Subprime Mortgage crisis with the crash of Lehman Brothers and AIG

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SECOND YEAR BBA SEMESTER III
BUSINESS AND ECONOMIC
ENVIRONMENT – EC 203
GROUP PROJECT
TOPIC: Subprime Mortgage Crisis with
the Crash of Lehman Brothers
SUBMITTED BY:
1. Prashant Ratnani 17131024
2. Siddhant Shah 17131026
3. Shah Darsh 17131022
4. Bijal Shah 17131012
5. Aayushi Patel 17131038

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The US Economy & its emergence
 The Country of United States has had a tough time in the world
economy since its foundation in 1492 by Christopher Columbus.
 The Economy had a major upside and downfall in 17th
Century and
the 18th
Century.
 They also fought Civil wars between the rich and poor people of the
country and somehow with the efforts of President Abraham Lincon
it saved the country from dividing into 2 parts.
 In the early 19th
century the world was in the Industrial development
era and all the countries like the great Britain, European countries,
Russia, Japan and many more were growing at a higher pace and US
economy at that time had great innovators and businessmen like
JOHN.D.ROCKAFELLER, HENRY FORD, J.P.MORGAN & ROTHSCHILD
who had seen the US economy as a great industrial superpower.
 But somehow the economy has various boom and bust period within
itself in the past 200 years which stagnated its growth in the long
term so all the rich and wealthy people the country decided to meet
together at one place (Jekyll Island) and draft the legislation policy of
having a permanent central bank in the United States of America.
 In 1913, bankers and politicians decided that it was in the country's
best interest, and theirs, to have a permanent central bank.
 They created the Federal Reserve, among its jobs, expand or
contract the supply of a single national currency, the Federal Reserve
note.
 The dollar was tied to gold standard system and strategic control of
the dollar would avoid booms that lead to busts. At least that was
the plan.
 Then came 1929. The great depression would have a profound effect
on monetary policy worldwide.

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 The Great Depression had wiped out millions of investors wealth in
just 2 years, the Dow Jones Industrial Average came down from 360
points in 1929 to 40 points in 1933.
 The Unemployment rate in the economy went from 10% in 1929 to
40% in 1933. The economic deflation in the US was around 25%.
 The Federal Reserve had printed nearly all the money it legally could
to pump life back into the economy, but still the US economy wasn’t
coming out of deflation.
 So in 1933, President Roosevelt issued a controversial executive
order, forcing all U.S. citizens to sell their gold to the Federal Reserve
at a fixed price, or go to prison.
 The dollar had become the world's most stable and trusted currency.
Other countries pegged their currency to the dollar, which could still
be redeemed for gold.
 In 1971, President Nixon settled the matter. He severed United
States' currency from the gold standard. This led to the rise of the US
National Debt as the government started borrowing money from
foreign countries for meeting the development of the economy in
surplus.
 Since 1971, the US National Debt has increased from US$100 Million
to US$21.5 Trillion in September 2018. Today it is even more than
the combined GDP of the entire country.
 The United States saw several Boom’s and Bust’s cycles in this period
it had several Stock Market crashes since then like the:
1. The Stock Market crash of 1987
2. The Dot.com Bubble Bust of 1999-2000
3. The Housing Crash of 2008
4. Soon we will have one more in next 1 or 2 years, let’s be prepared

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How it all started in the first place
 In the year 2000 when the dot.com bubble got bust the Federal
Reserve Bank reduced the interest rates from 5% to 1%.
 The reason for decrease in interest rates was mainly because of
decrease in borrowing from the people in Unites States.
 This led to increase in inflation rates and increase in demand for
housing loans which led to, too many people asking for loans and
buying.
 Real estate purchases rose not only for subprime borrowers, but for
well-off Americans as well.
 As prices rose and people expected a continuation of that, investors
who got burned by the dot.com bubble of early 2000s and needed a
replacement in their portfolio started investing in real estate.
 Housing prices were rising rapidly, and the number of subprime
mortgages given out was rising even more. By 2005, some began to
fear that this was a housing bubble.
 From 2004-2006, the Federal Reserve raised the interest rate over a
dozen times in an attempt to slow this down and avoid serious
inflation.
 By the end of 2004, the interest rate was 2.25% and by mid-2006 it
was 5.25%.
 This was unable to stop the inevitable. The bubble got burst and in
2005 and 2006 the housing market crash back down to earth.
 Subprime mortgage lenders begin laying thousands of employees
off, if not filing for bankruptcy or shutting down entirely.
 Lehman Brothers and American International Group filed for
bankruptcy, as they had mortgaged backed securities of high risk
which were unsecured.

