An Introduction to the Subprime Crisis in the U.S.

Acknowledgement: Finance professors Ranjini Jha, Ken Vetzal, and numerous internet resources.

The American Dream

House Price

Soure: Office of Federal Housing Enterprise Oversight

Real Salary Growth

-0.08

-0.06

-0.04

-0.02

0

0.02

0.04

0.06

All private nonfarm workers. Source: Census Bureau

Major Causes for the “Housing Bubble”

• Mania for home ownership • Historically low interest rates • Risky mortgage products and lax lending

standards • Speculative fever

Subprime mortgages

• “Subprime" refers to loans that do not meet Fannie Mae or Freddie Mac guidelines. This is generally due to one or a combination of factors, including credit status of the borrower, income and job history, and income to mortgage payment ratio.

Types:

• ARMs• An interest-only loan• A stated income loan is a mortgage where the lender does not verify the borrower's income (sometimes called "liar loans“)

An Example of Subprime Mortgage

• Would you like a mortgage that lends you more than the value of your house?

• Would you like it structured so that your first payments are extra low?

• If the mortgage weren't structured that way, would you be unable to afford the payments?

• Are you convinced that real estate prices will continue to rise? • Do you have a poor credit history?

• Congratulations if you answered "Yes" to most or all of those questions! You're an ideal target for a subprime mortgage lender.

Adapted from cbc.ca

Securitization: MBS & CDO

• A mortgage-backed security (MBS) is a “bond” whose cash flows are backed by the principal and interest payments of a set of mortgage loans.

• Collateralized debt obligations (CDOs) are an unregulated type of asset-backed security and structured credit product. CDOs are constructed from a portfolio of fixed-income assets. These assets are divided by the ratings firms that assess their value into different tranches.

CDOs

Further: Credit Default Swap (CDS)

• In the previous slide, the last tranche (usually non-rated, in In the previous slide, the last tranche (usually non-rated, in some form of equity) is very risky (a.k.a. “toxic waste”)some form of equity) is very risky (a.k.a. “toxic waste”)

• What do banks do with the toxic waste?What do banks do with the toxic waste?– Buy insurance - Pay insurance premium to another financial institution Buy insurance - Pay insurance premium to another financial institution

for underwriting the risk of the toxic wastefor underwriting the risk of the toxic waste– This is one form of “credit default swap”This is one form of “credit default swap”

• The financial institution receives the premium regularlyThe financial institution receives the premium regularly– It packages these and sells the insurance premium on toxic waste as It packages these and sells the insurance premium on toxic waste as

synthetic CDOs synthetic CDOs

Credit Default Swaps (CDS)

NYT, February 17, 2008NYT, February 17, 2008

Speculative Fever (1)

Speculative Fever (2)

Speculative Fever (3): CDS Market

NYT, February 17, 2008NYT, February 17, 2008

Asset Quality

 

http://www.eurointelligence.com/Article3.1018+M58efe8bdb29.0.html17 June 2008 - Satyajit Das

Under US accounting rules, asset must be classified into:

Level 1 (Mark-To-Market) - liquid assets or instruments that are actively traded.

Level 2 (Mark-To-Model) - instruments that cannot be priced based on trade prices but are valued using observable inputs.

Level 3 (Mark-To-Make Believe or Mark-to-Myself) - the asset or liability cannot be priced using observable inputs and requires the use of modeling techniques and substantially subjective assumptions.

Asset quality uncertainty can be gauged by looking at bank’s Level 3 assets

Asset Quality – end 2007

 

Default rate rises markedly from 2005-2006 …

Chain Effect Leading to A Crisis

1. Surge in defaults and foreclosures 2. House prices fall3. Prices of MBS plunge4. Loss of financial institutions5. FIs have too little capital—too few assets compared with

debt• This problem is especially severe because everyone took on so much

debt during the bubble years

6. FIs have been trying to pay down their debt by selling assets, including those mortgage-backed securities,

• but this drives asset prices down (no one is buying due to lack of confidence and lack of liquidity)

• and 3 starts again• This vicious circle is what some called “paradox of deleveraging”

--Based on Paul Krugman ““Cash for Trash” NYT (Sep 22, 08)Cash for Trash” NYT (Sep 22, 08)

Biggest losses/write-downs since the beginning of 2007, in billions of US$ as of April 2008

• Citigroup $40.9• UBS $38• Merrill Lynch $31.7• Bank of America $14.9• Morgan Stanley $12.6• HSBC $12.4• JP Morgan Chase $9.7• IKB Deutsche $9.1• Washington Mutual $8.3• Deutsche Bank $7.5• Wachovia $7.3• Crédit Agricole $6.6• Credit Suisse $6.3• RBS $5.6• Mizuho Financial Group $5.5• Canadian Imperial Bank of Commerce $4.1• Société Générale $3.9

(Source: Bloomberg)

September Madness

Maybe basketball (March madness) is not your sports…

American Socialism?

• Government bailouts– Bear Stearns ($29 bn loan guarantee)– AIG ($86 bn bridge loan)– Fannie Mae and Freddie Mac ($200 bn pledges of protection)

• Through June 2008, the Fed had provided approximately $1.2 trillion in loans to various financial institutions through its Term auction facility.

• $700 bn (5% of US GDP) to purchase large amounts of illiquid, risky mortgage backed securities from financial institutions

Related readings(If you are on university network, you have no trouble accessing the papers below.)

• Internet & media resources: http://en.wikipedia.org/wiki/Causes_of_the_United_States_housing_bubblehttp://en.wikipedia.org/wiki/Subprime_mortgage_crisis#Housing_downturnhttp://news.bbc.co.uk/2/hi/business/7073131.stm

• Book and papers– 'The Subprime Solution,’ by Robert Shiller – http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1112467 – http://www.nera.com/image/SEC_SubprimeSeries_Part_II_FINAL_2-08.pdf– http://www.nera.com/image/SEC_SubprimeSeries_Part1_June2007_FINAL.pdf

(Accounting is responsible for the crisis?!)– http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1108556 (Michael Brennan)– http://ideas.repec.org/p/fip/fednsr/318.html (understanding

securitization)