US subprime crisis

The term subprime refers to mortgagees who are unable to qualify for prime mortgage rates. Reasons for this include poor credit rating, which includes payment delinquencies, charge offs, bankruptcies, low credit scores, large exiting liabilities and high loan value ratios. In other words, subprime mortgages simply mean lending to house borrowers with weak credit. Lenders did so by providing teasers like minimal or zero down payment, and low introductory adjustable rate mortgages, as well as lax documentation and credit checks. These subprime loans were fine as long as the housing market continued to boom and interest rates did not rise. When these conditions disappeared, the first to default were subprime borrowers. These defaults caused an implosion of the mortgage-backed securities (MBS) and the collateralized debt obligations (CDOs) industry. The blow out surfaced in June 2007 with the collapse of two subprime mortgage hedge funds managed by Bear Stearns, quickly followed by the suspension of three other funds managed by BNP Paribas. Interestingly, there were some forerunners to this spectacular blow out, and these could be observed already as of march 2007. However, as in any given environment of economic growth and prosperity, these were ignored.

There are four reasons why delinquencies on these loans rose significantly after mid-2005. 1. Subprime borrowers are typically not very creditworthy, often highly levered with high debt-to-income ratios, and the mortgages extended to them have relatively large loan-to value ratios. 2. In 2005 and 2006 the most common subprime loans were of the so called shortreset type. They were the 2/28or 3/27 hybrid ARMs (adjustable rate mortgages) subprime for which the interest rate initially charged is much lower than standard mortgage rates, but after a two to three year period, it is typically reset to a much higher rate. These loans had a relatively low fixed teaser rate for the first two or three years, and then reset semi-annually to an index plus a margin for the remaining period. A typical margin was 400 to 600 bps. Short-term interest rates began to increase in the U.S. from mid-2004 onwards. However, resets did not begin to translate into higher mortgage rates until sometime later. Debt service burdens for loans eventually increased, which led to financial distress for some of this group of borrowers. 3. Many subprime borrowers had counted on being able to refinance or repay mortgages early through home sales and at the same time produce some equity cushion in a

market where home prices kept rising. As the rate of U.S. house price appreciation began to decline after April 2005 the possibility to refinance early was pushed further into the future and many subprime borrowers ended up incurring higher mortgage costs than they might have expected to bear at the time of taking their mortgage. 4. The availability of subprime mortgages was amplified by investor demand for higher yielding assets. A major contributor to the crisis was the huge demand by CDOs for BBB mortgage bonds which allowed substantial growth in home equity loans.

Role of securitization in the crisis

Securitization has played a major role in the crisis. In many cases it facilitated the misalignment of interests. Moreover securitization also enabled the development of synthetic market in subprime MBS which had effect of multiplying the impact of a default. MortgageBacked Securities (MBS) are the securitization of housing mortgages. They have enabled banks and mortgage companies to increase the velocity and turnover of loans as banks and mortgage companies securitized and sold off these loans. This is known as the originationdistribution model. The volume of MBS originated and traded reached $3 trillion in 2005 in a U.S. housing mortgage industry of $10 trillion. Securitization enabled banks and mortgage companies, the originators of these loans, to take on more loans as they moved the securitized loans off their books. In the early nineties, financial innovation took these MBS to a higher level in terms of complication and leverage with the introduction of collateralized debt obligations (CDOs). CDOs are simply the bundling of a class of asset-backed securities into a special purpose vehicle and then rearranging these assets into different tranches with different credit ratings, interest rate payments, and priority of repayment. For example, a CDO could consist of 100 subprime MBS. Using historical rates of default and recovery, it can be assumed that in an extreme case of default, the loss ratio is no more than 10%. These subprime MBS are then divided into AAA tranche (70%), mezzanine tranche (20%), and subordinated tranche (10%). An investor, depending on risk propensity, can choose which tranche to invest in. The AAA tranche pays lowest interest rate, but provides highest priority in terms of debt repayment. To further complicate matters, these CDOs were used as underlying assets and repackaged to the next level of CDOs. This is referred to as CDO squared and after another round, it becomes CDO cubed. Layered on top of these are CDOs of credit default swaps (CDS) that multiplied the risks further. However, these were marketed as spreading the risks. They were seen as a revolutionary tool to combine all different asset classes covering a wide range of investment possibilities into one product, thus theoretically spreading the risks as much as possible. This was ignoring the underlying assumptions. The defaults are confined not only to the underlying securities, but also the contracts written (CDS) on the traded securities. The higher the level of CDO, the more removed it is from the actual underlying security, complicating the pricing of these CDOs. The volume of CDOs issued tripled between 2004 and 2006 from $125 billion to $350 billion per year (Bloomberg). These CDOs were distributed far and wide. It was not only banks

