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Imperfect information and the housing finance crisis: A descriptive overview


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Title: Imperfect information and the housing finance crisis: A descriptive overview

Imperfect information and the housing finance
crisis A descriptive overview
  • Richard Green

Journal of Housing Economics 17 (2008) 262271
Sub-Optimal Choices
  • We now know that the subprime market presented
    consumers with sub-optimal choices that they
    took, and that it contained many market
    imperfections. The interesting question, then, is
    what were the sources of imperfections.
  • Paper discusses possible sources of market
    failure. Market imperfections in the Mortgage
    Finance System are classic
  • asymmetric information and agency problems.
  • asymmetries and agency problems were not
    one-sided, but rather involved a multiple set of

  • In the United States, a credit score is a number
    based on a statistical analysis of a person's
    credit files, that in theory represents the
    creditworthiness of that person, which is the
    likelihood that the person will pay their bills.
    A credit score is primarily based on credit
    report information, typically from one of the
    three major credit bureaus Experian, TransUnion,
    and Equifax. Income is not considered by the
    major credit bureaus when calculating a credit
  • There are different methods of calculating credit
    scores. FICO, the most widely known type of
    credit score, is a credit score developed by Fair
    Isaac Corporation. It is used by many mortgage
    lenders that use a risk-based system to determine
    the possibility that the borrower may default on
    financial obligations to the mortgage lender. The
    credit bureaus all have their own credit scores
    Equifax's ScorePower, Experian's PLUS score, and
    TransUnion's credit score, and each also sells
    the VantageScore credit score. In addition, many
    large lenders, including the major credit card
    issuers, have developed their own proprietary
    scoring models.

Prime Market
  • Within the realm of the traditional
    conventional-conforming market, borrowers are
    relatively homogenous in terms of down-payments
    and credit scores as measured by FICO.
  • Any variations tend to result in modest
    differences in default and prepayment
    probabilities that are reasonably well understood
    by the market.
  • This is why traditional conforming mortgages may
    be placed into pools that sell as commodities in
    a very liquid securities market.

Pretty Complete Information
  • Prime mortgages are highly standardized
  • - borrowers fill out a standardized loan
  • - appraisers use a standardized appraisal form,
  • - borrowers provided standardized documentation
    for income and assets.
  • Because Fannie Mae and Freddie Mac hold or
    guarantee millions of loans, they effectively
    have a large data set with which to calibrate
    models of mortgage default.

The GSEs (Govt Sponsored Enterprises)
  • The GSEs use econometric models to estimate
    probability functions a general form of this
    function is P(dX,H), where X is a set of
    explanatory variables and H is a set of
    parameters that maps the Xs to delinquency and
    default probabilities.
  • If the model is well specified, and the Xs have
    large explanatory power, it is difficult for
    borrowers to have an information advantage over
    lenders the distribution of unobserved
    characteristics of borrowers will either be small
    or irrelevant.
  • One of the things that allowed the GSEs to
    specify their models well is that they rationed
    loans only borrowers whose measured Xs were
    above a certain standard were given loans, which
    also created homogeneity among the borrower pool.
  • From the perspective of Holmstroms (1979)
    classic model of informational asymmetry, even
    uninformed agents could borrow in the prime
    market and investors could invest in the prime
    market with confidence there was a sufficient
    flow of information to produce something close to
    a full information equilibrium.

Subprime market
  • By contrast, borrowers in the subprime market are
    highly heterogeneous and the differences are not
    fully transparent.
  • The subprime market originally served as a market
    for those who had equity in their house, but
    because of unemployment, hardship, or even
    over-use of credit found themselves shut out of
    the traditional mortgage market.
  • For example, Weicher (1997) concludes,
  • These data on the characteristics of subprime
    borrowers suggest that subprime home equity
    borrowers are basically the same sort of people
    as other homeowners and are able to make informed
    judgments about what is in their own best
  • Because of the higher default risk, heterogeneity
    in this group of borrowers is likely higher.

Subprime expanded dramatically
  • However, over the last 10 years, the markets
    volume expanded dramatically. The subprime market
    became a source of funds for first time
    homebuyers who otherwise would have had to wait
    to develop a positive credit history before
    buying a house.
  • With less equity and no established history of
    making mortgage payments, both the heterogeneity
    of the pool and the lack of market knowledge
    about how these loans would perform over a cycle
  • The subprime market also expanded rapidly into
    investor loans as websites such as became prevalent. Investors
    could use subprime loans subprime mortgages as a
    de facto call option for investing in a house.
  • And often, we suspect, mortgage lenders could not
    accurately distinguish between investor
    properties and homeowners.
  • This category includes victims of the housing
    finance system, but also exploiters of the
    housing finance system.

