The Subprime Panic

1
The Subprime Panic

• Working Paper by Gary B. Gorton
• National Bureau of Economic Research
• October 2008
• Presented by Rebekah Sundin

2
Summary of Contents

• Introduction
• Executive Summary of working paper
• Background of mortgage market in the U.S.A.
• Key Points
• Description of Terms (throughout presentation)
• Conclusion
• Pros/Cons of the Working Paper and other
  viewpoints

3
Introduction

• How the American Dream of home ownership
  turned into an international crisis
• Economic boom that led to easy credit housing
  boom stroked the demand for home ownership
• In fact, from March 1998 to March 2007, every
  rolling two year period displayed double digit
  house price appreciation. (pg. 20)
• Culture of easy credit, easy lending
• Increasingly sophisticated financial instruments
• Increasing prevalence of subprime mortgages in
  financial market
• Misunderstanding and misinformation of the
  subprime mortgages impact on financial markets

4
Executive Summary

• Gordon explains that intricate financial
  instruments created a chain of interlinked
  securities that served to inevitably hide the
  true value and weakness of subprime mortgages.
  The securitization design of the mortgages, cash
  flow triggers in the subprime market did not
  adequately protect against its exposure and even
  created incentives for further financial
  derivatives. Gordon argues that only after ABX
  indices began to estimate the true value of the
  subprime packages, did financial markets begin to
  realize the true risk of the bonds. As the
  subprime exposure began to be understood
  financial institutions discovered the
  far-reaching impact of the subprime bond trading
  and went into panic.

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Background

• How did it all begin?
• Lets start with Fannie Mae and Freddie Mac
• government sponsored enterprises (GSEs) to
  enhance the flow of credit to targeted sectors of
  the economy
• GSEs create a secondary market for loans
  securitization that helps to provide household
  borrowers cheaper loans, removes credit risk from
  bank balance sheets and provides standardized
  instruments.
• Lenders tend to provide GSEs with favorable
  interest rates, and the buyers of their
  securities offer them high prices because of
  implicit (perception of) a government guarantee.

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Fannie Mae

• Federal National Mortgage Association (FNMA)
• founded in 1938 during the Depression
• chartered by Congress in 1968 as a GSE
• does not make home loans directly to consumers,
  but uses secondary mortgage market to facilitate
  liquidity in the primary mortgage market thereby
  ensuring that funds are consistently available to
  the institutions that do lend money to home
  buyers

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• Federal Home Loan Mortgage Corporation(FHLMC)
• The FHLMC was created in 1970 to expand the
  secondary market for mortgages
• buys mortgages on the secondary market, pools
  them, and sells them as mortgage-backed
  securities to investors on the open market
• Freddie Mac has made home possible for one in
  six homebuyers and more than five million
  renters.

8
What are subprime mortgages and why should we
panic?
9
Key Points

• Section 2A Growing prevalence of subprime and
  Alt-A in mortgage market (Table 1)
• Section 2B Subprime Mortgage Design
• How to lend to risky borrowers?
• Using house appreciation to leverage risk over
  the short-term rolling over mortgage every 2-3
  years thanks to accelerated house appreciation
• What are Adjustable Rate Mortgages (ARM)?

10
Prevalence of Subprime mortgages in MBS
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What are Subprime Mortgages

• High risk, Short-term with high prepayment
  penalties re-financing necessary
• ARM
• Hybrid mortgages with fixed and floating rates
• Step-up mortgage rate
• Prepayment penalty not to re-finance early
• More susceptible to house prices
• What is predatory mortgage lending?
• Possible U.S. criminal investigation

12
Mortgage Brokers in the U.S.

• 75 of portfolio in subprime mortgages,
  lucrative, ability to establish control
• No stated income bank statements, no credit
  history, or missed previous mortgage payments, no
  down payment
• Supplied interest-only, 50-year, option-arm,
  adjustable-rate, 90-100LTV 100 cash out, high
  premiums

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Section 3 and 4

• Subprime securitization has dynamic tranching as
  a function of excess spread and prepayment and is
  sensitive to house prices as a result.
• These sections also explains how the subprime
  residential mortgage-backed securities were sold
  to CDOs, how CDOs were issued to structured
  investment vehicles (SIVs leveraged investment
  company that raises capital by issuing capital
  market securities ), and the synthetic creation
  of subprime RMBS risk.

