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2007
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Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012
The worst financial crisis since the 1930s started in 2007 in the
United States.
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Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012
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Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012
What happened
This, combined with very low interest rates, increased the demand for real estate
and prices rose.
Rising house prices meant that the lending was well covered by the underlying
collateral. If the borrower defaulted, the foreclosure would lead to little or no loss.
To continue to attract first time buyers and keep prices increasing they relaxed
lending standards further
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Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012
What happened
Bad practices: Features of the market: 100% mortgages, ARMs, teaser rates,
NINJAs, liar loans, non-recourse borrowing
ARM Adjustable rate mortgages: they had a low rate of interest for two or three years and be
followed by a much higher rate.
NINJAs No income, No jobs, No assets. Sometimes, the applicant income reports were not even
checked.
Borrowing was only guaranteed by the underlying asset. The borrower had no legal responsibility
for the repayment of the loan. This encouraged free riding by borrowers as they had an implicit
PUT option on their investment. As long as they understood they had a negative equity, some of
them chose to default.
Political interference: The US government had since the 1990s been trying to
expand home ownership, and had been applying pressure to mortgage lenders to
increase loans to low and moderate income households.
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Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012
What happened...
This abuse by borrowers meant that while in normal crisis a lender can expect
to recover around 75% of the amount owing in a foreclosure, in 2008 and
2009 recovery rates were as low as 25%.
In 2007 the bubble burst. Some borrowers could not afford their payments
when the teaser rates ended. Others had negative equity and recognized that
it was optimal for them to exercise their put options.
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Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012
What happened...
However this time the quality of the underlying mortgages was often very low,
with key information lacking.
Banks found it profitable to invest in the AAA rated tranches because the
promised return was significantly higher than the cost of funds and capital
requirements were low (due to high ratings).
U.S. real estate prices fell and products, created from the mortgages, that were
previously thought to be safe began to be viewed as risky
There was a flight to quality and credit spreads increased to very high levels
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Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012
Asset 1
Asset 2
Asset 3
SPV
Mezzanine Tranche
Principal:$20 million
Return = 10%
An asset-backed security
(ABS) is a security created
from the cash flows of
financial assets such as loans,
bonds, credit card receivables,
mortgages, auto loans,
A waterfall defines the precise
rules for allocating cash flows to
tranches
Asset n
Principal:
$100 million
Equity Tranche
Principal: $5 million
Return =30%
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Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012
The Waterfall
Asset
Cash
Flows
Senior
Tranche
Mezzanine Tranche
Equity Tranche
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Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012
ABSs
Subprime Mortgages
Different thicknesses
(25% vs. 10%) but
SAME AAA rating: is
this reasonable ?
ABS CDO
Senior Tranche (75%)
AAA
Mezzanine Tranche
(20%) BBB
Equity Tranches (5%)
Not Rated and usually retained
or sold to a hedge fund
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Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012
Losses on
Subprime
portfolios
Losses on
Mezzanine
Tranche of
ABS
Losses on
Equity
Tranche of
ABS CDO
Losses on
Mezzanine
Tranche of
ABS CDO
Losses on
Senior
Tranche of
ABS CDO
10%
25%
100%
100%
0%
15%
50%
100%
100%
33.3%
20%
75%
100%
100%
66.7%
25%
100%
100%
100%
100%
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Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012
Subprime
Mortgages
Junior AAA
5%
AA
3%
2%
BBB
ABS
AAA
81%
AA
11%
88%
NR
1%
1%
4%
BBB
3%
Senior AAA
62%
Senior AAA
60%
Junior AAA
14%
Junior AAA
27%
AA
8%
AA
4%
BB, NR
1%
A
BBB
NR
CDO of CDO
6%
6%
4%
A
BBB
NR
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Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012
3%
3%
2%
BBB Tranches
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Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012
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Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012
Importance of Transparency
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Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012
The subprime crisis was not the cause of our problems, it was just
the first link to be broken because it was the weakest.
Financial markets do play a role in the crisis, but they reflect the
overall degree of debt in the economy and the different connections
among social groups (savers and borrowers).
The western world faces a great demographic challenge that requires
an ever increasing social spending that at least since the 80s is not
being matched neither by productivity gains nor by base increasing
(i.e. more population or worked hours) GDP growth.
This fuelled the temptation to use debt as a way to replace real,
fundamental-justified increase of living standards.
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Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012
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Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012
This crisis is then a DEBT crisis, originated in the public and private sector
of most western economies, and accumulated in banks balance sheets.
The housing bubble and the subprime mortgage disaster are specific
episodes, but they are only part of a wider and structural overindebtedness problem which helped (in good years) to hide the fact that
living standards were already stagnating in the west and that only debt
could keep on increasing such levels of welfare.
The social contract is at risk. Debt is a burden for future generations,
(which do not even vote our deficit budgets). Pensions and health services
are at the center of a problem with demographic and social roots that
threatens the very core of our political system and intergenerational implicit
agreements.
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Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012
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Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012
Homework
Work in pairs to prepare up to 5 slides with a global overview of the
mortgage market in your home country:
-Which is the market share of home ownership vs. home rentals ?
-Which are the main features of mortgages? (fixed/floating, average
maturity, average cost, average household indebtedness)
-How has the housing market reacted to the global financial crisis:
increase/decrease in prices since 2007, non performing loans for banks,
-Were mortgage lending standards relaxed in the boom times? How?
-Which changes do you foresee in the way banks would assess in the
future credit risk arising from house mortgages?
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Risk Management and Financial Institutions 3e, Copyright John C. Hull 2012