The Subprime Mortgage

Crisis
MENAIL GHANI
MUHAMMAD ALI SHAH
MEHAK MASOOD
URFA RUBAB
RABIA YOUSAF
 Presentation Agenda
 Subprime mortgages
 Subprime Loans
 Housing bubble
 Main Players
 The Aftermath
 Implications
 Subprime mortgages
 A subprime mortgage is a type of loan granted to
individuals with poor credit histories.
 They charge interest rates that are above the typical interest

rate because of the risk that is involved on the part of the

lender.
 There are several different types of subprime mortgages,

but the most common is the adjustable rate mortgage

(ARM).
 ARMs can be misleading to subprime borrowers because

they initially pay a lower interest rate then the rate goes up
after some time.
 Types of Subprime Loans

 Interest-loans.
 ARM loans.
 Negative Amortization Loans
 Ultra-long fixed rate loans
 Balloon Loans
 No-money –down loans
 Events leading to Crises
 Housing price increase during 2000-2005, followed by
a levelling off and price decline
 Increase in the default and foreclosure rates beginning
in the second half of 2006
 Collapse of major investment banks in 2008
 2008 collapse of stock prices
 -20.0%
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Default Rate

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 Credit Enhancement and the Crash
of 2008

 The recent mortgage crisis discredited the use of credit

enhancement as a valid financial practice.
 Credit enhancement results in a faulty credit ratings as

it artificially inflates them.

 This in turn allows for those with bad credit ratings to

secure high-risk loans with an even higher risk of

defaulting
 Continued
 Because of credit enhancement, many credit rating
agencies such as Standard’s and Poor could not give
out accurate ratings.

 Many homeowners were allowed risky loans based on

faulty credit ratings. This led to many loan defaults and
home foreclosures.
 How did the housing bubble
develop?
 The housing bubble grew alongside the stock bubble in the
mid 1990s.
 The stock bubble increased the wealth of people, which led

them to spend money on consumption including bigger and

better houses.
 The increased demand led house prices to rise

 Also going on at this time was the slow recovery from the

2001 recession. This led the Federal Reserve Board to cut

interest rates in an effort to stimulate the economy.
 Between 1997 and 2006, the price of the typical American

house increased by 124%

 Major Causes for the “Housing
Bubble”

 Housing prices go up because demand goes up.

 Housing bubbles usually start with an increase in

demand , in the face of limited supply which takes a

relatively long period of time to replenish.
 Speculators enter the market, believing that profits can

be made through short-term buying and selling. This

further drives demand.
 It is impossible to predict and difficult to detect !
Why did the Housing Bubble Burst?
 Home prices reached their peak in the second quarter of 2006.
They did not fall drastically at first.
 Home prices fell by less than 2 percent from the 2nd quarter of
2006 to the 4th quarter of 2006.
 The foreclosure start rates increased by 43 percent over these two
quarters, and increased by 75 percent in 2007 compared to 2006.
 This implies that mortgage default rates began to rise as soon as
home prices began to fall.
 Just as rising home prices reinforced the continuing rise in home
prices, falling home prices reinforced the continuing fall in home
prices.
Continued
The increase in foreclosures added to the inventory of
homes available for sale.
 This further decreased home prices, putting more

homeowners into a negative equity position and leading to

more foreclosures.
 The increase in foreclosures also decreased the value of

mortgage-backed securities.
 This made it difficult for investment banks to issue new

mortgage-backed securities, eliminating a major source of

financing for new mortgage loans and contributing to the
continuing decline in home prices.
 Risky Lending

Americans
lost more than
a quarter of
their net
worth.
At the end of
2008, S&P
500 (stock
market) was
down 45
percent from
the high in
2007
The bursting of the housing bubbles
led to enormous losses

 Most of the losses were not incurred by homeowners

but by the financial system.
 Large losses were incurred by the following groups:

1. Mortgage lenders
2. Investment banks
3. Foreign investors
4. Insurance
 The bursting of any housing bubble would be expected to
have a negative effect on the economy for two reasons:
A. Home construction is an important economic activity, and
the decline in home construction would reduce GDP.
B. The decrease in home prices would also reduce household
consumption due to the wealth effect.

 But the bursting of this housing bubble caused more severe

and widespread harm than would be predicted from just these
two reasons.
 As mentioned previously, most of the losses were suffered by
the financial system, not by the homeowners. The bursting of
the housing bubble sent a shock through the entire financial
system.
The Subprime Mortgage Crisis Explained:

 Default.
 Auction.
 The bank sells the home.
 Increase in supply of homes
in the market.
 Billions of dollars were lost
in mortgage backed
securities
 Mortgage backed security
 Main Players

 The Federal Reserve

 Continued Reduction in Fed Rates
 Sudden increase in Money supply
 Rates remained low till 2005
 High Liquidity
 Continued
 2. Commercial Banks
 Lowered to lending rates to increase loan off take.
 As the prime market was nearing saturation, began

lending to subprime borrowers.

 Aggressively sold MBS, CDO.
 Additional funds raised by securitization was re-

deployed in the same manner.

 Non-traditional mortgages.
 MBS ratings influenced using parental linkages as well

as rating shopping
 Continued
 3.Home buyer
 Buying property well beyond their means.
 Buying for price arbitrage.
 Non-traditional mortgages leveraged their borrowing

capacity further.
 2yrs fixed rate, then floating rates: EMIs rose

exuberantly, house value fell.

 Thus making foreclosure a viable option.
 Accelerated downward spiral
 Continued

 4. Investment Banks
 Increased use of Secondary mortgage market
 Lenders sold their mortgages in the secondary market.
 Pooled mortgages into securities like CDOs and MBS
 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.
 Credit Default Swap (CDS)

 A swap contract
 The protection buyer makes a series of payments to the

protection seller and receives a payment if the credit

instrument experiences a credit occurrence (i.e.
defaulting on a loan)
 Typical credit instruments of CDSs are bonds and loans
 CDS and the Crash of 2008
 In 2007, the outstanding amount in credit defaults was
$68.2 trillion.
 By the end of 2008, that number had shrunk to $38.6

trillion.
 AIG’s potential losses due to irresponsible CDSs

reached a whopping $100 billion.

 The U.S. government had to bail out AIG due to risky

lending.
 The Aftermath
 There was a total of 2.2 million foreclosures in 2007,
up 75% from the roughly 1.26 million RealtyTrac
reported in 2006. RealtyTrac said 1% of all US
households were in 'some stage of foreclosure' in 2007,
up from 0.58% in 2006.
 By the end of 2008, home prices had dropped 20%
from their 2006 peak.
Lessons from the Great Depression
Avoid these policies:
Monetary contraction
Trade restrictions
Tax increases
Constant changes in policy; this merely creates
uncertainty and delays private sector recovery.
 Conclusion
 The rising house price and the healthy
economy boost the lenders to loan money to
people who had low credits. No one thought
about the upcoming disaster that struck the
United States' real-estate market.
 The house price went down, and the subprime

mortgage borrowers couldn't pay neither the

interest rate nor the debt because the value of
the house they bought went down.
Unemployment increased in the United States
and the economy was ruined.
 This eventually caused economic crisis all
over the world and brought disaster to all the
banks. Even though the crisis is now very
much relieved, there are still many victims of
the subprime mortgage crisis suffering from
financial crisis and in addition, credit crisis.
Because of the subprime mortgage crisis in
the United States, it caused the world once
more to reconstruct and refinance their
economic situation.