paper. This is
often cheaper than bank loans. Some institutional investors admitted trying to
sell Countrywide paper. Fifty other mortgage lenders had already filed for
Chapter 11 bankruptcy, and Countrywide Financial was cited as a possible
bankruptcy risk by Merrill Lynch and others on August 15. This combined with
news that its ability to issue new commercial paper might be severely
hampered put severe pressure on the stock. Its shares fell $3.17 to $21.29,
which was its biggest fall in a single day since the crash of 1987 - the shares
had fallen 50% so far that year. On August 15, 2007, Merrill Lynch advised its
clients to sell their stock in Countrywide.


Announcement of problems and bailouts
       On Thursday, August 16, 2007 the company expressed concerns over
liquidity because of the decline of the secondary market for securitized
mortgage obligations. Countrywide also announced its intent to draw on the
entire $11.5 billion credit line from a group of 40 banks including JPMorgan
Chase. On Friday August 17, many depositors sought to withdraw their bank
accounts. Countrywide also planned to make 90% of its loans conforming. By
this point stock shares had lost about 75% of their peak value and speculation
of bankruptcy broadened. At the same time the Federal Reserve Bank lowered
the discount rate 0.5% in a last-minute, early morning conference call. The Fed
accepted about $17.2 billion in repurchase agreements for mortgage backed
securities to aid in liquidity. This also helped calm the stock market and
investors promptly responded positively with the Dow posting gains.

Additionally, the firm was forced to restate income it had claimed from
accrued but unpaid interest on "exotic" mortgages where the initial pay rate
was less than the amortization rate. In 2007 it became apparent much of this
interest had become uncollectable.

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      In a letter dated August 20, Federal Reserve agreed to waive banking
regulations at the request of Citigroup and Bank of America. The Fed agreed to
exempt both banks from rules that limited the amount that federally-insured
banks can lend to related brokerage companies to 10% of bank capital. Until
then, banking regulation was that banks with federally insured deposits should
not be put at risk by brokerage subsidiaries' activities. On August 23, Citibank
and Bank of America said that they and two other banks accessed $500 million
in 30-day financing at the Fed's discount window. The same day, Countrywide
Financial obtained $2 billion of new capital from Bank of America Corp. For this
the Bank of America brokerage arm would get convertible preferred stock.

       On November 26, 2007, Countrywide stock was hammered on the NYSE,
dropping over 10% to a level of $8.64/share; less than half the share's value in
August when the firm faced bankruptcy rumors and a fraction of its value in
2006. One proximate cause were reports that the Atlanta Federal Home Loan
Bank had extended a large amount of its credit to Countrywide to offset its
inability to raise funds in the private market. Senator Chuck Schumer called for
an investigation as to the prudence of the FHLBB's action in this regard.

       From 2005 to 2007 Angelo R. Mozilo sold much of his CFC stock realizing
$291.5 million in profits. A class action suit was filed on behalf of shareholders
alleging securities violations.

      In September 2008, Countrywide sends letters to its mortgage
customers to inform that one of their employees had stolen identity
information that contained social security numbers and birth dates.
Countrywide apologizes in the letter and offers free credit monitoring for 90
days.


'Protect Our House' PR campaign
      In September 2007, after months of negative publicity and the
announcement of a reduction of 20% of its workforce, Countrywide launched a
public relations campaign aimed at demoralized employees. Employees were
expected to sign a pledge to "demonstrate their commitment to our efforts"
and "to tell the Countrywide story to all". Those who signed the pledge
received a green rubber Protect Our House wristband

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Takeover
      The endgame in Bank of America's $4 billion takeover of Countrywide
Financial began with a December phone call from Countrywide Chief Executive
Angelo Mozilo to his Bank of America counterpart, Kenneth D. Lewis. And on
January 11, 2008, Bank of America announced it had agreed to buy
Countrywide for $4 billion in an all-stock transaction. The stock's value settled
at about $5 1/2 per share following the announcement; it had been as low as
$4.43 before the Bank of America deal was announced.

