Sub-Prime Meltdown

Mortgages given to people with poor credit rating and high loan to value ratio at high interest rates.

Market Structure

Mortgages are packaged together and sold to investors – known as mortgage backed securities (MBS).
This process is called securitization. This increased the credit available to borrowers and improved the
liquidity of the mortgage market.

How sub-prime MBS got AAA rating?

It is very common for subprime loan pools to be carved up into “tranches” such that cash flows from
bonds will suit particular investor requirements. The idea is that the senior pieces are designed to get paid
preferentially. The triple-A tranche is not backed by specific loans, only by a set of rules governing cash
flows from the loans. So, depending on the level of subordination (the percentage by principal of the deal
that is designated as subordinate), the senior tranches are protected from losses up to a predetermined
level. This made it is possible
for the senior pieces to obtain investment grade status, even though the underlying collateral is subprime
debt.

In periods of low interest rates and rising value of houses, everything's good.

Reasons for the sub-prime defaults in 2007 –

 adverse trends in employment
 increase in short-term interest rates in June 2004
 the cooling of the housing market in 2006
 Introductory teaser interest rates for initial 2 yrs. Payment shock due to higher rates after that. 1
 Supposed relaxation of underwriting standards - overestimation of repayment capacity - expectation
that rising house prices would come to the rescue of otherwise unsound loans

As the housing market slowed and subprime borrowers faced higher rates, many were unable to refinance
and had no option but to default on their loans.

Prior to that time, several years of growth in the housing market meant that even when a subprime
borrower’s personal finances were stressed, the increase in home values provided the option to refinance
or even sell instead of going into delinquency.

The real problem behind the sub-prime mortgages

The real problem in the subprime mortgage crisis was inappropriate management of credit risk. From
purchasers of individual mortgages, to those responsible for creating and selling the tranched securities, to
the purchasers of the mortgage bonds, no one defined their level of risk tolerance, nor did they take
appropriate measures to price or manage the risks. Buyers of the mortgage bonds could not determine
appropriate risk premiums because they were often unaware that they were essentially buying “junk”
mortgages. They were unprepared for the lack of collateral supporting their mortgage bonds