Causes And Effects Of The Subprime Mortgage Crisis – A Global Perspective

Background of the Crisis

Questions:

1. Discuss and provide an example answering three questions regarding subprime mortgage. With an example explain possible causes of financial crisis. Explain how financial crisis affected businesses in your own country and other countries.

2. Use your analytical skill and knowledge to calculate expected return on NBA’s equity, preference shares and debt.  With expected return on equity, preference shares and debt calculate WACC?

The subprime mortgage crisis which occurred in United States was a nationwide crisis and alerted a situation of banking emergency. This crisis altogether triggered towards the recession of United States in 2007. There was a huge downfall in the prices of house which resulted to mortgage felony and shutdown of securities which were related to housing sector. On a precise note, the subprime mortgage crisis affected global markets worldwide.

If we consider another instance of a financial crisis, the first thing which strikes our mind is the “GREAT DEPRESSION” which started in 1930 and lasted mid 1940s. Pre Second World War, the world suffered and was illustrated as one of the longest and deepest depression of the century. In recent times, the term Great Depression is referred to the crash in stock market and subprime mortgage crisis which originated in United States. The decline in 1930s in the economy of world reached its bottommost point in 1933 when millions of Americans suffered due to no employment opportunities and further failures of bank added to the woe.

There were numerous causes for the financial crisis which affected the world. It included various structural loopholes and specific events which led to a huge depression and this downturn speeded from nation to nation. One of the major cause was a sudden downfall in the economy of United States which downturned most the countries. On the other hand, internal failing of each countries worsen the situation. There were desperate attempts to repair the economic downfall, but this ultimately led to a huge collapse in the trade around the world (History.com Staff, 2009).

The subprime mortgage crisis was mainly blamed among several factors such as due to financial institutions, credit rating agencies and consumers (Charles W. Bryant and Jane McGrath, 04 December 2007). The basic cause of this crisis was subprime lending. The people in United States were indebted on an increasing scale and the ratio of loan to disposable personal income rose to more than 125% in 2007 which was an alarming situation and this caused a big panic for the government. Such steep rise was mainly due to increase in mortgage. Another cause which added to the despair of crisis was loss of confidence among the consumers. There was a huge downturn in investment by people which latter on resulted in widespread unemployment.

During 2006, the prices of property saw a sudden decline and this resulted in raising difficulties for the borrowers to re-finance their debts. The rate of debts which were adjustable in nature witnessed to reset at a high interest rate which ultimately resulted in more pressure for the borrowers causing them to pay high monthly payment and consequently mortgage delinquency ascended.  The mortgages which were given a backing of securities, like subprime mortgage held by financial institutions worldwide starting to lose their worth. Investors around the globe lessen their purchase activity in these securities. There was huge concern regarding the working of credit markets and financial markets in United States which resulted in a tight credit across the globe and a slow growth in economy in United States and Europe.

Causes of the Subprime Mortgage Crisis

The crisis had a rigorous and enduring affect for number of countries around world. There was a severe recession which resulted in huge unemployment. The countries were suffering due to layoff by auto industry. (Charles W. Bryant and Jane McGrath, 04 December 2007).

The impact of financial crisis was such severe that the financial institutions started shutting down in 2007 and approximately more than half of private markets dealing in credit became unavailable due to lack of fund (NICOLE GELINAS, 2009). Further the system of banking was totally disrupted due to lack of capital. It was also stated that it would take number of years for the banking sector to recover from this downturn and that should be backed by huge gains which could help in lending (Martin Neil Baily and Douglas J. Elliott, 2009).

If we go through the effect of financial crisis in Australia, it was considerably less in comparison to other countries. The banking sector of Australia was still on a profitable path and did not require any capital input from the Government (Reserve Bank of Australia, 2010). On the other hand, the impact of the financial crisis was mainly on the prices of equity. The downfall in the prices resulted in reduction of wealth among the Australians and this decline was not recovered until 2009. The crisis also impacted the Australian Dollar as it depreciated steeply by over 25% in 2008.

The financial crisis had a huge impact on the economies of various countries. The crisis progressed from banking sector to independent debt. Countries along the globe started to aid their system of banking with the help of money from tax payers which was a serious desperate measure among the European Countries. Europe was the most impacted in the world due to the financial crisis, which lead to embark of asceticism programs. The rates of unemployment lead to a steep increase in countries such as Portugal, Spain and United Kingdom. Further the problem of budget deficit added to misery of the government.

The financial institutions among various countries failed which resulted in bailing out or mergers with other banks. The major cause was due to a sudden decline in the worth of securities which were backed by mortgage. There were scenarios of insolvency, such as Lehman Brothers, disruptions in credit market and further people started taking off their savings from these institutions.  

