INTRODUCTION:

The main purpose of this report is to analyze and understand what the mortgage crisis
subprime is, the causes and triggers which caused this phenomenon, the instruments
that intervened on it, and finally, the impact it had in the whole markets world.
As a point of departure, we stand in the earlies 2000s in the USA, where historically
was quite difficult to potential homebuyers to obtain mortgages, if they had below
average credit histories, provided small down payments or sought high-payment loans.
Two main events were the triggers which gave rise to the subprime mortgages and they
initiated the beginning of that mentioned crisis:
Hedge funds were making loads of money with bonus. They were earning
money out of the profit they generated with their risky investments, and
monetary banks could no compete against that.

After 11-S attacks, due to the climate of instability, the president of the FED
decided to drop the interest rate from 6,5% to 1% with the aim of reactivating
production and consumption through credits. George Bush announced this
reform as a way to fight against financial insecurity.

As a consequence of this, leveraging became really popular as asking for money was
really cheap. Hedge funds and investors asked for money to their banks as it was the
best moment to do so. Banks softened the conditions to loan acceptance and even
people with low income or no jobs were given a mortgage. This was seen by banks as
an opportunity to compete against hedge funds in terms of profitability. The mortgage
were signed with a variable interest rate which was the key point to calculate the
monthly payments.
Banks were aware that the loans they were giving were risky so they gave them a
different name (subprime mortgages) and as they were now allowed to create
financial derivatives, they invented a new instrument called mortgage backed security
that was sold to investors as a safety investment. But, what subprime mortgages and
mortgage backed securities are?

What is a Subprime Mortgage?

Subprime mortgages, or so-called junk mortgages, have jumped to popularity as the

main cause of the financial crisis experienced by the United States.

A subprime mortgage or junk mortgage is a high risk mortgage and usually has no
collateral, so the probability that the mortgage acquirer does not pay their debt is really
high. Some financial institutions in the United States were specialized in offering
mortgages to people who could not certify a repayment capacity. Those people could
not guarantee the mortgage payment, and that is why it becomes a mortgage of the
highest risk.
These mortgages were mainly granted for the housing purchase, and although the
person did not have enough resources to fully guarantee the payment of the mortgage,
these banks assumed that their clients would do the impossible to pay, since no one
wants to lose their home.
As any high risk investment also means a high return as an incentive to take the risk,
these mortgages have a much higher interest than normal mortgages, so it is a big
business for the financial institutions that are dedicated to this type of investments.

The problem arises when the economic situation of American citizens began to get
worse due to unemployment and low wages. There was a moment where they simply
could not pay that mortgage, so they became what they are, ``junk mortgages without
any value. With that crisis provoked by these mortgages the estate market went down.
The bubble created around it simply exploded, which caused that the homes lost a lot of
their value. These mortgages are simply unrecoverable.

Regulation and desregulation. MBS

The regulation of the American economic situation was carried out by means of the law
The Glass-Steagall Act, that is generally known as the United States Banking Act,
which entered into force on June 16, 1933 and was the law that established the Federal
Deposit Insurance Corporation (FDIC) It introduced banking reforms to control
speculation, among its features highlights the separation between deposit banking and
investment banking. This law was promulgated by the Franklin D. Roosevelt
Administration to prevent a situation like the crisis of 1929 from recurring.

The crisis of 1929 caused panic to lose the savings, and that was the reason why there
was a massive withdrawal of deposits of the banks, which took numerous entities to the
bankruptcy.

The characteristics of this law were:

- Total separation between deposit banking and investment banking (stock
exchange).
- Creation of a banking system made up of national, state and local banks. The
Anti-monopoly Act (Sherman Act) prevented unfair competition between them.
- Banks were banned from participating in boards of directors of industrial,
commercial and service companies.

However, as banks saw the increased benefits of riskier activities, they began to crack
down on regulatory walls between commercial banks and other financial services in the
1970s. Beginning in the 1980s, and in response to the insistent hammering of petitions,
regulators began to weaken the strict prohibition of mixed ownership.
The revocation of the Glass-Steagall eliminated the legal prohibition of combining
between commercial banks, on the one hand, and investment banks and other financial
services on the other.

A mortgage security (MBS) is a type of asset backed by security that is secured by a

mortgage or mortgages collection. Mortgages are sold to a group of people (a
government agency or investment bank) that securitizes, or packages, the loans into a
guarantee that investors can buy. Mortgages from an MBS can be residential or
commercial, depending on whether it is an MBS from the Agency or an MBS not
belonging to the Agency.

