Subprime mortgage crisis a case study on morgan stanley

1. Introduction The US Subprime Mortgage Crisis in 2007 has had a severe impact on the global financial system. The collapses of Bear Stearns and Lehman Brothers, the acquisition of Merrill Lynch by the Bank of America and the conversion of Morgan Stanley and Goldman Sachs into bank-holding companies have all resulted from this subprime crisis that shocked the world and directly triggered the greatest global financial crisis since the Great Depression.

The underlying factors leading to the crisis were in fact the new inventions in the US housing market – the subprime mortgage lending and securitization technology that significantly magnified the impact of the default risk of these loans on the whole financial system. This report, hence, aims to provide an understanding of how the subprime mortgage lending and securitization played a part in bringing about the Subprime Mortgage Crisis in 2007. A case study would follow our discussion to provide a further look into one of the financial institutions that was a casualty of the crisis but has nevertheless survived, Morgan Stanley.

Besides, external influences such as actions by the government and the central bank as well as the possible impact of the 2009 Financial Regulatory Reforms would also be addressed. 2. Subprime Mortgage Crisis – How did it all happen? 2. 1Credit Risk and Default Risk Credit risk refers to the risk of loss arising from borrower or counterparty default when a borrower, counterparty or obligor does not meet its financial obligations . However, default risk, which is also known as credit risk, is often attached with subprime mortgage loans.

Thus, we will use default risk instead of credit risk to describe the risk that borrowers of the subprime loans may fail to repay the principal and interests in a timely manner. 2. 2New inventions in the US mortgage market a. Subprime mortgage lending Subprime mortgages loans were invented more than a decade ago to target at people who could not qualify for the regular mortgages or could not make enough to afford mortgage payments. These loans have provided access to home ownership to more than 6 million households in the US over the past decade. Figure 1: Growth in subprime lending in the US

Subprime mortgage loan is a type of mortgage loans offered at interest rates higher than the normal prime rate to high-risk customers who are unable to qualify for prime-rate loans. For the traditional mortgage loans, qualification for loans is based on a number of factors such as income, assets and credit rating. However, for subprime mortgage loans, subprime borrowers are usually qualified for loans and the prices of the loans vary depending on the borrowers’ credit ratings, which means that the worse the credit rating is, the more expensive the loan will be. . Subprime Mortgage Securitization With the rise in subprime lending, financial institutions also came up with a new method of managing the default risk of these subprime loans – securitization. Securitization is the process of pooling and repackaging of homogenous illiquid assets into marketable securities that can be sold to investors. Traditionally, how the mortgage lending system works is that banks originate loans to the borrower and retain the default risk of these loans.

However, with the invention of securitization, banks instead adopted the “originate-to-distribute” model which enabled these mortgages to be repackaged into bonds called Mortgage-Back Securities (MBSs) and Collateralized Debt Obligations (CDOs) and sold to investors. Hence, the default risk of the underlying mortgage loans could then be transferred to the buyers of these bonds. The two types of securitized mortgages that played a critical part in the subprime mortgage crisis are MBSs and CDOs. 1. Mortgage-Backed Securities MBSs are the products of the securitization of a portfolio of mortgage loans.

They are, by definition, financial securities which are backed by the real-estates or the mortgages. The mortgage lenders sold these packages of loans in the secondary market while collecting the principals and interest payments from the mortgage loans to pass them on to the purchasers of the MBSs. In our case of subprime mortgage lending, MBSs promise a very high rate of return due to the inherent default risk of the subprime mortgages. 2. Collateralized Debt Obligations CDO represents a re-securitization in which a pool is created from tranches of already issued securitizations such as MBSs.

Since the credit ratings of MBSswere low due to the high default risk of their underlying subprime mortgages, MBSs often appeared unattractive to investors and fund managers. However, by slicing up the MBS into several tranches of bonds with different maturities and credit risk, investment banks were able to increase the saleability of these once unattractive, low-rating MBSs by forming a new portfolio of securities with higher ratings. CDO tranching appeals to a wider range of investors as they can match each investor’ credit risk preference with the appropriate tranche.

A typical CDO structure can be split into three main slices called senior (low risk), mezzanine (middle risk) and equity (high risk) tranches as shown. Figure 2: A typical CDO tranching structure The division of CDO into various different tranches indicates the sequential allocation of the underlying assets’ default risk. And since higher risks generate higher returns, the equity tranche will receive the highestreturn to compensate for taking on the highest default risk, as compared to the senior or mezzanine tranches.