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 Lehman Brothers was one of the largest investment banks in the
world for years. It was also one of the first investment banks to get
very involved with investing in mortgages, something that would pay
off until it became their downfall.
 The plummeting price of real estate and the widespread defaulting
on mortgages crushed Lehman Brothers. They were forced to close
their subprime lenders, and despite their many attempts to stop the
bleeding (such as issuing stock) they continued to take on losses
until, on Sept. 15, 2008, Lehman Brothers applied for bankruptcy.
 Lehman Brothers was one of the most prominent financial-service
firms in the world. Its rapid descent into bankruptcy was a major
cause of the 2008 stock market crash.

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What cause subprime mortgage
crisis?
 In 1996 USA was going through a Dot.com Boom and in between
2000 and 2002 the Dot.com Bubble busted and Stock market
crashed as investors started withdrawing their money from the Stock
market.
 Interest rates were also low thus investors weren’t interested to
keep their money in banks thus investors were in search of good
investment option in United States
 At that time the prices of Real Estate were on a rise and therefore
the government also encouraged people to buy houses.
 Since Interest rates were very low, due to which people were buying
more houses and thus the demand of housing and the prices also
went up.
 This led to more investors diverting towards US real estate market as
prices of Real Estate were increasing due to high demand and they
can generate high income from sales of Real Estate.

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 Investment Banks in USA also wanted to take benefit of the rising
trend of real estate in the market.
 Morgan Stanley, Goldman Sachs and Lehman Brothers were
investment banks in USA at that time.
 Investment banks started acquiring loans from the bank and started
making derivative instruments like collatenalized debt obligation
(CDO) and started selling them to individual investors.
 Many investment banks started getting “AAA” credit rating from
agencies in order to sell their CDOs.
 In a normal case if a bank gives loan to borrowers it verifies the basic
details of buyers such as income statement and credit score of the
buyer.
 Since the loans were being transferred to investment banks and
these investment banks were then transferring the loans to
institutional investors in the form of CDOs.
 Investment banks started transferring risk of subprime loans to
institutional investors.
 Since Credit Rating agencies started rating the CDO’s at “AAA” rating
the investors flooded to buy those securities in huge demand.
 Due to high demand for CDO’s by the Investment Banks they started
asking banks for more loans and banks started giving out more loans
to the people at high risk of not getting repayment on time and
defaulting loans.
 This led to rise in low quality loans or Subprime loans, in order to
earn more money from Investment Banks in the form of commission
the banks started giving more of Subprime loans.
 Investment Banks in order to earn more money from Subprime loans
started getting “AAA” credit rating from rating agencies like Moody’s
so that investors buy more of those CDO’s.

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 Countrywide Financial Corporation and Amerquest Mortgage
Company together had given Subprime loans of $177 Billion.
 From 2000 to 2007 Investment Banks were selling Billions of Dollars
worth of CDO’s and earning Billions of Dollars worth of profits by
selling them to investors at a high risk.
 With all this Credit Rating agencies were also making huge amounts
in profits, Moody’s which is one of the biggest credit rating agency of
USA, saw a surge in its Net profit by 4 times between the year 2000
to 2007.
 American International Group(AIG) which is USA biggest insurance
company started giving insurance against CDO’s known as Credit
Default Swap(CDS).
 Since almost 70% of the CDO’s were given “AAA” rating AIG started
giving insurance against all CDO’s to protect investors money.
 AIG didn’t realize that if CDO’s fail then they will have to repay back
money in huge sum and they might go under huge losses.
 Banks in USA had given housing loans to borrowers in a Adjustable
Rate with a fixed interest rate of 1%, but due to high demand in
housing market the Federal Reserve on United States of America
increased interest rates from 1% in 2000 to 6.5% in 2007.

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 Borrowers had taken loans from the banks at Adjustable Interest
Rate due to which in the initial years they had to less amounts in the
form of EMI’s but as the interest rates increased their EMI’s also
increased.
 The result was that people who had taken Subprime loans were not
able to payback the loan amount and they started defaulting on their
loan payments.
 Banks then started selling the houses of the people who had
defaulted on their loan payment, this happened because banks
didn’t check the credibility of the borrowers before giving them
loans.
 Borrowers had taken loans for their property from the banks in the
form of 100% loans and they had not paid any amount of down
payment for their loans.
 50% of the Borrowers had taken loans from the banks in the form of
100% loans and didn’t pay any down payment.
 Due to this many people started defaulting on their loans and the
banks had a huge supply of houses which were ready to be sold in
the market but due to low housing demand and huge supply of
houses the price of Real Estate decreased by almost 80%.

