An overview of the US subprime crisis
Structure of this update <ul><li>Outline of the current crisis </li></ul><ul><li>Implications of the current situation </l...
Subprime Mortgage Market is in trouble <ul><li>More than 50 subprime lenders have folded up </li></ul><ul><li>HSBC had dir...
A wobbly subprime market <ul><li>Leading indicators of defaults in loans are gone up substantially </li></ul><ul><ul><li>D...
Implications of the current state <ul><li>When a homeowner defaults, he loses his home </li></ul><ul><li>An indicator of l...
… Implications… <ul><li>Home prices have dropped </li></ul><ul><li>Industries that support home building have slumped: cem...
How did we get here… <ul><li>“ Innovation has brought about a multitude of new products, such as sub-prime loans… Where on...
The Sub prime business <ul><li>The subprime market refers to lenders who are happy to lend to those with a poor risk profi...
Negative aspects of subprime lending <ul><li>Subprime borrowers are even more likely to default, because of their characte...
Economics and default risk Incomes tend to rise; ability to borrow improves  Banks are also keen  to lend so that the boom...
Theoretical background <ul><li>It should be noted that prudent financiers always appear to lag behind in a boom time </li>...
What is being done <ul><li>Refinancing of “risky” mortgages is a solution </li></ul><ul><li>Keeping borrowers solvent has ...
What is being done <ul><li>FNMA (Fannie Mae) and FDMC (Freddie Mac) have been intervening </li></ul><ul><li>They are buyin...
Two heroes: Freddie Mac and Fannie Mae <ul><li>Thus, the distressed assets will cease to be distressed and their value wil...
Role of Fannie Mae/ Freddie Mac <ul><li>Buy assets from other lenders, releasing money to them </li></ul><ul><li>They hold...
Things to watch Signals and impact in the Bond and CDO market
How did subprime lending impact banking sector? <ul><li>Sub prime lenders are in the unregulated space, and their access t...
CDOs and Mortgage Defaults
Story of a CDO sold by Credit Suisse <ul><li>Return of 10% p.a </li></ul><ul><li>Yield on similarly rated bond: 8% p.a </l...
This particular issue had <ul><li>Risky debt including junk bonds </li></ul><ul><li>But also a large chunk of subprime hom...
The role of ratings… <ul><li>Rating leads to a perception of safety which is not based on reality </li></ul><ul><li>Rating...
However, CDO building/ Securitisation is… <ul><li>Not equivalent to rating corporate debt </li></ul><ul><li>It is financia...
… CDOs continued.. <ul><li>The subprime paper is built into a number of CDOs over the last few years </li></ul><ul><li>The...
… CDOs continued.. <ul><li>It is now apprehended that as homeloan defaults widen, and as the subprime problem deepens, the...
Mortgage/ subprime exposure <ul><li>Has caused global ripples </li></ul><ul><li>Because of indirect exposure through MBS/B...
The Bond Market <ul><li>Bond investors have stopped funding leveraged buyouts, in anticipation of a mortgage crisis led by...
Bond markets  <ul><li>Lenders see combination of factors </li></ul><ul><ul><li>Worst slump in housing prices ever since th...
In Conclusion… <ul><li>Nouriel Roubini, economics professor at New York University, says the housing bust is slowly pullin...
Soothing words from the Fed <ul><li>Last week the Fed left rates unchanged; undoubtedly an increase would have brought a w...
