financial-crisis-2008

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


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)

http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm

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


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

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?

http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html

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.


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


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


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

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