Standard Chartered Bank announces $3 billion rights issue

Standard Chartered Bank has gone ahead with raising capital to weather the economic downturn and take advantage of the opportunities available in current situation. StanChart is listed on London and Hong Kong stock exchanges. StanChart announced that it will raise £1.78bn through rights issue at 390 pence per share, huge discount to its current market price of 760 pence per share. Existing shareholders will have the option of subscribing 30 new shares for every 91 shares held. This step will raise its Tire-1 capital ratio to 7.4% from 6.1%. This is in line with the industry wide shift of Tire-1 capital ratio towards 8%.

Temasek Holdings Pte is currently the biggest shareholder in StanChart with owning about 19% of the company. If Temasek goes ahead with the rights it can increase its stake to 22%. But this will make StanChart lose the right of printing Hong Kong currency. According to Hong Kong Monetary Authority regulations no bank with more than 20% owned by foreign government can issue currency notes in Hong Kong.

Remarkably, StanChart has so far been relatively insulated from the subprime crisis because of its focus on emerging markets like India, Taiwan etc. But now the economic situation spreading, even the emerging economies are not insulated and it is good option to raise capital while you still can.

US' struggle to save financials continues with Citi

The US Treasury (UST) appears to have been haunted by Lehman Brothers woes. UST cannot see Citigroup falling down. It is such a big player in the financial system that its failure can jolt the already feeble banking system. According to an article on BBC news:

"If the bank were to collapse, it could have caused financial havoc around the globe, seizing up fragile lending markets and causing untold losses among institutions holding debt and financial products backed by the company. "

So here comes the biggy-big rescue package for the giant. Some crucial points in the package are:

• A pool of $306 billion assets identified and Citigroup will bear first $29 billion losses on it rest to be absorbed by UST , Federal Reserve (Fed) and Federal Deposit Insurance Corp. (FDIC).
• Treasury department will give $20 billion from the $700 billion package passed for rescuing the entire financial industry. This is under the Troubled Asset Relief Program (TARP).
  
• Govt will get $7 billion of preferred shares with 8% dividends.
  
• Dividends will be limited to $0.01 per share for next 3 years.
  
• 10 year warrants of $2.7 billion to FDIC and Treasury department at strike price of $10.61 per share.
• Citibank to help distressed homeowners.

The Citi's term sheet of agreement is available from Citigroup's website.

The impact of this package will be that Citigroup's capital adequacy will improve with additional $40 billion in capital benefits. This capital infusion will make the Citigroup's Tier-1 capital ratio at 14% well above the mandatory requirement. On the other hand this rescue has increased the burden on the US government and more than trillion dollars of tax-payers money is at stake. With more and more companies lined up for protection the $700 billion may fall well short. Automobile giants like GM and Ford are so close to bankcrupcy and they certainly require some capital infusion to keep them alive.

Despite the lucrative package, investors at Wall Street are still skeptical about the long term outcome of this. But one thing is sure that if this works out well in near future more of such packages will be seen making their way.

A survival question for Citibank

Citigroup is too big to fail, you must be kidding... Not anymore.

Amidst the fray of failing banks Citibank may be the biggest addition. From being the world's biggest bank about a year and a half ago, today Citibank has serious threats of solvency. This is reflected in its stock price which has plummeted from about $30 per share to about $4 per share. Citibank was under the speculators radar since Vikram Pandit had replaced Chuck as the leader. But with the bank losing Wachovia Corp. deal to Wells Fargo & Co., the negatives started outweighing. And with the continuing losses of billions of dollar every quarter, the stock price saw a sharp decline of about 60% in last week amid speculations of a possible takeover or merger.

Citibank is one of the biggest banks of the world and employs more than 350,000 people. It reduced its workforce by 11,000 in the latest quarter ending September 2008. It has a customer base of more than 200 million and operations in close to 140 countries. Citibank's total assets declined by $50 billion in this quarter, thats 13% decline to 2,050 billion dollars. The question is that with accumulated losses every quarter and a large amount of risky assets still in the bank's portfolio, isn't the future shaky for Citi?

Speculation is that US government is working on a plan to rescue the bank. It will be a tough task ahead for the government to bail out the giant (though not so giant anymore).

