My class presentation at IIMA which contains an overview of the credit crisis till Dec 2008.

1. By Raghu Subramanian

2. Treasury Yield Curve
8
7
6
5
Yield
4
3M T-Bill
3 10 Yr T-Bill
Eff. Fed funds rate
2
1
0

3. For more information go to
http://www.nytimes.com/interactive/2007/08/25/business/20
070826_HOUSING_GRAPHIC.html

4. Fixed rate loans

Floating rate loans

3/1, 5/1, 7/1 Adjustable rate mortgages

(ARM)
Interest only loans

Ninja loans (No income, no job and no assets)


5. ◦ In 2006, 22% of homes purchased (1.65 million
units) were for investment purposes.
◦ Additional 14% (1.07 million units) purchased as
vacation homes
◦ During 2005, these figures were 28% and 12%
◦ An estimated one-third of ARM originated between
2004 and 2006 had quot;teaserquot; rates below 4%, which
after expiry would significantly increase the
mortgage payment
◦ The share of subprime mortgages to total
originations was 5% ($35 billion) in 1994, 9% in
1996, 13% ($160 billion) in 1999, and 20% ($600
billion) in 2006.

6. Prime loans

◦ Loans given to people with credit scores of > 680
Alt-A loans

◦ Loans given to people with credit scores of <= 680
Subprime loans

◦ Loans given to people with credit scores of <= 620

8. Declining home prices

Foreclosures

Rising commodity prices


9. Feb 2007

◦ HSBC's first-ever profits warning came in February
this year when a $10.6bn (£5bn) hole in the
company's US sub-prime business was revealed.
Aug 10 2007

◦ The next jolt came from French bank BNP
Paribas, which said early in the day that it was
freezing three investment funds once worth a
combined $2.17 billion because of losses related
to U.S. housing loans.

10. Market size is $2 trillion

This market is used to fund short term

financing based on asset backed commercial
paper such as homes and autos
Banks used asset backed commercial paper to

fund long term investments

11. 13th Sept 2007

◦ General maturity times are 30-40 days but have
shortened to a week
◦ Banks are increasingly finding it difficult to raise
short term funds for their asset backed commercial
paper and fund their long term investments
◦ This means that their cost of capital has risen with
yields demanded having gone higher
◦ Also exacerbated by the fact that many buyers
moved to buying treasuries instead of commercial
paper

12. 18th Sept 2007

◦ Fed cuts both federal fund and discount rates by 50
basis points and signals more rate cuts.
◦ Markets all around the world stage a huge rally.
◦ Dow Jones goes up 330 points or 2.5%, Nasdaq up
2.7%, S&P up 3%
The dollar falls against a basket of currencies

Commodity prices hit the roof

Treasuries stage a substantial rally


13. Nov 2007

◦ Ambac, guarantees $546 billion of securities.
◦ MBIA guarantees about $652 billion of municipal
and structured finance bonds
◦ FGIC has insured $314 billion of debt
◦ Concerns in credit quality of securities prompts
S&P and Moody to nearly downgrade AMBAC and
MBIA.

15. Proposes to buy the muni bond insurance

business.
Declines to purchase their CDO bond

insurance businesses.
Markets jump higher signaling the entry of

Warren Buffet as a sign of confidence.
AMBAC & MBIA decides to raise additional

capital through equity dilution to keep its
AAA rating.

16. Jan 21 2008

◦ Many worldwide markets took a beating as
indices crashed lower.
◦ In response the Fed cut rates by 75 basis points
to calm markets
◦ However, it was later found that the volatility was
due to Societe Generale unloading a Euro 50
billion of equity derivatives during this time from
Jerome Kerviel’s portfolio.

17. Auction rate security refers to a debt

instrument with a long-term nominal
maturity for which the interest rate is
regularly reset through a dutch auction
Attractive market as it is cheaper to raise

funds through this market.
Size of the market in 2008 was $200 billion


18. Feb 7 2008

◦ First instances of failed auctions occurred
◦ Citigroup, UBS, Merrill Lynch, Morgan Stanley and
others refused to act as buyers of last resort since
they wanted to protect their own capital
◦ These banks had marketed ARS as safe securities.
◦ Class action lawsuits were filed against these banks
◦ ML agrees to buyback $10 billion of ARS
◦ Citibank agrees to buyback $7.5 billion of ARS
◦ BOFA agrees to buyback $4.5 billion of ARS
◦ Wachovia agrees to buyback $9 billion of ARS
◦ UBS agrees to buyback $9 billion of ARS

19. July 2007

◦ Two Bear Stearns hedge funds collapse.. Why did this
happen.
 These funds purchased CDO’s that pay an interest above the
cost of borrowing
 They leveraged themselves about 25 times to purchase more
CDO’s
 The subprime market came under stress and creditors
demanded higher collateral against these assets putting a
strain on Bear Stearns’ balance sheet
 Other funds started to sell bonds to preempt Bear from
selling before them.
 Prices went down further and Bear Stearns had to offload
debt from its books leading to significant losses.

