What is SUBPRIME?

 SUBPRIME MORTGAGE – It is the mortgage for people with shaky credit,

or specifically, people who is unlikely to be able to pay the mortgage.
 Usually it’s given to those who are seeking money to finance their houses.
When ?
The dotcom bubble of 00-01 and 9/11 attacks drove the US FEDERAL
RESERVE to follow an ultra-easy monetary policy to curb RECESSION.

ncrease in mortgage Y?
Boom and bust in Housing market
 Low interest rates due to gov’t policies.

 Rise in the housing price.

Y ? …cont’d
High risk mortgage loan and lending/borrowing practice
 lending more and more loans to high risk borrowers and immigrants.
• Government policies.
• Policies of the central bank.
Ultimately….Downturn & crash
• Interest rates started rising due to
inflationary concern.
• The overbuilding of homes during
the boom period eventually led
to a surplus inventory of homes causing home prices to decline .
Causes ….
• Offering NINJA loans.
• Payment options.
 Mortgage-backed securities(MBS)

 Which derive their value from mortgage payments and housing prices.

 Had enabled financial institutions and investors around the world to invest
in the U.S. housing market.

 Major banks and financial institutions had borrowed and invested heavily in
MBS and reported losses of approximately US$435 billion as of 17 July 2008.
 There are four primary types of
risks..
 Credit risk
the risk that the homeowner or borrower will be unable or unwilling to pay
back the loan.

 Asset price risk

the risk that assets will depreciate in value, resulting in financial losses.

 Liquidity risk
the risk that a business entity will be unable to obtain financing.

 Counterparty risk
the risk that a party to a contract will be unable or unwilling to uphold their
obligations.
 Impact on INDIA
 FOREX,equity and commodity markets.
 INDIAN RUPEE.
 INDIAN BOURSES ( came down from
21,200 in Jan 2008 to 7,700 level in
Nov 2008)

Reason
 The foreign banks and hedge funds started unloading their holding in
INDIAN EQUITIES resulting in fall in the stock price and weakening the
domestic currency.

 Hitting the IT enabled services, since a majority of the Indian IT firms derive
75% of their revenues from US.
 Tourism sector was badly affected. Now it is the time to promote the aggressive
health tourism.
 Impacts ….cont’d
 A recession in US has seen theloss of some
jobs in India.
 The subprime crisis has leg to near loss of
confidence in the American stock market.
 The near recession situation in the US has lead to a loss of demand for Indian
exports hence loss of export earnings for India.
 Investment banks and other financial institutions are on a job slashing spree to
cut costs.
 There will be several implications for the banking sectors. Indian banks have to
follow stricter norms while disbursing loans.
 The number of investor accounts at stock exchange has surged. A crash in
the equity price is effecting more people than ever before.
 Initiatives by gov’t
 The US gov’t to stimulate the economic growth enacted a LAW on “ECONOMIC
STIMULUS PACKAGE” of $168 billion mainly in the form of tax rebates.

 was acquired by JP MORGAN CHASE with the support of US

FEDERAL RESERVE.

 was taken over by for $50 billion.

 The US FEDERAL RESERVE provided a loan of $85 billion to the
troubled insurance giant resulting in the US gov’t acquiring a 79.9%
stake in the company.
 The US gov’t announced a $700 billion bail-out package to stimulate
the economy.
 Investment banks like and
converted themselves as regular banks.
PICTORIAL- CRISIS
History of Lehman Brothers

 Founded in 1850 as a commodities trading business.

 In 1977, merged with Kuhn, Loeb & Co., an investment bank.

 Increase in the revenues and grew in employees.

