Subprime Crisis

A Primer

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 Types of housing loans
 Prime mortgages
 Subprime Mortgages
 Alt-a Mortgages
 Home equity loans

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 Subprime Mortgage

 Subprime mortgages are residential loans that do

not conform to the criteria for prime borrowers.
These loans are also called Stated/income
and/or stated assets(SISA) loans or no
income/no assets (NINA) loans or no
income/no job or assets (NINJA) loans

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 Alt-a Mortgage
 Alt-a is another class of mortgage in respect of
which although the loans qualify for the A-
rating or the moody’s or other rating firms,
albeit for an alternative means. That means the
mortgage itself will have some issues that
increase its risk profile. These issues include
higher LTV(above 55%) and DTI (above 85%)
or inadequate documentation of the borrower’s
income.

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 Home Equity loan
 It is a type of loan in which the borrower uses
the equity in his/her home as collateral. Home
equity is the value of a homeowner’s
unencumbered interest in the property, i.e. the
difference between home’s fair market value
and the unpaid balance of the mortgage and
any outstanding debt over home. Home Equity
loan requires a good to excellent credit history
and reasonable LTV and combined LTV ratios.

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 Who are the subprime Borrowers?
 Subprime borrowers are low rated and high risk
borrowers . Normally credit assessment of the
borrowers is based on certain prime criteria, viz:
 Credit scoring

 Debt service to income ratio (DTI) and

 Loan to value ratio (LTV)

Subprime borrowers are borrowers who fail to meet

the prime criteria or with a tarnished/limited
credit history or with a credit history but elected
not to provide verification of income/assets.

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 When the subprime crises surfaced?
 The first sign of a crisis emerged in March 2007 when
New Century Financial corporation, one of the largest
subprime lenders in the US were suspended amid fears
that the firm could be heading for Bankruptcy
 Accredited Home Lenders Holding, another subprime
lender announced that it would pass on $2.7 billions of
its loans at a heavy discount.
 In May 2007 share of Bear Sterns had come under
pressure and in June 2007 Merrill Lynch &CO , its banker
, freezed and attempted to sell$800 millions of bonds
used as collaterals for loans made to Bear Sterns’ hedge
funds that were used to bet on the subprime mortgage
market. Merrill Lynch &Co was unable to sell the
collaterals
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 When the Subprime crisis
surfaced? (Contd)
 In July 2007, General Electric decided to sell the WMC
mortgage , its subprime lending wing
In August 2007 Goldman Sachs, a US investment bank

announced financial support of $3 billion for one of tits

struggling hedge funds viz. Global Equity Opportunities
hedge funds hit by defaulting subprime mortgages.
In August 2007 Countrywide Financial, a leading US

residential mortgage lender, caused a heavy sell off in Wall

Street and Asian stock markets.
The Deutsche NIBC announced losses of €137 million from

asset based securities in the first half of year.

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 When the subprime crisis surfaced?
(Contd)
 On August 9, 2007 BNP Paribas French Bank
suspended operations of three of its investment
funds worth €1.6 billion citing problems in the
US subprime mortgage sector .
 Macquarie Bank, a high flying Australian Bank
declared a loss of 25% in its Fortress Fund.
 On September 13,2007 British Bank Northern
Rock, facing liquidity constraints applied for
emergency funds from the Bank Of England.

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 Timing of the crisis.

 2001- 2005 Housing Bubble

 Housing prices increase by 10% nationally;

25 % per year in California

 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

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 Timing of the crisis (Contd)
 Bubble Bursts 2005-
 Slowdown in US Economy
 Housing Construction Declines.
 Home sales all; prices fall

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 Timing of the crisis (Contd)
 Bankruptcies - 2007
 25 February – March Subprime Market
Collapses
 April 2, Largest US Subprime Lender New
Century Financial files for Bankruptcy

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 Timing of the crisis (Contd)
 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
 November 1- Fed injects $41Billion into Money
Supply for banks to Borrow

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 Timing of the crisis (contd)
 Timing 2008
 March 14- Bear Sternss gets Funding from Fed and
 March 16th is acquired by JP Morgan
 Sept 7th, Federal Reserve takes over Fannie Mae
 and Freddie Mac
 September 14- Merrill Lynch sold to Bank of
America
 September 15th Lehman Bros. files for Bankruptcy
 Sept 17- Fed loans AIG $85 Billions
 Sept 19. Paulson unveils Financial Rescue Plan

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 Subprime Loans
Subprime mortgage is granted to borrowers
whose credit history is not sufficient to get a
conventional mortgage. Often these
borrowers have impaired or even no credit
history. High Risk!

