Subprime Meltdown

Subprime MeltdownAkshit SharmaC. PraveenVenkat AchyuthOverviewWhat is the Subprime crisis?What were the main reasons of crisisWhat was the impact on leading companiesWhat were the risks involvedHow the Fed respondedConclusions

Traditional US Housing MarketTraditional fixed 30-year mortgage2/28 mortgagesSubprime borrowers: loan applications did not meet existing standards poor credit records, high existing debt-to-income ratios, or even no income proofsSubprime loans had higher interest rates and fees compared to Prime loans: 29% of the home loans made in 2006 had high interest rates .

Source: Financial Crisis Inquiry Commission4Rising US Federal Fund RatesBetween May 2004 and May 2006, the Fed raised its interest rate from 1.25 percent to 5.25 percent in part because of concerns over increases in inflation.

Rising default rate of ARMAccording to Bernanke, by August 2007, nearly 16% of subprime mortgages with adjustable rates were in default. The problem then spiraled, as low housing prices led to defaults, which, in a vicious cycle, lowered housing prices even more leading to a bubble burst in housing prices.In an environment with subprime borrowers facing mortgages whose rates were moving from low rates to much higher market rates, the effect on housing prices was even more severe.

Securitization into MBS Securitization involves lumping together large numbers of individual financial instruments such as mortgages and then slicing and dicing them into different pieces that appeal to different types of investors. A hedge fund may take the riskiest piece in the hope of realizing a high return. A pension fund may take a relatively safe portion.

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Source: Financial Crisis Inquiry Commission9Financial Institutions packaged subprime and other mortgages into securities. Under the assumption that the housing market continued to boom, these securities would perform. However when the mortgages defaulted, the lower tranches were left worthless.Securitization into MBS

Financial Innovations: CDO10Source: Financial Crisis Inquiry CommissionAccording to a Lehman Brothers report, a substantial fraction of subordinate MBS securities (rated below AAA) were held by collateralized debt obligation (CDO) entities in 2007. It was common for CDOs to hold assets of other CDOs. CDOs were also heavily involved in markets for derivatives securities (CDS).Role of Rating AgenciesRating agencies generously applied favorable ratings to wide variety of assets. Since agencies profited at the issuance of an asset grade and were not paid based on the assets actual performance, the incentives of rating agencies were in question. Under criticism as well was their methodology for rating assets. One argument rating agencies, and also government regulators, was that they did not offer the compensation or prestige to attract top quality talent and so would always be a step behind financial innovation.11In principle, combining large numbers of assets can diversify the risk associated with any individual asset. In the case of the sub-prime crisis, however, the underlying mortgages proved to be significantly riskier than most investors realized.Banks that generated the mortgages sold them off and did not have to bear the consequences if their particular mortgages went bad; as a result, lending standards deteriorated.Moreover, securitization is based to a great extent on the supposition that a large fraction of mortgages will not go bad at the same time. After all, the history of the U.S. housing market was that while some regions experienced large declines, the overall national market was relatively stable. When the Fed raised interest rates, more and more subprime mortgages went under, housing prices fell nationwide, and this led to even more defaults. Securitization did not insulate investors from aggregate risk.

11Subprime MeltdownAs sophisticated financial instruments were developed and traded, it became difficult to know how much exposure an individual bank had to this risk. The investors who were holding these mortgage-backed securities often turned out to be the large commercial and investment banks themselves. The declines in housing prices and the stock market combined with leverage to threaten the solvency of many financial institutions.A Balance Sheet CrisisBefore the financial crisis, major investment banks had high leverage ratios. For example, when Bear Stearns collapsed, its leverage was 35 to 1. Roughly speaking, the major investment banks owned complex investment portfolios, including significant quantities of soon-to-be toxic assets, that were financed with heavy leverage. Given this extraordinary leverage, major investment banks were in such a precarious position that a relatively small aggregate shock could send them over the insolvency edge.Bear Stearns LiquidityFollowing Lehman Brothers collapse, access to liquidity was sharply curtailed. To fund their daily operations, banks were forced to sell some of their less liquid assets at fire sale prices, reducing their net worth all the way to insolvency.

Subprime Meltdown

15Sept 29, 2008: The biggest single-day loss ever in the history of the Dow occurred on, when it dropped 777.68 points, or approximately $1.2 trillion in market value.

