CRISIS ON THE STREET Historical regularity

T.Ramaswamy

Returning HomeJ O B S The Emerging landscape

BUBBLES, PANICS FROM THE PAST Tulip-Bulb Bubble of 1634 The South Sea Bubble:

A virus caused tulips to develop stripes. Tulips were in high demand and some sold houses to buy them. Half lb Witte Croonen 64 guilders to 1668 in Jan 1637 and back to 37 in 1642. Bulb prices collapse and then Holland goes into a recession. Many small investors were highly leveraged to buy tulip bulbs, and many loans were defaulted on. The

small investors ended up being hurt the most.

In 1711 The South Sea Company stock price soared. New companies went public and enjoyed immediate stock inflation as the public poured in money. The South Seas Company saw their stock rise from 55 to 1,000 and Directors sold all their stock. The stock plummeted.

The small investors ended up being hurt the most.Newton was one of the losers in the South Sea Bubble I have learned to predict the movement of celestial bodies but not the movement of man in markets.

OVERCONFIDENCEMARKET CRASH OF 1929Margin purchases Buying on credit Investment Pools Build group Trade stock amongst selves Release good rumors about the

stock Start a stampede, then get out in Miami for around $800,000 in 1923 could be sold Land bought Florida in 1924 for twice the price. Next year, that land could be sold for $4,000,000. One third of the Miami population became real estate agents and the bubble collapsed. The small investors ended up being hurt the most.

Heavy Credit fueled speculation during the 1920s brought a chain reaction of farm foreclosures and bank failures when agricultural prices fell

Japan's Burst Bubble $ 3 TRILLION IN BAD DEBTS JAPAN'S ECONOMY SUFFERED THE LOST DECADE Land prices double from 1987 to 1990 Total land Japanese land value is 3 times greater than the US Higher land prices lead to higher stock prices

BIS on crisis in JapanAggressive Financial Institutions Protracted Monetary easing Policies causing rise in land prices Overconfidence and Euphoria

ALL A BUBBLE Nikkei 225 stock index Doubles from 1983 to 1986 And from 1986 to 1989 10,000 in 1983, 20,000 in 1986, 40,000 in1989

Ginza district land is $300,000 per sq meter

High stock prices equity finance boom Funds from equity finance purchase of more stock and land

ZAITECH-SpeculationBubble fueled by a Japanese corporate invention, "zaitech," or "Financial Engineering,Speculation. corporations raised funds on the markets and recycled back into further speculative market activities again and again.Investors would then rush to purchase their stock, driving prices and earnings even higher and providing more funds for the company's speculative actions. Land speculation important part of that bubble economy. Banks often accepted property as collateral for loans. Now, more than a decade later, average Japanese land prices are still falling and banks are only just pulling out of a landrelated bad-loans crisis.

A lot of similarities in the Dow 1929-32 Nasdaq 2000-02 & Japan 1980-901929-32: Total drop 77% Japan: Total drop 63% Plus land 2002: Drop off peak S&P 500: 50% NASDAQ: 80% Painful memories last a generation

The Dow returned to pre-1929 levels in late 1954

Weekly chart of the Peaks along the X- Axis, with Y- Axis representing Percentage change

World Output & Trade 1929 & Present Falls compared

Global activity forecast -1.4 % 2009 & + 2.5 % 2010. Advanced economies -3.8% 2009 + 0.6 % 2010

World industrial production continues to track closely the 1930s fall, with no clear signs of green shoots.

World trade has stabilised, but these are still following paths far below the ones they followed in the Great Depression.

Differences in the debts composition from the 1930s to today

NIGHTMARES FROM OVERLOADED DEBT

2002-2006: Total Credit increased by $8T; Mortgage debt increased 60% to $9.5T and Subprime debt increased by $2T when GDP increased $2.8T Household Sector Debt: 125% of GDP Household borrowing (flow) peaked at 15% of Disposal Income For bottom half of income distribution, debt doubled from 92 to 04, to almost 100% of income

Debt Almost 350% of GDP

2.1T$

Japans Bubble Economy crisis a precursor to Subprime Crisis Debt-financed speculative bubble Burst end-1989 Two decades later, still in low level Depression Government debt far higher, private debt slightly lowerPercent

Japan Debt to GDP Ratios GDP Ratios300 200 130

120 150 200 110 100 100 100 50 90

Government Private Private Aggregate Debt

But economy still mired in economic slump

$ 6.3T0 80 1970 1970 1975 1975 1980 1980 1985 1985 1990 1990 1995 1995 2000 2000 2005 2005 2010 2010

Cant pump prime way out of debt crisis that simply swaps public debt for private Debt should never have been issued in the first place "We've passed through an era of profound irresponsibility. We cannot go to the kind of risk-taking that leads to BUBBLES THAT INEVITABLY BURST.

Aggregate losses of japanese banks 30% of GDP

No economic reality for the boom that Japan had

Questions on the Size of the bubble & The capacity to overcome

Size of the Japanese bubble In comparison Appears to be much higher

At the beginning of the crisis Japan had Total Debt to GDP ratio of 260% US presently has a Total Debt to GDP ratio of over 350%

25% of US public debt is owed to foreigners

Global Scenario

Contractionary forces are circular self-reinforcing: Loans are going bust Asset prices are falling Credit markets are deteriorating Financial institutions are going bankrupt Business and consumer confidence is deteriorating Demand is declining Production is plunging Job losses are rising Economy is shrinking

World trade is projected to contract by 9.0 per cent in 2009 Global GDP is projected to shrink by 2.9 per cent All advanced economies US, Europe and Japan - having gone into recession, the contagion of the crisis from the financial sector to the real sector has been dramatically severe. Russian Economy has fallen into a deep recession. and Russian ruble has lost about 35% of its value against the $ since mid-July.

Recession hard on the Young

Young people face the highest unemployment rates of any age group. 19% of young adults are unemployed compared to only 7% of 30 and over. Young adults are 2.5 times more likely than older adults to have been impacted by a job loss. Thirty percent of young adults ages 18-29 say they or a member of their family has been impacted by a job loss. Among adults ages 40 and over, only 12 percent report a job loss in the household. More young people face cuts in wages or work hours than older adults, especially if they hold part-time jobs.

Young adults carry increasingly large amounts of debt with 37 %having more than $5,000 in debt, over mortgages and student loans. Young adults are among the least likely to have health insurance now job loss is causing even more to lose coverage. Young adults are making choices, in response to their economic challenges, that have long term consequences such as delaying school or marriage.

Could Japan loose Another decade

Cumulative losses 15 T $

Japan GDP figures 1st Q 2009 are the worst ever - an annualised plunge of more than 15 per cent, USA worsened from -3.8% to -6.1% Current recession began in Months in Duration 50 Dec. 2007 and is already the 43 45 We will rebuild. longest since 1981. It is now 40 35 We will recover.-also the longest recession since30 25 20 15 10 5 0Aug. 1929 May 1937 Feb. 1945 Nov. 1948 July 1953 Aug. 1957 Apr. 1960 Dec. 1969 Nov. 1973 Jan. 1980 Jul. 1981 Jul. 1990 Mar. 2001 Dec. 2007

Length of US Recessions,1929-Present*

President Barack Obama addressing a joint session of Congress13 8

the Great Depression.16 6 8 8 18

OIL

16 SHOCK

11 February 24, 2009 10 10 8

11

* As of May 2009, inclusive Economic Research; Insurance Information Institute.

