Transcript 2008 Economic Crisis - Westfield State University

2008 Credit Crisis
Its connection to subprime mortgage
crisis
By
Supriya Sarnikar, J.D., Ph.D. (economics)
Asst. Professor
Economics and Management Department
Westfield State College
The Beginnings of the Crisis
• You have heard that the current credit
crisis began in the housing market.
• We will look at the basics of the
mortgage market to understand how it
affected the financial markets.
• But first, we will look at the meaning of
some financial terms that you will
encounter in this presentation.
Some Terminology
• Mortgage – to pledge property as security for a loan
• Collateral – the property that is pledged
• Liquidity – ease of conversion of an asset into cash
• Security – A certificate (paper or electronic) that gives
certain rights to the lender.
• Securitization –
process involving pooling loans and creating
securities backed by the loans.
• Bonds/Debt instrument –
A security that gives
the holder a right to receive a fixed amount (called “face value”) on a
fixed date in the future (date of maturity) and right to receive
periodic interest payments (called the “coupon rate” ).
Conventional Mortgage Process…
• …begins when a buyer wishing to buy a house,
approaches a bank/financial institutions for a loan.
• Bank/Financial Institution checks borrower’s credit
history, income, other financial data (such as other
debts owed), and then decides whether to make the
loan.
• Once the loan is made, the bank’s money is tied up
for the duration of the loan (typically 30 years). This
made traditional real estate loans very illiquid.
• Securitization of mortgages was meant to turn
these illiquid loans into more liquid assets..
What is Securitization of Mortgages
• Mortgage securitization is the process in which
several real estate loans are pooled together and
then broken up into smaller pieces to be sold to
investors.
• Just like stock ownership makes it possible for each
one of us (no matter how wealthy or not wealthy) to
own a piece of a company (instead of the whole),
and enjoy shares of the profits, mortgage
securitization, in theory, makes it possible for
investors to hold a piece of the mortgage and enjoy
shares of the interest (and principal) payments.
Securitization can be a good thing..
• ..because it allows money to flow from the savers
(and investors who are willing to bear the risk), to
the borrowers who do not have the money but want
to use it.
• Obviously, the bank (or other financial institution)
that made the original loan is also already
performing this function. So why the securitization?
• Answer: The bank may not be willing to make too many
real estate loans if its money will be tied up for such long
durations. By breaking the loans into pieces and selling it to
investors, the bank turns an illiquid loan into a liquid asset.
The money that is now freed up can be used to fund other
productive activities..
Mortgage Securitization is not new..
• In 1968, GNMA (Ginnie May) was first authorized by
Congress to issue Mortgage backed Securities to
finance its home loans.
• FNMA (Fannie May) and FHMC (Freddie Mac) have
been issuing Mortgage backed securities since the
1980s.
• The mortgage backed securities created with pools
of subprime loans are thought to be the culprits in
the current financial crisis and these were issued
starting in the mid-1990s.
•
Source: “Credit Crunch of 2008,” by Paul Mizen in Federal Reserve Bank of St. Louis Review,
September/October 2008, 90(5), pp. 531-567.
Mortgages
Conventional Vs. Jumbo, Alt-A, and Subprime
• Conventional Mortgages adhered to certain
standards.
•Borrowers must have good credit rating
•Income documentation required
•Down payment required (typically 20%)
•Principal balance could not be higher than a certain amount ($729,750 in 2008)
• Jumbo Loans
•Made to borrowers with good credit (i.e., prime borrowers) but the principal
balance is larger than the Agency (Fannie and Freddie) limits (729,750 in
2008).
• Alt-A Loans
•Made to prime borrowers but lax on other standards such as income
documentation or down payment requirements
• Subprime Loans
•Made to borrowers with bad credit ratings. Other standards may also be
relaxed.
Source: “Understanding the Securitization of Subprime Mortgage Credit’” Ashcraft and Schuermann, Federal Reserve Bank of New
York Staff Report 318, March 2008.
Subprime loans increased dramatically…
Source: “Money for Nothing and Checks for Free” by John Kiff and Paul Mills, IMF Working
Paper, July 2007.
But were still a small part of all mortages..
Source: “Money for Nothing and Checks for Free” by John Kiff and Paul Mills, IMF Working
Paper, July 2007.
The Subprime Mortgage Securitization
Process
Warehouse
Lender
(makes short term
loans to Issuer for
purchase of
mortgages)
Credit
Rating
Agency
Requests
loan
Mortgagor
(Borrower)
Provides
loan
Bank/Financial
Institution
(Originator)
Loan sold
Arranger/
Issuer
Loans pooled
and sold to
Trust
Makes loan
payments
SPV
(Trust)
Provides customer
service to borrower
Servicer
(is employed by Trust
to collect loan
payments etc.)