Subprime Meltdown16Subprime MeltdownSource: The World Bank, http://data.worldbank.org/data-catalog

1790-07 = 2.8%17The Crisis In a Nutshell : Sequence of Events

During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006.Major banks and other financial institutions around the world have reported losses of approximately US$435 billion as of 17 July 2008During the week of September 14, 2008 the crisis accelerated, developing into a global financial crisis18

Impact

Understanding the risks involved in the subprime crisis

Credit Risk Asset Price RiskLiquidity RiskCounterparty riskSystemic RiskShadow Banking ??

Credit risk: Traditionally, the risk of default (calledcredit risk) would be assumed by the bank originating the loan. However, due to innovations in securitization, credit risk is frequently transferred to third-party investors. The rights to mortgage payments have been repackaged into a variety of complex investment vehicles, generally categorized as (MBS) or (CDO). A CDO, essentially, is a repacking of existing debt, and in recent years MBS collateral has made up a large proportion of issuance. In exchange for purchasing MBS or CDO and assuming credit risk, third-party investors receive a claim on the mortgage assets and related cash flows, which become collateral in the event of default. Another method of safeguarding against defaults is the CDS, in which one party pays a premium and the other party pays them if a particular financial instrument defaults.

Asset price risk: MBS and CDO asset valuation is complex and related "fair value" or "mark to market" accounting is subject to wide interpretation. The valuation is derived from both the collectibility of subprime mortgage payments and the existence of a viable market into which these assets can be sold, which are interrelated. Rising mortgage delinquency rates have reduced demand for such assets. Banks and institutional investors have recognized substantial losses as they revalue their MBS downward. Several companies that borrowed money using MBS or CDO assets ascollateralhave facedmargin calls, as lenders executed their contractual rights to get their money back.There is some debate regarding whether fair value accounting should be suspended or modified temporarily, as large write-downs of difficult-to-value MBS and CDO assets may have exacerbated the crisis.

Liquidity risk: Many companies rely on access to short-term funding markets for cash to operate (i.e., liquidity), such as thecommercial paperand repurchase markets. Companies andstructured investment vehicles(SIV) often obtain short-term loans by issuing commercial paper, pledging mortgage assets or CDO as collateral. Investors provide cash in exchange for the commercial paper, receiving money-market interest rates. However, because of concerns regarding the value of the mortgage asset collateral linked to subprime and Alt-A loans, the ability of many companies to issue such paper has been significantly affected.[57]The amount of commercial paper issued as of 18 October 2007 dropped by 25%, to $888 billion, from the 8 August level. In addition, the interest rate charged by investors to provide loans for commercial paper has increased substantially above historical levels.

Counterparty risk: Major investment banks and other financial institutions have taken significant positions incredit derivativetransactions, some of which serve as a form of credit default insurance. Due to the effects of the risks above, the financial health of investment banks has declined, potentially increasing the risk to theircounterpartiesand creating further uncertainty in financial markets. The demise and bailout ofBear Stearnswas due in-part to its role in these derivatives.

Systemic risk: The aggregate effect of these and other risks has recently been calledsystemic risk. According to Nobel laureate Dr.A. Michael Spence, "systemic risk escalates in the financial system when formerly uncorrelated risks shift and become highly correlated. When that happens, then insurance and diversification models fail. There are two striking aspects of the current crisis and its origins. One is that systemic risk built steadily in the system. The second is that this buildup went either unnoticed or was not acted upon. That means that it was not perceived by the majority of participants until it was too late. Financial innovation, intended to redistribute and reduce risk, appears mainly to have hidden it from view. An important challenge going forward is to better understand these dynamics as the analytical underpinning of an early warning system with respect to financial instability."[60]

21Feds Immediate ResponseFurther ActionSignaling through rate cutsExpansion of Balance sheet Credit EasingMortgage Lending Rules - HOEPAOpen market operations purchasing ABS

ConclusionDeflationIncreased Money SupplyMoral Hazard ??Rent ShillerRating Agencies or Investment bankersChart16391046661363534333330

In Us $ (billion)CompanyBillion US $Top 10 Bankruptcies

Sheet1CompanyIndustryIn Us $ (billion)2008-Lehman BrothersInvestment banking6392002-WorldcomTelecommunications1042001-EnronEnergy662002-Conseco IncFinance and Insurance612001-Pacific Gas and Electric CompanyPublicly owned utility361987-TexacoOil351988-Financial Corp. of AmericaSavings & Loan342005-Refco IncCommodities brokerage332008-IndyMac Bacorp IncRetail Mortgage332002-Global Crossing Ltd.Telecommunications30

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In Us $ (billion)CompanyBillion US $Top 10 Bankruptcies

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