Housing Bubbles, Mortgage Crisis, and Credit Crunches

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Housing Bubbles, Mortgage Crisis, and Credit
Crunches
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Primary Mortgage Market

• In a traditional loan, a bank or another lender
  might lend money to an individual to buy a home
  out of the funds deposited with that bank or
  lender. The bank or lender would charge interest
  and accept monthly payments on the loan until the
  loan was repaid after 30 years.
• The credit risk (default risk) is entirely born
  by the local bank.
• Advantage little moral hazard since banks have
  strong incentives not to make bad loans.
• Disadvantages small markets may not have enough
  liquidity. Borrowing may shut down if local banks
  are in trouble. Local banks hold an undiversified
  portfolio and are thus exposed to more risk.

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Fannie Mae and Freddie Mac

• The Federal National Mortgage Association (FNMA),
  commonly known as Fannie Mae, is a publicly owned
  government sponsored enterprise (GSE).
• It is a stockholder-owned corporation authorized
  to make loans and loan guarantees.
• Fannie Mae was founded as a government agency in
  1938 as part of Franklin Delano Roosevelt's New
  Deal to provide liquidity to the mortgage market.
  For the next 30 years,
• The Federal Home Loan Mortgage Corporation
  (FHLMC) , commonly known as Freddie Mac, was
  created in 1970 to expand the secondary market
  for mortgages and create competition
• Fannie Mae is the leading participant in the U.S.
  secondary mortgage market, which serves to
  provide liquidity to the to ensure that mortgage
  companies, savings and loans, commercial banks,
  credit unions, and state and local housing
  finance agencies have enough funds to lend to
  home buyers.

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Secondary Market

• By buying mortgages and repackaging the loans for
  resale via mortgage-backed securities, or by
  owning mortgages outright, Fannie Mae and Freddie
  Mac, provide banks and other financial
  institutions with fresh money to make new loans.
• Investors can buy and hold a diversified
  portfolio of mortgage backed securities.
• This gives the United States housing and credit
  markets flexibility and liquidity.
• Later, Fannie Mae expanded to also buy mortgage
  bonds or loans outright using borrowed money, and
  made money based on the difference between
  interest it receives from the bonds and what it
  has to pay on its borrowings.

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MBS and CDOs

• Owing to a form of financial engineering called
  securitization, many mortgage lenders have passed
  the rights to the mortgage payments and related
  credit/default risk to third-party investors via
  mortgage-backed securities (MBS) and
  collateralized debt obligations (CDO).
• Corporate, individual and institutional investors
  holding MBS or CDO face significant losses, as
  the value of the underlying mortgage assets
  declined.

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Asset Price Risk

• Asset price risk MBS and CDO asset valuation is
  complex and related fair value accounting is
  subject to wide interpretation.
• The valuation is derived from both the
  collectibility of subprime mortgage payments and
  the existence of a viable market into which these
  assets can be sold, which are interrelated.
• Rising mortgage delinquency rates have reduced
  demand for such assets. Banks and institutional
  investors have recognized substantial losses as
  they revalue their MBS downward.
• Several companies that borrowed money using MBS
  or CDO assets as collateral have faced margin
  calls, as lenders executed their contractual
  rights to get their money back.

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Mortgage Insurance

• Even though many investors might purchase bonds
  that are based on multiple mortgages, betting
  that only very few of them would have any
  problems, the US government sought to increase
  demand for these bonds (and therefore supply of
  mortgages, and therefore, lower mortgage interest
  rates) by creating Fannie Mae to guarantee the
  bonds.
• What Fannie Mae does is essentially makes any
  missed payments to the bondholder that the
  borrower misses, and also makes up for any loss
  for the loan not being fully repaid either by the
  borrower or from the sale of the house, and skims
  a certain percentage of the payment each month
  and holds the funds in reserve as insurance
  against these scenarios.
• Therefore investors believe they have no risk
  unless Fannie Mae itself becomes bankrupt. This
  process is essentially similar to what is known
  as bond insurance and is also used very often in
  State and City municipal bonds.

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Problems

• GSEs hold a large fraction of the undiversified
  risk in the housing market. The other fraction is
  held by international investors.
• Local banks have fewer incentives to screen
  mortgage applicants since they no longer bear the
  risk, they just make commissions from selling
  mortgages.
• Investors have little knowledge about the exact
  type of mortgages that they are holding. As a
  consequence they have a hard time evaluating the
  risk associated with the investments,
• Credit Rating Agencies may not be of much help
  and may provide bad incentives if they
  misclassify investments.

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Market for Derivatives

• FNMA is a financial corporation which uses
  derivatives to "hedge" its cash flow.
• Derivative products it uses include interest rate
  swaps and options to enter interest rate swaps.
• These markets are the domains of U.S. investment
  banks as well as other large international.
• Globalization of credit market risk.
• Securitization often utilizes a special purpose
  vehicle (SPV), alternatively known as a special
  purpose entity (SPE) or special purpose company
  (SPC), in order to reduce the risk of bankruptcy
  and thereby obtain lower interest rates from
  potential lenders.