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 Subprime Mortgages
 Most Issuers of Sub-Prime Mortgages sold the
mortgages to financial institutions (private
and semi-public).
 Higher rates or return.
 Bought by banks, traders, hedge funds,
school boards, town all over the world
 As long as house prices increase, default by
single individual is not problematic as
financial institution can sell house for a higher
amount than mortgage amount
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 Subprime Lending
 In 2006, with steep rise in default on
subprime mortgages,
 Investments were nearly worthless
 Difficulty of financial institutions to raise new
capital/borrow- assets were almost worthless,
or hard to assess actual value
 Risk of bank runs

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 Federal Reserve and treasury
 Rescues of Bear Sterns, Freddie Mac, Fannie
mae, AIG
 Lets Lehman Brothers fail (Largest
Bankruptcy $600 Billion in Assets, 25,000
employees)

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 Fed and Treasury Actions
 Fannie Mae and Freddie Mac
 Support housing markets- guarantee
mortgages, issue own bonds (which were
implicitly backed by US government.)
 Government guarantee allows FM and FC to
borrow at lower rates.

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 Freddie Mac and Fannie Mae
 Strayed from core mission by buying
mortgages that were below standards.
 Did not have enough capital to pay off bonds
it issued.
 Massive amount of debt held - repercussion
in the world financial sector.
 Treasury agrees to guarantee debt (and wipe
out shareholders if it does).
 No investor wants to lend more to FM an FM.
 Taken over by Treasury
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 Lehmans
 Bad investments in real estates.
 Rolling over $100 billion a month to finance
its investments and assets.
 Short-lending to Lehman,but assets were
long maturity.
People/institutions stopped lending when they
realized how large the loss in real estate
portfolio. Also, lower credit rating that
prevented certain parties from lending to it

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 American Insurance
 Had to raise money because it had written
$57billion in insurance contracts whose
payouts depended on loss in real-estate
related investments. (Credit Default Swaps)
 Lower credit ratings meant that needed to
raise collateral. ($15 billion). Without
collateral, it would be considered to have
defaulted on the CDS. S.
 $160 Billion in bonds issued throught the world

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 American Insurance Guarantee
 No one willing to lend the new collateral.
 Other large financial institutions had
guaranteed AIG’s bonds.
 Fed Loans $85 billion.
 Fed has the option of buying up to 80% of
AIG’s shares; is replacing its management; is
nearly wiping out all of its shareholders; assets
will be sold over next few years (Manchester
United)

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 Bear Sterns
 Bear Sterns
 Bear Stern was similar to Lehman but saved.
 Fed had imperfect information.
 Occurred earlier on, and counterparties were
 not prepared for demise of BS- ripple effect.

 Also, Fed had modified its lending facility so

that it could prevent runs on banks affected
by a bankruptcy.
 Fed had announced that the Bear
Intervention was essentially a one time event.
 Warning to other banks
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 Cash For Trash
 Treasury Secretary Paulson proposes to create $700
Billion fund to buy troubled assets
 Congress wants to amend it so that government gets
some shares in company that sells bad debt to US
government.
 Paul Krugman thinks favors this ammendment. The
financial sector desperately needs new capital/funds.
 If you give funds, you should get a share of

ownership. Also, this prevents the people who mad

the mess getting super rich from it.

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 Implications
 Lack of confidence means people less likely
to put their savings in banks.
 Less funding in banks, means harder to
obtain credit/loans for both households and
consumers.
 Less investment and slower growth in the
future.

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 Reasons For The Crisis
 Boom and bust in housing market
 Speculation
 High risk Mortgage loans and lending practices
 Securitization Practices
 Inaccurate credit ratings
 Government Policies
 Policies of central banks
 Financial institution debt levels and incentives
 Credit default swaps
 Inflow of funds due to trade deficits
 Boom and collapse of shadow banking systems
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 Boom and bust in housing market

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Boom and bust in housing market (Contd)

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 Securitization practices

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 Inaccurate Credit Ratings

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 Policies of Central Banks

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 Financial Institution debt levels and
incentives

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 The Mortgage Crisis - Key Contributors