However, when things go wrong, for example, subprime loans’ borrowers start to default or CDOs cannot maintain sufficient cash flows for investors, the equity tranche will be the first to be affected, then the mezzanine tranche and ultimately the senior tranche. Hence, CDOs do not change the risks of the underlying mortgage loans but rather allocate these risks among different tranche holders. Financial institutions have made use of this nature of CDO tranching to entice investors to buy these securities and make profits. c.

Problems with Subprime Mortgage Lending and Securitization With these great inventions in the mortgage sector causing the rising demand in mortgage loans as well asmortgage securities, the rush to bring in more business and transactions can lead to moral hazard and lax business practices by banks such as not ensuring the credit quality of the borrowers or providing loans without the need for borrowers to prove their income. In fact, in order to satisfy the huge demand for more mortgages and more securities, the mortgage qualification guidelines have indeed loosened onsiderably over the past decade, from “Stated Income, Verified Assets” (SIVA) loans to “No income, Verified assets” (NIVA) loans and ultimately, to “No Income, No Assets” (NINA) loans. One of the reasons why banks kept loosening its lending standards was because they did not keep these mortgages but sold them, and hence transferred their default risk instead to global investors. This would in turn enable these banks to replenish their funds and issue more loans and generate more transaction fees without incurring risks. Therefore, all they needed to care was making more mortgage transactions.

The consequence of banks’ ignorant attitude towards lending criteria will be investors’ increased exposure to default risk of these subprime mortgage loans. Given thesubprime loans as collateral, the values of MBSs are sensitive to fluctuating prices of the real-estate. So when real-estate prices drop, the probability of default on mortgage loans would increase dramatically because borrowers mightnot be able to sell their houses at or above the mortgage value and they cannot afford to pay back with their own income or assets.

This, hence, increasesthe risk and reduces the value of MBSs holding these subprime mortgages as collateral. Ultimately, it is the investors who have purchased these MBSs that would get hurt when the underlying subprime loans default. ? 2. 3Subprime Mortgage Crisis – The Timeline Phase I – Increasing demand for asset and loan In the years leading up to the crisis, a large inflow of foreign money flowed into the US . Together with the low interest rate at that time, this created excess capital in the US. When people had more excess money to spend, their investment needs increased.

There was thus a high demand for buying assets such as properties for investment purposes. More and more people wanted to borrow money from banks to fulfill these investment needs, which made banks’ credit conditions gradually easier as described above. The ease of making loan led to the credit booms – borrowers assumed a large debt load. Phase II – MBSs and CDOs were created to satisfy the demand To satisfy the growing asset demand, banks created MBSs and subsequently CDOs – which, as explained above, derived their values from mortgage payments and housing prices.

These structured financial products were in great demand during that period as they provided more liquidity, higher returns and greater flexibility for investors. Even international institutions and investors started buying MBSs and CDOs and, thus, investing in the US housing market. Phase III – US housing bubble burst In 2005 – 2006, the US Housing bubble started to grow due to the large demand for properties specially houses. It became increasingly easy to get a loan, especially with the new subprime lending system , which allowed more people to get a house.

The demand for houses pushed house prices up, and this trend attracted investors who wanted to buy houses to sell at a later date at higher prices. This further pushed house prices up, and more people then started to have difficulties in paying their mortgages. They had to take a loan against their house which now had a higher value to pay off their debt, but as a whole getting them into a bigger debt. House prices continued to increase until they reached a level that was no longer sustainable for normal household income. This was when the bubble burst.

Average household income did not change, but with sky-high house price, people were not able to pay off their mortgages. This was when the event that everyone thought would rarely happen actually happened: a large number of people defaulted on their mortgages. Phase IV – Start of house mortgage defaults When people defaulted, their houses were taken. The number of defaults increasing rapidly means the number of houses available also increased. The supply for houses started to grow while there were no more buyers by this time.

The lack of demand made house prices plunge down, which made many mortgage holders have negative equity – their debt is now larger than their house value. The vicious cycle continues as house prices decreased drastically and the number of defaults and foreclosures continued to increase. Interest rate in turn also increased. Phase V – MBSs and CDOs lostvalue and affected all FIs and Investors Mortgage payments are the basis of MBSs and CDOs. When there were no payments, these structured products started losing their values.