S&L Crisis

The US market which peaked earlier in the decade at 17 plus million units per annum is now down to an annualised rate of 9.5 million units Sales have fallen by almost 40 percent since 2008 and are now less than sales in the Chinese market March Unemployment in US Increases to 8.5%How societies choose to Fail or succeedJ Diamond Elites Insulate Themselves Joseph Tainter/Colin Renfrew

The collapse of complex societiesUnder stress complex societies lack the option to diversify,

Complex societies rose rapidly, flourished for some time and came to a rather sudden endExamples (old) Egypt 2500 BC invasions? Akkad 2200 BC environmental? Harappa 1800 BC environ. /Aryans? Minoan Palaces 1400 BC vulcanoes? Hittites 1200 BC barbarians? Classic Maya 800 AD environmental? Anasaz 1300 AD environmental Mesopotamia, Cradle of Civilization (Modern Iraq: Assyrians, Babylonians, Sumerians- 6000 BC 500 BC. Mineral salts from repeated irrigation, no crop rotation decimated farming by 2300 BC). Fertile no more.

Often minor reasons cited that appear insufficient to cause major effects like collapse Underlying reason is change in structure Evolution of a society steady increase of complexity Initially: Strong growth, large rewards for early complexity Saturation, marginal

benefit of complexity decreasesReserves depleted, makes society prone to collapse

Is societal collapse a possibility? Environment + Economics =Tipping Point (It wouldnt be the first time!)

...what is perhaps most intriguing in theevolution of human societies is the regularity with which the pattern of increasing complexity is interrupted by collapse (Joseph Tainter 1995, The Sustainability of Complex Societies).

Atmospheric Carbon Dioxide:A 30% Anthropogenic Increase in a CenturyExtra resources produces diminishing returns. Then negative returns. Along comes a systemic shock. Shock might be internal (resource exhaustion) Or external (foreign war). And the shock triggers collapse. When collapse occurs, it almost always occurs rapidly. Things decay to a lower state of complexity.

Why do some societies make disastrous decisions? Failure to anticipate Failure to perceive that a problem has arisen Rational bad behavior (ISEP-It is somebody elses problem) Conflicts of interest between elites and the masses Disastrous societal values Religion Irrational failures Unworkable solutions Poor leadership Isolated elites

An in-built capacity of human brain/mind system An act or the power of foreseeing, prescience An act of looking forward, a view forward Action in reference to the future, prudence

What is Foresight?

The Ultimate Driver: The Second Law of Thermodynamics Any spontaneous change in an isolated system reduces its potential and increases its entropy. The same basic forces apply to the ECONOMY. Degradation is the primary process in the universe. Status of the Second Law [Thermodynamics]holds the supreme position among the laws of nature (Sir Arthur Eddington).[Thermodynamics] is the only theory of a general nature of which I am convinced that it will never be overthrown (Albert Einstein)

Michio KakuHyperspace: a Scientific Odyssey Through Parallel Universes, Time Warps, and the 10th Dimension,

Extreme Future More risk more opportunity

International Innovation Index Led by USA, Japan

Juan Enriquez: Tech evolution will eclipse the financial crisis Engineering of Cell, Tissues, Robots, Nano Technology, will driveTechnology accounts for one-half of output (GDP) growth in all industrialized nations

March 2009 US research has found that: A third of US output growth stems from productivity enhancing innovations at the workplace level (Sandra Black & Lisa Lynch on organisational innovation and productivity, 2001, 2004) When employees are highly engaged, their companies achieved 26% higher labour productivity, lower turnover and 13% higher returns to shareholders over last 5 years (Watson Wyatt WorkUSA Survey 2008/09)

The global financial crisis changes everything... But for innovation and skills, it changes nothing. Our challenge is to link short-term fiscal stimulus to longer term competitive advantage.

Jim Carroll - Innovators get

out in front of the recession

65% of the children In Kindergarten today will WORK IN JOBS THAT DO NOT EXIST YET VIJAY GOVINDARAJAN -World's leading expert on strategy and innovation In these troubled times, innovation is more critical than ever because it paves the way to increased profitability, business solutions and growth.

Innovation: Key driver of GLOBAL GDP

Labor Hours/ Vehicle

What Is Increasing Productivity?

Recession is above us

Innovation is within usFuture is ahead of us Ford 35.79 hours Daimler/Chrysler 33.71 hours GM 33.19 hours Honda 32.51 hours

Toyota 29.4 hoursNissan 28.46 hours

Source: Detroit Free Press, June 2, 2006

Source: 2005 National Innovation Survey, Council on Competitiveness

EXPONENTIAL DRIVERS

NO HISTORICAL LIMITS

Moores Law In 1965 Gordon Moore, co-founder ofIntel predicted that the number of transistors per integrated circuit would double every 18 months

Integrated circuit is a miniaturized electronic circuit of semiconductor embedded in the substrate of semiconductor

PLICATION: Price performance of computing will continue toimprove exponentially

COMPUTING+ COMMUNICATION TECHNOLOGIES=MOBILEINNOVATION LEAPFROGS WITH CONVERGENCE

India World No 2- 441 M

Theoretical FoundationsCONVERGENCEGame theory, Network algorithms Scale, complexity, interactivity Network design Internet Algorithms, Social Computing Reliability Security, privacy, intrusion detection Computer Networks CSP: Signal processing for wireless Analog Communications Multimedia signal processing Phone -1983 Collaborative/distributive signal processing Hybrid networking CC CCSPCSP Computing CCSP: Signal Processing Power efficiency Computation versus communication tradeoff compression, Radio Phone-1900s

CC:

Operations research Physical, Biological, Social Sciences

A Few Tech Capacity Growth Rates Are Almost Independent of Socioeconomic Cycles

There are many natural cycles: PlutocracyDemocracy, Boom-Bust, Conflict-Peace Ray Kurzweil first noted that a generalized, centurylong Moores Law was unaffected by the U.S. Great Depression of the 1930s.

The key issue for the 21st century

Sigma curve growth

vs.

exponential

The exponential growth of computing Intergated goes back 100 years Circuits (2D) 5 paradigm Discrete shifts so far transistors Paradigm shifts keep exponential Vacuum growth going tubesRelay based computers

Electromagnetic calculator

DISRUPTIVE TRANSFORMATION Moores Law:

Fundamental Drivers of Convergence in computational acceleration

Doubling of processing power every 18 months at same cost. Metcalfs Law: Value of a network increases geometrically as the network endpoints increase. Reeds Law: The utility of large networks, particularly social networks, can scale exponentially with the size of the network. Market Law: As competition increases, industry players with appropriate Scale will innovate and drive consumer costs down.

Convergent and predictable developmental forces Contingent and unpredictable evolutionary choices we may use to create unique and creative paths

Increasing intimacy of the human-machine and physical-digital interface.

Creative networks seed disruptive transformation by QUANTUM LEAPS

Living in times of exponential change Over 7 billion searches on Google / month Number of SMS text messages sent daily > Pager >

12 BN,

3 BN when ( worlds population 6.7 billion, 2007)

Convergent Evolution: Troodon and the Dinosauroid Hypothesis

Dale Russell, 1982: Few dinosaurs developed bipedalism, binocular vision, complex hands with opposable thumbs, and brain-to-body ratios equivalent to modern birds. They were intelligent pack-hunters both diurnally and nocturnally. Dominant planetary species had superior intelligence, hunting, and manipulation skills lost with the K-T event 65 million years ago.

