MONETRIX

SUBPRIME CONTAGION

Ankit Taparia
Nikhil Agarwal
SUBPRIME CONTAGION
What are Subprime mortgages? What
are the mediums involved?
SUBPRIME LOANS:
TECHNICALLY SPEAKING
According to Fair Isaac Corporation FICO
score, loans with score below 680 are
subprime loans.
 These scores are calculated by factoring
weightage to:
 Payment history
 How much is owed
 Length of credit history
 New credit
 Types of credit in use
MEDIUM: COLLATERAL DEBT
OBLIGATIONS
Bankers pool together many risky loans to
borrowers with highly suspect credit-
worthiness
They make bundles of these securities and
market to investors with different appetites
of risk
Underwriter pulls together thousands of
loans to serve as collateral; slices it into
tranches with varying levels of risk and
return
Investors get hit in different ways in case of
default
High risk  slightly below investment
grade  safe paper
MEDIUM: CREDIT DEFAULT
SWAPS
Creation of CDO only the first step
Other banks offered protection against
probability of default on CDOs
Second order derivatives; new income
stream
Could again be bundled and sold as third
order derivatives
SUBPRIME CONTAGION
HOW SUB PRIME MIGHT END UP
IN YOUR INVESTMENTS
CHAIN REACTION OF
DEFAULTS
People began acting as if risk had
disappeared
Allowed people without financial health to
buy houses
No buyers for financial instruments backed
by mortgages
Housing bubble popped  Subprime
meltdown  decrease in investor
confidence about junk bonds
Financial institution A can’t sell its
mortgage-backed securities, so it can’t
raise enough cash to make the payment it
owes to institution B, which then doesn’t
have the cash to pay institution C, and
HOW MARKETS GOT INTO A BEAR
HUG
Overnight interest rates shot up above the
central banks’ targets
CP was used to finance Ninja mortgages given
to people with no income, no jobs, no assets;
CP market out of buyers
Selling off a delinquent’s home might not
yield enough collateral to pay back the loan
Uncertainty regarding who holds the toxic
paper
SUBPRIME CONTAGION
THE CULPRITS
 Lenders who made lenient loans: Lenders began
proposing these structures as a way to make
homes affordable; no documentation of
borrowers’ income, only interest payment option,
piggybacks
 Home buyers who sought easy mortgages:
Buyers putting less than 20% have little incentive
to avoid default, piggyback mortgages free them
from private insurance to protect the lender
 Wall Street underwriters who turned them into
securities: Purchase piggybacks to turn them into
high-yield securities; shop around for higher
ratings
 Investors who wanted higher yields: Interest
rates were low; their search ended here
 Banks who are wary of counterparty risks:
Accentuating the situation by sitting on cash,
BEHIND THE SCENE CULPRITS: THE
CREDIT RATING AGENCIES
 S&P believed a ‘piggyback’, where borrowers
simultaneously take out a second loan for down
payment was no more likely to default than a
standard loan
 Assign top ratings to questionable securities- making
them seem as safe as a treasury bond
 Lucrative market- twice as high a fees for securities
backed by home loans
 Collaboration with underwriters- influence creation of
such securities
 Had the securities received the risky ratings as
present, many mutual funds and pension funds would
have been barred from buying them
 Money managers lacked the resources to analyze
pools of assets and relied on rating companies
 Piggyback loans 43% more likely to default than
others; still majority share of pool value are these
(52%-Washington Mutual Inc)
SUBPRIME CONTAGION
TRIGGERS IN ACTION
TRIGGER 1: BEAR STEARNS
(US)
 Sponsored two hedge funds invested in subprime
paper
 Most cash came from outside investors
 Leveraged by borrowing from other banks
 Investors tried to take out cash when subprime
hit; Bear closed funds
 Lenders demanded more collateral (margin call)
 After initial refusal, the I-Bank had to provide a
$1.6 bn. Credit line to least risky fund
 Creditors seized the assets of the other fund
 Suggested Bear had liquidity problems
 How AAA ratings can’t be relied upon
 Undermined confidence in mark-to-market model
MARK TO MODEL
For a frequently traded asset, financial
institutions value it by looking it at market
price
Mortgage security tranches (‘Equity’  AAA)
are not frequently traded
 Valued by reference to mathematical models
Ignores liquidity: selling in a hurry say on a
margin call will only fetch what somebody is
willing to pay

