2007 subprime mortgage financial crisis

2007 subprime crisis 1/11 Team Chien Jaune – EMBA ESCEM Promo 5 - Subprime Crisis Contents Introduction 1. Background information 1.1 Theory of money - basics 1.2 Understanding the causes and risks of the subprime crisis 1.3 Understanding the impact on corporations and investors 2. Causes of the crisis 2.1 Role of lenders 2.2 Role of Borrowers 2.3 Role of government and regulators 2.4 Role of rating agencies 2.5 Role of central banks 3. Impacts 3.1 Impact on stock markets 3.2 Impact on financial institutions 4. Actions to manage the crisis 5. Impact in Europe and France 6. Expectations and forecasts 2/11 Team Chien Jaune – EMBA ESCEM Promo 5 - Subprime Crisis Introduction The subprime mortgage financial crisis of 2007 was a sharp rise in home foreclosures which started in the United States during the fall of 2006 and has become a global financial crisis within a year. The sharp rise in foreclosures after the fall in housing values caused several major subprime mortgage lenders to shut down or file for bankruptcy. This activity has helped lead to the stock price collapse of some of the largest lenders such as Countrywide Financial, Washington Mutual, the government sponsored Fannie Mae, and Citigroup, a component of the Dow Jones Industrial Average. Subprime loan packages became investment vehicles available for purchase by banks and other investment entities throughout the world, and the U.S.-created crisis is thought by many to have had its effect on stock markets globally. Several hedge funds became worthless, and some coordinated national bank interventions became necessary. Many factors contributed to the crisis, but the most immediate causes were a rising interest rate environment which caused people with adjustable rate mortgages to see significant increases in their loan payments amid declining property values. This left many borrowers unable or unwilling to meet their financial commitments, and many lenders without a means to recoup their losses. Steeply rising house values during the 2001–2005 United States housing bubble had tempted new buyers to borrow beyond their means, and existing owners to borrow money by refinancing their existing mortgages, using as collateral the increased value of their real estate. In the case of loans made to marginal credit-worthy customers, commonly known as subprime loans, the lenders tended to "look the other way". Then prices began to fall. Observers of the meltdown suggest that blame needs to be shared between the mortgage provider and the consumer, the house owner/borrower. They highlighted the predatory lending practices of subprime lenders and the lack of effective government oversight. Others have charged mortgage brokers with steering borrowers to unaffordable loans, and their house appraisers with inflating housing values. Mortgages are normally originated by banks and mortgage companies, who in turn borrow the money by selling loan packages to Wall Street and various types of investment funds who in turn may have borrowed their money from low or zero interest sources such as Japan, known as the carry trade. The actual and ultimate valuation ascribed to a fixed investment through these generational levels became inscrutable. Thus, it is claimed by some that Wall Street helped to distribute risk by shifting it from providers who should have known what was going on to consumers who did not. On the other hand, consumer-borrowers have been criticized for overstating their incomes on loan applications, which did not require verification and entering into loan agreements they could not meet or did not understand, or were motivated by greed. 3/11 Team Chien Jaune – EMBA ESCEM Promo 5 - Subprime Crisis 1. Background information Subprime lending is a general term that refers to the practice of making loans to borrowers who do not qualify for market interest rates because of problems with their credit history or the inability to prove that they have enough income to support the monthly payment on the loan for which they are applying. Subprime loans or mortgages are risky for both creditors and debtors because of the combination of high interest rates, bad credit history, and murky financial situations often associated with subprime applicants. A subprime loan is one that is offered at an interest rate higher than A-paper loans due to the increased risk. Subprime, therefore, is not the same as "Alt-A", because Alt-A loans qualify for the "A-rating" by Moody's or other rating firms, albeit for an "alternative" means. 