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 Money Supply in the US economy increased from $4.8 Trillion to
$7.4 Trillion between years 2000 to 2008.
 In 2008 when Real Estate prices started dropping a house bought in
the year 2005 for US$100,000 was valued at US$70,000 in the year
2008.
 Borrowers started defaulting their loans as the value of their house
started decreasing.
 Due to this the value of CDO’s in the market became zero and
investors lost all their money.
 The Investors and fund managers who were aware of the Subprime
loans had bought CDS’s in large amounts to protect their investment,
and when CDO’s failed they earned a huge profit from the Insurance
companies.
 American International Group in 2008 reported a loss of US$99
Billion due to too many CDO’s failing and paying money to investors
for their investment paid to them in CDS’s.
 The Federal Reserve Bank paid AIG a sum of US$85 Billion to bail
them out of their losses which they incurred.
 The total accumulated loss by all financial intermediaries was upto
US$450 Billion dollars.
 There was no regulation on CDO’s and CDS’s and because of this a
crisis started growing in the US economy due to which credit crunch
started growing in the US economy and many businesses also started
going shutting down as credit was unavailable
 This led to rise in Unemployment in the US economy and also led to
global recession which affected global markets.
 US Stock Market Dow Jones crashed from 16000 bps and came down
to 6000 bps.
 Indian Stock Market Sensex came down from 24000 bps to 8000 bps.

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Effects of Subprime Mortgage
Crisis
 Home prices fell tremendously as the housing bubble completely
burst. This crushed many recent homeowners, who were seeing
interest rates on their mortgage rise rapidly as the value of the home
deteriorated.
 Unable to pay their mortgage on a monthly payment and unable to
sell the home without taking a massive loss, many had no choice.
 The banks foreclosed on their houses. Homeowners were left in
ruins, and many suburbs turned into ghost towns.
 Even homeowners with good credit who qualified for standard
mortgages struggled with the steadily rising interest rates.
 By the time these homes were foreclosed upon, they had cratered in
value. That meant banks were also taking massive losses on real
estate.
 Investors got hit hard as well, as the value of the mortgage-backed
securities they were investing in tumbled.

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 This was made more difficult due to people still buying homes even
as the bubble began to burst in 2006 into early 2007.
 Loans were still being given out and taken as sales slumped.
Investment banks who bought and sold these loans that were being
defaulted on started failing.
 Lenders no longer had the money to continue giving them out. By
2008, the economy was in complete freefall. Some institutions got
bailed out by the government. Other banks, who had gotten so
involved in the mortgage business, were not so lucky.
 The US National Debt rapidly increased after the housing crisis as the
Federal Reserve and the US government had to spend trillions of
dollars to bail out the financial intermediaries.
 Since 2008 the US National Debt has increased from $5 Trillion to
$21.5 Trillion in 2018.
 Each American citizen owes the US Government $600,000 in the
form of Money spent on them over the years.
 The US economy has been stable since the crash of 2008 as stock
market took 3 years to recover from a huge meltdown.

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Lehman Brothers and their Crisis
 Lehman Brothers was one of the largest investment banks in the
world for years.
 It was also one of the first investment banks to get very involved
with investing in mortgages, something that would pay off until it
became their downfall.
 The plummeting price of real estate and the widespread defaulting
on mortgages crushed Lehman Brothers.
 They were forced to close their subprime lenders, and despite their
many attempts to stop the bleeding they continued to take on losses
until, on Sept. 15, 2008, Lehman Brothers applied for bankruptcy.
 Lehman Brothers was one of the most prominent financial-service
firms in the world. Its rapid descent into bankruptcy was a major
cause of the 2008 stock market crash.
 Lehman Brothers share price dropped from US$60 to 25 cents a
share in late 2008.

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AIG and their Crisis
 The collapse and near-failure of insurance giant American Interna-
tional Group (AIG) was a major moment in the recent financial crisis,
AIG a global company with about $1 Trillion in assets prior to the cri-
sis, lost $99 billion in 2008.
 On September 16 of that year, the Federal Reserve Bank of New York
stepped in with an $85 billion loan to keep the failing company from
going under.
 AIG's bailout has not come without controversy. Some have
criticized whether or not it is appropriate for the government to
use taxpayer money to purchase a struggling insurance company.
Also, the use of the public funds to pay out bonuses to AIG's officials
has only caused its own uproar.
 However, others have said that, if successful, the bailout will actually
benefit taxpayers due to returns on the government's shares of the
company's equity.
 AIG's share price dropped from US$1000 to 1 dollar a share in late
2008.

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Conclusion
 The Subprime Mortgage Crisis of 2008 had a huge impact on the US
economy and the world economy as a whole, it made many concept
in economics false by stating that anything can happen if money isn’t
used wisely.
 If the Federal Reserve and the government wouldn’t have come in
between and reacted to the situation then the housing crash would
have been the worst financial disaster for the United States of
America.
 The Global monetary loss due to housing crash was over US$ 10
Trillion.
 Many businesses went bankrupt and people lost their jobs and
homes to live.
 The Housing Crash taught us that if financial intermediaries are not
regulated then they might misuse the power that money has and use
it to their benefit to earn more profits.
 The Crisis could have been avoided if the Federal Reserve chairman
Alan Greenspan would have made some regulations on the sales of
CDO’s and CDS’s so that investment banking companies and
investors don’t misuse it.

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Bibliography
1. thestreet.com
2. investopedia.com
3. scribed.com
4. youtube.com