Sub Prime Debt

8/8/2019 Sub Prime Debt

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GLOBAL MARKETS, Asia Pacific

October 2010

Subprime Lending


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Introductiony Subprime lending , als o calle d "B-Pape r ", "nea r -prime" or "se cond cha nce" le nding , is a

ge ne r al te rm tha t r efe r s to the p r a ctice of mak ing loans to borrowe r s who do not qualifyf or ma r ke t inte r es t r a tes be cause of proble ms with the ir cr e dit his tor y.

y G e ne r ally, s ubp rime mortg a ges a r e f or borrowe r s with cr edit s cor es * of unde r 620 .S ubp rime loans have highe r r a tes than eq uivale nt prime loa ns. H ow much highe r depe nds on factor s s uch as cr e dit s cor e, s ize of down pay ment, delinque ncies his tor y of the b orrowe r in the r e cent pas t e tc . A s ubp rime loan is als o mor e likely to have apr epay me nt pe nalty.

y S ubp rime le nding e ncom passes a va rie ty of cr e dit ins trum ents, including s ubp rimemortg ages, s ubp rime ca r loa ns, a nd s ubp rime cr e dit ca rds, a mong othe r s.

y The C onc ep t of a C redit Score - In the US a cr edit s cor e is a num be r typically be twee n 300 and 85 0 a nd is base d on the s ta tis tical a nalys is of a pe r s on's cr e dit f iles. T he num be r r ep

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s cor e is p rima rily base d on cr e dit r ep ort inf orm a tion, typically f rom the thr ee major cr edit bur ea us - Expe ria n, Eq uifax & T r a nsU nion .


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S ubp rime Le nding Te rmsy A ve r y common mortg a ge in the s ubp rime ma r ke t is the 2/28 ARM. T his is a n adjustable rate

mortgage (ARM) on which th e r a te is f ixe d f or 2 yea r s, a nd the n r ese t to eq ual the val ue of ar a te index a t tha t time ( i.e. af te r 2yr s ) plus a ma rgin f or the bala nce 28yr s. Be ca use thema rgins a r e high , the r a te on mo s t 2/28s will of te n rise s ha r ply a t the 2-yea r ma r k, eve n if ma r ke t r a tes do not ch a nge during th e pe riod.

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Ra te Indices common ly use d is the 1-yea r CMT, b ut othe r choic es include, 6- month LIBOR,6-month Tr eas ur y B ill, e tc .

y Som e b orrowe r s with poor cr e dit s cor es take a 2/28 a t a high r a te a nd pla n to r eb uild the ir cr e dit during the 2-yea r pe riod. T he ir pla n is to r ef ina nce a t a be tte r r a te a t tha t time f or thebala nce of 28 yea r s. T he major thr ea t to s uch a pla n is a p r epay ment pe nalty. It is common f or s ubp rime l oan contr acts to include a p r epay me nt pe nalty f or the f ir s t 5 yea r s of the l oa n,

with an ave r a ge r a te of 5% of the p rincipal.

The lending job was madeeasier with exotic mortgagessuch as so-called no-docloans, which enableborrowers to get loanswithout having to supplyevidence of income or savings, and option ARMs,adjustable-rate mortgagesthat let people pick how big

a payment they will makefrom month to month.

The loans offer upfrontteaser rates at the cost of taking the deferredpayments onto the balanceof the loan.


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S ubp rime mon ey tr a ily Through se curitiza tion , mortg a ge risks a r e passe d through f rom s ubp rime le nde r s to ba nks a nd

ultima tely to inves tor s.

Securitization


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For e clos ur e P roc essP r e-F or e clos ur ey Cus tome r misses mortg a ge pay me nt.y La te notice se nd by ba nk.y Cus tome r misses a ddition al pay me nts.y Ba nk a tte mp ts in writing a nd by p hon e to cont a ct cu s tome r a nd r es olve s itua tion .y No a rr a nge me nts a r e a gr ee d u pon a nd cu s tome r continu es to miss pay me nts.y Ba nk iss ues de ma nd f or pay me nt und e r the note in f ull.y No pay me nts or a rr a nge me nts a ccep table to the ba nk a r e ma de.