The last word has not been said on this topic…
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Housing Market In USA

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Housing Market In USA

  1. 1. An overview of the US subprime crisis
  2. 2. Structure of this update <ul><li>Outline of the current crisis </li></ul><ul><li>Implications of the current situation </li></ul><ul><li>How did we get here </li></ul><ul><li>Theoretical background: the link between economic cycles and defaults </li></ul><ul><li>Events to watch </li></ul><ul><ul><li>Bond market </li></ul></ul><ul><ul><li>CDO </li></ul></ul><ul><ul><li>Recovery plans </li></ul></ul>
  3. 3. Subprime Mortgage Market is in trouble <ul><li>More than 50 subprime lenders have folded up </li></ul><ul><li>HSBC had direct exposure in the subprime market and took a significant write off, issuing profits warnings for the first time in its history </li></ul><ul><li>Events of default have gone up substantially </li></ul><ul><ul><li>Default notices, </li></ul></ul><ul><ul><li>auction sales, </li></ul></ul><ul><ul><li>repossessions </li></ul></ul><ul><ul><li>are all up dramatically </li></ul></ul>
  4. 4. A wobbly subprime market <ul><li>Leading indicators of defaults in loans are gone up substantially </li></ul><ul><ul><li>Delayed payments </li></ul></ul><ul><ul><li>Overdue past 60 days </li></ul></ul><ul><ul><li>More problems in loans made in 2006 than in 2005 </li></ul></ul><ul><li>These are leading indicators of default: if a loan has been well serviced for a number of years, probability of default is low because the borrower has greater equity in the property </li></ul><ul><li>When markets wobble (especially after a boom phase) and house prices drop, those who took loans just very recently are more likely to default than those who took loans a few years ago </li></ul>
  5. 5. Implications of the current state <ul><li>When a homeowner defaults, he loses his home </li></ul><ul><li>An indicator of likelihood of default </li></ul><ul><ul><li>Balloon payments in the loan contract </li></ul></ul><ul><ul><li>Interest rates with resets which are bound to result in high rates, as market rates rise </li></ul></ul><ul><ul><li>These features are to be found in subprime loans </li></ul></ul><ul><li>Foreclosures tend to trigger economic downturns because they impact consumer confidence which makes the markets further tank </li></ul><ul><li>Housing accounts for 23% of US GDP </li></ul><ul><li>2.2 million homeowners with upto US$ 164 bn face the risk of foreclosure </li></ul>
  6. 6. … Implications… <ul><li>Home prices have dropped </li></ul><ul><li>Industries that support home building have slumped: cement, construction companies etc.; so also their stock prices </li></ul><ul><li>A basket of bellwether stocks that reflect the state of the housing market have hit new lows, clearly heralding bleaker conditions </li></ul><ul><li>Home building has traditionally led recessions and recoveries </li></ul><ul><li>US-wide, policy makers and politicians are worried about the adverse economic impact of a wider recession </li></ul>
  7. 7. How did we get here… <ul><li>“ Innovation has brought about a multitude of new products, such as sub-prime loans… Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in sub-prime mortgage lending… fostering constructive innovation that is both responsive to market demand and beneficial to consumers.” </li></ul><ul><li>So said Alan Greenspan, then chairman of the US Federal Reserve, on 8 April 2005. </li></ul><ul><li>He was referring to the positive effects of the subprime lending business </li></ul>
  8. 8. The Sub prime business <ul><li>The subprime market refers to lenders who are happy to lend to those with a poor risk profile </li></ul><ul><li>Since no one else will lend to them, these people are happy to pay higher rates so long as they get loans </li></ul><ul><li>Therefore, subprime lenders enjoy a higher yield on their assets </li></ul><ul><li>Subprime loans are usually floating rate loans and impose stiff penalties on defaults </li></ul><ul><li>Subprime loans rose from 5% of all origination in 1995 to 16% by 2006 </li></ul><ul><li>When markets stumble it is the weak borrowers who default first </li></ul>
  9. 9. Negative aspects of subprime lending <ul><li>Subprime borrowers are even more likely to default, because of their characteristics in the first place, like: </li></ul><ul><ul><li>Overleveraged </li></ul></ul><ul><ul><li>Poor credit record </li></ul></ul><ul><ul><li>No collateral </li></ul></ul><ul><ul><li>No payment record </li></ul></ul><ul><ul><li>A FICO score which will not justify a loan </li></ul></ul><ul><li>Now there is talk of such lenders having engaged in predatory lending practices: wrong sales of loans to those who cannot afford them </li></ul><ul><li>These are largely unregulated market players funded by Wall Street </li></ul>