Large financial institutions fell one after another as they did not have enough financial cushion to make up for their losses in MBSs and CDOs. Their financial strength as well as ability to lend was severely affected, which in turn decreased consumer confidence. Investors around the world holding on to these high default-risk securities also suffered as the borrowers of the underlying mortgage loans defaulted. All of these factors came together and slowed down the overall economic activity. ? 3. Case Study on Morgan Stanley . 1Core Business Headquartered in New York and providing global financial services to financial institutions, governments, corporations and individuals , Morgan Stanley has offices in 33 countries with approximately 45,000 employees. The company reported US$317 billion as total assets as on 30th June 2009 . Morgan Stanley has profitable franchises in investment banking, equities, commodities and prime brokerage, but also risky investments in commercial real estate and leveraged loans. 3. 2Business Structure

Morgan Stanley has three core businesses: Institutional Securities, Global Wealth Management Group, and Asset Management. Institutional Securities comprises the Equities and the Fixed Income divisions and provides institutions with capital raising and financial advisory services including advice on mergers and acquisitions, and corporate lending. Global Wealth Management Group provides high net worth individuals and hedge funds with brokerage and wealth planning services. The Global Wealth Management Group is combined with Citi’s Smith Barney to form Morgan Stanley Smith Barney Holdings.

Asset Management provides asset management services in fixed income, equity and alternative investments, to institutional investors such as pension plans and non-profit organizations. 3. 3Extent of Involvement in Subprime Mortgage Lending Morgan Stanley seems to have expanded its presence in asset-backed securities at an inappropriate time. It ranked 10th among asset-backed underwriters in 2005 but jumped to 3rd in year 2007. Morgan Stanley is an active player in the subprime mortgage sector. Besides issuing home loans to borrowers with poor credit, it also buys and repackages them as tranches and sells them to investors.

The bank was also one of many Wall Street firms to provide financing to subprime mortgage provider New Century Financial, which went bankrupt in April 2007. 3. 4 Impact of Crisis on Morgan Stanley and its Management Strategies In November 2007, Morgan Stanley reported loss of $3. 7billion from its subprime mortgage exposure, which reduced fourth quarter earnings by $2. 5billion . It also had to write down $940million of losses on balance sheet caused by mortgages trading and sell off its Discover Credit Card division . In addition, Morgan Stanley has written down $15. 7 billion in mortgage-backed securities .

As a result, its stock fell dramatically as investors lost confidence and became increasingly convinced that Morgan Stanley would not survive, even with a $700 billion bailout plan by the US government to buy its mortgage-backed securities . However, Morgan Stanley responded quickly to extricate itself from crisis. On 21 September 2008, Morgan Stanley, together with Goldman Sachs, applied to the Federal Reserve to transform itself into a bank holding company. This allowed Morgan Stanley to redefine itself and function as a commercial bank, taking in deposits to raise capital instead of selling loans and bonds.

Therefore, the company became less reliant on the bond market and reduced its exposure to credit risk. Furthermore, this move subjected the company to more stringent regulations by Federal Reserve and supervisions from bank examiners , which would prevent it from engaging in sloppy business practices. Moreover, Morgan Stanley tried to rescue itself through mergers. It talked with Wachovia bank although it was unsuccessful. It also raised its capital by exchanging around 10% of its shares to receive $5 billion from the China Investment Corporation.

Besides, the company sealed deal with Mitsubishi Financial Group to sell 20% of the company for $9 billion. All these actions aim to diversify Morgan Stanley’s pure investment banking focus and redeem investors’ confidence. As a result, the company’s share almost doubled in October 2008. Additionally, Morgan Stanley tried to reduce costs and increase business efficiency by cutting 10% of the staff in the institutional securities group in November 2008. On 1 June 2009, Morgan Stanley purchased Smith Barney from Citigroup and combined its wealth management unit with Smith Barney brokerage division.

