The Sub- Prime Mortgage Crisis

It won’t just go away!!!

Lot* No. 25-45-327-1

• Referred to as cadastres in Czech Republic and most

civil law jurisdictions.

So, how does a mortgage work???

- First, it is a “charge on title” – registered debt using a parcel of property as a guarantee. The parcel of property has a “lot” number, and anything built on it is also part of the guarantee.

- A mortgage is registered until the loan is fully paid. It is indivisible, and the property can not be sold until either the mortgagor (the company that owns the mortgage) agrees or the loan is paid out. - A mortgage may be sold by the mortgagor, and very frequently is. Mortgages are grouped together, or “bundled” for sale, with all rights in the mortgage contract transferred to the purchasor, or “investor”. This is called a “securitized” obligation, or bond. - Because of this, ratings agencies have traditionally considered this type of investment of the best quality, or “AAA”.

- Insurance is also purchased to reduce risk. This is bought by the purchasor of the mortgages, or “investor” (usually a bank)

MortgageBroker

1. Mortgage Broker –the person or company which encourages potential borrowers to apply for mortgages. The broker is the middle-man, and makes a commission on each mortgage placed, but takes no responsibility for its quality.

• In an interview on CNBC, the owner of a brokerage admitted that some of his best brokers were 17-year pizza delivery workers – they made up to $10,000 a month

Mortgagor

MortgageBroker Mortgagor – The company or bank that

places the mortgages.

• Competition to lend is fierce, so aggressive marketing is used.

• When all else fails, change the standards. Eventually gave NINJA loans (No Income No Job or Assets)

• Will sell mortgages to an investor, thereby avoiding responsibility if the mortgages go bad

Mortgagor

Mortgage

Mortgage

Mortgage

Mortgage

MortgageBroker Rating Agency

Ratings Agencies – Standard and Poor’s and Moody’s – they are paid by Investors and Mortgagors to determine how safe an investment is.

• Typically, a mortgage-backed investment should be safer than an unbacked investment security – or so they thought

• When an analyst at S&P. the largest rating agency asked to see the credit files, this was his boss’ reply:

‘Any request for loan level tapes is TOTALLY UNREASONABLE!!! Most investors don't have it and can't provide it. [W]e MUST produce a credit estimate. It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so.’

Mortgagor

Mortgage

Mortgage

Mortgage

Mortgage

Rating Agency

Insurance

MortgageBroker

Insurance Companies – These are special insurance firms like MBIA or Ambac, which insure tens of trillions of dollars of mortgages against normal risk.

• Risk and premiums are both based on ratingsprovided by the ratings agencies.

Mortgagor

Mortgage

Mortgage

Mortgage

Mortgage

Investor

Rating Agency

Insurance

MortgageBroker

Investors – This is a diverse group of investment firms which purchase mortgages in large blocks based on ratings and insurance to limit risk. Large investment banks and firms such as Merrill Lynch, Morgan Stanley and Goldman Sachs are in this group.

• The investments, purchased in large blocs, are sub-divided and sold to customers to whom the risk is transferred.

MortgagorInvestorFunds paid to

Mortgagor

Mortgagor

Mortgage

Mortgage

Mortgage

Mortgage

Mortgagor begins the process once againThis is the financial equivalent of re-cycling money

MortgageBroker

Let’s not forget…

Federal Reserve – a privately owned banking group which works as the central bank in the US. It is in charge of monetary policy, and famously encouraged potential borrowers to consider ARMs.

And their view…

“I can understand the mistakes many financially naïve borrowers made but have a hard time understanding how so many investment professionals could have

been so wrong.” — William Poole, St. Louis Fed (Jan.8, 2008)

Poole's list of five key mistakes:

• Borrowers took on mortgages they could not afford.

• Mortgage brokers put too many people in unsuitable mortgages. They knew, for instance, that adjustable-rate mortgages probably wouldn't be right for many borrowers if interest rates rose as the market expected.

• Investment banks jeopardized their reputations by securitizing mortgages without doing due diligence on the underlying assets • Rating agencies put their stamp of approval on securitized mortgages without considering whether AAA ratings could be maintained if house prices fell. • Investors scooped up those securities without doing adequate analysis first. "Investors too readily accepted the AAA ratings at face value,"

Mortgagor

Mortgage

Mortgage

Mortgage

Mortgage

Mortgagor begins the process once againThis is the financial equivalent of re-cycling money

MortgageBroker

___Net Increase 414.89 (27.3%)

2.4% 1.7%

$300,000 25 year amortization – 3.6% = 1,518.02 per month

6.0% = 1,932.90

1.65% 1.4%

Note – No change in payment once taken

What happened???

- First, the mortgage lenders (mortgagors) became very competitive in the hot housing market, and offered loans to borrowers who normally would not qualify. These are sub-prime mortgages.

- They also got into Adjustable Rate Mortgages (ARMs) which, when the rates were low, had relatively small monthly payments

In mid 2005, an interest only ARM was 4.6%. a 30 year fixed was 5.2%

On a $300,000, if no interest was paid on the ARM, it would be about $1,163.23 per month

A 30 year fixed mortgage would be $1,647.33

- Ratings agencies ignored signs that the quality of loans was declining and continued to rate these loans ‘AAA’

- When rates began to go up because the Fed was trying to respond to signs of inflation, many borrowers were not able to continue with their payments.

- Legal action to take back the houses from the borrowers (foreclosures) increased Y/Y in December 2007 by 75%.

