Subprime

MONETRIX SUBPRIME CONTAGION Ankit Taparia Nikhil Agarwal

SUBPRIME CONTAGION What are Subprime mortgages? What

are the mediums involved?

SUBPRIME LOANS: TECHNICALLY SPEAKING According to Fair Isaac Corporation FICO

score, loans with score below 680 are subprime loans.  These scores are calculated by factoring weightage to: Payment history  How much is owed  Length of credit history  New credit  Types of credit in use 

MEDIUM: COLLATERAL DEBT OBLIGATIONS Bankers pool together many risky loans to

borrowers with highly suspect creditworthiness They make bundles of these securities and market to investors with different appetites of risk Underwriter pulls together thousands of loans to serve as collateral; slices it into tranches with varying levels of risk and return Investors get hit in different ways in case of default High risk  slightly below investment grade  safe paper

MEDIUM: CREDIT DEFAULT SWAPS Creation of CDO only the first step Other banks offered protection against

probability of default on CDOs Second order derivatives; new income stream Could again be bundled and sold as third order derivatives

SUBPRIME CONTAGION

HOW SUB PRIME MIGHT END UP IN YOUR INVESTMENTS

CHAIN REACTION OF DEFAULTS People

began acting as if risk had disappeared Allowed people without financial health to buy houses No buyers for financial instruments backed by mortgages Housing bubble popped  Subprime meltdown  decrease in investor confidence about junk bonds Financial institution A can’t sell its mortgage-backed securities, so it can’t raise enough cash to make the payment it owes to institution B, which then doesn’t have the cash to pay institution C, and

HOW MARKETS GOT INTO A BEAR HUG Overnight interest rates shot up above the

central banks’ targets CP was used to finance Ninja mortgages given to people with no income, no jobs, no assets; CP market out of buyers Selling off a delinquent’s home might not yield enough collateral to pay back the loan Uncertainty regarding who holds the toxic paper

SUBPRIME CONTAGION

THE CULPRITS  Lenders who made lenient loans: Lenders began

proposing these structures as a way to make homes affordable; no documentation of borrowers’ income, only interest payment option, piggybacks  Home buyers who sought easy mortgages: Buyers putting less than 20% have little incentive to avoid default, piggyback mortgages free them from private insurance to protect the lender  Wall Street underwriters who turned them into securities: Purchase piggybacks to turn them into high-yield securities; shop around for higher ratings  Investors who wanted higher yields: Interest rates were low; their search ended here  Banks who are wary of counterparty risks: Accentuating the situation by sitting on cash,

BEHIND THE SCENE CULPRITS: THE CREDIT RATING AGENCIES  S&P believed a ‘piggyback’, where borrowers

simultaneously take out a second loan for down payment was no more likely to default than a standard loan  Assign top ratings to questionable securities- making them seem as safe as a treasury bond  Lucrative market- twice as high a fees for securities backed by home loans  Collaboration with underwriters- influence creation of such securities  Had the securities received the risky ratings as present, many mutual funds and pension funds would have been barred from buying them  Money managers lacked the resources to analyze pools of assets and relied on rating companies  Piggyback loans 43% more likely to default than others; still majority share of pool value are these (52%-Washington Mutual Inc)

SUBPRIME CONTAGION

TRIGGERS IN ACTION

TRIGGER 1: BEAR STEARNS (US)  Sponsored two hedge funds invested in subprime

paper  Most cash came from outside investors  Leveraged by borrowing from other banks  Investors tried to take out cash when subprime hit; Bear closed funds  Lenders demanded more collateral (margin call)  After initial refusal, the I-Bank had to provide a $1.6 bn. Credit line to least risky fund  Creditors seized the assets of the other fund  Suggested Bear had liquidity problems  How AAA ratings can’t be relied upon  Undermined confidence in mark-to-market model

MARK TO MODEL For a frequently traded asset, financial

institutions value it by looking it at market price Mortgage security tranches (‘Equity’  AAA) are not frequently traded  Valued by reference to mathematical models Ignores liquidity: selling in a hurry say on a margin call will only fetch what somebody is willing to pay <-BACK