      After more than six months of financial deterioration at Countrywide --
despite a $2 billion infusion of cash from Bank of America in August -- Mozilo
said he was ready to throw in the towel, according to Lewis.

      At the same time, having watched Countrywide dramatically retool its
operations in a bid to survive, Bank of America executives began to believe
Countrywide's big U.S. mortgage business might be worth having.

      "The ability to get that kind of size and scale became more appealing as
we saw the business model change to a model we could accept," Lewis said.
"We considered the lawsuits, the negative publicity that Countrywide had. We
weighed the short-term pain versus what we think will be a very good deal for
our shareholders."

      Bank of America deployed 60 analysts from its headquarters in
Charlotte, N.C., to Countrywide's headquarters in Calabasas, Calif. After four
weeks analyzing Countrywide's legal and financial predicament, and modeling
how its loan portfolio was likely to perform, Bank of America offered an all-
stock deal valued at $4 billion for Countrywide -- a fraction of the company's
$24 billion market value a year ago.[citation needed] Countrywide
shareholders approved the deal on June 25, 2008and it closed July 2, 2008.
Bank of America announced on June 26, 2008 that the takover of Countrywide
Financial Corp. will result in the loss of 7,500 jobs over the next two years.

The deal is a landmark in the housing crisis, given Countrywide's prominence as
the nation's largest mortgage lender, at least until recently.




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Real estate bubble
A real estate bubble or property bubble (or housing bubble for residential
markets) is a type of economic bubble that occurs periodically in local or global
real estate markets. It is characterized by rapid increases in valuations of real
property such as housing until they reach unsustainable levels relative to
incomes and other economic elements.


Current real estate bubbles
As with any type of economic bubble, it is often claimed that a real estate
bubble is difficult for many to identify except in hindsight, after the crash. The
crash of the Japanese asset price bubble from 1990 on has been very damaging
to the Japanese economy and the lives of many Japanese who have lived
through it [1], as is also true of the recent crash of the real estate bubble in
China's largest city, Shanghai [2]. Unlike a stock market crash following a
bubble, a real-estate "crash" is usually a slower process, because the real
estate market is less liquid than the stock market. Other sectors such as office,
hotel and retail generally move along with the residential market, being
affected by many of same variables (incomes, interest rates, etc.) and also
sharing the "wealth effect" of booms. Therefore this article focuses on housing
bubbles and mentions other sectors only when their situation differs from
housing.

As of 2007, real estate bubbles have existed in the recent past or are widely
believed to still exist in many parts of the world, especially in the United States,
Argentina, Britain, Netherlands, Italy, Australia, New Zealand, Ireland, Spain,
France, Poland, South Africa, Israel, Greece, Bulgaria, Croatia, Canada, Norway,
Singapore, South Korea, Sweden, Baltic states, India, Romania, Russia, Ukraine
and China.[citation needed] U.S. Federal Reserve Chairman Alan Greenspan
said in mid-2005 that "at a minimum, there's a little 'froth' (in the U.S. housing
market) … it's hard not to see that there are a lot of local bubbles" [3]. The
Economist magazine, writing at the same time, went further, saying "the
worldwide rise in house prices is the biggest bubble in history".



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Housing market indicators
       In attempting to identify bubbles before they burst, economists have
developed a number of financial ratios and economic indicators that can be
used to evaluate whether homes in a given area are fairly valued. By
comparing current levels to previous levels that have proven unsustainable in
the past (i.e. led to or at least accompanied crashes), one can make an
educated guess as to whether a given real estate market is experiencing a
bubble. Indicators describe two interwoven aspects of housing bubble: a
valuation component and a debt (or leverage) component. The valuation
component measures how expensive houses are relative to what most people
can afford, and the debt component measures how indebted households
become in buying them for home or profit (and also how much exposure the
banks accumulate by lending for them). A basic summary of the progress of
housing indicators for U.S. cities is provided by Business Week [5]. See also:
real estate economics and real estate trends.




