Sub-Prime Mortgage Crisis of 2008

The sub-prime mortgage crisis (a financial crisis) was triggered by a significant decline in housing prices and related
mortgage payment delinquencies and foreclosures in the United States. The effect was felt across the financial markets and
global banking systems, as investments related to housing prices declined significantly in value, placing the health of key
financial institutions and government-sponsored enterprises at risk. Funds available for personal and business spending
declined as financial institutions tightened lending practices. The banking community faced a lack of trust amongst
themselves, which led to higher borrowing rates. Subsequently, the central banks of major countries have been reducing
base interest rates for their economies.

The crisis began with the bursting of the United States housing bubble and high default rates on "sub-prime" adjustable rate
mortgages (ARMs). Government policies and competitive pressures for several years prior to the crisis encouraged higher
risk lending practices. Further, an increase in loan incentives such as easy initial terms and a long-term trend of rising
housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance
at more favorable terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006–
2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically
as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Foreclosures
accelerated in the United States in late 2006 and triggered a global financial crisis through 2007 and 2008.

Financial products called mortgage-backed securities (MBS), which derive their value from mortgage payments and housing
prices, had enabled financial institutions and investors around the world to invest in the U.S. housing market. Banks and
financial institutions had borrowed and invested heavily in MBS and have reported huge losses. The liquidity and solvency
concerns regarding key financial institutions drove central banks to take action to provide funds to banks to encourage
lending to worthy borrowers and to restore faith in the commercial paper markets, which are integral to funding business
th
operations. When Lehman collapsed on 15 September 2008, the money markets literally came to a standstill, due to which
the banks faced a tough time managing their daily liquidity concerns. It was then that Mr. Henry Paulson had proposed the
$700 billion bailout package.

The risks to the broader economy created by the housing market downturn were primary factors in several decisions by
central banks around the world to cut interest rates and governments to implement economic stimulus packages. These
actions were designed to stimulate economic growth and inspire confidence in the financial markets. Effects on global stock
markets due to the crisis have been dramatic. Between 1 January and 11 October 2008, owners of stocks in U.S.
corporations had suffered about $8 trillion in losses, as their holdings declined in value from $20 trillion to $12 trillion.
Losses in other countries have averaged about 40%. Losses in the stock markets and housing value declines place further
downward pressure on consumer spending, a key economic engine. Leaders of the larger developed and emerging nations
met in November 2008 to formulate strategies for addressing the crisis.

Securitization
Securitization refers to the process of pooling and repackaging of cash flow producing financial assets into securities that
are then sold to investors. All assets can be securitized as long as they are associated with cash flow. Hence, the securities
which are the outcome of securitization processes are termed asset-backed securities (ABS).

Securitization utilizes a special purpose vehicle in order to reduce the risk of bankruptcy and thereby obtain lower interest
rates from potential lenders. A credit derivative is also generally used to change the credit quality of the underlying portfolio
so that it will be acceptable to the final investors.

Motives for Securitization

1. Reduces funding costs: Through securitization, a company rated BB but with AA worthy cash flow would be able to
borrow at possibly AA rates. This is the number one reason to securitize a cash flow and can have tremendous impacts
on borrowing costs. The difference between BB debt and AA debt can be multiple hundreds of basis points. For
example, Moody's downgraded Ford Motor Credit's rating in January 2002, but senior automobile backed securities,
issued by Ford Motor Credit in January 2002 and April 2002, continued to be rated AAA because of the strength of the
underlying collateral and other credit enhancements.

Disclaimer: We believe that information provided here is correct to the best of our knowledge but we do not guarantee its accuracy. Opinions expressed
herein are personal to the analysts & do not solicit any offer to buy or sell any security. All rights for these reports are reserved by Futures First and no part
of this publication may be reproduced or distributed in any form or by any means or stored in any database without the written permission of Futures First.
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Figure 1: Securitization

2. Reduces asset-liability mismatch: Securitization can offer perfect matched funding by eliminating funding exposure in
terms of both duration and pricing basis. Essentially, in most banks and finance companies, the liability book or the
funding is from borrowings. This often comes at a high cost. Securitization allows such banks and finance companies to
create a self-funded asset book.