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Section 3 The Design and Complexity of Subprime
RMBS Bonds

• Securitization
• Subprime lenders tended to rely on securitization
  of the mortgages (see Table 2)
• Note that in 2005 and 2006 originations were
  about 1.2 trillion of which 80 percent was
  securitized. (Gordon, pg. 6)
• Cash inflows
• But unlike other securitizations, because of
  re-financing, there were expectations of early
  cash inflows. Gordon explains the risk that this
  created
• The credit enhancement for, and the size of, the
  tranches (and hence the degree of subordination)
  will depend on the incoming cash over time. The
  dynamics of this make the risk inherent in the
  securitization of subprime mortgages dependent on
  the refinancing of the mortgages, which in turn
  depends on house prices.The cash flow comes
  largely from prepayment of the underlying
  mortgages through refinancing.In some cases,
  this can lead to a leakage of protection for
  higher rated tranches. (pg. 7)
• Hence, the securitization design and early cash
  flows tended to subvert the risk inherent in the
  subprime loans. Yet expectations of increasing
  house prices allowed this risk to be manageable.

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15
Mortgage Originations and Subprime Securitization
(Table 1)
16
Subprime RMBS (Figure 1)
17
Subprime RMBS

• Residential mortgage-backed securities (RMBS)
• REMIC (Real Estate Mortgage Investment Conduit
  an investment vehicle that holds commercial and
  residential mortgages in trust, and issues
  securities representing undivided interests in
  these mortgages.
• Two types of asset-backed securities (ABS) and
  mortgage-backed securities (MBS)
• A senior/subordinate shifting of interest
  structure (senior/sub), sometimes called the
  6-pack structure (because there are 3 mezzanine
  bonds and 3 subordinate bonds junior to the AAA
  bonds), or
• An excess spread/overcollateralization (XS/OC)
  structure. Over-collateralization means that the
  collateral balance exceeds the bond balance, that
  is, deal assets exceed deal liabilities.
• Subprime RMBS bonds
• additional layer of support from excess spread
  (the interest paid minus the spread out on of
  RMBS bonds.
• initially more assets (collateral) than
  liabilities (bonds).

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Falling House Prices
20
Falling house prices

• Between 2001 and 2005 homeowners enjoyed an
  average increase of 54.4 percent in the value of
  their houses (pg. 21)
• But when housing prices began to drop, it became
  harder for families to refinance. Remember
  mortgage brokers have control over decision to
  refinance in the subprime market
• Current state of mortgage market (underwriting)

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22
ABX Index

• Launched in January 2006
• Measured the risk of owning subprime mortgage
  bonds
• .

23
ABX index (figure 4)
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Subprime Panic

• Falling house prices,
• the role of the ABX indices
• the runs on the SIVs (structured investment
  vehicles that raises capital by issuing capital
  market securities and/or asset-backed commercial
  paper (ABCP).

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Section C. Asymmetrical Information

• The intricate chain of securitizations were
  susceptible to house prices. While there was
  general knowledge of a housing bubble, no one
  could determine the size of the bubble, its
  duration, or its impact. Hence investors
  continued to make bets on the housing bubble.
• Gordon explains, That is, there was a lack of
  common knowledge about the effects and timing of
  house price changes and about the appearance of
  increases in delinquencies. This explains why the
  interlinked chain of securities, structures, and
  derivatives, did not unravel for awhile. (pg.
  21)
• The implicit contractual arrangement between SIV
  sponsors and investors led sponsoring banks to
  take the off-balance sheet SIVs back onto their
  balance sheets, when there was no explicit
  obligation to do so. (Pg 31)

26
Shadow Banking System

• The banking system was metamorphosing into an
  off-balance sheet and derivatives worldthe
  shadow banking system
• The capital markets, through the sale of
  intermediary-originated loans via securitization,
  and the distribution of risk through derivatives,
  highlight the centrality of capital markets and
  illustrate the flexibility of structured
  products.
• So what happened?
• Finally holders of short term liabilities
  (mostly commercial paper, but also repo) refused
  to fund banks due to rational fears of lossin
  the current case, due to expected losses on
  subprime and subprime-related securities and
  subprime-linked derivatives. In the current case,
  the run started on off-balance sheet vehicles and
  led to a general sudden drying up of liquidity in
  the repo market, and a scramble for cash, as
  counterparties called collateral and refused to
  lend. As with the earlier panics, the problem at
  root is a lack of information. (pg. 31)
• Repo market The repo market is one in which two
  participants agree that one will sell securities
  to another and make a commitment to repurchase
  equivalent securities on a future specified date,
  or on call, at a specified price. In effect, it
  is a way of borrowing or lending stock for cash,
  with the stock serving as collateral.

