Overview of the US Housing Bubble

 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.

â—Â Discuss the possible causes of the financial crisis.
â—Â Discuss the impact of the financial crisis on financial institutions and businesses elsewhere including your own country.
â—Â 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.

Tax rate is 30%.

The subprime mortgage crisis broke down when the housing bubble of the United States busted in the year 2001. These crisis further gained their full strength during the period of 2005. This is concerned with the rapid increase in the values of the properties that took place in the country of United States. This was being done so that each and every citizen could afford a house. Then there came a time when the prices of the houses were lower than the amount of the debt. The housing bubble started in the country around 2006. These were identified after the correction of the market.

(Business, CCH, 2015)

The following were the causes that were identified:

1. The banks and the lenders over relied on the distribution channels that existed outside their won roof. They started to force the people whom they knew the maximum amount of loans that they could. This resulted in the lower quality of the standards that ensured the alone and they could not be repaid.

2. The private mortgage market took over the control of the crisis with the help of their high risk mortgage products. This resulted in the higher quality of the loans that were bad in reality.

3. The bans were told to make the loans work and the underwriters did not even know what they were up to and what they were doing. They were asked to give loans to each and every one without checking their backgrounds.

Causes of the Subprime Mortgage Crisis

4. Unscrupulous appraisers had the same intention as that of the lender of giving the loans.

5. There were a lack of the down payments and aggressive loan programs like that of the pay option arm and the other such interest only options that contributed to the mess of the mortgage. The prices of the houses were soaring up and the lenders had to come up with some innovative trick, so they came up with the idea of the interest only payments or the negative amortization. This resulted in a huge amount of bad debt.

(Truth about mortgage, 2015)

The Internal Monetary fund report that was released during the period of April 8, 2005 indicated that the US prices of the houses were falling continuously. Further, the delinquencies on the residential mortgage market led to the losses of $656 billion dollars. When these were combined with the factors with the losses from the other categories of the loans that originated and the securities that were issued in the United States were the ones that were related with the real estate.

In sum total, the IMF indicated that there was a loss of $945 billion.

(Business CH, 2015)

The country of the United Sates was the one that was hit the most hard. The industries that were hit the hardest were the banking industry, real estate and the construction industry. There were some millions of the homes that were closed down but no one was there to buy them. It was the largest crisis in the history.

But the third world countries were the ones that had a great deal of problems to deal with. The poverty had touched the level that could never have been imagined before. The third world countries had suffered the direct result of the financial crisis.

The investment in the third world countries especially from the banks and the government had declined. The effects on the economies of the third world countries were so hit that the people were rendered jobless and they had no money whatsoever to invest in the economy and the business.

(Development goals, 2015)

The great depression, as it is popularly known as of the 1930’s resulted in the implementation of the financial regulations so as to stabilize the economy and give the Americans a confidence in the banks. The banks are widely considered to be boring but safe. The interest rates were said to be low but so was the inflation. Also, the deposits were being protected by the Federal Deposit Insurance Corporation. The great depression resulted in the shooting up of the prices of the oil and led to the rise in the inflation. The years 1973 to 1974 marked the year of confidence in the regulations that were designed during the period. The rising inflation in the country of United States led the foreigners to lose their confidence in the US dollar as one of the leading currencies and sough to purchase gold. This created a huge amount of volatility in the financial system and increased opportunities so that the higher rate of interest could be earned.

(Pearson highered, 2015)

the financial institutions in the developing countries were not affected by the financial crisis due to the reason of the usage of the traditional financial system but in the countries like the United States, the individuals and the groups are required to have a very good track record so as to gain some credit or the loans and it is due to this reason that the risk is minimum. But the banks andthe financialinstitutions in the developing countries had to undergo many contractions in the lines of credit and reduced financial flows. The IMF had failed to respond to the Asian crisis since it had failed immensely. It was unable to predict the banking crisis that was the result of the currency crisis.

(Bruegel, 2015)

2.

A. The following is the required solution:

Price	30
Dividend	1.5
Growth rate	5%
Gordon growth model	D1/(ke-g)
Ke	10.2500%

Where D1 is the dividend after considering the growth rate (1.5*105%)

G is the growth rate

Ke is the return on equity

B. The following is the required solution:

Final dividend	2.3
Price	25
Dividend discount model	Current price=dividend/return
Return	9.20%

 
C. The following is the required solution:

Fair value	1000
Coupon rate	9%
Current price	950
Pre tax cost of debt	9%
After tax cost of debt	6%

D. The following is the required solution:

Particulars	Number of shares	Amounts
Ordinary shares	50,000.00	1,500,000.00
Preference shares	1,500,000.00	37,500,000.00
Liabilities		25,000,000.00
Total market value of the assets		64,000,000.00

E. The following is the required solution:

Weighted average cost of capital=E*Re/(E+D+P)+D*(1-t)*Kd/(E+D+P)+P*rp/(K+D+P)
Particulars	Cost	Weight	Weighted cost
Equity	10.25%	39.81%	4.08%
Preference shares	9.20%	35.73%	3.29%
Debt	6.30%	24.47%	1.54%
Total	25.75%	100.00%	8.91%

F. The following is the required solution:

There will be no change in the WACC due to the change in the liabilities.

References:

business.cch.com, (2015). The Subprime Lending Crisis: Causes and Effects of the Mortgage Meltdown. [Online] Available at: https://business.cch.com/images/banner/subprime.pdf [Accessed 27 Jan. 2015].

Developmentgoals.com, (2015). The effect of the financial crisis on the third world | Development Goals. [Online] Available at: https://www.developmentgoals.com/more-resources/financial-crisis-third-world.html [Accessed 27 Jan. 2015].

Robertson, C. (2015). What Caused the Mortgage Crisis? | The Truth about Mortgage.com. [Online] Thetruthaboutmortgage.com. Available at: https://www.thetruthaboutmortgage.com/what-caused-the-mortgage-crisis/ [Accessed 27 Jan. 2015].

www.bruegel.org, (2015). Impact of financial crisis. [Online] Available at: https://www.bruegel.org/…files/…/Crisis…/AEEF4PPDenisJ.Snower.pdf [Accessed 27 Jan. 2015].

www.pearsonhighered.com, (2015). The Global Financial Crisis. [Online] Available at: https://www.pearsonhighered.com/assets/hip/us/hip_us_pearsonhighered/samplechapter/0205231527.pdf [Accessed 27 Jan. 2015].