Merrill Lynch faces huge loss due to bad mortgage write-downs

Last time when I wrote about Merrill Lynch posting record losses in its 93 years of existence, I knew some more pain was left, what the results exceeded all imaginations. Merrill Lynch reported fourth quarter loss of 8.6 billion USD from continuing operations. This is huge considering the profits it earned in 2006 - $7.5 billion. Total write-downs for this year so far have been around $16.5 billion. The breakup of the write-downs is like:
$9.9 billion - collateralized debt obligations (CDO),
$1.6 billion - sub-prime mortgages
$3.1 billion - bond insurance
$0.9 billion - residential mortgages
$0.2 billion - real estate investment

This is the second biggest write-down so far. Earlier Citigroup has written-down more than 23 billion dollars and reported close to 10 billion dollar loss in fourth quarter. Both these firms have been on a look-out for capital raising since last quarter and have successfully raised billions of dollars. But with the sub-prime crisis not coming to end these investment banks are poised to have a very tough time ahead.

Merrill had earlier replaced Stan O' Neal from the chief executive position following the sub-prime crisis. The new CEO of Merrill, Mr John A. Thain, has a lot of responsibility in bringing back Merrill to its original status. According to a report on Merrill Lynch's website, Mr. Thain said:

"While the firm's earnings performance for the year is clearly unacceptable, over the last few weeks we have substantially strengthened the firm's liquidity and balance sheet,.. In addition, a great majority of Merrill Lynch's key businesses delivered record results in 2007, and as I look ahead to 2008, the firm is intensely focused on continuing this momentum and delivering growth and increased profitability for our shareholders and employees."

With the declaration of results on 17 January Merrill's stock price fell by more than 10% in a single day. The stock has been falling since 2007 from a highs of around 100 to current price of 49.45 per share.

Bear Stearns CEO steps down

James E. Cayne stepped down as chief executive officer of Bear Stearns. Though retiring from the firm he will remain on the the board of directors as chairman. Alan D. Schwartz, president of Bear Stearns, will be taking over the responsibility of the chief executive officer of the fifth largest investment bank in US.

Alan D. Schwartz joined Bear Stearns in 1976. He became executive vice president and head of the Investment Banking Division in 1985, president and co-chief operating officer in June 2001 and sole president in August of 2007.

This step is looked as an aftermath of the sub-prime crisis of which Bear Stearns was also lost over billion dollars in bad debts. Since the announcement of write-offs there has been reshuffling of major positions at the affected investments banks including Citigroup, Merrill Lynch, Morgan Stanley etc.

"Founded in 1923, The Bear Stearns Companies Inc. is a leading financial services firm serving governments, corporations, institutions and individuals worldwide. The Company's core business lines include institutional equities, fixed income, investment banking, global clearing services, asset management, and private client services. Headquartered in New York City, the Company has approximately 14,000 employees worldwide."

For additional information about Bear Stearns, please visit the firm's website at www.bearstearns.com.

Can Vikram Pandit, new CEO, rescue Citi?

Citi is having a bad time and so are its management. After the exit of Chuck Prince from the company, Citigroup was in search for a new visionary who could lead the company out of ongoing crisis. No doubt it must have been a tough task to select the CEO of such a large organization. Finally Vikram Pandit has been given the responsibility of chief executive of Citigroup.

Vikram Pandit, an Indian, is 50 year old and is a well respected investment banker. But this is the first time he will be leading a big corporation like citi. Critics doubt whether he could prevent citi from disaster. Pandit is looked as a cautious and conservative banker. Earlier he was Chairman and CEO of Citi's Institutional Clients Group.
Citi website has biography of Mr. Pandit. Some of key points are:"He was a founding member and chairman of the members committee of Old Lane, LP, a multi-strategy hedge fund and private equity fund manager that was acquired by Citi in 2007.
Prior to forming Old Lane, Mr. Pandit was President and Chief Operating Officer of Morgan Stanley's institutional securities and investment banking business and was a member of the firm's Management Committee....