3. Lower capital requirements: Some firms, due to legal, regulatory, or other reasons, have a limit or range that their
leverage is allowed to be. By securitizing some of their assets, which qualify as a sale for accounting purposes, these
firms will be able to lessen the equity on their balance sheets while maintaining the "earning power" of the asset.

4. Locking in profits: For a given block of business, the total profits have not yet emerged and thus remain uncertain.
Once the block has been securitized, the level of profits has now been locked in for that company, thus the risk of profit
not emerging, or the benefit of super-profits, has now been passed on.

5. Transfer risks (credit, liquidity, prepayment, reinvestment, asset concentration): Securitization makes it possible
to transfer risks from an entity that does not want to bear it, to one that does. Two good examples of this are
catastrophe bonds and Entertainment Securitizations. Similarly, by securitizing a block of business (thereby locking in a
degree of profits), the company has effectively freed up its balance to go out and write more profitable business.

6. Off balance sheet: Derivatives of many types have in the past been referred to as "off-balance-sheet." This term
implies that the use of derivatives has no balance sheet impact. While there are differences among the various
accounting standards internationally, there is a general trend towards the requirement to record derivatives at fair value
on the balance sheet. There is also a generally accepted principle that, where derivatives are being used as a hedge
against underlying assets or liabilities, accounting adjustments are required to ensure that the gain/loss on the hedged
instrument is recognized in the income statement on a similar basis as the underlying assets and liabilities.
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7. Earnings: Securitization makes it possible to record an earnings bounce without any real addition to the firm. When a
securitization takes place, there often is a "true sale" that takes place between the Originator (the parent company) and
the SPE. This sale has to be for the market value of the underlying assets for the "true sale" to stick and thus this sale is
reflected on the parent company's balance sheet, which will boost earnings for that quarter by the amount of the sale.
While not illegal in any respect, this does distort the true earnings of the parent company.

8. Admissibility: Future cash flows may not get full credit in a company's accounts (life insurance companies, for
example, may not always get full credit for future surpluses in their regulatory balance sheet), and a securitization
effectively turns an admissible future surplus flow into an admissible immediate cash asset.

9. Liquidity: Future cash flows may simply be balance sheet items which currently are not available for spending,
whereas once the book has been securitized, the cash would be available for immediate spending or investment. This
also creates a reinvestment book which may well be at better rates.

Mortgage backed security

A mortgage backed security (MBS) is an asset backed security whose cash flows are backed by the principal and interest
payments of a set of mortgage loans. Payments are typically made monthly over the lifetime of the underlying loans.

Figure 2: Mortgage Backed Securities

The total market value of all outstanding mortgages at the end of the first quarter of 2006 was approximately $6.1 trillion,
according to the Bond Market Association. This is much larger than the market value of outstanding asset-backed
securities. The MBS market overtook the market for US Treasury notes and bonds in 2000.
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According to Bloomberg, gross U.S. issuance of agency MBS was:

1. 2005: $ 958 billion

2. 2006: $ 903 billion
3. 2007: $ 1,148 billion
4. 2008: $ 1,152 billion
5. 2009: $ 385 billion (till March 2009)

Failures and major government bailouts of financial institutions

1. Bear Stearns was acquired by J.P. Morgan Chase in March 2008 for $1.2 billion. The sale was conditional on the Fed's
lending Bear Sterns US$29 billion on a non-recourse basis.

2. Northern Rock encountering difficulty obtaining the credit it required to remain in business was nationalized on 17
February 2008. As of 8 October 8 2008, UK taxpayer liability arising from this takeover had risen to £87 billion ($150
billion), according to Robert Chote, director of the Institute for Fiscal Studies.