1% of all US households were in some state of foreclosure in 2007 vs .58 in 2006 (RealTrac)

- Housing sales dropped by 26% (Y/Y NYT Jan. 29, 2008)

What depends on housing ????

• Building materials • Financial services• Labour (carpenters, welders, electricians etc)• Furnishings• Repairs• Taxes• Professional services (land surveyors, lawyers etc)• Refinancing• Collateral for business and personal loans• Urban development

Impact of the Crisis Ripples Outward

1. Investors stop buying securitized mortgage bonds. This means that money which was available for mortgages in the past is no longer available. “Good borrowers” have trouble finding money.

2. Ratings agencies are no longer trusted. This means that the evaluation of other instruments – e.g. corporate bonds – is also suspect. Lenders are wary, slowing this market also. 3. Insurance companies such as MBIA announce record

losses, increasing speculation that this type of insurance may soon be unable to pay losses.

4. Mortgage lenders facing major losses must seek shelter. E.g. Countrywide, the largest lender, was taken over by the Bank of America

5. Losses continue to be announced. By the end of Jan 2008: - Merrill Lynch – 8.4 Billion- Citigroup – 5.9 Billion- UBS – 13.7 Billion- Bear Stearns – 3.2 Billion (pledged for hedge fund)- Morgan Stanley – 9.7 Billion- JP Morgan Chase 1.3 Billion- Deutsche Bank - 3.4 Billion - Swiss Re (Insurer)1.07 Billion- FGIC (Insurer) 1.3 Billion (“capital shortfall”)- MBIA (Insurer)- Ambac (Insurer)

Reuters reported on Feb 1 that the banking industry wrote down more than $130 Billion last year due to the sub-prime crisis.

6. CEO’s of many of the large banks were forced to resign as a result of this crisis

7. IMF twice predicted that the total cost of the crisis would be $1 trillion. Serious industry experts think

$2,000bn is more likely - four times what we've seen to this point (July 2008). 8. Sept 8, 2008 - US Treasury steps in to rescue

Fannie Mae and Freddie Mac, the two companies which guarantee half of all US mortgages, exposing US taxpayers to $5 trillion of debt in the world's biggest financial bail-out. US Treasury Secretary Hank Paulson says the two companies are simply too big to be allowed to fail. The government reportedly injected $100 bln into each

9. Sept 14, 2008: Lehman Brothers files for bankruptcy and becomes the first major bank to collapse since the start of the credit crisis. Alan Greenspan, the former chairman of the US Federal Reserve, describes the failure as "probably a once in a century type of event" and warns that other major firms will also go bust.

10. Sept 15, 2008 - 94-year-old Merrill Lynch & Co. agreed late Sunday to sell itself to Bank of America Corp. for $50 billion.

11. September 14-16, 2008 – AIG is reportedly in talks with Federal Reserve to raise $75-100bln to remain afloat. If this company fails, it will compromise assets held by banks all around the world, and could spark a major crisis in dollar-denominated assets.

12. September 16, 2008 The Federal Reserve leaves interest rates unchanged.

13. Oil prices drop below $93 a barrel over fears of a

world-wide recession

Cost of Credit Crisis Bloomberg

Posted: 2009-05-31 01:16:53+05:30 ISTUpdated: May 31, 2009 at 0116 hrs IST

James Pressley Let’s pause for a minute and think about $15 trillion. That’s roughly how much money the US has committed toward rescuing the economy from the credit meltdown, housing collapse and recession, according to the number-crunching of Barry Ritholtz, chief executive officer of research firm FusionIQ.

Eleazar David Melendez 02/14/2013 7:49 pm EST

Financial Crisis Cost Tops $22 Trillion, GAO Says

The 2008 financial crisis cost the U.S. economy more than $22 trillion, a study by the Government Accountability Office published Thursday said. The financial reform law that aims to prevent another crisis, by contrast, will cost a fraction of that.

"The 2007-2009 financial crisis, like past financial crises, was associated with not only a steep decline in output but also the most severe economic downturn since the Great Depression of the 1930s," the GAO wrote in the report. The agency said the financial crisis toll on economic output may be as much as $13 trillion -- an entire year's gross domestic product. The office said paper wealth lost by U.S. homeowners totalled $9.1 billion. Additionally, the GAO noted, economic losses associated with increased mortgage foreclosures and higher unemployment since 2008 need to be considered as additional costs.

The report, five years after the collapse of mortgage-focused hedge funds in late-2007 set off a year-long banking panic and a deep recession, was published as part of a cost-benefit analysis of the Dodd-Frank financial reform law of 2010. The GAO tried to determine if the benefits of preventing a future economic meltdown exceeded the costs of implementing that law.

- 504 points !!!

Conclusion• The full impact has probably not been felt. Hedge funds are attempting to provide “cover”, but it is unlikely that they will be able to. This chart shows the extent of the problem. The final figure on derivatives outstanding at the end of December 2007 was $681 trillion (Bank for International Settlements).

• Joseph Stiglitz spoke at The World Economic Forum in Davos in 2009, and pointed out that many of the economic products (derivatives) developed by “whiz kids” are not fully understood

• Final rule – the basics are the basics. This crisis arose because most of the players forgot that a mortgage must be repaid over a long term. It is not a short term commitment and requires care and attention when placed. It cannot and should not be marketed like hamburgers.

http://www.youtube.com/watch?feature=player_embedded&v=K7Pahd2X-eE