MHQ Financial Services by jolinmilioncherie

VIEWS: 3 PAGES: 43

									The 2008- Financial Crisis
Sept 15 2008
Lehman Collapse
US
     Lehman Collapse
Green line: Real value (in 2009 dollars) of earnings on the S&P500
Dashed blue line: arithmetic average of green line for the preceding
    US
10 years. (Data source: Robert Shiller)                    Lehman Collapse
Lehman Collapse
Global Trade Volume (Goods+Services)
Vast Decrease in Demand, Consumption = 60% of GDP…
“Why are they lending money to people
  who can’t afford to pay it back?”
             Alex Blumberg, 05.09.2008. Producer “This American Life,”
                   thislife.org/Radio_Episode.aspx?sched=1242
             “Prime” Lending
    How to Buy a House – The Old Fashioned Way




   Credit risk
   Lending characteristics
   The consumer is “buying” a loan product
   Consumer needs must fit into the lending
    product box
    Paying off a 30-year fixed rate loan:
             monthly payment schedule



$
$
$
$
$
$
$
    $
“ARMs” Adjustable Rate Mortgages
   interest rate is fixed -- but only for a specified time
      reset every 2, 3, or 5 years


   Reset occurs according to reference interest rate.
     For example: i = 10 Year US Treasury Bill + 3%
            with caps/floors


   A 3 year ARM is cheaper (lower interest) than a 30
    year fixed contract
              “Balloon” Mortgages
   “30 due in 5” loans ask the borrower to make
    payments as if s/he had a thirty year mortgage,
    but the remaining principal (the “balloon”) is due
    after five years.

   If you don’t get a new loan in 5 year, you have to
    sell the house (or default)…
       Different from ARM since there is no agreement that
        the lender will carry the loan in the future
          “Interest Only” Mortgages
   “Home owner” makes only interest payments, but
    never gains equity in the home

   Why would anyone do this?
     Pray

        Income increases, so eventually pay principle

        Hope housing prices increase to make money
         when the house is “flipped.”
“Negative Amortization” Mortgages
     Monthly loan payment is smaller (!) than the
      interest charged.
     Outstanding loan balance increases over time.

     The “home owner” never actually pays down
      the loan and never actually pays the full
      interest. The missing interest payment is
      added to the amount owed!
       “Subprime” Loans Part I

   Designed for homebuyers with poor or
    No (!) credit and income history

   NINJA Loans
     (No Income, No Asset Verification)



   “Teaser rates” (1 year ARMs)
      Usually with prepayment penalty


           The Value of Subprime
Subprime opened market to many unserved
  homebuyers (should they have been served???)

   Who is to blame?
     The lender for offering the product?

     The borrower for accepting the product?



     Turns out neither if the markets had been
      properly regulated…
             Creative Mortgages Catch On Like A Wildfire




Note: Percentages represent the dollar amount of purchase and refinance mortgages originated in the year indicated
and pooled into private label securities that have certain characteristics. In dollar terms, jumbo, Alt-A, and subprime
mortgages represented about 19, 16, and 24 percent of mortgage originations in 2006 (excluding home equity
loans), respectively.
             Creative Mortgages Catch On Like A Wildfire




Note: Percentages represent the dollar amount of purchase and refinance mortgages originated in the year indicated
and pooled into private label securities that have certain characteristics. In dollar terms, jumbo, Alt-A, and subprime
mortgages represented about 19, 16, and 24 percent of mortgage originations in 2006 (excluding home equity
loans), respectively.
        If its too good to be true,
    it usually is too good to be true
   What kind of repayment can we (should we)
    expect from NINJA loans?
   Who on earth would originate a NINJA loan???
                                          Default Rates
             Subprime ARM>Subprime FRM> FHA>PRIME

    16%
            % of Loans 90 days+ delinquent/or foreclosure (%)
                                                                Subprime
    14%               – Recession
                                                                  FRM

    12%

    10%
                                                         Subprime
                                                           ARM
      8%

      6%
                                                                FHA & VA
      4%

      2%
                 Prime Conventional
      0




                                                                                         2006



                                                                                                2007
                                             2001
          1998



                      1999



                                 2000




                                                         2002



                                                                    2003



                                                                           2004



Source: Mortgage Bankers Association                                              2005
(Quarterly data not seasonally adjusted;1998Q1-2007Q3)
                                          Default Rates
             Subprime ARM>Subprime FRM> FHA>PRIME

    16%
                 Loans 90 days or more delinquent or in foreclosure (%)
                                                                Subprime
    14%               – Recession
                                                                  FRM

    12%

    10%
                                                         Subprime
                                                           ARM
      8%

      6%
                                                                FHA & VA
      4%

      2%
                 Prime Conventional
      0




                                                                                         2006



                                                                                                2007
                                             2001
          1998



                      1999



                                 2000




                                                         2002



                                                                    2003



                                                                           2004



Source: Mortgage Bankers Association                                              2005
(Quarterly data not seasonally adjusted;1998Q1-2007Q3)
Anatomy of “Mortgage Backed Securities”
                                        Loan 4           $1 Billion in Loans
Loan 1      Loan 2           Loan 3
                                      Subprime…




