Sub Prime (Pawan)

8/3/2019 Sub Prime (Pawan)

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LEHMAN BROTHERS The Rise and Fall of


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Points should present in the project.

Content. Background of Lehman brothers.

Little (History) Their Business.

Genesis of Crises. US Mortgage Industry.

Reason For Failure of Lehman Brothers.

Sub Prime Crises

Regulators Role


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Content

Rating Agency. --- FICO credit rating agency.

Auditors Role in 5 to 10 years

back.(Accounting fraud) Post Crises Scenario.

Lessons Learnt.


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Fair Isaac Company (FICO) score


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Credit rating.

35% Payment history Late payments on bills, such as amortgage, credit card or automobile loan, can cause a FICO score todrop. Paying bills on time will improve your FICO score.

30% Credit utilization The ratio of current revolving debt (suchas credit card balances) to the total available revolving credit orcredit limit. You can improve your FICO scores by paying off debtand lowering the credit utilization ratio. Alternatively, applying forand receiving the credit limit increase will also drive down theutilization ratio. Closing of existing revolving accounts will typicallyadversely affect this ratio and therefore have a negative impact on

their FICO score.

15% Length of credit history As your credit history ages it canhave a positive impact on their FICO score.[6]


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10% Types of credit used (installment, revolving, consumerfinance, mortgage) You can benefit by having a history ofmanaging different types of credit.[7]

10% Recent search for credit Credit inquiries, which occurwhen you are seeking new credit, can hurt your score. Individualsshopping for a mortgage or auto loan over a short period will likelynot experience a decrease in their scores as a result of these typesof inquiries, however.[8] While all credit inquiries are recorded anddisplayed on your credit report for a period of time, credit inquiriesthat were made yourself (to check your credit), by your employer(for employee verification) or by companies initiating prescreened

offers of credit or insurance do not have any impact on your creditscore


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SCORES.

The FICO score ranges form low of 350 to 850,lower the score the more likely that borrowerwill not manage the new credit well.

The rating is divided into 3 partsPrime :- These are someone to whom lenders are eager

to do business..

Alt A :- These have good credit history but with

something not quite right. Eg) An investor or borrowerwhose income has not been documented and verifiedmay classify as Alt - A

Sub Prime :- These have a blemished credit history.


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Default credit rating system

The person whose score has less than 620 is

considered as Sub-Prime and average score is

near about 700.

But during that period a score of 650 is

considered as good score for lending because

it fetch higher interest rates.


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EVERY ENDING HAS ABEGINNINGG.SO LETS SEE THE

BEGINNING OF

LEHMANBROTHERS


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About Lehman Brothers.

Lehman Brothers founded in 1850, is a global

financial-services firm.

The firm does business inInvestment banking,

Equity and fixed-income sales,

Research and trading,

Investment management,Private equity, and private banking.

It is a primary dealer in the U.S. Treasury securities

market.


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History In 1844, 23-year-old Henry Lehman, the son of a

cattle merchant, emigrated to the United States fromRimpar, Bavaria. He settled in Montgomery,Alabama, where he opened a dry-goods store.

Later on his borther joined in his business, at thatpoint of time he change the name from H Lehmanto H Lehman & brothers

Later on one more brother joined his business at that

point of time Lehman Brothers came into picture. In 1850 Lehman brothers set up the merchant

bank in New York after making money in railwaybonds. In this way this finance giant came into

existence in USA.


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Every Body

Should Own House. (1)

Financial Success can be defined by size and qualityof the house that we own.

After Great Depression of 1929, Govt policies are

drafted in such a way that it motivates and facilitatesevery American to Own a home.

So the they created FHA :-Federal HousingAdministration , Fannie Mae , and Freddie Mac

Earlier financial Institution would pay loan and holdthem until maturity, but advent of mortgage backedsecurities remove the incentives for financialinstitution.


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CR Act (2)

In February 1970, the U.S. Department of Housing

and Urban Development created the transaction

using a mortgage-backed security.

CRA(Community Reinvestment Act) was introduced

into the system and it was mandatory for the bank to

help the needs of subprime creditors. This was also

an objective of CRA that is to provide equal

opportunity for poor.

Banks were not allowed to expand or mearge unless

they have good CRA number.