3. The GSEs Fannie Mae and Freddie Mac were both placed in conservatorship in September 2008, according to the U.S.
Treasury Department. The Federal government took over the management of the pair. The two GSEs have more than
US$ 5 trillion in mortgage backed securities (MBS) and other debt outstanding.

4. Merrill Lynch was acquired by Bank of America in September 2008 for $50 billion.

5. Scottish banking group HBOS agreed on 17 September 2008 to an emergency acquisition by its UK rival Lloyds TSB,
after a major decline in HBOS's share price stemming from growing fears about its exposure to British and American
MBSs. The UK government made this takeover possible by agreeing to waive its competition rules.

6. Lehman Brothers declared bankruptcy on 15 September 2008, after the Secretary of the Treasury Henry Paulson, citing
moral hazard, refused to bail it out.

7. AIG received an $85 billion emergency loan in September 2008 from the Federal Reserve which AIG is expected to
repay by gradually selling off its assets. In exchange, the Federal acquired a 79.9% equity stake in AIG. The Fed
reported that AIG had drawn down $70.3 billion of this $85 billion in a mere three weeks. AIG announced that it may
seek an additional $37.8 billion in secured funding from the Fed.

8. Washington Mutual (WaMu), Seattle thrift, was seized in September 2008 by the USA Office of Thrift Supervision
(OTS). Most of WaMu's untroubled assets were to be sold to J.P. Morgan Chase.

9. British bank BRADFORD & BINGLEY was nationalized on 29 September 2008 by the UK government. The government
assumed control of the bank's £50 billion mortgage and loan portfolio, while its deposit and branch network are to be
sold to Spain's Grupo Santander.

10. In November 2008, the U.S. government announced it was purchasing $27 billion of preferred stock in CITIGROUP, a
US bank with over $2 trillion in assets, and warrants on 4.5% of its common stock. The preferred stock carries an 8%
dividend. This purchase follows an earlier purchase of $25 billion of the same preferred stock using TARP funds.

Build up and fallout

The reasons, proposed for this crisis, are varied and complex. The crisis can be attributed to a number of factors pervasive
in both housing and credit markets, factors which emerged over a number of years. Causes proposed include the inability of
homeowners to make their mortgage payments, poor judgment by borrowers and/or lenders, speculation and overbuilding
during the boom period, risky mortgage products, high personal and corporate debt levels, financial products that distributed
and perhaps concealed the risk of mortgage default, monetary policy, and government regulation (or the lack thereof).

Boom and bust in the housing market

Low interest rates and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis.
The USA home ownership rate increased from 64% in 1994 (about where it had been since 1980) to an all-time high of
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69.2% in 2004. Sub-prime lending was a major contributor to this increase in home ownership rates and in the overall
demand for housing.

Figure 3: US House Prices

This rise in demand fueled rising house prices and consumer spending. Between 1997 and 2006, the price of the typical
American house increased by 124%. During the two decades ending in 2001, the national median home price ranged from
2.9 to 3.1 times median household income. This ratio rose to 4.0 in 2004 and 4.6 in 2006. This housing bubble resulted in
quite a few homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out
second mortgages secured by the price appreciation. USA household debt as a percentage of annual disposable personal
income was 142% at the end of 2007, versus 101% in 1999.
A culture of consumerism is a factor "in an economy based on immediate gratification." Americans spent $800 billion per
year more than they earned. Household debt grew from $705 billion at yearend 1974, 60% of disposable personal income,
to $7.4 trillion at yearend 2000, and finally to $14.5 trillion in midyear 2008, 134% of disposable personal income. During
2008, the typical USA household owned 13 credit cards, with 40% of households carrying a balance, up from 6% in 1970.
This credit and house price explosion led to a building boom and a surplus of unsold homes. House prices began to decline
in the summer of 2006. Easy credit, and a belief that house prices would continue to appreciate, encouraged many sub-
prime borrowers to obtain adjustable-rate mortgages. These mortgages enticed borrowers with a below market interest rate
for some predetermined period, followed by market interest rates for the remainder of the mortgage's term. Borrowers who
could not make the higher payments once the initial grace period ended would try to refinance their mortgages. Refinancing
became more difficult, once house prices began to decline in many parts of the USA. Borrowers who found themselves
unable to escape higher monthly payments by refinancing began to default.

