Sub-Prime Crisis – Prime Concern

Sai Kumar Swamy,PGDM, IIM Bangalore

AgendaDefinition

PrimeSub-Prime

Origin of CrisisWhy did the bubble

burst?Interesting statsWhy did the Financial

Giants collapse?The answer

CDOAdvantageMBS & CDSLinkageEnd GameHow the cookie formed?How the cookie crumbled?

PrimePrime Borrower

Borrow < 80 % Good credit bureau record Monthly payment < 25 % income Good Credit Score

Banks like them - Credit WorthySafe Lower Interest ratePay Lower Mortgage Rates

SubprimeSubprime Borrower

Tarnished credit records Low Credit score Borrow a higher proportion High Mortgage to Income ratio

Banks are wary of these customersRisky Higher Interest ratePay Higher Mortgage Rates

Origin of Crisis - 1Housing Bubble 2001- 2005 Housing prices increase Cheaper Credit

Federal Reserve Lowers the Federal Funds RateFrom 6.5% to 1.75 % between May 2000 and December 2001

Greater Access to Credit Sub-Prime Market

Mortgages to risky individualsIncrease in Buyers

Origin of Crisis - 2Sub-prime mortgages

Government Policies ECOA - 1974 CRA - 1977

Competitive pressuresIncrease in loan incentivesEasy initial terms

ARM (ARM – Adjustable Rate Mortgages)Rising Housing pricesDropping interest rates

Origin of Crisis - 3Housing prices peak in mid-2006Building boomFresh Supply created to exploit market conditionsSurplus of homesHousing Bubble Bursts Home Sales fall Supply exceeds Demand More Sellers than Buyers Prices of Houses decrease

WHY??Housing Construction DeclinesSlowdown in US Economy

Why did the bubble burst?No clear cut reason – Many factors responsibleFactors

Greed of BorrowersARMRefinancing doldrumsSupply glut

Led to ForeclosuresStarted vicious cycleSupply of homes Prices Homeowners Equity

Interesting Stats - 1Increase 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 - 2Household Debt

$705Bn – 1974 $7.4Tn – 2000 $14.5Tn – 2008

Household debt as % of Disposable Income60% – 1974 134% in 2008

The AnswerCDO/CMO

Collateralized Debt Obligation

MBSMortgage based Securities

CDSCredit Default Swaps

CDOA structured credit productIs an Asset backed security

Based on pools of assetsCollateral – Cash flows from this pool of assetsSecuritization makes these assets available for investmentEx: Credit Card payments; Auto loans; Home loans

Constructed from a portfolio of fixed income assetsTraded in the marketSize of the Market

CDOs Credit Ratings

CDOs

Senior : AAA

MezzanineAA to BB

Equity : Unrated

AdvantageBrings together a pool of assets which otherwise cannot be traded

easilyPooling converts them into tradable instrumentsSecurities can be further broken into discrete tranches

Helps market them to investors with different risk appetitesLowers risk for originator

When the pool performs badly the owner takes the lossThe originator earns fees for servicing the asset poolOriginator earns money with NO residual liability

DownsideOriginator has NO incentive to reduce riskOriginator works toward Loan Volumes than Loan Quality

MBSIs an Asset backed SecurityBacked by

PrincipalInterest Payments

Federal National Mortgage Association (FNMA or Fannie Mae)Buys Mortgages and sells them as MBS to investorsFormed in 1934 and privatized in 1968

Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)2nd player in the MBS marketFormed in 1970

Given AAA rating and sold across the world

CDSContract

in which the buyer of CDS makes a series of payments to the seller to indemnify against a loss on the Credit instrument

Ex: 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

End game - 1Bankruptcies - 2007

February – March Subprime Market Collapses

April 2 One of the largest US Subprime Lender New Century Financial files for

BankruptcyUS 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 InstitutionsPrime Reason

Liabilities - Short termAssets - Long term & IlliquidVicious Cycle

AIGDemand for settlement of 100’s of Billions of CDS it

issued led to its collapse

Bear StearnsLehman Brothers

End Game - 2Fed injects $41Billion into Money Supply for banks to

BorrowBear Sterns gets Funding from Fed Acquired by JP

Morgan Federal Reserve takes over Fannie Mae and Freddie MacMerrill Lynch sold to Bank of AmericaLehman Bros. files for BankruptcyFed loans AIG $85 BillionsPaulson unveils Financial Rescue PlanTARP - $700BnDodd-Frank Law – 2010How it happened in a snapshot!

Case-Shiller Index

US Home Prices

Fed Funds Rate & Mortgage Rates

ECOA - 1974Equal Credit Opportunity ActSeeks to outlaw

Discrimination of loan applicants on the basis of Race Color Religion National Origin Marital Status Sex Age

FI’s subject to Civil Liability

CRA - 1977Community Reinvestment ActRedliningSeeks to address

Discrimination of applicants based on Area & Neighborhood

No civil liabilityNo specific criteria to evaluate complianceRating 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 MortgagesA loan where the interest rate is periodically adjustedSalient Features

Initial rateAdjustment periodIndex rate – Treasury securities, LIBOR etc.MarginDiscountsNegative 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!