SUB-PRIME

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          SUB-PRIME
Correcting Easy Money and Over-Spending


                   Scott Gryk

               February 29, 2008




         Professor Richard E. Frazier, Jr.

               Corporate Finance
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         Investopedia defines subprime as, “A classification of borrowers with a tarnished or limited credit

history. …” BusinessWeek’s article, Housing Meltdown, spoke with Goldman Sachs chief economists Jan Hatzius

who estimates that banks and financial companies will experience about $200 Billion in real estate losses. The

companies and individual borrowers affected by subprime loan defaults are numerous. A large number of financial

institutions are experiencing financial losses, companies such as: Morgan Stanley, Merrill Lynch, Citigroup,

Countrywide Mortgage, AIG, and AMBAC, etc. Investment companies that you here about almost every day in the

news. The negative financial and market indicators are clear. Mortgage-backed loans, credit and housing are

experiencing economic and financial downturns; the downturns and stagnant markets isn’t bad news for everyone.

The center of the subprime headlines is defaulted mortgages. Where do home mortgages end up within U.S.

financial institutions, who is holding the bad debt or transferring the subprime risk, what indicators are signaling

financial troubles in U.S. real estate market and what are the down stream effects on consumers, lenders and larger

financial institutions.


    Two of the larger loan instruments contributing to the recent mortgage problems are low initial ARMs,

adjustable rate mortgages, and easy mortgage and equity approvals. ARM rates are frequently lower than fixed loan

rates and subsequently annually fluctuate to market conditions, both rate increases and decreases. Rising adjusted

interest rates considerably increase a borrower’s monthly payment. If a borrower is unable to refinance to a fixed

rate within the first few years of an ARM mortgage, their monthly mortgage payments could easily jump by 45%

(see exhibit 2 Amortization Differences, year 4 increased rate). Variable mortgages are risky. Short term external

factors can make refinancing difficult, therefore leaving the homeowner with large monthly mortgage payments.

Moreover, with an equity loan, once the equity cash is gone, the debt still remains in the mortgage. Steve Kroft

describes a Stockton CA couple whose ARM monthly mortgage rose from $2,500 to $4,500. The increased monthly

payment is when borrowers begin to show signs of financial distress by being delinquent on payment or simply

stopping payments. The S&P Case/Schiller report is a widely accepted indicator of housing sales throughout the

U.S. and is an accurate index indicator of home values and thoroughly documents the reduction in U.S. home values.


     The S&P/Case-Shiller is another indicator of real estate market value. The report collects 23 indices from 20

metropolitan regions, two composite indices and a single national index. The Case-Shiller report documents the

total U.S. residential real estate value at $22.4 trillion in 2006, including all residential real-estate and non-profit
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organizations. The S&P/Case-Schiller National Home Price Indices shows consistent sale price declines since Q2

2006. The Case/Schiller method uses the differences between a sold home that sold twice amongst two time periods,

as Professor Schiller calls it in the announcement podcast a “repeat sales method.” The only three metropolitan

indexes that showed small increases during this period are Portland OR, Charlotte NC and Seattle WA. The decrease

in market value is one reason equity loans are becoming harder to get, therefore restricting one channel of cash for

homeowners. The remaining metropolitan and national indices show declining real estate values. The real-estate

markets currently show decreasing value but the SP/Case-Schiller report shows housing asset classes have returned

10.94% annualized from March 1997-February 2007. Assets, investments and real-estate can’t continually grow;

there must be times for market adjustments, as there was in the early-mid 1990s real estate market. The decreases in

housing values and the higher inventories of unsold homes, makes the current environment very appealing for both

real-estate investors and home owners who have cash and high FICO ratings, but hurt the financial organizations

holding the defaulted loans and the consumer, who have reduced FICO ratings.


    Lenders, brokers and borrowers all financially benefited from mortgage-backed securities. As Jim Grant editor

of “Grant’s Interest Rate Observer” discussed with 60 Minutes correspondent Steve Kroft, “At every step in the

way, somebody has his or her hand out, getting paid.” Grant goes on to name some specific beneficiaries of easy

lending practices. Jim Grant captures the beneficiaries in the interview, “The broker got paid. He or she was happy.

The lending officer, ditto. The rating agencies got paid for passing judgment on these securities. They, too, were

pleased, and their stockholders were happy. And on and on.” Steve Kroft’s 60 Minutes story The Subprime

Meltdown, discusses how new house mortgages were being issued with small to no down payments; since market

values were still rising, these new homeowners frequently tapped the new homes equity, which gave them further

cash and higher mortgage debt. Now, the lending institutions were looking at decreased market values and the

banks or mortgage insurers aren’t receiving payments for their loans. The banks are then stuck with the collateral,

the homes. The 60 Minutes story The Subprime Meltdown cites banks in NV, CA, Southern FL. and Ohio that are

holding bank auctions to move the backlog of foreclosed homes.


