Subprime

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Official Power point presentation by Mr Neeraj Batra ,Chairman of infinity business school and one of India's leading investment bankers.The presentation explains the sub prime crisis.

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Subprime

  1. 1. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  2. 2. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL BACKGROUND : OLD WINE IN NEW BOTTLE • The U.S. Junk Bond scandal (1980s) • Savings & Loan Scandal (1990s) • LTCM (1994) • Us Sub Prime Meltdown (2007)© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  3. 3. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL HOME MORTAGES (TRADITIONAL MODEL) • Home loans are usually given for long term • Usually this period varies between 20 to 28 years • The bank lends against collateral of the property • The bank finances only a certain % of the property • The borrower funds the balance with a down payment© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  4. 4. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL • The borrower must have adequate steady income to raise loan • The lender collects adequate documentary evidence of credit worthiness and income sources • The borrower pays an equated monthly installment • This represents a partial loan repayment and interest • At times there maybe a moratorium period involved • During the entire pendency of the property is mortgaged to the bank© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  5. 5. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL ASSET BACKED SECURITIES (Mortgage Backed Securities Collateralized Debt Obligations) •After the dotcom bust & 9/11attack mood was subdued •The US Fed slashed interest rates to kick start the economy •House mortgages became affordable for everyone including the low income groups (LIG) •The US had launched asset backed securities (ABS) in 1980s to catalyze the bond market •In any ABS essentially a bank sold its portfolio of mortgages to a SPV© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  6. 6. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL PACKAGING OF THE ABS : THE ABCDS •Given the low rate of interest rates the mortgage market grew in leaps and bounds •Lenders grew lax as US housing reached a 10 year Bull Cycle •Soon credit checks, income checks became lax as banks introduced no documentation loans •Technically these represented “Sub-Prime” or lower quality assets •The sub prime ABS were avoided by the risk averse institutions and pension funds •Bankers soon started packaging lower quality loans (read Sub Prime) into a basket in the SPVs© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  7. 7. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL •Usually these were sold in tranches of sequentially ranked debt •Each of these tranches was accordingly rated from AAA to double B although all the mortgages comprised sub prime loans •These were then sold onwards to investors who received higher yields for lower ratings (which wore greater default risk e.g. BBB- bears risk beyond 8 % default rate and AAA only beyond 24 % of Portfolio) •The ABS have a FV which can represent the state of portfolios •Banks initially sold these ABS to two major mortgage financiers: Freddie Mac And Fannie Mae.© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  8. 8. SUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  9. 9. SUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  10. 10. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL •The Federal National Mortgage Association (Fannie Mae) & The Federal Home Loan Mortgage Corporation (Freddie Mac) are Quasi Govt. entities. These Financed MBS and Also Guaranteed Payments. Cumulative exposure of USD 5.5 Tn (Agst 12 Tn Total Mortgages) •This gave banks more liquidity, allowing them to sell assets •The spread provided effective off balance sheet financing •This increased the banks ROA and improved its capital adequacy ratio© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  11. 11. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL THE Credit Default Swaps (CDS) • These tranches were sequentially risked ranked from AAA to BBB- Despite the fact all the Loans were Sub Prime. This was achieved by only making BBB- Holders accountable for first 8% losses. The AAA Tranches did not participate in any losses till delinquencies exceeded 24 % • By 2003 Wall Street packaged this Further with a credit default swap called CDS to improve the ratings of the ABS.The seller of CDS provided protection to a buyer against default on principal/interest. This allowed even a sequentially lower rated Debt ABS to get a Higher Rating of AAA. The CDS was sold as a spread over the MBS return. • Thus even pension funds were able to look at otherwise risky assets backed with CDS. The writer of the CDS was meant to charge the premium after assessing the risk of the underlying portfolio. However Firms like AIG grew reckless as there were virtually no defaults© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  12. 12. SUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  13. 13. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL THE ABS with the CDS •The sub prime now was packaged with 4 powerful features •Being an ABS it was moderately liquid and could be traded in the OTC •It was sold as tranches of sequentially rated paper. However the MBS allowed AAA paper out of Sub Prime Loans due to the sequential rating based on Delinquency Participation. •It had a higher yield than traditional bonds •The Credit default swap made it possible for Pension funds and several institutions to convert even BB rated paper to AAA. •Each ABS security gets a separate CDS and is guaranteed for the life of the Loan against payment of quarterly premiums by the Buyer to the Seller. •The most risky use of the CDS was for the PAUG (Pay As You Go) category of MBS.© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  14. 14. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL THE ABS & ABCDS •Incase of a default both the principal and the interest was compensated by the seller •Thus the ABCDS seller guarantees principal write downs, principal shortfalls and interest shortfalls •The buyer pays the quarterly CDS premium to the Seller. •This carries on during the life of this type of loan which may last 25 to 30 years •Thus the Buyer of the protection needs to also assess the credit risk of the Seller •The ABCDS allows both physical and cash settlement options to the buyer.© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  15. 15. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL SECURITISATION MACHINE : A SIMPLE ANALYSIS •The Sub Prime borrowers took loans from banks at 8.50 % •The Bank took a set of sub prime loans and sold it to its SPV at 7.75% yield •The SPV sold it onwards as ABS as the following: •AAA (Participate > 24 %) At 5% •AA (Participate>20%) At 5.50% •A (Participate >18%) At 6.00% •BBB (Participate 15%) At 6.50% •BB (Participate >12%) At 7.00% •B (Participate >10%) At 7.50% •The bank makes a Spread On The Lending Rate Vs The Rate At Which The MBS Was Sold And Keeps the BBB- or Equity Portion Which takes the first hit upto 8% Delinquency earning 7.75% oni it. Thus its managed to sell 92% of its exposure© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  16. 16. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL WHY DID THE MBS-CDS WORK •There were several reasons why the sub prime loans grew in popularity •The low interest rates made house loans attractive for borrowers •The Congress encouraged small loans and home ownership in patriotic light •As more people borrowed property prices rose faster than interest rates •The delinquency rate was low since it was easy to repossess and sell the property at a profit •The CDS made it very attractive for institutional investors •Being an ABS it had moderate liquidity and marketability.The top hedge funds and investment banks flocked it to improve spreads. Fannie Mae/Freddie Mac were soon crowded out by Merrill and Bear Stearns. •The instrument actually allowed hedge funds to short the ABS market. This was since Sellers of The CDS allowed Buyers without Any Investment in the MBS to buy the CDS against it.© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  17. 17. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL WHAT WAS WRONG WITH THE PRODUCT I •More than 80 % of home mortgages of the last 5 yr loans were securitised and sold here were several reasons why this was to become a problem •The ABS was a disparate animal comprising low quality mortgages which could be sold as AAA. Allowing Speculators to Buy CDS created a way of shorting the MBS. •The rising property market falsely lulled a scientific analysis of risks •The CDS posed a huge off balance sheet risk for the hedge funds in the longer run •Since the credit originator did not hold the loan the due diligence process was cosmetic •Global funds (Japanese) flowed freely into ABS based on the marketing by US investment banks© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  18. 18. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL WHAT WAS WRONG WITH THE PRODUCT I •Debt became a fungible commodity losing the sense of holding to maturity •Credit analysis became a secondary focus and marketing took precedence •For a period there was hardly any defaults in the sub prime portfolio and it yielded higher returns •The banks focused more on the FICO scores of borrowers and little to DCS •Contrary to popular belief several high income groups also comprise sub prime risks due to ignorance of DSC. •As housing prices rose, CDS costs and demand started raising costs for new borrowers© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  19. 19. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL WHAT WAS WRONG WITH THE PRODUCT II •The new borrower was now wooed with higher costs with the following incentives •100 % financing and no down payment •Long moratorium towards principal loan repayments •A skip EMI clause in some cases •Low docs or even no docs loans which did not need proof of steady income •Deterioration and even ignoring of the debt servicing ability computation •Low initial teaser rate that later ballooned into the higher amortisation •Soon graduate students,immigrant temporary blue collars were qualifying for USD 200,000 loans© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  20. 20. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL WHAT WAS WRONG WITH THE PRODUCT II • Meanwhile housing prices continued to go up • Easy refinancing options were another nail in the sub prime coffin • By 2006 sub prime loans were 20 % of all home mortgages in the US • By 2006 46 % of all sub prime loans were low or no docs • By 2006 the average sub prime loan was 94 % of CLTV (combined loan to total value) • By 2006 75 % of these loans carried the 2/28 arms (adjustable rate mortgages)© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  21. 21. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL SPREAD OF THE CONTAGION • As information on the sub prime spread investment banks started seeing delinquency • Housing prices started falling due to repossessions • More defaults started as borrowers could not either sell or service loans • Housing sales were expected to slow down by 60 % over the next two years • Risk related to ABS was re - priced by the markets as much as 900/1500 basis points higher© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  22. 22. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL • Accordingly the ABS started quoting at a huge discount • The liquidity for such instruments contracted hugely • The hedge funds/investment banks stand exposed to insurance claims and bonds of dubious quality • Bear Sterns, Macguarie Bank,Sowwod Capital,Lehman Bros.Citi,Aig all faced huge losses due to the Contagion to other high yielding Bond markets • As the cost of debt was re-priced, hedge funds started selling their equities to fund the new relative value . Credit spreads started widening further© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  23. 23. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL THE PANIC QUICKFIX •The US Congress swept the Sub prime under the carpet by encouraging. Nearly 1 Trillion of Support was finally provided in Bailing Out financial Instituions. • Bear Sterns and Lehman Bros. went Belly Up. •Foreclosure accounting standards were changed •The Central Banks pumped over USD 800 Bn in a unique concerted action to introduce liquidity into the markets •Wall street Was Bailed Out While Main Street Was Left To Bleed© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  24. 24. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL • Lenders were encouraged to renegotiate terms • Tax breaks were proposed for home borrowers • The government was paranoid in fixing this problem and to Bailout Freddie Mac/Fannie Mae and AIG • Socializing the Sub prime cost and bailout went down the S & L path as the TARP (Troubled Asset Restructuring Plan) was Launched. • Unfortunately in this case most of the risk was outside the banking regulations and held privately • Goldman Sachs /JP Morgan were the biggest beneficiaries of the AIG Bailout.© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  25. 25. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL THE GLOBAL CONTAGION • As defaults occurred in the CDO’s (Collateralised Debt obligations) it has had the following impact: •The Sub prime book was roughly USD 700 billion, delinquency rate is roughly 13% currently •Several investment banks such as Bear Sterns Folded some of their hedge funds •There was a flight to safety as US treasuries (10 yr) fall in yield from 5.1% to 3% in 12 months© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  26. 26. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL THE GLOBAL CONTAGION • As risk premiums were re-priced, emerging markets faced the brunt of the selling • Hedge funds faced redemption pressures and global liquidity will be withdrawn • All this was reflected in equity markets as investor turned cautious and withdraw money • Money went back from equity to secure debt markets such as UST • Demand for sovereign securities was on the rise as investors turn risk averse • The Dollar/Yen carry forward trades were unwound, impacting liquidity further the USD/yen traded at 93 (From 120 earlier)© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  27. 27. The Sub-Prime CrisisSUB PRIME CRISIS IN USA GCMI 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL THE GLOBAL CONTAGION • The consumer confidence in the US suffered and spending slowed down • As consumer credit becomes unavailable the US economy contracted further • The dollar surplus regions such as the oil producing countries and Asia were hit as global demand contracted and Oil Prices collapsed • Delinquent sub prime loans of USD 300-350 billion hit HNIs, Hedge funds, BFIs over the next 12 months • Sub prime books attracted a risk premium of 1200/1500 basis points and there was little liquidity / credit available© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS
  28. 28. SUB PRIME CRISIS IN USA GCMI The Sub-Prime Crisis 2010 KEY CONCEPTS IN ECONOMICS INFINITY BUSINESS SCHOOL Source: ENAM Securities© 2010 INFINITY BUSINESS SCHOOL www.inbuss.org Neeraj Batra GLOBONOMICS

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