Financial Crises of 2007

8/14/2019 Financial Crises of 2007

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Munibah Munir

Mcom 4th(finance)2008-ag-141


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Financial Crises


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Sub prime Mean A classification of borrowers with a

tarnished or limited credit

history. Lenders will use a creditscoring system to determine whichloans a borrower may qualify for.

Sub prime loans carry more creditrisk, and as such, will carry higherinterest rates as well


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Sub prime Mortgage

Mean Borrowers with lower credit ratings.

Conventional mortgage is notoffered.

Sub prime mortgages at a rate thatis higher than a conventional

mortgage in order to compensatethem for carrying more risk.


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Sub prime Mortgage limited income

Higher rate of default than primemortgage loans


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Sub prime Lenders Not qualify for loans from mainstream lenders. Prices, uniformly higher than those quoted by

mainstream lenders.They would lend money to consumers that

have bad credit. Risk is offset with a higher interest rate


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qualify for prime financing termsbut can qualify for sub prime

financing terms. Failure to qualify for prime

financing


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Sub prime Borrowers weakened credit histories Debt-to-income ratios.

Down payment Ratio of total expense (including debt

payments) to income. Income and assets.


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Borrower profiles A good payment record(years)

To refinance into mainstream ratesafter two to three years.


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Sub prime Lending

Terms The 2/28 ARM

An adjustable rate mortgage onwhich the rate is fixed for 2 years,and then reset to equal the valueof a rate index at that time, plus a

margin.


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Sub prime Lending

Terms 3/27ARM

3/27 mortgages have a three-yearfixed-interest-rate period afterwhich the interest rate begins tofloat based on an index plus a

margin (known as the fully indexedinterest rate).


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Collateralized Debt

Obligation Different types of debt and credit

risk.

Different types of debt are oftenreferred to as 'slices'.

Each slice has a different maturity

and risk associated with it. Higher the risk, the more the CDO

pays.


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Default RiskThe risk that companies or

individuals will be unable to pay

the contractual interest or principalon their debt obligations.

Risk that you will not get paid.


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Credit default swaps Financial instruments used as a

hedge and protection for

debtholders, in particular MBSinvestors, from the risk of default.

As of 2008, unable to perform his

obligations under the CDScontract.


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Mortgage-backed

security An asset-backed security or debt

obligation that represents a claim

on the cash flows from mortgageloans, most commonly onresidential property.


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Commercial mortgage-

backed securities

Are secured by commercial and multifamilyproperties (such as apartment buildings, retailor office properties, hotels, schools, industrial

properties and other commercial sites). Theproperties of these loans vary, with longer-term loans (5 years or longer) often being atfixed interest rates and having restrictions onprepayment, while shorter-term loans (13

years) are usually at variable rates and freelypre-payable.


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Background U.S. house prices peaked in mid-2006

An increase in loan incentives such as

easy initial terms and a long-term trendof rising housing prices had encouragedborrowers to assume difficultmortgages in the belief they would beable to quickly refinance at morefavorable terms.


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Background 20062007 in many parts of the

U.S., refinancing became more

difficult. Defaults and foreclosure activity

increased.


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Proponents

Credit problems

Lenders have seen that a tiered

pricing arrangement, one whichallows these individuals to receiveloans but pay a higher interest rate

and higher fees, may allow loanswhich otherwise would not occur.


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Causes

inability of homeowners to maketheir mortgage payments

speculation and overbuildingduring the boom period

, international trade imbalances

government regulation

ETC


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Three important Causes

Influx of moneys from the privatesector.

Banks entering into the mortgagebond market.

Predatory lending practices of

mortgage brokers.. Specifically the adjustable-rate

mortgage, 2-28 loan.

umm on nanc a


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umm on nanc aMarkets and the WorldEconomy(2008)

Unsound risk managementpractices.

Increasingly complex and opaquefinancial products.

Policy-makers, regulators and

supervisors, ETC.


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Impacts

investors to take their money outof risky mortgage bonds

put it into commodities as "storesof value".(food&raw material)


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Losses

International Monetary Fund estimated

U.S. and European banks lost more than

$1 trillion losses are expected to top $2.8 trillion

from 2007-10. U.S. banks losses wereforecast to hit $1 trillion and Europeanbank losses will reach $1.6 trillion.


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Losses

U.S. banks were about 60 percentthrough their losses

British and eurozone banks only 40percent.


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Response

Various agencies and regulators,as well as political officials, began

to take additional, morecomprehensive steps to handle thecrisis.

Financial Crises of 2007

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