GLOBAL MARKETS, Asia Pacific

Subprime Lending

August 2007
Introduction
 Subprime lending, also called "B-Paper", "near-prime" or "second chance" lending, 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.

 Generally, subprime mortgages are for borrowers with credit scores* of under 620.
Subprime loans have higher rates than equivalent prime loans. How much higher depends
on factors such as credit score, size of down payment, delinquencies history of the
borrower in the recent past etc. A subprime loan is also more likely to have a prepayment
penalty.

 Subprime lending encompasses a variety of credit instruments, including subprime

mortgages, subprime car loans, and subprime credit cards, among others.

 The Concept of a Credit Score - 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. The number
represents the creditworthiness of that person (higher the number the better). A credit
score is primarily based on credit report information, typically from the three major credit
bureaus - Experian, Equifax & TransUnion.

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Subprime Lending Terms
The lending job was made  A very common mortgage in the subprime market is the 2/28 ARM. This is an adjustable rate
easier with exotic
mortgages such as so-
mortgage (ARM) on which the rate is fixed for 2 years, and then reset to equal the value of a
called no-doc loans, which rate index at that time (i.e. after 2yrs) plus a margin for the balance 28yrs. Because the
enable borrowers to get margins are high, the rate on most 2/28s will often rise sharply at the 2-year mark, even if
loans without having to market rates do not change during the period.
supply evidence of income
or savings, and option
ARMs, adjustable-rate
mortgages that let people
pick how big a payment they  Rate Indices commonly used is the 1-year CMT, but other choices include, 6-month LIBOR, 6-
will make from month to month Treasury Bill, etc.
month.

The loans offer upfront

teaser rates at the cost of
taking the deferred
payments onto the balance
of the loan.
 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. Their plan is to refinance at a better rate at that time for the
balance of 28 years. The major threat to such a plan is a prepayment penalty. It is common for
subprime loan contracts to include a prepayment penalty for the first 5 years of the loan, with
an average rate of 5% of the principal.

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 Subprime money trail
 Through securitization, mortgage risks are passed through from subprime lenders to banks and
ultimately to investors.

Securitization

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Foreclosure Process
After foreclosure, properties
are usually auctioned off by
the investors. Bidders quote
prices much lower than
market value, leading to
losses to the funds as these
proceeds do not cover the
underlying loan obligations.
Pre-Foreclosure
 Customer misses mortgage payment.
 Late notice send by bank.
 Customer misses additional payments.
 Bank attempts in writing and by phone to contact customer and resolve situation.
 No arrangements are agreed upon and customer continues to miss payments.
 Bank issues demand for payment under the note in full.
 No payments or arrangements acceptable to the bank are made.
Formal Legal Foreclosure Process
 Bank sends by certified mail Notice of Intent to Foreclose.
 Bank begins action in the court system to foreclose.
 Legal notices as required by law begin to be published in local papers.
 No payment or settlement arrangements are made with the lender.
 Notice and waiting periods expire.
 Court holds hearing regarding banks claim.
 Court issues order allowing bank to foreclose.
 Legal notice of actual foreclosure sale and advertisements published in local papers.
 No payment arrangements or settlements reached with the bank.
 House sold at auction to highest bidder.
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Subprime Mortgage Meltdown
Sharp increases in
delinquency rates,
particularly on subprime
mortgages, in the fourth
quarter of 2006 set off alarm
bells in mortgage credit and
equity markets.
The delinquency rate on all
mortgages rose from 5.1%
at the end of 2005 to 5.3% at
the end of 2006, but on
subprimes the rate jumped
from 11.6% to 13.3%.
 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. The sharp rise in
foreclosures has caused several major subprime mortgage lenders, such as New Century
Financial Corporation, to shut down or file for bankruptcy, leading to the collapse of stock
prices for many in the subprime mortgage industry.
 Key Events
– March 13 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.“
– June 21, 2007 - foreclosure data was released indicating that the number of residential mortgages going
into foreclosure hit a record in the first quarter of 2007, with the biggest increases coming in the so-
called "subprime" market of borrowers with weaker credit histories.
– June 21, 2007 - The Bear Stearns Companies, Inc. announced that it is preparing to shut down two
hedge funds.
– July 10, 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.
– July 18, 2007 - 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.
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 The “Exploding ARM Reset” problem
 It is estimated that ARMs taken from 2004-2005 will have an increase in interest cost of at least 35%. So for e.g. if a
mortgage borrower was paying 6%, post reset they could be paying 8.10% (i.e. 6% + 35% of 6%)
 The following chart illustrates the rise in floating interest rates to be reset. These are the most common indices used to
fix ARMs rate after 2 years (6-month LIBOR, 6-month CD, 3-month Treasury Bill, and 1-year CMT). For example, 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, 6-month LIBOR was at 3.40%). On April 2007, the 6-month
LIBOR is at 5.35%, so the borrower’s new ARM interest rate will be 8.35% (i.e. 5.35% + 3.00%). This is a 39% increase
(from 6% to 8.35%).

