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THE SUB-PRIME CRISIS From the real-estate bubble to the global financial crisis Claudio Morelli Martina Tognaccini.

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Presentation on theme: "THE SUB-PRIME CRISIS From the real-estate bubble to the global financial crisis Claudio Morelli Martina Tognaccini."— Presentation transcript:

1 THE SUB-PRIME CRISIS From the real-estate bubble to the global financial crisis Claudio Morelli Martina Tognaccini

2 Analysis of the clinic case Backward 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 burst What the regulators and financial institution tried and are trying to do to fight the started global financial crisis.

3 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

4 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

5 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 crash the 11 September 2001 the 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 %

6 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securities (MBS) which includes loans to low income borrowers  to increase home ownership 1999  President Clinton repealed the Glass-Steagall Act which had separated commercial and investment banks.

7 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

8 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.

9 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

10 Financial Market Grater amount of mortgages  more securitization  higher return

11 Financial Market Investment 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 BUYER Risk Seller HEDGING POSITION PROTECTION SELLER Risk Buyer SPECULATIVE POSITION CREDIT RISK Cost Of Protection Agreed Amount

12 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….?

13 The House Bubble Burst The prices dropped to their real value

14 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

15 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

16 Consequences for Financial market

17 Effects of the increase of leverage Many 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?

18 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

19 Risk factors They were the key of the financial meltdown (Financial Crisis Inquiry Commission, January 2011) Rating Agencies High 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

20 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 CDSs Off-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

21 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!)

22 Lessons to be learnt  Need of a stronger regulation for the banks and need of a first regulation for SBS  Caution in applying Monetary Policies  Caution in the usage of high risk mortgages  Need of a well diversified portfolio in the banks’ balance sheet  Need of a regulamentation for Rating Agencies  Caution in the usage high risk Derivatives  Need of avoiding the arbitrage between banking and trading book  Need of a Global standardized regulation of the financial system

23 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:

24 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 Risk 3. 8% capital charge in all cases.

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