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 How the cookie formed? How the cookie crumbled?

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

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

Origin of Crisis - 1 Housing Bubble  Housing prices increaseincrease Cheaper Credit Federal Reserve Lowers the Federal Funds RateRate From 6.5% to 1.75 % between May 2000 and December 2001 Greater Access to Credit Sub-Prime Market Mortgages to risky individualsrisky Increase in Buyers

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

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

Why did the bubble burst? No clear cut reason – Many factors responsible Factors Greed of Borrowers ARM Refinancing doldrums Supply glutglut Led to ForeclosuresForeclosures Started vicious cyclevicious cycle Supply of homes Prices Homeowners Equity

Interesting Stats - 1 Increase in Home-ownership rate 64% in 1994 – 70% in 2004 Increase in Housing price – Increased by 124% Median Home price 2001  2.9X of Median Household Income 4X in 2004 & 4.6X in 2006 Household Debt 77% in % in 2007 (Is it 27% or 127%?) Unsold Homes 4Mn homes for sale 2.9Mn of these were vacant!!

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

Why did the Financial Giants collapse?

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

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 MarketMarket

CDOs Credit Ratingss CDOs Senior : AAA Mezzanine AA to BB Equity : Unrated

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

MBS Is an Asset backed SecuritySecurity 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) 2 nd player in the MBS market Formed in 1970 Given AAA rating and sold across the world

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

So what’s the Linkage?

End game - 1 Bankruptcies 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

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

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 it happened in a snapshot!!

Annexures

Case-Shiller Index

US Home PricesPrices

Fed Funds Rate & Mortgage Rates&Rates

ECOA 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 LiabilityCivil Liability

CRA Community Reinvestment Act Redliningg 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

Philadelphiaa

ARM – Adjustable Rate MortgagesAdjustable 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 Northrates

The Mortgage Market

MBS Downgradess

US Home Sales InventoryInventory

Foreclosures

Vicious Cycle - Foreclosures

How the Chain works

Sub-Prime Mortgagess

CDO - MBS -

Securitization Market Activityy

Leverage Ratios – Investment BanksInvestment Banks

How the Cookie Formed!

How the Cookie crumbled!

Only Qs – No Answers!