What’s Going on in Financial Markets?

A (hopefully) Simple Guide to the Question: Why is “Sub-Prime” the Word of the Year?

Genesis

Mortgage

Monthly Payment

Bank

Homeowner

Residential Mortgage

Backed Securities

Genesis

Bundled Mortgages

Buy1985: $372.1 billion2005: $5.75 trillion

Bank

Homeowner

Investor

Mortgage

GenesisBank

Homeowner

Investor

Interest Rates

0.00

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2001 2002 2003 2004 2005 2006

Fixed Mortgage Rate Variable Rate Gap

Case-Shiller Home Price Index

100

140

180

220

2001 - 2004

So, What Happened?Investor Bank

Demanding higher returns

Surging sub-primeoriginations

• Bundling prime and sub-prime mortgages led to higher returns.• The “new” RMBS carried higher risk that was not recognized.

Housing Affordability

100

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1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

61

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Housing Affordability Index

Home Ownership Rate

2005 - 2008

2005 – 2008

• Home prices had become too expensive and demand fell.

• 2003 – 2004 ARMs began to reset at substantially higher rates, particularly for sub-prime mortgage holders.

• Prices decline leaving some borrowers owing more than the value of their home.

• Mortgage defaults began to grow……and grow and grow

Result

• Default & foreclosure– Foreclosure rates soar. % of loans in

process is the highest ever– Sub-prime ARMs represent 43%,

but only 6.8% of total mortgages

• RMBS repriced– More than 17,000 downgraded by

S&P, Moody’s and Fitch– Investors reject them

• Write down value of assets– Citigroup: $18 billion– Morgan Stanley: $11 billion– Merrill Lynch: $8 billion– More than $120 billion total

Homeowner

Investor

Result

Bank

Investor

XCredit

Squeeze

Profits decline

Spending declines

Homeowners

Business