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Derivatives and Risk Management

THE SUBPRIME CRISIS

Derivatives and Risk Management

THE SUBPRIME CRISIS

Presented by:Misha Jashnani M-09-20Sarika Mankani M-09-29Ambar Kumar Nagpal M-09-32Malvika Saldanha M-09-44

Flow of the presentationFlow of the presentation

Background to the subprime crisis

Collateralized debt obligations

Credit Default swaps

The Turning Point

Impact of the Crisis

Background to the Subprime Crisis

Background to the Subprime Crisis

Home ownersMortgagesHouses

InvestorsMoneyInstitutions

Financial systemBanks and Brokers

Initially…..Initially…..

Investors looking to invest their moneyEarlier Federal Reserve T-billsHowever rates lowered to 1% by Alan

Greenspan (Dot com bust and September 11)

Cheap Credit for BanksTherefore banks borrow from Fed at 1%Surpluses from China, Japan and Middle East

Banks tend to leverageBanks tend to leverage

Banks borrowed money to amplify the outcome of the deal. Most banks make money this way.

Banks connect investors to Home owners through MortgagesBanks connect investors to Home owners through Mortgages

Mortgage Lender

Mortgage broker

Home owners

Mortgage

Role of Investment Banks Role of Investment Banks

» Investment bank borrows millions of dollars to buy thousands of mortgages

» Every month he gets payments from the home owners of all mortgages

COLLATERALIZED DEBT OBLIGATIONS

COLLATERALIZED DEBT OBLIGATIONS

What is CDO ????What is CDO ????

Tranches in CDOTranches in CDO

No Default Default

Rate of returns Rate of returns

SafeSafe

OkayOkay

RiskyRisky

3%

7%

10%

Ratings to CDORatings to CDO

Selling of CDO Selling of CDO

Credit default swaps allow one party to "buy" protection from another party for losses that might be incurred as a result of default by a specified reference credit (or credits).

Credit Default Swap Credit Default Swap

The Greed of the investor comes in………No more loan takers available

A new

Adding risk to mortgages–These are subprime mortgages.

The Greed and Sub prime lending

The Greed and Sub prime lending

VideoVideo

Every body is happy….Every body is happy….

With time the investment banker lands up with many defaulters and hence more homes in its foreclosures

This is not strange because these

were subprime loans by nature

the prices of houses as expected does not rise due to the huge supply of houses

Infact the prices of the houses comes downThe house owners realise that they are paying very

high mortgages for houses that are not worth much anymore.

Leading to defaults by even people who can afford to pay the mortgages but don’t want to pay anymore

People put their houses on saleLeading to further supply in the marketOr simply forsake their housesNow the investment banker has loans which are

worthlessThe basic security underlying these loans are

worthless houses. So he has no worst case solution either.

The investment banker tries to sell these bonds but there are no buyers

Either people he approaches are stuck with similar loans or are aware that these loans are worthless.

In many cases the investment banker has taken loans worth millions or billions of dollars to buy these bonds

Which he is now unable to repay Thus the whole financial system is in a crisis

The investment bankers the banks and the investors all are stuck with worthless bonds

None of these can bail out the otherMany of these go bankrupt now at this stage the investor in on the verge of

bankruptcy calls up the home owner to stake claim on the house

Bringing more houses on sale and the crisis continues

Thank youThank you