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Subprime Meltdown

Akshit Sharma
C. Praveen
Venkat Achyuth

Overview
What is the Subprime crisis?
What were the main reasons of crisis
What was the impact on leading
companies
What were the risks involved
How the Fed responded
Conclusions

Traditional US Housing
Market
Traditional fixed 30-year mortgage
2/28 mortgages
Subprime borrowers: loan applications did not
meet existing standards poor credit records,
high existing debt-to-income ratios, or even no
income proofs
Subprime 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 Commission 4

Rising US Federal Fund


Rates

Between 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 ARM


According 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.

Securitization
into MBS
Financial

Institutions

packaged

subprime and other mortgages


into

securities.

assumption

Under

that

the

the

housing

market continued to boom, these


securities

would

perform.

However when the mortgages


defaulted,

the

lower

were left worthless.

Source: Financial Crisis Inquiry Commission

tranches

Financial Innovations: CDO


According 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).

Source: Financial Crisis Inquiry Commission

10

Role of Rating Agencies


Rating 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.
11

Subprime Meltdown
As 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 Crisis


Before 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 Liquidity


Following 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
Sept 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.
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Subprime Meltdown

16

Subprime Meltdown

Source: The World Bank, http://data.worldbank.org/data-catalog

17

The 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
2008
During the week of September 14, 2008 the

Impact

Understanding the risks involved in the


subprime crisis

Credit Risk
Asset Price Risk
Liquidity Risk
Counterparty risk
Systemic Risk
Shadow Banking ??

Feds Immediate Response


Term Auction Facility (TAF)
December 12, 2007- Fed allows banks to annonymously borrow money from
the TAF

Term Securities Lending Facility (TSLF)

to allow primary dealers to give their troubled assets to the in exchange for
more liquid Treasury Securities

Primary Dealer Credit Facility (PDCF)


PDCF allowed primary dealers to borrow directly from the Fed - like a bank
would borrow from the discount window

Commercial Paper Funding Facility (CPFF)


October 7, 2008 - To prevent the U.S. economy from coming to a grinding halt
due to lack of cash, the Fed established the CPFF to buy short-term commercial
paper from major corporations

Swap Lines

Fed temporarily removed all limits on its swap lines with major central banks in
Europe

Further Action
Signaling through rate cuts
Expansion of Balance sheet Credit
Easing
Mortgage Lending Rules - HOEPA
Open market operations purchasing
ABS

Conclusion

Deflation
Increased Money Supply
Moral Hazard ??
Rent Shiller
Rating Agencies or Investment
bankers