A Primer on the Subprime Crisis

1
A Primer on the Subprime Crisis
School of Economics and Finance
2
US Interest Rates (cost of )
3
Role of Interest rates

• The core ingredient for a financial crisis is
  excessive lending and/or excessive risk taking.
• Low interest rates led to the opening of new
  mortgage markets (ie. new borrowers).
• The US dream of owning your own home spread to
  many sectors of US society including low income
  borrowers.
• The USA mortgage market comprises of
• (i) prime obligations/borrowers and
• (ii) subprime borrowers.

4
Subprime Mortgages

• Subprime mortgages are loans to borrowers with
  imperfect credit criteria.
• About 21 of all mortgage originations from 2004
  through 2006 were subprime, up from 9 from 1996
  through 2004
• Other higher risk mortgages included Alt-A (ie.
  low documentation) and NINJA (no income, no
  job/assets) loans.

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Traditional model of banking

• Banks raise funds (capital) from
• Depositors
• Issuing shares or bonds
• Banks then lend the funds to individuals in the
  form of mortgages
• Banks then have their capital tied up in the
  mortgages for a long period of time
• Mortgages are illiquid investments

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Financing of Subprime Mortgages

• Subprime mortgages were pooled together and sold
• The riskiest mortgages were pooled together into
  collateralized debt obligations (CDOs).
• To make these mortgages safer for investors, they
  had companies to act as mortgage guarantors, eg
  AIG.
• By packaging these mortgages together, the
  cashflows to investors were expected to be
  regular, safe and were given a AAA credit rating
  by Moodys Standard and Poors.
• Banks, super funds, state treasuries and many
  Australian city councils purchased these CDOs.

7
A Property Boom

• Cheap money led to a housing bubble and an
  unregulated US mortgage market.
• Credit standards collapsed as lenders scrambled
  to lend cheap money.
• Predatory lending practices grew. Borrowers on 7
  interest rates were convinced to refinance into
  larger borrowings at a 6.5 teaser rate.
• Mortgage brokers were lending money with two year
  teaser or honeymoon interest rates.
• The US property market boomed in the early to mid
  2000s.

8
US Mortgage Defaults have risen

• As at Sept 2008, 12 of all US subprime loans are
  in foreclosure (ie. in default).
• Source Reserve Bank of Australia (RBA)
  Financial Stability Review, Sept 2008.

9
People lose their houses

• Historical USA mortgage default rates were 0.5
  to 1.0 of all loans.
• As at 2008, Q2, 3.93 of all US prime loans are
  in default.
• As at 2008, Q2, 18.67 of all US subprime loans
  are in default.

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Impact of the crisis

• 18.67 of the mortgages in these CDOs have
  failed.
• During 2008, the value of these CDOs collapsed.
• In March2008, Wall St investment banks Bear
  Stearns dies.
• In Sept 2008, Lehman Brothers collapses, Merrill
  Lynch is purchased by Bank of America.
• In Sept 2008, AIG collapses as it could not
  afford to pay for all of these US mortgage
  defaults. The US government nationalises AIG by
  becoming 80 shareholder.

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Impact of the crisis

• Based on a current valuations, banks have lost a
  lot of their money on falling valuation on
  mortgages, ownership of CDOs and the selling of
  this CDS insurance.
• In October 2008, lack of confidence in global
  banking system leads to fear of lending money to
  each other. Credit markets totally freezes.