throughout the world that bought these CDOs, but also establishments such as town councils in far flung places like Australia that were chasing for higher yields. Bank of China alone is exposed to $9 billion of subprime CDOs. In this day, it is considered trivial that the CDOs were a complete disaster, but it should be pointed out that not more than a year ago, this was totally ignored.

The diagram above explains the process of securitization for the mortgage backed securities. Below we look at the various steps in a representative securitisation. In the first step, the mortgages are originated by a third-party independent mortgage broker, which sold the mortgage to the specialty finance company (banks were generally not heavily involved in the sub-prime mortgage origination business). While the specialty finance company did monitor the performance of brokers loans, in large measure the mortgage broker had no further exposure to the performance of the loan. Hence, at the very start of the process is a broker which is incentivised to generate as much volume as possible, largely without regard to the credit risk of the loans. The specialty finance company purchasing the loans had a franchise to protect and therefore had a greater interest in the quality of the mortgage loans being originated. However, with strong demand for the mortgages they created, these originators were able to originate mortgages and sell them for a profit almost immediately. Clearly, this made the originators less concerned about the ultimate performance of the loans, all else being equal. Moreover, the mortgage origination business has high operating leverage, so the originators needed to keep volumes high. And with many of them being monolines, they arguably had little choice but to originate whatever loans the market would bear. The originator pools the mortgage loans together and sells them into a trust, and that trust issues subprime MBS. The

cash flows that the trust is expected to generate are carved into tranches (slices), each of which has different credit risk (and/or different tenors). The ratings agencies examine the credit quality of the pool of loans and establish the sizing of the tranches required to earn a given rating. The rating is based on a combination of: the expected performance of the pool; the size of the tranche; the size of the credit enhancement backing the tranche; and structural features such as performance triggers. An important aspect of the sub-prime MBS market was the strong demand for subordinated (or mezzanine) sub-prime MBS (i.e., more junior tranches, in particular BBB and BBBtranches) from CDO managers. CDO managers bought the majority of these bonds in recent years and traditional cash buyers were largely absent. The reason the bonds were so attractive is that the rating agencies assumed that a portfolio of subordinate mezzanine bonds from various securitisations would not be highly correlated. Because of this assumption of low correlation, pooling sub-prime mezzanine bonds into a CDO structure enabled the CDO manager to create, in essence, new AAA-rated CDO bonds, using only BBB sub-prime MBS. The assumed diversification benefit drove the capital structure of the CDO. It was very attractive for the CDO manager and led to heavy demand for sub-prime mezzanines.

Consequences

Factors responsible 1. Home prices in the United States had been rising rapidly for several years now, this made lending to subprime borrowers also profitable. Many actually didnt believe that the US home prices would fall, they thought the prices would just moderate in a soft landing. 2. The originators of the subprime mortgages actually originated these mortgages and they were largely unregulated. 3. Buyers of the MBS and the related CDOs were over reliant on the credit ratings and particularly AAA buyers did little independent credit work. 4. Rating agencies were wrong due to following reasons a. They made overly optimistic assumptions on these new, untested types of mortgages b. They used an actuarial approach while evaluating the risks which tends to be backward looking c. They assumed soft landing for home prices .

