Subprime Ppt

Presented By: Kaushambi Ghosh Manish Madhukar Mohit Almal Pankaj Agarwal 1

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Agenda Subprime •Traditional Model Vs Subprime Model •Players in the Game

Bubble •Housing Bubble Why it burst?

Global Crisis Impact Events Bailouts What Next? 3

Subprime

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Traditional Model Vs Subprime Model

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Players in the GAME

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Players Player 1: Fed -- Fed kept the interest rate low during much of 1990s and particularly 2001-2005 (low oil prices, and low inflation prompted the policy), fueling the market -- During the 2001-2005, FFR was in the 1% to 3% range, and mostly in the 1% range -- Fed encouraged more risky ARM lending (Greenspan) Player 2: Mortgage Salespersons -- Worked on commission based on the number of arms successfully twisted 10

Contd.. Player 3: Primary Lenders -- No incentives for judicious lending Banks no longer needed to hold on to the mortgage, as use of mortgage-backed securities made risk taking more appealing -- Use of ARMs with low teaser rates (below market rates for a while, followed by much higher rates tied to index, LIBOR + some %). Teaser rates are popular when long-term interest rates are at historical lows (like much of this period), as they help lenders benefit from ARMs as rates rise -- Net Effect: Many loans were made to NINJA’s (people with No Income, No Jobs or Assets). 11

Contd.. Player 4: Other Financial Institutions -- Freddie Mac and Fannie Mae issued many Mortgage Backed Securities -- Other financial institutions that traded in these as well as derivatives based on real estate assets. Many of these were global institutions 12

Contd.. Player 5: Credit rating Agencies and Analysts -- Lack of market for many of these securities, so models were used to price them -- Inflated ratings, mostly in A range (similar to T-Bills) -- Conflict of Interest: Investment bankers’ analysts were rating investment bankers’ clients (scandal) -- For example, 3 months prior to its demise, AIG was rated strong buy (8 analysts), buy(3), hold (10))!!! Player 6: Home Buyers (Taking Excessive Risk) -- Home buyers were enjoying the ride -- New ones were joining the ride, even if unqualified -- Home ownership up from 60% in 1990s to 70%

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Bubble

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Historic Bubbles Dutch Tulip Mania South Sea Bubble British Railway Bubble US Railway Bubble Roaring Twenties Multi Bubble Internet Bubble Housing Bubble

(1630s) (1710s) (1840s) (1880s) (1920s) (1960s) (1990s) (2000s)

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Structure of a Bubble  Displacement

(diffusion of new technology starts)

 Take off

(stock prices show abnormal increase)

 Exuberance

(stock prices grow at very high rate)

 Critical Stage

(stock price growth slows down)

 Crash

(stock prices start tumbling)

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Population Dynamics in the Course of a Bubble

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Housing Bubble

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Why housing bubble burst????

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Process of Securitization

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Recap: Causes Boom and bust in the housing market

High-risk mortgage loans and lending practices Securitization practices Speculation

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Contd.. Inaccurate credit ratings Government policies

Policies of central banks Financial institution debt levels and incentives Credit default swaps 27

How bubble burst led to crisis???

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How did this turn into a crisis ? Step 1 - The housing boom in the US started fading out in 2007

Step 2 - Boom had led to massive increase in supply of housing Step 3 - Thus House prices started falling

Step 4 - This increased the default rate among sub-prime borrowers Step 5 - These borrowers were no longer able/willing to pay high price for a house that was declining in value Step 6 – Security/Guarantee being the house being bought , this increased the supply of houses for sale while lowering the demand, thereby lowering prices even further and setting off a vicious cycle 29

Ripple Effect-Suck Everything The housing bubble Defaults & write A hole in the bubble Banks go belly-up Banks get sucked in 30

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How it Unfolded???

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Impact

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Banks

Writedown($ billion)

Actions

Citigroup

55.1

Bailout by Fed Reserve($326 billion)

Merrill Lynch

51.8

Taken over by Bank of America

UBS

44.2

$5.3 billion Swiss government bailout

HSBC

27.4

Wachovia

22.5

Bank of America

21.2

Royal Bank of Scotland

14.9

Morgan Stanley

14.4

JP Morgan chase

14.3

Lehman Brothers

8.2

Files for Bankruptcy

AIG

18.5

bailed out by Federal reserve

Wells Fargo

bank holding companies

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Crashing Stock Indices 30000

Value

25000 20000 15000

10000 17th Jan' 2008

5000

25th Nov' 2008

0

Indices 37

List of events

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Date

Events

8th September

Fannie Mae/Freddie Mac placed into conservatorship by U.S. Government

14th September

Bank of America agrees to purchase Merrill Lynch for $35B

15th September

Lehman Brothers declares bankruptcy

16th September

Reserve Primary Fund “breaks the buck” U.S. government seizes control of AIG in $85B bailout

18th September

Treasury Secretary Paulson announces bailout plan

19th September

Governments worldwide announce short selling restrictions Treasury establishes Temporary Guarantee Program for money market funds

21st September

Fed allows investment banks Goldman Sachs and Morgan Stanley to become bank holding companies

