Questions :
1. Subprime mortgage crisis is an example of a financial crisis that affected global markets worldwide. Give another example of a financial crisis in your discussions below.
(a) Discuss the possible causes of the financial crisis.
(b) Discuss the impact of the financial crisis on financial institutions and businesses elsewhere including your own country.
(c) Explain how the financial crisis affected the economies of different countries.
2. NAB Ltd current share price is $30 and it has just paid a $1.50 dividend. Dividends of NAB are expected to grow at the rate of 5% per year.
(a) What is an estimated return that shareholders of NAB expect to earn?
(b) NAB Ltd also has preference share outstanding that pays fixed dividend of $2.30 per share. If preference stock is currently priced at $25, what is the return that preference share holders expect to earn?
(c) Five years ago NAB Ltd issued 15 year bond with face value of $1000 and coupon rate of 9%. The price of these bonds is currently is $950. What is NAB’s pre-tax and after-tax cost of debt?
(d) NAB Ltd has 5000,000 ordinary shares outstanding and 1,500,000 preference shares outstanding, and its equity has a total book value of $50,000,000. Its liability has a book value of $25,000,000. If NAB’s ordinary and preference shares are priced as in parts (A) and (B) above, what is the market value of NAB’s assets?
(e) What is weighted average cost of capital (WACC)
(f) If NAB’s liability increase by 100%. How the increase in liability will affect WACC of NAB. Explain.
Introduction
Let’s first understand the meaning of “Prime Mortgage” and “Subprime Mortgage”. Prime term is referred for highest quality borrowers, who are low default risk individuals. The interest rate charged from them is called “Prime Rate”. “Subprime” term is used for high risk borrowers. The risk of default is high in subprime borrowers.
Subprime mortgage loans are alike “Adjustable Rate Mortgages” which is offered to low credit scores. Adjustable rate mortgages are loan with low interest rate initially, but will rise to higher rate in future because of which the instalment payment liability exceeds drastically. A subprime mortgage loans are the loans given to borrowers having impaired credit records. A high interest rate is charged from them for accepting greater amount of risk. Subprime mortgages charge a rate higher than prime lending rate.
Subprime lending borrowers have weak credit histories. There low credit scores and low debt-to-income ratios shows there inability to pay debts on time. If a borrower is delinquent in making timely payments to the lender then that may lead to foreclosure proceedings.
Examples of other financial crisis
Causes of Subprime Mortgage Crisis
Before an approximate period of 10 years, a big amount of money was invested into U.S. market from foreign investors and that too at lower interest rates. This large amount flowed into U.S. banks and financial institutions made it easier for U.S. people to get credit. The subprime borrowers took large amount of money as ARM assuming that following the rise in the real estate prises, they would be able to pay the debts easily.
Many lenders approved large amount of loans to borrowers without even analysing and examining their ability to pay debts. Many borrowers were granted loans beyond their capacity to pay it afterwards. Borrowers assumed that they would be able to pay the debts as now they will borrow money, invest in real estate and when the prices would rise their investment values would also double. Home construction got boomed. The construction was so high that it exceeded the number of houses the buyers were willing to purchase. Supply exceeded demand and the real estate sector declined.
Because the real estate sector declined, the assumption of the ARM borrowers went wrong. Those who thought that the prices of the houses would rise and they will be able to pay the debt from that investment were left in lurch. And as the adjustments in ARM began, many borrowers defaulted.
Mortgage Backed Security introduced in the market following the steep fall in real estate values. Mortgage Backed Securities are the tradable securities sold to investors across the world which is secured by a mortgage. it was sold worldwide to thousands of investors who purchased the securities thinking it was rated by the popular credit rating agencies of U.S.
The housing market declined due to excess of supply over demand and the borrowers defaulted in making payment of home loans which further led to loss to the holders of Mortgage Backed Securities. These securities became so drastically became unreliable that they stopped being bought or sold in the market.
Because of this, many institutions and banks went through financial crisis and became unable to pay the obligations.
Impact of financial crisis
The failure of Mortgage Backed Securities left more than 100 mortgage companies bankrupt as they could no longer be sold to investors. This happened in late 2007. During the 4th quarter of 2007, the financial institutions who sold Mortgage Backed Securities who could not sell it to investors made huge amount of losses while adjusting the values of mortgages with MBS with their purchase prices. Now, banks were not in a position to lend money to investors because real estate was the main base to lend money to borrowers. During 1st Quarter 2008, merger took place between bank Bear Stearns and J P Morgan when it realised that it is unable to continue with its operations.
Many banks and mortgage lenders as well as real estate investment trusts made big amount of losses. Financial institutions suffered losses or write downs of around 150 billion dollars. Many other companies across the world filed for bankruptcy. Top management of many companies were forced to resign as well as many institutions got merged with other institutions.
According to IMFR report, the fall in housing prices and rise in delinquent mortgages created huge losses amounting to 565 billion dollars. While adding up this amount to with other financial instruments’ losses, it reached to 945 billion dollars. U.S. citizens lost their jobs. There came a big recession time in U.S.
The subprime loan payers who defaulted in making payment which led to foreclosure proceedings put their homes up for sale which involved the whole real estate sector. And therefore the prices of the houses declined steeply.
All the mortgage lenders were left in liquidity crunch with no business left with them. Hundreds of mortgage lenders have shut down their business and more than 50,000 people lost their jobs.