  10. 10. Economics and default risk Incomes tend to rise; ability to borrow improves Banks are also keen to lend so that the boom is reflected in their balance sheets as well Competition leads to lower rates; riskier credit decisions, customers tend to bargain Lower profitability is a result; profits and risk based pricing are important to build reserves for future bad times Borrowers take larger loans, second house, become speculators Banks search for growth in profits by seeking more borrowers; at better rates= subprime borrowers Because of many buyers funded by loans, property prices go sky-high If property prices correct downwards, weaker borrowers/ those who took loans recently are impacted: default Increasing instances of default alert the banks and they tighten their criteria, foreclosing if LTV drops Foreclosures releases property into the market, prices drop further BOOM RECESSION As prices drop, LTV drops further; as banks get scared they call back loans quicker than before In boom times, everyone does well
  11. 11. Theoretical background <ul><li>It should be noted that prudent financiers always appear to lag behind in a boom time </li></ul><ul><li>But they survive the bear times </li></ul><ul><li>In the US, housing prices have stopped going up/ started declining </li></ul><ul><li>Interest rates have started going up </li></ul><ul><li>The combination of higher interest and lower price reduces the economic incentive to repay declines </li></ul><ul><ul><li>Especially for recently taken loans </li></ul></ul><ul><li>Government, policy level and political concern over these events is because everyone wants to avoid a full blown recession </li></ul>
  12. 12. What is being done <ul><li>Refinancing of “risky” mortgages is a solution </li></ul><ul><li>Keeping borrowers solvent has become a national problem and there are taskforces in place in the USA </li></ul><ul><li>One State’s Policy level solution is to refinance floating rate loans with fixed rates backedup by a team of participating lenders </li></ul><ul><ul><li>This further needs back up financing, also state sponsored </li></ul></ul><ul><li>Attorney General’s are frowning upon marketing tactics of subprime lenders </li></ul><ul><ul><li>They are backing this up with powers to review foreclosures: thereby iimpacting recovery rights of the financier </li></ul></ul><ul><li>Intervention: either on the side of refinancing, or on the side of borrowers </li></ul><ul><li>Profiling and alerting of weak borrowers who are exposed has started </li></ul><ul><li>Many of these steps are being done by Government offices and officials at various levels </li></ul><ul><li>It is interesting to see this much intervention in a country that believes in free market forces </li></ul>
  13. 13. What is being done <ul><li>FNMA (Fannie Mae) and FDMC (Freddie Mac) have been intervening </li></ul><ul><li>They are buying the loans from financiers in the subprime space </li></ul><ul><li>There has also been an increase in demand for fixed rate loans in a rising interest rate scenario </li></ul><ul><li>Fixed rate loans and bonds backed by fixed rate loans are a speciality/ preference of these two institutions </li></ul><ul><li>The distress pieces which they are buying will be converted by them into fixed rate loans which will prevent defaults </li></ul><ul><li>Both institutions have balance sheets that support fixed rate exposure because they have long term sources of funding </li></ul>
  14. 14. Two heroes: Freddie Mac and Fannie Mae <ul><li>Thus, the distressed assets will cease to be distressed and their value will increase, this increase in value will accrue to both institutions </li></ul><ul><li>Their profitability will increase; this is reflected in their share price </li></ul><ul><li>In boom times, the rationale for such institutions was questioned. </li></ul><ul><li>There were also accounting scandals at both institutions </li></ul><ul><li>Now in bearish times, the institutional strength of these entities has come to the rescue and justified their role in the economy once again </li></ul><ul><li>It should be noted, both stayed out of subprime markets because it was not their mandate; and they stayed away despite temptation to make money in that space. </li></ul>
  15. 15. Role of Fannie Mae/ Freddie Mac <ul><li>Buy assets from other lenders, releasing money to them </li></ul><ul><li>They hold the mortgages and bonds as investments </li></ul><ul><li>Charge fee when they extend guarantees to loans packaged by other institutions </li></ul><ul><li>The extending of such guarantee and the fee they charge depends on how the loan package is structured nd the quality of the underlying loan </li></ul><ul><li>In a distress market, they are able to pick up other’s position at cheap prices </li></ul><ul><li>The regulations which were to be imposed on the institutions following the accounting scandals has been substantially toned down in the backdrop of the role they are playing in stabilising the borrowers of the subprime loans </li></ul><ul><li>It should be noted that their “intervention” is on the borrowers side. </li></ul>
  16. 16. Things to watch Signals and impact in the Bond and CDO market
  17. 17. How did subprime lending impact banking sector? <ul><li>Sub prime lenders are in the unregulated space, and their access to capital is not from the banking system but is from the capital market </li></ul><ul><li>But these mortgages found their way into the banking system through investment banking deals that bought and sold on these debts to investors the world over </li></ul><ul><li>HSBC bought a player who had a presence in the subprime market to gain such exposure </li></ul><ul><li>So, apart from the mortgage business itself, the space to watch is the Bonds and the CDO markets, and here is what the indicators are… </li></ul>
  18. 18. CDOs and Mortgage Defaults
