Sai Kumar Swamy,

PGDM, IIM Bangalore

Agenda

Definition
CDO

Prime
Advantage

Sub-Prime
MBS & CDS

Origin of Crisis
Linkage

Why did the bubble
End Game
burst?
How the cookie formed?

Interesting stats
How the cookie crumbled?

Why did the Financial
Giants collapse?

The answer
Prime

Prime Borrower

Borrow < 80 %

Good credit bureau record

Monthly payment < 25 % income

Good Credit Score

Banks like them - Credit Worthy

Safe
Lower Interest rate

Pay Lower Mortgage Rates
Subprime

Subprime Borrower

Tarnished credit records

Low Credit score

Borrow a higher proportion

High Mortgage to Income ratio

Banks are wary of these customers

Risky
Higher Interest rate

Pay Higher Mortgage Rates
Origin of Crisis - 1

Housing Bubble
2001- 2005

Housing prices increase

Cheaper Credit

Federal Reserve Lowers the federal Funds Rate

From 6.5% to 1.75 % between May 2000 and December 2001

Greater Access to Credit

Sub-Prime Market

Mortgages to risky individuals

Increase in Buyers
Origin of Crisis - 2

Sub-prime mortgages

Government Policies

ECOA - 1974

CRA - 1977

Competitive pressures

Increase in loan incentives

Easy initial terms

ARM (ARM – Adjustable Rate Mortgages)

Rising Housing prices

Dropping interest rates
Origin of Crisis - 3

Housing prices peak in mid-2006

Building boom

Fresh Supply created to exploit market conditions

Surplus of homes

Housing Bubble Bursts

Home Sales fall

Supply exceeds Demand

More Sellers than Buyers

Prices of Houses decrease

WHY??

Housing Construction Declines

Slowdown in US Economy
Why did the bubble burst?

No clear cut reason – Many factors responsible

Factors

Greed of Borrowers

ARM

Refinancing doldrums

Supply glut

Led to Foreclosures

Started vicious cycle

Supply of homes Prices Homeowners
Equity
Interesting Stats - 1

Increase in Home-ownership rate

64% in 1994 – 70% in 2004

Increase in Housing price

1997-2006 – Increased by 124%

Median Home price

2001
2.9% of Median Household Income

4% in 2004 & 4.6% in 2006

Household Debt

77% in 1990

127% in 2007 (Is it 27% or 127%?)

Unsold Homes

4Mn homes for sale

2.9Mn of these were vacant!!
Interesting Stats - 2

Household Debt

$705Bn – 1974

$7.4Tn – 2000

$14.5Tn – 2008

Household debt as % of Disposable Income

60% – 1974

134% in 2008
The Answer

CDO

Collateralized Debt Obligation

MBS

Mortgage based Securities

CDS

Credit Default Swaps
CDO

A structured credit product

Is an Asset backed security

Based on pools of assets

Collateral – Cash flows from this pool of assets

Securitization makes these assets available for
investment

Ex: Credit Card payments; Auto loans; Home loans

Constructed from a portfolio of fixed income assets

Traded in the market
CDOs Credit Ratings

Senior : AAA

Mezzanine
AA to BB

Equity : Unrated
Advantage

Brings together a pool of assets which otherwise cannot
be traded easily

Pooling converts them into tradable instruments

Securities can be further broken into discrete tranches

Helps market them to investors with different risk appetites

Lowers risk for originator

When the pool performs badly the owner takes the loss

The originator earns fees for servicing the asset pool

Originator earns money with NO residual liability

Downside

Originator has NO incentive to reduce risk

Originator works toward Loan Volumes than Loan Quality
MBS

Is an Asset backed Security

Backed by

Principal

Interest Payments

Federal National Mortgage Association (FNMA or Fannie
Mae)

Buys Mortgages and sells them as MBS to investors

Formed in 1934 and privatized in 1968

Federal Home Loan Mortgage Corporation (FHLMC or Freddie
Mac)

2nd player in the MBS market

Formed in 1970
Gi AAA ti d ld th ld
CDS

Contract

in which the buyer of CDS makes a series of payments to the
seller to indemnify against a loss on the Credit instrument

Ex:

Investor buys CDS from KLM Bank for XYZ Corporation

Investor makes regular payments to KLM till such time that XYZ defaults

If XYZ defaults then KLM pays investor a ONE-OFF payment

The CDS is terminated

Invented by JPMorgan in 1997
End game - 1

Bankruptcies - 2007

February – March

Subprime Market Collapses

April 2

One of the largest US Subprime Lender New Century
Financial files for Bankruptcy

US Government Interventions – 2007

August 17th , September 18th , Oct 1st

Fed lowers discount rate

New Hope Alliance created by US government to help
some subprime lenders
End Game - 2

November 1

Fed injects $41Billion into Money Supply for banks to Borrow

March 14

Bear Sterns gets Funding from Fed
Acquired by JP Morgan on
March 16th

Sept 7

Federal Reserve takes over Fannie Mae and Freddie Mac

September 14

Merrill Lynch sold to Bank of America

September 15

Lehman Bros. files for Bankruptcy

Sept 17

Fed loans AIG $85 Billions

Sept 19

Paulson unveils Financial Rescue Plan
ECOA - 1974

Equal Credit Opportunity Act

Seeks to outlaw

Discrimination of loan applicants on the basis of

Race

Color

Religion

National Origin

Marital Status

Sex

Age
FI’s subject to Civil Liability
CRA - 1977

Community Reinvestment Act

Seeks to address

Discrimination of applicants based on

Area & Neighborhood

No civil liability

No specific criteria to evaluate compliance

Rating assigned -

“Managers of financial institutions found that these loan portfolios, if properly

underwritten and managed, could be profitable“ - Ben Bernanke

“Usually did not involve disproportionately higher levels of default” - Ben
Bernanke
ARM – Adjustable Rate
Mortgages

A loan where the interest rate is periodically adjusted

Salient Features

Initial rate

Adjustment period

Index rate – Treasury securities, LIBOR etc.

Margin

Discounts

Negative amortization
US Home Sales Inventory
Foreclosures
Vicious Cycle - Foreclosures
How the Chain works
Leverage Ratios – Investment
Banks
How the Cookie Formed!
How the Cookie crumbled!
Sub-Prime Mortgages