Post on 06-May-2015
Now we are ready to look into the mess !
Evolution of home mortgage
Source :http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,Subprime Mortgage Market Turmoil, Christopher L. Peterson, Asst Prof of Law, Univ of Florida
1930s
Lender-Banks Borrower-Individuals
Home loan funding
Principal + interest payable over long term
• Owning a house was not affordable to many
• Great Depression brought industry to a halt. Large scale defaulters and lenders could not recover by reselling
• To simulate the industry again Government as part of New Deal policy created the Federal National Mortgage Association (Fannie Mae) in 1938. This created a secondary market for mortgages
Lender-Banks Borrower-Individuals
Home loan funding
Principal + interest payable over long term
Bought loan
Cash
Transfer of credit risk, market risk
Had Access to long term borrowing
Bought only those which conformed to certain underwriting standard ( called Prime
Mortgages)
Evolution continued…
Fannie Mae proved very successful . But by 1960s , borrowing done by it
constituted a significant share of the debt owed by US government.
1968- Government National Mortgage Association (Ginnie Mae) was
created to handle government guaranteed mortgages.
Fannie Mae became federally chartered, privately held
1970- Ginnie Mae developed MBS -- shifted the market risk to investors --
eliminated debt incurred to fund government housing program
1970-Federal National Mortgage Corporation (Freddie Mac) created
To securitize conventional mortgages
Provide competition to Fannie Mae
Over time Fannie Mae and Freddie Mac together provided enormous
amount of funding for US mortgage
Since Fannie Mae and Freddie Mac guaranteed loans, much of credit risk
stayed with them. Size and diversification allowed them to handle it.Source :http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,
New Model of mortgage lending
Lender-Banks
Home loan funding
Principal + interest payable over long term
Bought loan
Cash
Transfer of credit & market risk
MB
S
Cas
h
Transfer of market risk
Advantages
• More liquidity in market
• Risk spread out
• Long term funding for mortgage lending
• MBS- allows originators to earn fee income from underwriting activities without exposure to credit, market or liquidity risks as they see the loans they make
SPV
Sec
uriti
zatio
n fe
es
Further evolution..
1977- Private label securitization started first done by BOA and
Salomon Brothers
1980s- pricing, liquidity and tax hurdles were resolved in same
Unlike 2-3 party , private label securitization has 10 or more different
parties playing independent role
Big private players in this field were
Wells Frago
Lehman Brothers
Bear Stearns
JP Morgan
Goldman Sachs
Bank Of America
• Indymac
• Washington Mutual
• Countrywide
Structured finance: Structured finance: The players in securitizationThe players in securitization
OriginatorOriginator
End borrowersEnd borrowers
Conduit/trust/ Conduit/trust/ SPV/SPE/SIVSPV/SPE/SIV
Investment bank Investment bank (underwriter)(underwriter)
Rating agencyRating agency Institutional Institutional investorinvestor
End lendersEnd lenders
Insurance Insurance companycompany
BrokerBroker
ServicerServicer
$$
$$
$$
$$
$$
MortgagesMortgages
MortgagesMortgages
MBSMBS
I&P ($)I&P ($)
I&P ($)I&P ($)
MBS, I&P ($)MBS, I&P ($)
Financial Financial returns ($)returns ($)
LEGEND KEYLEGEND KEYO&G – interest and principalO&G – interest and principal
SPV – special purpose vehicleSPV – special purpose vehicleSPE – special purpose enterpriseSPE – special purpose enterpriseSIV – special investment vehicleSIV – special investment vehicle
MBS – mortgage backed securitiesMBS – mortgage backed securities
Founder: loan originator or Founder: loan originator or investment bankinvestment bank
Purpose: transfering ownerhship Purpose: transfering ownerhship of claims (loans) and collateral of claims (loans) and collateral (mortgages) in order to issue (mortgages) in order to issue mortgage backed securities mortgage backed securities
(bonds).(bonds).
Exposure of founder: implicit Exposure of founder: implicit guarantee in case of large losses.guarantee in case of large losses.
Assigns credit Assigns credit rating to issued rating to issued
MBSs.MBSs.
Organizes issuing of Organizes issuing of MBSs and places MBSs and places
MBSs to investors in MBSs to investors in financial markets.financial markets.
Broker places mortgage loans Broker places mortgage loans to borrowers for feeto borrowers for fee
Manages the flow of interests Manages the flow of interests and principal (I&P); usually, and principal (I&P); usually,
but not necessarilly the but not necessarilly the Originator Originator
Typically a specialized Typically a specialized mortgage bankmortgage bank
Mutual funds, Mutual funds, pension funds, pension funds, hedge funds…hedge funds…
Can assume part of Can assume part of risks (insurance of risks (insurance of mortgage loans, mortgage loans,
insurance of MBS insurance of MBS returns).returns).
