The Perfect Storm

1
The Perfect Storm

• What Went Wrong In the Sub-Prime Mortgage Market?
• Professor Jerome E. Hass
• Johnson Graduate School of Management
• Cornell University
• November 2008

2
Financing a Home Purchase In The Good Old Days
Bank Regulators
Conventional Mortgage Loan
Deposits
Home Buyer
Banks
Source Bank Depositors
Appraisers
Loan Secured by Property Appraiser hired by bank
Banks Hold Loans as Assets
Depositors hold checking and time deposits at
banks
Post Depression but Pre-1938
Who Assesses Controls Credit Worthiness?
3
FHA Fannie Mae Established to Expand the
Availability of Home Financing
Bank Regulators
FHA/VA Guarantee
Fannie Mae
FHA/VA Loans
Bonds
FHA/VA Mortgage Loan
Home Buyers
Banks
Source Bank Depositors Insurance Companies
Deposits
Conventional Mortgage Loan
Appraiser
Banks Hold Some FHA/VA and All Conventional
Loans Earn Servicing Fees from Fannie Mae
FM Bonds are Mortgage-Backed Securities (MBS)
Loan Secured by Property Appraiser hired by
bank FHA/VA adopt credit-worthiness standards
Fannie Mae Buys Holds Portfolio of FHA/VA
Mortgages
1938
Who Assesses Controls Credit Worthiness?
4
FHA/VA Guarantees

• FHA (late 1930s) and VA (1944) guarantee mortgage
  payments
• Impose set of constraints to minimize risk of
  default
• Loan/Value Ratio (generally lt 80)
• Financial Integrity of Borrower
• Credit History
• Employment Record
• Debt Burden Relative to Income and Assets
• Owner-Occupied
• Loans that meet the standard are conforming
  loans

5
Fannie Mae

• Federal National Mortgage Association
• Federal Agency
• Buys FHA/VA mortgage loans from the banks
• Issues bonds, guaranteed by the Federal
  government, that are purchased by savers
• Banks originated the mortgage loans (for a fee)
  and serviced the loans (for a fee)

6
Fannie Mae, Freddie Mac and Participation
Certificates Established to Further Expand the
Supply of Credit for Home Purchases
Bank Regulators
Ginnie Mae
FHA/VA Guarantee
Bonds
Fannie Mae
Freddie Mac
FHA/VA Loans
Bonds PTCs
Conventional Loans
FHA/VA Mortgage Loan
Home Buyers
Source Bank Depositors, Insurance Companies,
Mutual Funds
Banks
Deposits
Conventional Mortgage Loan
Appraisers
Ginnie Mae holds a portfolio of FHA/VA Loans
Fannie Mae and Freddie Mac hold portfolios of
Conventional Qualifying Mortgages Fannie Mae
Freddie Mac issue bonds and Pass-Through
Certificates (PTCs)
Loan Secured by Property Appraiser hired by bank
Banks hold some FHA/VA and some Conventional
Loans Earn Servicing Fees from loans sold to the
government agencies
Bond payments are linked to general mortgage
pool Participation Certificates payments are
tied to separate portfolio of mortgages
1968
Who Assesses Controls Credit Worthiness?
7
Two Maes, One Mac and PTCs

• Freddie Mac and Fannie Mae are both private,
  government-sponsored companies. Their stocks are
  publicly held. Banks can now broker (rather than
  hold) conventional mortgages, selling mortgage
  loans to Fannie Mae and Freddie Mac.
• Fannie Mae and Freddie Mac issue bonds against
  their mortgage pool and package Pass-Through
  Certificates.
• Pass-through certificates (PTCs) allow investors
  to purchase ownership of a specific portfolio of
  mortgages (rather than general claims against the
  company that holds mortgages as assets). All
  investors share pro-rata the cash flows from the
  specific portfolio. Most notably, they share
  prepayment and default risk (if not FHA/VA
  insured).

