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Yong Wang, PhD,CFA,FRM
Managing Director, Quantitative Analysis
RBC
Subprime Crisis Origin and Impact
July 17, 2008
York University
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Disclaimer
All the views expressed in this presentation are those of my own and do not necessarily represent the views of either Royal Bank of Canada.
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Subprime crisis origin and impact
– Background– Terms
• Subprime mortgage• Securitization
– The changing environment of interest rate– Origin– Potential problems and future outlook
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Background
The severe dislocation in financial markets triggered by U.S. Sub-prime mortgage problems which began in July 2007 worsened in October 2007 following rating agencies’ extensive downgrades of Residential Mortgage Backed Securities (RMBS) & valuation contagion in related products & securities.
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Subprime Crisis Timeline
June 2007
• WSJ reports that two hedge funds managed by Bear Stearns are scrambling to sell large amounts of mortgage securities.Early-July 2007
Market reacts negatively to LBO backlog.July 30, 2007
IKB Deutsche Industriebank AG, a German bank faced a bailout over sub-prime losses, invested 7.8 Bn EUR in U.S. real estate securities
August 13, 2007
In Canada, Coventree Capital Group Inc. failed to find buyers for CAD 950 mm of ABCP.August 16, 2007
In Canada, Third Party ABCP bail-out plan & agreement signed (Montreal Accord).
August 16, 2007
Federal Reserve lowers discount rate to 5.75% from 6.25%August 22, 2007
Bank of America injects USD 2.0 BN into Countrywide Financial CorpSeptember 14, 2007
Summer & Fall2008 ?…
August 9, 2007
BNP Paribas froze EUR 1.6 Bn of three of its funds that invested in U.S. sub-prime mortgages
Effective 30 July 2007, KfW assumed IKB's obligations under the liquidity facility to the ABCP conduit Rhinel & Funding Capital Corporation.
ECB injects moneyGoldman Sachs – USD 9.0 BN Global Alpha internal hedge fund is down 16% on the year during the week
In U.S., Countrywide Financial Corp draws on USD 11.5 Bn Credit line amid crisis in liquidity.
Depositors start to withdraw (GBP 2.0 BN in 2 days)Bank of England bails out 150 year old Northern Rock Plc
October 2007
Moody’s and S&P downgrade more than USD 100 billion in CDOs & MBSs
March 16, 2008
Federal Reserve / J.P. Morgan bailout of Bear Stearns – the speed of the collapse heightens anxietyabout the ability of other Broker-Dealers to fund their operations. Federal Reserve – creates a lendingfacility to improve the ability of primary dealers to finance securities inventories.
April 1, 2008 UBS – USD 19 bn more of writedowns, the most by any bank.Former UBS president calls for a break up of the bank.
Deutsche Bank AG – USD 3.9 bn more of writedowns.
April 25, 2008: Investors of Canadian non-bankABCP Investors voted overwhelmingly for arestructuring proposal on CAD 32 billion in frozenCanadian ABCP.
May 2, 2008: Ruling on fairness of plan.
May 31, 2008: Assuming legal approval & noappeals, investors may have new notes.
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Before Crisis
Download from FT.com
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After Crisis
Download from FT.com
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Background
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What is a subprime mortgage?
Special mortgage product for borrowers with bad credit quality
• FICO Score < 620 (300-850)
• Low net equity value
Interest rate relatively higher, low initial down-payment
Most popular product among subprime mortgages is the ARMs (Adjustable Rate Mortgage)
Total subprime loan in 1998 is roughly $150 billions(10% of total mortgages);in 2006 is $600 biillions (20% of total mortgages)
When housing price goes up, the house is good collateral. The net value is relatively high, it is easy to get the refinancing.
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Why subprime mortgage can become an nightmare - 2×28ARM
N=200,000,amortizing period = 30 years,initial teaser rate = 5%,from the third year, the rate is set to LIBOR+300bp
First two yearsMonthly payment=$1074,where the interest is $833,principal payment is $241
After two years,principal becomes $194,224• If interest rate is unchanged,Monthly payment = $1074• If LIBOR = 5% (total rate = 8%) , Monthly payment = $1450!
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The sub-prime market expands as investors seek yield-enhanced products
2005
Increased lending to poor quality borrowers
0
100
200
300
400
500
600
700
1998 1999 2000 2001 2002 2003 2004 2006
Bill
ions
(US$
)
0
5
10
15
20
25
Perc
ent o
f Tot
al
Subprime Originations Subprime % of Total Mortgage Originations
Increased lending to poor quality borrowers
0
100
200
300
400
500
600
700
1998 1999 2000 2001 2002 2003 2004 2006
Bill
ions
(US$
)
0
5
10
15
20
25
Perc
ent o
f Tot
al
Total subprime %of total mortgage
2005
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ARMs reset(Jan. 2007, Credit Suisse Fixed Income US Mortgage Strategy)
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The booming housing price stimulates the growth of the subprime market
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How subprime mortgage gets into the capital markets
The subprime mortgages are packaged into RMBS
Become CDO CollateralsInvestors ownedBecome the reference
in the synthetic products
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Securitization
Securitization is a process to generate asset-back securities through the packaging the assets that have some kind of steady cash flows
The key is to put all assets together and re-distribute the associated cash flows
The generated securities is registered and tradable
The securities are rated by the rating agencies, and owned by insurance companies, banks and hedge funds etc.
