The Subprime Mortgage Crisis Ann Dunn Andracchio Preeti Arunapuram Shailja Amin Arjun Ajmani.

The Subprime Mortgage Crisis

Ann Dunn AndracchioPreeti Arunapuram

Shailja AminArjun Ajmani

What is the Subprime Mortgage Crisis?

The Subprime Mortgage Crisis of 2008!!!

http://www.youtube.com/watch?v=9rifs5PuYUM

Credit Enhancement

• The process of reducing overall credit risk• Require additional collateral, insurance, or

other third party agreements• Provide lender with compensation in case

the borrower defaults

Credit EnhancementBecause the overall credit risk decreases, the borrower’s credit rating goes up, projecting a false image of good credit.

Credit EnhancementThere are many different types of credit enhancement. But the three most common forms are called subordination, overcollateralization, and excess spread.

Reference Portfolio

Loan

Loan

Bond

Bond

ABS

ABS

ABS

CDS

CDS

CDS

Other CDOS

Securities

AAA

AAA

BBBBB+ or <

Investor

Special Purpose Vehicle

Trustee

Credit Enhancement

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.

Credit Enhancement and the Crash of 2008

• 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.

The Housing Bubble

• In 2006, there was a boom in the housing market

• People bought expensive houses using loans with low interest rates

The Housing Bubble and the Crash of 2008

• Suddenly the rates would increase, borrowers could not afford new rates

• Foreclosures and other factors caused the housing market to decline

• When borrowers could not pay back the loans, banks lost money


• Other sectors also lost money (real-estate, construction, etc.)

• This started to affect the stock market when investors lost confidence in the economy


Loan Amount: $100,000Interest Rate: 1%Rate Adjustments: 3

Month Beginning Balance Principal Paid Interest Paid Interest Rate1 100,000 322 83 1%

13 97,126 472 324 4%25 95,314 528 397 5%

Risky Lending and the Crash of 2008

• 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


• Housing prices had dropped between 20% and 35% from 2010 Total home equity in the United States, which was valued at $13 trillion at its peak in 2006, had dropped to $8.8 trillion and was still dropping at the end of 2008.

• Retirement assets dropped by 22 percent from $10.3 trillion in 2006 to $8 trillion in 2008.


• Savings/Investment assets lost $1.2 trillion • Pension assets lost $1.3 trillion • The crisis caused panic in the financial sector

in the beginning of 2007.• Over 100 mortgage companies shut down. • CEOs of many large corporations are merging

companies or even resigning

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.


• When Lehman Brothers went bankrupt, around $400 million was owed to CDS protection buyers who hedged against the bank.– The actual amount

swapped amounted to $7.2 billion.


Many people believe that a large amount of CDS purchases which hedged against Bear Stearns led to the company’s downfall. Others believe that these CDSs were not a cause of Bear’s fall but an effect.


Because of the large effect that CDSs had on the subprime mortgage crisis and the subsequent economic recession, both politicians and civilians alike are pushing for more government regulation of credit default swaps.

Sources

• Inside the House of Money by Steven Drobny; pgs. 365-380

• Financial Futures Markets by Brendan Brown and Charles R. Geisst

The Subprime Mortgage Crisis Ann Dunn Andracchio Preeti Arunapuram Shailja Amin Arjun Ajmani.

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Transcript of The Subprime Mortgage Crisis Ann Dunn Andracchio Preeti Arunapuram Shailja Amin Arjun Ajmani.