8
First Boston Introduces the Collateralized
Mortgage Obligation (Extension of the
Pass-Through Certificates)
Ginnie Mae
Bank Regulators
FHA/VA Guarantee
Fannie Mae
Bonds PTCs
Freddie Mac
FHA/VA Loans
Conventional Loans
Rating Agency
FHA/VA
Home Buyers Owners
Array of Domestic Investors
Banks
Deposits
Brokers
Conventional
Collateralized Mortgage Obligation
Tranches
Conventional Loans
Appraiser
Bonds and tranches are Mortgage-Backed Securities
(MBS) PTCs are participation certificates Tranches
are structured cash flows from loan payments
Banks Hold Some FHA/VA and Conventional Loans
Earn Servicing Fees from Fannie Mae, Freddie Mac
and CMOs
CMOs are legal entities that hold mortgages and
PTCs and issue tranches Tranches restructure cash
flows from loans Sponsor gets interest rate
spread does due diligence on loans purchased
Ginnie Mae holds portfolio of FHA/VA
mortgages Fannie Mae Freddie Mac hold
portfolios of conventional mortgages and issue
bonds and PTCs
Brokers Paid Origination Fee Broker could be a
bank Broker or bank hires appraiser
Mortgage and Home Equity Loans
1983
Who Assesses Controls Credit Worthiness?
9
Brokers CMOs

• A Mortgage Loan Broker works with borrowers,
  makes the commitment to lend, makes loans
  (financed with usually short-term borrowed funds)
  and then sells packages of mortgages to banks
  and/or CMOs.
• A Collateralized Mortgage Obligation (CMO) is the
  legal owner of a set of pass-through certificates
  or mortgages (collectively the pool) that is
  financed by selling tranches (French word for
  slice) to investors, who receive payments
  according to a set of rules (the structure). The
  mortgages are the collateral.
• The structure can shift the payments of interest
  and principal across tranches to create
  securities with differing risk/return attributes
• Who gets paid first
• Principal versus interest cash flows
• Relative to some preset pattern
• The CMO sponsors (investment bankers, commercial
  banks) effectively earn the spread between cash
  flows received as owner of the mortgages or
  pass-through certificates and the cash flows
  required to service the tranches (value of the
  tranches less the cost of the mortgages in the
  pool)

10
Very Simple CMO Sequential Pay
All tranches receive contracted interest on
principal principal payments are made
sequentially
Which tranche bears the greatest risk of default
or prepayment? How will the tranches be rated
even if the overall set of mortgages are risky?
11
Credit Rating Agencies

• Majors SP, Moodys, Fitch
• Provide fee-based consulting service to CMOs
  help design the structure that will support
  target credit rating
• Fee Income for Rating Mortgage-Backed Securities
  issued by Fannie Mae, Freddie Mac and CMOs

12
Private Insurers Pile In -- Enticing Even Risk
Averting Investors
Ginnie Mae
Bank Regulators
FHA/VA Guarantee
Fannie Mae
Bonds PTCs
Freddie Mac
FHA/VA Loans
Conventional Loans
Rating Agency
FHA/VA
Home Owners
Large Array of Domestic Internatl Investors
Banks
Deposits
Brokers
Conventional
Conventional Loans
Tranches
CMOs
Appraiser
CMOs are legal entities that hold mortgages and
PTCs and issue tranches Tranches restructure cash
flows from loans Sponsors get interest rate
spread and does due diligence
Bonds, tranches and SIV loans and equity are MBSs
PTCs are participation certificates Tranches are
structured cash flows from loan payments
Loan Secured by Property
Banks Hold Some FHA/VA and Conventional Loans
Earn Servicing Fees from Fannie Mae, Freddie Mac
and CMOs
Ginnie Mae holds portfolio of FHA/VA
Mortgages Fannie Mae Freddie Mac hold
portfolios of Conventional Mortgages and issue
bonds and Pass-Through Certificates
Private Insurers
Brokers Paid Origination Fee Broker could be a
bank Broker or bank hires appraiser
Private Insurers guarantee bond or structured
cash flows for premium
Who Assesses Controls Credit Worthiness?
1990s
13
Private MBS Insurers

• Major Players MBIA, Ambac Financial Group,
  Financial Guarantee Insurance, Financial Security
  Assurance
• Started out as guarantors of municipal bonds
• Saw profit opportunity in providing guarantees to
  mortgage-backed securities issued by Freddie Mac
  and CMOs
• Misjudged the reserves required (Texas in
  mid-1980s was not worst case limited
  subprimes)