                                         Sold as $1 Billion
                      $850m              “Mortgage Backed Security”
                     AAA Rated
                                         S&P and Moody’s provide rating

    Not                                  Sold Globally
    Rated      $100m, BB Rated,


Rating:
AAA: “CREDIT RISK ALMOST ZERO                                          28
BB: SPCULATIVE, DETERIORATING SITUATION EXPECTED
                      The Anatomy of
 “Residential Mortgage Backed Securities (RMBS)”
                                        Loan 4
1000 1
Loan        Loan 2           Loan 3
                                      Subprime…




                      $850m
                     AAA Rated



    Not
    Rated      $100m, BB Rated,


Rating:
AAA: “CREDIT RISK ALMOST ZERO:                        29
BBB: “SPCULATIVE, DETERIORATING SITUATION EXPECTED”
                      The Anatomy of
 “Residential Mortgage Backed Securities (RMBS)”
                                        Loan 4
1000 1
Loan        Loan 2           Loan 3
                                      Subprime…
                                                  $1 Billion in Loans




                      $850m
                     AAA Rated



    Not
    Rated      $100m, BB Rated,


Rating:
AAA: “CREDIT RISK ALMOST ZERO:                                  30
BBB: “SPCULATIVE, DETERIORATING SITUATION EXPECTED”
             Who Does The Rating?
   No one buys a RMBS without knowing what
    the collateral is worth, and what the probability
    of repayment is. The RMBS has to be rated

   Credit Rating Agencies assess RMBS quality
       Standard and Poor’s (S&P)
       Moody’s
       Fitch

          Evaluate and report the risk involved
          with various investment alternatives.
          Assign Credit Rating (AAA, AAB,
          ABB…)
        Credit Rating Moral Hazard
   Conflict of Interest & Breakdown of Due Diligence
     Credit rating agencies want the business (they
      get paid by how many securities they rate)

       Lenders that package a MBS pay credit rating
        agencies for the rating
            Of course these Lenders seek the best rating to get
             the highest price of their MBS package

       Lenders “shop” their package to different Credit
        Agencies
        Credit Rating Moral Hazard
   Conflict of Interest & Breakdown of Due Diligence
     Credit Rating Agencies want the business (to
      get paid to provide a rating)
     Lenders that create and package MBS pay credit
      rating agencies for the rating
            Of course the companies want the best rating to get
             the highest price of their MBS package
       Lenders “shop” their package to different Credit
        Agencies

     This   is as if all movie reviewers were paid
        by the film studios AND only one review
        was ever released for each movies -- the
        one favored by the studios….
Cumulative Mortgage Debt Downgrade: $1.8 trillion
              The MBS Price Decline
As Risk is Upgraded As Quality of Mortgages is Downgraded




                      Record price
                        decline
         The Root Cause of the Crisis:
                FALSE CREDIT RATINGS
 Who     Is Hurt?
    1) Homeowners who bought a mortgage they can’t afford

    2) Banks that hold MBS
       WAMU, market cap. $300bil. (12/07) , sold for 1.9 bil. (9/08)
       Wachovia, market cap. $700 bil. (12/07), sold for 2.2 bil.
        (9/08)
       FDIC seized over 140 banks in 2009


    3) MBS were “insured” against default. The cost of the
     insurance should depend on credit risk. Insurance companies
     that insured MBS now find out their premiums were too low
        AIG seized. Taxpayer Cost: 85 billion (no buyer…)
            The Liquidity Trap
   Liquidity Trap: a situation when expansionary
    monetary policy becomes ineffective.

   The central bank can increase the money supply
    (“liquidity”) but investors prefer to hold money at
    zero interest rate than loan it out for profit.
   No change in lending because banks need funds
    to cover capital requirements or because they are
    afraid they never see the money again (Lehman)
               The Liquidity Trap
Money Demand, Money Supply,
and the Liquidity Trap
As the nominal interest rate
decreases to zero, once people
have enough money for
transaction purposes, they are
indifferent between holding
money and holding bonds. The
demand for money becomes
horizontal. This is because
when the nominal interest rate is
equal to zero, further increases
in the money supply have no
effect on the nominal interest
rate.
          Deriving the LM Curve
           In A Liquidity Trap
For low levels of
output, the LM curve
is a flat segment, with
a nominal interest rate
equal to zero. For
higher levels of output,
it is upward sloping:
An increase in income
leads to an increase in
the nominal interest
rate.
              Monetary Policy in a
                Liquidity Trap

In the presence of a
liquidity trap, there is
a limit to how much
monetary policy can
increase output.
Monetary policy may
not be able to
increase output back
to its natural level.
    The Liquidity Trap and Deflation
   If a country is in a recession, and the rate of
    inflation is negative, say -5%, then even if the
    nominal interest rate is zero, the real interest rate
    remains positive.
             r = i - π e = 0% - ( - 5%) = 5%
 In this situation, there is nothing the central
  bank can do to bring output above the natural
  level of output.
 In fact the larger the deflation, the higher the
  real interest rate!

								
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