Conclusion

The financial crisis is a situation which no country wants to face. Further if the major players in the global market face such severe crisis, then countries around the globe gets affected. The people who are mainly affected altogether are the common people, as they could not afford such disruptions in their daily lives. The unemployment factor, banking companies going insolvent, downfall in the prices of equity and various such consequences altogether affect the common people. The Government should come with a full proof plan in order to restrain from such kind of situations in future.

Reference:

Reserve Bank of Australia, 2010, 1301.0 – Year Book Australia, 2009–10. 2015. 1301.0 – Year Book Australia, 2009–10. [ONLINE] Available at:https://www.abs.gov.au/ausstats/[email protected]/0/FC66B912A0C2CF8ECA25773700169CF9?opendocument. [Accessed 14 January 2015].

Impact of the Crisis

NICOLE GELINAS, 2009 Can the Feds Uncrunch Credit? by Nicole Gelinas, City Journal Winter 2009. 2015. Can the Feds Uncrunch Credit? by Nicole Gelinas, City Journal Winter 2009. [ONLINE] Available at: https://www.city-journal.org/2009/19_1_credit.html. [Accessed 14 January 2015].

Martin Neil Baily and Douglas J. Elliott, 2009,The U.S. Financial and Economic Crisis: Where Does It Stand and Where Do We Go From Here? | Brookings Institution . 2015. The U.S. Financial and Economic Crisis: Where Does It Stand and Where Do We Go From Here? | Brookings Institution . [ONLINE] Available at:https://www.brookings.edu/research/papers/2009/06/15-economic-crisis-baily-elliott. [Accessed 14 January 2015].

Bryant, Charles W., and Jane McGrath.  “How Subprime Mortgages Work”  04 December 2007.  HowStuffWorks.com. <https://home.howstuffworks.com/real-estate/buying-home/subprime-mortgage.htm>  14 January 2015.

History.com Staff, 2009, The Great Depression – Facts & Summary – HISTORY.com. 2015. The Great Depression – Facts & Summary – HISTORY.com. [ONLINE] Available at: https://www.history.com/topics/great-depression. [Accessed 14 January 2015].

2. a) The estimated return to NAB’s shareholder has been calculated using this formula:

Return from equity=	D1    +G
	P0-f

(Obaidullah Jan , 2013)

By using the above formula, the cost of equity is 10.25% (please refer the excel sheet).While calculating the cost of equity, the dividend of $1.5 was paid last year (D0) which is expected to increase at the rate of 5% in further years. Therefore, $1.5 will be $ 1.575 next year on each share of NAB ltd.  Further the floatation cost was not present in the question and hence not considered while calculation of return that shareholders of NAB are expecting to earn.

b) The return of preference shareholders is calculated using this formula:

Return to Preference Shares=	D1
	P0

By using the above formula, the cost of preference shares turns out to be 9.2% (please refer the excel sheet).

c) Pre- tax cost of debt is 10%

Post- tax cost of debt is 7%

(Please refer the excel sheet).

While calculation of pre tax cost of debt, the tax rate of 30% is not considered. Further the method of Trial and Error is considered while calculating the cost of debt.  Hence the rate of 10% which has been considered is not a precise rate. The range of 5% (upwards and downwards) has been considered while evaluating the cost of debt.

d) While calculating the market value of NAB’s asset, we have used the market rates of equity shares and preference shares that are $30 and $25 respectively. The market value of asset turns out to be 2112, 50,000. (Please refer the excel sheet). Further the book value of debt has not been considered and the value has been converted to market value of debt, that is, $950 per bond.

e) The weighted average cost of capital is calculated using market weights rather than book value weights. The book value weights are not considered widely due to the fact that, the book value weights does not show correct picture of the working position of a company in comparison to the market scenario. The market conditions are captured if we use the market value of equity shares and preference shares. Further the cost of debt has been taken using after tax cost of debt rather than pre- tax. The after tax cost of debt has been taken because it would help NAB ltd to ascertain the exact value of its cost of capital, that is, after taking into consideration the tax rate assigned to NAB ltd (2015 Macabacus, LLC)

Hence the weighted average cost of capital turns out to be 9.7% approximately. In order to get the detailed calculation, please refer the excel sheet attached with this document.

f) The question states about the possible outcome to WACC would be, if the liability of NAB ltd increases by 100%. If the liability increases by 100%, that is the value of bond, the market value would turn to be $475, 00,000. The increase in value of liability would lay a huge impact on the WACC of the company. The WACC would turn to be 9.42% (please refer the excel sheet).

Reference:

 2015 Macabacus, LLC , Weighted-Average Cost of Capital (WACC). 2015. Weighted-Average Cost of Capital (WACC). [ONLINE] Available at:https://www.macabacus.com/valuation/dcf/wacc. [Accessed 14 January 2015].

 Obaidullah Jan , 2013, Cost of Equity | Definition | Formula | Examples. 2015. Cost of Equity | Definition | Formula | Examples. [ONLINE] Available at:https://termsexplained.com/832766/cost-of-equity. [Accessed 14 January 2015].