Housing affordability measures
The price to income ratio is the basic affordability measure for housing in a
given area. It is generally the ratio of median house prices to median familial
disposable incomes, expressed as a percentage or as years of income. It is
sometimes compiled separately for first time buyers and termed attainability.
This ratio, applied to individuals, is a basic component of mortgage lending
decisions. According to a back-of-the-envelope calculation by Goldman Sachs,
a comparison of median home prices to median household income suggests
that U.S. housing in 2005 is overvalued by 10%. "However, this estimate is
based on an average mortgage rate of about 6%, and we expect rates to rise,"

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                          EFFECT OF SUBPRIME

the firm's economics team wrote in a recent report. According to Goldman's
figures, a one-percentage-point rise in mortgage rates would reduce the fair
value of home prices by 8%.

The deposit to income ratio is the minimum required downpayment for a
typical mortgage[specify], expressed in months or years of income. It is
especially important for first-time buyers without existing home equity; if the
downpayment becomes too high then those buyers may find themselves
"priced out" of the market. For example, as of 2004 this ratio was equal to one
year of income in the UK (Nottingham Trent University paper).

Another variant is what the National Association of Realtors calls the "housing
affordability index" in its publications [6]. (The NAR's methodology was
criticized by some analysts as it does not account for inflation [7]. Other
analysts, however, consider the measure appropriate, because both the
income and housing cost data is expressed in terms that include inflation and,
all things being equal, the index implicitly includes inflation[citation needed]).
In either case, the usefulness of this ratio in identifying a bubble is debatable;
while downpayments normally increase with house valuations, bank lending
becomes increasingly lax during a bubble and mortgages are offered to
borrowers who would not normally qualify for them (see Housing debt
measures

The Affordability Index measures the ratio of the actual monthly cost of the
mortgage to take-home income. It is used more in the United Kingdom where
nearly all mortgages are variable and pegged to bank lending rates. It offers a
much more realistic measure of the ability of households to afford housing
than the crude price to income ratio. However it is more difficult to calculate,
and hence the price to income ratio is still more commonly used by pundits. In
recent years, lending practices have relaxed, allowing greater multiples of
income to be borrowed. Some speculate that this practice in the longterm
cannot be sustained and may ultimately lead to unaffordable mortgage
payments, and repossession for many.

The Median Multiple measures the ratio of the median house price to the
median annual household income. This measure has historically hovered
around a value of 3.0 or less, but in recent years has risen dramatically,

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                          EFFECT OF SUBPRIME

especially in markets with severe public policy constraints on land and
development. The

Inflation-adjusted home prices in Japan (1980–2005) compared to home price
appreciation in the United States, Britain, and Australia (1995–2005).

Demographia International Housing Affordability Survey uses the Median
Multiple in its 6-nation report.




The Affordability Index measures the ratio of the actual monthly cost of the
mortgage to take-home income. It is used more in the United Kingdom where
nearly all mortgages are variable and pegged to bank lending rates. It offers a
much more realistic measure of the ability of households to afford housing
than the crude price to income ratio. However it is more difficult to calculate,
and hence the price to income ratio is still more commonly used by pundits. In
recent years, lending practices have relaxed, allowing greater multiples of
income to be borrowed. Some speculate that this practice in the longterm

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                          EFFECT OF SUBPRIME

cannot be sustained and may ultimately lead to unaffordable mortgage
payments, and repossession for many.

The Median Multiple measures the      ratio of the median house price to the
median annual household income.        This measure has historically hovered
around a value of 3.0 or less, but     in recent years has risen dramatically,
especially in markets with severe     public policy constraints on land and
development. The

Inflation-adjusted home prices in Japan (1980–2005) compared to home price
appreciation in the United States, Britain, and Australia (1995–2005).