Mr. Pandit earned a PhD in Finance from Columbia University in 1986.... "

After being appointed CEO, Mr. Pandit said:

"During this challenging time, Citi's role in the global markets is more vital than ever. We will address our issues head-on while continuing to deliver value for our clients, shareholders, employees and the communities in which we operate."

Citi's stock prices have fallen by more than 35% during last three months. This is first time in five years that its stock prices went below 30 dollar mark. Earlier citi group had declared huge write-downs of 17 billion dollars and decline in operating profits. Currently citi faces a debt threat and it has done a stake sale worth 7.5 billion dollars to Abu Dhabi Investment Authority last month. Citi is also planning to lay-off 17000 employees to cut costs.

During an interview with Business Week Magazine, Mr Pandit said:

“There are three things I’m focusing on. One, we have to make sure we have the right productivity levels. And that runs the gamut of putting capital to work correctly in the right places.

Job two is to look at every one of our businesses . . . individually and collectively, to make sure they are the right businesses and they are positioned for the future we see in financial services....”

Banks’ CEOs and executives ousted due to subprime losses

Citi CEO Charles Prince







Merrill Lynch CEO Stanley O'Neal










UBS AG CEO Peter Wuffli










Bear Stearns Co- President Warren Spector







HSBC head North American business Bobby Mehta








Morgan Stanley Co-president Zoe Cruz

Zoe Cruz exits Morgan Stanley

Morgan Stanley on 29 November declared a number of management changes effective December 1, 2007. Zoe Cruz was shown the way out after 25 years at Morgan Stanley. She was one of the top 10 most powerful business women in 2007 according to Forbes.

Zoe Cruz's role as co-president of Morgan Stanley came to an end because of ongoing subprime crisis which claimed more than 3 billion dollars for the company. Walid A. Chammah and James P. Gorman have been named as co-presidents of the firm.

Morgan Stanley will announce its fourth quarter results around December 17, 2007. Skeptics feel that the ouster of Cruz before the results signals some more writedowns in the results. The New YorkTimes reported that the move represents a sharp reversal for Morgan’s chief executive, John J. Mack, who had supported and cultivated her career.

A report on cnn.money.com quoted Richard Bove( an analyst at Punk Ziegel):

"This must mean that Morgan Stanley is going to report write-downs much greater than previously suggested,"

Chairman and CEO John Mack said:

“Throughout her 25 years of distinguished service, Zoe has always demonstrated a deep commitment to Morgan Stanley. She has helped to build some of our most important and successful businesses and worked tirelessly to strengthen and grow our global franchise. We greatly appreciate the enormous contributions Zoe has made in a wide variety of roles, and we are confident that she will continue to do great things in the years ahead.”

Bloomberg reported that Morgan Stanley has taken bigger trading risks and expanded its mortgage securities business under the leadership of Mack. Mack joined in mid-2005 after former CEO Philip Purcell was forced to resign due to investor’s discontent.

Morgan Stanley is a leading global financial services providing firm. For further information about Morgan Stanley, please visit www.morganstanley.com.

Banks may freeze ARMs as sub-prime aid measure

Treasury Secretary, Fed and leading banks and lenders of sub-prime loans are reportedly working on some plan to extend the teaser rates on mortgages which were scheduled to be reset at higher levels in the coming months. Till now no formal agreement has been reported but things are expected to be made public by next week.

Treasury Department spokeswoman Jennifer Zuccarelli said; “We’ve all agreed that there should be some sort of standardized approach to reaching more homeowners faster,...”

Earlier Federal Reserve Chairman Ben Bernanke has hinted of another cut in interest rate to prevent economy from recession.

Recently a magazine reported Treasury Secretary Henry Paulson’s remark "We'll have broad agreement on criteria that will make it easier to modify mortgages in the volumes we need,...".

This comes at a stage when the foreclosures in this year have already reached about double of last year. A increase in the period with teaser interest rates will provide relief to the home loan takers who may find difficult to pay the increased installment.

Probably in the meeting the concerned authorities may be figuring out a mechanism to selectively give the interest rate rebate to those with good repayment history.

The parties attending the meeting were Treasury Secretary, Fed regulators, officials from OTS (Office of Thrift Supervision), bank executives from Citigroup, JPMorgan Chase & Co., Wells Fargo & Co.’s amongst others.

