Academic journal article Journal of the International Academy for Case Studies

Subprime Mortgages: A Case Providing the Perspectives of a Home Buyer and a CDO Trader

Academic journal article Journal of the International Academy for Case Studies

Subprime Mortgages: A Case Providing the Perspectives of a Home Buyer and a CDO Trader

Article excerpt

CASE DESCRIPTION

The case provides two levels of understanding the subprime mortgage crisis. The first level is from the perspective of home buyers worried about being closed out of an overheated housing market. The second level is from the perspective of investment firms trading exotic securities created by investment banks out of the subprime mortgages. The case could be used with undergraduate or graduate financial management students as well as in case courses. The calculations are straightforward and there are ethical issues. The case could be used in a business ethics course with the calculations provided the discussion ensuing would be on the home buyers' decisions, the mortgage lenders behavior, the investment bank's fiduciary responsibilities, and the moral hazards of any proposed legislation to remedy the crisis.

CASE SYNOPSIS

A couple buys a new home in 2006 in the Atlanta suburbs where prices have been rising. Lacking a down payment but with passable credit they purchase the home with a subprime mortgage that has the added complication of negative amortization on a six month interest only mortgage. When the mortgage resets at a rate pegged to the constant maturity T-Bill rate, the payments are much greater and they have difficulty making them. Their mortgage is one of many rolled up into Collateralized Debt Obligations (CDOs) created by investment banks. An investment company trading in CDOs has been making money using highly leveraged positions on what have been investment grade securities. When interest payments suddenly cease, the investment company is faced with a liquidity crisis. The case returns to the couple holding the subprime mortgage as they confront foreclosure with the added possibility of having to pay taxes on the difference between the sale price of their home and the amount they owe.

INTRODUCTION

In early 2006 Bill and Mary Wilkes, both just past 30 years old had been living in an Atlanta apartment for five years. Bill works in Atlanta's city administration and Mary is a receptionist at a mid-sized corporation in an office park outside Atlanta. They have looked for a house on and off for two years. A major impediment was that they had not been particularly successful in saving a down payment. Mary was fond of winter vacations and Bill was easily persuaded to buy the latest in high tech gadgetry, including a 50-inch HDTV and three high-end computers. He justified the computers since his job involved software services.

In 2005 Atlanta suburban housing prices continued an upward trend. In early 2006 Bill suggested to his wife that they have another look at the market. Kim Mitchell, a twenty-something broker with an easy smile, agreed to show them house listings in the suburbs.

The Wilkes' joint income is $75,000. Among their expenses is a car payment of $300 per month, which would be factored into any calculations a traditional mortgage broker would perform to see if they qualified for a mortgage, i.e., had sufficient income remaining after fixed expenses to make the payments. Monthly homeowners insurance and property taxes would also count toward their fixed expenses against which their income would be compared.

Mitchell took Bill and Mary on a tour of a selection of three bedroom homes. They weren't very excited about older homes so she steered them toward a new development. The model house was attractively decorated and they were sold on it at once.

"But can we afford it?" Bill wondered aloud.

Mary voiced a different problem. "And it is a further commute for us."

Kim turned up the sales pitch. "There aren't too many of these houses left. I know you saw the $319,000 price out front, but my company has a deal with the builder. We can get it for $300,000." With that, she took out her cell phone and said she was calling her office. When she hung up she said, "There are two left in this development at that special price. …

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