Steps taken
1. Signalling In August 2007, Committee announced that "downside risks to growth have increased appreciably," a signal that interest rate cuts might be forthcoming. Between 18 September 2007 and 30 April 2008, the target for the Federal funds rate was lowered from 5.25% to 2% and the discount rate was lowered from 5.75% to 2.25%, through six separate actions. 2. Open market operations The Fed and other central banks conducted open market operations to ensure member banks have access to funds (i.e., liquidity). These are effectively short-term loans to member banks collateralized by government securities. Central banks have also lowered the interest rates charged to member banks for short-term loans. Both measures were intended to effectively lubricate the financial system, in two key ways. First, they help provide access to funds for those entities with illiquid mortgage-backed securities. This helps these entities avoid selling the MBS at a steep loss. Second, the available funds stimulate the commercial paper market and general economic activity. 3. Term auction facility The Fed introduced Term auction facility (TAF) to provide short-term loans (liquidity) to banks. The Fed increased the monthly amount of these auctions to $100 billion during March 2008, up from $60 billion in prior months. In addition, term repurchase agreements expected to cumulate to $100 billion were announced, which enhance the ability of financial institutions to sell mortgage-backed and other debt. The Fed indicated that both the TAF and repurchase agreement amounts will continue and be increased as necessary. During March 2008, the Fed also expanded the types of institutions to which it lends money and the types of collateral it accepts for loans. 4. Reducing foreclosures Fed Chairman Bernanke advocated several solutions, including the reduction of loan principal amounts. This solution was highlighted to address a growing concern that an estimated 8.8 million U.S. homeowners (10%) with negative equity (homes worth less than the mortgage principal) would have a financial incentive to "walk away" from the property, further exacerbating the crisis. 5. Funds and guarantees In March 2008, the Fed also provided funds and guarantees to enable bank J.P. Morgan Chase to purchase Bear Stearns, a large financial institution with substantial mortgage-backed securities (MBS) investments that had recently plunged in value. This action was taken in part to avoid a potential fire sale of nearly U.S. $210 billion of Bear Stearns' MBS and other assets, which could have caused further devaluation in similar securities across the banking system. In addition, Bear had taken on a significant role in the financial system via credit derivatives, essentially insuring against (or speculating regarding) mortgage and other debt

defaults. The risk to its ability to perform its role as counterparty in these derivative arrangements was another major threat to the banking system. 6. Mortgage lending rules In July 2008, the Fed finalized new rules that apply to mortgage lenders. Fed Chairman Ben Bernanke stated that the rules "prohibit lenders from making higher-priced loans without due regard for consumers' ability to make the scheduled payments and require lenders to verify the income and assets on which they rely when making the credit decision. Also, for higherpriced loans, lenders now will be required to establish escrow accounts so that property taxes and insurance costs will be included in consumers' regular monthly payments...Other measures address the coercion of appraisers, servicer practices, and other issues. We believe the new rules will help to restore confidence in the mortgage market." 7. Commercial Paper Funding Facility (CPFF) On October 7, 2008 the Federal Reserve further expanded the collateral it will loan against, to include commercial paper. The action made the Fed a crucial source of credit for nonfinancial businesses in addition to commercial banks and investment firms. Fed officials said they'll buy as much of the debt as necessary to get the market functioning again. They refused to say how much that might be, but they noted that around $1.3 trillion worth of commercial paper would qualify. There was $1.61 trillion in outstanding commercial paper, seasonally adjusted, on the market as of October 1, 2008, according to the most recent data from the Fed. That was down from $1.70 trillion in the previous week. Since the summer of 2007, the market has shrunk from more than $2.2 trillion. 8. Term Asset-Backed Securities Loan Facility

In November 2008, the Fed announced the $200 billion Term Asset-Backed Securities Loan Facility (TALF). This program supported the issuance of asset-backed securities (ABS) collateralized by loans related to autos, credit cards, education, and small businesses. This step was taken to offset liquidity concerns.

In November 2008, the Fed announced a $600 billion program to purchase the MBS of the GSE, to help lower mortgage rates. In March 2009, the Fed announced that it was expanding the scope of the TALF program to allow loans against additional types of collateral.