1.1. Theory of money – basics Looking back at the subprime crisis, we spot on the fact that this financial bubble is not really the first one we have. All bubbles have basically the same characteristics. They appear into economical sectors where innovations allow the market to grow. Since, investments are more and more important into it. Money is borrowed to earn more profits and then the bubble is growing as interest rates and prices are linked. Irving Fischer’s equation explains this very easily with simple assumptions in a simple economical model. So P is price level, V the cash speed turn, M the cash in hands and T the number of transactions; then we have MV as cash out which is equal to PT as value of payment. If we consider T and V fixed (full production factors and stability of payments) and T impendent of M, then if the cash in hands is increased then prices increase. If interest rates are low then people and corporations don’t hesitate to borrow money from banks. Prices are going up without limit and they are disconnected to the real value of assets. Every one wants to make huge profits on a growing market. A financial crash is a panic mechanism of markets. When all financial operators realize that prices are far away from the real value, they sell their asset to avoid to loose money. Prices are going down and so panic operators. This is what happened with financial crashes in end of 80s, the internet bubble in end of 90s and now with real-estate bubble. When a bubble bursts, the remaining assets and cash disposed by central Banks to avoid an economical crisis generate the conditions for the birth of a brand new bubble...and may be the next one will be in China. 1.2. Understanding the causes and risks of the subprime crisis The reasons for this crisis are varied and complex. Understanding and managing the ripple effect through the world-wide economy is a critical challenge for governments, businesses, and investors. The risks related to the inability of homeowners to make their mortgage payments have been distributed broadly, due to innovations in securitization, with a series of consequential impacts. The crisis can be described as stemming from the inability of homeowners to make their mortgage payments due to a variety of factors such as poor judgment by either the borrower or the lender, mortgage incentives, and rising adjustable mortgage rates. Further, declining home prices have made re-financing more difficult. There are three primary risk categories involved: 4/11 Team Chien Jaune – EMBA ESCEM Promo 5 - Subprime Crisis    Credit risk: Traditionally, the risk of default (called credit risk) would be assumed by the bank originating the loan. However, due to innovations in securitization, credit risk is now shared more broadly with investors. This is because the rights to these mortgage payments have been repackaged into a variety of complex investment securities, generally categorized as mortgage-backed securities (MBS) or collateralized debt obligations (CDO). A CDO, essentially, is a repacking of existing debt, and in recent years MBS collateral has made up a large proportion of issuance. In exchange for purchasing the MBS, third-party investors receive a claim on the mortgage assets, which become collateral in the event of default. Further, the MBS investor has the right to cash flows related to the mortgage payments. To manage their risk, mortgage originators (e.g., banks or mortgage lenders) may also create separate legal entities, called special-purpose entities (SPE), to both assume the risk of default and issue the MBS. The banks effectively sell the mortgage assets (i.e., banking receivables, which are the rights to receive the mortgage payments) to these SPE. The SPE then sells the MBS to the investors. The mortgage assets in the SPE become the collateral. Asset price risk: Most CDOs require that a number of tests be satisfied on a periodic basis, such as tests of interest cash flows, collateral ratings, or market values. Because the ability of sub-prime and lower-quality (e.g., Alt-A) mortgage homeowners to pay is now in question, the value of the mortgage asset may be reduced suddenly. For deals with market value tests, if the valuation falls below certain levels, the CDO may be required by its terms to sell collateral in a short period of time, often at a steep loss, much like a stock brokerage account margin call. If the risk is not legally contained within an SPE or otherwise, the entity owning the mortgage collateral may be forced to sell other types of assets, as well, to satisfy the terms of the deal. Liquidity risk: A related risk involves the commercial paper market, a key source of funds (i.e., liquidity) for many companies. Companies and SPE called structured investment vehicles (SIV) often obtain short-term loans by issuing commercial paper, pledging mortgage assets or CDO as collateral. Investors provide cash in exchange for the commercial paper, receiving money-market interest rates. However, because of concerns regarding the value of the mortgage asset collateral linked to subprime and Alt-A loans, the ability of many companies to issue such paper has been significantly affected. The amount of commercial paper issued as of October 18, 2007 dropped by 25%, to $888 billion, from the August 8 level. In addition, the interest rate charged by investors to provide loans for commercial paper has increased substantially above historical levels. 