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12a Causes of the Subprime Crisis

by Dr Edward CY Yiu Associate Professor

Dept of Geography and Resource Management, Chinese University of Hong Kong

Housing Issues and Policy, Urban Studies Programme, CUHK

URSP3100

The Impacts of the Subprime Crisis

• US housing price drops from 200

to 130, or 35% drop.

• The deepest yoy plummet was -

20% in 2009.

• From Jan 2007 to Dec 2011, there were

more than 4 million completed

foreclosures and more than 8.2 million

foreclosure starts…

• Approx. 1.4 million homes, or 3.4% of all

homes with a mortgage were in the

national foreclosure inventory as of May

2012. (Global Research May 17, 2013)

The Impacts of the Subprime Crisis The first wave hit globally on Sep. 16, 2008 resulted in a global plunge of stock indices.

• US Dow Jones by 4.42%,

• US S&P500 by 4.6%,

• US Nasdaq by 3.6%,

• UK Times by 3.9%,

• France CAC by 3.8%,

• Germany DAX by 2.7%,

• Japan Nikkei by 4.95%,

• Hong Kong HSI by 5.4%,

• Taipei Weighted by 4.89%,

• Sydney SP/ASX by 1.4%,

• Singapore ST by 1.01%,

• Shanghai Composite by 4.47%,

• Seoul KOSPI by 6.1%,

• Bangkok SET by 2.78%,

• Russia by 11%.

(source: various)

The second wave hit on Sep. 30, 2008:

• The US Dow Jones by 777 points (a record)

The Subprime Crisis 2008 The US Federal Reserve spent more than US$900 billion in 2008

to rescue the crisis, including

• US$85b loan to AIG for 79.9% stake yesterday,

• US$87b to JPMorgan Chase for providing financing to underpin trades with units of bankrupt investment bank Lehman Brothers,

• at least US$200b as outstanding loans to banks issued through the Fed's Term Auction Facility,

• US$100b for Fannie Mae and US$100b for Freddie Mac (they are mortgage providers), by purchasing preferred stock to shore up their capital as needed,

• US$300b to Federal Housing Administration to refinance failing mortgage,

• US$4b grants to local communities to help them buy and repair homes abandoned due to mortgage foreclosures,

• US29b to finance JPMorgan Chase's government-brokered buyout of Bear Stearns.

(information from Reuters cited at The Standards on Sep 18, 2008)

The Subprime Crisis causes the

Global Financial Crisis The tsunami has already drowned at least 8 huge financial institutions in less than

1 year time:

• Sep. 2007, British mortgage lender Northern Rock was saved by the emergency fund from Bank of England,

• Mar. 2008, Bear Stearns investment bank was bought by JPMorgan Chase for US$236m, which was the first high-profile US sub-prime casualty,

• Apr. 2008, Royal Bank of Scotland asked shareholders for US$24b rights issue,

• Jul. 2008, the US Federal Reserve purchased the two mortgage giants Fannie Mae and Freddie Mac,

• Sep. 14, 2008, Lehman Brothers files for bankruptcy,

• Sep. 14, 2008, Merrill Lynch is bought by Bank of America for US$44.3b,

• Sep. 17, 2008, The US Federal Reserve purchased 79.9% stake of AIG for US$85b.

(information from Barrons cited at The Standards on Sep 18, 2008)

• On Sep. 19, 2008, HBOS, the UK's biggest mortgage lender, was taken over by Lloyds TSB, Britain's largest provider of checking accounts, by 12.2 billion pounds.

• On Sep. 28, 2008, Bradford & Bingley, the Britain's biggest lender to landlords is said to be taken over by the state. Separately, Washington Mutual, the 119-year-old bank in the US, sought Chapter 11 protection in US Bankruptcy Court late Friday (Sep. 26, 2008); Fortis Bank was saved by three European countries.

• On Sep. 29, 2008, the US$700 billion bailout plan was turned down in the Congress.

The Longer-term Impacts of the

Subprime Crisis

http://www.rba.gov.au/publications/confs/20

12/muellbauer.html ADJUSTMENTS!

The Spillover Impacts of the

Subprime Crisis

• Spillover to Europe PIIGS

• Global Financial Crisis 2008

• China RMB pegged to US by injetting

RMB4000b

• Mauellbauer, J. (2012) When is a

Housing Market Overheated Enough

to Threaten Stability?, RBA

Conference 2012.

http://www.rba.gov.au/publications/co

nfs/2012/muellbauer.html

Causes of the Subprime Crisis

• The US Treasury Secretary Hank Paulson has said repeatedly that the "root cause" of the problem is "the housing correction, which has resulted in illiquid mortgage-related assets that are choking off the flow of credit."

• John Rosner (2008 Sep. 30, the Standards) disagreed that "the troubled assets are the result, not the cause, of loose lending practices, a housing bubble that burst, a glut of unsold homes and home prices that are still too high relative to incomes and rental costs."

Causes of the Subprime Crisis

• Greedy?

• Loose Lending Practices? NINJA loans?

• Securitization of Mortgages? Problematic Credit Rating?

• Copula Assumption of Risk? Long Tail Effect?

• Complex investment vehicles (MBS, CDO, CDS)?

• Chinamerica? China saves too much? US spends too much?

• Negative RIR? Fiat Money?

• All the above?

• None of the above?

What is a Subprime Mortgage

• A subprime mortgage is a type of loan granted to individuals with poor credit histories, who, as a result of their deficient credit ratings, would not be able to qualify for conventional mortgages. Because subprime borrowers present a higher risk for lenders, subprime mortgages charge interest rates above the prime lending rate.