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 Why Crisis spread to other financial
institutions?
 All financial firms
use borrowed
funds to make
investments.
 All financial firms

are illiquid.
 No financial firm

can survive a run

Unassisted.
Assets=Borrowed funds(0.95)+Capital(0.05)
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Why Did the Crisis Spread to Other
Financial Institutions? (Contd)
Potential lenders were afraid to lend to financial
institutions whether or not they had substantial
balances of mortgage-backed securities among
their assets.
Potential lenders realized that they might not be
repaid if others refused to lend.
In a sense, the crisis moved lenders from “we all
lend” equilibrium to a “none of us
lend”equilibrium

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Why Did the Crisis Spread to Stock
Markets?
The sub-prime crisis morphed into a lending
crisis.
Lending is the life blood of investment.
Without lending, many firms cannot raise
funds to finance their operations, to install
new capital, or to purchase new technology.
Stock prices fell because the lending crisis
threatened lower firm earnings in the future

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 What steps have been taken to remedy
the crisis?
In 2007, the Federal reserve responded with its
standard policy tool. It began a series of
reductions in the Federal Funds Rate

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The Federal Reserve Act Gives the
Fed Other Powers
The Federal Reserve Act of 1913 was intended
to “furnish
an elastic currency” and to “afford means of
rediscounting commercial paper.”
Section 13, Paragraph 3 of the Act as amended
says:

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Time Line of US Actions
12-6-07 President Bush outline rescue plan for subprime
borrowers.
12-13-07 Fed coordinates offer by five central banks to
loan billions to commercial banks.
3-7-08 Fed makes $200B in loans available to banks
and other financial firms.
3-17-08 Fed backs $30B in loans to JP Morgan to
assist in acquisition of Bear Sterns.
7-14-08 Treasury announces loans to shore up Fannie
Mae and Freddie Mac.
9-7-08 Fannie and Freddie are nationalized.

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Time Line of US Actions
9-14-08 Lehman Brothers allowed to fail.
9-16-08 Fed announces $85B loan to AIG in return for
80% ownership share.
9-29-08 Congress rejects $700B bailout of financial
firms.
10-3-08 Congress passes amended bailout.
10-12-08 Fed okays Wells Fargo acquisition of
Wachovia.
10-14-08 US announces a $250B plan to purchase
shares in a wide variety of banks.
10-21-08 Fed pledges $540B to guarantee commercial
paper and CDs held by money market funds.

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The Response of US Stock Prices

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 Immediate Steps Taken
 The US Federal Reserve had injected $62 billion into
market on August 9, 2007 and the following day
 On August 17, 2007 the Federal Reserve had
decreased the discount rate by 50 basis points to 5.75
% and on September 18,2007 decreased FFR by 50
basis points to 4.75 % in view of shortage of liquidity
in markets, falling home prices and slowing growth.
 The European Central Bank (ECB) was quickest to
respond with releasing $131 billion of extra funds to
the money market on August 9, 2007 and pumped
€155.85 billion into European Markets to allay fears
of subprime mortgage related credit crunch
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 Immediate Steps taken (Contd)
 Several other Central Banks like Bank Of Canada,
Bank of Japan and Reserve Bank Of Australia
followed suit and injected liquidity support to their
banking systems in order to facilitate orderly
functioning of financial markets
 In Germany, IKB Deutsche Industriebank was
sheilded by providing €3.5 billion by KFW, a
government owned development bank.
 On September 14, 2007 Bank Of England provided
emergency funds to Northern Rock, a leading
mortgage bank of UK in the biggest bailout of a
British Bank in 30 years.
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 Impact on US Economy
 Job Cuts and massive layoffs
 Drying up of liquidity
 Tightening of consumer credit and downward
pressure on economic activity
 Led to Recession
 Effect on markets all over the Globe

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 Impact on Indian Economy
 Globally integrated economy so can’t remain immune to
the contagion effect.
 Massive withdrawal of funds by FII’S
 Panic selling in stock market due to news BNP Paribas
being hit by subprime crisis on August9,2007
 SEBI Chairman M Damodaran : He will be a bold man
who assumes that stock prices are a resultant of one single
factor. At the end of the day the price of stock is
determined by the demand and supply of that stock. A
fall in indices cannot be linked to one factor especially if it
is external. It would be an oversimplification if fall in the
market in India is linked only to the subprime mortgage
crisis in the US

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Impact on the Indian Economy (Contd)
 Housing Sector remains somewhat insulated
largely due to the Reserve Bank of India’s
proactive steps to check reckless lending to the
housing sector by stipulation of stringent credit
assessment

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