Lehmann Brothers Collapse&

LIBOR Scandal

Mortgage Cycles

Down Payment

Involvement of Investment banker

Down Payment

Investment Banker

Sub-Prime Mortgage Crisis

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Investment Banker

Sub-Prime Mortgage Crisis

Down Payment

Investment Banker

Sub-Prime Mortgage Crisis

Down Payment

Investment Banker

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$$

$

$

Other institutions like Pension Funds, Hedge Funds etc.

Sub-Prime Mortgage Crisis

Now to earn more money Investment banker wanted more mortgages. But brokers couldn’t find any because all those who were eligible, already have homeThey instituted a new type of mortgages.

Sub-Prime Mortgages: • No document, • No proof of income • Anyone can apply

Even if they default the value of house will be increasing and there won’t be any loss to Investment banks

Instead of lending to responsible home owners called prime mortgages banks started lending to sub prime mortgagesThis is the turning point

Sub-Prime Mortgage Crisis

Stems from a fundamental change in the way mortgages are funded.

Home Buyer

Mortgage Loan

Repayments

Bank

Home Valuation Income Check

1

2

1 Bank grants mortgage

2 Homebuyer pays bank

Traditional Model Sub-Prime ModelHome Buyer

Mortgage Loan

Repayments

Bank

Mortgage Bond Bond

Payments

Mortgage Bond market

• Banks have financed their mortgage lending through the deposits they receive from their customers.

• Limited the amount of mortgage lending they could do.

• New model where they sell on the mortgages to the bond markets.

• This has made it much easier to fund additional borrowing,

Mortgage broker

Rating Agencies

High-risk mortgage loans and lending/borrowing practices

The private sector has dramatically expanded its role in the mortgage bond market, which had

previously been dominated by

government-sponsored agencies like Freddie

Mac

The business proved extremely profitable for the banks, which earned a fee for each mortgage they sold on. They urged mortgage brokers to sell more and more of these

mortgages.

They specialised in new types of mortgages, such as sub-prime lending to

borrowers with poor credit histories and weak income, undocumented immigrants who were

shunned by the "prime" lenders like Freddie Mac.

Now the mortgage bond market is worth $6

trillion, and is the largest single part of the whole

$27 trillion US bond market, bigger even than

Treasury bonds.

• Between 1997 and 2006 (the peak of the housing bubble), the price of the typical American house increased by 124%

• While housing prices were increasing, consumers were saving less and both borrowing and spending more.

• Household debt grew from $705 billion at year end 1974 to $7.4 trillion at year end 2000, and finally to $14.5 trillion in midyear 2008.

• U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion

• From 2001 to 2007, U.S. mortgage debt almost doubled, and the amount of mortgage debt per household rose more than 63%, from $91,500 to $149,500, with essentially stagnant wages

Sub-Prime Mortgage Crisis vicious cycle

Lehman Brothers Bankruptcy

In 2003 and 2004, Lehman acquired five mortgage

lenders, including subprime lender BNC Mortgage and Aurora Loan

Services, which specialized in Alt-A loans (made to borrowers without full documentation).

Leverage ratio,(ratio of assets to owners equity), increased from approximately 24:1 in 2003 to

31:1 by 2007.

While generating tremendous profits during the boom, this

vulnerable position meant that just a 3–4% decline in the value

of its assets would entirely eliminate its book value of

equity.

Lehman's loss was apparently a result of having held on to large positions in subprime and other

lower-rated mortgage tranches when

securitizing the underlying mortgages.