 Lehman Brothers Inc (Lehman Brothers) once the 4th largest Investment
bank in the world filed for chapter 11 of bankruptcy on September
15th 2008.
CONT……Business Overview
 Investment Banking

Lehman's investment banking operations accounted for just 20% of the

company's 2007 revenue.
CONT……Business Overview
 Capital Market
 CONT……Business Overview
 Fixed Income

Over the last 8 years, roughly 40% of Lehman's net revenues have
come from fixed income sales and trading. Some of the different
fixed income investments that Lehman deals with include derivative
and swaps.
CONT……Business Overview
 Investment Management:

The investment management business provides a stable earning base

because its fee-based structure generates revenues based on assets under
management rather than the total number of transactions.
Business Overview
CONT……Business Overview
The fall of Lehman Brothers
 Reason for Collapse
Boom in real estate.
In 2003 and 2004, with the U.S. housing
boom well under way, Lehman acquired
five mortgage lenders, including subprime
lender BNC Mortgage and Aurora Loan Services, which specialized in Alt-A
loans (made to borrowers without full documentation).
Lehman's Colossal Miscalculation.
The Beginning of the End.
As the credit crisis erupted in August 2007 with the failure of two Bear
Stearns hedge funds , Lehman's stock fell sharply. During that month,
the company eliminated 2,500 mortgage related jobs and shut down
its BNC unit.
Hurtling Toward Failure.
Lehman's high degree of leverage - the ratio of total assets to
shareholders equity - was 31 in 2007, and its huge portfolio of
mortgage securities made it increasingly vulnerable to deteriorating
market conditions.
 Reason for Collapse
 The basic reason of Lehman going bankrupt is the amount of debt it
debt had
accumulated over a period of time.

 significant reduction in
reduction the prices of
real estate due to the mortgage
crisis in the US.

 The bank raised the interest rates for

rates the housing loans which made the
repayment of loans very difficult for the borrowers.

When Lehman had had a total debt of $639 billion in various areas, it
made an offer to Barclay's and Bank of America for acquisition but both
the banks turned down the offer because in the past, Lehman had failed
to keep good relations with these top banks in the country. So in the end,
Lehman had to file for bankruptcy.
 MERRILL LYNCH

 Merrill lynch was established in 1915 by Charles E Merrill

and Edmund C Lynch

 Merrill lynch is a wealth management division of bank of America with over

150000 financial advisor and $2.2trillion in client asset. it the world largest
brokerage formally known as Merrill lynch & Company. Prior to 2009 it
was publicly owned and traded under new York stock exchange under
the symbol MER .Merrill agreed to purchased by the bank of America on
14 September 2008 at heights of 2008 financial crises. It ceased to
work as a separate entity in 2009.
 Rise to Prominence
 It rose to prominence on the strengths of the brokerage
network as 15000+ as on 2006.that enabled it to place
the securities it underwrote directly.

 It went on public in 1971 and become the multinational corporation with

over $1.8 trillion in client asset.

 It operates in around more than 40 countries across the world.

 In 1977 it introduced its cash management account that enables its

customer to sweep their cash into money market mutual fund and also
includes check writings capabilities and credit card.

 In 1978 it buttressed its securities business by acquiring

White weld and Co. Merrill lynch was well known for its global private
client and strong sales force.
 SUBPRIME MORTGAGE
CRISES

 In NOV 2007 Merrill lynch announced to write down $8.4

billion in losses associates with national housing crises.

 In December 2007 the firm announced to sell its commercial finance business
to general electric and sell its major part of shares in stock to Temasek
holding a Singapore government investment group, in order to raise
capital.

 In one year between July 2007 and 2008 the company had lost almost.

 $19.2 billion or $ 52 million daily. Its share prices had also come down
significantly.
 SUBPRIME MORTGAGE
CRISES
 Two weeks later the company announced to sell its select
hedge funds and securities in an effort to reduce the
exposure to mortgage related
investment.
 Temasek holding agreed to purchase the funds and raised its investment in the
company by $ 3.4 billion.
 In August 2008 the company froze hiring and revealed they had charged
almost $30 billion to their subsidiary in United Kingdom, exempting them
from taxes in the country.
 By September 2008 the company had lost 51.8 billion in mortgage
backed securities as a part of subprime mortgage crises.
COLLATERALIZED DEBT OBLIGATION (CDO)
CONTROVERSIES.

 Merrill Lynch, like many other banks was heavily involved in

mortgage based collateralized debt obligation market in
early 2000s.

 It was the NO. 1 global underwriter of the CDOs in 2004

 To provide ready supply of mortgage for the CDOs, Merrill first

purchased the Franklin financial Corp, the largest subprime lender in the
country in 2006
COLLATERALIZED DEBT OBLIGATION (CDO)
CONTROVERSIES.