3
1-Year CMT
2 3-Month T-Bill
6-Month LIBOR
1 6-month CD

0
D ec -03

D ec -04

D ec -05

D ec -06
F eb-06
F e b -0 4

F eb-05

F eb-07
O c t- 0 3

J un-04

O c t- 0 4

J un-05

O c t- 0 5

J un-06

O c t- 0 6

J un-07
Aug-03

Aug-04

Aug-05

A u g -0 6
Apr-04

Apr-05

Apr-06

Apr-07
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 The “Exploding ARM Reset” problem (continued)
 Expected Adjustable Rate Mortgage Reset Schedule. The worst has yet to come.

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Collapse of Mortgage Lenders
 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.

1. The American Home Mortgage Investment Corp. (AHM) was the 10th largest residential
mortgage lender in the US, having originated about USD 60 billion of mortgage loan
during 2006 from 550 offices in 47 states.

2. On 28 July, AHM announced it was delaying the payment of its common dividend due to
“disruptions” in the credit markets in the past few weeks causing major writedowns of its
loan and security portfolios, leading to margin calls with respect to its credit facilities.

3. On 31 July, 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.

4. On 3 August, AHM announced it would fire all 7,000 of its production employees as it
was shutting down operations.

5. A bankruptcy filing is now a very real possibility.

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Why Hedge Funds are in Trouble
Hedge funds are always
seeking capital. They can
seek money directly from
institutions or individuals,
or they can do the easiest
thing and seek money from
those who are offering it:
"fund of funds" managers
who, specifically, look for
managers to place other
people's monies.
Leveraging – If I take USD 1
million to invest in a 7% p.a.
bond for 1 year, return is
USD 70,000. Instead, if I
have limits with a bank, I
can borrow USD 10 million
(pledge my USD 1 million as
collateral) and invest in the
same 7% bond. My yield on
my USD 1 million is
effectively 70% (USD
700,000 return) less cost of
borrowing the USD 10
million.
 A perspective of how hedge funds can get in trouble
1. 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, little
documentation, etc.) and offers hedge funds a bond that yields 7%. A hedge fund
manager might say, "OK, I have $1 billion under management. I will go to the bank and
borrow 10 billion and invest in these kinds of bonds.“
2. These trades continue to perform well regardless of the stock market, as long as
houses go up in value, mortgages get paid, employment rates are strong…that's all that
matters. The bonds will pay, so hedge funds keep buying more mortgage-backed
securities and borrowing money to leverage.
3. Now housing stops going up in 2006, and in 2007, 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, 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, or leveraged amount, plays a big
role in this).
4. The hedge fund doesn’t have much cash (its invest it all and also borrowed more to
invest), so it needs to sell some of the bonds. The problem is, no one wants the bonds
now as defaults on mortgages are mounting up.
5. By the time the hedge fund finishes selling the bonds, the collateral is all gone, and the
fund then closes.
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Rating Agencies’ Role
 Other key players that have a major role in supporting the appetite for risky subprime loans
are the credit-ratings agencies, such as Moody’s Investors Service, Fitch Ratings and
Standard & Poor’s.

 When a bank creates a CDO, it meets with credit raters to discuss the quality of the
contents, including subprime debt. They divide the CDO in pieces in order to get the
desired rating for each portion (or “tranches,”).

 Throughout last year, these agencies raised no red flags about securities backed by
subprime mortgages, and they continued to give investment-grade ratings to these
securities based on the tranches expected to perform the best. Some bonds backed by
subprime mortgages fell by more than 50 cents on the dollar this year without their credit
ratings changing.

 In July 2007, Moody's and Standard & Poor's cut ratings on billions of dollars of bonds
backed by subprime mortgages, on expectations home-loan defaults will rise. Moody's in
its report said the criticism of its subprime debt rankings stem from ``a lingering confusion''
about its role. Credit ratings provide an assessment of default risk for the ``hold-to-maturity
credit world'' rather than addressing the ``volatility-liquidity issues'' that interest investors
such as hedge funds.

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 Some Statistics
 Pension funds are among the buyers of the equity tranche (riskiest, first-loss portion) of CDOs

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 Statistics continued…
 Top subprime mortgage originators in 2006 and 2005

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Statistics continued…

Subprime 60+ day delinquency rate by vintage Subprime Foreclosure and REO* rate by vintage

* Real Estate Owned. Property which is in the possession of a lender as a result of foreclosure or forfeiture.

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

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

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Disclaimer

The HSBC Group, its subsidiaries and affiliates, believe the information
provided herein is reliable. While every care is taken to ensure accuracy,
the information is furnished to the recipients with no warranty as to the
completeness and accuracy of its contents and on condition that any errors or
omissions shall not be made the basis for any claim, demand or cause for
action.

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