Disruptive innovation/Transformation improves a product or service in ways that the market does not expect

Networking drives Innovation at all stages in the value chainC reator - G it out ets C onnector F inds a digs for op nd portunities S ees the need and initiates S etim ju p from om es m s C reate to D o T itio al ro o p litician an rad n le f o s d sen r m ag e io an em nt but can be anyon e

BPR Six Sigma Supply Chain

CREATOR, CONNECTOR, DOER, DEVELOPER- G it together ets T ranslates vision into optio ns, solutions C onnects the dots P n g, P licy & R lan in o esearc , h S cien tist Learns by thinkin g

F cu o a st a t in in /p o sse o s n b r ct h k g r ce s

F cu o e e p r n s o s na x e ie ce r l

D oer - G it done ets

D eveloper

G it better ets

D elivers, m akes it happ gets it en, do ne P ject M a er, F n ro an g ro t -lin e staff, E fo n rcem t en Le arns frompractica experience l D oers and C onne ctors are op posites

G it ready to go, m ets akes it w ork E g eer, IT D elo e n in ev p r, A u tan H cco n t, R Learns by thinkin g D lopers think eve creators n ot focused C reators: D evelopers don t see the big picture

Mdr i ai n i i i n M i tyo G v r m tS r i e o en to D so I i sr f o en e evc s z v n n

Duck-rabbit optical illusion . A paradigm shift could cause same information to be seen in a different way. LAW OF ACCLERATING RETURNSTechnological change is exponential and this century may see more like 20,000 years of progress. Within a few decades, machine intelligence will surpass human intelligence,

15 separate lists of key events in human history show an exponential trend on a logarithmic graph. Clear trend of SMOOTH ACCELERATION of change and complexity through biological evolution and then technological evolution. QUANTUM LEAPS

Q U A N T U MWe tend think of a future period at todays rate of progress our memories are dominated by But we are doubling our rate of progress every ten years So in this century we will experience 20,000 years of progress at todays rate.

DARPA Accomplishments-Father of Internet1960Saturn UCAV Vela Hotel Global Hawk

Ground Surveillance Radar

1970ATACMS

TMR

2000

MEMS

JSF M-16 Rifle JSTARS MALD

1980Stealth Fighter Arpanet

Uncooled IR

1990

BAT

Sea Shadow

GPS

Taurus Launch Vehicle

Predator

Defense Advanced Research Projects Agency (DARPA)

Explores quantum biologyQuantum mechanics and IT Faster, more powerful computers, next-gen radars and radios, and encryption thats all-but-impossible to break"QuBE," "Quantum Effects in Biological Environments." Scientists have recently discovered that quantum energy transfers allow plants and cynobacteria to convert sunlight into chemical energy nearly instantly, and with almost 100 percent efficiency.

INNOVATION TAKING QUANTUM LEAPS

S I N G U L A R I T Y

I set the date for the

Singularity- representing aprofound and disruptive transformation in human capability- as 2045. The nonbiological intelligence created in that year will be one billion times more powerful than all human intelligence today."

The Singularity is Near, When Humans Transcend Biology - Ray Kurzweil (2005)

ACCLERATED INNOVATION

Time as a critical success factor

WEALTH CREATION IS NOW KNOWLEDGE DEPENDANT

Information conceptPersonal Computing concept knowlegeconcept net concept virtual concept

Know-howconceptKHC

Change potential

agricultaural concept LAND IS WEALTH

MONEY IS WEALTH

NC PC-C

VC

industrialConceptPC-C

VC NC 1993 KC KHC 1999

Quantum Economy

1781

1981

1997

2005 time

PC-C = Personal Computing concept; VI = virtual concept; NC = net-concept; KC = knowledge concept; KHC= Know-how-concept

Wertprozessmanagement/Wirtschaftsinformatik, Universitt Innsb ruck

THE GRAPH FOR CHANGE POTENTIAL WHICH IS INFORMATION & Seite 8 KNOWLEDGE BASED RISES VERTICALLY AT ALMOST 90 Degrees

Indias GDP growth contribution is mainly SERVICES

Services is 54% of GDP

Better understanding of the knowledge economy WORK ON INTANGIBLESOld economy = tangibles traditional machines, production lines etc

In 2007 Know how, Software design Tangible Assets=Knowledge or Intangible Assets Reputation, Brand Trust in the company, Structure of the company, Strategy (balanced scorecards) Relations with personnel, Relations with clients,

Intangibles assets =New Economy

Better understanding of innovation:Value of Intangible Assets has increased With Knowledge and Innovation

Relate intangibles to innovation

$3 trillion missing from our accounting of capital stock NBER paper by Corrado, Hulten and Sichel "Intangible Capital and Economic Growth."

Intangible Assets 140%> Tangible Assets Results for U.S Economy,(70.4%) (29.6%) (60%) (25%) (15%)

Source: Corrado, Hulten and Sichel (2005)

Basic Determinants of Sources of Growth/ Growth Accounts Model Output is key measure of standard of living Output is driven by capital (K) labor (L) intermediate inputs (E, M, S) productivity (LP, MFP) Capital and labor can by divided into quantity quality/composition

Output increases that cannot be explained by these inputs are attributed to multifactor productivity (MFP)

Even in the Traditional Growth Accounts System the Knowledge Economy Features Strongly but Unequal4.01980-1995 1995-2004

3.0 2.0 1.0 0.0

The knowledge economy

ICT capital (IT hardware, communications equipment)-1.0EU15ex USA-SIC Japan EU15ex USA-SIC Japan

Other capital (plant, machinery, buildings)

Hours worked ICT Capital MFP

Non-ICT Capital Labour Composition

Fast Growing Countries Get Bigger Bang from Knowledge Economy, Notably MFP5.0 4.0 3.0 2.0 1.0 0.0 -1.0GER ITA LUX DNK BEL FRA AUT NLD SWE UK ESP USA FIN

During the period 1978-04 -Bosworth & Collins MFP contributed

3.8% to growth for China1.6% growth for India

Hours worked ICT Capital MFP

Non-ICT Capital Labour Composition

Higher-Order Skills Have Grown in Importance, Driven by Technological Change and Globalization

HIGHER PRODUCTIVITY Means INNOVATION

U.S. Productivity Growth Has Accelerated, Increasing Its Lead over Europe and Japan

Entrepreneurship & FDI Follow High Productivity

Growth rate of High Tech Exports Higher than any Other segment

World exports by type of industry ($ b.) & Export growth rates, 1990-2000 (% p.a.)1800 1600 1400 1200 1000 800 600 400 200 0 RB mnf Medium-tech Low-tech Hi-tech 1990 1995 2000

18% 16% 14% 12% 10% 8% 6% 4% 2% 0%To tal ar y Pr im tu re d RB

Industrial D eveloping

LT

High Tech Exports are dependant on Productivity & Innovation

M

an uf ac

M T

HT

Shares of world manufactured exports by technology: note when RB, MT and LT shares peak (1976 to 2000, %)35 30 25 20 15 10 5 0