This will likely increase the client assets base to $1. 7 trillion. Morgan Stanley also made profits by investing in Chinese real estate projects during the current property boom in China. For example, on June 27, 2008, a Morgan Stanley affiliate acquired a 30% stake in Clearwater Bay project for about $775 million and currently it is valued at more than $2. 5 billion. With these ongoing strategies, Morgan Stanley can position itself well to prevent another crisis. 4. Market Analysis 4. 1The current trend of credit risk in the market

Currently nearly one-third of the U. S. lending mechanism is frozen and will continue to be frozen. Traditional banking system needs to take a few years to generate strong profits to ensure that there is sufficient capital to support the additional lending volume. Moreover, due to difficulty in gauging credit risk in current instable economic condition, banks and commercial finance companies are more cautious in monitoring their credit risk. Similarly, financial institutions have raised their lending criteria and demand higher interest rates from borrowers.

These changes tighten the credit market and the lack of new loan originations also adds pressure to properly mitigate risk in existing portfolios. 4. 2How do Morgan Stanley’s competitors manage credit risk During the 2008 financial turmoil, three of the five largest investment banks in U. S either went bankrupt or were sold at fire-sale prices to other banks. Lehman Brothers went bankrupt after failing to find a buyer. Bear Stearns was sold to JP Morgan and Merrill Lynch was sold to Bank of America. The remaining two investment banks, Morgan Stanley and Goldman Sachs, were transformed into commercial banks. a. Goldman Sachs

Goldman positioned itself well in the storm to persevere through the subprime crisis and profited in the bonds market by shorting subprime mortgage-backed securities. Goldman also tried to avoid large subprime write-downs in 2007, and offset losses on non-prime securitized loans by extricating mortgage positions. Besides, Goldman decided to attract more high net-worth investors and widen its business through acquisition and mergers. For example, company managed to attract US$5 billion infusion from Warren Buffett’s conglomerate and acquire imploded mortgage company Popular Financial Holdings in the third quarter of 2008.

These moves and plans taken have helped the company to survive the credit calamities and outperform its competitors in the industry. b. Other banks and financial institutions Moving away from the traditionally held view that judging credit is fundamentally an “art”, many banks are adopting new approaches to reduce their exposure to credit risk. Institutions such as JP Morgan Chase, Citibank and Bank of America have developed global credit exposure information systems to closely monitor pricing and exposure which change continuously in real time.

Citibank, for one, has applied an artificial intelligence system to one segment of its commercial lending business. Bank of Montreal is also applying portfolio theory to the management of its commercial loans. 4. 3Other/external influences The USA Federal Reserve, the European Central Bank, and other central banks took immediate response by injecting huge amount of capital into the credit market to provide more liquidity by purchasing government debts and troubled private assets from banks. For example, the governments of European nations and the U. S. aised the capital of their national banking systems by $1. 5 trillion, by purchasing newly issued preferred stock in their major banks. These steps are taken to expand money supplies to avoid the risk of a deflationary spiral, in which lower wages and higher unemployment lead to a self-reinforcing decline in global consumption. Furthermore, the Basel Committee on Banking Supervision also came out with new regulations. These new rules and regulations aim to develop a much more reliable financial banking system which prevents banks from having risky operations and therefore reduces exposure to credit risk. . 2009 Financial Regulatory Reform and its effect on Financial Market On 17th June 2009, US Treasury Department released Obama administration’s plan titled “Financial Regulatory Reform: A New Foundation” to tighten the regulatory structure of the US financial system. The proposal consists of five objectives: I. Promote Robust Supervision and Regulation of Financial Firms II. Establish Comprehensive Regulation of Financial Markets III. Protect Consumers and Investor from Financial Abuse IV. Provide the Government with the Tools it Needs to Manage Financial Crises V.

Raise International Regulatory Standards and Improve International Cooperation In summary, the proposal has addressed the weaknesses at major financial institution including capital adequacy, liquidity management, and risk management and recognized the harm that interconnected and highly leveraged institutions could inflict on the financial system. The creation of a Financial Services Oversight Council (chaired by Treasury) in the proposal allows a much more consolidated supervisory system of banks and other insured depository institutions.

More importantly, the Fed is given more authority over all of the financial institutions so that they can legally step earlier and more flexibly than before. The proposal also recommended the set-up of an independent Consumer Financial Protection Agency to protect consumers of financial products, including credit and auto loans, “from abuse, unfairness, deception, and discrimination”. This will ensure consumers can make well-informed and educated decisions regarding financial products, markets operate efficiently and fairly, and “traditionally underserved consumers and communities have access to financial services”.

