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Yong Wang, PhD，CFA，FRM

Managing Director, Quantitative Analysis

RBC

Subprime Crisis Origin and Impact

July 17, 2008

York University

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Disclaimer

All the views expressed in this presentation are those of my own and do not necessarily represent the views of either Royal Bank of Canada.

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Subprime crisis origin and impact

– Background– Terms

• Subprime mortgage• Securitization

– The changing environment of interest rate– Origin– Potential problems and future outlook

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Background

The severe dislocation in financial markets triggered by U.S. Sub-prime mortgage problems which began in July 2007 worsened in October 2007 following rating agencies’ extensive downgrades of Residential Mortgage Backed Securities (RMBS) & valuation contagion in related products & securities.

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Subprime Crisis Timeline

June 2007

• WSJ reports that two hedge funds managed by Bear Stearns are scrambling to sell large amounts of mortgage securities.Early-July 2007

Market reacts negatively to LBO backlog.July 30, 2007

IKB Deutsche Industriebank AG, a German bank faced a bailout over sub-prime losses, invested 7.8 Bn EUR in U.S. real estate securities

August 13, 2007

In Canada, Coventree Capital Group Inc. failed to find buyers for CAD 950 mm of ABCP.August 16, 2007

In Canada, Third Party ABCP bail-out plan & agreement signed (Montreal Accord).

August 16, 2007

Federal Reserve lowers discount rate to 5.75% from 6.25%August 22, 2007

Bank of America injects USD 2.0 BN into Countrywide Financial CorpSeptember 14, 2007

Summer & Fall2008 ?…

August 9, 2007

BNP Paribas froze EUR 1.6 Bn of three of its funds that invested in U.S. sub-prime mortgages

Effective 30 July 2007, KfW assumed IKB's obligations under the liquidity facility to the ABCP conduit Rhinel & Funding Capital Corporation.

ECB injects moneyGoldman Sachs – USD 9.0 BN Global Alpha internal hedge fund is down 16% on the year during the week

In U.S., Countrywide Financial Corp draws on USD 11.5 Bn Credit line amid crisis in liquidity.

Depositors start to withdraw (GBP 2.0 BN in 2 days)Bank of England bails out 150 year old Northern Rock Plc

October 2007

Moody’s and S&P downgrade more than USD 100 billion in CDOs & MBSs

March 16, 2008

Federal Reserve / J.P. Morgan bailout of Bear Stearns – the speed of the collapse heightens anxietyabout the ability of other Broker-Dealers to fund their operations. Federal Reserve – creates a lendingfacility to improve the ability of primary dealers to finance securities inventories.

April 1, 2008 UBS – USD 19 bn more of writedowns, the most by any bank.Former UBS president calls for a break up of the bank.

Deutsche Bank AG – USD 3.9 bn more of writedowns.

April 25, 2008: Investors of Canadian non-bankABCP Investors voted overwhelmingly for arestructuring proposal on CAD 32 billion in frozenCanadian ABCP.

May 2, 2008: Ruling on fairness of plan.

May 31, 2008: Assuming legal approval & noappeals, investors may have new notes.

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Before Crisis

Download from FT.com

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After Crisis

Download from FT.com

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Background

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What is a subprime mortgage？

Special mortgage product for borrowers with bad credit quality

• FICO Score < 620 （300-850）

• Low net equity value

Interest rate relatively higher, low initial down-payment

Most popular product among subprime mortgages is the ARMs (Adjustable Rate Mortgage)

Total subprime loan in 1998 is roughly $150 billions(10% of total mortgages)；in 2006 is $600 biillions (20% of total mortgages)

When housing price goes up, the house is good collateral. The net value is relatively high, it is easy to get the refinancing.

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Why subprime mortgage can become an nightmare - 2×28ARM

N=200,000，amortizing period = 30 years，initial teaser rate = 5%，from the third year, the rate is set to LIBOR+300bp

First two yearsMonthly payment=$1074，where the interest is $833，principal payment is $241

After two years，principal becomes $194,224• If interest rate is unchanged，Monthly payment = $1074• If LIBOR = 5% (total rate = 8%) ， Monthly payment = $1450！

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The sub-prime market expands as investors seek yield-enhanced products

2005

Increased lending to poor quality borrowers

0

100

200

300

400

500

600

700

1998 1999 2000 2001 2002 2003 2004 2006

Bill

ions

(US$

)

0

5

10

15

20

25

Perc

ent o

f Tot

al

Subprime Originations Subprime % of Total Mortgage Originations

Increased lending to poor quality borrowers

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100

200

300

400

500

600

700

1998 1999 2000 2001 2002 2003 2004 2006

Bill

ions

(US$

)

0

5

10

15

20

25

Perc

ent o

f Tot

al

Total subprime %of total mortgage

2005

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ARMs reset（Jan. 2007, Credit Suisse Fixed Income US Mortgage Strategy)

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The booming housing price stimulates the growth of the subprime market

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How subprime mortgage gets into the capital markets

The subprime mortgages are packaged into RMBS

Become CDO CollateralsInvestors ownedBecome the reference

in the synthetic products

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Securitization

Securitization is a process to generate asset-back securities through the packaging the assets that have some kind of steady cash flows

The key is to put all assets together and re-distribute the associated cash flows

The generated securities is registered and tradable

The securities are rated by the rating agencies, and owned by insurance companies, banks and hedge funds etc.