  19. 19. Story of a CDO sold by Credit Suisse <ul><li>Return of 10% p.a </li></ul><ul><li>Yield on similarly rated bond: 8% p.a </li></ul><ul><li>Top rated by </li></ul><ul><ul><li>Moody’s </li></ul></ul><ul><ul><li>S&P </li></ul></ul><ul><ul><li>Fitch </li></ul></ul><ul><li>Investment Grade rating for 95% of the securities in the portfolio </li></ul>
  20. 20. This particular issue had <ul><li>Risky debt including junk bonds </li></ul><ul><li>But also a large chunk of subprime homeloans </li></ul><ul><li>Due to the problems in the subprime market, the value of the portfolio has eroded by over 35% </li></ul>
  21. 21. The role of ratings… <ul><li>Rating leads to a perception of safety which is not based on reality </li></ul><ul><li>Ratings agencies issue disclaimers alongside the rating saying investment decisions are not to be based on the ratings </li></ul><ul><li>Rating agencies play a full role in putting together the CDO: it is not just an arms length rating of the same </li></ul><ul><li>Rating companies insist policing CDOs is not their job </li></ul><ul><li>Regulators think it should be; no clarity </li></ul>
  22. 22. However, CDO building/ Securitisation is… <ul><li>Not equivalent to rating corporate debt </li></ul><ul><li>It is financial engineering </li></ul><ul><li>Rating agencies assist the CDO issuers by </li></ul><ul><ul><li>Helping build the pool </li></ul></ul><ul><ul><li>Slicing tranches out of it </li></ul></ul><ul><ul><li>Rate each tranche separately </li></ul></ul><ul><ul><li>The engineering comes in with the art of maximising the size of highly rated tranches </li></ul></ul><ul><ul><li>In effect, through this process, paper that has greater underlying risk, is highly rated, masking the underlying nature of the portfolio </li></ul></ul>
  23. 23. … CDOs continued.. <ul><li>The subprime paper is built into a number of CDOs over the last few years </li></ul><ul><li>These were great to enhance yields </li></ul><ul><li>However with the increase in subprime defaults the quality of the CDOs are going to be adversely impacted </li></ul><ul><li>CDO valuation is not a transparent exercise because of the illiquid nature of the instruments and lack of marking to market (though, some of the component instruments could be marked to market quite easily, and are possibly liquid investments) </li></ul>
  24. 24. … CDOs continued.. <ul><li>It is now apprehended that as homeloan defaults widen, and as the subprime problem deepens, these CDOs will get impacted as well. </li></ul><ul><li>It is estimated that for 2006 alone over US$ 100 billion of subprime loans are embedded in the US$ 375 billion worth of CDOs which were issued. </li></ul>
  25. 25. Mortgage/ subprime exposure <ul><li>Has caused global ripples </li></ul><ul><li>Because of indirect exposure through MBS/Bonds </li></ul><ul><li>But also through CDOs </li></ul><ul><li>Through institutions entering markets they did not quite understand during a boom phase </li></ul><ul><li>HSBC’s write off is around US$ 10 bn </li></ul><ul><li>American banks have lesser direct exposure but are equally exposed through MBS and CDO </li></ul><ul><li>The ripple effect of CDOs is yet to be fully felt because of the nature of the CDO </li></ul><ul><li>But the hunger for including these high yielding assets in their securitisation portfolio caused this exposure </li></ul>
  26. 26. The Bond Market <ul><li>Bond investors have stopped funding leveraged buyouts, in anticipation of a mortgage crisis led by US </li></ul><ul><li>The resultant economic downturn will pull down those companies that carry debt </li></ul><ul><li>Thus, their hesitation at funding debt for those very companies </li></ul><ul><li>Larger proportion of lower rated debt now, in terms of new debt issues </li></ul>
  27. 27. Bond markets <ul><li>Lenders see combination of factors </li></ul><ul><ul><li>Worst slump in housing prices ever since the Great Depression in 1932 </li></ul></ul><ul><ul><li>Slowest US growth in 4 years </li></ul></ul><ul><ul><li>Increasing rates: Fed hikes </li></ul></ul><ul><ul><li>Junk bonds have lost value </li></ul></ul><ul><ul><ul><li>Investors in junk have started withdrawing investments </li></ul></ul></ul><ul><li>As a result debt issues have been hard negotiated, with lenders rejecting soft terms which dominated till recently </li></ul><ul><li>Debt issues have been postponed </li></ul>
  28. 28. In Conclusion… <ul><li>Nouriel Roubini, economics professor at New York University, says the housing bust is slowly pulling America into recession. He cites a 14.4pc drop in housing starts last month; an expected loss of 600,000 real estate jobs in 2007; a sharp fall in home equity withdrawals - down from 6pc of GDP at the top of the boom; and a squeeze as $1,000bn of mortgages are adjusted upwards this year to higher interest rates. </li></ul>
  29. 29. Soothing words from the Fed <ul><li>Last week the Fed left rates unchanged; undoubtedly an increase would have brought a whole host of floating rate mortgages into dangerous territory </li></ul><ul><li>For now, the US Federal Reserve believes the damage can be contained. </li></ul><ul><li>&quot;I don't think there'll be a large impact on prime mortgages from the sub-prime market,&quot; said governor Susan Schmidt Bies. (July 2007) </li></ul>
  30. 30. The last word has not been said on this topic…

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