14
The Derivative of a Derivative The Structured
Investment Vehicle
Ginnie Mae
Bank Regulators
FHA/VA Guarantee
Fannie Mae
Bonds PTCs
Freddie Mac
FHA/VA Loans
Conventional Loans
Rating Agency
FHA/VA
Home Buyer
Investors
Banks
Deposits
Brokers
Conventional
Conventional Loans
Short-term debt equity
Tranches
CMOs
SIVs
Appraiser
CMOs are legal entities that hold mortgages and
PTCs and issue tranches Tranches restructure cash
flows from loans Sponsors get interest rate
spread and does due diligence
Bonds, tranches and SIV loans and equity are MBSs
PTCs are participation certificates Tranches are
structured cash flows from loan payments
Loan Secured by Property
Banks Hold Some FHA/VA and Conventional Loans
Earn Servicing Fees from Fannie Mae, Freddie Mac
and CMOs
Ginnie Mae holds portfolio of FHA/VA
Mortgages Fannie Mae Freddie Mac hold
portfolios of Conventional Mortgages and issue
bonds and Pass-Through Certificates
Private Insurers
Brokers Paid Origination Fee Broker could be a
bank Broker or bank hires appraiser
Structured Investment Vehicles hold MBSs using
short-term debt and investor equity Private Ins
guarantees cash flows
Who Assesses Controls Credit Worthiness?
Early 2000s
15
Structured Investment Vehicle

• Purchases and holds mortgaged-backed securities
• Finances the purchases with short-term debt and
  equity (highly leveraged)
• Sponsoring bank or investment banker does not
  guarantee short-term debt but has moral
  commitment to support it (off balance sheet
  debt) sponsor holds most of equity (97) and the
  spread generates high return on equity (plus mgmt
  fees)
• Example
• 100 of Tranche 3 is expected to earn 10
• 90 Short-term debt costs 7
• Expected Return on Equity
• (100 x 10) (90 x 7)/(100-90)
• 3.7/10 37

16
Now Add Mortgages for the Financially-Challenged
Home Buyer

• Sub-Prime Mortgages
• ALT-A Mortgages
• Option ARMS

17
What is a Subprime Mortgage?

• Borrower has credit score less than 620 FICO
  (Fair Isaac Corporation) score
• Habitually late paying bills
• Numerous credit inquiries
• Irregular employment history
• Debt outstanding relative to assets
• High loan/value ratio (gt80)
• Higher interest rate than prime loans
• More likely to have prepayment penalty
• Often linked with high fees (closing costs)
• Can be second (home equity) mortgage in an
  80/10/10 or 80/15/5 structure (first/second/down)

18
What is an Alt-A Mortgage?

• A mortgage for which the borrower has not
  provided adequate documentation regarding income
  or other measures of ability to make the mortgage
  payments

19
Adjustable Rate Mortgages

• ARMs have been around for a long time
• initial rate is set for, say, five years
• reset each five years using a formula expressed
  usually in basis points over some market rate
  (such as 5-year Treasury bond rate)
• Example Reset Rate Treasury 250bp
• Treasury 4.5 ? Rate 7
• There is often a cap on the increase and the rate

20
The Option ARM

• During the initial period (say 3 years), the
  monthly payments are set below the contractual
  interest rate, with the shortfall being added
  monthly to the mortgage principal balance
• After the initial period, the mortgage payments
  reset, to either a conventional ARM or a fixed
  rate mortgage but the monthly rates are based
  on the mortgage principal balance at the end of
  the initial period
• The increase in the monthly payments can be
  staggering

21
So What Happened?

• Starting in 2001 ..

22
The Recession of 2001


23
SP500 Takes Nose-Dive in 2001-02

• Federal Reserve Sets Out to Stimulate Economy
  Without Fueling Inflation

24
Federal Reserve Responds Cuts Interest Rates

• Short-Term Rates drop to less than 2!
• FED increases rates starting in 2004 as it begins
  to worry about inflation
• FED cuts rates in mid-2007 as economic growth
  begins to be threatened

25
Long-Term Interest Rates Drop
26
Mortgage Rates Declined
27
Secondary Demand Drivers for Residential Housing
Added More Fuel to the Fire