Demographia International Housing Affordability Survey uses the Median
Multiple in its 6-nation report.


Housing debt measures
The housing debt to income ratio or debt-service ratio is the ratio of mortgage
payments to disposable income. When the ratio gets too high, households
become increasingly dependent on rising property values to service their debt.
A variant of this indicator measures total home ownership costs, including
mortgage payments, utilities and property taxes, as a percentage of a typical
household's monthly pre-tax income; for example see RBC Economics' reports
for the Canadian markets

The housing debt to equity ratio (not to be confused with the corporate debt
to equity ratio), also called loan to value, is the ratio of the mortgage debt to
the value of the underlying property; it measures financial leverage. This ratio
increases when homeowners refinance and tap into their home equity through
a second mortgage or home equity loan. A ratio of 1 means 100% leverage;
higher than 1 means negative equity.




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Housing ownership and rent measures
The ownership ratio is the proportion of households who own their homes as
opposed to renting. It tends to rise steadily with incomes. Also, governments
often enact measures such as tax cuts or subsidized financing to encourage
and facilitate home ownership. If a rise in ownership is not supported by a rise
in incomes, it can mean either that buyers are taking advantage of low interest
rates (which must eventually rise again as the economy heats up) or that home
loans are awarded more liberally, to borrowers with poor credit. Therefore a
high ownership ratio combined with an increased rate of subprime lending
may signal higher debt levels associated with bubbles.


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The price-to-earnings ratio or P/E ratio is the common metric used to assess
the relative valuation of equities. To compute the P/E ratio for the case of a
rented house, divide the price of the house by its potential earnings or net
income, which is the market rent of the house minus expenses, which include
maintenance and property taxes. This formula is:




The house price-to-earnings ratio provides a direct comparison to P/E ratios
used to analyze other uses of the money tied up in a home. Compare this ratio
to the simpler but less accurate price-rent ratio below.

The price-rent ratio is the average cost of ownership divided by the received
rent income (if buying to let) or the estimated rent that would be paid if
renting (if buying to reside):




The latter is often measured using the "owner's equivalent rent" numbers
published by the Bureau of Labor Statistics. It can be viewed as the real estate
equivalent of stocks' price-earnings ratio; in other terms it measures how much
the buyer is paying for each dollar of received rent income (or dollar saved
from rent spending). Rents, just like corporate and personal incomes, are
generally tied very closely to supply and demand fundamentals; one rarely
sees an unsustainable "rent bubble" (or "income bubble" for that matter).
Therefore a rapid increase of home prices combined with a flat renting market
can signal the onset of a bubble. The U.S. price-rent ratio was 18% higher than
its long-run average as of October 2004

The gross rental yield, a measure used in the United Kingdom, is the total
yearly gross rent divided by the house price and expressed as a percentage




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                          EFFECT OF SUBPRIME

This is the reciprocal of the house price-rent ratio. The net rental yield deducts
the landlord's expenses (and sometimes estimated rental voids) from the gross
rent before doing the above calculation; this is the reciprocal of the house P/E
ratio.

Because rents are received throughout the year rather than at its end, both the
gross and net rental yields calculated by the above are somewhat less than the
true rental yields obtained when taking into account the monthly nature of the
rental payments. * The occupancy rate (opposite: vacancy rate) is the number
of occupied units divided by the total number of units in a given region (in
commercial real estate, it is usually expressed terms of area such as square
meters for different grades of buildings). A low occupancy rate means that the
market is in a state of oversupply brought about by speculative construction
and purchase. In this context, supply-and-demand numbers can be misleading:
sales demand exceeds supply, but rent demand does not.




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Indian property bubble
       The origins of Indian Property Market Bubble can be traced to the
interest rate reductions made by the NDA coalition government in the years
following 2001. Home Loan Rates fell to a (then) historical lows of 7.5% in early
2004. This prepared the basis for the massive increase in real estate property
prices across India. Low interest rates triggered huge interest in individuals to
borrow to own their own homes and this triggered an increase in demand for
real estate across India.