Resource based Medium Technolo gy

High Technolo gy

International competitiveness has Low become an essential Structural drivers of competitive performance: Technolo precondition Skills, FDI, domestic technological effort, gy for growth ICT infrastructure.1978 1980 1986 1992 1998 2000 1982 1984 1988 1990 1994 1996

1976

The share of high tech exports in some OECD countries 1988-2001In the advanced countries high tech growth export came to predominate30

% of total exports of goods

25

20

15

10

USA Japan United Kingdom Netherlands FINLAND Switzerland France Sweden EU Germany Denmark

5

01988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Norway

2006 China with 16.9% share (EUR 217 Mn) overtakes US, EU-27 Source: Statistics Finland, according to the OECD product catalogue defined in 1995 In High Technology Exports

GROWTH OF WORLD MERCHANDISE EXPORTS TO GDPWorld Exports have on average grown MORE

THAN TWICE THE GDPGrowth of Exports has enabled growth of GDP High Technology Exports have been the fastest growing segment

Indeed Value creation is linked to knowledge applied to knowledge. This new tool of production is more important than capital and technology because capital becomes less important than knowledge in the value creation process

India's High Technology Exports is less than 5%

1.2 TN 2007

Chinas Exports High Technology Low Technology

Indias Exports Resource based Primary products

175 BN 2008

The Competitive Advantage of NationsMichael Porters competitive advantage model advocated success via national competitive advantages in firms, clusters, innovative products.Based on industry case studies in 10 nations, Porter developed his Diamond Model of four key interlinked production factors. Pro-active governments can stimulate these factors, but theyre very difficult for firms to duplicate, resulting in national competitive advantages. For example, outsourcing occurs because cheap labor is unavailable inside advanced economies. Ease of technology flows undermine any absolute and comparative advantages they may have over Third World. Factor conditions created by sustainable, heavy investments in specialized production factors: skilled labor, capital, infrastructure Demand domestic pressures for quality Related & supporting industries facilitate continuous info exchanges promoting innovation Firm strategy, structure & rivalry firm organization & nature of domestic rivalries

European Innovation ScorecardINDIA CAN SCALE WITH INNOVATION Prosperity depends on the productivity with which a nation

uses itsProsperity Prosperity

Productivity Productivity

human, capital, and natural resources.

Innovative Capacity Innovative Capacity

Competition the driving force for Productivity- Efficiency Best practices Creating products and processes Innovation

World Bank study shows Unweighted by Population INNOVATION IN INDIA Moves up with developed economies

During the period 1993-04 MFP contributed

In growth 4% for China 2.3% for India

Chinas exports comparable with those of mature economies REVEALED COMPARATIVE ADVANTAGE BALASSA INDEX CHINA INDIAHigh Tech Low Tech Medium-High 1.5 1.2 0.7 0.2 2.0 0.6

India a global innovator for high-tech products and services is Underperforming relative to its innovation potential

CHINA ACCLERATES FROM 1999

Indias total exports less than half of Chinas High Technology Exports

China High Tech consists of - ElectronicsTelecommunication, Computers-Office Machines

Production is now global making recession impact greater. Stage(s) of production to be followed up by another country (ies). World Trade has increased by 30% due to vertical specialization as per Economist.Processing trade accounts for 57% of Chinas foreign trade, in 2006 and exports have a high dependency ratio on imports, especially in Foreign-invested Enterprises Telecommunication equipment, computer, other electronic equipment, transport equipment, electric equipment and machinery, chemicals, metals smelting and pressing, metal products have vertical specialization beyond 50% in Chinas Exports.

VERTICAL SPECIALIZATION & PRODUCTION GLOBALIZATION

Investment India 23% China 44%

Household Consumption India 65% China 41%

Net Exporter, High Investment, Exchange Rate

67000 -100,000 Shops shut in 6 months

Exports down 25%

Shoe factories, clothing, toys, furniture, Lighting fixtures shutting down,

BANK ASSETS Than 175% Of the GDP

FINANCIAL SYSTEM

Oil Shock 1973, Savings & Loans Crisis 1981 Technology bubble of 2000 NO EFFECT ON INTANGIBLE INVESTMENTS

Intel chief: Recession can't halt innovation

During Technology Bubble Facebook Web 2 Myspace

GROWTH IN KNOWLEDGE ECONOMY

RECESSION PROOF

China is supported by a three-legged stool, but two legs are now broken- Hard landing Chinas economic growth is supported by three primary legs: - US and European cannot consume at the Export-led growth debt-supported levels they have at the past. - Rising unemployment, price declines in Real property growth real property have slowed sales. -The consensus among economists is no. Government spending And even more worrying, is the belief that Chinese government policy response could make the global financial crisis worse.

BSE & Shanghai composite Compared

Chinas Job Bazaar About 5,590,000 graduates in 2008 About 6,100,000 graduates in 2009 2008 graduate employment rate was 70% 2009 summer most difficult time for Chinese economy. In 2009, 24-30 Mn rural migrants look for employment, alongwith 7 Mn graduates In 2009 Guangdong job fair more then 20,000 graduates with Master degree compete for 4,000 jobs Overcapacity/closure in several manufacturing industries China may look to increase Services sector to GDP beyond 40% & Compete with India

Upscale Creativity competencies

AT Kearney ranks India ahead of China, Czech Republic & Philippines on attractiveness for Offshore

Can we hold the advantage for long in the competition

NEED to UPGRADE SKILLLSMcKinsey states only 25 per cent of engineering graduates, 15 per cent of our finance and accounting professionals and 10 per cent of professionals with degrees, in India, are suitable for working in multinational companies.

Philippines BPO market Almost equals Indias BPO market of USD 13 BN

China Knocking at the door

India has80 of the Worlds 117 SEI CMM Level-5 companies

Complimentary vibes"Asia should not be painted with one brush; India has separated itself from the pack; it is not unduly dependent on external demand, and it has an increasingly powerful IT-enabled, services-led growth dynamic." Stephen Roach Chief Global Economist & Managing Director Morgan Stanley

"India is not just about IT or business process outsourcing. We see it as an incubator for giant global corporations driven by IT strategy. Prof Warren McFarlan Harvard Business SchoolThe economic dominance of the US is already over. What is emerging is a world economy. India is becoming a powerhouse very fast. I think Indias progress is far more impressive than Chinas. Peter Drucker Management Guru In Fortune

TURBOCHARGING INNOVATION

INFRASTRUCTURE INNOVATION SKILLS

I N N O V A T I O N I S T H E K E Y INNOVATION IS THE KEY DRIVER FOR GROWTH

I N N O V A T I O N I S T H E K E Y

Notwithstanding the financial crisis, the United States is the most competitive economy in the world, a position it has held for several years. The country has a strong footing to ride out business cycle shifts and economic shocks.

Competitiveness as the set of institutions, policies, and factors that determine the level of productivity of a country. Productivity of a country determines its ability to sustain a high level of income. In the long run, standards of living can be expanded only with technological

innovation. Innovation is important for economies as they approach the frontiers of knowledge

IMD World Competitiveness Yearbook 2008

United States is first in the rankings, in 2008. In 1989, Japan

was 1 and US 3rd

.

Japans then competitiveness seemed unassailable, with a strong domination in economic dynamism, industrial efficiency and innovation. Japanese crisis followed a period of economic boom, real estate price follies and exuberant assets expansion. Liberalization took place without the appropriate regulatory environment. Japanese crisis spread from the stock market to real estate and then developed into a credit crunch and finally into a major crisis of the financial system. As a consequence, no bank was too big to fail!. Will this happen to the US? The US has a few trumps in hand: the Japanese breakdown of the 1990s provides some forewarning.