What is a CDO?

Collateralized Debt Obligation comes from Mortgage Back Securities (MBS) and is one
of the financial products due to which the Financial Crisis began. Basically CDOs are
debt issues from different qualities, different credit ratings, interest rate payments and
priority of repayment , from mortgages without risk until Subprime products. This
products used to receive a very high rate for the Rating Agencies despite of they usually
contains more than a half of Subprime products.

The volume of CDOs issued tripled between 2004 and 2006 from $125 billion to $350
billion per year. These CDOs were distributed far and wide. Not only banks throughout
the world, but also staid establishments such as town councils,and for example Bank of
China alone was exposed to $9 billion of subprime CDOs and two German state banks
were bailed out by the government for their exposition in the CDOs Market.

Why the Rating Agencies valued CDOs with AAA?

Rating Agencies were in charge of evaluating mortgage loans that CDOs contained.
Mainly S&P and Moodys. A issue subprime bond could be composed of around 3.000
mortgage loans and it could have a value around 400 millions dollars.

The statistics and calculations that Rating Agencies usually used to calculate the bonds
rate was based on false premise which was: Banking had done a good business giving
loans and they had denied the loan to people with a lot of risk of default.

If you are not economist and just want to know more about Financial Crisis my
colleagues and I strongly recommend the film The Big Short to understand better the
beginnings of the Financial Crisis and how the CDOs and Rating Agencies worked. You
are able to check how the Rating Agencies almost were forced to give AAA rating to
CDOs and very complex financial products because if not the Financial Banks would go
to others Rating Agencies.

Credit Default Swaps

A Credit Default Swap is an insurance contract between the seller of a CDO or bond,
which would be an insurance company like AIG, and the buyer of a CDO or bond, such
as a hedge fund which believes that CDOs arent as safe as everybody says they are.
AIG would sell an insurance policy on the risk of a bond default. If you bought that
policy, youd make regular premium payments to AIG so that in case the bond defaults,
AIG would give you protection against the entire worth of the bond. In short, a CDS
bets against a Subprime Mortgage expecting that that Subprime Mortgage suffers a
default.

The seller of a CDS is typically a reinsurance company like AIG Financial Products,
Zurich Re, and Credit Suisse Financial Products. These companies looked at certain
bonds and CDOs, thought that they wouldnt default, and offered to sell insurance on
them. They thought that they could rake in a few million every single year in more or
less perfect safety: They thought that the risk had been engineered away.

So far, we have explained what a MBS, a CDO and credit ratings are, but there is still
one more concept that needs to be explained because it made the crisis way bigger than
it would have been. This concept is the credit default swap.

As we explained before, during 1999 the government voted to abolish the Glass-
Steagall Act that forbid monetary banks to create financial derivatives. During this
period of deregulation, a new derivative appeared and it was called SWAP. A swap
can be defined as a derivative whose value depend on something else, in plain words, it
was a bet against everything. It was possible to speculate with which number would
Wall Street close that day or even if a person would be able to repay their loan.

As it happens in every crisis, some people could forecast the catastrophe that was about
to occur. A few hedge funds realized that all the loans that were given were subprime
and also that they were signed with a variable interest rate. Nonetheless, the rating
agencies were giving the CDOs a AAA rate. If the interest increased (as it happened)
people would have to make a monthly payment 200% times bigger than the one they
were doing.

When the hedge funds were aware of this, they went to the investment banks with a
proposal, the creation of a credit default swap. A CDS was a bet against the housing
market that was considered solid by that time. Hedge funds would have to pay a
premium every year until the housing market collapsed, but, if the housing market
collapse they would have to pay to the hedge funds 25 dollars for each dollar bet. All the
investment banks accepted the CDS as they were saw as easy money and they also
involved insurance companies as a way to ensure payments.

Few years later, the housing bubble exploded and the investment banks lose the bet.
This caused them the loss of billions of dollars, many of them were bankrupt and some
insurance companies had to be rescued with public money.

The consequence of this crisis, which are still present nowadays, are the following:

Increase on the unemployment rate: As the crisis started to affect all sectors,
people started to lose their jobs.

Increased difficulty of selling a house: During that time, it was almost

impossible to sell a house so the banks ended up with thousands of unoccupied
houses.
 More rigorous conditions to obtains a loan: Nowadays banks are peakier with
the people to whom they give a credit.