As of March 2008, an estimated 8.8 million homeowners — 10.8% of all homeowners — had zero or negative equity in their
homes, meaning their homes were worth less than their mortgages. Homeowners in this situation have an incentive to "walk
away" from the homes, even though doing so damages their credit rating for a number of years. The reasons is that unlike
what is the case in most other countries, American residential mortgages are non-recourse loans; once the creditor has
regained the property purchased with a mortgage in default, he has no further claim against the defaulting borrower's
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income or assets. By November 2008, an estimated 12 million USA homeowners had negative equity. As more borrowers
stop paying their mortgage payments, foreclosures and the supply of homes for sale increase. This places downward
pressure on housing prices, which further lowers homeowners' equity. The decline in mortgage payments also reduces the
value of mortgage-backed securities, which erodes the net worth and financial health of banks. This vicious cycle is at the
heart of the crisis.

Increasing foreclosure rates increases the inventory of houses offered for sale. The number of new homes sold in 2007 was
26.4% less than in the preceding year. By January 2008, the inventory of unsold new homes was 9.8 times the December
2007 sales volume, the highest value of this ratio since 1981. Furthermore, nearly four million existing homes were for sale,
of which almost 2.9 million were vacant.

This overhang of unsold homes excess lowered house prices. As prices declined, more homeowners were at risk of default
or foreclosure. By November 2007, the S&P/Case-Shiller price index of USA house prices had declined about 8% from its
Q2 2006 peak, and by May 2008 it had fallen 18.4%. The price decline between December 2006 and December 2007 was
10.4%, and by May 2008 the index had declined 15.8%. House prices are expected to continue declining until this inventory
of unsold homes (an instance of excess supply) declines to normal levels.

Financial institution debt levels and incentives

Figure 4: Leverage Ratios for Major Investment Banks

Many financial institutions, investment banks in particular, issued large amounts of debt during 2004–2007, and invested the
proceeds in mortgage-backed securities (MBS), essentially betting that house prices would continue to rise, and those
households would continue to make their mortgage payments. Borrowing at a lower interest rate and investing the proceeds
at a higher interest rate is a form of financial leverage. This is analogous to an individual taking out a second mortgage on
his residence to invest in the stock market. This strategy proved profitable during the housing boom, but resulted in large
losses when house prices began to decline and mortgages began to default. Beginning in 2007, financial institutions and
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individual investors holding MBS also suffered significant losses from mortgage payment defaults and the resulting decline
in the value of MBS.

A 2004 SEC ruling allowed USA investment banks to issue substantially more debt, which was then used to purchase MBS.
Over 2004-07, the top five US investment banks each significantly increased their financial leverage (see diagram), which
increased their vulnerability to the declining value of MBSs. These five institutions reported over $4.1 trillion in debt for fiscal
year 2007, about 30% of USA nominal GDP for 2007. Three investment banks either went bankrupt (Lehman Brothers) or
were sold at fire sale prices to other banks (Bear Stearns and Merrill Lynch) during September 2008. The failure of 3 of the
5 large USA investment banks augmented the instability in the global financial system. The remaining two investment
banks, J P Morgan and Goldman Sachs, opted to become commercial banks, thereby subjecting themselves to more
stringent regulation.

Credit default swaps

Credit defaults swaps (CDS) are insurance contracts used to protect debt holders, in particular MBS investors, from the risk
of default. As the net worth of banks and other financial institutions deteriorated because of losses related to sub-prime
mortgages, the likelihood increased that those providing the insurance would have to pay their counterparties. This created
uncertainty across the system, as investors wondered which companies would be required to pay to cover mortgage
defaults.

