Wednesday, November 19, 2008

Sub Prime Crisis: What It Is All About?

What Is Sub Prime Lending?

Sub prime lending (also known as B-paper, near-prime, non-prime, or second chance lending) generally refers to lending at a higher expectation of risk than that of A-paper, and generally accompanied by higher interest rates. In the United States, mortgage lending specifically, the term "sub prime" refers to loans that do not meet Fannie Mae or Freddie Mac guidelines. This is generally due to one or a combination of factors, including credit status of the borrower, income and job history, and income to mortgage payment ratio. The phrase also refers to bank loans taken on property that cannot be sold on the primary market, including loans on certain types of investment properties and to certain types of self-employed persons. Sub prime lending encompasses a variety of credit instruments, including mortgages, car loans, and credit cards.

In late 2006, falling housing prices and rising delinquencies in mortgages in the US triggered the “sub-prime” crisis. Initially thought to be limited in scope and well contained, it rapidly turned into a global financial crisis. Low interest rates, loose monetary policy and excessive capital flows turbo-charged by “financial engineering” created a gigantic debt bubble that has fuelled financial markets and increased asset prices dramatically over recent decades’

To date, the crisis has resulted in losses to financial institutions of more than US$300bn. In mid-2008, the markets seemed to take the view that the worst was past, but investors should perhaps heed the words of Sir Winston Churchill, that ‘this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.’

The global financial system is currently undergoing a significant de leveraging. Banks have been forced to raise equity, capital and debt at record levels to finance losses together with “involuntary asset growth”. This has led to significant increase in the cost of credit and reduced the availability of debt in financial markets. The scarcity of debt will deleverage the “real” economy that in turn may trigger defaults and further losses for financial.

The “chain reaction” of the credit crisis entails complex positive and negative feedback loops. This process will take time to play out. The end result will be a significant reduction in the level of debt in the global financial system. Actions of central banks - lower interest rates, liquidity support, bailouts - will smooth the transition, but cannot prevent the adjustment from taking place.

Meaning Of  Sub Prime:

 Subprime lending, also called "B-Paper", "near-prime" or "second chance" 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.

Generally, subprime mortgages are for borrowers with credit scores* of under 620.Subprime loans have higher rates than equivalent prime loans. How much higher depends on factors such as credit score, size of down payment, delinquencies history of the borrower in the recent past etc. A subprime loan is also more likely to have a prepayment penalty.

Subprime lending encompasses a variety of credit instruments, including subprime mortgages, subprime car loans, and subprime credit cards, among others.

The Concept of a Credit Score - In the US a credit score is a number typically between300 and 850 and is based on the statistical analysis of a person's credit files. The number represents the creditworthiness of that person (higher the number the better). A credit score is primarily based on credit report information, typically from the three major credit bureaus - Experian, Equifax & TransUnion.

The lending job was made easier with exotic mortgages such as so-called no-doc loans, which enable borrowers to get loans without having to supply evidence of income or savings, and option ARMs, adjustable-rate mortgages that let people pick how big a payment they will make from month to month.

The loans offer upfront teaser rates at the cost of taking the deferred payments onto the balance of the loan.

 A very common mortgage in the subprime market is the 2/28 ARM. This is an adjustable rate mortgage (ARM) on which the rate is fixed for 2 years, and then reset to equal the value of a rate index at that time (i.e. after 2yrs) plus a margin for the balance 28yrs. Because the margins are high, the rate on most 2/28s will often rise sharply at the 2-year mark, even if market rates do not change during the period.

Some borrowers with poor credit scores take a 2/28 at a high rate and plan to rebuild their credit during the 2-year period. Their plan is to refinance at a better rate at that time for the balance of 28 years. The major threat to such a plan is a prepayment penalty. 

The US sub-prime mortgage crisis has lead to plunging property prices, a slowdown in the US economy, and billions in losses by banks. It stems from a fundamental change in the way mortgages are fundedTraditionally, banks have financed their mortgage lending through the deposits they receive from their customers. This has limited the amount of mortgage lending they could do. In recent years, banks have moved to a new model where they sell on the mortgages to the bond markets. This has made it much easier to fund additional borrowing.But it has also led to abuses as banks no longer have the incentive to check carefully the mortgages they issue. 

Fore Clouser Process:

Customer misses mortgage payment.

Late notice send by bank.

Customer misses additional payments.

Bank attempts in writing and by phone to contact customer and resolve situation.

No arrangements are agreed upon and customer continues to miss payments.

Bank issues demand for payment under the note in full.

No payments or arrangements acceptable to the bank are made.

Formality Of Fourclouser:

Bank sends by certified mail Notice of Intent to Foreclose.

