Transcript Who, What, Where and Why

What, Who, Where and Why
of the Subprime Crisis
By: Ken Cyree, University of
Mississippi
Presented to Carroll University
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What are Subprime Loans
• “High-cost lending to high risk customers”
• Customers typically have poor or no credit
history and little or no down payment
• Often have high debt-to-income ratios (>
50% in many cases)
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How were they made?
1. Mortgage Brokers, receiving commission
for loan volume, make subprime loans
2. Loans packaged together and sold to a
large bank or Wall St. firm
3. The Wall St. Firms re-package as a CDO
and sells to Hedge Funds
4. Hedge funds buy using debt and also
create derivative securities against these
CDOs, selling these derivatives to others
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How were they made?
5. Rates reset or economic conditions
worsen for the original loan borrowers
who cannot pay timely or default
6. As borrowers default, foreclosures rise,
banks are less willing to lend slowing
housing demand, so home prices fall
7. Even banks who made NO subprime
mortgages have collateral values fall and
less business as willingness to lend falls
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Who are Subprime Borrowers
FICO
Score
Characteristics
Rate
A
> 620
No late payments.
Prime
B
550-580 2-4 late payments in
2 years
+1.75% to
+ 2.75%
C
520-580 2-4 late payments,
some > 60 Days
+3.0% to
+4.25%
D
< 520
Credit
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Frequently late
+4.5 or more
Who are the lenders?
• Largely, non-bank mortgage lenders like
Countrywide and American Century
– Proportions of subprime lending by non-banks: 2004
= 51%; 2005 = 52%, 2006 = 46%
– In 2003 8% of all home loans originated were
subprime and by 2006 it was 28%
• In 2007, 64% of foreclosures were subprime
– In 2003 there were $332 billion subprime loans
outstanding and in 2007 there were $1.3 trillion, a
292% increase in four years.
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Why make subprime loans?
• 70% of subprime loans have prepayment
penalties, compared to 2% of prime loans
• From 2004 to 2006, about 90% had
“exploding” payments with the average
payment increasing 30-50%
• Mortgage lenders could package them and
sell them as mortgage backed securities
with no recourse to FNMA and FHLMC.
– Lots of fee income and no risk = disaster
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When did it start?
• Some believe it started with CRA in the
late 1970s, but there is plenty of blame to
go around:
– Fannie Mae… has been under increasing
pressure from the Clinton Administration to
expand mortgage loans among low and
moderate income people and felt pressure
from stock holders to maintain its phenomenal
growth in profits. (NY Times, Sept. 30, 1999)
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Who’s to blame?
• The Bush Administration touted home
ownership, especially among minority
borrowers
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Who’s to Blame?
– The Federal Reserve, which cut interest rates after the dot-com
bubble burst, made credit cheap fueling the housing bubble.
– Home buyers, who took advantage of easy credit to buy more
house than they could afford.
– Credit Rating Agencies who believed diversification across
geography would avoid systemic failure, and took fees from
investment banks compromising their rating independence
– Alan Greenspan who encouraged Americans to take out
adjustable rate mortgages near the peak of the housing bubble
– Wall Street firms who paid too little attention to the quality of the
risky loans that they bundled and sold.
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More blame to spread around
– The Bush administration failed to provide needed government oversight
of the increasingly dicey mortgage-backed securities market
– Mark-to-market accounting rules which require “exit price” adjustments
and worsen losses in crises.
– Democrats opposed the Federal Housing Enterprise Regulatory Reform
Act of 2005, which would have established a single, independent
regulatory body with jurisdiction over Fannie and Freddie – a move that
the Government Accountability Office had recommended in a 2004
report.
– Current House Banking Committee chairman Rep. Barney Frank of
Massachusetts opposed legislation to reorganize oversight in 2000
(when Clinton was still president), 2003 and 2004, saying of the 2000
legislation that concern about Fannie and Freddie was "overblown."
– In 2008, Senate Banking Committee chairman Chris Dodd called a
Bush proposal for an independent agency to regulate the two entities
"ill-advised."
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More blame to spread around
– The Credit Default Swap (CDS) market was
essentially zero in 2000 and peaked at $62
Trillion in 2008, almost the value of the entire
world economy
– These guarantees allowed selling of
Structured Investment Vehicles (SIV) or
Collateralized Debt Obligations (CDOs) since
the CDS “insured” them from default, so there
was no incentive to investigate the mortgages
or other bonds in the CDO or SIV.
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What do we do to fix it?
• No one knows for sure.
• TARP added capital to banks so they could write
off the losses.
– Encourages future bad loans
– We may not have enough to save the largest banks
• The “bad bank” concept might work, but at what
price does the government buy or guarantee the
bad loans?
• If we do nothing, the banking system will fail.
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