Transcript Sub-Prime Crisis – Prime Concern

Sai Kumar Swamy,
PGDM, IIM Bangalore
Agenda
 Definition
 Prime
 Sub-Prime
 Origin of Crisis
 CDO
 Why did the bubble burst?
 End Game
 Interesting stats
 How the cookie formed?
 Why did the Financial
 How the cookie crumbled?
Giants collapse?
 The answer
 Advantage
 MBS & CDS
 Linkage
Prime
 Prime Borrower
 Borrow < 80 %
 Good credit bureau record
 Monthly payment < 25 % income
 Good Credit Score
 Banks like them - Credit Worthy
 Safe  Lower Interest rate
 Pay Lower Mortgage Rates
Subprime
 Subprime Borrower
 Tarnished credit records
 Low Credit score
 Borrow a higher proportion
 High Mortgage to Income ratio
 Banks are wary of these customers
 Risky  Higher Interest rate
 Pay Higher Mortgage Rates
Origin of Crisis - 1
 Housing Bubble  2001- 2005
 Housing prices increase
 Cheaper Credit
 Federal Reserve Lowers the Federal Funds Rate
 From 6.5% to 1.75 % between May 2000 and December 2001
 Greater Access to Credit
 Sub-Prime Market
 Mortgages to risky individuals
 Increase in Buyers
Origin of Crisis - 2
 Sub-prime mortgages
 Government Policies
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ECOA - 1974
CRA - 1977
 Competitive pressures
 Increase in loan incentives
 Easy initial terms

ARM (ARM – Adjustable Rate Mortgages)
 Rising Housing prices
 Dropping interest rates
Origin of Crisis - 3
 Housing prices peak in mid-2006
 Building boom
 Fresh Supply created to exploit market conditions
 Surplus of homes
 Housing Bubble Bursts
 Home Sales fall
 Supply exceeds Demand
 More Sellers than Buyers
 Prices of Houses decrease

WHY??
 Housing Construction Declines
 Slowdown in US Economy
Why did the bubble burst?
 No clear cut reason – Many factors responsible
 Factors
 Greed of Borrowers
 ARM
 Refinancing doldrums
 Supply glut
 Led to Foreclosures
 Started vicious cycle
 Supply of homes
Prices
Homeowners Equity
Interesting Stats - 1
 Increase in Home-ownership rate
 64% in 1994 – 70% in 2004
 Increase in Housing price
 1997-2006 – Increased by 124%
 Median Home price
 2001 2.9X of Median Household Income
 4X in 2004 & 4.6X in 2006
 Household Debt
 77% in 1990
 127% in 2007 (Is it 27% or 127%?)
 Unsold Homes
 4Mn homes for sale
 2.9Mn of these were vacant!!
Interesting Stats - 2
 Household Debt
 $705Bn – 1974
 $7.4Tn – 2000
 $14.5Tn – 2008
 Household debt as % of Disposable Income
 60% – 1974
 134% in 2008
Why did the Financial Giants collapse?
The Answer
 CDO/CMO
 Collateralized Debt Obligation
 MBS
 Mortgage based Securities
 CDS
 Credit Default Swaps
CDO
 A structured credit product
 Is an Asset backed security
 Based on pools of assets
 Collateral – Cash flows from this pool of assets
 Securitization makes these assets available for investment
 Ex: Credit Card payments; Auto loans; Home loans
 Constructed from a portfolio of fixed income assets
 Traded in the market
 Size of the Market
CDOs Credit Ratings
Senior : AAA
CDOs
Mezzanine
AA to BB
Equity : Unrated
Advantage
 Brings together a pool of assets which otherwise cannot be
traded easily
 Pooling converts them into tradable instruments
 Securities can be further broken into discrete tranches
 Helps market them to investors with different risk appetites
 Lowers risk for originator
 When the pool performs badly the owner takes the loss
 The originator earns fees for servicing the asset pool
 Originator earns money with NO residual liability
 Downside
 Originator has NO incentive to reduce risk
 Originator works toward Loan Volumes than Loan Quality
MBS
 Is an Asset backed Security
 Backed by
 Principal
 Interest Payments
 Federal National Mortgage Association (FNMA or Fannie Mae)
 Buys Mortgages and sells them as MBS to investors
 Formed in 1934 and privatized in 1968
 Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)
 2nd player in the MBS market
 Formed in 1970
 Given AAA rating and sold across the world
CDS
 Contract
 in which the buyer of CDS makes a series of payments to the seller to
indemnify against a loss on the Credit instrument
 Ex:

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
Investor buys CDS from KLM Bank for XYZ Corporation
Investor makes regular payments to KLM till such time that XYZ defaults
If XYZ defaults then KLM pays investor a ONE-OFF payment
The CDS is terminated
 Invented by JPMorgan in 1997
So what’s the Linkage?
End game - 1
 Bankruptcies - 2007
 February – March

Subprime Market Collapses
 April 2

One of the largest US Subprime Lender New Century Financial
files for Bankruptcy
 US Government Interventions – 2007
 August 17th , September 18th , Oct 1st
 Fed lowers discount rate
 New Hope Alliance created by US government to help some
subprime lenders
Collapse of Institutions
 Prime Reason
 Liabilities - Short term
 Assets - Long term & Illiquid
 Vicious Cycle
 AIG
 Demand for settlement of 100’s of Billions of CDS it issued led to its
collapse
 Bear Stearns
 Lehman Brothers
End Game - 2
 Fed injects $41Billion into Money Supply for banks to
Borrow
 Bear Sterns gets Funding from Fed  Acquired by JP
Morgan
 Federal Reserve takes over Fannie Mae and Freddie Mac
 Merrill Lynch sold to Bank of America
 Lehman Bros. files for Bankruptcy
 Fed loans AIG $85 Billions
 Paulson unveils Financial Rescue Plan
 TARP - $700Bn
 Dodd-Frank Law – 2010
 How it happened in a snapshot!
Annexures
Case-Shiller Index
US Home Prices
Fed Funds Rate & Mortgage Rates
ECOA - 1974
 Equal Credit Opportunity Act
 Seeks to outlaw
 Discrimination of loan applicants on the basis of

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Race
Color
Religion
National Origin
Marital Status
Sex
Age
FI’s subject to Civil Liability
CRA - 1977
 Community Reinvestment Act
 Redlining
 Seeks to address
 Discrimination of applicants based on

Area & Neighborhood
 No civil liability
 No specific criteria to evaluate compliance
 Rating assigned –
 “Managers of financial institutions found that these loan portfolios, if
properly underwritten and managed, could be profitable“ - Ben Bernanke
 “Usually did not involve disproportionately higher levels of default” - Ben
Bernanke
Philadelphia
ARM – Adjustable Rate Mortgages
 A loan where the interest rate is periodically adjusted
 Salient Features
 Initial rate
 Adjustment period
 Index rate – Treasury securities, LIBOR etc.
 Margin
 Discounts
 Negative amortization
 Major contributor to the Crisis when Interest rates went North
The Mortgage Market
MBS Downgrades
US Home Sales Inventory
Foreclosures
Vicious Cycle - Foreclosures
How the Chain works
Sub-Prime Mortgages
CDO - MBS
Securitization Market Activity
Leverage Ratios – Investment Banks
How the Cookie Formed!
How the Cookie crumbled!
Only Qs – No Answers!