The Economic Meltdown – Risks and Rewards of the Mortgage Crisis

By Bruce Toews Based on a presentation given to WWU alumni at 2010 alumni weekend.

In the game of capitalism, the basic equation is that with

risk

comes

reward.

Players play at their own risk . . .

Many times they win

. . . But when they lose, there’s plenty of blame to spread around.

The First Recorded Speculative Bubble:

Tip-Toeing Thru the Tulips

At the peak of tulip mania in early 1637, tulip contracts sold for more than 20 times the annual income of a skilled craftsman.

Median sale price of existing single-family homes (1890 = 100%) (inflation adjusted)

Minsky Moment

Peaked, Summer 2006 Likely path?

Risk Blame Game

Risk Taker #1 Greenspan & the Fed

In hindsight, Greenspan dropped the Fed Funds rate too far for too long . . .

BusinessWeek

, July 19, 2008 It was the Federal Reserve-engineered decline in rates that inflated the housing bubble . . .

Fed Chair, ‘87-’06

You can have your pie . . . and eat it too.

Bernanke, 3/10/09: “Next time the Fed will take the punch bowl away before the party gets too wild . . . “

Risk Blame Game

Risk Taker #2 Foreign Investors Provide Easy Money

Easy Money

G.W. Bush, Address to the Nation, Sept. 24, 2008

“For more than a decade, a massive amount of money flowed into the United States from investors abroad . . . This large influx of money . . . along with low interest rates made it easier for Americans to get credit .”

The Blame Game

Risk Taker #3 The American Consumer

Ignorance is not bliss

Many consumers were (are) incredibly ignorant about personal finances I was trying to figure out which is worse, ignorance or apathy . . . Then I realized I didn’t know and I didn’t care.

When the money runs out before the month does . . .

A culture of credit seemed so natural

National Debt-to-Income Ratios If my income is less than my outgo, then my upkeep will be my downfall

Equity Borrowers

Too many raided their homes like a piggy bank The American Dream backfires

Too many underestimated the full costs of homeownership

Dishonest Borrowers

   Mortgage fraud on loan apps skyrocketed 674% from 2003 to 2007 Of loans with early-payment defaults in 2005-2006, 70% had misrepresentations on the loan apps Borrowers overstated income/assets or understated liabilities/expenses

Speculative Borrowers

•

During 2005-06, 40% of homes purchased were not primary residences

•

During 2005-06, 85% of condos purchased in Miami were for investment purposes (i.e. flipping)

The Blame Game

Risk Taker #4 Lenders

Unsound & Greedy Lending

Ninja Loans ( n o i ncome, n o j ob, no a ssets) Many lenders quickly processed loans without documentation on purpose in order to get the origination fee (and then sell the loan).

Unsound & Greedy Lending

• Debt-to-Income Ratios (DTI)

– Old rule of thumb : PITI <= 29% of gross income – Revised rule of thumb : PITI <= 50% of gross income

• No money down

– Used to be 20% down, then 5%, then 0%, then -5 % – 80/20 loans or 105% LTV loans

Unsound & Greedy Lending

Interest-only and neg. amortization ARMs

Unsound & Greedy Lending

Subprimes made up an increasing portion of total mortgages from 5% in 1994 to 20% in 2006

The subprime risk premium went from 3% in 2000 to 1% in 2007. Lenders stopped charging higher interest rates to more risky borrowers.

In recent testimony, Greenspan said the one mistake he made was to assume that lenders, out of self interest, would make the correct judgments about risk premiums

Underwater Case Study

(when the mortgage is worth more than the house is)

Today, nearly one in five homeowners nationwide has negative equity (underwater loans)!

The Blame Game

Risk Taker #5 Mortgage Investors World-Wide

Securitization

• Spreading the risk of sub-prime mortgages around the world

• Your home loan is sold by your lender (in a package along with other home loans) to investors all around the world • Such investors include hedge funds, pension funds, insurance co., etc.

Subprime Borrower

Pmts

Mortgage Broker

(Countrywide, Hm Loan Ctr, etc.)

$$ Loan Servicer Pmts

Rating Agencies

(Moody’s, S&P, etc. did a poor job)

Credit Insurance

( Credit Default Swaps Issued by AIG, etc.)

MBS=Mortgage-Backed Securities; CDS=Credit Default Swaps

Simplified Process of Securitization Banks

(BofA, Wells, etc.)

$$ Loan

MBS Issuer

(Investment banks, FNMA, etc.)

Pmts $$ MBS

World-wide Investors

(Hedge Funds, Pension Funds, Endowments, Insurance Co., etc.)

The Blame Game

Risk Taker #6 Risk Managers

Credit Default Swaps

Described by Buffet as “financial weapons of mass destruction.”



World-wide GDP in 2007 was $54 trillion



Global est. value of CDS in 2007 was $58 trillion!!!

CDS were ticking time bombs in almost every major investment portfolio

As a tell-tale symbol, the DJIA recently replaced AIG with Kraft (Altria) – a financial stock substituted with a food/tobacco stock!

AIG rolled the dice by providing CDS on $700B of Lehman Bros. When the bonds went bad, AIG could not make good.

An AIG executive said as late as August 2007 that “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those [CDS] transactions.”

Rating Agencies

How a bad bond is made to look good

New York State Attorney General Andrew Cuomo's office has issued subpoenas to S&P, Moody's and Fitch -- specifically asking "how much each

knew about flaws in the mortgage products that they rated triple-A."

The Blame Game

Risk Taker #7 The U.S. Government

Encouraging Risk: Uncle Sam

The government encouraged many of these subprime mortgages in an effort to increase home ownership among the low income and minorities . . . a noble but risky goal.

Uncle Sam has his fingers crossed as he blows some hot air

Fear . . .

c

auses risk-taking to cease Risks shift to the Gov’t

• FDR said in Mar/33: “The only thing we have to fear is fear itself.” • The real crisis is one of confidence • Consumers stop consuming • Businesses stop producing • Investors stop investing • Banks stop lending • Key institutions are too big to fail • Gov’t is the only entity left that has the capacity to inject capital and confidence into the economy

Uncle Sam Absorbing Risk

Postponing Pain

-- Ignoring pain is dangerous -- Need to accept the paybacks and the penalties of risk-taking -- When will we be willing to pay the consequences of our risky behavior?!