Notesale: Turn your study into money

Document Preview

Extracts from the notes are below, to see the PDF you'll receive please use the links above

---

Subprime  Mortgages:  What  they  are  and  why  they  went  wrong
...
 Most  people  cannot  afford  to  buy  their  
own  houses  outright,  so  they  get  a  loan  to  cover  the  rest  from  their  local  bank
...
 This,  paid  
back  over  time,  is  their  mortgage
...
 However,  a  single  mortgage  is  a  very  risky  investment  on  its  own,  and  
as  a  result  few  ever  buy  them
...
 
• However,  the  investment  bankers  don’t  really  want  to  hold  this  on  their  books  for  
such  an  extended  period  of  time,  so  they  securitize  the  big  pool  of  loans
...
 So  if  10%  of  the  borrowers  
default,  a  buyer  of  a  bond  from  the  pool  would  only  lose  10%  of  his  investment
...
 
 
This  is  the  first  generation  of  mortgage  bonds  as  invented  by  Bob  Dall  and  Lewis  Ranieri  at  
the  Salomon  Brothers  in  1980
...
 This  meant  that  the  government  risk  assessed  and  
guaranteed  the  loans,  done  by  private  companies  but  had  the  same  effect
...
 It  did  not  have  a  defined  period,  
because  homeowners  have  the  right,  both  in  America  and  in  England,  to  refinance  
their  mortgage  at  any  time  they  wish
...
 So  the  lender-­‐  now  the  buyer  of  
the  bonds,  receives  his  money  back,  but  misses  out  on  the  interest  he  would  have  
gained  if  the  loan  had  not  been  re-­‐payed
...
 
• The  bond  technicians  at  Salomon  Brothers  had  another  idea
...
 This  first  tranche  would  be  paid  in  full  before  anyone  in  the  
second  tranche  received  anything,  and  so  one
...
 This  allowed  a  rough  time  span  to  be  given  to  each  tranche  of  the  pool,  and  so  
allowed  them  to  be  priced  more  accurately
...
 
• A  CDO,  (Collateralised  Debt  Obligation)  is  just  a  big  tower  of  debt  al  heaped  in  
together
...
 CDO’s  from  2000-­‐2008  were  packed  with  ever  increasing  sums  of  

subprime  mortgage  debt
...
 
 
             Now  many  people  may  have  heard  the  term  CDO,  probably  spoken  about  in  hushed  
tones,  but  it  is  important  to  grasp  that  all  of  this  so  far  was  used  in  safe  financial  ways  in  the  
1980s,  this  is  not  a  model  only  used  in  the  run  up  to  2008
...
 
                 This  all  worked  so  well  because  only  prime  borrowers,  or  people  with  a  very  good  
credit  history  and  either  well  paid  or  secure  jobs  were  used,  Thus,  almost  no  one  defaulted-­‐
who  doesn’t  pay  their  mortgage-­‐and  the  market  took  off
...
 The  problems  emerged  when  borrowers  ceased  to  pay  back  loans  in  large  numbers  
(because  of  the  teaser  rate  ending),  and  house  prices  fell-­‐  so  there  was  no  equity  in  the  
home,  eliminating  the  possibility  of  another  loan  for  the  borrower,  and  ensuring  a  
substantial  loss  for  the  asset  backed  bonds  that  comprised  the  CDO
...
 
 
• But  there  are  only  so  many  credit  worthy  people  needing  loans
...
 After  all,  the  brokers  did  not  hold  
the  loan,  they  would  sell  it  as  fast  as  possible  to  the  nearest  investment  bank  so  their  
risk  was  supposedly  zero
...
 Subprime  
borrowers
...
   
                 These  loans  started  to  be  added  to  the  CDOs,  and  this  gradually  increased  the  risk  of  
the  bonds
...
 
 
 
• There  was  such  an  abundance  of  new  subprime  loans  that  the  banks  started  to  
make  CDOs  comprised  almost  solely  of  subprime  loans
...
 Yes,  these  loans  carried  a  much  higher  risk,  but  they  had  a  high  
return,  and  if  banks  and  investors  knew  and  understood  the  risk,  the  number  of  
loans  in  the  pool  that  comprised  the  bonds  would  give  the  entire  thing  some  
stability
...
   
         Again,  as  long  as  most  of  the  borrowers  repay,  there  is  no  problem  with  this  type  of  
loan
...
 
               The  regulators,  Moody’s,  Standard  and  Poor’s  and  Fitch  gave  these  bonds  very  high  
ratings,  with  the  upper  tranches  given  triple  A,  middle  tranches  given  AA,  and  lower  
tranches  given  BB  or  BBB
...
 
 

The  Murkier  side  of  the  industry:  
 
The  whole  model  was  supposed  to  be  able  to  discard  bad  or  extremely  risky  loans  at  every  
step,  but  there  were  several  gaping  flaws
...
 
People  with  multiple  bankruptcies  struggling  with  their  current  mortgage  could,  and  
were  encouraged  to  buy  a  second  house
...
 
