Sub-Prime Crisis

Dr. Green

False Prosperity of the Credit Economy

• Low interest rates– Car loans—no money down or low interest– Credit card loans—0% teaser rates– Mortgages• First

– Prime– Sub-prime

• Second and third

• Passing the risks onto others

Consequences• Overvalued assets– Commodities– Houses– Stocks and bonds

• Overleveraged consumers• Declining assets leads to– Banks needing to improve their capital base– Unwillingness to loan even though interest rates are

low• Federal Reserve loan directly to banks to get

them to loan

The "Arb" Game is Overby Doug Noland October 16, 2008

• Securitization led to the under-pricing of risk, which led to • a massive (and self-reinforcing) over-extension of risky loans –

– for real estate, – for speculating in securities markets, – for funding enterprising businesses and municipalities, and – for consuming.

• This historic expansion of risky Credits altered the very fabric of our Economic Structure. – asset inflation, – over-consumption, and – a finance-driven “services” Bubble economy.

• The consequences were momentous, and the unavoidable economic restructuring has now commenced

Credit Default Swaps

• Before the big drop ion price, the U.S. residential housing market was worth roughly $20 trillion.

• The total value of “credits” – mortgage backed securities, corporate bonds and the like – is around $10 trillion.

• The total value of the Credit Default Swap market – unregulated contracts traders can use to make bets – is somewhere between $35 and $60 trillion.

CDS

• Wall Street made leveraged bets on the assumption home prices wouldn’t fall

• They made these bets in a completely unstructured fashion, with no real due diligence as to whom was on the other side or whether they could pay.

• Counterparty risk

CDS

• You agree to pay me a premium, up front and yearly, for the next five years.

• I agree that if the collateralized mortgage-backed securities you own defaults, I will pay you its full value.

• It is such a good deal for you that you ask me to insure other debts.

CDS

• Your friend, who doesn’t own any CMBS, hears about the deal and asks me to insure them if the same CMBS securities default, even though they don’t own any themselves.

• I agree, and you pay me premiums.• Companies all over the world did this.

CDS

• No one ever set aside any capital to pay in the event that the instruments they were insuring actually did default.

• The bilateral contracts have a provision for margin to be posted by the one who wrote them or by American International Group Inc. (AIG), if these virtual-insurance-contracts start to go against them.

AIG

• AIG was bailed out to the tune of $80 billion, because it had margin calls on CDS contracts it wrote.

• They need an additional $38 billion because they are experiencing more margin calls on their credit default swaps.

Crowd’s thinking

• Housing prices aren’t going to fall• Companies aren’t going to default• Everything is under control because we’ve all

calculated our Value at Risk.

Value At Risk

Leverage

• The global contagion is the direct result of margin calls.

• Margin is the amount one needs to put up to establish or maintain a position.

Margin Calls

• In volatile markets, prices can fall very quickly.• If the equity (value of securities minus what

you owe the brokerage) in your account falls below the maintenance margin, the brokerage will issue a "margin call".

• A margin call forces the investor to either– liquidate his/her position – add more cash to the account.

Real Economy

Special Purpose VehicleBrokers LendersBorrowers

InvestmentBanks Rating Agencies Investors

CDS

SecuritizationCDOs

Risk Process

Leverage

Risks

• Currency risks• Credit risk• Default risk• Interest rate risk• Liquidity risks• Counterparty risks