Formal Le gal F or e clos ur e P rocessy Ba nk se nd s by ce rtif ie d ma il Notice of Inte nt to For e close.y Ba nk be gins a ction in the court sys te m to f or e close.y Le gal notices as r eq uir e d by la w be gin to be p ublis he d in local pape r s.y No pay me nt or se ttleme nt a rr a nge me nts a r e ma de with the le nde r .y Notice a nd wa iting pe riods exp ir e.y Court ho lds hea ring r e ga rding ba nks cla im.y Court iss ues ord e r allowing ba nk to f or e close.y Le gal notice of actual f or e clos ur e sale a nd a dve rtise me nts p ublis he d in local pape r s.y No pay me nt a rr a nge me nts or se ttleme nts r ea che d with the ba nk.y Hou se s old a t a uction to high es t b idde r .

After foreclosure, propertiesare usually auctioned off bythe investors. Bidders quoteprices much lower thanmarket value, leading tolosses to the funds as theseproceeds do not cover theunderlying loan obligations.


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The Expl oding ARM Rese t proble my It is es tima ted tha t ARMs take n f rom 200 4 -200 5 will have a n incr ease in inte r es t cos t of a t leas t 35%. S o f or e. g. if a

mortg a ge b orrowe r was pay ing 6%, p os t r ese t they cou ld be pay ing 8.1 0% ( i.e. 6% + 35% of 6% )y The f ollowing cha rt illus tr a tes the rise in floa ting inte r es t r a tes to be r ese t. These a r e the mo s t common indices use d to

f ix ARMs r a te af te r 2 yea r s (6- month LIBOR, 6- month CD, 3- month Tr eas ur y B ill, and 1-yea r CMT). F or exa mple, amortg a ge b orrowe r in April 200 5 may e nte r into a n ARM whe r e he will pay 6% f or the f ir s t 2 yea r s a nd 6-month LIBOR+ 3% f or the r e ma ining 28 yea r s (ass uming a t April 200 5, 6- month LIBOR was a t 3. 4 0%). O n April 2007 , the 6- month LIBOR is a t 5.35%, s o the b orrowe rs ne w ARM inte r es t r a te will be 8.35% ( i.e. 5.35% + 3. 00% ). This is a 39% increase(f rom 6% to 8.35% ).

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y Expe cte d Ad jus table Ra te M ortga ge Rese t S che du le. T he wor s t has ye t to com e.

The Expl oding ARM Rese t proble m (continu e d)


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Collapse of Mortg a ge Le nd e r sy The f ollowing is a n exa mple of how a la rge s ize d playe r fell und e r the dr ama tic

r e tr e nchm ent of cr edit ava ilab ility due to the r e ce nt contr action o f the s ubp rimema r ke t.

1. The Ame rican Hom e Mortg a ge Inves tment Cor p. (AHM) was the 1 0th larges t r es ide ntialmortg age le nde r in the US, hav ing origina ted ab out USD 6 0 billion of mortg age loanduring 200 6 f rom 55 0 off ices in 4 7 s ta tes.

2. On 28 Ju ly, AHM a nnounc e d it was delay ing the pay me nt of its common di vide nd du eto dis ruptions in the cr e dit ma r ke ts in the pas t few weeks ca us ing major writedown s of its loa n a nd se curity portf olios, lea ding to m a rgin calls with r espe ct to its cr edit facilities.

3. On 31 Ju ly, AHM r elease d a s ta teme nt tha t i t was unable to borrow on its cr e ditfacilities a nd s o was unable to f und its outs ta nding mortg a ge loa n commitm e nts f or tha tday.

4 . On 3 Augu s t, AHM a nnounc e d it would f ir e all 7,000 o f its p roduction e mployees as itwas s hutting down o pe r a tions.

5. A ba nkruptcy f iling is now a ve r y r eal p oss ibility.


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Why He dge F und s a r e in Trou bley A pe r spe ctive of how h e dge f und s ca n ge t in trouble

1. An inves tment ba nk poo ls a pa cka ge of subp rime mortg ages iss ue d by the Ame ricanHom e Mortg a ge ( und e r lying mortg a ges a r e 2/28 ARMs with initial tease r r a tes, l ittledocum e nta tion, e tc .) a nd o ffer s hedg e f und s a b ond th a t yields 7%. A he dg e f undmanage r might say, "OK, I have $1 b illion und e r ma na ge me nt. I will go to the ba nk a ndborrow 10 billion a nd inves t in these k inds of bond s.

