THE SUB-PRIME CRISIS

From the real-estate bubble to the global financial crisis

Claudio MorelliMartina Tognaccini

Analysis of the clinic caseBackward analysis of the

environment in which the «virus» took place.

Focus on the problems that led to sub-prime crisis

Risk factors that caused the burstWhat the regulators and financial

institution tried and are trying to do to fight the started global financial crisis.

The beginning of a nightmare

Burst of the subprime crisis at the end of 2006 in United States

Peaks in: August 2007: collapse in the value of

MBS for many leading banks in US and Europe

September 2008: bankruptcy of Lehman Brothers

GLOBAL FINANCIAL CRISIS AND

ECONOMIC RECESSION

Roots of the subprime crisis

Housing Bubble

It is generally agreed that a “cocktail of various ingredients” (Weber 2008) caused the turmoil on US market. While the ingredients considered in isolation seemed to be rather innocuous, their dynamic interaction turned out to be a highly dangerous mixture.

Monetary policy

Government policies

Financial instruments

Monetary Policy Lowering of the FED funds rate target from 6,5% to 1% during

the period 2000-2003 To soften the effects of: the dot.com crash

the 11 September 2001the risk of deflation

Stable rate at 1% until June 2004. Increase of 425 bps of the rate from July 2004 to July 2006

5,25 % Stable rate until September 2007 Lowering of the target rate from October 2007 to December

2008 0/0.25 %

Government Policy Background

1982 Alternative Mortgage Transactions Parity Act (AMTPA): allowed housing buyers to write adjustable rate mortgages, such as Option adjustable rate and Interest only Mortgages.

1995 President Clinton gave the first government tax incentives to Government Sponsored Enterprise (GSE) for purchasing mortgage backed securities (MBS) which includes loans to low income borrowers to increase home ownership

1999 President Clinton repealed the Glass-Steagall Act which had separated commercial and investment banks.

House Bubble From 2000 to the first half of 2006 US lived a great

explosion in the real estate market

INCREASE IN HOUSE

PRICES

Between 1998 and 2006 the price of a typical American house icreased by 83%.US home mortgage debt relative to GDP increased from 46 %during the 90’s to 73% in 2006.

great demand (1st house and speculation)

+ building boom

+ low interest rates

Financial Market (1) Easy credit conditions, and lower interest rate led to an

increase of mortgages. Banks started to sell high risk mortgages:

SUBPRIME MORTGAGES: loans given to people who had unstable income, low credit ratings and could not afford a prime mortgage; proof of income or of employment were no longer needed. They are composed by the Adjustable Rate Mortgages in which the rate is periodically adjusted on the FED target rate, the interested-only ARM and the Option ARM.

ALTERNATIVE A PAPER MORTGAGES (ALT-A): between prime and subprime. Need not complete documentation and a low credit rating.

Need of funds (high demand of mortgages) SECURITIZATION

Transformed the subprime mortgages issued in bonds and sold them as collateral in the bond market.

Instrument to securitize: Collateralized Mortgage Obligations (CMOs): MBS

& ABS

Mortgage Backed Securities (MBS)

Asset Backed Securities (ABS) Collateralized Debts Obligations (CDOs):

structured CMO

- senior

- mezzanine

- junior

Financial Market (2)

Classes with different return and risk. Each of them is composed by several trancheses with different ratings. They were a POOL of risky asset threw in the bond market

Financial Market

Grater amount of mortgages more securitization higher return

Financial MarketInvestment banks financed mortgages through

SECURITIZATION and hedged risk through CREDIT DEFAULT SWAPS (CDSS)

The buyer makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults.

COLLATERALIZED BOND

PROTECTION BUYERRisk Seller

HEDGING POSITION

PROTECTION SELLERRisk Buyer

SPECULATIVE POSITION

CREDIT RISK

Cost Of Protection

Agreed Amount

All that glitters ain't gold!

Until the firs half of 2006: Low interest rate, foreign investments, permissive government policies, speculation of investors and financial institutions, increase of subprime mortgages, diffusion of financial engineering tools such as securitization and CDS, positive expectations on the future…

Optimal Scenario

But in the 2nd half of 2006 the House Prices incorporated the increase of the Fed rate …

And then….?