Currently, “if a large, interconnected bank holding company or other non-bank financial firm nears failure during a financial crisis, there are only two untenable options: obtain emergency funding from the US government as in the case of AIG, or file for bankruptcy as in the case of Lehman Brothers”. The lack of regulatory framework during the crisis had therefore led to the ability of the US government to save Bear Sterns and AIG through its lending authority, but insufficient capability to save Lehman Brothers from its bankruptcy.

In the wake of this disorderly resolution, it is vital to create a regulation regime which allows an orderly resolution of failing bank-holding companies (BHCs) when the financial system’s stability is at risk. Last but not least, the proposal emphasizes the need for international rules for financial regulations to be consistent with those implemented in the US. This includes the four core issues: regulatory capital standards, oversight of global financial markets, supervision of internationally active financial firms, and crisis prevention and management.

The international capital structure is therefore strengthened, with the modification of Basel II to mitigate its weaknesses which had been demonstrated during the global crisis turmoil. 6. Conclusion Our report has given an overall view of the roots and factors that contributed to the subprime mortgage crisis that has affected numerous financial institutions around the globe, with a case study of Morgan Stanley as one of the institutions that were severely affected yet have survived the fall.

The Financial Regulatory Reform was also included as the new prevention measure against future crisis, although the effectiveness of the new policies is still a question of the future. Bibliography 1. Morgan Stanley Securities Services Inc. , Statement of Financial Condition as of 30 June 2009, page 11, http://www. morganstanley. com/about/ir/shareholder/morganstanley_securitiesservices_inc. pdf 2. The US Subprime Mortgage Crisis: Issues raised and Lessons learnt, Commission and Growth and Development, Working Paper No. 28 http://www. growthcommission. rg/storage/cgdev/documents/gcwp028web. pdf 3. Wikipedia, the Internet, http://en. wikipedia. org/wiki/Credit_risk http://en. wikipedia. org/wiki/Morgan_Stanley 4. http://www. guardian. co. uk/business/2007/nov/08/creditcrunch. housingmarket 5. http://topics. nytimes. com/top/news/business/companies/morgan_stanley/index. html? scp=1-spot&sq=Morgan%20Stanley&st=cse 6. http://curiouslyinspired. wordpress. com/2008/09/19/morgan-stanley-goldmans-and-the-credit-crunch/ 7. http://useconomy. about. com/gi/o. htm? zi=1/XJ&zTi=1&sdn=useconomy&cdn=newsissues&tm=4&f=10&su=p649. 3. 36. ip_&tt=11&bt=1&bts=1&zu=http%3A//www. bloomberg. com/apps/news%3Fpid%3D20601087%26sid%3DaSfyFs2LTxYs%26refer%3Dhome 8. http://www. nytimes. com/2009/03/02/business/worldbusiness/02morgan. html 9. http://www. nytimes. com/2008/10/12/books/review/Anders-t. html? _r=1 10. http://useconomy. about. com/gi/o. htm? zi=1/XJ&zTi=1&sdn=useconomy&cdn=newsissues&tm=4&f=10&su=p649. 3. 336. ip_&tt=11&bt=1&bts=1&zu=http%3A//www. bloomberg. com/apps/news%3Fpid%3D20601087%26sid%3DaSfyFs2LTxYs%26refer%3Dhome 11. http://redalyc. uaemex. mx/redalyc/html/399/39903308/39903308. html 12.

The New York Times,Mortgage lender New Century Financial files for bankruptcy, April 2 2007; http://www. nytimes. com/2007/04/02/business/worldbusiness/02iht-loans. 5. 5118838. html 13. Goldman, Morgan Stanley Bring Down Curtain on an Era, Bloomberg, Sep 22, 2008http://useconomy. about. com/gi/o. htm? zi=1/XJ&zTi=1&sdn=useconomy&cdn=newsissues&tm=4&f=10&su=p649. 3. 336. ip_&tt=11&bt=1&bts=1&zu=http%3A//www. bloomberg. com/apps/news%3Fpid%3D20601087%26sid%3DaSfyFs2LTxYs%26refer%3Dhome 14. http://www. gibsondunn. com/Publications/Pages/FinancialRegulatoryReformConsumerFinancialProtection. aspx

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