According to an estimate, about 2 million house owners whose rates are going to be reset and may face foreclosures in 2008 if defaulted.

US subprime crisis: Can 2 million homeowners be rescued?

About seven hundred thousand houses in US had to undergo foreclosure in 2005 and this year the figure is likely to double. Even more the size of the ARM which is expected to get reset in next eight months is about 600 billion and includes some 2 million houseowners.

The foreclosures and home-mortgage defaults are likely to cause more pain in US because a lot of mortgages will be having the expiry of the freedom period (interest only), and teaser rates (initial low rates). The payment on these mortagages may rise considerably and lead to higher defaults. According to Bank of America $362 billion ARM is up for reset its interest rates. But this is not the only reason. According to a report by Wall Street Journal many subprime loans went bad during their initial periods.

“…While many accounts portray resetting rates as the big factor behind the surge in home-loan defaults and foreclosures this year, that isn't quite the case. Many of the subprime mortgages that have driven up the default rate went bad in their first year or so, well before their interest rate had a chance to go higher...”

{Teaser rate is a reasonably low interest rate in the starting, which is increased after a set period, generally 2 years. An example of a teaser rate is a rate of 6.5% which rises to 9.5% after two years.}

Adding to the pain is the crash of housing market due to which the value of property has reduced drastically leaving many borrowers and house owners with a loan amount more than the value of their property.

How can the situation be controlled?

The situation is getting out-of-control by the time. Though Fed has reduced the interest rates, its effect is not significant. The country’s money supply is squeezing and dollar is degrading. Injecting more money supply into the system, lowering interest rates further may help solve the situation, but in the long run better regulatory measures are required to prevent or identify any kind of uncontrolled activities in the economy early to limit the damage. Big banks can recover from billions of write-offs in their balance sheet but what about a normal person who has lost all his/her life’s earnings including his house. It’s a very urgent matter and needs to be dealt with immediately to control the extent of damage.

How deep is Japan in subprime mess?

According to an estimate by Japan’s Financial Services Agency (FSA) Japanese financial institutions have lost over 230 billion ¥ (Yen) or about 2 billion dollars this fiscal half year because of degradation of the US sub-prime investments. This is about 17% of its total exposure of 1.3 trillion ¥ ($12 billion) in the securitized instruments as of September 2007.

Official estimate by the Japanese financial supervisors on the impact of US sub-prime crisis and came after the Japanese largest financial lender Mitsubishi UFJ Financial Group reported its half yearly results. FSA had surveyed 575 financial institutions in Japan primarily to gauge the extent of sub-prime related exposure and its impact of their performance. These included 10 major banking groups, 110 regional banks and a total of 455 cooperative financial institutions.

Out of the 1.3 trillion Yen exposure 1.2 trillion is to the top 10 banking groups. According to Nikkei, Japan's leading six banking groups are likely suffer a total loss in excess of 300 billion yen ($2.75 billion) due to bad debts originating from the slump in the U.S. housing market. Regional banks were less affected. They were hit by about 15 billion yen loss.

The six leading lending institutions of Japan are:

1. Mitsubishi UFJ Financial Group
2. Sumitomo Mitsui Financial Group
3. Mizuho Financial Group
4. Sumitomo Trust & Banking
5. Resona Holdings
6. Mitsui Trust Holdings

The above six banks have written-down 115 billion yen ($1.1 billion) as bad debt. All of these, including, the top three banks, which are also known as megabanks, have shown a decline in profit so far this year.

Mitsubishi UFJ Financial Group Inc., Japan's largest bank, has reported a loss of 260 billion yen in subprime mortgage related investments. The exposure of Mizuho, Japan's second-largest bank, is about 800 billion yen in the US mortgage-linked securities as of the end of September. 575 Japanese banks and credit unions held subprime-related products worth $1.2 billion in book value and recognized $985 million in unrealized valuation losses.

Yoshimi Watanabe, Minister of State for Financial Services and Administrative Reform, said at a briefing in Tokyo:

"In response to this market turbulence, we will pay due attention to the status of risk management by financial institutions and the conditions of financial markets from a wide range of standpoints, while cooperating with other authorities in Japan and abroad."