Because of the crisis in real estate business, many home builders quitted the business and many real estate brokers decided to shut down the business. Many Wall Street firms who sold securities to investors made huge losses and suffered liquidity crunches. It not only impacted the financial institutions but also affected many other sectors like stock exchange, banking institutions, and many other big sectors.
Stock exchange got badly affected by the crisis. When U.S. investment bank Lehman Brothers got bankrupted, dividend yield on S&P500 index got negatively affected. The U.S. stock exchange was characterised as negative stock exchange during 2008. KOSPI dropping about 7% in one day, this was the example of daily large falls that became regular during recession time. Many other securities got adverse effect on market prices and it caused major losses to many investors of U.S. The recession affected the other stock markets also like, Brazil and Korea being the highest affected economy.
Apart from the above listed sectors, the special purpose entities, investors, insurance companies homeowners as well as minorities affected adversely.
The U.S. economy affected so badly during the crisis, the above listed affected areas are just few examples of the effects.
Impact on different world economies
The subprime crisis in U.S. has affected the different countries’ economies too. Below are some of the examples of the economies which got affected due to the crisis took place in U.S. Spain and United Kingdom who have great value added share of financial services, have been drawn in. Those having big manufacturing sector and integration into the international division of labour were the most effected economies of the world.
Impact on German economy
The economic system in Germany was highest affected. Germany’s annual economic growth rate was 1% in 2008 and the rate became -4.7% in 2009. Between last quarter of 2007 and 2008, the households’ financial wealth in Germany decreased sharply; this was mainly due to the steep fall in the prises of shares.
Impact on Brazilian economy
In 2009, Brazilian export business affected very badly because of the crisis. In 2010, trading amount exceeded largely the levels of 2008. Exports increased sharply starting from 1999 till 2008, the growth went double-digit since 2003. The export growth of Brazil was very strong compared to average export growth of the world, and the Brazil economy increased their share of world trade. The Brazil’s share in exports of technology decreased steadily. In 2010, the manufactured goods’ share in total export was 39.40%, while the raw materials’ share of exports increased up to 44.60%. Till 2010, the exported high-tech goods share decreased, and in 2009 had only a share of 7.30% after 8.60%.
Impact on Chinese economy
China started raising interest to control its overheated economy from 2006. Default rate went up following the increased pressure on borrowers. Moreover, during the housing booms, the commercial banks of the People’s Republic of China did not provide any innovative mortgage products to the buyers who were willing to purchase. China’s GDP continued grew at a very high rate in the first half of 2008, in spite of a few serious disasters of nature that can hit many more country parts very badly. Banks of China need to tighten up their operations and follow different criteria set by the Chinese countries to prevent and safe Chinese economy from such a crisis.
Impact on Indian Economy
Stock market of India suffered heavily because of the US crisis. The SENSEX reached at 15,733 points in 2007. The SENSEX then showed a huge correction on after reaching a big high in 2007 because of selling Foreign Institutional Investors to be back at 15,160 points. The policy rate was cut from 9% to 3.25% in April 2009. This was the RBI’s steep reduction in the policy interest rates. In September 2008, the CRR was made from 9% to 5% with a view to inject liquidity into the system of banking in January 2009. The SEBI started making corrective steps to save the Indian Capital Market from booms and boosts of different economies crisis.
These were the effects of subprime crisis of US on different economies. Although, some effects were positive or some effects were positive.
Estimated return for equity shareholders
Estimated return for preference shareholders
Pre tax and after tax cost of debt of NAB Ltd
Part B.d)-Market value of NAB’s assets
Weighted average cost of capital
Effect of liability increase on WACC
The amount of liability isn’t specified in the question. Therefore, in the given case there will not be any change in the value of WACC.
References
ANON, N.D., “Subprime”, Accessed on 29th January 2015, <https://business.cch.com/images/banner/subprime.pdf>
ANON, N.D., “Mortgage backed Securities”, Accessed on 29th January 2015, <https://useconomy.about.com/od/glossary/g/mortgage_securi.htm>
ANON, N.D., “The impact of US Subprime mortgage crisis”, Accessed on 29th January 2015, <https://www.eria.org/ERIA-DP-2009-10.pdf>
ANON, N.D., “Subprime crisis, causes, consequences and cures”, Accessed on 29th January 2015, <https://www.voxeu.org/article/subprime-crisis-causes-consequences-and-cures>
ANON, N.D., “Spill over effects of mortgage credit crisis in USA on Europe”, Accessed on 29th January 2015, <https://www.google.co.in/url?
ANON, N.D., “Subprime crisis in US”, Accessed on 29th January 2015, <https://www.igidr.ac.in/money/mfc-11/BhanuMurthy_KV_Deb_%20Ashis.pdf>
ANON, N.D., “Impact of subprime crisis on world economy”, Accessed on 29th January 2015, <https://www.scribd.com/doc/14477388/Impact-of-Subprime-Crisis-on-World-Economy#scribd>
ANON, N.D., “Impact of the US subprime crisis on global basis”, Accessed on 29th January 2015, <https://www.ccmf-uwi.org/files/publications/seminar/cdaseking_08.pdf>
ANON, N.D., “Impact of subprime crisis on world and East Asia”, Accessed on 29th January 2015, <https://mpra.ub.uni-muenchen.de/14722/>.
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