An Introduction to the

Subprime Crisis in the U.S.

Acknowledgement: Finance professors Ranjini

Jha, Ken Vetzal, and numerous internet
resources.
The American Dream
 House Price

Soure: Office of Federal Housing Enterprise Oversight

 Real Salary Growth
0.06

0.04

0.02

0
ar
65
67
69
71
73

75
77
79

81
83
85
87
89
91
93

95
97
99
01

03
Ye
19
19
19
19
19

19
19
19

19
19
19
19
19
19
19

19
19
19
20

20
-0.02

-0.04

-0.06

-0.08

All private nonfarm workers. Source: Census Bureau

 Major Causes for the Housing Bubble
Mania for home ownership
Historically low interest rates
Risky mortgage products and lax lending
standards
Speculative fever
 Subprime mortgages
Subprime" refers to loans that do not meet Fannie
Mae or Freddie Mac guidelines. This is generally
due to one or a combination of factors, including
credit status of the borrower, income and job history,
and income to mortgage payment ratio.

Types:

ARMs
An interest-only loan
A stated income loan is a
mortgage where the lender does
not verify the borrower's income
(sometimes called "liar loans)
 An Example of Subprime Mortgage
Would you like a mortgage that lends you more than the value of
your house?
Would you like it structured so that your first payments are extra
low?
If the mortgage weren't structured that way, would you be unable to
afford the payments?
Are you convinced that real estate prices will continue to rise?
Do you have a poor credit history?

Congratulations if you answered "Yes" to most or all of those

questions! You're an ideal target for a subprime mortgage lender.

Adapted from cbc.ca

 Securitization: MBS & CDO
A mortgage-backed security (MBS) is a bond whose cash flows are
backed by the principal and interest payments of a set of mortgage loans.

Collateralized debt obligations (CDOs) are an unregulated type of asset-

backed security and structured credit product. CDOs are constructed from a
portfolio of fixed-income assets. These assets are divided by the ratings
firms that assess their value into different tranches.
CDOs
 Further: Credit Default Swap (CDS)

In the previous slide, the last tranche (usually non-rated, in

some form of equity) is very risky (a.k.a. toxic waste)

What do banks do with the toxic waste?

Buy insurance - Pay insurance premium to another financial institution
for underwriting the risk of the toxic waste
This is one form of credit default swap

The financial institution receives the premium regularly

It packages these and sells the insurance premium on toxic waste as
synthetic CDOs
Credit Default Swaps (CDS)
NYT, February 17, 2008
Speculative Fever (1)
Speculative Fever (2)
Speculative Fever (3): CDS Market
NYT, February 17, 2008
 Asset Quality
http://www.eurointelligence.com/Article3.1018+M58efe8bdb29.0.html
17 June 2008 - Satyajit Das

Under US accounting rules, asset must be classified into:

Level 1 (Mark-To-Market) - liquid assets or instruments that are actively

traded.

Level 2 (Mark-To-Model) - instruments that cannot be priced based on

trade prices but are valued using observable inputs.

Level 3 (Mark-To-Make Believe or Mark-to-Myself) - the asset or liability

cannot be priced using observable inputs and requires the use of
modeling techniques and substantially subjective assumptions.

Asset quality uncertainty can be gauged by looking at banks Level 3

assets
Asset Quality end 2007
Default rate rises markedly from 2005-
2006
 Chain Effect Leading to A Crisis

1. Surge in defaults and foreclosures

2. House prices fall
3. Prices of MBS plunge
4. Loss of financial institutions
5. FIs have too little capitaltoo few assets compared with
debt
This problem is especially severe because everyone took on so much
debt during the bubble years
6. FIs have been trying to pay down their debt by selling
assets, including those mortgage-backed securities,
but this drives asset prices down (no one is buying due to lack of
confidence and lack of liquidity)
and 3 starts again
This vicious circle is what some called paradox of deleveraging

--Based on Paul Krugman

Cash for Trash NYT (Sep 22, 08)
 Biggest losses/write-downs since the beginning of
2007, in billions of US$ as of April 2008
(Source: Bloomberg)

Citigroup $40.9
UBS $38
Merrill Lynch $31.7
Bank of America $14.9
Morgan Stanley $12.6
HSBC $12.4
JP Morgan Chase $9.7
IKB Deutsche $9.1
Washington Mutual $8.3
Deutsche Bank $7.5
Wachovia $7.3
Crdit Agricole $6.6
Credit Suisse $6.3
RBS $5.6
Mizuho Financial Group $5.5
Canadian Imperial Bank of Commerce $4.1
Socit Gnrale $3.9
 September Madness

Maybe basketball (March madness) is not your sports

 American Socialism?
Government bailouts
Bear Stearns ($29 bn loan guarantee)
AIG ($86 bn bridge loan)
Fannie Mae and Freddie Mac ($200 bn pledges of protection)

Through June 2008, the Fed had provided approximately $1.2

trillion in loans to various financial institutions through its
Term auction facility.

$700 bn (5% of US GDP) to purchase large amounts of

illiquid, risky mortgage backed securities from financial
institutions
 Related readings
(If you are on university network, you have no trouble accessing the papers below.)

Internet & media resources:

http://en.wikipedia.org/wiki/Causes_of_the_United_States_housing_bubble
http://en.wikipedia.org/wiki/Subprime_mortgage_crisis#Housing_downturn
http://news.bbc.co.uk/2/hi/business/7073131.stm
Book and papers
'The Subprime Solution, by Robert Shiller
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1112467
http://www.nera.com/image/SEC_SubprimeSeries_Part_II_FINAL_2-08.pdf
http://www.nera.com/image/SEC_SubprimeSeries_Part1_June2007_FINAL.pdf
(Accounting is responsible for the crisis?!)
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1108556 (Michael Brennan)
http://ideas.repec.org/p/fip/fednsr/318.html (understanding
securitization)