1.3. Understanding the impact on corporations and investors Average investors and corporations face a variety of risks due to the inability of mortgage holders to pay. These vary by legal entity. Some general exposures by entity type include:  Bank corporations: The earnings reported by major banks are adversely affected by defaults on mortgages they issue and retain. Companies value their mortgage assets (receivables) based on estimates of collections from homeowners. Companies record expenses in the current period to adjust this valuation, increasing their bad debt reserves and reducing earnings. Rapid or unexpected changes in mortgage asset valuation can lead to volatility in earnings and stock prices. The ability of lenders to predict future collections is a complex task subject to a multitude of variables. 5/11 Team Chien Jaune – EMBA ESCEM Promo 5 - Subprime Crisis    Mortgage lenders and Real Estate Investment Trusts: These entities face similar risks to banks. In addition, they have business models with significant reliance on the ability to regularly secure new financing through CDO or commercial paper issuance secured by mortgages. Investors have become reluctant to fund such investments and are demanding higher interest rates. Such lenders are at increased risk of significant reductions in book value due to asset sales at unfavorable prices and several have filed bankruptcy. Special purpose entities (SPE): Like corporations, SPE are required to revalue their mortgage assets based on estimates of collection of mortgage payments. If this valuation falls below a certain level, or if cash flow falls below contractual levels, investors may have immediate rights to the mortgage asset collateral. This can also cause the rapid sale of assets at unfavorable prices. Other SPE called structured investment vehicles (SIV) issue commercial paper and use the proceeds to purchase securitized assets such as CDO. These entities have been affected by mortgage asset devaluation. Several major SIV are associated with large banks. Investors: The stocks or bonds of the entities above are affected by the lower earnings and uncertainty regarding the valuation of mortgage assets and related payment collection. 6/11 Team Chien Jaune – EMBA ESCEM Promo 5 - Subprime Crisis 2. Causes of the crisis 2.1. Role of lenders A variety of factors have caused lenders to offer an increasing array of higher-risk loans to higher-risk borrowers. The share of subprime mortgages to total originations increased from 9% in 1996, to 20% in 2006. Due to securitization, investor appetite for mortgage-backed securities (MBS), and the tendency of rating agencies to assign investment-grade ratings to MBS, loans with a high risk of default could be originated, packaged and the risk readily transferred to others. In addition to considering higher-risk borrowers, lenders have offered increasingly high risk loan options and incentives to them. One example is the interest-only adjustable-rate mortgage (ARM), which allows the homeowner to pay just the interest (not principal) during an initial period. Another example is a "payment option" loan, in which the homeowner can pay a variable amount, but any interest not paid is added to the principal. Further, an estimated one-third of ARM originated between 2004-2006 had "teaser" rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment. 2.2 Role of Borrowers Some homeowners had been using the increased property value experienced in the housing bubble to refinance their homes with lower interest rates and take out second mortgages against the added value to use the funds for consumer spending. Between 1997 and 2006, American home prices increased by 124%. Easy credit, combined with the assumption that housing prices would continue to appreciate, also encouraged many subprime borrowers to obtain ARMs they could not afford after the initial incentive period. With housing prices now depreciating moderately in many parts of the U.S., refinancing has become difficult, leaving homeowners with higher payments than anticipated. The housing bubble was largely fed by the lowering of interest rates to record low levels to diminish the blow of the massive collapse of the dot-com bubble. The collapse of the housing bubble, and resultant decline in property values, and increase in defaults has left lenders unable to recover losses. 2.3. Role of government and regulators Some observers claim that government policy actually encouraged the development of the subprime debacle through legislation like the Community Reinvestment Act, which they say forces banks to lend to otherwise uncreditworthy consumers. Regulators have turned their attention to rating agencies, who they think may have been conflicted in rating securitization transactions containing subprime mortgages. 