• The  recently  bankrupt  could  get  a  mortgage  very  easily,  it  was  simple  for  the  
Mortgage  brokers  to  fudge  a  few  forms,  claim  that  they  had  properly  investigated  
the  borrower,  loan  the  money  and  sell  the  loan  to  a  bank
...
   
• They  enticed  people  in  with  what’s  known  as  a  teaser  rate
...
 However,  the  teaser  rate  was  allowing  the  
mortgage  brokers  to  pass  off  a  customer  as  credit  worthy  based  on  the  teaser  rate,  
usually  one  or  two  per  cent
...
 
 
Banker  mistakes:  
• The  big  investment  banks  like  Goldman  Sachs,  Merrill  Lynch,  and  the  Lehman  
Brothers  had  to  compete  to  buy  these  loans,  as  in  any  capitalist  market
...
 They  bought  
far  too  many  to  check  each  and  every  one
...
 You  wouldn’t  bother  to  check  each  one,  and  you  
certainly  wouldn’t  bother  to  research  each  borrower  and  discuss  his/her  relative  
merits  and  strengths
...
 Also  the  level  of  complexity  being  
worked  with,  meant  that  hardly  anyone  knew  what  was  in  these  pools
...
 Even  if  they  didn’t  know  the  exact  format  of  the  loans  they  must  
have  had  a  clear  picture  of  what  was  going  on
...
 
The  banks  also  pushed  mortgage  brokers  to  make  and  sell  them  more  loans,  to  increase  the  
total  number  of  assets  available  in  the  market,  to  increase  revenue  for  themselves
...
 As  part  of  previous  government  legislation,  
all  bonds  issued  by  a  bank,  or  from  Ginnie  Mae,  Freddie  Mac  or  Fannie  Mae,  had  to  
undergo  checks  and  testing  by  an  approved  regulatory  agency
...
 So  the  regulators  didn’t  look  into  these  loan  pools  much  either,  and  as  a  
result  gave  them  low  risk  ratings,  even  the  subprime  CDOs
...
 However,  what  they  did  not  know  was  
that  the  borrowers  were  only  repaying  the  loans  at  the  teaser  rate,  they  had  not  
calculated  what  would  happen  when  the  interest  rate  rose
...
 Investors  could  
not  understand  the  level  of  complexity-­‐  loans  were  being  taken  into  their  constituent  parts  
and  repacked,  and  it  was  beyond  the  level  of  many  investors
...
 Just
...
 This  coincided  with  the  end  of  the  teaser  rate  for  
many  of  the  loans,  of  which  a  record  number  had  been  made  in  2005
...
 This  started  the  credit  
crunch  in  August  2007,  when  banks  ceased  to  lend  to  each  other-­‐  they  didn’t  know  who  
held  bad  CDOs  and  were  unsure  they’d  get  money  back
...
 Banks  were  unable  to  carry  out  their  short  term  borrowing  to  finance  their  
long  term  lending  and  so  began  to  go  bust
...
   
       
It  wasn’t  the  best  year
...
 This  
side  bet  industry,  known  as  the  industry  of  credit  default  swaps  was  worth  nearly  a  trillion  
dollars
...
 If  the  bond  lost  
value  however,  the  buyer  was  liable  to  the  seller  for  that  amount
...
 
 
 
future  
 
Subprime  a  vital  part  of  mortgages-­‐  less  than  bad  credit  history  can  get  loans  
Bluestone-­‐  helps  the  most  vulnerable  in  society
...
 Although  of  course,  investors  and  banks  fled  the  market  well  
before  that,  and  remain  cautious,  quite  rightly
...
 Subprime  does  not  
mean  that  the  loan  is  automatically  bad
...
 
           Especially  in  the  current  climate,  when  house  prices  are  rising,  and  the  number  of  
affordable  homes  being  bought  is  extremely  low,  loans  are  needed  to  provide  liquidity  to  
the  market
...
 
   
• Bluestone  co
...
 This  may  seem  like  absolute  madness,  but  the  catch  is  
that  they  only  lend  to  people  who  have  failed  payments  because  of  an  event  like  
redundancy,  or  serious  illness,  or  the  breakdown  of  an  abusive  relationship
...
 
 
• However,  Bluestone  suffer  with  liquidity
...
 They  need  to  have  external  
funding
...
 The  government,  or  
the  banks
...
 (You  still  have  to  pay  stamp  duty  as  a  first  time  buyer  if  the  
property  is  above  250,000  although  it  is  reduced
...
 
 
• A  necessary  change  would  be  that  the  mortgage  brokers  would  have  to  be  
companies  like  bluestone,  perhaps  certified  as  responsible  by  the  regulators
...
 Any  buyer  or  seller  at  any  point  
should  be  able  to  see  the  entire  list  of  mortgage  loans  with  all  its  detail,  so  that  any  
risk  can  be  identified  by  one  of  the  parties  in  the  chain  
 
 
 



---