Possible inter linkage in the US subprime mortgage market
Source: http://www.norges-bank.no/templates/article____66901.aspx
Reasons for forming of Subprime mess
Giant pool of money available for investment through savings of Oil exporters , economic
development in BRIC countries.
Private share in mortgage market growth in large part through origination and
securitization of high risk sub-prime and Alt-A mortgages.
Building up of the housing bubble
Private Banks made use of CDOs to sell to investors
• Lax regulations which did not keep pace with the innovations happening in financial
engineering
• US kept interest rates too low for too long in post dotcom bust period
• Hedge funds, Wall street firms and instructional investors found lower tranches in MBS
and CDO attractive which were highly risky
• Hedge funds leverage ratio of the order of 500%.
• To sum up in 3 words as noted by Harvard dean: Leverage(high), Transparency (low)
and Liquidity (abundant)
Big assumptions
Belief that modern capital markets had become so much more advanced than their
predecessors that banks would always be able to trade debt securities. This
encouraged banks to keep lowering lending standards, since they assumed they
could sell the risk on.
Many investors assumed that the credit rating agencies offered an easy and cost-
effective compass with which to navigate this ever more complex world. Thus many
continued to purchase complex securities throughout the first half of 2007 – even
though most investors barely understood these products.
Most crucially, there was a widespread assumption that the process of “slicing and
dicing” debt had made the financial system more stable. Policymakers thought
that because the pain of any potential credit defaults was spread among millions of
investors, rather than concentrated in particular banks, it would be much easier for
the system to absorb shocks than in the past.
Housing prices will keep going up all time
Source :http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html
Misaligned incentives & pitfalls
“churning” of capital “allows even an institution without a great amount of fixed capital
to make a huge amount of loans, lending in a year much more money than it has
If an individual or class of victims obtains a large judgment, the lender’s management
can simply declare bankruptcy, liquidate whatever limited assets are left, and possibly
reform a new company a short time later.
Securitization conduit divides various lending tasks into multiple corporate entities—a
broker, an originator, a servicer, a document custodian, etc.—the conduit tends to
prevent the accumulation of a large enough pool of at risk assets to attract the
attention of class action attorneys, which tend to be the only actors capable of
obtaining system-impacting judgments.
Source : Subprime Mortgage Market Turmoil , testimony by Christopher L. Peterson
Good days turn bad. Crisis at the door (mid 2006 onwards):
Through financial innovations loans issued to borrowers at minimal rate,
adjusted rate. By mid 2006 time to pay bigger amounts comes
Household income did not increase in same proportion as house prices
Subprime mortgage owners start defaulting
Rating agencies revise ratings of MBS/CDO as expected number of
defaults turn out higher. Many ratings are lowered
Bewildered investors lost faith in ratings, many stop buying MBS/CDO
altogether
Alarm bell at SIV/SPVs
Banks find themselves in non-comfortable position , stop making loans
Housing prices plummet owing to increase in foreclosure, delinquency
and stoppage of loans
what a mess….
More frenzy in market and more defaults, again revised ratings, again further
stoppage of funding and further stoppage of loans, further fall in house prices as
demand and supply mismatch....problem feeding itself in circular fashion.
As MBS/CDO market is shaken….investors start debating other derivatives true
worth…panic spreads across and people start getting out….further hurting the banks
The crisis unfolded as silent Tsunami on Wall Street where by the time people
realized the graveness of the mess they were in , it had gone beyond control.
Since, most of the player in the market, mortgage brokers, investment banks were
running in debts. They are suddenly caught unaware and are in insolvency and start
tumbling down….many are saved by nationalization as their fall would spread the
contagion way far .
Central government start pumping in money as last resort but one thing is surely not
returning soon and which is very vital in financial industry -FAITH.
In Short
Source :http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,
Those good old days were gone now!!
How Subprime became Global Financial Crisis?
Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html
In b
illio
n U
S $
How could problems with subprime mortgages, being such a small sector of global financial markets, provoke such dislocation?
Build up into a financial crisis…
In 2003, Bank of International Settlements(BIS) repeatedly warned that risk dispersion might not
always be benign. But US Federal Reserve was convinced that financial innovation had changed
the system in a fundamentally beneficial way.
No efforts made to correct debt to equity ratios of bank
Huge trust in the intellectual capital of Wall Street –supported by the fact that banks were making
big money.
When high rates of subprime default emerged in late 2006, market players assumed that the
system would absorb the pain.
Initial estimate of subprime loss put to $50bn-$100bn by US FED
Subprime losses started to hit the financial system in the early summer of 2007 in unexpected
ways. As the surprise spread, the pillars of faith that had supported the credit boom started to
crumble.
Investors woke up to the fact that it was dangerous to use the ratings agencies as a guide for
complex debt securities.
