MENAIL GHANI

MUHAMMAD ALI SHAH

MEHAK MASOOD
URFA RUBAB
RABIA YOUSAF
 Subprime mortgages
 Subprime Loans
 Housing bubble
 Main Players
 The Aftermath
 Implications
 A subprime mortgage is a type of loan granted to
individuals with poor credit histories.
 They charge interest rates that are above the typical
interest rate because of the risk that is involved on the
part of the lender.
 There are several different types of subprime
mortgages, but the most common is the adjustable rate
mortgage (ARM).
 ARMs can be misleading to subprime borrowers
because they initially pay a lower interest rate then the
rate goes up after some time.
 Interest- loans.
 ARM loans.
 Negative Amortization Loans
 Ultra-long fixed rate loans
 Balloon Loans
 No-money –down loans
 Housing price increase during 2000-2005, followed by
a levelling off and price decline
 Increase in the default and foreclosure rates beginning
in the second half of 2006
 Collapse of major investment banks in 2008
 2008 collapse of stock prices
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 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
 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 grew alongside the stock bubble in the
mid 1990s.
 The stock bubble increased the wealth of people, which led
them to spend money on consumption including bigger and
better houses.
 The increased demand led house prices to rise
 Also going on at this time was the slow recovery from the
2001 recession. This led the Federal Reserve Board to cut
interest rates in an effort to stimulate the economy.
 Between 1997 and 2006, the price of the typical American
house increased by 124%
 Housing prices go up because demand goes up.
 Housing bubbles usually start with an increase in
demand , in the face of limited supply which takes a
relatively long period of time to replenish.
 Speculators enter the market, believing that profits can
be made through short-term buying and selling. This
further drives demand.
 It is impossible to predict and difficult to detect !
 Home prices reached their peak in the second quarter of
2006. They did not fall drastically at first.
 Home prices fell by less than 2 percent from the 2nd quarter
of 2006 to the 4th quarter of 2006.
 The foreclosure start rates increased by 43 percent over
these two quarters, and increased by 75 percent in 2007
compared to 2006.
 This implies that mortgage default rates began to rise as
soon as home prices began to fall.
 Just as rising home prices reinforced the continuing rise in
home prices, falling home prices reinforced the continuing
fall in home prices.
The increase in foreclosures added to the inventory of
homes available for sale.
 This further decreased home prices, putting more
homeowners into a negative equity position and leading
to more foreclosures.
 The increase in foreclosures also decreased the value
of mortgage-backed securities.
 This made it difficult for investment banks to issue
new mortgage-backed securities, eliminating a major
source of financing for new mortgage loans and
contributing to the continuing decline in home prices.
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
 Most of the losses were not incurred by homeowners
but by the financial system.
 Large losses were incurred by the following groups:
1. Mortgage lenders
2. Investment banks
3. Foreign investors
4. Insurance
 The bursting of any housing bubble would be expected to
have a negative effect on the economy for two reasons:
A. Home construction is an important economic activity,
and the decline in home construction would reduce GDP.
B. The decrease in home prices would also reduce
household consumption due to the wealth effect.

 But the bursting of this housing bubble caused more severe

and widespread harm than would be predicted from just
these two reasons.
 As mentioned previously, most of the losses were suffered
by the financial system, not by the homeowners. The
bursting of the housing bubble sent a shock through the
entire financial system.
 Default.
 Auction.
 The bank sells the home.
 Increase in supply of homes
in the market.
 Billions of dollars were lost
in mortgage backed
securities
 Mortgage backed security
 The Federal Reserve
 Continued Reduction in Fed Rates
 Sudden increase in Money supply
 Rates remained low till 2005
 High Liquidity
 2. Commercial Banks
 Lowered to lending rates to increase loan off take.
 As the prime market was nearing saturation, began
lending to subprime borrowers.
 Aggressively sold MBS, CDO.
 Additional funds raised by securitization was re-
deployed in the same manner.
 Non-traditional mortgages.
 MBS ratings influenced using parental linkages as well
as rating shopping
 3. Home buyer
 Buying property well beyond their means.
 Buying for price arbitrage.
 Non-traditional mortgages leveraged their borrowing
capacity further.
 2yrs fixed rate, then floating rates: EMIs rose
exuberantly, house value fell.
 Thus making foreclosure a viable option.
 Accelerated downward spiral
 4. Investment Banks
 Increased use of Secondary mortgage market
 Lenders sold their mortgages in the secondary market.
 Pooled mortgages into securities like CDOs and MBS
 A mortgage-backed security (MBS) is a “bond”
whose cash flows are backed by the principal and
interest payments of a set of mortgage loans.

 Collateralized debt obligations (CDOs) are an

unregulated type of asset-backed security and
structured credit product. CDOs are constructed from a
portfolio of fixed-income assets. These assets are
divided by the ratings firms that assess their value into
different tranches.
 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
 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.
 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.
 There was a total of 2.2 million foreclosures in 2007,
up 75% from the roughly 1.26 million RealtyTrac
reported in 2006. RealtyTrac said 1% of all US
households were in 'some stage of foreclosure' in 2007,
up from 0.58% in 2006.
 By the end of 2008, home prices had dropped 20%
from their 2006 peak.
Avoid these policies:
Monetary contraction
Trade restrictions
Tax increases
Constant changes in policy; this merely creates
uncertainty and delays private sector recovery.
 The rising house price and the healthy
economy boost the lenders to loan money to
people who had low credits. No one thought
about the upcoming disaster that struck the
United States' real-estate market.
 The house price went down, and the
subprime mortgage borrowers couldn't pay
neither the interest rate nor the debt because
the value of the house they bought went
down. Unemployment increased in the United
States and the economy was ruined.
 This eventually caused economic crisis all
over the world and brought disaster to all the
banks. Even though the crisis is now very
much relieved, there are still many victims of
the subprime mortgage crisis suffering from
financial crisis and in addition, credit crisis.
Because of the subprime mortgage crisis in
the United States, it caused the world once
more to reconstruct and refinance their
economic situation.