Subprime Lending Crisis

1. Subprime Lending Crisis Professor Thomas Cosimano Department of Finance

2. Housing Prices

3. Expected Defaults on Mortgages.

4. Expected Losses on Jumbo, Subprime, and Alt-A MBS • Fannie and Freddie hold mainly prime mortgages. Subprime loans are mainly non-agency. • Total Non-Agency $1963Billion Agency $4,021Billion • Default Rate 25% 5% • Expected Loss 20% 20% • Estimated Total Losses $98Billion $40Billion • Why has the stock market drop $8 Trillion over the last year? • Trust and lack of trust!!!

5. Financing of Mortgages • Balance sheet of Commercial Bank such as Chase Manhattan • Typical mortgage is 30 years fixed rate loan. Prime mortgage borrower is required to put 20% down and good credit rating. • Banks are required to hold 6% of assets in the form of equity. Assets Liability plus Net Worth Deposits $94 Mortgages $100 Equity $6

6. Capital of Commercial Banks. Source: Thomson Financial (2007). Ratios are computed as the average capital ratio for the top 25 largest banks based on reported risk-weighted assets. Ratios for 2003−2006 are based on end-of-year reporting while ratios for 2007 are based on third quarter reporting.

7. Decline in housing and mortgages. • Starting 2007 price of houses fall. Decrease of over 15% in Florida, California, and Arizona. • Increase in foreclosures of adjustable subprime loans from 8%-27%.

8. Suppose 5% of bank’s mortgages are lost. • Balance sheet of Chase Manhattan • Depositors with less than $100,000 are not concern since deposits are insured by FDIC. • Chase is forced to raise equity back to required 6% of assets. Assets Liability plus Net Worth Deposits $94 Mortgages $95 Equity $1

9. Suppose Chase does not want mortgages. • Based on experience Long term assets do not match well with short term liabilities. • Chase thinks mortgages are subject to too much interest rate and price risk. • Sell mortgage back security to someone who has long term liabilities. Partially remove mortgages from balance sheet. • Examples Pension Funds. • Fannie and Freddie designed to facilitate this process. Assets Liability plus Net Worth Mortgages $100 Deposits $94 Equity $6

10. SIV of Lehman Brothers buys MBS funds which are funded with commercial paper from Merrill Lynch • Starting in late 70’s depositors of commercial banks convinced to place funds in money market accounts at Investment banks such as Merrill Lynch. • Some money market accounts invest in prime commercial paper—short term bonds. Others invest in US Treasury Securities. Neither Lehman nor Merrill Lynch are regulated since they do not meet legal definition of commercial bank. Consolidation of Lehman Brothers and its SIV Consolidation of Merrill Lynch and its SIV Commercial Paper Lehman $97 Commercial paper Others $933 Commercial Paper $97 Equity $3 Money market Accounts $1000 Equity $30 Mortgage Back Security $100

11. Suppose we look at same 5% cut in value of mortgages. • Lehman losses $5, so their net worth is negative. Forced to declare bankruptcy September 15. • Merrill is paid only $95 after bankruptcy proceedings. Equity drops to $28. • Depositors do not know how much Merrill will lose. Depositors demand their deposits, since deposits are not insured by FDIC. • Result is a bank run. Merrill is taken over by Chase Manhattan. Lehman Brothers Merrill Lynch Mortgage Back Security $95 Commercial Paper $97 Equity -$2 Commercial Paper to Lehman $95 Commercial paper Others $933 Money market deposits $1000 Equity $28

12. Bank Run. • When deposits are short term and depositors are not sure about longer term and/or illiquid assets of the firm, individuals withdraw their funds and place them in safer investments. • After the Failure of Lehman, the Reserve Primary Fund and a few others, who invested in Lehman CP, had to reduce value of fund, September 17 - called “break the buck.” • Investor’s started withdrawing $100 of Billions from money market accounts, that invest in CP and placed them in accounts, that invest in US Treasuries. • MBS, Commercial Paper and Interbank lending are frozen. Implies prices are significantly lower. • If financial firms have to liquidate now they would go bankrupt, however over the longer term some asset values will go back to “normal.”

13. Financial Institutions and Trust. • Investor’s have lost trust in the soundness of financial institutions, since they do not know which are in sound financial position. • Who has assets tied to the well performing companies, mortgages etc? • Someone has to step in an establish who is and who is not financially sound. • Purpose of Bailout plan is to establish this confidence.

14. Bailout Bill • $700 Billion is authorization to buy and or guarantee assets so that confidence is restored. • How to do this? • Establish guarantee of asset values. The governments of the world have to vouch for the soundness of assets by acting as co-signer on loans. • Buy assets that have long term value but currently are depressed. • Purchase subprime and prime mortgages. • Governments buy bank capital in exchange for these assets. • Total Cost will probably not be $700 Billion. Once markets start to function effectively the values will move back to “normal.” • Program is dependent on leaders establishing confidence and clearly explaining what is being done.

15. “I have no idea what the stock market is going to do next month or six months from now,” Warren Buffett told CNBC on Friday. “I do know that the American economy, over a period of time, will do very well, and people who own a piece of it will do well.”