The Sub Prime Crisis : A Primer

1. The Sub Prime Crisis : A Primer By A.V. Vedpuriswar

2. Terminology The term "subprime" is applied to the lowest of three main categories of assets Prime, Alt-A Subprime This is the way home loans are classified in the US mortgage market.

3. Prime Mortgages Prime mortgages are for amounts that are relatively small compared to the value of the property. They pertain to borrowers who have a clean credit history and sufficient current income to meet payments.

4. Alt-A Alt-A lies between Prime and Sub prime in terms of loan quality.

5. Sub prime Sub prime borrowers have a credit quality that is too low for Prime mortgages. Reasons can include a flawed credit history low income levels relative to the necessary mortgage payments.

6. The build up to the crisis Sub prime borrowers got loans on easy terms. The mortgage contract had a low-fixed interest rate for an initial period of two to five years. Thereafter, the interest rate was to be reset to correspond to fair market rates for the respective borrower. These borrowers were able to roll-over their mortgages after a specified number of years by repaying the outstanding loan with funds from a new mortgage loan based on the higher valuation of the property.

7. Securitisation complicates matters Previously, mortgages appeared directly on a bank's balance sheet and had to be backed up by equity capital. Securitization allowed banks to bundle loans into tradable securities and sell part of their loan risks in the market. Consequently, banks were able to issue more mortgage loans for the same amount of equity capital than before.

8. Back to the borrowers Real estate prices started to drop in 2007 while interest rates rose. This shut off the easy gains from refinancing mortgages. The reset rates , significantly higher than the initial fixed "teaser rate�, were unaffordable for sub prime borrowers. Mortgage delinquencies and defaults followed as a matter of course.

9. Tranches Collateralized Debt Obligations (CDOs) are divided into slices, or tranches, that have senior or subordinated claims against all payments received by the borrowers in the underlying pool of mort-gages.

10. Tranches 1,2 Tranche 1, the "AAA"-rated tranche, has a senior claim on all interest and principal payments of the mortgage pool. No other tranche may receive any cash-flows if payments on the AAA tranche are unmet. Tranche 2, the "A"-rated tranche, is subordinated to the AAA tranche, but senior to all remaining tranches.

11. Tranches 3,4 Tranche 3, the "BB"-rated or High Yield tranche represents another 5% of the overall volume and is subordinated to both higher-rated tranches. The lowest tranche is called the "Equity tranche." It equals 3% of the pool volume and receives anything that is left over after the payment obligations of all other tranches have been fully met.

12. Who have been affected the most? The banks struggling the most today had a larger inventory of loans and retained parts of the bonds they created. When the market broke down, they were unable to sell those positions as market liquidity dried up virtually overnight. In 2006 and 2007, the banks with a strong credit rating were able to take on debt at very low interest rates.

13. The strategy adopted by banks Typically, AAA tranches of a sub prime security offered significantly higher coupons compared to the interest costs of banks. Banks earned an extra yield by investing in sub prime bonds and funding this investment by selling short-dated bonds ("commercial paper"). Often, this was done by off-balance sheet subsidiaries, so called SIVs (Structured Investment Vehicles) . But now such sources of funding have dried up.

14. Marking to Market Accounting standards force banks to ensure that the value of any asset on a bank's balance sheet is never higher than the asset's fair value. For traded assets, like stocks, fair value or market value can easily be observed on a stock exchange. However, sub prime bonds are illiquid. In most cases there is no price available for them. So observable prices for similar assets must be used as an indication..

15. The ABX Index There are a series of indexes, called ABX, where each reflects a basket of mortgage-backed bonds of a certain rating and vintage. Most banks use those indexes to determine the current market value of their positions. However, those indexes reflect less liquid instruments and their power to predict fair asset values is questionable

16. How ABX works The ABX tracks the performance of a basket of credit default swaps based on U.S. sub prime home loans. The index is by no means perfect - traders use credit default swaps as a betting tool, and it doesn't reflect the true value of the underlying securities. But it does offer a gauge of the demand for them. A decline in the ABX suggests that the securities have become more risky and that investors have lost confidence in them.

17. The ABX has five separate indices based on the rating of the underlying sub prime securities, ranging from AAA to BBB-minus. A new series is issued every six months to reflect the 20 largest current deals. 

18. Will profits come back? Positions that have been written down may not be written up again. Gains in value can only be realized by selling the asset, or if the asset has a higher pay-off at maturity.

19. Conclusion By warehousing assets of questionable quality and by assuming risks they did not understand, banks got into trouble. Credit risk became converted into market risk. To deal with the liquidity crunch, central banks have done a lot.

20. But it will take time for confidence to come back. The banks which have done better, like Goldman were the ones who avoided warehousing. Meanwhile, the possibility of a breakdown of the financial system has been avoided at least for the time being.