GLOBAL MARKETS, Asia Pacific

Subprime Lending
October 2010

among others. delinquencies history of the borrower in the recent past etc. Subprime loans have higher rates than equivalent prime loans. subprime mortgages are for borrowers with credit scores* of under 620. is a general term that refers to the practice of making loans to borrowers who do not qualify for market interest rates because of problems with their credit history. Equifax & TransUnion.In the US a credit score is a number typically between 300 and 850 and is based on the statistical analysis of a person's credit files. How much higher depends on factors such as credit score. subprime car loans. y The Concept of a Credit Score . y Subprime lending encompasses a variety of credit instruments. also called "B-Paper". including subprime mortgages. "near-prime" or "second chance" lending. size of down payment. A subprime loan is also more likely to have a prepayment penalty. typically from the three major credit bureaus .Experian. y Generally. 2 . A credit score is primarily based on credit report information.Introduction y Subprime lending. The number represents the creditworthiness of that person (higher the number the better). and subprime credit cards.

3 . after 2yrs) plus a margin for the balance 28yrs. Because the margins are high. y A very common mortgage in the subprime market is the 2/28 ARM.Subprime Lending Terms The lending job was made easier with exotic mortgages such as so-called no-doc loans. the rate on most 2/28s will often rise sharply at the 2-year mark.e. It is common for subprime loan contracts to include a prepayment penalty for the first 5 years of the loan. The major threat to such a plan is a prepayment penalty. 6-month LIBOR. y Some borrowers with poor credit scores take a 2/28 at a high rate and plan to rebuild their credit during the 2-year period. y Rate Indices commonly used is the 1-year CMT. which enable borrowers to get loans without having to supply evidence of income or savings. even if market rates do not change during the period. but other choices include. with an average rate of 5% of the principal. and then reset to equal the value of a rate index at that time (i. etc. and option ARMs. This is an adjustable rate mortgage (ARM) on which the rate is fixed for 2 years. Their plan is to refinance at a better rate at that time for the balance of 28 years. adjustable-rate mortgages that let people pick how big a payment they will make from month to month. The loans offer upfront teaser rates at the cost of taking the deferred payments onto the balance of the loan. 6-month Treasury Bill.

Subprime money trail y Through securitization. mortgage risks are passed through from subprime lenders to banks and ultimately to investors. Securitization 4 .

No arrangements are agreed upon and customer continues to miss payments. No payment arrangements or settlements reached with the bank. Formal Legal Foreclosure Process y y y y y y y y y y Bank sends by certified mail Notice of Intent to Foreclose. No payments or arrangements acceptable to the bank are made. properties are usually auctioned off by the investors. Court holds hearing regarding banks claim. Bank begins action in the court system to foreclose. House sold at auction to highest bidder. Bank attempts in writing and by phone to contact customer and resolve situation. Notice and waiting periods expire. No payment or settlement arrangements are made with the lender. Bidders quote prices much lower than market value. Late notice send by bank. Legal notices as required by law begin to be published in local papers. Legal notice of actual foreclosure sale and advertisements published in local papers. Bank issues demand for payment under the note in full. leading to losses to the funds as these proceeds do not cover the underlying loan obligations. Customer misses additional payments. Pre-Foreclosure y y y y y y y Customer misses mortgage payment.Foreclosure Process After foreclosure. 5 . Court issues order allowing bank to foreclose.

6% to 13. 2007 . with the biggest increases coming in the so-called "subprime" market of borrowers with weaker credit histories. such as New Century Financial Corporation. 6 . 2007 .the Wall Street Journal reported that "banks and larger mortgage lenders are trying to force smaller mortgage lenders to buy back some of the same loans that the larger entities eagerly purchased from the smaller mortgage originators in 2005 and 2006. by enforcing what the industry calls repurchase agreements.Bear Stearns said that investors in its two failed hedge funds will get little if any money back after ``unprecedented declines in the value of securities used to bet on subprime mortgages. The delinquency rate on all mortgages rose from 5.3% at the end of 2006. in the fourth quarter of 2006 set off alarm bells in mortgage credit and equity markets. 2007 . Inc.1% at the end of 2005 to 5. 2007 . ± July 18. announced that it is preparing to shut down two hedge funds. particularly on subprime mortgages. leading to the collapse of stock prices for many in the subprime mortgage industry. y Key Events ± March 13 2007 .Standard & Poor's said it may cut credit ratings on $12 billion in bonds backed by subprime mortgages because losses will rise beyond its previous expectations. The sharp rise in foreclosures has caused several major subprime mortgage lenders. y The subprime mortgage meltdown refers to the rush of subprime mortgage foreclosures that began in the United States in late 2006 and has continued into 2007. ± June 21. ± July 10.Subprime Mortgage Meltdown Sharp increases in delinquency rates.3%.foreclosure data was released indicating that the number of residential mortgages going into foreclosure hit a record in the first quarter of 2007. but on subprimes the rate jumped from 11.³ ± June 21. to shut down or file for bankruptcy.The Bear Stearns Companies.