     Banks, lenders, investment houses and financial institutions are all affected by the increased defaulted

mortgages (see exhibit 1, sequence of mortgage risk movement). Now, loans aren’t being paid and depending upon

who is holding the loans will be the bear the financial losses. Investment banks “write down” their collateralized
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loan losses, banks and loan companies foreclose the properties and in many cases, can’t sell the property due to the

high inventories of sales and tighter lending restrictions, less available money for borrowers. If the mortgages are

bundled or repackaged into mortgage-backed securities, which provide bond like coupon payments, the securities

may be unable to provide investors their returns; requiring a securities insurer like AMBAC to cover the loss

through risk pooling of thousands of loans, a common statistical risk management method used by insurance

companies. AMBAC and MBIA, both mortgage resellers and insurers, stock prices (showing close to 80% decline

in stock prices) reflect the company’s struggles with high risk mortgage-backed assets, (see exhibit 3). The

financial trail of these mortgages really is a “House of Cards” and in some cases the security insurers are the

institutions holding the bad debt, that isn’t producing all of the expected monthly cash inflows from foreclosed

homes. All of these financial losses result in tighter lending criteria. As cited in the Businessweek article Housing

Meltdown, “Subprime lending is nearly shut down, home-equity loans and lines of credit are scarce…A survey of

real estate agents found that a third of planned home sales were canceled or delayed last fall because of loan

problems.” Yes, there are numerous indicators of a struggling real estate and credit sector, but the negative

indicators shouldn’t be a surprise to people and according to Businessweek’s Consumer Crunch interview with

Christopher D. Carroll, “…most of the spending cutbacks won’t cost Americans their factory jobs…” ; maybe an

advantage to a global economy.


    TheStreet.com writer and podcast host Simon Constable discussed the fact that banks are loaning AMBAC, a

mortgage repackage and insurer, money to cushion there financial losses. The banks need the financial leverage of

AMBAC, MBIA, Fannie Mae and Freddie Mac. Fannie and Freddie are both government backed mortgage insurers

so therefore are considered, until a recent credit watch listing that was just removed, highly rated loan insurers. I

believe banks are moving cash to AMBAC to protect both the bank’s ability to continue write loans through the

mortgage insurers’ loan pooling and investing while continuing to have their mortgage loans insured or protected.

Loan insurers accomplish through risk pooling thousands of repackaged loans. The loans are pooled, shrunk down

into affordable investment packages of possibly thousands of individual loans sold to private and corporate

investors. I believe this is where the subprime loan’s high risk is being realized; actuaries and underwriters probably

underestimated the amount of bad loans. Many of the bad debt loans end up here, in the hands of large investment

firms that repackage and reissue these mortgages as bond style investments for resale; monthly coupon annuities and
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eventually loan payments made back to the investor. Therefore, the banks have a vested interest in the financial

strength of these mortgage insurers; this is why cash is being pushed to the struggling AMBAC and others (see

exhibit 3 for decrease in stock value of AMBAC and MBIA). These insurers allow smaller banks to continue to write

loans. Luckily in the case of bad mortgages, the U.S. is now a participant in a global economy, thus reducing the

bad loan negative effects to particular sectors of the U.S. economy, not the entire economy.


    The world is now, more than ever, a global economy, good news for the general financial health of the country,

in the subprime case. The subprime loan problems do reach outside the U.S. for instance, the Swiss bank Credit

Suisse has exposure to the U.S. subprime mortgages but has contained their losses. But, as the BusinessWeek

article Consume Crunch reports the U.S. spends $740 billion a year on foreign imports, “That’s fully one-third of

consumer spending on goods outside of food and energy.” The U.S. will likely avoid a large recession since we

import many of our products, the consumer cutback will likely reduce U.S. imports. Conversely, the US exports

many products to growing nations such as India, markets not affected by the U.S. subprime defaults; therefore,

limiting the bad loan effects to certain sectors and not the entire U.S. economy. Another common theme of the

financial press is, the consumer will need to cut back on spending and some parts of the economy will be hit harder

than others. Non-financial businesses still have access to inexpensive capital. This is good news for business of

non-financial industries. The article Consumer Crunch captures this point, “…it’s still a low-rate world for most

nonfinancial corporations, which have access to relatively cheap funds…”


    Throughout the cascading of bad mortgage notes, corporate write-downs, home foreclosures and the many

financial indicators of slowing real-estate and credit markets, I believe the real-estate and credit markets are simply

correcting themselves. As cited by Michael Mandel, “In the past 25 years, Americans have kept shopping through

good times and bad.” Peter Coy cites the fact regarding a hypothetical 25% drop in the housing market, “It would

put the national price level right back on its long-term growth trend line, a surprisingly modest 4% a year after

inflation.” I personally believe real estate is currently overvalued market adjusting from consumer over-borrowing

and loose lending practices. Real estate will eventually appreciate again over time. The psychology and financial

effects to the homeowner are, have I lost any money (market value) on my real estate investment in the short term

and if I need to sell, will I be able to when the for sale inventory is so high?
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    These market conditions do favor bearish individuals, who save, have liquidity and maintain a high FICO credit

scores. The increased home inventory coupled with the decrease in home prices give the prudent consumers

purchasing leverage. The housing markets will again appreciate; it’s a question of when. As long as the

unemployment rates maintain at their current low levels and banks don’t completely shutdown loans, there will be

consumers who can get affordable mortgages. The banks and financial institutions are just one contributor of the

subprime problem while greedy borrowers are the other co-conspirator.


    Banks and underwriters continued to write high risk loans and investment firms continued to resell and pool

these mortgages. The Housing Meltdown article’s interview of Peter D. Schiff perfectly captures these liberal loan

practices, “Observers with a Calvinist streak see a housing crash as not only necessary but also positive.” I will force

Americans to live within their means,..” Within the same article Mildred Wilkins, a foreclosure counselor, further

advances this sentiment, “We have been fed the illusion that acquiring a home was a magic key to stability, to

wealth-building,” I agree a home is an investment, but it’s not a quick investment to purchase with little money

down and immediately draw on equity. Again Wilkins captures another dimension to this problem, politicians.

Wilkins says, “…calling it a myth foisted on lower-income Americans by politicians serving the builders and

bankers.” I believe U.S. Banks and lending organization must tighten lending practices.


    In conclusion, blame can be evenly spread throughout all parties’ involved: bankers, underwriters, borrowers,

investment houses, Wall Street and politicians. All are equally responsible. The article Housing Meltdown

mentions two Bush Administration plans for softening the fall-out; described in the article Housing Meltdown,

“FHASecure, which offers new mortgages to well-qualified borrowers, and Hope Now, a private-sector program to

streamline the modification of unaffordable loans.” Additionally the Federal Reserve is lowering interest rates,

which should result in continued borrowing. Personally, I don’t look to the government to solve many financial

problems; a 2007 tax rebate from the taxes we’ve already paid to stimulate the economy? Why wouldn’t taxes be

permanently reduced to keep the money flowing. I view this subprime issue as good for long-term homeowner

buyers. I agree with The Times of London commentary in response to lowering British housing prices by Chris

Hamnet, “Great news! House prices are down.” Maybe the Housing Meltdown article’s final sentence captures best

my feelings about subprime, “The bigger the boom, the harder the fall.” It’s time for real-estate to correct its value

and a time for cautious and responsible buyers to find fair priced homes.
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Resources Cited and Used


    -   Kroft, Steve. “The Subprime Meltdown” 60 Minutes. CBS. 27 Jan 2008
         http://60minutes.yahoo.com/segment/134/subprime_meltdown, transcript:
         http://www.cbsnews.com/stories/2008/01/25/60minutes/printable3752515.shtml

    -   Coy, Peter. “Housing Meltdown.” BusinessWeek 31 Jan 2008
        http://www.businessweek.com/magazine/content/08_06/b4070040767516.htm

    -    Hamnet, Chris. “Great news! Housing Prices are Down a market correction is essential.” Times of London 28 Jan
        2008. Times of London On-line 2 Mar 2008
        http://www.timesonline.co.uk/tol/comment/columnists/guest_contributors/article3260831.ece

    -   S&P/Case-Shiller® Home Price Indices. 26 Feb 2008. Standard & Poor’s. 29 Feb 2008. Podcast and Reports
        http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_csmahp/0,0,0,0,0,0,0,0,0,1,1,0,0,0,0,0.html
    -   Investopedia, http://www.investopedia.com/terms/s/subprime.asp

    -   Credit Suisse http://news.yahoo.com/s/afp/20080212/bs_afp/switzerlandbankingcompanyearningscreditsuisse

    -   Constable, Simon. “AMBAC Saves the Day”. TheStreet.com. Podcast 22 Feb 2008

                                                           Appendixes


        Exhibit 1

        Sequence of Mortgage Risk Movement
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Exhibit 2

Amortization Differences




Exhibit 3

AMBAC & MBIA 2 Year Stock Prices

				
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