sub-prime crisis – prime concern
DESCRIPTION
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 - PowerPoint PPT PresentationTRANSCRIPT
Sai Kumar Swamy,PGDM, IIM Bangalore
AgendaDefinition
PrimeSub-Prime
Origin of CrisisWhy did the bubble
burst?Interesting statsWhy did the Financial
Giants collapse?The answer
CDOAdvantageMBS & CDSLinkageEnd GameHow the cookie formed?How the cookie crumbled?
PrimePrime Borrower
Borrow < 80 % Good credit bureau record Monthly payment < 25 % income Good Credit Score
Banks like them - Credit WorthySafe Lower Interest ratePay Lower Mortgage Rates
SubprimeSubprime Borrower
Tarnished credit records Low Credit score Borrow a higher proportion High Mortgage to Income ratio
Banks are wary of these customersRisky Higher Interest ratePay Higher Mortgage Rates
Origin of Crisis - 1Housing Bubble 2001- 2005 Housing prices increase Cheaper Credit
Federal Reserve Lowers the Federal Funds RateFrom 6.5% to 1.75 % between May 2000 and December 2001
Greater Access to Credit Sub-Prime Market
Mortgages to risky individualsIncrease in Buyers
Origin of Crisis - 2Sub-prime mortgages
Government Policies ECOA - 1974 CRA - 1977
Competitive pressuresIncrease in loan incentivesEasy initial terms
ARM (ARM – Adjustable Rate Mortgages)Rising Housing pricesDropping interest rates
Origin of Crisis - 3Housing prices peak in mid-2006Building boomFresh Supply created to exploit market conditionsSurplus of homesHousing Bubble Bursts Home Sales fall Supply exceeds Demand More Sellers than Buyers Prices of Houses decrease
WHY??Housing Construction DeclinesSlowdown in US Economy
Why did the bubble burst?No clear cut reason – Many factors responsibleFactors
Greed of BorrowersARMRefinancing doldrumsSupply glut
Led to ForeclosuresStarted vicious cycleSupply of homes Prices Homeowners Equity
Interesting Stats - 1Increase 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!!
Interesting Stats - 2Household Debt
$705Bn – 1974 $7.4Tn – 2000 $14.5Tn – 2008
Household debt as % of Disposable Income60% – 1974 134% in 2008
The AnswerCDO/CMO
Collateralized Debt Obligation
MBSMortgage based Securities
CDSCredit Default Swaps
CDOA structured credit productIs an Asset backed security
Based on pools of assetsCollateral – Cash flows from this pool of assetsSecuritization makes these assets available for investmentEx: Credit Card payments; Auto loans; Home loans
Constructed from a portfolio of fixed income assetsTraded in the marketSize of the Market
CDOs Credit Ratings
CDOs
Senior : AAA
MezzanineAA to BB
Equity : Unrated
AdvantageBrings together a pool of assets which otherwise cannot be traded
easilyPooling converts them into tradable instrumentsSecurities can be further broken into discrete tranches
Helps market them to investors with different risk appetitesLowers risk for originator
When the pool performs badly the owner takes the lossThe originator earns fees for servicing the asset poolOriginator earns money with NO residual liability
DownsideOriginator has NO incentive to reduce riskOriginator works toward Loan Volumes than Loan Quality
MBSIs an Asset backed SecurityBacked by
PrincipalInterest Payments
Federal National Mortgage Association (FNMA or Fannie Mae)Buys Mortgages and sells them as MBS to investorsFormed in 1934 and privatized in 1968
Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)2nd player in the MBS marketFormed in 1970
Given AAA rating and sold across the world
CDSContract
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
End game - 1Bankruptcies - 2007
February – March Subprime Market Collapses
April 2 One of the largest US Subprime Lender New Century Financial files for
BankruptcyUS 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
Collapse of InstitutionsPrime Reason
Liabilities - Short termAssets - Long term & IlliquidVicious Cycle
AIGDemand for settlement of 100’s of Billions of CDS it
issued led to its collapse
Bear StearnsLehman Brothers
End Game - 2Fed injects $41Billion into Money Supply for banks to
BorrowBear Sterns gets Funding from Fed Acquired by JP
Morgan Federal Reserve takes over Fannie Mae and Freddie MacMerrill Lynch sold to Bank of AmericaLehman Bros. files for BankruptcyFed loans AIG $85 BillionsPaulson unveils Financial Rescue PlanTARP - $700BnDodd-Frank Law – 2010How it happened in a snapshot!
Case-Shiller Index
US Home Prices
Fed Funds Rate & Mortgage Rates
ECOA - 1974Equal Credit Opportunity ActSeeks 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
CRA - 1977Community Reinvestment ActRedliningSeeks to address
Discrimination of applicants based on Area & Neighborhood
No civil liabilityNo specific criteria to evaluate complianceRating 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
Philadelphia
ARM – Adjustable Rate MortgagesA loan where the interest rate is periodically adjustedSalient Features
Initial rateAdjustment periodIndex rate – Treasury securities, LIBOR etc.MarginDiscountsNegative amortization
Major contributor to the Crisis when Interest rates went North
The Mortgage Market
MBS Downgrades
US Home Sales Inventory
Foreclosures
Vicious Cycle - Foreclosures
How the Chain works
Sub-Prime Mortgages
CDO - MBS
Securitization Market Activity
Leverage Ratios – Investment Banks
How the Cookie Formed!
How the Cookie crumbled!