International Finance Final

7/28/2019 International Finance Final

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Sub-Prime Lending Crisis

Rishabh Rai 2010G02

Gunjan Punjabi 2010G03

Neeru Kalra 2010G05

Sameer Kanikdale 2010G06

Jagdish Amrutkar 2010G07

Prasanna Bhuibhar 2010G44


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What is Sub-Prime lending?

In finance, subprime lending (also referred to asnear-prime, non-prime, and second-chancelending)

making loans to people who may have difficulty

maintaining the repayment schedule. For. e.g, theyoung, the discriminated-against, the peoplewithout a lot of money in the bank to use for adown payment

Subprime loans are for persons with blemished orlimited credit histories.

The loans carry a higher rate of interest than primeloans to compensate for increased credit risk.


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Sub Prime Lending The term subprime refers to the credit quality of

particular borrowers, who have weakened credithistories and a greater risk of loan default than primeborrowers.

Subprime borrowers have credit ratings that mightinclude:

Limited debt experience (so the lender's assessor

simply does not know, and assumes the worst)

No possession of property assets that could be used assecurity (for the lender to sell in case of default)


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Sub-Prime lending

Excessive debt (the known income of the individualor family is unlikely to be enough to pay livingexpenses + interest + repayment)

A history of late or sometimes missed payments sothat the loan period had to be extended, failures topay debts completely (default debt)

Any legal judgments such as "orders to pay" orbankruptcy (sometimes known in Britain as countycourt judgments or CCJs).


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How did it Started ? In the years leading up to the crisis, significant amounts of foreign money

flowed into the U.S. from fast-growing economies in Asia and oil-producingcountries.

This inflow of funds combined with low U.S. interest rates from 20022004contributed to easy credit conditions, which fueled both housing and creditbubbles. Loans of various types (e.g., mortgage, credit card, and auto) wereeasy to obtain and consumers assumed an unprecedented debt load

The subprime crisis arose from 'bundling' American subprime and Americanregular mortgages which were traditionally isolated from, and sold in aseparate market from prime loans.

These 'bundles' of mixed (prime and subprime) mortgages were the basisasset-backed securities so the 'probable' rate of return looked superb (since

subprime lenders pay higher premiums, and the loans were anyway securedagainst saleable real-estate, and so, theoretically 'could not fail').

The inflated house-price bubble burst, property valuations plummeted andthe real rate of return on investment could not be estimated, and soconfidence in these instruments collapsed, and all were considered to be

almost worthless..


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Subprime mortgage crisis The U.S. subprime mortgage crisis was one of the first

indicators of the late-2000s financial crisis, characterized by

a rise in subprime mortgage delinquencies and foreclosures,and the resulting decline of securities backed by saidmortgages.

The percentage of new lower-quality subprime mortgagesrose from the historical 8% or lower range to approximately20% from 2003 to 2006

For E.g. $500,000 loan at a 4% interest rate for 30 yearsequates to a payment of about $2,400 a month. But thesame loan at 10% for 27 years (after the adjustable periodends) equates to a payment of $4,220

The total cost of the above loan at 4% is $864,000, whilethe higher rate of 10% would incur a lifetime cost of$1,367,280


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How did it started ?

Subprime Lending Crisis

Leading to downward pressure on housing prices and lowering home owner's equity and also reduced the value of mortgage

Defaulting by borrowers, supply for homes increased

Borrowers were unable to make higher payment and re-financing became more difficult once housing prices began to decline

This credit lead to boom and eventually to a surplus unsold homes which caused housing price declining in Mid 2006

Increase in home ownership which drove prices higher

Fueling of housing market boom and encouraging debt financing

Easy credit conditions

Lowest Interest Rate

Inflow of FDI

Steady Growth of economy

Increase demand of homes

This promoted higher lending and higher risk taking by new home buyer


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Risks of the subprime crises

Credit risks

Traditionally, the risk of default (called credit risk) would be

assumed by the bank originating the loan. However, due to

innovations in securitization, credit risk is now shared more

broadly with investors.

Asset price risk:

Fundamentally derives from the collectibles of subprime

mortgage payments, which is difficult to predict due to lack

of precedent and rising delinquency rates.

Liquidity risk

The amount of commercial paper issued as of October 18,

2007 dropped by 25%, to $888 billion, from the August 8

level.


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Securitization Securitization is the process in which certain types of assets

are pooled so that they can be repackaged into interest-bearing securities.

securitization reduced their borrowing costs and, in the case

of banks, lowered regulatory minimum capital requirements.

Unlike conventional debt, securitization does not inflate acompanys liabilities.

Instead it produces funds for future investment without

balance sheet growth.