2.4. Role of rating agencies Rating agencies are now under scrutiny for giving investment-grade ratings to securitization transactions holding subprime mortgages. Higher ratings are theoretically due to the multiple 7/11 Team Chien Jaune – EMBA ESCEM Promo 5 - Subprime Crisis independent mortgages held in the MBS per the agencies, but critics claim that conflicts of interest were in play. 2.5. Role of central banks Central banks are primarily concerned with managing the rate of inflation and avoiding recessions. They are also the “lenders of last resort” to ensure liquidity. They are less concerned with avoiding asset bubbles, such as the housing bubble and dotcom bubble. Central banks have generally chosen to react after such bubbles burst to minimize collateral impact on the economy, rather than trying to avoid the bubble itself. This is because identifying an asset bubble and determining the proper monetary policy to properly deflate it are not proven concepts. There is significant debate among economists regarding whether this is the optimal strategy. 3. Impacts 3.1. Impact on stock markets On July 19, 2007, the Dow Jones Industrial Average hit a record high, closing above 14,000 for the first time. By August 15, the Dow had dropped below 13,000 and the S&P 500 had crossed into negative territory year-to-date. Mortgage lenders and home builders fared terribly, but losses cut across sectors, with some of the worst-hit industries, such as metals & mining companies, having only the vaguest connection with lending or mortgages. 3.2. Impact on financial institutions Many banks, mortgage lenders, real estate investment trusts (REIT), and hedge funds suffered significant losses as a result of mortgage payment defaults or mortgage asset devaluation. As of December 11, 2007 banks had recognized subprime-related losses or writedowns exceeding U.S. $60 billion, with an additional $8-$11 billion expected from Citibank. Other companies from around the world, such as IKB Deutsche Industriebank, have also suffered significant losses and scores of mortgage lenders have filed for bankruptcy. Top management has not escaped unscathed, as the CEOs of Merrill Lynch and Citigroup were forced to resign within a week of each other. 4. Actions to manage the crisis  Central banks have 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 (called the discount rate in the U.S.) for shortterm loans. Both measures effectively lubricate the financial system, in two key ways. First, they help provide access to funds for those entities with illiquid mortgagebacked assets. This helps lenders, SPE, and SIV avoid selling mortgage-backed assets at a steep loss. Second, the available funds stimulate the commercial paper market and 8/11 Team Chien Jaune – EMBA ESCEM Promo 5 - Subprime Crisis    general economic activity. Specific responses by central banks are included in the subprime crisis impact timeline. Lenders and homeowners both may benefit from avoiding foreclosure, which is a costly and lengthy process. Some lenders have taken action to reach out to homeowners to provide more favorable mortgage terms (i.e., loan modification or refinancing). Homeowners have also been encouraged to contact their lenders to discuss alternatives. Credit rating agencies help evaluate and report on the risk involved with various investment alternatives. The rating processes can be re-examined and improved to encourage greater transparency to the risks involved with complex mortgage-backed securities and the entities that provide them. Rating agencies have recently begun to aggressively downgrade large amounts of mortgage-backed debt. Regulators and legislators can take action regarding lending practices, bankruptcy protection, tax policies, affordable housing, credit counseling, education, and the licensing and qualifications of lenders. President Bush's plan August 31, 2007 Created FHA-Secure for refinancing some borrowers with interest rate increases. On October 10, 2007 – Hope Now Alliance, was created by the US Government and private industry to help some sub-prime borrowers. The U.S. Treasury Department is working directly with major banks to develop a systematic means of modifying loans for a significant portion of borrowers facing ARM increases, rather than working through loans on a case-by-case basis. On December 6 , 2007, President George W. Bush announced a plan to voluntarily and temporarily freeze the mortgages of a limited number of mortgage debtors holding ARMs. 6. Impact in Europe and in France This kind of crisis would have not happened in continental Europe and specificly in France. Indeed, in France, only the State has the right to have unreasonnable debts (he has to borrow money to finance the interest of it’s debt). The impact of US subprime crisis is indirect in Europe. It appears through