Remits loan payments to Trust
and advances unpaid interest
payments.
issues
securities
Investors
Adapted from: “Understanding the Securitization of Subprime Mortgage Credit’” Ashcraft and Schuermann,
Federal Reserve Bank of New York Staff Report 318, March 2008.
Source: “Understanding the Securitization of Subprime Mortgage Credit’” Ashcraft and
Schuermann, Federal Reserve Bank of New York Staff Report 318, March 2008.
Source: “Understanding the Securitization of Subprime Mortgage Credit’” Ashcraft and Schuermann,
Federal Reserve Bank of New York Staff Report 318, March 2008.
Source: “Money for Nothing and Checks for Free” by John Kiff and Paul Mills, IMF Working
Paper, July 2007.
Creation of the M.B.Securities- A Highly
Simplified illustration..
• Originator makes, lets say, a 100 loans adding up
to, say, $80 million. The expected payback is $80
million (Principal) plus the interest payments of,
say, $5million (assuming no defaults).
• The originator pools the 100 loans and sells to the
Arranger for, say, $82 million. (The Arranger is
willing to pay more than $80 million because it
expects to receive some interest payments).
• The Arranger then divides up the $80 million into
several smaller pieces. Let’s say 1000 bonds each
with a face value of 80,000 and some interest rate
(called a coupon rate). Now it wants to sell these
bonds to investors.
Securitization creates a distance between
the investor and the borrower..
• So how can an investor know whether the
mortgages that secure its investment are
healthy?
• Several checks and balances exist but also
many problems also exist at each stage of
the securitization process.
• Investors relied heavily on credit ratings
provided by the Rating Agencies.
The Role of Credit Rating Agencies
• Credit rating agencies, such as Moody’s, Standard & Poor, and
Fitch, are paid by financial institutions to provide easy to
read/understand ratings of the risk associated with various
debt instruments.
• Each Agency has its own scale of indicators and own models to
determine default risk
A
•
•
•
•
•
sample scale of ratings
AAA – extremely safe, very low risk
AA – very strong credit, low risk
A – strong credit
BBB – Good credit
BB – good credit but vulnerable to economic conditions
Role of credit Rating Agencies- contd.
• In rating Mortgage Backed Securities (MBS), the rating
agencies relied on information provided by the
Issuer/Arranger.
• Their rating models were publicly available and Issuers often
consulted with the rating agencies when constructing the loan
pools and creating the MBS.
• The models used by the rating agencies relied on historical
data (typically, 1992-2000) of mortgage default and
foreclosure frequency rates. But the type of loans made during
2001-2007 were very different from the types of loans made
during 1992-2000. The later loans were much more risky.
Source: “Credit Crunch of 2008,” by Paul Mizen in Federal Reserve Bank of St. Louis
Review, September/October 2008, 90(5), pp. 531-567.
Structuring the Deal- the Devil in the
Details
• The potential investors in these mortgage
backed securities were mainly institutions
that were restricted by regulation to buying
investment grade bonds. (Typically these are bonds that
are rated BBB or better).
• So, for an Arranger to sell these mortgage
backed bonds, a rating of BBB or better was
essential.
• Working in consultation with the credit rating
agencies, the deals were structured in a way
that would give most of the bonds AAA
(safe) rating.
Structured Deals – Converting Subprime
Loans into AAA bonds
• To convert a pool of loans to AAA securities, the Issuer had to
provide Credit Enhancements (CE) in the form of
• Over Collateralization: For example, $80 million loans are backed
by real estate that is valued at more than $80 million. Or, more
typically, the collective face value of the MBS is less than the
underlying loan.
• Excess Spread: The weighted average of the coupon rates on the
MBS is less than the interest rate on the underlying home loan.
• Subordination: In our example, the 1000 securities are divided
into tranches (groups)- senior, mezzanine, equity, and residual
tranches. Typically, about 80% of the bonds were designated
senior tranche and were rated AAA, the rest were rated A, BBB
and lower. The mezzanine, equity, and residual tranches are
“subordinated” to the senior tranche. That means any money
repaid by the borrower is first applied to the AAA tranche before
any money is paid to the mezzanine, equity, and residual
tranches.
• Additionally, the investors were assured of the safety of the
bonds by the insurance provided by monoline insurers such as
AMBAC, MBIA etc.
Source: “Money for Nothing and Checks for Free” by John Kiff and Paul Mills, IMF
Collateralized Debt Obligations
(CDOs)
• No natural market for BB and C rated
MBS.