According to Seiji Nakamura, a policy board member of the Bank of Japan, :

"We need to watch closely if the subprime problem will affect the global economy and if there will be a spillover effect on the Japanese economy,"

Financial institutions sub-prime writedowns

Update(2) November 16, 2007

Announced Write-downs
Bank	Billion USD
CITIGROUP	13.5
MERRILL LYNCH	8.4
MORGAN STANLEY	4.6
BANK OF AMERICA	3.8
U BS	3.7
HSBC	3.4
DEUTSCHE BANK	3.2
WACHOVIA	2.3
CREDIT SUISSE	1.9
BEAR STEARNS	1.9
JP MORGAN CHASE	1.6
GOLDMAN SACHS	1.5
LEHMAN BROTHERS	0.7
COUNTRYWIDE	0.7

Prince resigns as Citi struggles

Charles Prince, CEO of US biggest bank Citi, resigned from his position as chairman and CEO on Sunday taking the responsibility for the business. He has been CEO of Citigroup for past four years. He has been replaced by Sir Win Bischof as interim CEO and Robert Rubin as chairman of Citi.

Managing an organization of the size of Citi is a very challenging task and Mr. Prince had worked hard to bring all the units of Citi under one umbrella. In the recent past Citigroup has done many mergers and acquisitions. In 1998 it has acquired of Salomon Inc., the successor of Salomon Brothers, the Investment bank which started the Mortgage Based Security (MBO).

Owing to the subprime crisis the rating agencies have downgraded many Collateralized Debt Obligations (CDO) and their mortgage securities. Because of this the valuations of these CDOs have fallen significantly and has impacted almost all banks which had exposure to mortgage based securities. In continuation to its earlier writedowns Citigroup Inc. has recently announced that its sub-prime writedowns may increase further to about $8b - $11b. Citi's total assets are about $2.3 trillion and is the world's largest bank by assets. Citi owns about $55b of subprime mortgage.

According to an estimate the total subprime mortgage based securities outstanding may be more than a trillion dollars.

About Citi:
200 million customer
100 countries
Domain: Consumer banking and credit, Investment banking, Securities brokerage, and Wealth management
Major Brands: Citibank, CitiFinancial, Primerica, Smith Barney, & Banamex

Sub-prime fallout on banks

Effect on third quarter results:

Citigroup
CEO Chuck Prince likely to resign
Net profit of $ 2.4b against profit of $5.5b in the same quarter last year

Bank of America (BofA)
Slashed 3,000 jobs
The company is also exiting the wholesale mortgage business.
Net profit of $ 3.7b against profit of $5.4b in the same quarter last year

Merrill Lynch
CEO Stanley O'Neal resigned from his post on Oct. 30
Net loss of $ 2.2b against profit of $3.1b in the same quarter last year

Deutsche Bank (biggest private German bank)
Third-quarter write-downs of €2.16 billion($3.17 billion)
Investment arm reported a pre-tax loss of €179m
Total earnings up y 31% at €1.62 billion(US$2.3 billion)

Bear Stearns
Co-president and COO Warren Spector had to exit because of two Bear Stearns hedge funds meltdown.
600 job cuts in mortgage and investment banking businesses.
New York-based Bear booked a $200 million loss in the third quarter related to the hedge funds. Quarterly net income in the period ending August 2007 dropped 61% to $171.3 million.
Revenue fell to $1.3 billion from $2.13 billion last year.

Lehman Brothers
Closed its subprime mortgage unit BNC Mortgage in August and cut down 1,200 jobs.
$700 million write-down in third-quarter
Third quarter results to be declared on November 8

Morgan Stanley
Cut 600 jobs, scaled down its residential mortgage business.
Income fell to $1.47 billion from $1.59 billion.

Wachovia
Net Income decreased to $1.7b from $1.9 billion Quarter on Quarter basis while it was $2.3 billion in previous quarter of this year.

UBS (biggest Swiss bank)
Third-quarter loss of 830 million Swiss francs ($712 million) vs. a profit of 2.2 billion

Credit Suisse (the second-biggest Swiss bank)
Write-downs of 2.2 billion Swiss francs in the third
decline in net income to $1.1 billion, down 31 percent from the previous quarter.