Bank begins action in the court system to foreclose.

Legal notices as required by law begin to be published in local papers.

No payment or settlement arrangements are made with the lender.

Notice and waiting periods expire.Court holds hearing regarding banks claim.

Court issues order allowing bank to foreclose.

Legal notice of actual foreclosure sale and advertisements published in local papers.

No payment arrangements or settlements reached with the bank.

House sold at auction to highest bidder.

The Mortgage Meltdown:

The subprime mortgage meltdown refers to the rush of subprime mortgage foreclosures that began in the United States in late 2006 and has continued into 2007. The sharp rise in foreclosures has caused several major subprime mortgage lenders, such as New Century Financial Corporation, to shut down or file for bankruptcy, leading to the collapse of stock prices for many in the subprime mortgage industry.

The crisis was slow in coming, but it could have been anticipated several years in advance. It had its origins in the bursting of the Internet bubble in late 2000. The Fed responded by cutting the federal funds rate from 6.5 percent to 3.5 percent within the space of just a few months. Then came the terrorist attack of September 11, 2001. To counteract the disruption of the economy, the Fed continued to lower rates—all the way down to 1 percent by July 2003, the lowest rate in half a century, where it stayed for a full year. For thirty-one consecutive months the base inflation-adjusted short-term interest rate was negative.

Cheap money engendered a housing bubble, an explosion of leveraged buyouts, and other excesses. When money is free, the rational lender will keep on lending until there is no one else to lend to. Mortgage lenders relaxed their standards and invented new ways to stimulate business and generate fees. Investment banks on Wall Street developed a variety of new techniques to hive credit risk off to other investors, like pension funds and mutual funds, which were hungry for yield. They also created structured investment vehicles (SIVs) to keep their own positions off their balance sheets. From 2000 until mid-2005, the market value of existing homes grew by more than 50 percent, and there was a frenzy of new construction. Merrill Lynch estimated that about half of all American GDP growth in the first half of 2005 was housing related, either directly, through home building and housing-related purchases like new furniture, or indirectly,by spending the cash generated from the refinancing of mortgages. Martin Feldstein, a former chairman of the Council of Economic Advisers, estimated that from 1997 through 2006, consumers drew more than $9 trillion in cash out of their home equity. A 2005 study led by Alan Greenspan estimated that in the 2000s, home equity withdrawals were financing 3 percent of all personal consumption. By the first quarter of 2006, home equity extraction made up nearly 10 percent of disposable personal income. Double-digit price increases in house prices engendered speculation. When the value of property is expected to rise more than the cost of borrowing, it makes sense to own more property than one wants to occupy. 

By 2005, 40 percent of all homes purchased were not meant to serve as permanent residences but as investments or second homes.† Since growth in real median income was anemic in the 2000s, lenders strained ingenuity to make houses appear affordable. The most popular devices were adjustable rate mortgages (ARMs) with “teaser,” below-market initial rates for an initial two-year period. It was assumed that after two years, when the higher rate kicked in, the mortgage would be refinanced, taking advantage of the higher prices and generating a new set of fees for the lenders. Credit standards collapsed, and mortgages were made widely available to people with low credit ratings (called subprime mortgages), many of whom were well-to-do. “Alt-A” (or liar loans), with low or no documentation, were common, including, at the extreme, “ninja” loans (no job, no income, no assets), frequently with the active connivance of the mortgage brokers and mortgage lenders.

Time Bomb:– 

March 13 2007 - the Wall Street Journal reported that "banks and larger mortgage lenders are trying to force smaller mortgage lenders to buy back some of the same loans that the larger entities eagerly purchased from the smaller mortgage originators in 2005 and 2006, by enforcing what the industry calls repurchase agreements.“

June 21, 2007 - foreclosure data was released indicating that the number of residential mortgages going into foreclosure hit a record in the first quarter of 2007, with the biggest increases coming in the so-called "subprime" market of borrowers with weaker credit histories.

June 21, 2007 - The Bear Stearns Companies, Inc. announced that it is preparing to shut down two hedge funds.

July 10, 2007 - Standard & Poor's said it may cut credit ratings on $12 billion in bonds backed by subprime mortgages because losses will rise beyond its previous expectations.

July 18, 2007 - Bear Stearns said that investors in its two failed hedge funds will get little if any money back after ``unprecedented declines in the value of securities used to bet on subprime mortgages.

Fall Like A Pack Of Cards:

 These are the following  examples of how a large sized player fell under the dramatic retrenchment of credit availability due to the recent contraction of the subprime market.


1. The American Home Mortgage Investment Corp. (AHM) was the 10th largest residential mortgage lender in the US, having originated about USD 60 billion of mortgage loan during 2006 from 550 offices in 47 states.