• NINJA Loans: Mortgage loans to ones who are No-Income, No-Job or Assets.

• Non-recourse Debt: If the borrower defaults, the issuer can seize the collateral, but cannot seek out the borrower for any further compensation, even if the collateral does not cover the full value of the defaulted amount. This is one instance where the borrower does not have personal liability for the loan.

• (http://www.investopedia.com)

Amount of Subprime Mortgage

Securitization of Mortgage

Real Estate Finance

Direct Real

Estate Stocks Derivatives

Spot

markets Forward

contracts

(Pre-sales)

Developers REITs MBS / ABS

Others

Index

derivatives

Funds /

Bonds

Sale &

Purchase

Rental

Developme

nt

Real

Options Financing

Bond

Collaterals

Mortgage /

Reversed

Mortgage

BOT / PPP /

Project

Finance

Land

Auction

Futures

Options

Swap

CDO

CDS

Sales

Strategies

Portfolio

Investment

MBS: Mortgage-backed Securities

ABS: Asset-backed Securities

CDO: collateralized debt obligation

CDS: credit default swap

REAL ESTATE ECONOMICS AND FINANCE

The Subprime Crisis 08 is triggered by the Leveraging of the Real Estate Markets

Quality Assurance of Assets

When Real Estate Becomes

Virtual Financial Derivatives

DIRECT

REAL ESTATE

Mortgages /

Collaterals

(Leveraged) MBS / REITs /

ABS

(Leveraged) CDO / CDS /

Minibonds

(Leveraged)

Market

Plummets Sub-prime

Crisis

Financial

Institutions

Quake Global

Financial

Tsunami

MBS/REITs/ABS CDO / CDS / Minibonds

DERIVATIVES – Less Tangible REAL ESTATE -

More Tangible

AAA

DIRECT

REAL ESTATE MORTGAGE

?

What is CDO? A collateralized debt obligation (CDO) is

a type of structured asset-backed security

(ABS), and mortgage-backed security

(MBS).

a CDO can be thought of as a

promise to pay investors in a

prescribed sequence, based on the

cash flow the CDO collects from the

pool of bonds or other assets it

owns. The CDO is "sliced" into

"tranches",

1 MBS -> n CDOs (Amplification)

What is CDS? • A credit default swap (CDS) is a

financial swap agreement that the seller

of the CDS will compensate the buyer in

the event of a loan default.

• It was invented by JP Morgan in 1994.

• A CDS is considered insurance against

non-payment.

• A buyer of a CDS might be speculating

on the possibility that the third party will

indeed default.

• Default risk is transferred to other CDS

buyers, thus moral hazard.

CDO+CDS = Risk-free Asset?

• If CDS sellers default?

(counterparty risk)

• i.e if insurance companies go

bankrupt, how to insure the

insurers?

Gaussian Copula Model

• The crisis exposed significant weaknesses in the Coupla model. The underlying

assumption of the model that correlations between different assets where

constant over time and could be combined into one number, had proved to be an

serious misjudgement;

• The most popular approach to find the distributions for the time to default (Rj,Ri),

was to use observed market data from another type of CDS. (Forslund and

Johansson 2012);

• Result in a general underestimation of risk, and overconfidence.

Chinamerica

• Savings

• Export

• Producer

• Buy TB

China

• Spenders

• Import

• Consumer

• Sell TB

US

• Lower IR

• Higher Inf

• US can spend more now - repay less future

• China can export more now – less unemployment

Global Finance

Money is fiat, real interest rate can be Negative

An Analogy: A win-win?

• No business

• Few customers

• Overstocks

Retailer

• No savings

• Spendaholic (cannot stop from consuming)

Shopper

• Retailer offers low interest non-callable and recyclable loans to shoppers

• A win-win solution?

• Good business of the retailer

• Unlimited spending of the shopper

Financial

Intermediary

China’s Holding of US Debt

US currency index drops from 120 to 70

US interest rate drops from 6.25% to 1%

1/2000

1/2008

1/2013 11/9 terrorist

attack, 2001 Subprime

Crisis Housing

price drops

Negative RIR 2001-06 US

Mike Shedlock | May 09, 2013 Negative Real Interest Rates Fuel Yet Another Housing Bubble,

http://finance.townhall.com/columnists/mikeshedlock/2013/05/09/negative-real-interest-rates-fuel-yet-another-housing-

bubble-n1591391

RIR v Subprime Crisis

Subprime Crisis 2007 - US

• Rise from 75 in 1991 to 226 in 2007;

• 201% up in 16-year;

• Drop from 226 in 2007 to 158 in 2012;

• 30% down in 5-year or longer.

Real Interest Rate of US - Negative 2003 - 2005

• Negative 2% in 2003 - 2006;

• Positive since mid 2006;

• Subprime crisis in 2007;

• Now, RIR is positive because of deflation.

US Housing Price Change v. RIR

US Annual Housing Return v. RIR

• Correlation very strong;

• especially in negative RIR zone;

• gradient = -1.5

Causes of the Subprime Crisis

• Greedy?

• Loose Lending Practices? NINJA loans?

• Problematic Credit Rating?

• Complex investment vehicles (MBS, CDO, CDS)?

• Copula Assumption of Risk? Long Tail Effect?

• Chinamerica? China saves too much? US spends too much?

• Negative RIR? Fiat Money?

• All the above?

• None of the above?

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The End

comments are welcome. Enquiries to:

ecyyiu@cuhk.edu.hk