New Leaders of Financial Giants – Case of Citi Group and Merrill Lynch:
This report will review the precarious positions of Citigroup Inc. and Merrill Lynch at the beginning of the subprime mortgage crisis. Both companies had been hit hard by the recent economic problems, and both had recently hired new management in an attempt to navigate through these difficult times. Since risk management failures were viewed as the primary catapult of the crisis, the thinking was that managers with risk management experience would be able to introduce innovative techniques to improve the respective company’s positions. The report will analyze some of the solutions ...view middle of the document...
e. underlying pool of mortgages and the CDO structure being used. At the peak of 2006, Securities Industry and Financial Markets Association (SIFMA) estimated the size of the global of CDO market at USD 520 billion.
A subprime mortgage is a mortgage where borrower does not have the capacity to pay the principal and interest. An example of this type of loan is the 2/28 adjustable subprime mortgage in which the borrower was not required to put any money down. In other words, the loan funded 100% of the cost of the property, and the buyer did not have an equity investment. These mortgages had two-year teaser interest rates (i.e., below market rates) that subsequently adjusted up by about five percentage points at the end of the two-year period. Full interest payments were optional, which meant that negative amortization was possible at the discretion of the borrower. From 2004 to 2006, the majority of less creditworthy borrowers used this type of mortgage.
Why were subprime mortgage loans issued in the first place if borrowers did not have capacity to repay the loans? This was because property prices were steadily increasing, which made the lenders confident that they can rely on the collateral in case of default. Essentially, marginal borrowers had been granted a free at-the-money call option on the property. The option was free because no down payment or origination fees were required to obtain the mortgage. It was a call because, if the property value increased above the purchase (strike) price, all of the gains accrued to the borrower (the option holder). As long as housing prices kept going up, borrowers continued to make their monthly payments because doing so allowed them to continue to hold the valuable call option. Eventually, property values reached unsustainable levels, new buyers willing to pay higher prices failed to emerge, and prices began to decline. Credit rating agencies had assumed that low default rates would continue into the future, but, by the first quarter of 2007, there was a sudden increase in early defaults on mortgages made in 2006. In essence, borrowers realized that with declining property values, their call options were now worthless and they had no incentive to make their monthly payments.
The financial institutions, mutual funds and hedge funds held the CDOs. Subprime Mortgage Backed debt offered higher return as compared to the prime of conforming mortgage-backed debt. In order to boost profitability, financial institutions invested in CDO by issuing loans and earned handsome net interest margin. They also used the CDO to get short-term liquidity in the Repo Market. When the homeowners realized that the outstanding principal on the mortgage was higher than the property valued, they simply refused to make further payments thus vicious cycle of default of CDOs initiated and CDOs backed by subprime mortgages was no longer acceptable as collateral in Repo Market. The major banks did not lend each other...