 In between 2006 and 2007 Merrill was lead underwriter on

136 CDOs worth around$ 93 billion. By the end of 2007 the
value of these CDOs was start collapsing, creating a billion dollars loses
to the company.
 In mid 2008 Merrill sold the group of CDOs which had once valued $ 30.6
billion to Star lone funds at just $ 1.7 billion and $ 5.1 billion loan.
 In April 2009 a bond insurance company MBIA sued Merrill for fraud and
five other violation related to CDOs.These were.
a) “ML series” CDOs
b) Broderick CDOs 2
c) High bridge ABS CDO
d) Broderick CDO 3
e) Newbury Street CDO.
And among the other things Merrill lynch had also defrauded MBIA about the
qualities of these CDOs also. When the value lost, MBIA wound up owing to
Merrill a large amount of money.
 Acquisition by bank of america

 Significant losses were attributed to the

drop in the value of large and unhedged
mortgage portfolio in the form of the collateralized debt obligation.

 Trading partner’s loss of confidence in Merrill lynch solvency and its ability to
refinance short term debt ultimately leads to its sale.

 On September 14 2008 Bank of America announced to purchase Merrill

lynch for $ 38.25 billion in stock in order to avoid damages between
banks and federals regulators.
 Overview of Fannie Mae
and Freddie Mac
 Founded in 1938, the Federal National Mortgage Association (FNMA)
(NYSE: FNM).

 In 1970, the Federal Home Loan Mortgage Corporation (FHLMC)

(NYSE: FRE), also known as Freddie Mac, was the second GSE of the
United States federal government to purchase mortgages on the
secondary market.

 The name "Fannie Mae" and "Freddie Mac" is a creative pronunciation

of the company's initialism that has been adopted officially for ease of
identification.  
 Causes of Subprime crises on
Fannie and Fraddie
 Fannie and Freddie were government sponsored entities (GSE's).

 By December 2007, when banks began to constricting their lending,

they were really the only lender still operating, responsible for 90% of
all mortgages.

 Between 2005-2007, few of the mortgages acquired were conventional

fixed-interest loans with 20% down.

 In 2005, the Senate sponsored a bill that sought to forbid them from
holding mortgage-backed securities in their portfolio because it wanted
to reduce the risk to the government.
 Causes of Subprime crises
on Fannie and Fraddie
 by 2007 only 17% of their total portfolio was either subprime or Alt-A
loans.

 For Fannie and Freddie, the 17% of subprime and Alt-A loans made up
over half of the losses in 2007.
  
Effects on the subprime
mortgage crisis
 Banks can be assured that Fannie and Freddie have funds to purchase
conforming loans, so they can increase such lending.

 In 2006, Fannie and Freddie insured 24 percent of all subprime loans .

 Lower borrowing costs for banks typically increase the "spread"

between the rate at which they borrow and which they lend.

 Adjustable rate mortgage (ARM) rates are reduced

 Effects on the subprime
mortgage crisis
 The government's role as the primary investor allows a systematic loan
refinancing process.

 The government can restructure mortgages so that the loan balance is

reduced.

 With home prices more stabilized, the value of mortgage-backed

securities receives some upward support
 Government support for
Fannie Mae and Freddie Mac
 Federal Reserve purchases of $23 billion in GSE debt (out of a potential
$100 billion) and $53 billion in GSE-held mortgage backed securities
(out of a potential $500 billion).

 Federal Reserve purchases of $24 billion in GSE debt.

 Treasury Department purchases of $14 billion in GSE stock (out of a

potential $200 billion).

 Treasury Department purchases of $71 billion in mortgage backed

securities.

 Federal Reserve extension of primary credit rate for loans to the GSEs.
 Fannie Mae/Freddie Mac
Share
 The share of all mortgages held by Fannie Mae and Freddie Mac rose from 25
percent in 1990 to 45 percent in 2001.
 Their share has fluctuated modestly around 45 percent since 2001.

Freddie Mac/Fannie Mae Share of Outstanding Mortgages

50%

45%

40%

35%

30%

25%

20%
Source: Office of Federal Housing Enterprise Oversight, www.ofheo.gov.
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20