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Sub-Prime Crisis – Prime Concern

Sub-Prime Crisis – Prime Concern. Sai Kumar Swamy, PGDM, IIM Bangalore. Agenda. Definition Prime Sub-Prime Origin of Crisis Why did the bubble burst? Interesting stats Why did the Financial Giants collapse? The answer. CDO Advantage MBS & CDS Linkage End Game

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Sub-Prime Crisis – Prime Concern

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  1. Sub-Prime Crisis – Prime Concern Sai Kumar Swamy, PGDM, IIM Bangalore

  2. Agenda • Definition • Prime • Sub-Prime • Origin of Crisis • Why did the bubble burst? • Interesting stats • Why did the Financial Giants collapse? • The answer • CDO • Advantage • MBS & CDS • Linkage • End Game • How the cookie formed? • How the cookie crumbled?

  3. Prime • Prime Borrower • Borrow < 80 % • Good credit bureau record • Monthly payment < 25 % income • Good Credit Score • Banks like them - Credit Worthy • Safe Lower Interest rate • Pay Lower Mortgage Rates

  4. Subprime • Subprime Borrower • Tarnished credit records • Low Credit score • Borrow a higher proportion • High Mortgage to Income ratio • Banks are wary of these customers • Risky Higher Interest rate • Pay Higher Mortgage Rates

  5. Origin of Crisis - 1 • Housing Bubble  2001- 2005 • Housing prices increase • Cheaper Credit • Federal Reserve Lowers the Federal Funds Rate • From 6.5% to 1.75 % between May 2000 and December 2001 • Greater Access to Credit • Sub-Prime Market • Mortgages to risky individuals • Increase in Buyers

  6. Origin of Crisis - 2 • Sub-prime mortgages • Government Policies • ECOA - 1974 • CRA - 1977 • Competitive pressures • Increase in loan incentives • Easy initial terms • ARM (ARM – Adjustable Rate Mortgages) • Rising Housing prices • Dropping interest rates

  7. Origin of Crisis - 3 • Housing prices peak in mid-2006 • Building boom • Fresh Supply created to exploit market conditions • Surplus of homes • Housing Bubble Bursts • Home Sales fall • Supply exceeds Demand • More Sellers than Buyers • Prices of Houses decrease • WHY?? • Housing Construction Declines • Slowdown in US Economy

  8. Why did the bubble burst? • No clear cut reason – Many factors responsible • Factors • Greed of Borrowers • ARM • Refinancing doldrums • Supply glut • Led to Foreclosures • Started vicious cycle • Supply of homes Prices Homeowners Equity

  9. Interesting Stats - 1 • Increase 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!!

  10. Interesting Stats - 2 • Household Debt • $705Bn – 1974 • $7.4Tn – 2000 • $14.5Tn – 2008 • Household debt as % of Disposable Income • 60% – 1974 • 134% in 2008

  11. Why did the Financial Giants collapse?

  12. The Answer • CDO/CMO • Collateralized Debt Obligation • MBS • Mortgage based Securities • CDS • Credit Default Swaps

  13. CDO • A structured credit product • Is an Asset backed security • Based on pools of assets • Collateral – Cash flows from this pool of assets • Securitization makes these assets available for investment • Ex: Credit Card payments; Auto loans; Home loans • Constructed from a portfolio of fixed income assets • Traded in the market • Size of the Market

  14. CDOs Credit Ratings Senior : AAA CDOs Mezzanine AA to BB Equity : Unrated

  15. Advantage • Brings together a pool of assets which otherwise cannot be traded easily • Pooling converts them into tradable instruments • Securities can be further broken into discrete tranches • Helps market them to investors with different risk appetites • Lowers risk for originator • When the pool performs badly the owner takes the loss • The originator earns fees for servicing the asset pool • Originator earns money with NO residual liability • Downside • Originator has NO incentive to reduce risk • Originator works toward Loan Volumes than Loan Quality

  16. MBS • Is an Asset backed Security • Backed by • Principal • Interest Payments • Federal National Mortgage Association (FNMA or Fannie Mae) • Buys Mortgages and sells them as MBS to investors • Formed in 1934 and privatized in 1968 • Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) • 2nd player in the MBS market • Formed in 1970 • Given AAA rating and sold across the world

  17. CDS • Contract • 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

  18. So what’s the Linkage?

  19. End game - 1 • Bankruptcies - 2007 • February – March • Subprime Market Collapses • April 2 • One of the largest US Subprime Lender New Century Financial files for Bankruptcy • US 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

  20. Collapse of Institutions • Prime Reason • Liabilities - Short term • Assets - Long term & Illiquid • Vicious Cycle • AIG • Demand for settlement of 100’s of Billions of CDS it issued led to its collapse • Bear Stearns • Lehman Brothers

  21. End Game - 2 • Fed injects $41Billion into Money Supply for banks to Borrow • Bear Sterns gets Funding from Fed  Acquired by JP Morgan • Federal Reserve takes over Fannie Mae and Freddie Mac • Merrill Lynch sold to Bank of America • Lehman Bros. files for Bankruptcy • Fed loans AIG $85 Billions • Paulson unveils Financial Rescue Plan • TARP - $700Bn • Dodd-Frank Law – 2010 • How ithappened in a snapshot!

  22. Annexures

  23. Case-Shiller Index

  24. US Home Prices

  25. Fed Funds Rate & Mortgage Rates

  26. ECOA - 1974 • Equal Credit Opportunity Act • Seeks 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

  27. CRA - 1977 • Community Reinvestment Act • Redlining • Seeks to address • Discrimination of applicants based on • Area & Neighborhood • No civil liability • No specific criteria to evaluate compliance • Rating 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

  28. Philadelphia

  29. ARM – Adjustable Rate Mortgages • A loan where the interest rate is periodically adjusted • Salient Features • Initial rate • Adjustment period • Index rate – Treasury securities, LIBOR etc. • Margin • Discounts • Negative amortization • Major contributor to the Crisis when Interest rates went North

  30. The Mortgage Market

  31. MBS Downgrades

  32. US Home Sales Inventory

  33. Foreclosures

  34. Vicious Cycle - Foreclosures

  35. How the Chain works

  36. Sub-Prime Mortgages

  37. CDO - MBS

  38. Securitization Market Activity

  39. Leverage Ratios – Investment Banks

  40. How the Cookie Formed!

  41. How the Cookie crumbled!

  42. Only Qs – No Answers!

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