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One Simple Example

Asset pool is composed

of three corporate bonds X, Y, Z

All bonds have identical

credit rating

This CDO has three tranches – equity, mezz & senior tranches

•When one bond defaults, the equity tranche will take loss

•Two bonds default, the equity + mezz tranches will take loss

•All three bonds default, all tranches will take loss

CDO gives investors exposures to the risks of joint default

Equity tranche

Mezz tranche

Senior tranche

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What Happened?

Sub-prime Mortgage Loans

Sub-prime RMBS

AAA

AA

A

BBB

BB, NR

High Grade ABS CDO

Senior AAA

Junior AAA

AA

BBB

NR

Mezz ABS CDO

A

Senior AAA

Junior AAA

AA

BBB

NR

A

Sub-prime Mortgage Loans … Sub-prime RMBS … ABS CDO

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Who’s Owns What?

Who holds mezzanine RMBS?

– CDOs

– Who holds mezzanine ABS CDO securities?

– Other CDOs

– Who holds Aaa ABS CDO securities?

– Mostly banks and bond insurers

– Who holds Aaa subprime RMBS?

– SIVs, ABCP programs, portfolio investors

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The MBS Market Composition

1. Total MBS 6.8 trillions，exceeding the US Treasuries

2. USA GDP is roughly 13.8 trillions

3. The size of equity market is 45 trillion，US equity is roughly 23.5 trillions

4. The size of global derivatives markets is roughly 480 trillions

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Crisis

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Interest Rate and Delinquency

利率环境与抵押贷款拖欠率

Fed Fund rate Delinquency

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Housing price return from 1987 to June 2007

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ABX Subprime Index

From London based Markit

Based on 20 CDS prices

Reflects the market price of subprime MBS

Four series (06-1,06-2;07-1,07-2)，each series has 5 tranches (AAA, AA, A, BBB, BBB-).

ABX-HE-07-2 is the On-the-run

The issue of ABX-HE-08-1 series is delayed.

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2007 Credit Crunch

ABX 2006-2 (January 1, 2007 - November 6, 2007)

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5

10

15

20

25

30

35

40

45

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55

60

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70

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80

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90

95

100

105

Janu

ary 2,

2007

Janu

ary 16

, 200

7

Janu

ary 30

, 200

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Februa

ry 13

, 200

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Februa

ry 27

, 200

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March 1

3, 20

07

March 2

7, 20

07

April 1

0, 200

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April 2

4, 200

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May 8,

2007

May 22

, 200

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June

5, 200

7

June

19, 2

007

July

3, 200

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July

17, 2

007

July

31, 2

007

Augus

t 14, 2

007

Augus

t 28, 2

007

Septem

ber 1

1, 20

07

Septem

ber 2

5, 20

07

Octobe

r 9, 2

007

Octobe

r 23,

2007

Novembe

r 6, 2

007

Pric

e

2006-2 AAA2006-2 AA2006-2 A2006-2 BBB2006-2 BBB-

First Indications

that there may be credit quality & liquidity

issues with Sub-prime

ABS & structured products. Full blown credit-crunch & losses

resulting from U.S. sub-prime mortgage exposure. RBC CM

reports $35 mm in losses.

Prelude

Part I

The index is maintained by Markit, an independent source of credit derivative pricing.ABX is constructed in conjunction with a consortium of key asset-backed security trading desks.

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CDO’s Leverage Effect

CDO Composed by Subprime RMBS

When Subprime Loss > 10%，what is the loss for RMBS？What is the loss for RMBS-CDO？

RMBS Composed by Subprimes

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Bear Stearns Collapse

Established：1923

Headquarter：New York

Total employees：13,566 (11/2006)

Products：Financial Services，Investment Banking，Investment Services

Market caps• Jan 2007：24 billions

• July 2007：20 billions

• Current：1.55 billions

MBS holding：28 billions，subprime holding is 17 billions

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Writedowns

Americas42%

Asia6%

Europe52%

Subprime Writedowns & Credit Losses -

$382.8 Billion, Globally:

Writedown & credit losses stemming from the collapse of U.S. Subprime mortgage market

announced by commercial & investment banks have reached $382.8 Billion, globally.

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Who to blame?

Subprime Loan Providers (Commercial Banks & Other Financial Institutions)

• Profit driven• Loss credit standard

Investment Banks• Profit driven• Overly reliance on math model, under-estimate the embedded risk

Regulatory Bodies• Low regulatory standard on credit risk management

Rating Agencies• Conflict of interests

Investors (including borrowers & RMBS buyers)• Simplified assumption on housing market• Overly reliance on rating agencies

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2007 Subprime Crisis vs. 1998 LCTM Crisis

The reasons

The role of math models in the crisis

Market price vs. model price

Counterparty credit risk

Impact and magnitude

Liquidity！ Liquidity ！ Liquidity ！

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Future outlook as of May 31, 08

The crisis is not completely over• Compared to Feb. 2007, the foreclosure has increased by 112%

• Compared to Feb. 2007, S&P/Case-Shiller index has dropped by 12.7%，which may trigger more defaults

• S&P 500 dropped by 11.1% (Mar 2007 - Mar 2008)

• GDP: 0.6%

• Inflation 4.3%

Many financial institutions may have quite material write-downsBond insurers may have quite substantial loss due to senior level CDO holdingsFinancial institutions will improve the credit, this will reduce the total available fund, which may slow down the economical growth

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Subprime Crisis Origin & Impact

Q & Ayong.wang@rbc.com

Office: 416-974-8612

Cell：647-292-4250