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One Simple Example
Asset pool is composed
of three corporate bonds X, Y, Z
All bonds have identical
credit rating
This CDO has three tranches – equity, mezz & senior tranches
•When one bond defaults, the equity tranche will take loss
•Two bonds default, the equity + mezz tranches will take loss
•All three bonds default, all tranches will take loss
CDO gives investors exposures to the risks of joint default
Equity tranche
Mezz tranche
Senior tranche
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What Happened?
Sub-prime Mortgage Loans
Sub-prime RMBS
AAA
AA
A
BBB
BB, NR
High Grade ABS CDO
Senior AAA
Junior AAA
AA
BBB
NR
Mezz ABS CDO
A
Senior AAA
Junior AAA
AA
BBB
NR
A
Sub-prime Mortgage Loans … Sub-prime RMBS … ABS CDO
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Who’s Owns What?
Who holds mezzanine RMBS?
– CDOs
– Who holds mezzanine ABS CDO securities?
– Other CDOs
– Who holds Aaa ABS CDO securities?
– Mostly banks and bond insurers
– Who holds Aaa subprime RMBS?
– SIVs, ABCP programs, portfolio investors
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The MBS Market Composition
1. Total MBS 6.8 trillions,exceeding the US Treasuries
2. USA GDP is roughly 13.8 trillions
3. The size of equity market is 45 trillion,US equity is roughly 23.5 trillions
4. The size of global derivatives markets is roughly 480 trillions
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Crisis
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Interest Rate and Delinquency
利率环境与抵押贷款拖欠率
Fed Fund rate Delinquency
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Housing price return from 1987 to June 2007
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ABX Subprime Index
From London based Markit
Based on 20 CDS prices
Reflects the market price of subprime MBS
Four series (06-1,06-2;07-1,07-2),each series has 5 tranches (AAA, AA, A, BBB, BBB-).
ABX-HE-07-2 is the On-the-run
The issue of ABX-HE-08-1 series is delayed.
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2007 Credit Crunch
ABX 2006-2 (January 1, 2007 - November 6, 2007)
0
5
10
15
20
25
30
35
40
45
50
55
60
65
70
75
80
85
90
95
100
105
Janu
ary 2,
2007
Janu
ary 16
, 200
7
Janu
ary 30
, 200
7
Februa
ry 13
, 200
7
Februa
ry 27
, 200
7
March 1
3, 20
07
March 2
7, 20
07
April 1
0, 200
7
April 2
4, 200
7
May 8,
2007
May 22
, 200
7
June
5, 200
7
June
19, 2
007
July
3, 200
7
July
17, 2
007
July
31, 2
007
Augus
t 14, 2
007
Augus
t 28, 2
007
Septem
ber 1
1, 20
07
Septem
ber 2
5, 20
07
Octobe
r 9, 2
007
Octobe
r 23,
2007
Novembe
r 6, 2
007
Pric
e
2006-2 AAA2006-2 AA2006-2 A2006-2 BBB2006-2 BBB-
First Indications
that there may be credit quality & liquidity
issues with Sub-prime
ABS & structured products. Full blown credit-crunch & losses
resulting from U.S. sub-prime mortgage exposure. RBC CM
reports $35 mm in losses.
Prelude
Part I
The index is maintained by Markit, an independent source of credit derivative pricing.ABX is constructed in conjunction with a consortium of key asset-backed security trading desks.
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CDO’s Leverage Effect
CDO Composed by Subprime RMBS
When Subprime Loss > 10%,what is the loss for RMBS?What is the loss for RMBS-CDO?
RMBS Composed by Subprimes
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Bear Stearns Collapse
Established:1923
Headquarter:New York
Total employees:13,566 (11/2006)
Products:Financial Services,Investment Banking,Investment Services
Market caps• Jan 2007:24 billions
• July 2007:20 billions
• Current:1.55 billions
MBS holding:28 billions,subprime holding is 17 billions
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Writedowns
Americas42%
Asia6%
Europe52%
Subprime Writedowns & Credit Losses -
$382.8 Billion, Globally:
Writedown & credit losses stemming from the collapse of U.S. Subprime mortgage market
announced by commercial & investment banks have reached $382.8 Billion, globally.
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Who to blame?
Subprime Loan Providers (Commercial Banks & Other Financial Institutions)
• Profit driven• Loss credit standard
Investment Banks• Profit driven• Overly reliance on math model, under-estimate the embedded risk
Regulatory Bodies• Low regulatory standard on credit risk management
Rating Agencies• Conflict of interests
Investors (including borrowers & RMBS buyers)• Simplified assumption on housing market• Overly reliance on rating agencies
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2007 Subprime Crisis vs. 1998 LCTM Crisis
The reasons
The role of math models in the crisis
Market price vs. model price
Counterparty credit risk
Impact and magnitude
Liquidity! Liquidity ! Liquidity !
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Future outlook as of May 31, 08
The crisis is not completely over• Compared to Feb. 2007, the foreclosure has increased by 112%
• Compared to Feb. 2007, S&P/Case-Shiller index has dropped by 12.7%,which may trigger more defaults
• S&P 500 dropped by 11.1% (Mar 2007 - Mar 2008)
• GDP: 0.6%
• Inflation 4.3%
Many financial institutions may have quite material write-downsBond insurers may have quite substantial loss due to senior level CDO holdingsFinancial institutions will improve the credit, this will reduce the total available fund, which may slow down the economical growth