• Luxury Fever ala Bob Frank Improve our position
  in life (keeping up with the Jones or aspiring to
  be among the top)
• Bigger House
• Fancier Appliances and Décor
• Better Neighborhood
• Better Schools
• Wealth Effect of Rising Stock Market and Home
  Prices
• Second Homes for Retirees (Baby Boomers)
• Ability to deduct interest on first and second
  home mortgages

28
How Do Investors React to Low Interest Rate
Environment?

• Dont Like It Seek Additional Returns
• Willing to take higher risks to get higher
  expected return -- Risk Premiums Shrink
• Institutional investors (including foreign banks)
  are attracted to lower quality CMO tranches of
  CMOs made up of sub-prime mortgages to earn
  higher rates of return
• Investment banks create SIVs to generate fees
  equity income
• CREDIT FOR HOME LOANS (AND CREDIT CARDS) IS
  AVAILABLE TO ALMOST EVERYONE!!!!

29
Subprime Mortgages and Option ARMs Became
Increasingly Popular

• Pressure from Whitehouse and Congress beginning
  in late 1990s to make home loans to relatively
  disadvantaged persons
• Low income
• Habitually late payment record
• Unstable employment history
• Minimal down-payment capability
• High ratio of existing debt to income and wealth
• Mortgage Bankers Association Survey (2H04-1H05)
• Ordinary ARMS fell from 46 to 46
• Option ARMs increased from 17 to 23
• Alt-A mortgages increased from 8 to 11

30
Sub-Prime Loans Fueled the Housing Market

• At the end of 2003, outstanding sub-prime
  mortgages totaled 322 Billion, less than 3 of
  all mortgages outstanding
• In 2006, most of the mortgage loans made were
  sub-prime and almost all were securitized (bought
  by CMOs and Freddie/Fannie)
• By the end of the 3rd quarter of 2007,
  outstanding sub-prime mortgages totaled 1.3
  Trillion, more than 10 of all mortgages
  outstanding and a much larger percentage of loans
  packaged in CMO structures

31
Demand Supply React The Price of Houses
Increased
32
New Housing Starts Increased
33
Then What Happened?
34
Then The Bubble Burst!
35
National Average House Price Data Does Not Tell
The Story
36
What Happened in 2006-08?

• As the housing prices first failed to increase,
  option ARMS began to default on reset
• As housing prices began to decline, loan/value
  ratios increased, in some instances to greater
  than 100 and occupants or owners began to
  default
• In 2006, default rates increased significantly
• Investors begins to realize that a large
  percentage of sub-prime loans made in 2005-06
  will default in 2008-09 if housing prices
  continue to fall
• Given the high cost of foreclosure (legal and
  abandonment effects), net collateral value of
  highly leveraged loans is expected to become
  increasingly negative

37
What Happened in 2007?

• Default experience and expectations drive market
  values of lower quality (higher risk) CMO
  tranches downward -- thin markets make it
  difficult to get firm price quotes
• Some CMO (institutional) investors start to panic
  and sell, driving prices down significantly
  (perhaps more than underlying values warrant)
• SIVs sponsors find their equity base evaporating
  first try to inject new equity into their sinking
  entities and then abandon ship (liquidate
  putting further pressure on prices of low quality
  CMO tranches)
• Lenders to SIVs withdraw ASAP lenders to other
  risky borrowers (e.g., leveraged buyouts) follow
  suit (when in doubt, hunker down!)

38
What Happened in 2007?

• Demand for new housing slumps
• Speculative real estate developers and builders
  cannot sell units coming into market some
  consumers who have committed to purchase units
  back out some developers/builders default on
  their loans
• Building supply companies suffer a decline in
  demand for their goods
• MBS insurance companies suffer losses and
  financial distress (forcing them to seek
  additional financing at the expense of existing
  shareholders)

39
Who Is To Blame for This Mess?

• 1 Credit Rating Agencies
• Conflict of Interest
• Agency paid to consult re structures and provide
  ratings
• Good ratings promote more business because
  institutional investors subject to regulation
  (insurance companies, banks, pension funds,
  trusts) need investment grade ratings to hold
  securities
• What does a rating mean? (Moodys Baa Default
  Rates 1993-2005)
• Corporate Bonds 2.2
• CMOs 24
• Failed to predict (model failure)
• full impact falling home prices on sub-prime
  defaults
• full impact of foreclosures on realized values
• full impact of expected defaults and foreclosures
  on market value of highly illiquid CMO securities

