The Subprime Mortgage Crisis

1
The Subprime Mortgage Crisis

• . More than 20 of subprime loans originated in
  2005 and 2006 are seriously delinquent
• 13 of the loans originated in 2007 are
  delinquent.
• One result has been a sharp contraction in credit
  for mortgage borrowers, down 38 from the fourth
  quarter of 2006 and down 90 for subprime
  borrowers.
• The number of vacant homes listed for sale, 2.2
  Million was up 39 from a year earlier.
• Home prices have fallen by 12.5 since their
  high in July 2006.
• Projections by Fitch Rating Agency are that 43
  of recent subprime loans will be lost to
  foreclosure.
• It is estimated that 2 million people could lose
  their homes,.
• It is also estimated that 14 million households
  will have negative equity

2
Causes of the Subprime Crisis

• One of the major factors contributing to the
  crisis was the fact that interest rates were
  below 3 continuously from September 2001 to May
  2005 having been below 3 for only 5 months of
  the previous decade.
• moral hazard of originator zip codes where
  there was much demand in the nineties showed the
  growth in subprime and the large distribution
  immediately after origination
• Demand for A rated paper by institutional
  investors

3
. 70 of the loans originated by New Century
had low initial teaser rates.

• More than 40 of the loans were underwritten on a
  stated income basis. These are so called liar
  loans because there is no need to verify claimed
  income.
• Another common loan product which offered a
  high degree of risk was so called 80-20 loans
  which are involved two separate loans to do the
  same transaction a first lien of 80 and a
  second lien of 20 resulting in a combined
  finance of 100 of the value of the property.
• New Centurys Chief Credit Officer noted in 2004
  that New Century had no standards for loan
  quality.
• Instead of whether borrowers could meet their
  obligations under the loans, the predominant
  standard was whether the loan could be sold or
  repackaged in the secondary market

4
New Century did not account for loans that needed
to be repurchased

• by ignoring the backlog from older loans and
  interest which needed to be paid to investors.
• understated the repurchase reserves by more than
  104 Million dollars in the third quarter of 2006.
  
• Several interviewees claimed that KPMG actually
  suggested the changes to the repurchase reserve
• classic problems in corporate governance
  including a dysfunctional board, an audit
  committee which failed to focus on issues, a lack
  of internal controls and a flawed internal audit
  function

5
CDOs are resecuritizations

• Like RMBS Collateralized Debt Obligations have
  tranches thus theres double securitization
• Internal interest rate spread external credit
  enhancement for Senior Tranches as well as junior
  tranche subordination
• Many other derivatives used at all levels
  including swap to fixed rate for ARMs.
• SIVs are off balance sheet but reputational risk
• ABS CDOs used derivatives to take on more BBB
  tranches than actually existed

6
Credit rating agencies are to blame

• 1 Rating agencies appear to have seriously
  underestimated that amount that needed to be
  placed in junior tranches in order to secure
  senior tranches.
• 2 The disparity in default between structured
  finance ratings and firm specific ratings has
  been as great as 10 to 1.
• 3 Of more than 198 tranches (parts of CDOs)
  downgraded between October and early December
  2007, the median downgrade was seven notches and
  30 were downgraded 10 notches
• 4 whereas on the entire Moodys data base of
  corporate bonds since 1970, no Aaa bond was
  downgraded more than six notches to A in a single
  step.

7
Moodys earnings rose 375 over the last six years

• net income rose from 159 Million in 2000 to
  425 Million in 2004
• Structured Finance accounted for 43 of Moodys
  earnings whereas a few years ago it had been in
  the single digits
• Approximately, 90 of fees are paid for by the
  issuer 2006

8
CRA Problems

• CRAs are immune from liability as the publishers
  of financial information
• Since rating agencies are paid to issue a
  rating, they have a weak incentive to update that
  rating.
• Did not downgrade until 07 but aware of problem
  in 06
• Underwriters can forum shop
• The CRA is relying on the statements of mortgage
  originators and underwriters. Due diligence
  should be for CRA
• Forum Shopping

9
14 Million Homes have negative equity

• Different from other recessions
• Foreclosure can cost from 20 to 50
• Servicers have incentive to modify mortgages
• The Pooling and Service agreements generally give
  servicers the right to modify contracts if such
  modifications are in the interests of the lenders
  
