Sub Prime Crisis Report Final

SUB PRIME CRISIS What is Sub-Prime? Sub-Prime lending (‘less than prime’, ‘second chance lending’) is a term used by financial institutions for lending money to low credit worthy customers. It involves giving loans in ways that do not meet ‘prime’ standards and are hence put in the riskiest type of consumer loans, typically sold in the secondary market. The credit standards are determined by various factors such as the size of the loan, borrower credit rating, ratio of borrower debt to income or assets, ratio of loan to value or collateral, documentation provided on those loans which do not meet Fannie Mae or Freddie Mac underwriting guidelines for prime mortgages etc. Sub-prime lending encompasses a variety of credit types, including mortgages, auto loans, and credit cards. Sub-prime borrowers show data on their credit reports associated with higher default rates, including limited debt experience, excessive debt, a history of missed payments, failures to pay debts, and recorded bankruptcies. Sub-prime lenders often take on risks associated with lending to people with poor credit ratings or limited credit histories Securitization: The process through which an issuer creates a financial instrument by combining other financial assets and then marketing different tiers of the repackaged instruments to investors. The process can encompass any type of financial asset and promotes liquidity in the marketplace. Mortgage-backed securities are a perfect example of securitization. By combining mortgages into one large pool, the issuer can divide the large pool into smaller pieces based on each individual mortgage's inherent risk of default and then sell those smaller pieces to investors. The process creates liquidity by enabling smaller investors to purchase shares in a larger asset pool. Using the mortgage-backed security example, individual retail investors are able to purchase portions of a mortgage as a type of bond. Without the securitization of mortgages, retail investors may not be able to afford to buy into a large pool of mortgages. Mortgage Backed Securities (MBS): A type of asset-backed security that is secured by a mortgage or collection of mortgages. These securities must also be grouped in one of the top two ratings as determined by a accredited credit rating agency, and usually pay periodic payments that are similar to coupon payments. Furthermore, the mortgage must have originated from a regulated and authorized financial institution. When you invest in a mortgage-backed security you are essentially lending money to a home buyer or business. An MBS is a way for a smaller regional bank to lend mortgages to its customers without having to worry about whether the customers have the assets to cover the loan. Instead, the bank acts as a middleman between the home buyer and the investment markets. This type of security is also commonly used to redirect the interest and principal payments from

the pool of mortgages to shareholders. These payments can be further broken down into different classes of securities, depending on the riskiness of different mortgages as they are classified under the MBS. Collateralized Mortgage Obligations: A type of mortgage-backed security that creates separate pools of pass-through rates for different classes of bondholders with varying maturities, called tranches. The repayments from the pool of pass-through securities are used to retire the bonds in the order specified by the bonds' prospectus. Here is an example how a very simple CMO works: The investors in the CMO are divided up into three classes. They are called either class A, B or C investors. Each class differs in the order they receive principal payments, but receives interest payments as long as it is not completely paid off. Class A investors are paid out first with prepayments and repayments until they are paid off. Then class B investors are paid off, followed by class C investors. In a situation like this, class A investors bear most of the prepayment risk, while class C investors bear the least. Collateralized Debt Obligation: It is an investment-grade security backed by a pool of bonds, loans and other assets. CDOs do not specialize in one type of debt but are often non-mortgage loans or bonds. Similar in structure to a collateralized mortgage obligation (CMO) or collateralized bond obligation (CBO), CDOs are unique in that they represent different types of debt and credit risk. In the case of CDOs, these different types of debt are often referred to as 'tranches' or 'slices'. Each slice has a different maturity and risk associated with it. The higher the risk, the more the CDO pays.

Impact On the Public:

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The subprime crisis has caused mass unemployment in the U.S with as many as 65,400 jobs lost as on September 2008 due the bankruptcy of giants like bear stearns and lehman brothers.

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A decline in economic activity in the US resulted in lower disposable incomes of the public and hence a decline in demand.

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Housing price declines left consumers with less wealth, which placed downward pressure on consumption

On Institutional Investors: •

Swiss bank had shares or stakes in many company now all of them have been beaten down completely so this loss had to be faced by Swiss bank also.

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Unitech, an indian company which builds luxary apartments, had small stake in lehman brother because of which it has to face 2000 crore loss. In January Unitech price was 500 now it is 40.

On the economy:

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The subprime crisis in the US, following the collapse of the housing sector boom, has sent ripples through the economies of many countries including india and china who make their biggest exports to U.S. A decline in economic activity in the US resulted in lower disposable incomes and hence a decline in demand. Simultaneously there was a rise in supply due to repayments and foreclosures arising out of a higher interest rate.

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There is a major Cash crunch in the US especially which will lead to crash crunch all over the world. There is no money in the market.

On the Banks: •

The banks have to survive for existence now. They have leveraged more than their capital which resulted in bad loans bad debts

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The banks have lost trust in each other and aren’t lending to each other

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Credit crunch- Banks don’t have enough money to lend to People any more.

Case Study: Lehman Brothers Lehman Brothers Holdings Inc. was a global financial-services firm that did business in investment banking, equity and fixed-income sales, research and trading, investment management, private equity, and private banking. Reasons•

Lehman's loss was apparently a result of having held on to large positions in subprime and other lower-rated mortgage tranches when securitizing the underlying mortgages; whether Lehman did this because it was simply unable to sell the lower-rated bonds, or made a conscious decision to hold them, is unclear. In any event, huge losses accrued in lower-rated mortgage-backed securities throughout 2008.

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Investor confidence continued to erode as Lehman saw its share price plummeted more than 95%.