Countrywide
Loss of $1.2b in third quarter against profit of $0.6b previous year.
First Quarterly Loss in 25 Years

Goldman Sachs
Reportedly made money on subprime business due to short positions

Chuck Price, CEO of Citigroup, is expected to resign

Citigroup's CEO, Charles O. (Chuck) Prince III, is reported to be planning to step down as Citigroup’s chairman and chief executive. (Source: Wall Street Journal).

Citigroup, the world's largest banking organization, has reported its third quarter earnings plunge by 57% due to writing down of sub-prime mortgage. Citigroup has seen a hit of $2.2 billion due to mortgage-backed securities (MBS) and credit trading. Further write-downs are not ruled out. Citigroup’s shares have crash down by about a quarter of its value since it reported decline in earnings last month. Citigroup is no longer world’s biggest bank by market capitalization. China’s ICBC has overtaken Citigroup in the rankings.

Earlier this week CEO and chairman of Merrill Lynch, Stan O’Neal, had resigned following his company’s $7.9 billion write-down due to sub-prime crisis. Bear Stearns CEO James Cayne is also facing scrutiny criticism of his leadership.

Most US banks have taken colossal hits from risky mortgage securities in the third-quarter of 2007. Merrill Lynch topping the list with $7.9 billion write-downs; UBS is second with write-downs of $3.4 billion. Fourth-quarter results may also get battered by recession in the U.S. housing and mortgage markets. According to some analysts Citigroup may have to suffer another $4 billion of write-downs in the fourth quarter.

Merrill Lynch posts record losses in 93 years

The largest US brokerage Merrill Lynch had suffered worst quarter since its inception year 1914. The write-downs across CDOs and U.S. subprime mortgages were close to $7.9 billion. Earlier it had reported that this to be close to $4.5 billion. The net loss for the third quarter was $2.24 billion. Merrill's chief executive Stan O' Neal is under heavy pressure from board of directors over the handling of the crisis and is likely to resign.

This loss has made Merrill Lynch the biggest setback of the sub-prime crisis. Its losses were more than the combined losses of the rest of the US brokerage. Earlier Bear Stearns had to close two of its hedge funds and suffer $1.5 billion loss.

Merrill Lynch's reported a total net revenues of $577 million in the third quarter of 2007 which was down 94 percent from $9664 million in the second quarter of 2007 and $9833 million in the third quarter of 2006.

"Mortgage and leveraged finance-related write-downs in our FICC business depressed our financial performance for the quarter. In light of difficult credit markets and additional analysis by management during our quarter-end closing process, we re-examined our remaining CDO positions with more conservative assumptions. The result is a larger write-down of these assets than initially anticipated," said Stan O'Neal, chairman and chief executive officer. "We expect market conditions for subprime mortgage-related assets to continue to be uncertain and we are working to resolve the remaining impact from our positions," Mr. O'Neal continued. "Away from the mortgage-related areas, we continue to believe that secular trends in the global economy are favorable and that our businesses can perform well, as they have all year."

Source :Merrill Lynch Press Release

Securitization

This article tries to explain what is securitization. Lets consider what a bank does? A bank gives loans to its borrowers. If it is a small bank we call it as a sub originator and this small bank transfers these loan to a bigger bank which is called as originator. Now, this originator can sell off this loans to a trust and get money. And this trust sells of these loans in form of bonds to various bond holders

Now this trust collects money from the bondholders and gives it to Originator. And now this originator can lend of this money to more borrowers. Selling off the loans to a trust is known as Securitization.

Sub-prime crisis - Origin and Impact

The origins of this crisis can be traced from late 1990s, when the dotcom bubble started. After the crash of the dotcom bubble in 2000s most of the countries including US were facing economic recession. Interest rates were low during these periods and lending standards were not good. This led to the rise of another bubble in 2001 in the form of real estate. The prices of the real estate property sky rocketed during this period. There was a rat-race for buying houses and people were taking loans as it was very cheaply and easily available. Lending agencies used innovative products to attract customers. During 2004 through 2006, concepts like ‘teaser rates’ became popular in mortgages. These teaser rates (initial low interest rate) applied through varied time period, ranging from few months to couple of years depending on the mortgage creditworthiness. The thing which the borrowers forgot was that at the end of this freedom period the rates can rise rapidly, raising the minimum instalment to be paid out of their capacity. During this period lenders were so confident that they qualified borrowers only by their ability to pay the teaser rates.