• Repackaged into CDOs with other
collateralized loans such as car loans.
• No natural market for lower tranches
of CDOs. These are repackaged into
CDO2. Lower tranches of CDO2 are
repackaged into CDO3.
Source: “Money for Nothing and Checks for Free” by John Kiff and Paul Mills, IMF Working
Paper, July 2007.
Structured Deals – Each MBS and CDO
is unique..
• For any given pool of loans the rating agency, (or its publicly
available rating model), told the Issuer how much credit
enhancement would be necessary for the MBS tranches to
receive AAA rating.
• The Issuers often bundled car loans and credit card loans with
subprime mortgages to get the desired credit enhancements
(especially for the CDOs).
• This turned the previously standardized MBS market (with
virtually no chance of default) into a market with high risk.
And, especially, into a market with risk that was very difficult
to price.
• Compounding the risk pricing problems, were falling housing
prices and several incentive and information problems at each
stage of the securitization process.
Incentive Problems in the Securitization
Process
Warehouse
Lender
Credit
Rating
Agency
(Makes short term
loans to Issuer for
funding mortgage
purchases)
Predatory
Borrowing
Mortgagor
(Borrower)
Predatory
Lending
Moral Hazard
Originator
(gets closing costs,
points paid by
borrower PLUS sale
proceeds of loan)
Makes warranties to
Arranger
Adverse Selection
Mortgage
Fraud
Arranger/
Issuer
(gets fees paid
by investors plus
any premium
paid over the par
value)
Adverse
Selection
Servicer
(gets paid fixed fee based
on outstanding loan
value)
Moral Hazard
Model Error
SPV
(Trust)
Principal
Agent
problem
Investors
Adapted from: “Understanding the Securitization of Subprime Mortgage Credit’” Ashcraft and Schuermann,
Source: “Understanding the Securitization of Subprime Mortgage Credit’” Ashcraft and Schuermann,
Federal Reserve Bank of New York Staff Report 318, March 2008.
Source: “Understanding the Securitization of Subprime Mortgage Credit’” Ashcraft and Schuermann,
Federal Reserve Bank of New York Staff Report 318, March 2008.
What triggered the credit crunch?
• Falling housing prices increased defaults.
• Investors began to exercise “put back” options that
put the Originators on the hook for the bad loans.
• High leverage meant that a small loss on subprime
loans translated into huge losses of capital.
• The run on the banks started a chain reaction that
resulted in the failure of several stand-alone
(monoline) banks and insurers.
• Doubts about the extent of losses suffered by each
institution created large scale uncertainty that froze
the credit market.
What Now?
• Credit Crisis is real. But what is the
solution?
• Is a bailout necessary? If so, what
should a good bailout do?
• Depends on whether the credit crisis is
due to
• Inadequate capital, or
• Lack of confidence, or
• Both inadequate capital and lack of confidence
The current bailout/rescue plan
• Mainly addresses the problem of lack
of confidence. Seeks to restore
confidence by:
• Govt. buying up the “toxic” assets
• Critical question is “at what price?”
• Seeks to find the price through a reverse
auction.
Reverse Auctions
• Problems with using reverse auctions
in this case
• Each “toxic” asset is different. The CDOs
and MBS are not all alike.
• Asymmetric Information - Banks know
more about the quality of the securities
than the government.
• Adverse Selection - Banks are likely to
offer the worst securities for sale at the
auction and keep the good (more
valuable, profitable) ones to themselves.
Alternatives to bailout plan
• Why not simply help the homeowners
who are in foreclosure?
• Curing current foreclosures is not enough.
• Future defaults will have to be picked up by taxpayers as
well for this to work.
• Estimated $6 trillion of potentially problematic loans made.
Very expensive to bailout homeowners..
• Moral hazard issue – more are likely to default is
government bails out. This is also a problem with current
plan to directly help banks.
• Problematic loans were made in other markets (car loans,
credit cards) as well. Curing defaults in housing markets
may not be enough to avert deeper recession.
Alternatives to Bailout plan
• Demanding stock (share in profits) in
return for providing capital to troubled
banks.
• Good idea from taxpayer’s perspective
but not likely to help if bankers do not
participate.
No easy answers..
• Rules of auction and other details of bailout
are critical for
• preventing a deeper and longer recession, as well
as,
• Not enriching banks at the expense of tax payers.
Treasury Secretary has 45 days to come up
with the details of the plan to buy toxic
assets.
Watch for more details..
Meanwhile, time is running out as evidenced
by the deepening of the crisis.