Lehman Brothers

• Started as a general store at 1844

• 4th largest investment bank in US

• 25,000 employees worldwide

• In 2007, Lehman underwrote more mortgage-backed securities than any other firm

• $85-billion portfolio, or four times its shareholders' equity

• London Interbank Offered Rate (LIBOR) is a benchmark interest rate based on the rates at which banks lend unsecured funds to each other on the London interbank market

• It is computed in London but reflects the borrowing costs of 18 banks, including firms in Europe and Japan as well as three American institutions: Bank of America, Citigroup, and JPMorgan Chase

• The ICE Benchmark Administration (IBA) took over administration from the British Bankers Association (BBA) on August 1, 2014

What is LIBOR

A representative panel of global banks submit an estimate of their borrowing costs

The average is taken to determine LIBOR by first removing the highest and lowest 25 percent of submissions

This rate is published at 11 am by Reuters each day

Calculated for five different currencies-the U.S. dollar, the euro, the British pound sterling, the Japanese yen, and the Swiss Franc

Calculated daily for seven different maturity lengths from overnight to one year

How Does it Work

How Does LIBOR affect the Global economy

• Many banks worldwide use Libor as a base rate for setting short term interest rates on consumer and corporate loans. When Libor rises, rates and payments on loans often increase; likewise, they fall when Libor goes down

Short Term Interest Rates

• Some financial products are based on Libor; mutual-fund companies, Hedge funds, Money market funds and bond funds are affected by LIBORInvestors

• Libor is also used to provide private-sector economists and central bankers with insights into market expectations of economic performance and interest rate developments

Economists & Central Bankers

• Many Indian Companies have borrowed funds through external commercial borrowings. Until March 2012,this amounted to $104.4 billion. Most of these overseas debt are linked to Libor

Impact on India

LIBOR Scandal

New York Fed comes to know

about false reporting of ratesBritish Regulators

Informed of Rate Problems

Barclays: $450 Million Settlement:, Barclays‘ accused of

falsely reporting lower rates 2005-

2009,

UBS: $1.5 Billion Settlement- Justice

Deparment files criminal charges against two UBS

traders;

Royal Bank of Scotland: $612

Million Fine; Japanes unit forced

to plead guilty in criminal

wrongdoing

Rabobank: $1 Billion Settlement;

Chairman Piet Moerland resigns

8 Financial Institutions: $2.3 Billion Fine: EU

fined Citigroup, JPMorgan Chase,

Deutsche Bank, Royal Bank of Scotland and

Société Générale and 3 others

Deutsche Bank will pay a $2.5 billion penalty to United States and British

authorities.

Oct 2013June 2012 Dec 2012 Feb 2013April- May 2008 Dec 2013 Apr 2015

Member banks were colluding and were falsely inflating or deflating the borrowing rates

Motive for manipulating the rates

To reflect good financial health: Higher rates signal distress whereas lower signify sound condition of the bank. During 2007-09, Barclays submitted low LIBOR rates to ward off any concerns about its financial health.

Benefit of Derivatives Traders: Traders requested the rate submitters to submit rates that would benefit their trading position

Timeline of the Scandal

Source: The New York Times- Tracking the LIBOR scandal;The LIBOR scandal, Review of Banking & Financial Law

Effects of manipulating LIBOR

Prices of bonds on the banks’ balance sheet changes

Any loans on the balance sheet tied to LIBOR will now be paid at a different rate in the future

Student loan, mortgage backed loans will suffer from a higher rate

Lenders of cash will receive a lower rate than what they should actually receive if rigged downwards

Upward rigging will lead to a lower absolute return on equities

The manipulation of Libor caused Derivative payments on interest rate swaps to be returns smaller than they should have been, resulting in high losses to derivative market participants 

Source: The Libor Scandal and Its Effects Explained , Securities & Financial Consulting

Institutions Involved

Barclays Bank of America BTMU Citi

Credit Suisse Deutsche Bank Lloyds HSBC

HBOS JP Morgan Rabo Bank RBC

RBS UBS West LB Norinchuckin

Penalty payments by big banks involved in the fixing of the London interbank rate (LIBOR) and its global variants total about $US9 billion.

Last November, British and US regulators imposed fines totaling $US3.4 billion on five banks- JP Morgan,RBS, HSBC, Citibank, and UBS