The future belongs to person who hasLarge collection of tools/skills to draw

Creativity Logical Thinking Abstract thinking.Demand for mundane is diminishingThinking and understanding about complex things in simple ways.Rudich www.discretemath.com

Bisociation-The idea accelerator

Convergence of seemingly unrelated conceptsArthur Koestler "The Act of Creation" used this term to distinguish analogical thinking that leads to great creativity from the more pedestrian thinking

The Mathematicians Mathematicianfor

is called the

applied to Computer Science, Cancer research, Polymer chemistry, crystallography, string theory etc.

the Modern World, 1969. -Now Ramanujans work is

600 conjectures! NEWMAN in M.Klein (Ed.) Math in

When two seemingly unrelated things are shown to have unanticipated connections. Quantum field theory & Topology of 4D diff. manifolds; K-theory, Diff.Geometry & Elliptic PDE; Wavelets & Data analysis [genomics], Quantum gravity

Renaissance- a Medici contributionLeonardo da Vinci, Michelangelo and Raphael

Top 5 American employers in India: General Electric:: 17,800 employees Hewlett-Packard : 11,000 employees IBM : 6,000 employees American Express: 4,000 employeesDell : 3,800 employees

38% of doctors in the USA 12% of scientists in the USA 36% of NASA scientists 34% of Microsoft employees 28% of IBM employees 17% of INTEL scientists 13% of XEROX employees

At intersection of fields, disciplines, 150,000 IT pros in cultures, you can Bengalru against combine existing 120,000 in Silicon concepts into a large number of extraordinary Valley. new ideas

Synectic thinking1 2 3 4 5 6 7 8

Synectic thinking is the process of discovering the links that unite seemingly disconnected elements by using TRIGGERS Subtract 9 Change Scale 17 PrevaricateRepeat Combine Add Transfer Empathize Animate Superimpose 10 11 12 13 14 15 16 Substitute Fragment Isolate Distort Disguise Contradict Parody 18 19 20 21 22 23 Analogize Hybridize Metamorphose Symbolize Mythologize Fantasize

Synectics mobilizes both sides of the brain, the right brain (the dreamer), and the left brain (the reasoner) by combination and or

Two-way process of mentoring

EmpowermentDumbledore: Headmaster at Hogwarts. He continually offers Harry Potter advice and is a

Mentor and coach benefit from the networking, sharing of ideas and interaction. Lifelong friendship and betterment.

MENTORto him.

Behind

every successful person, somewhere, somehow, someone cared about their growth and development

Mentoring is a process rather than an event. Mentors must see themselves as managers of a process.

Dr Beverley Kaye, Up is Not the Only Way, 1997

PSPD Model MENTORMaintenance

Value of Infosys Employee Around Rs 1 CroreQuality People Transparency

Predictability

SustainabilityTranslating clients to partners Long-term relationship

Our assets

walk out of the door each evening. We have to make sure that they come back the next morning.

It is not our Abilities that show What we are, it is Our choicesHigher value services Increase revenue productivity

Offshore Software Development Centers

GrowthExposure limits for client concentration Exposure limit for dotcom businesses Exposure limit for opportunity businesses (like Y2K) Geographical diversification

Offshore model - Global Delivery Upsell to existing customers Iterative Model of Development

The consequences of our actions are always so complicated, so diverse, that predicting the future is a very difficult business indeed.

Profitability

De-risking

Enhancing creativityTask Actions Exchange Behaviours EmpowermentGiving autonomy Trusting and delegating

Ideas guidance

Person Characteristics Social support Being approachable

Giving resource support for creativity Giving advisory feedback Giving rewards and recognition for creativity Giving supportive encouragement to be creative Not criticizing ideas Having integrity with others ideas

Being fun to work with Being accessible to employees

Creative OrientationBeing Creative Willingness to Change Openness to ideas and optimism

Distinguishing characteristic of cubism is the presence of multiple viewpoints, in physics -coordinate systems Cubism 1905-1939

"I start with an abstraction in order to arrive at true fact."

Cubist painting shows the front, back and side views of an object all at the same time,

B U S I N E S S C Y C L E S

Four Kondratieff waves in U.S.US T Bond, US PPI US Stock-S&P 500 ABX-Mining

B U S I N E S S C Y C L E S

In 1926, Kondratieff published "Long Waves in Economic Life". Report seen as a criticism of Joseph Stalin's total collectivization of Agriculture and executed. Existence of 50- to 60-year Business cycles also shown by Dutch economists , J. van Gelderen and Samuel de Wolff, in 1913. K-Wave interpretations range from Evolutionists, Neo-Marxists and Neo-Schumpeterians

In K Wave Technology & Innovation play a pivotal role WITH HISTORICAL REGULARITY

Neo-Schumpeterian Economics deals with dynamic processes causing qualitative transformation of economies driven by the introduction of novelties. It studies innovation and learning behavior on the micro-level of an economy. Industry dynamics on the meso-level Innovation driven growth and competitiveness on the macro-level of the economy.

Financial bubbles arise in each period of Technology Revolution LESSONS FROM THE PAST BUBBLE ARE FORGOTTEN

IMPORTANT we are in it right now?

The worlds best Technology Companies Like IBM and Cook report speak highly of Carlota Perez and her works on Technology and innovation

We have passed through it

Canals

Railways

Roads

Airports

Buckingham canal

Madras Railway

1954

But history also shows thatINSTABILITY RECESSION RECOMPOSITION

EACH MAJOR TECHNOLOGY BUBBLE IS FOLLOWED BY A GOLDEN AGEINSTALLATION PERIODBubble

DEPLOYMENT PERIODGolden Age

the five revolutions in parallel

1 2 3 4 5Irruption

The great Canal mania 179397 British leap

Railway mania 184850 The Victorian Boom New frontier bubbles 189395 The Belle poque (Europe) The Progressive Era (USA) The Roaring The post-war 192943 Twenties Golden Age Internet mania

2001??

?Synergy Maturity

FrenzyCOLLAPSE COLLAPSE

V W U LUS Housing market has Lost $ 6 trillion value in 2006-08 Chinas GDP in 2007 3.4 trillion

US Corporations Have lost about $ 8 trillion value Since Jan 2008 Global equity loss $17 trillion

Job losses in 18 months 6 Million in US

Around to retire are The WORST HIT

V U W L-An Answer The key question is therefore how long this recession will last? The blog's research has highlighted 4 main scenarios: V-shaped. The optimistic view is that recovery is just round the corner. But this seems unlikely, given the headwinds of the credit crunch and looming over-capacity in many key chemical products. U-shaped. This is the blog's base case. It implies the recession bottoms in 2010/11, and then begins to recover. Early decisions to close high-cost plants, and cancel unnecessary new capacities, would also be required. W-shaped. This is often seen in serious recessions. Severe destocking leads to an apparent early recovery, as the value chain restocks. But demand then slips back again, before properly recovering. L-shaped. This is the worst case scenario, as it implies demand could fail to recover by 2011, and might instead remain at a low level. This would mirror Japan's experience post-1990.