20. 13th Mar 2008

◦ Bear Stearns' available liquid funds fell from $12.4
billion to $2 billion, as customers pulled out money
◦ Other financial institutions refused to provide
short-term loans as counterparty risk reached a
high.
◦ Bear Stearns experienced what is called “a run on
the bank” due to which it could not arrange for
enough money to sustain its operations

21. The Fed steps in and takes $30 billion of

mortgages onto its books
It provides J.P.Morgan with financing to take

over Bear Stearns
It did this because the risk of not doing so

would endanger the entire financial system.
How ?? Is the question asked by many.

Enter Credit Default swaps (CDS)


22. Size of market is $62 Trillion

The swaps became one-way bets on the

demise of financial institutions as traders
hedged the risk that their partners might
implode.
Traditionally, CDS are used as insurance to

protect bonds against default.
However CDS have now become instruments

of speculation with CDS positions far
exceeding those of the bonds they insure.

23. A company may have $1 billion worth of

bonds outstanding but $10 billion worth of
CDS on those bonds.
When a company defaults, the sellers of CDS

contracts have to pay the bondholders.

24. At the time of its collapse, it was estimated

that Bear Stearns had $60 billion worth of
bonds.
Not rescuing Bear would mean that bond

insurance would have to make huge payouts
on CDS contracts outstanding against those
bonds.
This could have lead to downgrades of these

insurers which would have led to further write
downs for the entire financial system.

25. Combined Mortgage book stands at $5 Trillion
◦
Mortgage defaults were increasing rapidly.
◦
Estimated losses were at $50 billion
◦
Issued $3 billion worth bonds at record high
◦
spreads to treasury bonds.
◦ Required to issue $233 billion more worth bonds
which the government would probably have been
forced to buy.
◦ Therefore, the government decided to take over the
two institutions

26. ◦ Lehman did not come clean on its write downs.
◦ For a month before declaring
bankruptcy, customers withdrew $400 billion
◦ Banks stopped lending to Lehman
◦ CEO Richard Fuld ignored warning signs assuming
that the company cannot fail
◦ Firm was unable to raise capital by selling off its
assets as Bank of America and Barclays backed out
of the bidding process two days before bankruptcy.
◦ It was estimated that Lehman had $85 billion worth
of toxic assets.

27. The fall of Lehman was gradual rather than

sudden so market participants had time to
adjust.
Lehman was a buyer and seller of CDS

contracts so the net effect was considered to
be manageable.
However, Lehman did cause massive

problems that almost led to AIG going bust.

28. In 2006, Merrill Lynch purchased First

Franklin, one of the largest issuers of
subprime mortgages. This makes Merrill
Lynch the largest player in the market.
The tightening credit conditions force ML to

take massive write downs to the point where
its own survival comes into question
It sells mortgages worth $29 billion for $7

billion in a bid to raise capital
Finally it sells itself out to Bank of America


29. BOFA gains access to Merrill Lynch’s

investment banking business, one which it
never able to achieve on its own
It also gains access to Merrill’s huge

brokerage business.
BOFA can now cross sell its brokerage

services to its deposit holders

30. AIG sells insurance for bonds by issuing CDS.

Just before and during Lehman’s

collapse, CDS spreads hit the roof.
This prompted credit rating agencies to call

into question the quality of bonds insured by
AIG which led to AIG being downgraded
The downgrade led to AIG having to provide

an additional $13 billion in collateral which it
could not raise since all markets were frozen

31. The Fed bails out AIG with an $85 billion package and

takes an 80% equity stake in the firm
The failure of AIG would mean that the bonds insured by

AIG would hold little value since the insurance cover would
no longer exist.
This would to further write downs and further tightening

of credit conditions.
CDS spreads would widen further which would take cost of

funding to untenable levels.
Banks would hoard capital and stop lending to each other

which would lead to further tightening of credit
conditions.
The resulting impact of all this was considered to be so

large that the Fed had no choice but to bail out AIG.

32. Goldman Sachs and Morgan Stanley shares take a

beating
Treasury bonds stage a huge rally

Morgan Stanley and Wachovia talk merger

Money market funds trade under $1 after

Lehman goes bankrupt
Hank Paulson proposes a $700 Billion bailout

Goldman Sachs and Morgan Stanley get into

commercial banking. The pure play investment
banking model is almost extinct.
Buffett strikes a sweet deal with Goldman Sachs

WAMU goes under and J.P.Morgan laps up its

assets

33. ◦ In 2006, Wachovia purchased Golden West Financial
◦ Golden West had a huge portfolio of option
adjustable rate mortgages (around $26 billion) that
let borrowers make minimum payments less than
what they owe.
◦ CDS swaps protecting $10 million of Wachovia 5 yr
bonds traded for the equivalent of $3.5 million
initially and $500,000 a year compared with
$670,000 a year and no upfront payment the
previous day.
◦ Citibank buys Wachovia for $1 a share.

34. The $700 billion bailout plan is rejected by

the U.S house of representatives
Treasury yields sink 45%

Oil drops by $10 per barrel

Gold goes up 3%

The CBOE volatility index hits the highest ever

value
The S&P 500 falls by 9%.

European governments bail out a bunch of

European banks

35. Q&A

36. It is the spread between the 3 month Eurolibor and the 3 month T-Bill

3 month Libor is the rate at which banks borrow from each other

Typical spread is 50 basis points

6
5
4
3
3 month T-Bill
2
3 month EuroLibor
1
0