Sai Kumar Swamy, PGDM, IIM Bangalore
Agenda
Definition
Prime Sub-Prime
Origin of Crisis Why did the bubble burst? Interesting stats Why did the Financial Giants collapse? The answer
CDO Advantage MBS & CDS Linkage End Game How the cookie formed? How the cookie crumbled?
Prime
Prime Borrower
Borrow < 80 % Good credit bureau record Monthly payment < 25 % income Good Credit Score Banks like them - Credit Worthy Safe Lower Interest rate Pay Lower Mortgage Rates
Subprime
Subprime Borrower Tarnished credit records Low Credit score Borrow a higher proportion High Mortgage to Income ratio Banks are wary of these customers Risky Higher Interest rate Pay Higher Mortgage Rates
Origin of Crisis - 1
Housing Bubble 2001- 2005 Housing prices increase Cheaper Credit
Federal Reserve Lowers the federal Funds Rate From 6.5% to 1.75 % between May 2000 and December 2001
Greater Access to Credit Sub-Prime Market
Mortgages to risky individuals Increase in Buyers
Origin of Crisis - 2
Sub-prime mortgages
Government Policies
ECOA - 1974 CRA - 1977
Competitive pressures Increase in loan incentives Easy initial terms
ARM (ARM – Adjustable Rate Mortgages)
Rising Housing prices Dropping interest rates
Origin of Crisis - 3
Housing prices peak in mid-2006 Building boom Fresh Supply created to exploit market conditions Surplus of homes Housing Bubble Bursts
Home Sales fall Supply exceeds Demand More Sellers than Buyers Prices of Houses decrease WHY??
Housing Construction Declines Slowdown in US Economy
Why did the bubble burst?
No clear cut reason – Many factors responsible Factors
Greed of Borrowers ARM Refinancing doldrums Supply glut
Led to Foreclosures
Started vicious cycle Supply of homes Equity Prices Homeowners
Interesting Stats - 1
Increase in Home-ownership rate
64% in 1994 – 70% in 2004
Increase in Housing price
1997-2006 – Increased by 124%
Median Home price
2001 2.9% of Median Household Income 4% in 2004...