5.e.35%.40%).0 5 J un-04 J un-05 J un-06 c t. the 6-month LIBOR is at 5.00%).g. if a mortgage borrower was paying 6%. a mortgage borrower in April 2005 may enter into an ARM where he will pay 6% for the first 2 years and 6-month LIBOR + 3% for the remaining 28 years (assuming at April 2005.35% + 3. This is a 39% increase (from 6% to 8. These are the most common indices used to fix ARMs rate after 2 years (6-month LIBOR.ill IB O R 7 . post reset they could be paying 8.10% (i. 6% + 35% of 6%) y The following chart illustrates the rise in floating interest rates to be reset.e.0 4 c t. For example.0 3 c t.35%). 3-month Treasury Bill. So for e. and 1-year CMT). 6 5 4 3   ¢   2 36- c -03 c -04 c -05 c -06 -04 -05 -06 c t.35% (i.The ³Exploding ARM Reset´ problem y It is estimated that ARMs taken from 2004-2005 will have an increase in interest cost of at least 35%. 6-month LIBOR was at 3.0 6 -07 J un-07 ug-03 ug-04 ug-05 ug-06 r-04 r-05 r-06 r-07 0   ¦   £ ¥ ¤   6 -m o n t   ©¨ ont ont   £ ¡   § ¦   £ ¥ ¤ £ ¢ ¡   ¦   £ ¥ ¤ £ ¢ ¡   ¦   £ ¥ ¤ £ ¢ ¡ -Y r T T. so the borrower¶s new ARM interest rate will be 8. 6-month CD. On April 2007.

The ³Exploding ARM Reset´ problem (continued) y Expected Adjustable Rate Mortgage Reset Schedule. The worst has yet to come. 8 .

5. The American Home Mortgage Investment Corp. 4. 1.000 of its production employees as it was shutting down operations. AHM announced it was delaying the payment of its common dividend due to ³disruptions´ in the credit markets in the past few weeks causing major writedowns of its loan and security portfolios. 9 . having originated about USD 60 billion of mortgage loan during 2006 from 550 offices in 47 states. 2. On 31 July.Collapse of Mortgage Lenders y The following is an example of how a large sized player fell under the dramatic retrenchment of credit availability due to the recent contraction of the subprime market. 3. AHM released a statement that it was unable to borrow on its credit facilities and so was unable to fund its outstanding mortgage loan commitments for that day. On 3 August. A bankruptcy filing is now a very real possibility. AHM announced it would fire all 7. On 28 July. (AHM) was the 10th largest residential mortgage lender in the US. leading to margin calls with respect to its credit facilities.

return is USD 70.000. I can borrow USD 10 million (pledge my USD 1 million as collateral) and invest in the same 7% bond. A hedge fund manager might say. The problem is. Instead.³ 2. I have $1 billion under management. the collateral is all gone.Why Hedge Funds are in Trouble Hedge funds are always seeking capital. An investment bank pools a package of subprime mortgages issued by the American Home Mortgage (underlying mortgages are 2/28 ARMs with initial teaser rates. as long as houses go up in value. and the fund then closes. 5. etc. My yield on my USD 1 million is effectively 70% (USD 700. Leveraging ± If I take USD 1 million to invest in a 7% p. little documentation. look for managers to place other people's monies. 4. They can seek money directly from institutions or individuals. I will go to the bank and borrow 10 billion and invest in these kinds of bonds. plays a big role in this). Now housing stops going up in 2006. so hedge funds keep buying more mortgage-backed securities and borrowing money to leverage. By the time the hedge fund finishes selling the bonds. or leveraged amount.a. no one wants the bonds now as defaults on mortgages are mounting up. The hedge fund doesn¶t have much cash (its invest it all and also borrowed more to invest). and in 2007. 3. employment rates are strong«that's all that matters. The bonds will pay. or they can do the easiest thing and seek money from those who are offering it: "fund of funds" managers who. "OK. mortgages get paid. These trades continue to perform well regardless of the stock market. the bonds moved down in value and to the point where hedge funds must put up more collateral to keep the trades on. This is simply because on a mark-to-market basis. if I have limits with a bank. like any interest rate swap. the net present value of the hedge fund¶s side is much lower than that of the counterparty bank¶s (the borrowed portion to invest in the bonds. specifically.) and offers hedge funds a bond that yields 7%. y A perspective of how hedge funds can get in trouble 1.000 return) less cost of borrowing the USD 10 million. 10 . so it needs to sell some of the bonds. bond for 1 year.

´). such as Moody¶s Investors Service. 11 . Moody's and Standard & Poor's cut ratings on billions of dollars of bonds backed by subprime mortgages. They divide the CDO in pieces in order to get the desired rating for each portion (or ³tranches. these agencies raised no red flags about securities backed by subprime mortgages. including subprime debt. Credit ratings provide an assessment of default risk for the ``hold-tomaturity credit world'' rather than addressing the ``volatility-liquidity issues'' that interest investors such as hedge funds. it meets with credit raters to discuss the quality of the contents. and they continued to give investment-grade ratings to these securities based on the tranches expected to perform the best. y In July 2007. Some bonds backed by subprime mortgages fell by more than 50 cents on the dollar this year without their credit ratings changing. on expectations home-loan defaults will rise. y Throughout last year. y When a bank creates a CDO.Rating Agencies¶ Role y Other key players that have a major role in supporting the appetite for risky subprime loans are the credit-ratings agencies. Fitch Ratings and Standard & Poor¶s. Moody's in its report said the criticism of its subprime debt rankings stem from ``a lingering confusion'' about its role.

first-loss portion) of CDOs 12 .Some Statistics y Pension funds are among the buyers of the equity tranche (riskiest.

Statistics continued« y Top subprime mortgage originators in 2006 and 2005 13 .

14 . Property which is in the possession of a lender as a result of foreclosure or forfeiture.Statistics continued« Subprime 60+ day delinquency rate by vintage Subprime Foreclosure and REO* rate by vintage * Real Estate Owned.

CDS price changes of Originators Countrywide Financial Corp. CDS price changes 15 .

CDS price changes 16 .CDS price changes of Originators (continued) Washington Mutual Inc.

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