A Brief Mystery of Subprime (Stinkin’ Hawking)* A Primer for MBA Finance students and other wannabes trying to understand The Big Bang (how the world began to end ) *with due apologies to Mr. Stephen Hawking and his “Brief History of Time” Recommend you download and play the pps slideshare.com may not support online animation
Home Loan: Birth of a Mortgage 20 th century folks Business as usual: Citizen wants to buy house. Seeks loan from Lending Company. Agrees to pay EMI covering principal and interest. Pledges house as collateral (house will belong to lender if borrower does not replay loan). Lender thinks Value of house will only increase, so if borrower does not repay, lender can take possession of the house and sell it off for higher price, thus get his loan repaid, no risk! Deal called Mortgage. Thank you for signing up the Mortgage. Here’s the money! Happy house-buying!! Here you are. Sign up this “Mortgage” deal, whereby I would loan you the amount and you promise to repay in monthly instalments and if you don’t, I will possess that house you buy. One deal done! I’ve got this safe mortgage paper giving me monthly interest cashflow I need a loan to buy a house. Can you give me a loan? Sure. You will repay me the principal and some interest with monthly instalments over so many years. OK? Sure, Chief. Good. Ummm, just what if you default … don’t pay up some time later? I would need you to put up your house as a “collateral” – it will belong to me if you default. Then I will sell it off and recover my money… Acceptable? OK. What’s the document to be signed? $$ $$$ Borrower Lender Thank you too. Bye !!! Mortgage Sdf slfk asfkj a sfks sfasd a adf sd fsd a sdslkfsd asd fksdfk sfjsa sdkf fs sdk fksdfj sd ddkfjsdkf asff adkf fkds fklsdf sa fsdf sdfj adfk kdfj dkfjd kjfasdkf d fdf dkfj sdkfjasdk sdfksdfk sdkfj skdfjaskdf asfsakf asfdfk skdfsd sdkf sddfsdfj sfasf fasdfk askjfasdfjaslskjfa sfasf kasfkjaskf askf aksfkjas sdlfsd fs dfksd fjsdk welrkwkle fksda sdkfsdfks lkasdfkl jsdfkj dkf dsvk sd sfjsdk fsdkf asfkjasdf asdlfk asdf sjsdkf ______________ ________________ Sdkfskdjfk fdbdf df f akdfkasd k Asdkfkldsjfklsd dfjas df Asd rreooti sdfo ofodfdgjk
Securitization: Birth of a Mortgage backed Security (MBS). An MBS is sold to another financial institution for cash at a discount. This makes the expected instalment payments from the main borrower to be accrued to the buyer of the MBS. The buyer get his funds from his sources, and is interested in large cashflows, which the MBS promises him. The seller of the MBS can now use the money he receives to lend and sign up more mortgages. Lender So many borrowers! So many mortgages! Business is good. Let me now “securitize” these mortgages into a Mortgage Backed Security, which I will sell to those big blokes on Wall Street, who deal in such “derivatives”. This MBS I am “writing” states that the buyer of this paper will get the monthly payments from all these mortgages which I am attaching to it. Done!! An MBS is ready for sale. This has 500 mortgages each of 100,000 US$ par for 15 years. Let’s now go sell this MBS to that biggie on WallStreet and get back some cash for further business MBS Sdf slfk asfkj a sfks sfasd a adf sd fsd a sdslkfsd asd fksdfk sfjsa sdkf fs sdk fksdfj sd ddkfjsdkf asff adkf fkds fklsdf sa fsdf sdfj adfk kdfj dkfjd kjfasdkf d fdf dkfj sdkfjasdk sdfksdfk sdkfj skdfjaskdf asfsakf asfdfk skdfsd sdkf sddfsdfj sfasf fasdfk askjfasdfjaslskjfa sfasf kasfkjaskf askf aksfkjas sdlfsd fs dfksd fjsdk welrkwkle fksda sdkfsdfks lkasdfkl jsdfkj dkf dsvk sd sfjsdk fsdkf asfkjasdf asdlfSdf Asdfkdsfhj Asd rreooti sdfo ofodfdgjk MBS Mortgage Sdf slfk asfkj a sfks sfasd a adf sd fsd a sdslkfsd asd fksdfk sfjsa sdkf fs sdk fksdfj sd ddkfjsdkf asff adkf fkds fklsdf sa fsdf sdfj adfk kdfj dkfjd kjfasdkf d fdf dkfj sdkfjasdk sdfksdfk sdkfj skdfjaskdf asfsakf asfdfk skdfsd sdkf sddfsdfj sfasf fasdfk askjfasdfjaslskjfa sfasf kasfkjaskf askf aksfkjas sdlfsd fs dfksd fjsdk welrkwkle fksda sdkfsdfks lkasdfkl jsdfkj dkf dsvk sd sfjsdk fsdkf asfkjasdf asdlfk asdf sjsdkf ______________ ________________ Sdkfskdjfk fdbdf df f akdfkasd k Asdkfkldsjfklsd dfjas df Asd rreooti sdfo ofodfdgjk
Birth of a Collateralized Derivative Obligation ( CDO ). The Buyer of the MBS aggregates such securities into another bundle with a covering security called a CDO. CDOs, being privately negotiated, are out of purvue of regulatory bodies. The CDO can be further sold to some institutions, funds and investment banks. Fannie Mae and Freddie Mac were US government backed (funded) funds with social motives. The pension and other such money invested in them was “invested” in buying CDOs hoping to get good monthly returns. They source their funds from widows, orphans, pension funds and general public at large, who expect a safe and periodic return on their money deposited with these funds.