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In its June to August period last in 2007, the bank said it would make write downs of $700m as it adjusted the value of its investments in residential mortgages and commercial property.

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In 2008 this figure soared to $7.8bn, which resulted in Lehman reporting the largest net loss in its history.

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None of the U.S. banks wanted to trade with lehman brothers or wanted to buy it out because of its financial position. They still had $54bn of exposure to hard-to-value mortgage-backed securities.

The U.S. government didn’t bailout lehman brothers because it had already rescued Bear Stearns earlier in the year and it didn’t want to put the burden of the bank’s poor decisions on the shoulders of the American taxpayers. The U.S. Treasury believed a trading house like Lehman, which has little direct connection with retail markets and ordinary homeowners, could be allowed to go bust without causing the kind of systemic risk posed by Fannie and Freddie who almost owned half of the mortgage market.

Case Study: JPMorgan Chase & Co. JPMorgan Chase & Co.is a leading global financial services firm with assets of $2.1 trillion operating in more than 60 countries employing over a 200000. Their clients include millions of U.S. consumers and many of the world's most prominent corporate, institutional and government clients. They were one of the biggest banking groups which survived the sub prime crisis Reasons for JP Morgan’s Survival: •

JP Morgan’s Managing director said that they had a prudent internal control and risk management mechanism. A prudential management strategy with strict risk control is vital to fend off any crisis that may emerge.

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Several months before the U.S. subprime mortgage crisis surfaced in the spring of 2007, JPMorgan had detected accumulated risks associated with subprime mortgage securities and other complex structured financial products as the U.S. housing market bubble started to burst.

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The company then dumped those risky assets in the second half of 2006. In this way, JPMorgan had avoided major losses after it shied away from risky structured financial products unlike its other contemporaries like Lehman Brothers and Bear sterns

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JPMorgan has not recorded a group loss in any single quarter since the financial crisis broke out in the summer of 2007 unlike many of its peers in the United States and Europe.

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JPMorgan has a solid capital adequacy ratio which played a key role in helping it win clients during the time of crisis. At the end of the first quarter in 2007, JPMorgan has a capital adequacy ratio of 11.3 percent. *Banking groups are usually considered well capitalized if they have a capital adequacy ratio higher than 8 percent. •

A strong balance sheet boosted the confidence of investors in JPMorgan and helped the company expand its business despite prevailing market disruptions in the financial crisis.

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JPMorgan also benefited from some "anti-cyclical" measures, which included setting aside funds in booming business years to cover possible losses in bad years.

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Apart from increased financial activities, JPMorgan's strong quarterly performance was boosted by record revenue(8.3 billion dollars) and profit(1.6 billion) at its investment banking division, partly due to less severe market competition after the financial crisis took down several big-name U.S. investment banks like Bear Stearns and Lehman Brothers.

JPMorgan’s achievement is widely considered a major operational success as tremendous market volatility and severe global economic downturn has forced numerous U.S. and European banks and other financial institutions to go belly up or ask for government bailout money.

Summary From 2001-2004 when the U.S. mortgage market was booming the Federal reserve cut down the interest rates to as low as 1%. This made the availability of loans very easy. Banks decided to give loans to low credit worthy customers, i.e. sub prime customers (at higher interest rates. These loans were given without the otherwise strict regulations prevailing in the U.S. For instance sometimes the lenders didn’t even enquire about the income statement of the prospective borrower. So they gave the loans with ARMs (adjustable rate of mortgage). ARMs are when the rate of interest is fixed for a certain period of repayment and can be increased after that. These loans are divided into different grades-A,B and C respectively in the decreasing order of the credit-worthiness of the customers. The banks, to securitize these loans, create pools of multiple loans and sell them off to other financial institutions like investment banking institutions (e.g. lehman brothers) as packages at a lower price. For example if a bank/mortgage loan giving institution (like Fannie Mae and Freddie Mac) gives loans worth 100 million, creates a pools and sells them off to an investment banking institution, it will do so at a lower price, say 80 millions. Now it is the investment bank’s responsibility to collect the EMIs/repayment from the customers. Thus Lehman brothers being a high credit worthy, ‘prime’ institution can, on the collateral of these 80 million, leverage their position multiple times to take loans and float securities/bonds in the secondary market (Collateral Mortgage Obligations, Collateral Debt Obligations). Say, if they are able to leverage their position 10 times, they can take loans worth 800 million on the collateral of those 80 million. They convert these loans into securities and bonds and sell them in the secondary market. (Banks also invest in the secondary market). But to be on the safer side, they get their packages insured with insurance agencies (e.g AIG). Since such a trustworthy company was insuring them, the low grade packages were automatically declared higher grade by the credit rating agencies. So, in short some really risky bad mortgage loads were re packaged by the investment banks and then insured and converted in to AAA and BBB rated investments (Securities, Bonds, CDO’s, CMO’s). When the customers default with their EMI’s the first to be hit are the institutional investors because the investment banks stop their interest payments. Then a chain reaction continues. Since home loans were so easily available and property prices were faultily assumed to always be rising, property became the most popular way of investment. As a result of this the construction market boomed and there came a point where there were more houses than people willing to buy. The supply exceeded the demand. This was the point where the growing bubble finally burst. The property market crashed. All investors, including banks investing in property, lost out. The customers who took loans on home mortgages were not able to re-finance them, due

to the falling prices as well as the increasing ARMs. When the loans could not be recovered, the mortgages (houses) were captured but this hardly helped as the prices had fallen much lower than the value of the loans. Delinquencies increased exorbitantly.