Clinton administration- Home ownership rate increased 1.94 percent per year Bush administration- Home ownership rate increased 0.37 percent per year AND IN THE END A WELFARE PROGRAM ENDED IN A MESS

Loss of manufacturing jobs: Only in the U.S.? Manufacturing jobs: 1993 normalized to 100

3m jobs lost in the U.S. Its a worldwide phenomenon!Does the trade deficit cause unemployment?

The New US Economy- The US is now an information economy Manufacturing continues to shrink, while services continue to grow Information sectors comprise over 60% of total GNP value added in the private sector Information services (consumer and industrial) dominate the US economy

Unemployment dropsSince 2000

Trade deficit expands

Before 2000

Income Concentration StressIncredible greed

Historian Douglas Astolfi sees Incredible greed" in three periods. First in the 1870s during a speculative boom, next the Roaring '20s and third is in progress

Inequality of Distribution: top 1% and 10% have largest share since 1928; In 2005 income rose by 9%, but actually fell for bottom 90% FINANCIAL EXCESSES HAVE CONTRIBUTED TO THIS

The Wealth Concentration StressBubble had been corrupting the ethos of Japanese society, therefore excess must be purged from system. Specifically, BOJ Governor Mieno Yasushi (from December 1989 till December 1994) declared that the late 1980s boom had hastened a decline in morals, fostered inequalities in the distribution of wealth, and undermined the stabilityof Japanese society by weakening the ethos of labor, the notion of working by the sweat of your brow. (quotes on p. 132 of Flath)

In 1920 the richest 5% received 30% of the national income down to 15.6% by 1969 and disparity is back. Among the Industrialized nations the US has the highest concentration of individual wealth-roughly 3 times of Germany.

Casino Capitalism flourishes best with Income and Wealth concentration

The Wealth Concentration Stress Wealth concentration in 1929 imposed an extraordinary stress on the economic system, a threat not approached again until the most recent decade

Casino capitalism,' an instability a phenomenon which Susan Strange links to five trends: innovations in the way in which financial markets work; the sheer size of markets; commercial banks turned into investment banks; the emergence of Asian nations as players; and the shift to self-regulation

In practice because of the way society assimilates a revolution

THE DIFFUSION PROCESS IS BROKEN IN TWOFirst 20-30 years Second 20-30 yearsTURNING POINT

INSTALLATION PERIOD

DEPLOYMENT PERIOD

TURBULENT CREATIVE DESTRUCTIONEmergence of the new Decline of the old ESTABLISHMENT OF THE NEW PARADIGM modernizing the oldINSTABILITY AND UNCERTAINTY

GOLDEN AGE OF GROWTHExpansion of new and renewed economy FULL FLOURISHING OF THE TRIUMPHANT PARADIGM and gestation of the next

1971

2000

Time

We are here

The special conditions for FINANCIAL FRENZY ... EXCITE financial capital in the Installation Period and ATTRACT of a technological revolution available money towards allThe amazing SUCCESSES of the new entrepreneur s

the technological revolution

Spectacular profits and growing capital gains

Excess demand in the stock marke ends up leading to ASSET INFLATION

The MASSIVE DELUSION makes many unprofitable projects appear viable

ting even more funds and preparing the inevitable c

Genesis of a CrisisExcess Global Liquidity Originate-andDistribute Model Mortgage Securitization Mispricing of Risk Credit Default Swaps Excessive Financial Leverage

Scant Regulatory Oversight

Rising Real Estate Prices Deterioration of Underwriting Standards Low Interest Drive to Increase Rates Investment Returns

Crisis

Mauro F. Guilln, The Wharton School.

25 years ago, economists were extolling the virtues of financial deregulation and innovation; a maverick ( colleagues called him radical to crackpot) Hyman P. Minsky maintained a more negative view of Wall Street; that

played the role of arsonists, setting the entire economy ablaze.bankers, traders, and other financiers periodically Wall Street encouraged businesses and individuals

to take on too

much risk,step

generating ruinous boom-and-bust cycles. Government to in and regulate the moneymen.

References to Minskys hypothesis have become commonplace in the reports of Wall Street analysts.

5 stages of Minskys Model of Credit Cycle

Displacementwhen investors get excited about something

Euphoriaextend credit to ever more dubious borrowers,

Banks and lenders

Boom

Profit taking

And panic.,

A Longer-Term Perspective on Home PricesDid the origins of the Housing bubble lie in the Technology bubble1890=100220 200 180 160 140 120 100 80 60World War I Great Depression World War II 1970s 1980s Boom Boom Current Boom Median

220 200 180 160 140 120 100

Home Price To Median Income

In real terms, the cost of constructing a home 80 hasnt really 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980changed much in the last 27 1990 2000 2010 years, while home prices, in real terms, have doubled.

60

Source: Robert J. Shiller, 2006.

In 2005, 1,283,000 new single-family houses were sold, compared with an average of 609,000 per year during 19901995.

How to Recognize a Housing Bubble In the long run, house prices nationally have followed inflation In the long run, house prices have risen more or less with rents (same market)

CRA

The Technology bubble lead to the Housing bubble ?

Unless some fundamental factor has changed, then the run-up since 1997 is a bubble. Largest home builders, such as D. R. Horton, Pulte,and Lennar, saw large share prices and revenues in 20042005

A bubble or a speculative mania is a trade in high volumes at prices that are considerably at variance from intrinsic values

Social psychology factors

Greater fool theory - driven by perennially optimists (fools) Greed - irrational exuberance of overly bullish investors arefavored by the greed

Herding a self-fulfilling prophecy or bandwagon effect Wishful Thinking Bias exaggerate that their team/idea will win. Liquidity - excessive monetary liquidity in the financial systeminappropriate lending standards by the banks, causes asset markets to be vulnerable to volatile hyperinflation caused by short-term,

leveraged speculation

Financial instability hypothesis: Each stage [of the business cycle] nurtures forces that lead to its own destruction. Stability accompanied by financial innovation and reduction in the margin of safety Casino Finance Investment strategy classified as extremely high risk. Using borrowed money (margin) to invest is riskier because leverage results in amplified gains and losses. Three cyclical financial states:

hedge, speculative, and Ponzi finance

Result: Minskys Financial Instability Hypothesis Financial Innovation is at the Heart of Economic Change Linked Innovation of Schumpeter with Keynes Recognition of Business Cycles

Minsky argument Financial complexity and fragility increases during periods of stability Competition drives both borrowers and lenders to take on more risk Financial system dominated by Ponzi finance dependent on rising asset prices and further borrowing Vulnerable to small rises in interest rates Credit crunch may be triggered by not unusual event

Minsky argument Crisis creates danger of debt deflation, requiring intervention by authorities Intervention to prevent debt deflation leads to appearance of another new era However, it encourages fresh risk-taking which increases probability of another crisis Intervention also raises chances of stagflationPercentage of Population 30

25

Sub Prime FICO80% & Income to loan repayment ratio >45%18 15 12 8 5

27

20

15

National Distribution of FICO Scores

13

10

5 2 0 up to 499 500-549 550-599 600-649 650-699 700-479 750-799 800

Minsky argument:

Greenspan reflation

Federal Reserve has intervened on numerous occasions to prevent a financial crisis from having ill-effects (e.g. October 1987, early 1990s, LTCM) Greenspan put encourages greater risk-taking: each of these interventions created a new source of instability (e.g. junk bond mania, Mexican crisis, tech boom) Fed saw off threat of debt deflation after collapse of stock market bubble in 2002 Deflation avoided but no return to financial conservatism Rising leverage increases risk of another financial accident

FDIC List of Problem Banks

Greenspan & BuffetWhen the tide goes out that you learn who's been swimming naked.

