Interest rates had been cut to 1% after Dot-com bubble Cheap credit widely available as a result of loose monetary

policies

Background
Likely to repay their mortgages Adhered to strict underwriting practices No proof of income No documentation No down payment Unlikely to repay Prime

No discrimination among poor and rich, must lend to them Unregulated OTC market Wrong Incentives for the management of financial institutions

Home Owners
Subprime

Unsatisfied with the low yield on Treasury bills (1%) Since CDOs (senior tranche) were AAA rated + protected by credit default swap, CDOs became very popular Major buyers:pension funds, universities endownment fund, hedge funds and etc.

Usually considered as investment grade Could be securitised in normal market More difficult to securitise as higher risks involved Many lenders chose to sell their subprime mortgage assets to investment banks Big players include Wachovia, Countrywide Financial & etc. Warehousing risks arise from unsold subprime mortgages (Toxic assets) Loose underwriting practices Believing in home prices would rise forever Responsible for Subprime Prime

Investors - Financial institutions

Looking for high yield investments

Lenders/Mortgage originators

Investment banks borrowed heavily to buy subprime mortgages from lenders Special purpose vehicles Putting those mortgages into special purpose vehicles as collateral to create CDOs unsold subprime mortgages became Toxic assets Equity tranche - First to absorb loss, last to receive payments represents 5-10% of the value of mortgage pool Highest risks - major buyer including hedge funds

Credit Crisis

They were paid by bonds issuer to provide credit rating on CDOs E.g.. Fitch, Standard & Poors, Moody's Conflict of interest + biased caused by wrong incentives Responsible for

Investment banks Credit Rating agency

Collaterised Debt obligations

Mezzanine tranche - in the middle

represents 5-10% of the value of mortgage pool represents the balance of the value of mortgage pool

Senior tranche - First to receive payments, last to suffer loss

AAA rated - same level of rating as government bonds Protected by credit default swap

Default rate increased substantially, foreclosure shot up Huge unsold home inventory (roughly 9 -10 months) Supply was significantly greater than demand Banks had become reluctant to lend on the interbank market, especially after Lehman went broke This created huge systemic risks Borrowing rate began to rise Virtually no buyers investment banks were not able to meet their obligations Banks were forced to take huge write off Unemployment rate shot up Deteriorating consumer confidence Recession Restricted CDOs' market Frozen credit market Plummeting home prices

Lehman had more than 30 times leverage by the time it went broke Highly leveraged Small mistake would wipe out the entire equity

Give protection to buyer of financial instruments in case of default

Credit default swap Dooms-day

Capital injection buying preference shares of banks, e.g. TARP funds Offering loan guarantees Create bad banks to buy up toxic-assets from banks Selling below intrinsic value, e.g. 20 cents on the dollar Create market for CDOs Restore market confidence Online auctiona site: https://zd.zionsdirect.com/

Problem: Seller of CDS unable to meet its obligations Major issuer: AIG

Toxic assets

Solutions

creates the new money electronically Quantitative easing aims to stimulate the economy and lower borrowing costs Not actually printing money

Credit Crisis.mmap - 5/15/2009 - Mindjet