• Servicers should look to the interest of the
  bondholders as an aggregate

10
Second liens mean the first might not be
underwater

• Widespread foreclosure is a game of musical
  chairs
• But lower prices mean some rewarded for not
  biting off more than they can chew
• FHA Secure provides some FHA refinancing
• Hope Now relates only to 08 and 09 resets not in
  default

11
Federal Reserve Board announced changes to Reg Z
(truth in lending)

• Creditors would be prohibited from engaging in a
  pattern or practice of lending without
  considering borrowers ability to repay.
• Creditors would be required to verify the income
  and assets they rely upon in making a loan
• Prepayment penalties would be allowed only in
  certain circumstance No prepayment penalties
  for sixty days before a possible payment increase
• Creditors would have to establish escrow accounts
  for taxes and insurance

12
Treasury Blueprint and new Legislation for Anti
Predatory Lending

• Treasury blueprint calls for federal mortgage
  originator regulator
• Legislation would require ability to repay,
  borrowers benefit financially no steering
• And holder in Due Course rule modified making
  Wall Street firms liable in some circumstances

13
Housing Stablization Bill 300 Billion in New FHA
Guarantees

• 35 debt to income ratio to prevent gaming
• 3 loan loss reserve for FHA
• 2 closing costs
• Bring LTV ratio to 90 of appraised value. Thus
  85 paid to lender
• Government to share profits greater of 3 or
  100 of profit in year 1 going down to 20 in
  year 5, 0 thereafter

14
Housing Stablization Bill

• Eligibility restricted to owner occuped
• Senior loan must originate before 2007
• Extinguishes all prior loans but doesnt deal
  with problem of junior liens
• Assesses lender compliance and rates of
  delinquency
• Bulk sale or auction process to be studied
• Additional bill 15 Billion dollars in
  Neighborhood Stablization

15
Other Proposals

• Keep the risk of redefault with the
  securitization trust Schemes to penalize lender
  if redefault or delinquency
• FDICs Shiela Bair proposed Gov. to pay down 20
  of principal which is amortized after five years
  and paid back. Lender to pay interest on 20 for
  five years
• This proposal goes to ability to pay rather than
  negative equity
• GSEs should raise new capital and have new
  regulator

16
Additional Bills

• Bill to amend bankruptcy code to allow cram down
  of amount owed on principal residence.
• Bill to define servicers duties to make it
  easier for servicers to modify mortgages
• Both intended to overcome three obstacles to
  servicer modification tranche warfare, servicers
  overwhelmed piggy back junior liens

17
Loan Modifications as of January

• Seven out of ten mortgages not in any workout
  plan
• 2/3 of loan modifications not completed in the
  following month
• Number of delinquent loans stacking up from 21
  to 28
• Only 4 of loans that reset in January February
  received loan modifications of more than five
  years although more of those in negotiation have
  permanent modification

18
Bear Stearns Bailout and Financial Fall out

• 29 Billion in guarantee of Bear assets JP Morgan
  assumes a billion in liability
• Investment Banks now perform functions of banks
  Treasury Blueprint would give Fed access to books
  and records in crisis not enough for democrats
• Require investment banks to hold more capital. 10
  to 1 rather than 33 to 1 like Bear Stearns (Alan
  Blinder)

19
Investment banks under Fed Umbrella

• Investment banks have access to discount window
• Term lending facilities accepts RMBS as
  collateral
• Strengthen capital requirements for investment
  banks from 33 to 1 (Bear Stearns) to about 12 to
  1 (Alan Blinder )

20
Financial Stability Forum International Basel
Committee

• raise Basel II capital requirements for certain
  structured financial instruments
• Introduce additional capital requirements for
  default and event risk in trading books of banks
  and securities firms
• Strengthen the capital treatment of liquidity
  facilities to off balance sheet entities
• capital requirements for highly rated tranches of
  CDOs of ABS

21
FSF Continued

• VAR models not sensitive to asset class
• Reputational Risk to be Considered Require
  banks to hold capital for off balance sheet SIVs
  (Alan Blinder)
• Reconsider role of CRA in internal as well as
  ratings based approach
• Central Bank Cooperation Liquidity plan across
  border Swap Agreements plan to deal with weak
  banks