Greenspan stated: US housing construction with low interest rate would stimulate other entrepreneurial economic activity and stop the US from sliding into a recession. As predicted : housing construction and prices zoomed upwards, thousands of new jobs were created and the US growth leapt forward. Speculative selling or buying of houses, is not as easy as speculating in securities. Sellers have to incur substantial transaction costs like brokerage fees and taxes and these costs act as dampeners to speculation. Greenspan overlooked a financial innovation called "mortgage-backed securities" a type of "derivatives". The burst housing bubble carried "the mess they created" not only in the United States but also to other parts of the world. Warren Buffett whose financial acumen Americans respect the most, described the destructive power the derivatives wield as Weapons of mass destruction", Contracts devised by madmen" " Like hell easy to enter and almost impossible to exit."

Stock market bubble accompanied by record corporate sector financial deficit Telecoms firms and dotcoms were Ponzi finance units, dependent on rising asset prices and access to capital When capital markets closed the bubble collapsed, triggering a corporate credit crunch

Minsky argument: supporting evidence

The dot-com burst affected Primarily business capital spending which constitutes 10-12% of GDP Housing bubble felt in consumption and construction accounting for 78% of the GDP (consumption alone is over 70% of the GDP)Source: Wynne Godley, Levy Institute

Minsky argument: supporting evidenceRising household sector financial deficit

Ponzi nation: since the bubble burst household sector has run an increasing financial deficit consumer borrowing (net new lending) running at c.15% of personal disposable income in 2004

Home mortgage debt increased 100% from 4.9 T in 2001 to 9.8 T in 2007

Minsky argument: supporting evidence Household sectors margin of safety has declined (Debt liabilities exceed liquid assets) Balance sheets buoyed by illiquid residential housing assets Debt-service levels at record highs despite low interest rates Mortgage borrowers turning to exotic finance: hybrid adjustable-rate mortgages, interest-only and pay option ARMS.A household sector where millions of households are insolvent, into negative equity territory and may loose homes;Source: Andrew Hunt Economics

Payment Structure, by Mortgage Type $200,000, June, 2004Loan Product Initial Reset Payment Payment Reset Date Payment Increase Increase (%)

30-Year FRM 3/1 ARM 3/1 I-O ARM Option ARMteaser rate''

$1,237 $1,237 $1,039 $1,420 $786 $643 $1,462

None June, 2007 June, 2007

$0 $381 $676 $912

$1,555 August 2007

Unpaid interest added to the 37% mortgage balance 86% Owing more on the Mortgage In 142% NegAm

0%

Assumptions: Option ARM has a 7.5% annual increase limit and a 110% negative amortization cap; Option ARM interest accrual is based off 1 year ARM rate as reported by Fannie Mae; Option ARM Minimum Payment is equivalent to a 1% interest rate; FRM is from Fannie Mae 30 Year FRM Index; ARM is set from LIBOR plus a 2.25% margin; 3/1 Interest Only ARM amortizes in 30 Years.

Example: The Teaser MortgageCarpenter, wife two children Annual income $50,000 $350,000 house in Phoenix, Arizona $15,000 down $335,000 mortgage TERMS 1% annual interest 30 months zero amortization Adjustable rate: after 30 months interest rate goes to 7% amortization goes to 10 years So... Today $350,000 house in Phoenix worth about $245,000 Mortgage $335,000 Equity: -$90,000 Probably a non-recourse loan Besides no other assets 129

RESULT: initial mortgage payments $279.16 per month after 30 months mortgage payments $3,977.78 per month! PAYMENT SHOCK!

2-28, $200,000 Hybrid ARM, No Change in interest Rates$2,500 100% 90% $2,000 80% 70% $1,500 60% 50% $1,000 40% 30% $500 20% 10% $0%

Monthly Payment (Principal & Interest)

Teaser Rate Monthly Payment Post-Tax DTI $1,311 61%

Fully Indexed Rate $1,948 90%

In "payment shock." the repayments may go up --as much as double or triple With income barely sufficient to meet the installments

Subprime ARM resets were one of the catalysts for the mortgage crisis. Dean Baker, co-director of the Center for Economic and Policy Research "it's almost impossible to imagine any bank or financial institution going unscathed and the losses will easily exceed that of the S&L debacle.

Post-Tax Debt-to-Income

Reasons for Credit Card Debt

48% 38% 34%

car repairs home repairs major household appliance 29% an illness or medical expense 25% a layoff or job

loss 21% college tuition

Minsky argument: supporting evidence Financial operators taking advantage of stability to play the carry trade (Ever greening of outstandings) Rising leverage in private equity, mortgage-backed securities, etc. Leverage ratio at Investment Banks The quieter the markets get, the greater the leverage. Gerald Lucas, chiefbond strategist, Bank of America (FT, 17 June 2004)

Source: Portales Partners, Bianco Research

Dependence on Debt?Leverage Ratios At Biggest Investment Banks

Level 3 assets( illiquid, valuation based on management Assumptions) as percentage of equity: Bear Sterns 313%, Morgan Stanley 235%, Goldman Sachs 192%, Lehman Brothers 171%, Merrill Lynch 130%,

Total assets to total shareholder equity 40March 2008 March 2008

35 30 25 20 15

March 2001

Bear Stearns

Morgan Stanley

Merrill Lynch

Lehman Bros.*

Goldman Sachs

Note: the latest figure is as Impact of*leptokurtosis :of December 2007 under-estimating risk during turbulent market periods by using Value-at-Risk Sources: Bloomberg. methodology based on normal distribution assumption. VaR incorrectly assumes that all risks can be quantified

Flawed SEC Program Failed to Rein in Investment Banks

SEC rules required the investment banks to limit their debt-to-net-capital ratio at 15 and limits on their risky investments along with capital as cushion for asset defaults. SEC in 2004(after "heavy lobbying") increased leverage for additional debt. Used to purchase MBS based on self generated computer models to determine financial risk. 5 US investment banks had $4.1 trillion debt in 2007, roughly 30% size of the U.S. economy. Increased financial leverage added to the vulnerability. Increased leverage for Investment Banks In 2004 SEC ruling expecting Self regulation a great CASINO LOBBYING, as three went Bankrupt at fire sale prices creating instability in the Global financial system.

Wall Street and the Subprime Disaster - Investment Banks Fueling the Subprime Boom, Making Billions, and Causing a worldwide crisis. Wall Street's best and brightest, lauded in Barron's and Institutional Investor for their superior investing acumen and unrivalled ability to gauge and manage risk I: Investment banks subprime motive: billions in revenues and bonuses. CDOs replaced tech stocks, as the hottest products II: Investment banks provided subprime lenders with essential funding.Investment banks supplied with lines of credit like Purchase agreements and Warehouse lines of credit that were tapped on a daily basis

III: Pressure from Wall Street caused spike in predatory lending.The investment banks pushed lenders to produce more loans with high rates and prepayment penalties

IV: Investment banks pumped up demand for risk-laden subprime bonds.Set inflated prices for the bonds and encouraged investors to purchase the bonds, including financial products that were largely untested.

