The Subprime Mortgage Crisis

Ann Dunn Andracchio

Preeti Arunapuram
Shailja Amin
Arjun Ajmani
What is the Subprime Mortgage Crisis?
The Subprime Mortgage Crisis of 2008!!!
 Credit Enhancement

• The process of reducing overall credit risk

• Require additional collateral, insurance, or
other third party agreements
• Provide lender with compensation in case
the borrower defaults
 Credit Enhancement
Because the overall
credit risk decreases,
the borrower’s credit
rating goes up,
projecting a false
image of good credit.
 Credit Enhancement
There are many
different types of credit
enhancement. But the
three most common
forms are called
subordination,
overcollateralization,
and excess spread.
 Trustee
Credit
Enhancement Special Purpose
Vehicle
Investor

Reference Portfolio Securities

Loan ABS CDS AAA

Loan ABS CDS AA

ABS CDS A
BBB
Bond Other BB+ or <
Bond CDOS
 Credit Enhancement and the Crash of
2008
• The recent mortgage crisis discredited the use
of credit enhancement as a valid financial
practice.
• Credit enhancement results in a faulty credit
ratings as it artificially inflates them.
• This in turn allows for those with bad credit
ratings to secure high-risk loans with an even
higher risk of defaulting.
 Credit Enhancement and the Crash of
2008
• Because of credit enhancement, many credit
rating agencies such as Standard’s and Poor
could not give out accurate ratings.
• Many homeowners were allowed risky loans
based on faulty credit ratings. This led to many
loan defaults and home foreclosures.
 The Housing Bubble
• In 2006, there was
a boom in the
housing market
• People bought
expensive houses
using loans with
low interest rates
 The Housing Bubble and the Crash of
2008
• Suddenly the rates would increase, borrowers
could not afford new rates
• Foreclosures and other factors caused the
housing market to decline
• When borrowers could not pay back the loans,
banks lost money
The Housing Bubble and the Crash of
2008
• Other sectors also
lost money (real-
estate,
construction, etc.)
• This started to
affect the stock
market when
investors lost
confidence in the
economy
The Housing Bubble and the Crash of
2008
Loan Amount: $100,000
Interest Rate: 1%
Rate Adjustments: 3

Month Beginning Balance Principal Paid Interest Paid Interest Rate

1 100,000 322 83 1%
13 97,126 472 324 4%
25 95,314 528 397 5%
Risky Lending and the Crash of 2008
• Americans lost more
than a quarter of
their net worth.
• At the end of 2008,
S&P 500 (stock
market) was down 45
percent from the
high in 2007
 Risky Lending and the Crash of 2008
• Housing prices had dropped between 20% and
35% from 2010 Total home equity in the
United States, which was valued at $13 trillion
at its peak in 2006, had dropped to $8.8
trillion and was still dropping at the end of
2008.
• Retirement assets dropped by 22 percent from
$10.3 trillion in 2006 to $8 trillion in 2008.
 Risky Lending and the Crash of 2008
• Savings/Investment assets lost $1.2 trillion
• Pension assets lost $1.3 trillion
• The crisis caused panic in the financial sector
in the beginning of 2007.
• Over 100 mortgage companies shut down.
• CEOs of many large corporations are merging
companies or even resigning
 Credit Default Swap (CDS)
• A swap contract
• The protection buyer makes a series of
payments to the protection seller and receives
a payment if the credit instrument
experiences a credit occurrence (i.e.
defaulting on a loan)
• Typical credit instruments of CDSs are bonds
and loans
 CDS and the Crash of 2008
• In 2007, the outstanding amount in credit
defaults was $68.2 trillion.
• By the end of 2008, that number had
shrunk to $38.6 trillion.
 CDS and the Crash of 2008

AIG’s potential losses due to irresponsible

CDSs reached a whopping $100 billion.
– The U.S. government had to bail out AIG due
to risky lending.
 CDS and the Crash of 2008
• When Lehman
Brothers went
bankrupt, around $400
million was owed to
CDS protection buyers
who hedged against
the bank.
– The actual amount
swapped amounted to
$7.2 billion.
CDS and the Crash of 2008
Many people believe
that a large amount of
CDS purchases which
hedged against Bear
Stearns led to the
company’s downfall.
Others believe that
these CDSs were not a
cause of Bear’s fall but
an effect.
 CDS and the Crash of 2008

Because of the large effect that CDSs had on the

subprime mortgage crisis and the subsequent
economic recession, both politicians and
civilians alike are pushing for more government
regulation of credit default swaps.
 Sources
• Inside the House of Money by Steven Drobny;
pgs. 365-380
• Financial Futures Markets by Brendan Brown
and Charles R. Geisst