  • In finance, an option is a contract between a
    buyer and a seller that gives the buyer the
    rightbut not the obligationto buy or to sell a
    particular asset (the underlying asset) at a
    later day at an agreed price.
  • In return for granting the option, the seller
    collects a payment (the premium) from the buyer.
    A call option gives the buyer the right to buy
    the underlying asset a put option gives the
    buyer of the option the right to sell the
    underlying asset.
  • If the buyer chooses to exercise this right, the
    seller is obliged to sell or buy the asset at the
    agreed price. The buyer may choose not to
    exercise the right and let it expire. The
    underlying asset can be a piece of property, or
    shares of stock or some other security, such as,
    among others, a futures contract. For example,
    buying a call option provides the right to buy a
    specified quantity of a security at a set agreed
    amount, known as the 'strike price' at some time
    on or before expiration, while buying a put
    option provides the right to sell.
  • Upon the option holder's choice to exercise the
    option, the party who sold, or wrote the option,
    must fulfill the terms of the contract.

Buying Call Options
  • Buying a call option - This is a graphical
    interpretation of the payoffs and profits
    generated by a call option from the buyer 's
    perspective. The higher the stock price the
    higher the profit. Eventually, the price of the
    underlying security would become high enough to
    fully compensate for the price of the option.

Writing Call Options
  • Writing a call option - This is a graphical
    interpretation of the payoffs and profits
    generated by a call option from the writer 's
    perspective of the option. Profit is maximized
    when the strike price exceeds the price of the
    underlying security, because the option expires
    worthless and the writer keeps the premium.

Borrower FICO Scores
No/low documentation loans
Upgrades/Downgrades of Securities
2.1.1. Borrowers tapping equity
  • Consumers have two ways of getting equity out of
    their houses
  • Cash-out refinancing
  • Home-equity lines of credit.
  • A cash-out finance takes place when a borrower
    pays off one mortgage and replaces it with a
    larger mortgage. Cash-out refinances are a
    particularly large part of the refinance market
    when market interest rates are rising under such
    conditions, consumers simply looking to reduce
    their monthly mortgage payments will not
  • According to the most recent Freddie Mac
    refinance survey, 87 of all refinances in the
    third quarter of 2007 were cash-out refinances.

First-time home-buyers
  • Home equity lines of credit (HELOCS) allow
    borrowers to tap into home equity without going
    through the relatively lengthy, and often more
    costly, process of obtaining a first-lien
  • It also allows owners to borrow amounts they wish
    when they wish there is not a fixed payment
  • On the other hand, HELOCS are usually tied to a
    short-term interest rates, such as LIBOR, and as
    such do not give borrowers the benefit of known
    mortgage payments from month-to-month. They also
    typically carry higher margins than first-lien
    adjustable rate mortgages, again partially
    offsetting the flexibility and less arduous
    origination process
  • Interest payments are generally tax deductible
    (if itemizing)

First-time (continued)
  • U.S. govt has long encouraged owner-occupancy.
  • In June 2002, President Bush issued Americas
    Homeownership Challenge to the real estate and
    mortgage finance industries to encourage them to
    join the effort to close the gap that exists
    between the homeownership rates of minorities and
  • The President also announced the goal of
    increasing the number of minority homeowners by
    at least 5.5 million families before the end of
    the decade. Under his leadership, the overall
    U.S. homeownership rate in the second quarter of
    2004 was at an all time high of 69.2 percent,
    minority homeownership set a new record of 51
    percent in the second quarter, up 0.2 percentage
    point from the first quarter and up 2.1
    percentage points from a year earlier.

  • Nevertheless, with loan products that allowed
    borrowers to become owners with little or no
    equity, the prospect of being a homeowner was
    surely irresistible to many families who never
    thought they would be able to become homeowners.
  • Subprime lending allowed borrows to buy a house
    without any equityand according to First
    American LoanPerformance data, the percent of
    purchase money subprime mortgages having LTVs in
    excess of 100 increased from 1.6 in 2000 to
    28.6 in 2006.
  • Having no home equity, these households more
    resemble renters than owners with respect to
    incentives to maintain, mobility, etc. To the
    extent buyers with little or no money down also
    had little in the way of financial resources, any
    major housing expense, such as the need to
    replace a roof or a furnace, could lead to
  • This also means that when such households face a
    trigger event, such as job loss, illness or
    divorce, they have might very well be in a
    position where the wise financial action is to

Investor Properties
  • Some of the more exotic subprime mortgage
    products resembled call options, and as such
    should have been attractive to speculators in a
    hot housing market.
  • Two products in particular stand out the 228
    adjustable rate mortgage, which carried lower
    interest rates for two years, and then reset to a
    rate with a high margin over LIBOR or one-year
    treasury securities
  • The so-called option-ARM, where borrowers had
    a negative amortization option. Investors could
    purchase a house in a market with high levels of
    appreciation and have low carrying costs for a
    few years. In the event that house prices rose
    substantially, the investor could sell at a very
    high internal rate of return (because
    down-payments and monthly payments would be low).
  • In the event house prices fell (which, of course,
    they did), the investor could default at low
    cost. Consequently, some of the subprime products
    attracted speculators. As we shall discuss later,
    it is a bit of a surprise that investors in
    mortgage-backed securities didnt understand the
    kind of adverse selection that were an inevitable
    consequence of these products.