27
Over-liquidity of low interest rates submerges
the housing market
28
Asymmetric Information (contd)

• In the current crisis there was a loss of
  information due to the complexity of the chain.
  it is not possible to penetrate the chain
  backwards and value the chain based on the
  underlying mortgages. The structure itself does
  not allow for valuation based on the underlying
  mortgages, as a practical matter. There are (at
  least) two layers of structured products in CDOs.
  Information is lost because of the difficulty of
  penetrating to the core assets. Nor is it
  possible for those at the start of the chain to
  use their information to value the chain
  upwards so to speak.
• Agency relationships were also substituted for
  actual information.

29
Asymmetric information (contd)

• Economists think of information as a signal
  about the future payoff of a security. Agents
  obtain signals by expending resources. The costs
  of learning the signal are recovered by trading
  on this private information. In the process the
  asset price aggregates the information.
• The initial signal concerns the underwriting
  standards for the mortgagesas different
  portfolios are formed, each requires multiple
  signals. Essentially incentive-compatible
  arrangements are substituted for the actual
  signals, which are too complex to be transmitted.
  (pg. 26)

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Exposure of ABS
31
Who is at risk?

• Investors (trading or investing in securities or
  derivatives)
• Banks and financial institutions that warehouse
  the securities or RMBS (exposed to market risk
  during this time) and that hold interest-only
  securities, principal-only securities and
  residual securities.
• Mortgage companies (hold on to servicing rights
  up to 10 of total assets)

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Section 6 Alternative Hypothesis and Incentives

• Originate-to-distribute view, incentives have
  been fundamentally altered blames rating
  agencies originators and underwriters of loans
  that no longer have an incentive to pay attention
  to the risks of loans they originate, since they
  are not residual claimants on these loans.
• Another problem in the securitization design is
  that financial institutions earned fees on
  transferring credit risk in the short-term with
  supposedly little exposure due to short-term
  nature of holding the bond this incentivized
  increasing amount of CDS.

33
Residential Mortgage-Related Net Exposures and
Losses ( millions)
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Gordons Conclusion

• Current crisis can be described as a bank panic
• The lack of details in both the financial
  institutional setting and the security design of
  subprime mortgages have created a banking panic
• Lack of information of expected losses on
  subprime and subprime-related securities and
  subprime-linked derivatives has lead to drying up
  of credit markets

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Gordons Rescue Plan

• Offer deposit insurance
• Use Clearinghouse loan certificates to allow
  markets to fix the problem of asymmetrical
  information. The process of the auction would
  create transparency with respect to the prices of
  these securities. The markets will then provide a
  clearinghouse price for the contaminated
  securities. This information and guarantees will
  help lending institutions to continue lending.

37
Critiques and Personal Reflection

• House price bubble Greenspan bubble
• Regulators demand banks increase capital in
  times of boom to prepare for downturn
• Balcerowicz monetary policy was too loose cut
  too much, too low interest rates. prices
  inflated banks provide cheap loans. Increased
  demand for houses and stocks.
• Governments to blame create easy credit
  incentives for home owners to have access to
  financing.
• Failure of private sector to manage risk
• Ensure risks are understood.
• Prevent shift of assets of off-balance sheets -
  banks had incentive to move to structured
  investment vehicles
• Credit rating agencies wrong in estimating the
  value of instruments triple A models of risk
  management were flawed. Using historical data
  covered good times.

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U.S. Bailout details

• US 700bn rescue package signed on October 3,
  2008
• The US Treasury is to invest 250bn in a number
  of banks as part of a package of measures aimed
  at restoring confidence in its financial sector.
• US Treasury will also issue blanket guarantee all
  bank deposits and new debt issues by banks for a
  period of three years and an additional
  guarantee on new debt issued by banks will be put
  in place for a period of three years.
• At least 125bn is to go to nine of America's
  largest banks, including Citigroup, JPMorgan
  Chase and Bank of America, in exchange for
  capital under the rescue plan.
• Additional funds The Fed said it would provide
  up to 540 billion in financing to money market
  mutual funds in a new program called the Money
  Market Investor Funding Facility, that will buy
  from money market mutual funds certificates of
  deposit, bank notes and commercial paper, which
  is short-term debt companies issue to raise money
  for payroll or supplies.
• Money market funds hold about one-third of
  commercial paper.
• Fed officials said that about 500 billion has
  flowed out of prime money market funds since
  August as investors worried about their ability
  to redeem shares.

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Government Bailout
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Bailout difficulties

• But how will Treasury structure the pricing and
  purchase of the troubled assets, which are
  troubled precisely because they're
  difficult-to-value. Challenges from holding
  illiquid mortgage backed securities, to illiquid
  whole loans, to raising needed capital, to simply
  facing a crisis of confidence.

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• Thank you

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More cartoons, anyone?
44
Future of U.S. Housing Market?
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