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Housing Bubbles

• Housing bubbles may occur in local or global real
  estate markets. They are typically characterized,
  in their late stages, by rapid increases in the
  valuations of real property until unsustainable
  levels are reached relative to incomes,
  price-to-rent ratios, and other economic
  indicators of affordability.
• This may be followed by decreases in home prices
  that can result in many owners holding negative
  equity a mortgage debt higher than the value of
  the property.
• The underlying causes of the housing bubble are
  complex factors include historically-low
  interest rates, lax lending standards, and a
  speculative fever

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The Recent Bubble

• The United States housing bubble is an economic
  bubble in many parts of the U.S. housing market
  including areas of California, Florida, New York,
  Michigan, the Northeast Corridor, and the
  Southwest markets.
• On a national level, housing prices peaked in
  early 2005, began declining in 2006 and have not
  yet bottomed. Increased foreclosure rates in
  20062007 by U.S.
• Home prices declined as increasing foreclosures
  added to the already large inventory of homes and
  stricter lending standards made it more and more
  difficult for borrowers to get mortgages.

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High Risk Loans

• A variety of factors have caused lenders to offer
  an increasing array of higher-risk loans to
  higher-risk borrowers. These high risk loans
  included the "No Income, No Job and no Assets"
  loans, sometimes referred to as Ninja loans.
• The share of subprime mortgages to total
  originations was 5 (35 billion) in 1994, 9 in
  1996, 13 (160 billion) in 1999, and 20 (600
  billion) in 2006.
• The average difference in mortgage interest rates
  between subprime and prime mortgages (the
  "subprime markup" or "risk premium") declined
  from 2.8 percentage points (280 basis points) in
  2001, to 1.3 percentage points in 2007.

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Creative Mortgages

• One example is the interest-only adjustable-rate
  mortgage (ARM), which allows the homeowner to pay
  just the interest (not principal) during an
  initial period.
• Another example is a "payment option" loan, in
  which the homeowner can pay a variable amount,
  but any interest not paid is added to the
  principal.
• An estimated one-third of ARM originated between
  20042006 had "teaser" rates below 4, which then
  increased significantly after some initial
  period, as much as doubling the monthly payment

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Subprime Mortgage Crisis

• In 2007, the subprime mortgage crisis began. An
  increasing number of borrowers, often with poor
  credit, that were defaulting on their mortgages
  caused a precipitous decrease in demand for any
  mortgage-backed securities (MBS) that weren't
  guaranteed by Fannie Mae or Freddie Mac.
• Foreclosures accelerated in the United States in
  late 2006. During 2007, nearly 1.3 million U.S.
  housing properties were subject to foreclosure
  activity, up 79 from 2006
• This depreciation in home prices led to growing
  losses for the GSEs as well as investment banks
  with large holdings of MBS.
• Fannie Mae and smaller Freddie Mac own or
  guarantee almost half of all home loans in the
  United States. They faced billions of dollars in
  potential losses, and may need to raise
  additional, potentially substantial, amounts of
  new capital as the current downturn in the U.S.
  housing market continues.

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Subprime Fallout

• In March 2007, the United States' subprime
  mortgage industry collapsed due to
  higher-than-expected home foreclosure rates, with
  more than 25 subprime lenders declaring
  bankruptcy
• The subprime mortgage market meltdown has
  resulted in large earnings reductions for large
  Wall Street investment banks trading in
  mortgage-backed securities, especially Bear
  Stearns, Lehman Brothers , Goldman Sachs, Merrill
  Lynch, and Morgan Stanley.
• The widespread dispersion of credit risk and the
  unclear effect on financial institutions caused
  reduced lending activity and increased spreads on
  higher interest rates. Similarly, the ability of
  corporations to obtain funds through the issuance
  of commercial paper was affected. This aspect of
  the crisis is consistent with a credit crunch.
• International banks have so far written of 435
  billion in debt.
• In March 2008, the Fed also provided funds and
  guarantees to enable bank J.P. Morgan Chase to
  purchase Bear Stearns.
• 15 September 2008, Lehman Brothers filed for
  Chapter 11. Merrill sold itself to Bank of
  America.

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Organizational Issues

• Principal-agent and moral hazard problems
• Compensation issues bonus give short term
  incentives, options give long term incentives.
• Risk management measuring the exposure to risk
  and implementing adequate strategies to limit the
  exposure.
• Oversight and Control

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Role of the Federal Government

• Fannie Mae receives no direct government funding
  or backing Fannie Mae securities carry no
  government guarantee of being repaid. This is
  explicitly stated in the law that authorizes
  GSEs, on the securities themselves, and in many
  public communications issued by Fannie Mae.
• Neither the certificates nor payments of
  principal and interest on the certificates are
  guaranteed by the United States government. The
  certificates do not constitute a debt or
  obligation of the United States or any of its
  agencies or instrumentalities other than Fannie
  Mae.
• There has been a wide belief that FNMA securities
  are backed by some sort of implied federal
  guarantee, and a majority of investors believed
  that the government would prevent a disastrous
  default.
• On September 7, 2008, Federal Housing Finance
  Agency (FHFA) director James B. Lockhart III
  announced he had put Fannie Mae and Freddie Mac
  under the conservatorship of the FHFA.

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The Role of the Federal Reserve

• Between 18 September 2007 and 30 April 2008, the
  target for the Federal funds rate was lowered
  from 5.25 to 2 and the discount rate was
  lowered from 5.75 to 2.25, through six separate
  actions.
• The most innovative response to the credit crisis
  has been the expansion of the Feds tool kit from
  control of short-term interest rates to the
  deployment of its balance-sheet to restore
  liquidity to specific markets, such as that for
  inter-bank loans.
• A year ago 91 of the Feds assets were invested
  in government bonds. Now the share is 52.