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.(Instructor's Note)

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.(Instructor's Note)

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.

INSTRUCTORS' NOTES

Suggested Questions and Answers

There are two sets of questions provided. The first set is directed toward undergraduate finance students and leads them through the analysis in a step-by-step fashion. The second set of questions is more open ended and is better used for graduate students or more advanced undergraduates at the instructor's discretion. Instructors employing the second set of questions may refer to the discussion of the first set for guidance while allowing for more free ranging approaches that students may arrive at on their own.

Additional tables are provided below to be distributed at the discretion of the instructor. All information in the tables is available within the case with the exception of the revision in the tax law passed on December 20, 2007 eliminating the tax on forgiven mortgage debt. That information appears in the first set of questions and is ancillary to the case though it makes an interesting sidebar for discussion.

1. What is the monthly payment for the initial six months on the 30 year 2% interest only mortgage? Be sure to add in all additional costs rolled into the mortgage as described in the case.

The mortgage for 317,000 consists of the items as shown below:

For interest only at 2% the monthly payment is (0.02/12)*317000 = 528.33

2. What would the monthly payment be for the mortgage at the ARM rate of 5.17% that prevailed at the closing of the loan?

1734.81

3. According to the terms of the mortgage the difference between the introductory rate and the current ARM rate (5.17%) is added to the principal increasing the principal on the mortgage (negative amortization). What is the new principal when the loan resets in six months?

(1734.81--528.33)*6 + 317,000 = 324,238.87

4. Under the reset terms, the ARM benchmark is the constant maturity Treasury bill rate which is 5.27% at the time of reset. Considering that the term has been reduced by six months (29 1/2 years remaining), what is the new mortgage payment?

2564. …

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