2. These tr a des continu e to pe r f orm well r e ga rdless of the s tock ma r ke t, as l ong ashou ses go up in value, mortg ages ge t pa id, e mployme nt r a tes a r e s trongth a t's all

tha t ma tte r s. T he b ond s will pay, s o he dg e f und s keep b uying mor e mortg age-ba cke dse curities a nd borrowing mon ey to leve r a ge.

3. Now hou s ing s tops going u p in 2006, a nd in 2007 , the b ond s move d down in value a ndto the p oint whe r e he dge f und s mus t put up mor e co llate r al to keep the tr a des on . Thisis s imply be ca use on a ma r k-to-ma r ke t bas is, l ike a ny inte r es t r a te s wap, the ne tpr ese nt value of the he dge f unds s ide is much lowe r tha n tha t of the count e r pa rtyba nks ( the b orrowe d portion to inves t in the b ond s, or leve r a ge d a mount , plays a b igrole in this ).

4 . The he dge f und do es nt have much c as h (its inves t it all a nd als o borrowe d mor e toinves t), s o it nee ds to sell s ome of the b ond s. T he p roble m is, no on e wa nts the b ond snow as defa ults on mortg ages a r e mounting u p.

5. By the time the hedg e f und f inis hes sell ing the b ond s, the co llate r al is all gon e, a nd thef und th en closes.

H edge funds are alwaysseeking capital. They canseek money directly frominstitutions or individuals, or they can do the easiest thingand seek money from thosewho are offering it: "fund of funds" managers who,specifically, look for managers to place other people's monies.

Leveraging If I take USD 1million to invest in a 7% p.a.bond for 1 year, return isUSD 70,000. Instead, if Ihave limits with a bank, I canborrow USD 10 million(pledge my USD 1 million ascollateral) and invest in the

same 7% bond. My yield onmy USD 1 million iseffectively 70% (USD700,000 return) less cost of borrowing the USD 10million.


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Ra ting Age ncies Roley O the r key playe r s tha t have a major role in s upp orting the appe tite f or risky s ubp rime

loa ns a r e the cr e dit-r a tings a ge ncies, s uch as M ood ys Inves tor s Se r vice, F itch Ra tingsand S ta nda rd & Poors.

y Whe n a ba nk cr ea tes a CDO, it mee ts with cr edit r a te r s to dis cuss the q ual ity of thecont e nts, including s ubp rime deb t. They divide the CDO in pie ces in orde r to ge t thedes ir e d r a ting f or ea ch portion (or tr a nch es, ).

y Throughout las t yea r , these a gencies r a ise d no r e d flags ab out se curities ba cke d bys ubp rime mortg a ges, a nd they continu e d to g ive inves tme nt-gr ade r a tings to thesese curities base d on the tr a nch es expe cte d to pe r f orm the bes t. S om e b ond s ba cke d bys ubp rime mortg ages fell by mor e tha n 50 ce nts on the do llar this yea r without the ir cr e ditr a tings changing .

y In Ju ly 2007 , Mood y's a nd S ta nda rd & Poor' s cut r a tings on billions of do llar s of bond sba cke d by s ubp rime mortg a ges, on expe cta tions hom e-loa n defa ults will rise. M ood y's inits r ep ort sa id the criticism of its s ubp rime deb t r a nkings s tem f rom ``a l inge ring con f us ion''ab out its role. C r edit r a tings p rovide a n assess me nt of defa ult risk f or the ``ho ld-to-ma turity cr edit wor ld'' r a the r tha n a ddr ess ing the ``volatility-liquidity iss ues '' tha t inte r es tinves tor s s uch as hedg e f und s.


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S om e S ta tis ticsy Pe ns ion f unds a r e a mong the b uye r s of the eq uity tr a nch e ( risk ies t, f ir s t-loss p ortion) of CDOs


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S ta tis tics continu e dy Top s ubp rime mortg a ge origina tor s in 200 6 a nd 200 5


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S ubp rime F or e clos ur e a nd REO* r a te by v inta geS ubp rime 6 0+ day del inque ncy r a te by v inta ge

* Real Estate Owned. Property which is in the possession of a lender as a result of foreclosure or forfeiture.

S ta tis tics continu e d


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Countr ywide F ina ncial C or p. CDS p rice cha nges

CDS p rice ch a ng es of Origina tor s


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Was hington Mutu al Inc. CDS p rice cha nges

CDS p rice ch a ng es of Origina tor s ( continu e d)

Sub Prime Debt

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