V: The big five investment banks paid more than $38 billion as bonus in 2007INVESTMENT BANK REVENUES AND BONUSES ROSE TO NEW RECORDS ON STRENGTH OF SUBPRIME WAVE

Minsky argument: supporting evidence Narrowing risk spreads: credit default swaps VIX index (Chicago Board

Options Exchange Volatility Index, a popular measure of the implied volatility of S&P 500 index ) emerging market and high yield spreadsLower quality high yield issues40 35 30 Percent 25 20 15 10 5 0 1983 1984 1985 1986 1987 1988 1989 1990 1991 1993 1992 1994 1995 1996 1997 1998 1999 2000 2001

Record low quality of high yield issuance in 2004

Percentage of High Yield New Issuance, Senior Equivalent B- or Lower

Source: Leverage World

Minsky argument: supporting evidence Financial innovation to evade regulation and increase leverage: CDOs-squared, etc. Rapid growth of credit derivatives and other structured financial products Financial system increasingly vulnerable to liquidity risk Likelihood of another financial accident highFOMC concluded on 30.01.2008 There is no singular reason for risk management failures on this scale.

Source: Fitch Ratings

Financial AlchemyWall Street has a way to transform 1.The CDO 2.Multiply CDOs risky debt into CDOs rated AAA or Aaa.A CDO is a company typically incorporated offshore that buys collateral such as bonds, mortgage-backed securities and loans and sells debt securities with varying degrees of riskInterest payment

A CDO with collateral consisting of pieces of other CDOs is called a CDO squared. When a CDO is built of CDO squareds, its called a CDO cubed.

$

CDO squareds

COLLATERAL

SECURITIES

CDO CDO

CDO CDO

Bonds

AAA

CDO cubedsCDO CDO CDO CDO

Mortgage- Other assetbacked Backed securities securities

AA-

BBB

CDO

CDO

CDO

CDO

Unrated equity(toxic waste)

CDO

CDO

CDO

CDO

Potential losses

$

CDO

CDO

CDO

CDO

Source: Bloomberg Markets, July 2007

Higher ratings were believed justified by various credit enhancements including over-collateralization (pledging collateral in excess of debt issued), credit default insurance, with investors to bear the first losses.Rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities from Q3 2007 to Q2 2008 With securitization, the model became "originate to distribute" model, with transfer of credit risk through MBS. Investment-grade ratings to MBS, loans with a high risk of default could be originated and packaged to others.

From Sows Ear to Silk PurseAlchemy of securitisation (act 1)MB AssetsSubprime mortgages Slice and Dice CDOsStructured Securities A new firm with opaque assets Static pool, so stuck with assets for life Capital structure created from scratch

NINJA Loans, Teaser Rates

Credit Rating Agencies

BBB

Mortgage Lender

Investment Banks

Pensions, Hedges, Banks

The proliferation and the uncertainty about the real values of the Derivatives accelerated the recent collapse of the investment houses and magnified the panic Source: Invesco Perpetual. For illustrative purposes only. which crippled the global financial system.

e hg H, yks R er o M i i

AAA

Back to Sows EarAlchemy of securitisation (act 2)Opaque structures Of CDOs MB AssetsSubprime mortgages Slice and Dice CDOs

NINJA Loans, Teaser Rates

Credit Rating Agencies

BBB

??

Mortgage Lender

Investment Banks

Pensions, Hedges, Banks

CDO Managers collect a series of BBB tranches and repackage them with a cascading Invesco Perpetual. For illustrative purposes only. tiers are paid out first cash waterfall so that the top Source: on all the tranches thus allowing them to be rated AAA by rating agencies

i Y r e hg H, yks R er o M i i

AAA

The additional problems with complicated structuresTypical Mezzanine CDO of ABSUnderlying loans Typical RMBS Underlyin gAAA AA A A A BBB BBB BBB BBB BBB BBB BBB BBB BBB BBB BBB BBB BBB BBB BBB BBB BBB CDO

CDO of ABS100% 90% 80%

AAA

Super senior

Potential loss 75%

70% 60% 50% 40% 30% 20% 10% 0%

AA

AAA AA AEquity

Potential loss 10%

A BBB BBBUnrated

The crisis was triggered, transmitted and fueled not by widespread defaults on debt instruments as in past credit crises but through excessive leverage (borrowing) and widespread securitization of complex structured financial products. Source: Citi. The leverage amplified even small changes in real (or perceived) risk associated with the underlying debt instruments which were then transmitted globally via securitization

Rating Agencies Failed Public says SEC

Piggy backing Schemes By renters

Excess spread, Overcollateralization Financial support, to cover stressed scenarios Subordination, Wrapped Securities Letter of Credit, Credit Insurance

Credit enhancement is a key part of the securitization transaction in structured finance, and is important for credit rating agencies when rating a securitization which is subject to ingoing surveillance

Asset valuation crisis in CDOs Three factors to value an asset are price transparency, liquidity and methodology of valuation. Hedge funds needed tradable prices to value CDO and found no bids. Hedge funds incurred heavy losses in CDOs in mid 2007 due to difficulty in pricing these complex instruments. French bank BNP Paribas shut down three funds in Aug 2007 with exposures to the U.S. sub-prime market because it said it could not value the funds.

Basket Valuation

SEC began checking the books at Wall Street to ensure a consistent method for valuing sub-prime mortgages in the inventory. And also whether they have marked down their own positions when they marked down the value of their clients' assets.

Subprime and CDOs: Illiquifying the Liquified

Opacity

Financial regulators hampered by the opacity of over-the-counter CDO where only qualified investors may peruse the deal documents and performance reports. Currently none of the bank regulatory agencies (OCC, Federal Reserve, or FDIC) are deemed qualified investors. Regulators must receive permission from each issuer. The pipeline of CDO deals can be difficult to assess with details of the transactions inaccessible. Many deals are put together on a reverse inquiry basis or as private transactions and the credits underlying the deals are not revealed. Modeling the cashflow structures that underlie something like a CDO-squared, for example, is immensely complicated and very different to doing a standard credit analysis by looking at financials and credit ratios. In managing a CDO one has to be comfortable with the underlying dynamics of each structure, the fundamentals of the collateral and with the statistical chance of some of the names going into default. Looking at the correlation, is a whole different ballgame in comparison to a straight bond investment.

Mortgage loan market in the U.S. relative size of the subprime segment

The share of subprime increased by 130% from 2003 to 2005! The percent of loans securitized increased by 60% from 2001 to 2005!

Share of subprime In total U.S. economy (measured by GDP): 1% (2001), increasing to 5% (2005)

Sub prime Securitizations with weak underlying assets were driving the market

WALL STREETS FEAR INDEX

AAA RATED MORTGAGE BACKED SECURITIESThe ABX index launched in January 2007, serves as a benchmark of the market for securities backed by home loans issued to borrowers with weak credit and is a key point of reference for investors navigating the world of risky mortgage debt.

By appearing to provide a safety net, derivatives had the unintended effect of encouraging more risk-taking. Instead of dispersing risk, derivatives had amplified it

Rapid Growth of Alternative Mortgage Products and Structured Credit700

Origintions of Sub-Prime Mortgages, Issuance of Sub-Prime Mortgage-Backed Securities and Issunce of CDO's of Assets-Backed Securities(U.S.$, billions, annual rates) 700

Shift: 1970: