The Subprime Mortgage Industry: A reporter

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The Subprime Mortgage IndustryA reporters view

• Saskia ScholtesFinancial Times
• Saskia.Scholtes_at_ft.com
• [phone]

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The human side of the story

• Skewed incentives
• drive bad decisions

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The Actors

• Borrowers
• Lenders (originators their brokers)
• Securitization bankers
• Rating agencies
• Investors
• Policymakers regulators

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The Borrowers
INCENTIVES
Flexible mortgage products made it possible to stretch for the American Dream owning your own home. Speculation on rising house prices Keeping up with the Jones
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Borrowers made bad decisions

• Believing that rising house prices would bail
  them out, some overextended
• Some chose the low teaser rates of ARM loans,
  believing they could refinance before the rate
  reset
• Some inflated their incomes on low or no-doc loans

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But house prices can fall

• Source Office of Federal Housing Enterprise
  Oversight house price index

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The price losing your home

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The Lenders(originators their brokers)
INCENTIVES
Brokers paid with yield-spread premiums Higher origination volumes meant higher earnings Competition (aka Keeping up with the Jones)
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Riding the lending boom
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without a crash helmet

• The emphasis on volumes encouraged lenders to
  ignore The Three Cs
• Character
• Capacity
• Collateral
• rely instead on automated underwriting based on
  FICO scores and zip codes

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The price EPDs Bankruptcy

• When house price appreciation stalled,
• borrowers began to default in the first few
  months of the loan
• lenders faced repurchase demands for bad loans
  from Wall Street
• Poorly capitalized lenders were forced out of
  business

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New Century collapse
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The Securitization Bankers
INCENTIVES
Higher RMBS CDO deal volumes meant higher earnings and bigger bonuses Originate distribute model in theory meant that banks could avoid holding the risk Competition (aka Keeping up with the Jones)
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• Bear Stearns Riding the lending boom

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Bankers made bad decisions

1. Banks did not closely examine the loans. When
   originators folded, bankers held warehouses of
   unsecuritized and poorly underwritten mortgages
2. As mortgage loans turned sour, and buyers for new
   bonds disappeared, so did the revenue stream
3. They didnt distribute everything gt150bn of
   writedowns so far

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Credit crunch consequencesBear Stearns for 2 a
share
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The Rating Agencies
INCENTIVES
Higher RMBS CDO deal rating volumes meant higher earnings Rating agencies had an incentive to help deal structurers obtain the highest ratings Competition (aka Keeping up with the Jones)
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A boon for the rating agencies
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Rating agencies made bad decisions

• Over-reliance on historical data. Flexible
  mortgage products had never been offered to this
  group of borrowers before the data was
  irrelevant
• Over-reliance on modeling, eg. continued house
  price appreciation was baked into the cake

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The Investors
INCENTIVES
Subprime MBS and CDO products provided yield in a low-yield world And often came with AAA ratings Competition (aka Keeping up with the Jones)
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Investors made bad decisions

• Over-reliance on ratings
• As a substitute for credit analysis
• As a way to reach for yield, but maintain a high
  quality portfolio
• In the belief that AAA also means liquid trading
  instrument that will not lose market value

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Policymakers regulators
INCENTIVES
Boosting home ownership regarded as good public policy
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But it granted home loans to those who could not
afford to repay
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The reality is that too aggressively pursuing a
goal is perverse. Its not good public policy to
put people in homes theyre going to end up
losing.

• Dick Syron - CEO, Freddie Mac
• March 12, 2008