Mortgage Lending Models -Beginning

HOW SUB PRIME CRISIS SPREAD?FINANCIAL

INSTITUTIONMBS

SECURITISATION

LOWEST RISK /

HIGHEST RATING( SENIOR )

MEDIUM RISK( MEZZANINE )

HIGHEST RISK /

( EQUITY )

CDO

PROCEEDS SALE of LOAN

INVESTORS

BANKS

HEDGE FUNDS

INSURANC E COS.

PENSION FUNDS

LOAN

SUB-PRIME BORROWER BUYING HOME

SUB-PRIME LENDER

CDS

Rise of Mortgage Bond Market Mortgage Bond > 32%

Sub-prime lending 800$bn (2006) form 200$bn (2001)

Force closure , 2mn families affected -> wave across US

How it went wrong ????

Bubble burst …

COMPONENT OF CRISIS• Monetary Policy in the US and other Western Countries were eased aggressively after dot com bubble -> to • revive economy after dotcom bubble and increase investment, consumption (C)• Policy rates in the US reached 1% in June 2003.• The monetary excess during 2002-06 leading to Housing Boom.• Assets prices recorded strong gains. Demand constantly exceeded domestic output.• This mirrored in large growing Current Account deficit over the period.

• Creations of huge Forex Reserves at EMEs. The Forex Reserves deployed back in US Treasuries.

• EME’s (China/East Asian Countries) exporting to USA at low cost leading to growing surplus.

• This flood of dollar resulted in sharp rise in US spending -> C+G - Bubble stretched to limit !!!!

• Large Global imbalance due to very low interest rate and accommodative monetary policy.

• Major advance economies are in recession -> Global trade volume to contract by 11%• Predominately Sub-Prime mortgages sold to financial investors -> Low credit quality• Inflation in USA started to rise in 2004 – so rise in interest rate.• Housing prices depressed. With low/negligible margin; sub-prime-borrower encouraged to default –

• BUBBLE BURST -> CHAIN REACTION TRIGGERED• US regulatory failure, multiplicity of regulators, well over 100 at the federal and state level.• Role of rating agencies -> Hefty commission , their share went up 400% from 2002 - 2006• Default by such borrowing led to losses by financial institution -> Wiping of significant portion of capital • of Banks

• Mounted losses and dwindling net worth led to breakdown of trust among banks.

• Inter-bank money market nearly frozen. Failure of Lehman Brothers in September 2008.

• Complete loss of confidence -> Globalized Economy - > World wide impact - > India Isolated ?????

• Deep and lingering crisis in global financial market. This further leads to banking and currency crisis, employment and output losses.

Some big causes“housing never goes down” myth

• The Acts of Congress that required banks to lend money to the lower end of the spectre - meaning subprime people would could afford it.

• Era of late 90 s ′ when Freddie Mac and Fannie Mae are mandated to loosen lending standards for the “common good.” Enter the era of “sub-prime” lending.

• In the 1990s, unregulated investment banks started selling their own mortgage backed securities (MBS) packaged with subprime loans. It is these mixed (complex)sets of securities that could not fit into risk models that set off the subprime crisis.

• In recent years, Fannie and Freddie did buy mortgage-backed securities from investment banks, but never directly bought sub-prime mortgages from banks and other originators. They bought into the whole idea that these securities were appropriately rated for their risk.

• Banks offering 100% financing, 125% financing, 2 years ARMs (Adjustable Rate Mortgagae) with margins set right under the interest rate

• Ameriquest Mortgage and New Century entering the scene making uncanny amounts of money off the subprime market. This enticed the Big Banks aka Wells Fargo, Wachovia, Washington Mutual, Countrywide, Citi, BoA etc. to toss caution (and their risk matrixes) to the wind and invest big time in the failed concept of subprime lending! Hell the Ameriquest Mortgage and New Century Fat Cats (who will one day be in hell) are making this much money why shouldn't we jump into this too risky to be turn concept!

Effect on global economy……

Lessons ………….

For individuals……..• Never trust a mortgage salesman.

– Salesman, paid on a commission basis, had an incentive to sell as many mortgage products as possible.• Be wary of Special introductory 2 Year Deals.

– The secret of selling many sub prime mortgage deals was an attractive introductory period, with a significant discount on the base rate

• No Bubble lasts for Ever– American house prices were driven partly by economic factors, but also by a speculative bubble. To many,

rising house prices were evidence that they would continue to rise forever. Many of the sub prime mortgages were lent against a backdrop of confidence and optimistic expectations

• It is hard to predict Interest Rates• The importance of the Housing market on the economy.

– significant impact on consumer confidence, stock markets and the wider economy– Mortgage equity falls and this leads to lower consumer spending and growth. The crisis has also had an

impact on stock markets around the world.

For policy makers…….. • Central Bank should adopt a broader macro-prudential views of asset price movements, credit boom and the build up of systematic risk.• Asset price bubble leads to strong credit growth such as real estate and stock market.• Only substantial hike in policy rates can pick the bubble.• Pre-emptive action like hike in risk weights and provision norms for Banks.• Sharper focus on liquidity risk management, risk transmission.• Global imbalances are to be reduced to a manageable proportion.• US needs to save more & export more.• Asian Countries have to consume more, export less