The House Bubble Burst

The prices dropped to their real value

Consequences for Borrowers

Increase of interest rates generated:

Higher monthly payments for borrower with ARM

Increase of Delinquency

Increase of homes for sale

Lowering of house prices lowering of homeowners’ equity

Many borrowers found out to have zero or negative equity in their homes: their homes were worth less than their mortgages (about 15% in September 2008 and 23 in September 2010) BAD INVESTMENT

Increase of Foreclosures

Consequences for banks

Reduced the value of MBS which eroded the net worth and financial health of banks.

•Decline in mortgage payments •Lowering of credit ratings on MBS made by Rating agencies between Q3 200 7 and Q2 2008

The sale of the securitized mortgages was imperative, but no one wanted to buy them. ‘Leveraged assets’ became a curse and they

were defined “Toxic Waste”.

Disappearence of mutual trust among banks

Credit Crunch

Consequences for Financial market

Effects of the increase of leverageMany financial institutions issued large amounts of debt during 2004–2007, and invested the proceeds in MBS profitable strategy during the housing boom but then large losses

Leverage Ratio for major 5 US Investment Banks

What happened during 2008?

Risk factors

High Risk Mortgages (Subprime)

Shadow Banking System (SBS)

Financial institutions such as Hedge Funds whose transactions are not subjected to regulation counterparties of off-balance sheet operations made by investment banks covered their leverage levels from investors and regulators and made impossible to recognize financial institutions in bankruptcy

The lack of regulation led to the increase of: Credit Risk Counterparty Risk Liquidity Risk Systemic Risk

Risk factors

They were the key of the financial meltdown (Financial Crisis Inquiry Commission, January 2011)

Rating AgenciesHigh ratings to MBSs based on risky subprime mortgage loans so MBS were sold to investors

They suffered from conflicts of interest, as they were paid by investment banks

Their downgrades of MBS through 2007 and 2008 weakened markets and firms.

They increased : Liquidity Risk Moral Hazard

Risk Factors Securitization

Off-balance sheet bonds

Transfer of Credit Risk (Default and Migration) and Interest Rate Risk to the counterpart caused an undervaluation of Credit Risk

Arbitage between banking and trading book VaR

Increase of the Counterparty Risk

CDSsOff-balance sheet no good evaluation of risk with VaR

Complete mispricing of these instruments which did not considered the presence of the counterparty risk and, in particular, of the Wrong-Way Risk.Increase of them contributed to increase the Systemic Risk.

Risk Factor for Securitization Real Estate Price

Consequences of the Crisis

•Devastating effects on global stock markets: by November 2008, the S&P 500, was down 45 percent from its 2007 high (Losses in other countries have averaged about 40%).

•Collapse of several financial institutions and bailout of the key ones

•Job losses and lack of consumer spending

•Crisis of the real estate sector with high reduction of prices and increase of foreclosures which generated losses

•Financial speculation in commodity futures has contributed to the world food price and oil price increases.

•Complete lack of mutual trust among the banks of all over the world and complete failure of the financial system

The crisis spread from sub-prime to the whole sectors of US and global economies reducing the wealth of people (between 2007 and 2008 Americans lost more than a quarter of their net wealth!)

Lessons to be learnt

Need of a stronger regulation for the banks and need of a first regulation for SBS Caution in applying Monetary PoliciesCaution in the usage of high risk mortgages Need of a well diversified portfolio in the banks’ balance sheetNeed of a regulamentation for Rating AgenciesCaution in the usage high risk DerivativesNeed of avoiding the arbitrage between banking and trading bookNeed of a Global standardized regulation of the financial system

Regulatory proposal and long term solutions

July 21, 2010:  Dodd–Frank Wall Street Reform and Consumer Protection Act

1. Consolidation of the financial stability controlling systemic risk especially limiting the action of SIFIs;

2. Comprehensive regulation of financial markets, including increased transparency of derivatives;

3. Introduces significant regulation of hedge funds, Rating agencies and increases the regulatory of insurance industry

4. Tools for financial crises, including a "resolution regime";

5. Mortgage Reform with new standards:

Regulatory proposal and long term solutions

July 2009 Basel III : developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector. •improve the banking sector's ability to

absorb shocks•improve risk management and governance•strengthen banks' transparency and disclosures.

AIMS

3 requests to solve the arbitrage between trading & banking books:

1. Incremental Risk capital Charge (IRC)=incorporated into the trading book capital regime because of credit risk related products whose risk is not reflected in VaR

2. Stressed Value at Risk3. 8% capital charge in all cases.