In the summer of 2007, the agencies started downgrading billions of dollars of supposedly “ultra-
safe” debt – causing prices to crumble.
Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html
Poor Investors….
Shocked investors (sitting in all parts of the world) lost faith in ratings, many stopped buying
complex instruments altogether
That created an immediate funding crisis at many investment vehicles ( remember SIV), since most
had funded themselves by issuing notes in the asset-backed commercial paper market.
Many banks had not yet passed on the risk to others. Many were holding asset-backed securities in
“warehouses” and were working on splicing them up into CDOs, getting them rated by a credit
agency such as Moody’s or Standard & Poor’s. Several banks were caught out not only because it
took time to structure the securities but because they deliberately held on to what they regarded as
“safe” tranches of loans. Ex. UBS was badly damaged by retaining “super-senior” CDO debt.
It also meant that banks were no longer able to turn assets such as mortgages into subprime bonds
and sell these on.
That in turn meant the key assumption that the capital markets would always stay liquid – was
overturned.
Assumption that banks would be better protected from a crisis because of risk dispersion – also
cracked.
As investment vehicles lost their ability to raise finance, they turned to their banks for help. That
squeezed the banks’ balance sheets at the very moment that they were facing their own losses on
debt securities and finding it impossible to sell on loans. Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html
Desperate banks….
As a result, western banks found themselves running out of capital
Banks started hoarding cash and stopped lending to each other as financiers lost
faith in their ability to judge the health of other institutions – or even their own.
The London interbank offered rate(LIBOR), the main measure of interbank lending
rates, rose sharply
Firms became reluctant to participate in money markets ... as a result subprime credit
problems turned into a systemic liquidity crunch.
Vicious deleveraging spiral got under way. As banks scurried to improve their balance
sheets, they began selling assets and cutting loans to hedge funds.
But that hit asset prices, hurting those balance sheets once again.
Mark-to-market accounting forced banks to readjust their books after every panicky
price drop
Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html
Lessons learned & Action plans ….
lesson of the CDO collapse is that technology does not obviate the
need to assess a borrower carefully. Neither banks nor credit agencies
did this well enough on behalf of investors and it proved a painful
experience for everyone
In the medium term, regulators are preparing reforms that aim to make
the system look credible
These would force banks to hold more capital and ensure that the
securitization process is more transparent
Separately, groups such as the IIF are trying to introduce measures
that could rebuild confidence in complex financial instruments
More immediately, the banks are trying to rekindle investor trust by
replenishing their capital bases
Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html
Subprime losses by Big Banks
Worldwide :US$ 586.2 billion and still counting
Source: Financial Times
Finance & Economy
The collapse of an enormous financial institution stirs uncertainty,
and uncertainty rattles Wall Street. Lenders are happiest when they
are confident they will be repaid. If they think there's a chance that
borrowers will default, they simply don't make loans. Their refusal, in
turn, can shut down the economy and the financial system.
Financial system is what provides the funding for all the other
sectors of the economy, and if you have a broken financial system,
you have a broken economy
Investments devalued across the Globe
Source: BBC News, http://news.bbc.co.uk/2/hi/talking_point/7644574.stm
Subprime impact across globe
Source: Financial Times
Impact of Financial crisis-felt across the globe
Source: Reuters, http://www.reuters.com/news/globalcoverage/creditcrisis
Market share shifted from 2003 to mid 2006
76
43
24
57
0
20
40
60
80
100
2003 mid-2006
%
Year
Mortgage market % share
Government sponsered Private( Wall Street firms)
• Government share fell by 43% where as private share rose sharply by 138% over a period of 3 years
Between sub-prime and prime
• Subprime lending increased by massive 205% over 3 years • Alternative–A similarly expanded by 384%
• Increase in Prime was mere 16.7%
Global pool of money
Source:http://www.rbnz.govt.nz/speeches/2968727.html
Rise of Global Liquidity (1998 onwards)
Source:http://www.rbnz.govt.nz/speeches/2968727.html
FED interest rate
• To catch up with dot com boom FED kept interest rate low for long
•This indirectly resulted in investors looking for other safe heavens
• They got attracted to housing market
High Banks leverage ratio’s to fund MBS/CDO
Building up of the housing bubble
Housing prices and Income
Source: http://varbuzz.com/meltdown/
• Housing prices were increasing
•Income slope was almost flat
Starting 2006 housing bubble busted
LIBOR rate
Credit rating of complex financial instruments
Source: IMF and WSJ
Speedy Foreclosures
Top 10 Bankruptcies
The American way of debt
Source: http://www.nytimes.com/interactive/2008/07/20/business/20debt-trap.html?ei=5070
Average debt of American in 2004
Source: http://www.nytimes.com/interactive/2008/07/20/business/20debt-trap.html?ei=5070
Thanks