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LOGO
Derivatives and Risk Management
THE SUBPRIME CRISIS
Derivatives and Risk Management
THE SUBPRIME CRISIS
Presented by:Misha Jashnani M-09-20Sarika Mankani M-09-29Ambar Kumar Nagpal M-09-32Malvika Saldanha M-09-44
Flow of the presentationFlow of the presentation
Background to the subprime crisis
Collateralized debt obligations
Credit Default swaps
The Turning Point
Impact of the Crisis
Background to the Subprime Crisis
Background to the Subprime Crisis
Home ownersMortgagesHouses
InvestorsMoneyInstitutions
Financial systemBanks and Brokers
Initially…..Initially…..
Investors looking to invest their moneyEarlier Federal Reserve T-billsHowever rates lowered to 1% by Alan
Greenspan (Dot com bust and September 11)
Cheap Credit for BanksTherefore banks borrow from Fed at 1%Surpluses from China, Japan and Middle East
Banks tend to leverageBanks tend to leverage
Banks borrowed money to amplify the outcome of the deal. Most banks make money this way.
Banks connect investors to Home owners through MortgagesBanks connect investors to Home owners through Mortgages
Mortgage Lender
Mortgage broker
Home owners
Mortgage
Role of Investment Banks Role of Investment Banks
» Investment bank borrows millions of dollars to buy thousands of mortgages
» Every month he gets payments from the home owners of all mortgages
COLLATERALIZED DEBT OBLIGATIONS
COLLATERALIZED DEBT OBLIGATIONS
What is CDO ????What is CDO ????
Tranches in CDOTranches in CDO
No Default Default
Rate of returns Rate of returns
SafeSafe
OkayOkay
RiskyRisky
3%
7%
10%
Ratings to CDORatings to CDO
Selling of CDO Selling of CDO
Credit default swaps allow one party to "buy" protection from another party for losses that might be incurred as a result of default by a specified reference credit (or credits).
Credit Default Swap Credit Default Swap
The Greed of the investor comes in………No more loan takers available
A new
Adding risk to mortgages–These are subprime mortgages.
The Greed and Sub prime lending
The Greed and Sub prime lending
VideoVideo
Every body is happy….Every body is happy….
With time the investment banker lands up with many defaulters and hence more homes in its foreclosures
This is not strange because these
were subprime loans by nature
the prices of houses as expected does not rise due to the huge supply of houses
Infact the prices of the houses comes downThe house owners realise that they are paying very
high mortgages for houses that are not worth much anymore.
Leading to defaults by even people who can afford to pay the mortgages but don’t want to pay anymore
People put their houses on saleLeading to further supply in the marketOr simply forsake their housesNow the investment banker has loans which are
worthlessThe basic security underlying these loans are
worthless houses. So he has no worst case solution either.
The investment banker tries to sell these bonds but there are no buyers
Either people he approaches are stuck with similar loans or are aware that these loans are worthless.
In many cases the investment banker has taken loans worth millions or billions of dollars to buy these bonds
Which he is now unable to repay Thus the whole financial system is in a crisis
The investment bankers the banks and the investors all are stuck with worthless bonds
None of these can bail out the otherMany of these go bankrupt now at this stage the investor in on the verge of
bankruptcy calls up the home owner to stake claim on the house
Bringing more houses on sale and the crisis continues
Thank youThank you