Credit Rating for CDOs: For the institutions buying CDOs to have faith in the expected cash flows from this security, sellers got CDOs “rated” by agencies (like Standard & Poor or Moody’s) for their credit-default safety.
Underwriting CDO/MBS dafault : The CDO/MBS may be further “insured” for default. An underwriter company like AIG takes a small fee from the security seller in return of the promise to pay up instead, if the seller defaults (for any reason, including that the original mortgage lender defaulted and so no-one further in the chain got the money to pass on to his next buyer). The underwriter promises to back up the purchase of the “product” with a promise to pay on the original lender defaulting. Since this is not called “insurance” and is privately negotiated, these contracts too escape the regulatory body’s oversight.
Birth of the CDS (Credit Default Swaps) : The underwriting agency can creatively define instruments which essentially are swapping any default on interest revenues on the CDSs for a small fee upfront (like an insurance premium). The CDOs were seen as very risk-free since housing prices would always go up and hence any default would be covered with the collateral.
Birth of Dirty Hedge Funds : The Investment Bank may separate out the “riskiest” CDOs into a Special Purpose Vehicle (subsidiary) as equity, and start marking up that CDO since the underlying securities are getting better rated because the collateral houses are getting more expensive. A Hedge Fund is born. Hedge funds are privately managed and unregulated. LTCM went down for different reason, but as history shows, the bailers took in the poison.
The Virus spreads : International banks and funds invest public money in their countries and invest in these securities. Now global investors’ money is invested in financing the US housing buyer. Eg. Swiss Hedge Fund UBS (Dillon Read CM) or UK based HSBC or the German Hypo Real Estate Holding AG.
The Demon shows up: The overall Mortgage backed Derivatives business goes hyper-bullish. 1. US government liberalizes Banking sector (Gramm-Leach-Bliley Act 1999): Commercial banks could now run Investment Banking divisions 2. Relaxed Self-Regulation for Top banks relaxed on. Big 5 let off to self—monitor since Fed didn’t have enough manpower! 3. Interest Rates brought were down by Fed, making loans cheaper and letting many more people simply borrow and buy houses 4. Quarterly target-based remuneration drives personal greed of executives invest corporate moneys in high-risk securities and mortgages 5. Social Obligation Imperatives by US government encouraged high-risk lending to “economically weak” people – even NINA (no income, no asset) borrowers!
Day of Reckoning : Inevitably, the defaults increased, starting with the NINA/lower-strata borrowers and spreading like wildfire in volumes. The collateral housing became unsaleable, and housing prices started to reduce first in growth and then in absolute terms. The bubble burst. The ccle of further defaults led to further collapse of housing markets. The demon was hiding but big. The default spread, first consuming reserve funds of everyone in the chain, including the investment banks involved, underwriters, foreign funds and all investors in these.
Systemic Collapse and Socialist Help : All parties concerned tried to fund their commitments downstream with own funds, reached their limits, used leveraged funds if possible, further worsening the credit-risk in their markets, till they hit bankruptcy levels. Banks and parties involved were so large that their default commitments alone went to Billions of Dollars each! There was only one alternative to winding up: blackmail the public at large: if these real biggies collapse, they will take the system (and not just US, but international) down with them. There would be anarcy – so Governments better bail them out with public moneys. After rejecting the proposal once, the US senate finally passed a bill motivated to fund those posing a systemic risk (or any others) to the tune of the famous 700B$ dollar. Central Banks around the world followed suit. Europe was almost as badly affected. Asia was relatively better off due to lower exposure to these “toxic assets”
Impact on Indian Markets : The Share markets had significant FPI funding by subsidiaries and funds of the affected banks and agencies. The FIIs desperate to cover their bottoms back home (and world over) pulled out their dollars real fast from the equity markets in India. The share market collapsed, losing over 60% capital within months. Central Bank (RBI) diagnosis of it being just a liquidity issue bore solutions like cutting the CRR (over 2.5%), Repo (RBI-bank) rates by 1% and other measures. The market only hiccupped and continued its collapse. The US$ appreciated significantly (over 10%) wrt the INRupee.