Subprime crisis in us
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Subprime Crisis In US. Brief Banking History. Mesopotamia, >3000 years ago, storehouses for reserves of grain and animals, charged interest much like today

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Subprime Crisis In US

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Subprime Crisis In US

Brief Banking History

  • Mesopotamia, >3000 years ago, storehouses for reserves of grain and animals, charged interest much like today

  • Italy, Medici of Florence: first modern loan and deposit system to handle multiple currency, later improved by Dutch and British, imported to American colonies

  • Growing pains through a period of minimal regulation, legislation during Civil War: entire US banking system under federal regulation

Brief Banking History (2)

  • Credit crisis late in the 19th century and in 1907

  • The Great stock market crash of 1929: caused by too many high-risk loans under the assumptions that stock market would continue to rise unabated

  • Bubble prop in October 1929, run in risky on the nation’s banks. However, banks engaged in risky investments themselves with depositors’ cash, only to lose it all

Brief Banking History (3)

  • 1933: banks basic function ceased: Franklin Roosevelt put a few measures

  • Glass-Stegall Act: forbid commercial banks (BofA, pre-Merrill) from offering services of investment of insurance banks (AIG)

  • FDIC: promised to reimburse customers should a bank go out of business

Brief Banking History (4)

  • 1913, Federal Reserve created: “lender of last resort”, the central bank of US

  • Roosevelt polices slowly brought confidence in the banking system back up and helped end the Great Depression

  • 1999, Glass-Stegall Act repealed; commercial banks to re-enter stock biz

  • IB used to be big players for Gov’t and corporations could own commercial banks

Brief Banking History (5)

  • With a surging market, IBs made all kinds of money

  • Until a few years ago, housing propelling growth was unstoppable

  • Merrill Lynch and Lehman offered mortgages left and right, many to people with poor credit records, gambling that housing prices would continue to rise

Micro Economic Overview

S&L Crisis

  • Not a new phenomenon

  • Historical S&L crisis dates back to the Great Depression, Disintermedaition in the late 70’s, S&L crisis in 1989

  • 1989: 747 S&L bankruptcies with $160 billion of bailout, caused recession in 1991-92

  • 2008: In addition to $85 billion of bailout for AIG, $700 billion more for Wall Street

How large is $700 billion?

  • NASA fiscal year 2009: $17.6 billion

  • NSF annual budget: $6.1 billion

  • Military budget 2009: $481 billion

  • Social Security: $608 billion

  • $2,300 for each American

  • US national debt: $9 trillion

  • Can take 25,000 Rodriguez (NY Yankees)

  • The Forbes 400 richest people total $1.57 trillion

How big is subprime?

  • 2% of total loans in 2002 to 20% of total loans in 2006

  • US economy: $ 60 trillion

  • Mortgage Market: $12 trillion

  • Subprime: $2.4 trillion

  • Massive write-offs by the commercial banking and investment banking ($500 B)

Even Bigger Derivative

Subprime Mortgage

  • Loans to less than perfect credit

  • Any late payments, bankruptcies, liens, judgments, or other defaults blemish the credit history

  • Borrower with blemished credit history or no credit history does not qualify for the Prime Mortgage Loans: falls to subprime mortgage with high interest payments

Chronological Development

  • Countrywide (acquired by Bank of America)

  • Bear Sterns (acquired by JP Morgan Chase)

  • Lehman Brothers (CDO/CDS exposure $600B)

  • Merrill Lynch (acquired by Bank of America)

  • AIG ($500B CDS exposure, $250B Liable)

  • Washington Mutual (acquired by JP Morgan Chase)

  • Wachovia (acquired by Citigroup)

  • Morgan Stanley, Goldman Sachs (subprime, CDS exposure related to hedge funds): covert to chartered bank holding companies (part of $700 billion of US Gov’t bailout)

Chain of Reaction

  • Burst of US housing bubble and high default rates on “subprime” and “ARM”

  • Increase in defaults and foreclosure

  • Mortgage lenders and credit risk sellers were hit hard

  • Tighter lending, and increased spreads on interest rates

  • Contracted liquidity in the global credit markets and banking system

Who to blame?

  • Reagan Doctrine: Financial Deregulation ‘82

  • Democrats-led congress passed the law to provide more affordable mortgages to low income people (1992)

  • People who shouldn’t have been borrowing

  • These loans were packaged into CDOs rated AAA (IBs and rating agencies)

  • Investment Bank purchase w/o due diligence

  • Distributed throughout the world


  • Alpha generation: beat the market, theme of portfolio managers/ hedge fund managers

  • Earn higher mortgage or credit card rates

  • Bet on credit: three hedge funds speculation funded by investment banks

  • High leverage bet


  • Moral hazard

  • Conflicts of Interest

  • Regulation or deregulation

  • Quants: Fall of geniuses

  • Financial engineering without comprehensive understanding of risk management

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