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(3)

In 1994 President Clinton unveiled NationalHomeownership strategy which make difficult for thebanks to achieve CRA..so as a result banks startedlending more to poor.

In 1996, Department of Housing Under Developmentgave Fannie Mae , and Freddie Mac target of42 % oftheir mortgages has to go low and moderate incomeborrowers and 12 % to affordable housing borrowerswith income less than 60 % of the median of thatArea.

By the end of 2000 and 2002 these targets haveincreased more.


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Genesis of Crises.

Birth of Subprime Financial shock was setmuch early after tech stock blast, 9/11, andinvasion of Afghanistan and Iraq.

Seeing this , FED has started reducing theirinterest rate and in 2003 it was record low, butthey were concern about the rising inflation.

Fearing their own economies would go slumpunder the weight other economies in theworld lower their interest rates.


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Federal Funds Rate.


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Fed Cut the rates beyond the point of

necessary.

It took too long for the Fed to bring theinterest rate on normalcy.

This unnatural lower interest rate , sky

rocketed the Asset and this time it was real

estate not stock market.


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Meanwhile in year 2003 , China Joined the World

Trade Organization ,this has open the flood gates

for china and he entered the global market.

Low cost Chinese made goods flooded markets

and price fell nearly everywhere and inflation

seem a remote concern.

Chinas explosive growth, driven by mgft andexports boosted global demand for oil and other

commodities.


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Us was facing trade deficitbecause 100sbillion dollar was flown to china as china hasbecome the exporter , so this money was

coming back to US in the form of investmentby china and other Asian market.

Initially this money was invested in UStreasury bonds which produce a low int rates.

Later on in the quest for higher returns theyexpanded to riskier financial instrument.


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Frenzied Innovation

2 factor that contributed the Innovative andriskier financial product .

Lower int rates and surging global investor

demand.

Wall street came up with variousproducts..few among those are futures optionand derivatives on government and corporatedebt and even bonds backed by residentialmortgage payments.


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Wall street Creation

Earlier the procedure was simple, which involvesingle borrower and single lender that is bankloan you money to buy single home , car and you

pay bank over time.. This whole scenario has changed when wall

street bank realized that individual loan andmortgages could be tied and securitized

A simple debt agreement can now be traded asjust with other bonds and stocks among investorworld.


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Now monthly mortgage payment make a trip

that is cash pooled from hundreds of others

individual mortgage payments and flow to

the investor who owned the new mortgage

backed securities.

Another innovation was they have sliced and

bundled them according to the risk appetite ofinvestor.


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Those who want to seek safe investment ispaid first and lower int rates.

By mid of the decade any asset which has cash

flow seemed to qualify for such slice and dicetreatment.

Residential mortgages loans

Merger and financing and even tolls generatedby public bridge and highways weresecuritized.


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DESIGNING PACKAGING AND RESELLING

BECAME THE MAJOR SOURCE OF FINANCE for

wall street bankers and salesman marketed

them to investor very well.


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Chain effect (Balance sheet effect)

Originally lenders were facing limitationbecause it was reflected on balance sheet butafter secutrization.this loans were re sold

and that money is used proceeds further loan. Government regulators like because it seems

that risk was spread broadly.

But the main problem was they were notassessing the lending side riskthey just gotcarried away in volumes


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GOLDEN ERA ENDS

Again Fed played a important role in the span

of 24 months it has increased 425Bps points.

As Interest went up market yield went up this has

resulted in 2 things.

Real Estate Price

start to fall

Market Lending and

Borrowing Rate

start to increase


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Lehman Debacle


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CDS (Credit Default Swaps)


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Mortgage Backed Securities.(MBS)

A type of asset-backed security that is securedby a mortgage or collection of mortgages.These securities must also be grouped in one

of the top two ratings as determined by aaccredited credit rating agency, and usuallypay periodic payments that are similar tocoupon payments. Furthermore, the mortgage

must have originated from a regulated andauthorized financial institution.


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ARM (Adjustable Rate Mortgage)

It ARM role proves to be significant for the

debacle of US Mortgage Industry.

ARM was develop in early 1980s wheninterest rates and inflation was high.

(+):-In the Initial years the borrower has to pay

Low Rate of Interest than Current interest

rate.

(-):- Lack of Transparency in the system.


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