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How Did The Subprime Bubble Burst?

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Bubbles burst and asset prices start to fall when a critical mass of people start to question the value of the asset. It happens when the ‘greater fool’ fails to show up, when people are no longer willing to pay more for the asset.

House prices began to fall in the US in 2006. Many home purchases were financed with sub-prime loans, which came with floating interest rates. When interest rates began to rise, it became increasingly expensive to service these loans, due to the higher monthly payments involved. Others mention to role played by teaser loans, which came with interest rates that grew exponentially after the first year. Borrowers were suddenly faced in higher instalment payments. In both cases, borrowers unable to service their loans opted for foreclosure, which had a depressing effect on house prices.

In his bestseller, A Colossal Failure of Common Sense, Lawrence Mcdonald describes how Lehman Brothers’ executives travelled to the headquarters of Countrywide Financial, and discovered a horrifying practice of mortgage loan applications being falsified and other breaches of procedure.

Around the same time, it also became evident that MBS sales were slowing, and that investors were no longer hungry for the high-yielding securities, as it became evident that the default rates were increasing. The reader should note at this point that the major investors of MBOs were institutional in nature, such as pension funds, hedge funds and university endowments. 10


Risk Capital and Institutional Risk Aversion

In his paper entitled ‘How Debt Markets Have Malfunctioned in the Crisis’, Arvind Krishnamurthy provides an explanation on why the prices of MBOs fell precipitously.

On a typical institutional balance sheet, asset purchases are largely funded by taking on debt. If a hedge fund wishes to buy 100 mil worth of MBOs, it may have 10 million in equity and borrow 90 million. This means that the fund is highly leveraged. The 10 mil worth of equity is known as the risk capital.

If the value of the MBOs decreases by 5 million, it means that the equity is only worth 5 million now. With the probability of the institution experiencing financial distress increasing, it becomes more risk averse and starts to cut down on its holdings of risky assets such as MBOs.

When there are many sellers in the market, prices can be impacted in a negative manner.

The Failure of Lehman Brothers

Lehman Brothers was unable to sell of its packaged MBOs at a certain point, which led to the firm having to sell them at a discount. We now know that Lehman Brothers essentially failed due to liquidity problems and the fact that it held too many illiquid assets which could not be redeemed in short notice.

Repo Financing

Another possible cause of the collapse of MBO prices is the collapse of the Repurchase Agreement (Repo) Financing market.

A Repo agreement is a loan that is collaterized by financial securities, often by the assets to be purchased. To buy $100 worth of MBOs, the trader approaches a lender, which agrees to forward the funds for the purchase minus a haircut of say $2. Thus, a trader only needs $2 in equity to fund the purchase. The purchased MBO is deposited with the lender as collateral and when the repo agreement reaches the end of its term, the funds are returned to the lender. 11

Repo agreements are usually made on a rolling basis, with equity being funded by past returns or past equity offerings. The repo financing arrangement is fast and convenient, and often poses little problem when asset values are stable.

However, there is also a counterparty aspect to this transaction. When securities are deposited with the lender in a repo transaction, there is a risk when the lender goes bankrupt. For example, if the repo haircut is $5 for a $100 transaction, the borrower may find itself with $95 in cash but with $100 worth of securities trapped with the lender. This is known as counterparty risk.

With the failure of Lehman Brothers, repo transactions and other forms of interbank lending came to a halt. At its height, Lehman Brothers was a preeminent investment house which acted as a central counterparty in many of these transactions. Its failure caused trust to evaporate and caused financial institutions to stop lending to each other.

When repo financing ground to a halt, financial institutions lost a key avenue to obtain financing to fund the purchase of risky assets, such as MBOs. This is another reason why the prices of MBOs and other risky assets experienced a significant decline in value.


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