     The Indian Property Market has been growing fast since March 2005,
when the current UPA government decided to open FDI in Real Estate. The
market has been growing at a dizzying rate of 100%+,and further[citation
needed]

      Real estate in Indian metropolises such as Mumbai, Delhi and Chennai
has sky rocketed to levels comparable with international cities like London.

       One remarkable point is the real-estate boom in Chennai and its
suburbs, leading to high prices in decent housing and then finally prices
dropped. For example, an apartment of 1500 square foot in a Chennai suburb
will cost around USD 200,000, whereas in Europe similar size costs about USD
450,000. In a class A suburb of New York you can buy a large house for around
same amount (450K). Per capita ratio is around 50:1 ($50,000 to $1100); this
suggests the presence of a bubble.

      However, speculations aside housing prices depend a lot on various
factors such as the age of the property, facilities, surrounding area etc. Hence,
the property bubble will burst for the places bought over priced with no
stronghold value to it.

      Some have suggested that given India's population density is closer to
that of Europe than that of America the real value of Indian Real Estate should
be close to European levels rather than American levels. When looked at in
that way Indian real estate is still cheap. This argument assumes the rapid
economic growth in India will have brought per capita income in India to
European levels within the next 5 years in urban areas.

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Contra argument to this is US prices should ideally move with
economy/inflation rate of 2-3% while Indian prices will gallop at the rate of
10% a year and probably more as the land distribution market is inefficient.

      By its very definition a bubble is a short term phenomenon while Indian
real estate market has continued on a secular upward trend, apart from
periodic adjustments, in the last 10 years. Bear in mind that there are almost
400 million Indians waiting to hit the middle class group and they will exert
additional pressure on the system. Affordability is the most important factor
when it comes to housing prices and middle class housing is much levels of
affordability in most of the major cities in India. People who compare India
with developed European cities, forget the huge difference in affordability in
both areas. Of course there is a huge demand for housing but they can only
buy what they can afford.

One of the big problem of real-estate market is that supply lags behind
demand by about 5 years (Plan-Approve-Finance-Construct time).

Lack of efficient signals to market participants means that there will be periods
of mismatch between suppliers and buyers hence leading to cycles of booms
and busts.

As of May 1st 2008, the Indian housing market has already started declining.
Prices have started to drop to some extent in few major cities.




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 Sub-prime impact on India
       The collapse of Lehman Brothers and the bail out of Bear Sterns, Merrill
Lynch, AIG and housing mortgage majors Fannie Mae and Freddie Mac is but
the latest wave of the sub-prime financial crisis that first hit international
financial markets in August 2007. In August 2007, India was on a sustained
growth path, close to 9 per cent, the rise in trend growth underpinned by a
sharp increase in both domestic savings and investments from under 30 per
cent of the GDP to over 35 per cent within a space of five years. Wholesale
Price Inflation (WPI) was within the tolerance band of 5-7 per cent. Global
optimism regarding India’s future growth prospects, particularly that of its
burgeoning Information Technology (IT) sector, was generating a tsunami of
capital inflows that kept the central bank battling on two separate but
interrelated fronts: Mopping up excess dollars to prevent appreciation of the
rupee and sterilising the monetary fall out of this reserve accumulation to keep
inflation in check.

      The sub-prime crisis did not affect India directly. Indeed, the initial
expectation was that robust growth in China and India would rescue the global
economy as emerging markets had ‘decoupled’ sufficiently from OECD
countries. This resulted in an influx of capital, currency appreciation and a
stock market boom. However, once the credit storm in western markets
combined with the spike in commodity prices to coalesce into a ‘perfect storm’
of faltering growth and high inflation, the second round effects appear
ominous.