  • Green and Wachter (2008) set forth the nature of
    the problem Asymmetric information also arises
    because it is likely that mortgage originators
    understand mortgage pricing and risk better than
    borrowers. To make this concrete, consider the
    nature of mortgage disclosures.
  • The Truth in Lending Act requires that borrowers
    be informed of the Annual Percentage Rate (APR)
    on their mortgage. The APR rate is the internal
    rate of return on a mortgage based on its coupon
    rate, discount points, some fees amortization
    and term. The APR calculation assumes that
    borrowers never refinance, and makes no provision
    for certain fees such as prepayment penalties
    that expire before the loan matures.
  • As such, it does not give an accurate picture of
    mortgage cost. Both borrowers and investors in
    mortgages are interested in yield, which is the
    internal rate of return on a mortgage. But of
    course, the yield is not the same thing as the
    mortgage coupon rate (the basis on which the
    mortgage amortizes) or the Annual Percentage Rate
    (APR) (a rate that amortizes the cost of discount
    points over the amortization period of the
  • The yield is rather the true return/cost of a
    mortgage. Even in the context of a fixed-rate
    mortgage, disclosing effective cost is not

2.2. Intermediaries
  • A number of channels connect consumers to the
    mortgage market.
  • We may then ask what the equilibrium is between
    the broker and retail lending channels. To
    simplify, assume that the fundamental difference
    is capital brokers neednt hold it, while retail
    lenders do.

  • The prime market is chiefly rationed through
    underwriting standards, while the subprime market
    is priced. In this stylized economy, the
    appropriate capital for a prime mortgage is lower
    than the appropriate capital for a subprime loan,
    because default losses on prime loans are lower
    than on subprime loans.
  • Let us also say that it takes more effort to
    originate a subprime loan than a prime loan.

  • Retailers will want to avoid subprime loans,
    because capital is expensive, and because they
    will want to avoid costs associated with subprime
  • Brokers, on the other hand, will want to take on
    subprime loans, because if the loan fails, the
    broker suffers no costs. Consequently, from the
    standpoint of the broker, the distribution of
    profits is truncated at zero, and so the expected
    profit from subprime loans is greater than prime
  • Because the broker must engage in effort to
    originate the loan, it prefers loans whose
    realizations will be more profitable to it, and
    consequently will originate only subprime

Why did raters screw up?
  • The rating agencies may well have predicted
    performance poorly because their empirically
    based models of subprime loans did not predict
    substantial losses.
  • This was understandable considering that nominal
    house prices throughout the United States rose
    from the middle-1990s through the year 2004.
    Under these house prices conditions, borrowers
    that got into financial trouble had strong
    incentives to sell their house (and therefore
    keep some equity) rather than default. This may
    have led analysts to believe that a large portion
    of the credit risk in subprime securities was
    idiosyncratic, and hence diversifiable.

  • One of the great mysteries of the subprime crisis
    is why investors failed to understand the risk
    they were taking on when they bought securities
    backed by subprime mortgages.
  • Green speculates that investors were lulled into
    a false sense of security by the boom period for
    the housing market that lasted from around 1993
    (when markets on the East Coast and California
    pretty much hit bottom) to 2005. A similar
    malfunction in financial markets took place in
    1993, when after a remarkably extended worldwide
    bond market rally, rising interest rates caused
    leveraged investors with positions in
    long-duration fixed income securities to
    experience large losses.

Investors (2)
  • Another contributing factor is the structure of
    fund manager compensation. Hedge fund managers
    tend to be compensated by the 220 rule they
    get 2 of the value of the fund they are
    managing, and 20 of any yield the fund earns
    above a designated index. This compensation
    scheme is like an option the payoffs are
    asymmetric. If the fund does better than the
    index, the manager gains a lot if it does worse,
    the manager in the short run is no worse off than
    if the index matches the market (although in the
    longer run, underperforming funds will lose
  • A third possibility is that subprime based
    (collateralized debt obligations) CDOs were
    sufficiently complex to analyze that investors
    relied heavily on ratings agency risk
    assessments, and consequently higher rated
    tranches commanded a liquidity premium many
    investors face ratings-driven restrictions on
    investments that result in highly rated tranches
    benefiting from greater liquidity. At the same
    time, CDOs were not very transparent, and many
    investors, it seems, relied solely on rating
    agencies to properly evaluate risk.

Proposed Changes in Policy
  • (1) It should make sure that more parties in the
    lending chain have skin in the game. While
    reputational risk mitigates against bad behavior,
    there is not a substitute for financial
  • (2) It should make sure that parties in the
    lending chain are subject to federal supervision.
    This will both reduce regulatory arbitrage and
    investor monitoring costs, facilitating the flow
    of capital into this sector
  • (3) It should do what it can to improve
    disclosures throughout the lending chain.
    Borrowers must be better informed as to the
    consequences of their lending choices (although
    this will be difficult) ratings must be more
    consistent, and securities must be more