23rd September

Warren Buffett announces $5B investment in Goldman Sachs

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Date

Events

25th September

Washington Mutual is seized by FDIC; assets sold to JPMorgan for $1.9B

29th September

Citigroup agrees to acquire Wachovia with FDIC guarantee; a private transaction with Wells Fargo is later announced First bailout bill is rejected by U.S. House of Representatives

3rd October

- Congress passes TARP legislation

FDIC temporarily increases deposit insurance to $250,000 7th October

Fed announces Commercial Paper Funding Facility (CPFF)

8th October

Coordinated rate cut by central banks around the globe

13th October

Mitsubishi UFJ finalizes $9B equity investment in Morgan Stanley

14th October

Mitsubishi UFJ finalizes $9B equity investment in Morgan Stanley Treasury announces TARP Capital Purchase Program

21st October

Fed announces Money Market Investor Funding Facility (MMIFF)

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Loss in crisis 1000 900 800 700 600 500 Expon. (Series1) 400 300 200 100 0 savings and loan crisis(198695)

Banking crisis(1990-99)

Banking Crisis(98-99)

Subprime crisis(2007-present)

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IMF raises the loss amount to 1.4 trillion dollars

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Country wise Action United kingdom Has lined up a $850-billion rescue plan, May nationalise Royal Bank of Scotland Will recapitalise banks by up to $88 billion. Abbey, Barclays, HSBC, Llyods, Standard Chartered, HBOS and Nationwide Building Society can draw from an aggregate of $44 billion to boost their Tier 1 capital Bank of England will infuse liquidity of $351 billion through loans The government will guarantee $439 billion worth of short-and-medium term debt Britain has seized control of mortgage lender Bradford & Bingley Earlier this year nationalised Northern Rock Alarm: The total liabilities of Barclays of £1,300 billion (leverage ratio of over 60), surpass Britain's GDP

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Contd.. Belgium The government took partial control of the struggling Fortis Bank France, Belgium and Luxembourg stumped up $93 billion to recapitalise Dexia, a French-Belgian lender that ran up huge losses in its US operations Alarm: Fortis Bank's liabilities are several times larger than the GDP of Belgium (leverage ratio of 33)

Iceland The government has nationalised three of Iceland's biggest banks Accounts in these banks stand frozen 44

Contd.. United states May pick up ownership in failing US banks (Morgan Stanley is reported to be one) Fed ready to lend directly to stressed companies

Germany Has guaranteed all bank deposits Has organised a credit lifeline of euros 35 billion for blue-chip commercial real estate lender Hypo Real Estate Holding Alarm: The total liabilities of Deutsche Bank (leveraging ratio of over 50) amount to 2,000-billion euro, which is more than 80 per cent of the GDP of Germany

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Contd.. Singapore  Eased monetary policy for the first time since 2003 after sinking into its first recession in six years, hit by the meltdown in financial markets  The government revised its 2008 growth forecast to around 3 per cent from an earlier estimate of 4 to 5

Italy  UniCredit Bank has announced plans to raise its capital ratio by spinning of property assets

Ireland  Has guaranteed all bank deposits

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Contd.. Spain Will spend 50 billion Euros ($68 billion) to buy bank assets, almost a third of the proposed 2009 central government budget

Japan Yamato Life Insurance failed with $2.7 billion in debt The government may revive a bank-rescue law of the 1990s banking crisis Tokyo may set up a $100-billion fund to prop up smaller lenders Alarm: Real estate companies are folding up, forcing regional banks to raise reserves against bad loans 47

Bailout Ben

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Rationale for the Bailout Stabilise the Economy

Improve Liquidity Comprehensive Strategy Immediate and Significant Broad Impact

Second Bailout of $800 billion announced yesterday by FED

Investor Confidence Impact on Economy and GDP 49

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When the music stops in terms of liquidity, things will get complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing. Chuck Prince, Citigroup

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Now What???

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Liquidity Crunch The reduced availability of liquidity Interest rate premiums U.S.: Banks not lending to each other ROW: London Interbank Offered Rate (Libor) Libor is used to set rates on the $360 trillion of financial products worldwide. Three month Libor set an all time high last week at 5.34%.

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Overview of Credit Exposures and Estimated Losses (September 2008; billions of US dollars) Amount Outstanding

Estimated Losses

Residential Credit: Depository Institution Loans Non-Agency Securities GSE Exposures Subtotal

$2,889 $2,531 $4,807 $10,227

$308 $523 $76 $907

Non Residential Credit: Loans Non-Agency Securities Subtotal

$7,670 $5,440 $13,110

$195 $475 $670

Total

$23,337

$1,577 54

Estimated Costs of Banking Crisis Country

Period

Estimated Cost as % of GDP

United States

1980

2.5 %

Japan

1990

20.0 % est.

Norway

U.S.A.

1987-89

4.0 %

Korea

1997

60.0 % p

Indonesia

1997

80.0 % p

2007-2010

$700 billion = 5.0 % $1600 billion = 11.4 % $3200 billion = 22.8 %

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Is Depression Imminent: During the Great Depression Combined GDP of 7 largest economies dropped by 20% during 1929-1932 There were no deposit insurance, so people withdrew money from banks and many banks failed Fed increased interest rate (!!) and reduced liquidity  U.S. imposed heavy tariffs and other countries reciprocated lowering world trade by 70% The situation is much different as a lot is learned from experiences of the Great Depression 56

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