<-BACK
TRIGGER 2: IKB (GERMANY)
Virus crosses the Atlantic
Focused attention on the CP market, till now
a risk-free investment
IKB set up an off-balance sheet ‘conduit’ –
Rhineland Funding
Back-up loans and ‘credit enhancement’ used
to proclaim loans as risk-free
Funded itself with $19 bn. CP for securities,
including subprime
Banks providing back-up credit lines worried
that CP market would seize up when investors
realize how exposed Rhineland was to <-BACK
dodgy
TRIGGER 3: LBO BUBBLE
Banks initially provide debt, then syndicate
loans to others in market, taking a fee
The banks got stuck up with a variety of loans
they wanted to syndicate
Two big deals: Chrysler and Alliance Boots
$50 bn. Of LBO loans now stuck on their
balance sheets with another $200+ bn. in the
pipeline
Reluctant to make any more financing
Knock-out effect on share market

<-BACK
TRIGGER 4:TROUBLE AT BNP
PARIBAS
3 money market funds (even less riskier than
conduits)with assets of $1.5 bn.
35% invested in instruments exposed to
subprime market
“The complete evaporation of liquidity in
certain market segments of the US
securitization market has made it impossible
to value certain assets fairly regardless of
their credit rating.”
Some parts of credit market had shut down
No buyers for “certain assets” regardless of
quality
Credit ratings weren’t worth the paper they
were written on
SUBPRIME CONTAGION
THE IMPACT
Cushioned by high liquidity, bond markets
affected marginally
Gap between risk-free T-Bills and Commercial
Paper widened due to flight-to-quality
Hindalco and Tata Steel shares suffer a large
drop because of increased cost of funding for
low grade bonds issued for acquisitions
through their subsidiaries
Dividend yields on many top stocks in U.S.
have risen to tempting levels- stocks trading
at a bargain
PE firms rethinking the valuations of
committed leveraged buyouts, for negotiating
SUBSEQUENT IMPACTS
US Dollar actually went up against other
currencies- dollar a safe haven currency
Gold and other commodities see a fall-fall in
one asset class prompts a sell-off in others
due to diversification in a hedge fund
Top funds (Goldman Sachs, Highbridge, AQR,
Renaissance) lose up to a third of investors
money
Yen Carry Trades unwind; strengthening of
Japanese Yen
Investors bought back short positions in a
low-yielding currency
Chain reaction of losses around the globe- for
BLOOD IN WORLD STOCK
MARKETS

DOW JONES EURO FIRST 100

NSE SENSEX

NEKKEI ASX 200

KOSPI HANG SENG

SUBPRIME CONTAGION
 ALARM AT SEC
SEC is checking the methods used by
brokers for asset valuation to check if
they’re hiding losses
Controversy because of marking-to-market;
unlike listed stock or bonds, can’t be readily
bought or sold
Uncertainty in pricing and valuation; highly
subjective models
Repurchase agreements
 Short-term loans secured by T-bills and bonds
 Daily valuation of collateral
 Ask for more cash or securities
 Collateral seized in case of default
CENTRAL BANKS: AN EFFORT TO
STABILIZE
 FED :
released USD 24 billion on 9th Aug
allows term financing for up to 30 days
Mortgage backed securities, including unimpaired
subprime securities, to be accepted as collateral
 ECB :
released 95 billion Euros on 9th Aug
released 61 billion Euros on 10th Aug
Banks could have any amount of money at the base
rate 4%.
 Bank of Japan
released 1 trillion Yen on 10th Aug
* already withdrawn the amount back
 Central banks of Russia ($1.64 bn.) and Australia also
pumped money in the system-however they withdrew on
AN EFFORT TO STABILIZE
Reassessment or repricing of risk: U.S.
Treasury Secretary
Fed cuts discount rate by 50 points to 5.75%,
no cut in Fed funds rate
Availability and not price of cash a trouble-
Fed
Ensure that credit for good quality paper
doesn't dry up and give time to credit
markets to work out repayment strategies for
impaired loans
Criticism: Banks have better options open
(LIBOR=5.51%)
People’s Bank of China raised the one-
SUBPRIME CONTAGION
THE INDIAN MORTGAGE MARKET:
SAFER
Loan to value ratio is modest
Most home buyers end up paying certain
amount in cash, hence loan to value even
lower than known
Consumer Equity in property- can be sold on
default
No Indian bank or pure mortgage player offers
the interest only payment option, unlike the
US
THANK YOU!

QUESTIONS?