Subprime Lending Crisis

1
Subprime Lending Crisis

• Professor Thomas Cosimano
• Department of Finance

2
Housing Prices
3
Expected Defaults on Mortgages.
4
Expected Losses on Jumbo, Subprime, and Alt-A MBS

• Fannie and Freddie hold mainly prime mortgages.
  Subprime loans are mainly non-agency.
• Total Non-Agency 1963Billion Agency
  4,021Billion
• Default Rate 25 5
• Expected Loss 20 20
• Estimated
• Total Losses 98Billion
  40Billion
• Why has the stock market drop 8 Trillion over
  the last year?
• Trust and lack of trust!!!

5
Financing of Mortgages

• Balance sheet of Commercial Bank such as Chase
  Manhattan
• Typical mortgage is 30 years fixed rate loan.
  Prime mortgage borrower is required to put 20
  down and good credit rating.
• Banks are required to hold 6 of assets in the
  form of equity.

Assets
Liability plus Net Worth
Deposits 94
Mortgages 100
Equity 6
6
Capital of Commercial Banks.
Table 2. Average Capital Ratios of Top U.S. and European Banks 20032007 Table 2. Average Capital Ratios of Top U.S. and European Banks 20032007 Table 2. Average Capital Ratios of Top U.S. and European Banks 20032007 Table 2. Average Capital Ratios of Top U.S. and European Banks 20032007 Table 2. Average Capital Ratios of Top U.S. and European Banks 20032007 Table 2. Average Capital Ratios of Top U.S. and European Banks 20032007
T1 T2
  2003 2004 2005 2006 2007(Q3)


(in percent of risk-weighted assets) (in percent of risk-weighted assets) (in percent of risk-weighted assets) (in percent of risk-weighted assets) (in percent of risk-weighted assets) (in percent of risk-weighted assets)

U.S. Banks
Tier 1 Ratio 8.9 8.6 8.4 8.6 8.3
Tier 2 Ratio 3.8 3.5 3.4 3.5 3.2
Total Capital Ratio 12.8 12.3 11.9 12.0 11.4

European Banks
Tier 1 Ratio 8.7 8.7 8.5 8.5 8.1
Tier 2 Ratio 4.4 4.5 4.1 4.0 3.2
Total Capital Ratio 13.0 13.2 12.7 12.6 11.6
           





Source Thomson Financial (2007). Ratios are
computed as the average capital ratio for the top
25 largest banks based on reported risk-weighted
assets. Ratios for 2003-2006 are based on
end-of-year reporting while ratios for 2007 are
based on third quarter reporting.
7
Decline in housing and mortgages.

• Starting 2007 price of houses fall. Decrease of
  over 15 in Florida, California, and Arizona.
• Increase in foreclosures of adjustable subprime
  loans from 8-27.

8
Suppose 5 of banks mortgages are lost.

• Balance sheet of Chase Manhattan
• Depositors with less than 100,000 are not
  concern since deposits are insured by FDIC.
• Chase is forced to raise equity back to required
  6 of assets.

Assets
Liability plus Net Worth
Deposits 94
Mortgages 95
Equity 1
9
Suppose Chase does not want mortgages.

• Based on experience Long term assets do not match
  well with short term liabilities.
• Chase thinks mortgages are subject to too much
  interest rate and price risk.
• Sell mortgage back security to someone who has
  long term liabilities. Partially remove mortgages
  from balance sheet.
• Examples Pension Funds.
• Fannie and Freddie designed to facilitate this
  process.

Assets
Liability plus Net Worth
Deposits 94
Mortgages 100
Equity 6
10
SIV of Lehman Brothers buys MBS funds which are
funded with commercial paper from Merrill Lynch

• Starting in late 70s depositors of commercial
  banks convinced to place funds in money market
  accounts at Investment banks such as Merrill
  Lynch.
• Some money market accounts invest in prime
  commercial papershort term bonds. Others invest
  in US Treasury Securities.

Consolidation of Lehman Brothers and
its SIV
Consolidation of Merrill Lynch and its SIV
Commercial Paper Lehman 97 Commercial
paper Others 933
Commercial Paper 97 Equity 3
Money market Accounts 1000 Equity 30
Mortgage Back Security 100
11
Suppose we look at same 5 cut in value of
mortgages.

• Lehman losses 5, so their net worth is negative.
  Forced to declare bankruptcy September 15.
• Merrill is paid only 95 after bankruptcy
  proceedings. Equity drops to 28.
• Depositors do not know how much Merrill will
  lose. Depositors demand their deposits, since
  deposits are not insured by FDIC.
• Result is a bank run. Merrill is taken over by
  Chase Manhattan.

Lehman Brothers
Merrill Lynch
Mortgage Back Security 95
Commercial Paper 97 Equity -2
Commercial Paper to Lehman 95 Commercial
paper Others 933
Money market deposits 1000 Equity 28
12
Bank Run.

• When deposits are short term and depositors are
  not sure about longer term and/or illiquid assets
  of the firm, individuals withdraw their funds and
  place them in safer investments.
• After the Failure of Lehman, the Reserve Primary
  Fund and a few others, who invested in Lehman CP,
  had to reduce value of fund, September 17 -
  called break the buck.
• Investors started withdrawing 100 of Billions
  from money market accounts, that invest in CP and
  placed them in accounts, that invest in US
  Treasuries.
• MBS, Commercial Paper and Interbank lending are
  frozen. Implies prices are significantly lower.
• If financial firms have to liquidate now they
  would go bankrupt, however over the longer term
  some asset values will go back to normal.

13
Financial Institutions and Trust.

• Investors have lost trust in the soundness of
  financial institutions, since they do not know
  which are in sound financial position.
• Who has assets tied to the well performing
  companies, mortgages etc?
• Someone has to step in an establish who is and
  who is not financially sound.
• Purpose of Bailout plan is to establish this
  confidence.

14
Bailout Bill

• 700 Billion is authorization to buy and or
  guarantee assets so that confidence is restored.
• How to do this?
• Establish guarantee of asset values. The
  governments of the world have to vouch for the
  soundness of assets by acting as co-signer on
  loans.
• Buy assets that have long term value but
  currently are depressed.
• Purchase subprime and prime mortgages.
• Governments buy bank capital in exchange for
  these assets.
• Total Cost will probably not be 700 Billion.
  Once markets start to function effectively the
  values will move back to normal.
• Program is dependent on leaders establishing
  confidence and clearly explaining what is being
  done.

15
I have no idea what the stock market is going to
do next month or six months from now, Warren
Buffett told CNBC on Friday. I do know that the
American economy, over a period of time, will do
very well, and people who own a piece of it will
do well.
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