One may trace the sub-prime crisis to the securitization – conversion of home mortgages into bonds. The man behind securitization was an Investment Banker of 'Salomon Brothers' - Lewis S. Ranieri. In 1980s Salomon launched Mortgage-Based Securities (MBS) – bonds with bundles of mortgages, bought from bank lenders, as collateral. For this, Salomon used a special purpose vehicle known as Collateralized Mortgage Obligation (CMO). Monthly instalment was used to pay the interest on these bonds. We will discuss about securitization separately.

Securitization had some negative implications on the mortgage standards. Since anyone can originate a loan and sell it to the Investments Banks, which package them and sell them as MBS, it lead to originators writing risky loans as they need not worry about the payback of loan. This problem was dealt by slicing MBS into tranches on the basis of the risk profile. These tranches which may have different maturity period were given ratings by credit rating agencies like S&P and Fitch. The most risky tranches were difficult to sell except for the hedge funds and some pension funds. These hedge funds were so eager to buy these securities that they didn’t care about the huge impending risk associated with these tranches and continued to invest in them.

With the collapse of the housing bubble in mid 2005 real property price declined so much that many owners holding became negative equity, mortgage debt became higher than the value of the property. During the housing bubble, many property owners used their property as collateral to raise money for consumer spending. With the crash of housing markets these lenders faced huge defaulter problem and were unable to recover their losses.

Aggravating the issue was the rising interest rates, coupled with the maturity of the freedom period of teaser rates, which increased the monthly payments. Many house owners felt incapable of meeting their financial liabilities and went bankrupt. Amongst the institutional players affected were the sub-prime lenders, banks, housing developers, and investors like hedge funds and pension funds. The impact was not limited only to US, as UK’s leading subprime lender Northern Rock sought bankruptcy protection.

Sub-prime crisis - An Introduction

What is Sub-prime crisis?

In our earlier discussion on sub-prime mortgage, we acknowledged that both creditors and debtors carry high risk in such kind of lending. Sub-prime crisis is the result of those risks.

Sub-prime crisis is associated with the increase in foreclosures of the sub-prime mortgage borrowers. It was significant enough in the year 2006 to create headlines. In year 2007 the total value of the sub-prime mortgages was more than two trillion dollars, which makes about 15 % of the total mortgages. Due to the sub-prime mortgage market meltdown the houses of millions of Americans are under the risk of foreclosure. Over six hundred thousand of such foreclosures were initiated during the first half of 2007.

What is sub-prime mortgage?

To understand sub-prime crisis we have to first know sub-prime mortgage.

‘Mortgage’ according to the American Heritage Dictionary is

“A temporary, conditional pledge of property to a creditor as security for performance of an obligation or repayment of a debt.”

Sub-prime lending/mortgage is characterized by the following:

1. Loans to borrowers with poor credit history, poor credit rating
2. Risky to both borrowers and lenders
1. Borrowers can get their security/collateral foreclosed
2. Lenders can lose the money they have lent
3. The higher risk is counter balanced by higher interest rate
4. ‘subprime’ is the credit status of borrower and not the interest rate

Generally the sub-prime lenders offer some incentives since they are charging higher interest rate. Some of the schemes in market are:

Interest Only Loans – Paying only interest during the initial years,
Adjustable Rate Mortgage (ARM) – Mortgage in which interest rate is periodically changed depending on an index.
Hybrid ARM – Rate is fixed for a period of time and floating.
Option ARM – Borrower has option of choosing either a minimum payment or an interest only payment.
Teaser Rate – Getting loan at an initial fixed interest rate for couple of year and then converting it into variable rate.
NINJA Loan – Mortgage given to a person with No Income, No Job, and No Assets.
Liar Loan – Mortgage provided without requiring documentation from borrower.
Balloon Payment Loan – Mortgage which has a large balance due at maturity.

In the next article we will discuss about the sub-prime crisis. :)