Financial institutions employ securitization to transfer thecredit risk of the assets they originate from their balance

sheets to those of other financial institutions, such as banks,

insurance companies, and hedge funds.


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Securitization


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Sub-prime model

s


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Causes of Sub Prime CrisesCauses proposed include :

The inability of homeowners to make their mortgage payments (dueprimarily to adjustable-rate mortgages resetting,

Borrowers overextending, predatory lending, and speculation),

overbuilding during the boom period, risky mortgage products,increased power of mortgage originators.

Three important catalysts of the subprime crisis were the influx ofmoneys from the private sector.

The banks entering into the mortgage bond market. And the predatory lending practices of the mortgage lenders,

specifically the adjustable-rate mortgage


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Causes of Sub Prime Crises

Mortgage brokers and Under writersMortgage brokers originated 68% of all residential

loans in US

Sub prime and Alt A loans accounting 42% of the

volume

Brokers didnt determine whether borrower's could

repay the loans

Loans generated by Automated under writingsMinimal documentation

Decision in 30 seconds as opposed to the week


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Securitization as a structured finance process in

which assets, receivables or financial instruments

are acquired, classified into pools and offered

as collateral for third-party investment.

Due to securitization, investor appetite for

mortgage-backed securities (MBS) and the

tendency of rating agencies to assign investment-

grade ratings to MBS, loans with a high risk ofdefault could be originated, packaged and the risk

readily transferred to others.


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Causes of Sub Prime CrisesCredit rating agencies

Gave investment-grade ratings to securitization

transactions holding subprime mortgages

Higher ratings theoretically were due to the multiple,

independent mortgages held in the mortgage-backedsecurities, according to the agencies.

Critics claim that conflicts of interest were involved,

as rating agencies are paid by those companies sellingthe MBS to investors, such as investment

Banks.


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Borrowers role

Obtained ARMS that they could not afford after

initial incentive period


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Feds role

Chronology of regulatory neglect

banks and other lenders loosened their standards

for making riskier mortgage loans during the

housing boom.

Greenspan defended his actions, saying that the

Fed was not equipped to investigate deceptive

lending and that it was not to blame for the

housing bubble and its eventual bust.


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Government and Federal

Regulatory Policieslegislation like the Community Reinvestment Act,

which they claim forces banks to lend to

uncreditworthy consumers


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Impact

Stock markets

On July 19, 2007, the Dow Jones Industrial Average

hit a record high, closing above 14,000 for the first

time. By Aug. 15, 2007, the Dow had dropped

below 13,000.

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Financial institutions

Profits at the 8,533 U.S. banks insured by the

Federal Deposit Insurance Corporation (FDIC)

declined from $35.2 billion to $5.8 billion (83.5

percent) during the fourth quarter of 2007 versus

the prior year, due to soaring loan defaults and

provisions for loan losses.

I i


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Insurance companiesConcern for malicious burning to destroy property as a wayto escape from mortgages by some homeowners because

they can't or refuse to pay. The FBI reports that maliciousburning to destroy property has grew 4% in suburbs and2.2% in cities from 2005 to 2006.

Role of municipal bond "monoline" insurance corporations.Municipal bonds achieve higher debt ratings and suffered asignificant loss because of which rating agencies havedowngraded the bonds they insured or guaranteed. In turn,this required financial institutions holding the bonds tolower their valuation or to sell them. The impact of suchdevaluation on institutional investors and corporationsholding the bonds (including major banks) has beenestimated as high as $200 billion.

H i i (h )


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Housing prices (home owners)

According to the S&P/Case-Shiller housing price index, by

November 2007, average U.S. housing prices had fallen

approximately 8% from their 2006.The price decline in December 2007 versus the year-ago

period was 10.4%. Sales volume (units) of new homes

dropped by 26.4% in 2007 versus the prior year.


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Prime borrowers hit hardAs home prices continue to fall and banks tighten their lending

standards, people with prime credit histories now are falling behindon their payments for home loans, auto loans and credit cards.

Home Equity Falls to New LowThe Federal Reserve Board reported on March 5, 2008, that

Americans percentage of equity in their homes has fallen below 50

percent for the first time on record.

Homeowners percentage of equity declined to 47.9 percent in thefourth quarter of 2007the third straight quarter it was under 50

percent.


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Home foreclosures shot up to an all-time high in third

quarter 2007. The Mortgage

Bankers Association (MBA) in its quarterly snapshot of

the mortgage market released on

Dec. 6, 2007, reported that the percentage of all

mortgages nationwide that started the

foreclosure process jumped to a record high of 0.78percent.


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Lending practices in India

Credit ratings

Banks

NPA rules and regulations

Process of lendingRBI regulations

Conclusion about Indian practices


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Conclusion

Documents

International Finance Final