Transcript subprimecrisis

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 Over
by 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 –
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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 mortgagebacked 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
Securitization
CDOs
Borrowers
Investment
Banks
Brokers
Lenders
Rating Agencies
CDS
Special Purpose Vehicle
Investors
Risk Process
Borrowers
Investment
Banks
Mortgage
Brokers
Rating
Agencies
Banks
SPV
Investors
Leverage
Credit Default Swaps
Mortgage-backed
Securities
Sub-Prime
Mortgages
Risks
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Currency risks
Credit risk
Default risk
Interest rate risk
Liquidity risks
Counterparty risks