        The rise in oil prices dealt a severe terms of trade shock that sharply
worsened the current account, increasing India’s merchandise trade deficit by
50 per cent in April-July 2008 over the corresponding period last year.
Although oil prices are now substantially below the July peak, they would need
to fall much further to substantially abate the terms of trade shock in view of
the sharp depreciation of the rupee. While the impact of the financial crisis on
exports has been relatively muted so far, it must be recognised that while
adjustments in the financial sector are immediate, adjustments in the real
sector are lagged. It is becoming increasingly clear that the asset wealth loss,


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including housing equity that was a major source of household demand in
OECD countries in recent years, combined with prolonged deleveraging and
repricing of risk in international markets is leading to demand destruction in
these countries.

       Growth in the US has been surprisingly robust so far, registering an
annualised expansion of 3.3 per cent in the second quarter of 2008. But this
was mostly on account of the surge in exports consequent on the depreciation
of the dollar and the fiscal stimulus of $150 billion that counteracted the fall in
the household demand. The diminishing US trade deficit is weakening the
country’s role as a global consumer of the last resort. It now appears that both
the Euro area and Japan could be headed into recession by way of collateral
damage on account of the credit crunch, falling housing prices and contraction
of the US trade deficit and demand. It is these fears that seem to have turned
the tide in favour of the dollar and against commodity prices. As the impact of
the fiscal stimulus and the resurgence of US competitiveness on account of the
appreciating dollar runs out of steam, the decline in household demand and
consumer confidence on account of the continuing housing crisis is widely
expected to drive US growth lower in subsequent quarters. The real test of the
‘decoupling hypothesis’ would be if, given the downturn and crisis in the US,
Europe and Japan, capital were to flow back into emerging markets instead of
the traditional haven, namely US treasuries.

       While India is not as dependent on external markets as several other
developing countries, notably China, this cannot but have a dampening effect
on export growth as the US accounts for 15 per cent of India’s merchandise
exports (compared to 20 per cent in the case of both Brazil and China), while
western Europe accounts for another 23 per cent. The dependence on OECD,
and particularly on the US market, and on services exports, through which
India mostly plugs its yawning merchandise trade deficit, is even greater. Of
India’s trade deficit of $90 billion in 2007-08, 40 per cent was covered by IT-
related invisibles exports to the US and Europe. While the falling rupee could
make non-import intensive Indian merchandise exports more competitive,
since banking, financial services and insurance (BFSI) are at the centre of the
credit storm in western markets, there is likely to be shrinkage in both job


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                          EFFECT OF SUBPRIME

opportunities and export revenues in what is the largest outsourcing vertical of
India’s IT sector.

       The combination of current account and inflationary pressures has put
the Indian rupee under pressure since capital flows other than FDI are drying
up as a consequence of the credit freeze and repricing of risk in western capital
markets. There was a net outflow of $3.7 billion of FII from India during April-
August 2008. The reduction in capital flows may have made monetary
management easier, but the reduction is so sharp that the rupee is coming
under heavy pressure, having dipped below Rs 46 to the dollar, even as RBI’s
foreign exchange reserves have fallen by $20 billion between March 31 and
September 5, 2008. The reversal in FII flows has sharply reduced market
capitalisation on account of the stock market’s dependence on FII flows.
Although the current account deficit is eminently fundable in view of the large
stock of foreign currency reserves, rupee depreciation at this point will only
feed inflationary pressures. Fiscal pressures have moreover led international
credit agencies to consider downgrading India’s credit rating from investment
to speculative grade. Should this occur, the rupee would come under even
greater pressure through rebalancing of currency portfolios.

       Savings and investment, widely credited for the rise in trend growth over
the last few years, are both likely to be adversely affected. The Economic
Advisory Council to the PM estimated in July 2008 that the commodity terms
of trade shock could administer an additional fiscal shock of up to 4.5 per cent,
thereby sharply lowering savings. Although oil prices have fallen sharply since
this estimate was made, this would undo only some of the damage especially
in view of the depreciating rupee.

