The Subprime Mortgage Crisis Ann Dunn Andracchio Preeti Arunapuram Shailja Amin Arjun Ajmani

What is the Subprime Mortgage Crisis? The Subprime Mortgage Crisis of 2008!!!

Credit Enhancement The process of reducing overall credit risk Require additional collateral, insurance, or other third party agreements Provide lender with compensation in case the borrower defaults

Credit Enhancement Because the overall credit risk decreases, the borrower’s credit rating goes up, projecting a false image of good credit.

Credit Enhancement There are many different types of credit enhancement. But the three most common forms are called subordination, overcollateralization, and excess spread.

Special Purpose Vehicle Trustee Credit Enhancement Investor Special Purpose Vehicle Reference Portfolio Loan Bond ABS CDS Other CDOS Securities AAA AA A BBB BB+ or <

Credit Enhancement and the Crash of 2008 The recent mortgage crisis discredited the use of credit enhancement as a valid financial practice. Credit enhancement results in a faulty credit ratings as it artificially inflates them. This in turn allows for those with bad credit ratings to secure high-risk loans with an even higher risk of defaulting.

Credit Enhancement and the Crash of 2008 Because of credit enhancement, many credit rating agencies such as Standard’s and Poor could not give out accurate ratings. Many homeowners were allowed risky loans based on faulty credit ratings. This led to many loan defaults and home foreclosures.

The Housing Bubble In 2006, there was a boom in the housing market People bought expensive houses using loans with low interest rates

The Housing Bubble and the Crash of 2008 Suddenly the rates would increase, borrowers could not afford new rates Foreclosures and other factors caused the housing market to decline When borrowers could not pay back the loans, banks lost money

The Housing Bubble and the Crash of 2008 Other sectors also lost money (real-estate, construction, etc.) This started to affect the stock market when investors lost confidence in the economy

The Housing Bubble and the Crash of 2008 Loan Amount: $100,000 Interest Rate: 1% Rate Adjustments: 3

Risky Lending and the Crash of 2008 Americans lost more than a quarter of their net worth. At the end of 2008, S&P 500 (stock market) was down 45 percent from the high in 2007

Risky Lending and the Crash of 2008 Housing prices had dropped between 20% and 35% from 2010 Total home equity in the United States, which was valued at $13 trillion at its peak in 2006, had dropped to $8.8 trillion and was still dropping at the end of 2008. Retirement assets dropped by 22 percent from $10.3 trillion in 2006 to $8 trillion in 2008.

Risky Lending and the Crash of 2008 Savings/Investment assets lost $1.2 trillion Pension assets lost $1.3 trillion The crisis caused panic in the financial sector in the beginning of 2007. Over 100 mortgage companies shut down. CEOs of many large corporations are merging companies or even resigning

Credit Default Swap (CDS) A swap contract The protection buyer makes a series of payments to the protection seller and receives a payment if the credit instrument experiences a credit occurrence (i.e. defaulting on a loan) Typical credit instruments of CDSs are bonds and loans

CDS and the Crash of 2008 In 2007, the outstanding amount in credit defaults was $68.2 trillion. By the end of 2008, that number had shrunk to $38.6 trillion.

CDS and the Crash of 2008 AIG’s potential losses due to irresponsible CDSs reached a whopping $100 billion. The U.S. government had to bail out AIG due to risky lending.

CDS and the Crash of 2008 When Lehman Brothers went bankrupt, around $400 million was owed to CDS protection buyers who hedged against the bank. The actual amount swapped amounted to $7.2 billion.

CDS and the Crash of 2008 Many people believe that a large amount of CDS purchases which hedged against Bear Stearns led to the company’s downfall. Others believe that these CDSs were not a cause of Bear’s fall but an effect.

CDS and the Crash of 2008 Because of the large effect that CDSs had on the subprime mortgage crisis and the subsequent economic recession, both politicians and civilians alike are pushing for more government regulation of credit default swaps.

Sources Inside the House of Money by Steven Drobny; pgs. 365-380 Financial Futures Markets by Brendan Brown and Charles R. Geisst