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A Primer on the Subprime Crisis

A Primer on the Subprime Crisis. School of Economics and Finance. US Interest Rates (cost of $). Role of Interest rates. The core ingredient for a financial crisis is excessive lending and/or excessive risk taking.

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A Primer on the Subprime Crisis

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  1. A Primer on the Subprime Crisis School of Economics and Finance School of Economics and Finance

  2. US Interest Rates (cost of $) School of Economics and Finance

  3. Role of Interest rates • The core ingredient for a financial crisis is excessive lending and/or excessive risk taking. • Low interest rates led to the opening of new mortgage markets (ie. new borrowers). • The US dream of owning your own home spread to many sectors of US society including low income borrowers. • The USA mortgage market comprises of: (i) prime obligations/borrowers and (ii) subprime borrowers. School of Economics and Finance

  4. Subprime Mortgages Subprime mortgages are loans to borrowers with ‘imperfect’ credit criteria. About 21 % of all mortgage originations from 2004 through 2006 were subprime, up from 9 % from 1996 through 2004 Other higher risk mortgages included Alt-A (ie. low documentation) and NINJA (no income, no job/assets) loans. School of Economics and Finance

  5. Traditional model of banking • Banks raise funds (capital) from • Depositors • Issuing shares or bonds • Banks then lend the funds to individuals in the form of mortgages • Banks then have their capital tied up in the mortgages for a long period of time • Mortgages are illiquid investments School of Economics and Finance

  6. Financing of Subprime Mortgages Subprime mortgages were pooled together and sold The riskiest mortgages were pooled together into collateralized debt obligations (CDOs). To make these mortgages safer for investors, they had companies to act as mortgage guarantors, eg AIG. By packaging these mortgages together, the cashflows to investors were expected to be regular, safe and were given a AAA credit rating by Moodys & Standard and Poors. Banks, super funds, state treasuries and many Australian city councils purchased these CDOs. School of Economics and Finance

  7. A Property Boom Cheap money led to a housing bubble and an unregulated US mortgage market. Credit standards collapsed as lenders scrambled to lend cheap money. Predatory lending practices grew. Borrowers on 7% interest rates were convinced to refinance into larger borrowings at a 6.5% ‘teaser’ rate. Mortgage brokers were lending money with two year ‘teaser’ or honeymoon interest rates. The US property market boomed in the early to mid 2000s. School of Economics and Finance

  8. US Mortgage Defaults have risen • As at Sept 2008, 12% of all US subprime loans are in foreclosure (ie. in default). Source: Reserve Bank of Australia (RBA) Financial Stability Review, Sept 2008. School of Economics and Finance

  9. People lose their houses Historical USA mortgage default rates were 0.5% to 1.0% of all loans. As at 2008, Q2, 3.93% of all US prime loans are in default. As at 2008, Q2, 18.67% of all US subprime loans are in default. School of Economics and Finance

  10. Impact of the crisis 18.67% of the mortgages in these CDOs have failed. During 2008, the value of these CDOs collapsed. In March2008, Wall St investment banks Bear Stearns dies. In Sept 2008, Lehman Brothers collapses, Merrill Lynch is purchased by Bank of America. In Sept 2008, AIG collapses as it could not afford to pay for all of these US mortgage defaults. The US government nationalises AIG by becoming 80% shareholder. School of Economics and Finance

  11. Impact of the crisis Based on a current valuations, banks have lost a lot of their money on falling valuation on mortgages, ownership of CDOs and the selling of this CDS insurance. In October 2008, lack of confidence in global banking system leads to fear of lending money to each other. Credit markets totally freezes. School of Economics and Finance

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