TRIGGER 2: IKB (GERMANY) Virus crosses the Atlantic Focused attention on the CP market, till now

a risk-free investment IKB set up an off-balance sheet ‘conduit’ – Rhineland Funding Back-up loans and ‘credit enhancement’ used to proclaim loans as risk-free Funded itself with $19 bn. CP for securities, including subprime Banks providing back-up credit lines worried that CP market would seize up when investors realize how exposed Rhineland was to <-BACK dodgy

TRIGGER 3: LBO BUBBLE Banks initially provide debt, then syndicate

loans to others in market, taking a fee The banks got stuck up with a variety of loans they wanted to syndicate Two big deals: Chrysler and Alliance Boots $50 bn. Of LBO loans now stuck on their balance sheets with another $200+ bn. in the pipeline Reluctant to make any more financing Knock-out effect on share market <-BACK

TRIGGER 4:TROUBLE AT BNP PARIBAS 3 money market funds (even less riskier than

conduits)with assets of $1.5 bn. 35% invested in instruments exposed to subprime market “The complete evaporation of liquidity in certain market segments of the US securitization market has made it impossible to value certain assets fairly regardless of their credit rating.” Some parts of credit market had shut down No buyers for “certain assets” regardless of quality Credit ratings weren’t worth the paper they were written on

SUBPRIME CONTAGION

THE IMPACT Cushioned by high liquidity, bond markets

affected marginally Gap between risk-free T-Bills and Commercial Paper widened due to flight-to-quality Hindalco and Tata Steel shares suffer a large drop because of increased cost of funding for low grade bonds issued for acquisitions through their subsidiaries Dividend yields on many top stocks in U.S. have risen to tempting levels- stocks trading at a bargain PE firms rethinking the valuations of committed leveraged buyouts, for negotiating

SUBSEQUENT IMPACTS US Dollar actually went up against other

currencies- dollar a safe haven currency Gold and other commodities see a fall-fall in one asset class prompts a sell-off in others due to diversification in a hedge fund Top funds (Goldman Sachs, Highbridge, AQR, Renaissance) lose up to a third of investors money Yen Carry Trades unwind; strengthening of Japanese Yen Investors bought back short positions in a low-yielding currency Chain reaction of losses around the globe- for

BLOOD IN WORLD STOCK MARKETS DOW JONES

NSE

NEKKEI

KOSPI

EURO FIRST 100

SENSEX

ASX 200

HANG SENG

SUBPRIME CONTAGION

ALARM AT SEC SEC is checking the methods used by

brokers for asset valuation to check if they’re hiding losses Controversy because of marking-to-market; unlike listed stock or bonds, can’t be readily bought or sold Uncertainty in pricing and valuation; highly subjective models Repurchase agreements  Short-term loans secured by T-bills and bonds  Daily valuation of collateral  Ask for more cash or securities  Collateral seized in case of default

CENTRAL BANKS: AN EFFORT TO STABILIZE  FED :

released USD 24 billion on 9th Aug allows term financing for up to 30 days Mortgage backed securities, including unimpaired subprime securities, to be accepted as collateral  ECB : released 95 billion Euros on 9th Aug released 61 billion Euros on 10th Aug Banks could have any amount of money at the base rate 4%.  Bank of Japan released 1 trillion Yen on 10th Aug * already withdrawn the amount back  Central banks of Russia ($1.64 bn.) and Australia also pumped money in the system-however they withdrew on

AN EFFORT TO STABILIZE Reassessment or repricing of risk: U.S.

Treasury Secretary Fed cuts discount rate by 50 points to 5.75%, no cut in Fed funds rate Availability and not price of cash a troubleFed Ensure that credit for good quality paper doesn't dry up and give time to credit markets to work out repayment strategies for impaired loans Criticism: Banks have better options open (LIBOR=5.51%) People’s Bank of China raised the one-

SUBPRIME CONTAGION

THE INDIAN MORTGAGE MARKET: SAFER Loan to value ratio is modest Most home buyers end up paying certain

amount in cash, hence loan to value even lower than known Consumer Equity in property- can be sold on default No Indian bank or pure mortgage player offers the interest only payment option, unlike the US

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