40
Who Is To Blame for This Mess?

• 2 Unregulated (self-regulated?) investment
  bankers
• Who created CMOs and then purchased some of the
  lowest tranches, using borrowed funds to finance
  their purchases
• Who made risky real estate loans using borrowed
  funds
• Who created the heavily levered SIVs

41
Who Is To Blame for This Mess?

• 3 Mortgage Brokers
• Incentive make loans that can be sold to CMOs
  without regard to customers ability to pay
• Push Teaser ARMs (with prepayment penalty) that
  pay much higher Yield Spread Premium to broker
  from lender
• 4 Appraisers
• Discovered that relatively high appraisals lead
  to additional appraisal assignments
• Early scam was to get borrower to sign ARM
  (that paid broker, say, 4 of loan as YSP) and
  then have borrower refinance at lower rate, with
  broker and borrower sharing the super YSP ?
  prepay penalty.

42
Who Is To Blame For This Mess?

• 5 Investors including many financial
  institutions
• Failed to do their own due diligence
• Bought products they did not understand
• Chose to take risky positions in order to get a
  slightly higher expected rate of return
• Used leverage to finance purchase of CMOs in
  order to enhance the return on their investment
  and then had to sell CMOs into a depressed market
  when their debt supply started to dry up

43
Why Is This Called A Subprime Crisis?

• 90 of subprime mortgages made in 2004-06 had
  exploding resets (started with teaser rates)
• 14.4 Outstanding were in default at end of 2007,
  with default rates increasing as housing values
  fall
• More than 20 of subprime mortgages made in
  2005-06 are expected to default in 2008
• Recovery rates in foreclosure are at all-time
  lows, nearing 50
• 70 of subprime mortgages have prepayment penalty
  so even if you can refinance, .

44
What is the Fall-Out?

• Mortgages are going into default
• While some are being renegotiated, others are put
  into foreclosure
• The value of CMO tranches are very difficult to
  ascertain
• Requirements that holders of CMO tranches value
  their holdings at market means they are
  recording losses and are forced to sell at very
  low prices

45
Housing Prices Have Dropped Dramatically
NationalCity Bank, Housing Prices in America, 2Q,
2008
46
How Much Overpricing Remains?
NationalCity Bank, Housing Prices in America, 2Q
2008
47
Housing Prices 2006 vs 2008
NationalCity Bank, Housing Valuation Analysis 2Q
2006 (?) vs 2Q 2008
48
But

• The primary driver behind the value of housing is
  income and where is that going?
• The secondary driver behind the value of housing
  is credit availability and cost where is that
  going?
• Have housing prices hit bottom?
• When will housing construction pick up?

49
Mortgage Banking Assoc Forecast, Nov 08
50
What Have We Learned (Again)? There is No Free
Lunch in the Financial Markets
51
Lets Hope We Are On The Road To Recovery!
52
Teaser and Exploding Rate ARMs
Appraised Value 500K Loan/Value Ratio 90 Mortgage 450K Terms 360 months Interest Rate 10 Monthly Payment 3,949 Teaser Rate 4 Monthly Payment 1,500 Reset 5 years Reset to Conventional 30 yr Loan Balance EOY 5 582K Monthly Payment 5,107
After 5 Years Better employment record Higher Take-Home pay Lower Loan/Value Ratio If House Price ? 8 At end of 5 years House 688K Loan/Value Ratio 85 Equity in home 106K
53
What If Housing Prices Increase at only 2?
Appraised Value 500K Loan/Value Ratio 90 Mortgage 450K Terms 360 months Interest Rate 10 Monthly Payment 3,949 Teaser Rate 4 Monthly Payment 1,500 Reset 5 years Reset to Conventional 30 yr Loan Balance EOY 5 582K Monthly Payment 5,107
After 5 Years Better employment record Higher Take-Home pay Higher Loan/Value Ratio If House Price ? 2 At end of 5 years House 552K Loan/Value Ratio 105 Equity in home -30K
About 10 of outstanding ARMS at end of 2007 are
Teasers 1.8 million ARMS (450 billion) reset in
2008