the assets of banks, but not through the inability of borrowers to meet their financial commitments. In England, the homeowner’s rate is one of the highest; loan market is stable, and banks are not looking to risky borrowers as in US. The risk of crisis is only coming from the CDO owned by banks in the US market. As seen with the Northern Rock Bank which felt in bankruptcy, when all customers wanted to remove their money, the central bank of England let 1 billion euros to Northern Rock in order to face urgent deadlines. Meanwhile the bank has been recapitalized by a group of investors. In France, borrowers are not used to take variable rates loans; the direct impact of the increase of rates is only a few hundred or thousands borrowers who are not able to face their monthly payment. 9/11 Team Chien Jaune – EMBA ESCEM Promo 5 - Subprime Crisis In Germany, national market of loan is very low; people are not used to have loans. To invest, German banks have bougth opportunities and CDO on external markets and especially in US. The impact on German banks is higher than in England or France. The short term impacts of the crisis in Europe are multiple :  impact on the results of banks that have invested in CDO or MBS; those banks must put depreciation in their 2007 results to impact the value lost by their assets. Those results will be audited and published by first semester 2008. That’s why the Stock exchange crisis can’t stop before the looses of banks are known by middle of 2008. decrease of loans provided to borrowers who wants to buy houses, because rate increase and because banks don’t want to take risks anymore with the borrowers; it will be more difficult for potential buyers to lend money from banks. Decrease of loan made between banks; there is a liquidity short term problem, because banks stop to lend money to each other until the real impact on each bank results is known, and until solvability is known.   To face the short term impact in Europe, the European Central Bank has provided liquidities to the market with preferred rate in parallel with the Federal Bank, Bank of Canada, and Banque National Suisse ; but it is only a short term temporary solution. In short term there shouldn’t be other bankruptcy of bank in Europe, due to the coverage and the help of the ECB The medium and long term impact in Europe is not well defined depending especially if the ECB increases or decreases rates, or depending on the investment made by the emergent countries bank such as China, India, and Arabic countries which have a lot of liquidities. The target is of course not to postpone the problem and create a new speculation bubble that could appear in 2 or 3 years. 6. Expectations and forecasts Alan Greenspan has remarked that there is a one-in-three chance of recession from the fallout. Nouriel Roubini, a professor at New York University and head of Roubini Global Economics, has said that if the economy slips into recession "then you have a systemic banking crisis like we haven't had since the 1930s". On September 7, 2007, the Wall Street Journal reported that Alan Greenspan has said that the current turmoil in the financial markets is in many ways "identical" to the problems in 1987 and 1998. MarketWatch has cited several economic analysts with Stifel Nicolaus claiming that the problem mortgages are not limited to the subprime niche saying "the rapidly increasing scope and depth of the problems in the mortgage market suggest that the entire sector has plunged into a downward spiral similar to the subprime woes whereby each negative development 10/11 Team Chien Jaune – EMBA ESCEM Promo 5 - Subprime Crisis feeds further deterioration", calling it a "vicious cycle" and adding that they "continue to believe conditions will get worse". As described in the background section above, 16% of the estimated U.S. $1.3 trillion in subprime mortgages were in default as of October 2007, or approximately $200 billion. Considering that $500 billion in subprime mortgages will reset to higher rates over the next 12 months (placing additional pressure on homeowners) and recent increases in the payment default rate cited by the Federal Reserve, direct loss exposure would likely exceed the $200 billion figure. This figure may be increased significantly by "Alt-A" defaults. The impact will continue to fall most directly on homeowners and those retaining mortgage origination risk, primarily banks, mortgage lenders, or those funds and investors holding mortgage-backed securities. As cited above, many such entities have reported significant losses from both revising the valuation of mortage assets and the sale of MBS at steep losses. Regulators are carefully monitoring this exposure. In addition, a consortium of banks are establishing a fund to prepare for this impact and have committed nearly $100 billion as of last October. 11/11 Team Chien Jaune – EMBA ESCEM Promo 5 - Subprime Crisis