      While the domestic savings investment gap over the last few years was
modest, ranging from 1 to 1.5 per cent of the GDP, Indian companies and
public sector enterprises had become increasingly dependent on cheap
overseas finance for investment, possibly as a result of monetary tightening at
home and rupee appreciation. External commercial borrowings as a
percentage of gross capital formation of the corporate and public sectors rose
sharply from 3.2 per cent in 2005-06 to 12 per cent in 2006-07 and is likely to
be even higher in 2007-08. The dependence on foreign investment, net of


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                          EFFECT OF SUBPRIME

mplications for the outsourcing world
       The link between the sub-prime mortgage crisis in the US and the global
outsourcing economy stems from the fact that many mortgage companies
have outsourced their operations to outsourcing countries. With the closure of
these units, outsourcing contracts were automatically cancelled.Many back
office operations were shelved as a result, and billing rates, employee makeup
and strength, pay structure and profits were all drastically altered. As Deutsche
Bank, Germany's biggest bank, rightly points out, global economic growth is
taking a direct hit as a result of this crisis. WNS (Holdings), India’s second-
largest BPO, has reported that the US subprime lending crisis would have a
“material adverse impact” on its financial performance. The Bank of China, one
of Asia’s biggest banks, also disclosed considerable exposure to the US
impasse. IT major TCS has raised its billing rates by 3 to 4% for existing clients
and by 5% for new clients because of rising wages and rupee appreciation
against the dollar. And technology giant Infosys has declared that the impact of
the subprime crisis will be close to a $1 million this year. The list continues…

       So is the situation very bleak? Not so, according to industry experts
across the world. Only a handful of companies in outsourcing countries like
India are facing considerable exposure to the mortgage industry and the
impact will be confined to this number. Big players are in liaison with large
mortgage firms that have the capacity to tide over subprime problems. But
there is a more prominent silver lining in all this. Companies like IT forerunner
Infosys are taking the crisis in their stride, in spite of losses amounting to
around a million dollars and having to reassign employees who have lost jobs
in their BPO wing. Why the optimism? The possibilities of these large mortgage
firms withstanding the crisis and consolidating are very high. The result – more
outsourcing contract and that too of higher scope! Outsourcing economies
would win more business from the US when the subprime crisis curbed
spending there and companies are driven to cheaper service providers in other
countries. So this brief deadlock would actually work to the advantage of
outsourcing countries!

       But the proposal of the Indian Industry body PHD Chamber (PHDCCI) is
worth consideration here to avoid future impasses like this: To overcome such
situations, the BPO segment should increasingly go for balancing their risks by

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                          EFFECT OF SUBPRIME

taking up projects outside the US and focusing on e-governance and wiring
companies.


Impact of subprime crunch on the Software industry:
        R&D budget cuts: this is typical everytime there’s a downturn: large
corporations cut R&D budgets (which I find dumb since downturns are
excellent times for innovation and fostering one’s competitive advantage
through information systems; but well, I’m not in charge here). End result:
software sales aimed at R&D departments (eg. Dassault Systèmes’ CATIA) are
likely to suffer temporarily.


Impact on subprime crunch on IT consulting:
      Severe shortcuts are expected in IT consulting, especially in banking /
insurance where uncertainties are likely to remain higher for a short period of
time (a few months). Such redundancies will have a positive impact on the
software industry where finding skilled developers has become nothing less
than a nightmare. Last and not least, the subprime crunch is very likely to
accelerate the ongoing IT & BPO offshoring trend.


Impact on Venture Capital:
      On the one hand, venture capitalists may suffer from limited partners
(financial institutions in general + wealthy individuals and families) appearing
less eager to increase VC-managed funds. On the other hand, venture
capitalists invest in private equity that isn’t correlated with either the fixed
income market (high tech startups never raise debt).




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