 2. On 28 July, AHM announced it was delaying the payment of its common dividend due to “disruptions” in the credit markets in the past few weeks causing major writedowns of its loan and security portfolios, leading to margin calls with respect to its credit facilities.

 3. On 31 July, AHM released a statement that it was unable to borrow on its credit facilities and so was unable to fund its outstanding mortgage loan commitments for that day.

 4. On 3 August, AHM announced it would fire all 7,000 of its production employees as it was shutting down operations.

 5. A bankruptcy filing is now a very real possibility.

Hedge Funds In Trouble:

1. An investment bank pools a package of subprime mortgages issued by the American Home Mortgage (underlying mortgages are 2/28 ARMs with initial teaser rates, little documentation, etc.) and offers hedge funds a bond that yields 7%. A hedge fund manager might say, "OK, I have $1 billion under management. I will go to the bank and borrow 10 billion and invest in these kinds of bonds.“

 2. These trades continue to perform well regardless of the stock market, as long as houses go up in value, mortgages get paid, employment rates are strong…that's all that matters. The bonds will pay, so hedge funds keep buying more mortgage-backed securities and borrowing money to leverage.

3. Now housing stops going up in 2006, and in 2007, the bonds moved down in value and to the point where hedge funds must put up more collateral to keep the trades on. This is simply because on a mark-to-market basis, like any interest rate swap, the net present value of the hedge fund’s side is much lower than that of the counterparty banks (the borrowed portion to invest in the bonds, or leveraged amount, plays a big role in this).

 4. The hedge fund doesn’t have much cash (it has invested  it all and also borrowed more to invest), so it needs to sell some of the bonds. The problem is, no one wants the bonds now as defaults on mortgages are mounting up.

5. By the time the hedge fund finishes selling the bonds, the collateral is all gone, and the fund then closes.

Role Played By Rating Agencies:

Other key players that have a major role in supporting the appetite for risky subprime loans are the credit-ratings agencies, such as Moody’s Investors Service, Fitch Ratings and Standard & Poor’s.

When a bank creates a CDO, it meets with credit raters to discuss the quality of the contents, including subprime debt. They divide the CDO in pieces in order to get the desired rating for each portion (or “tranches,”).

Throughout last year, these agencies raised no red flags about securities backed by subprime mortgages, and they continued to give investment-grade ratings to these securities based on the tranches expected to perform the best. Some bonds backed by subprime mortgages fell by more than 50 cents on the dollar this year without their credit ratings changing.

In July 2007, Moody's and Standard & Poor's cut ratings on billions of dollars of bonds backed by subprime mortgages, on expectations home-loan defaults will rise. Moody's in its report said the criticism of its subprime debt rankings stem from ``a lingering confusion'' about its role. Credit ratings provide an assessment of default risk for the ``hold-to maturity credit world'' rather than addressing the ``volatility-liquidity issues'' that interest investors such as hedge funds.

Major Impact Of SUB PRIME Crisis: Crash Of House Prices.

The wave of repossessions is having a dramatic effect on house prices, reversing the housing boom of the last few years and causing the first national decline in house prices since the 1930s. There is a glut of four million unsold homes that is depressing prices, as builders have also been forced to lower prices to get rid of unsold properties. And house prices, which are currently declining at an annual rate of 4.5%, are expected to fall by at least 10% by next year - and more in areas like California and Florida which had the biggest boom.

Property Price Crash:

The property crash is also affecting the broader economy, with the building industry expected to cut its output by half, with the loss of between one and two million jobs. Many smaller builders will go out of business, and the larger firms are all suffering huge losses. The building industry makes up 15% of the US economy, but a slowdown in the property market also hits many other industries, for instance makers of durable goods, such as washing machines, and DIY stores, such as Home Depot.

Credit Crunch:

One reason the economic slowdown could get worse is that banks and other lenders are cutting back on how much credit they will make available. They are rejecting more people who apply for credit cards, insisting on bigger deposits for house purchase, and looking more closely at applications for personal loans.

The mortgage market has been particularly badly affected, with individuals finding it very difficult to get non-traditional mortgages, both sub-prime and "jumbo" (over the limit guaranteed by government-sponsored agencies). The banks have been forced to do this by the drying up of the wholesale bond markets and by the effect of the crisis on their own balance sheets.

Banks Runs:

Major Banks making heavy losses.

Lehman Bros went for liqidations.AIG went in deep trouble.All interbanking loans became deaer. LIBOR rate went up all time high in last thirty years.


CNN Money,Economist,Wall Stree Journal,CITI Bank,New York Times,The Economic Times,CNBC.




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