Like all swaps and other financial derivatives, CDS may either be used to hedge risks (specifically, to insure creditors
against default) or to profit from speculation. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with
estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. CDS are lightly
regulated. As of 2008, there was no central clearinghouse to honor CDS in the event a party to a CDS proved unable to
perform his obligations under the CDS contract. Required disclosure of CDS-related obligations has been criticized as
inadequate. Insurance companies such as American International Group (AIG), MBIA, and Ambac faced ratings
downgrades because widespread mortgage defaults increased their potential exposure to CDS losses. These firms had to
obtain additional funds (capital) to offset this exposure. AIG's having CDSs insuring $440 billion of MBS resulted in its
seeking and obtaining a Federal government bailout.

What one party loses under a CDS, the other party gains; CDSs merely reallocate existing wealth. Hence the question is
which side of the CDS will have to pay and will it be able to do so. When investment bank Lehman Brothers went bankrupt
in September 2008, there was much uncertainty as to which financial firms would be required to honor the CDS contracts
on its $600 billion of bonds outstanding. Merrill Lynch's large losses in 2008 were attributed in part to the drop in value of its
unhedged portfolio of collateralized debt obligations (CDOs) after AIG ceased offering CDS on Merrill's CDOs. The loss of
confidence of trading partners in Merrill Lynch's solvency and its ability to refinance its short-term debt led to its acquisition
by the Bank of America.

Response to the crisis

Federal Reserve Bank
The central bank of the USA, the Federal Reserve, in partnership with central banks around the world, has taken several
steps to address the crisis. Federal Reserve Chairman Ben Bernanke stated in early 2008: "Broadly, the Federal Reserve's
response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic
objectives through monetary policy." The Fed has: -

1. Lowered the target for the Federal funds rate from 5.25% to .25%. This took place between September 2007 and
December 2008;

2. Undertaken, along with other central banks, open market operations to ensure member banks remain liquid. These are
effectively short-term loans to member banks collateralized by government securities. Central banks have also lowered
the interest rates (called the discount rate in the USA) they charge member banks for short-term loans;

3. Used the Term Auction Facility (TAF) to provide short-term loans (liquidity) to banks. The Fed increased the monthly
amount of these auctions to $100 billion during March 2008, up from $60 billion in prior months;

4. Finalized, in July 2008, new rules for mortgage lenders.

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5. In October 2008, expanded the collateral it will lend against to include commercial paper, to help address continued
liquidity concerns.

Regulation
Regulators and legislators have contemplated taking action with respect to lending practices, bankruptcy protection, tax
policies, affordable housing, credit counseling, education, and the licensing and qualifications of lenders.

1. On 31 March 2008, a sweeping expansion of the Fed's regulatory powers was proposed, that would expand its
jurisdiction over non-bank financial institutions, and its authority to intervene in market crises.

2. Responding to concerns that lending was not properly regulated, the House and Senate are both considering bills to
further regulate lending practices.

3. Countrywide's VIP program has led ethics experts and key senators to recommend that members of Congress be
required to disclose information about the mortgages they take out.

4. Non-depository banks (e.g., investment banks and mortgage companies) are not subject to the same capital
requirements as depository banks. Many investment banks had limited capital to offset declines in their holdings of
MBSs, or to support their side of credit default insurance contracts.

5. On 18 September 2008, UK regulators announced a temporary ban on short-selling the stock of financial firms.

Other Steps
1. Economic stimulus act of 2008

2. Housing and economic recovery act of 2008

3. Hope now alliance

4. Bank capital replenishment from private sources

5. Emergency economic stabilization act of 2008

Bibliography
1. Bloomberg

2. www.moneymorning.com

3. www.wikipedia.com

4. www.federalreserve.gov