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					     2008 Credit Crisis
Its connection to subprime mortgage
                crisis

                         By
      Supriya Sarnikar, J.D., Ph.D. (economics)
                   Asst. Professor
      Economics and Management Department
               Westfield State College
The Beginnings of the Crisis

• You have heard that the current credit
  crisis began in the housing market.

• We will look at the basics of the
  mortgage market to understand how it
  affected the financial markets.

• But first, we will look at the meaning of
  some financial terms that you will
  encounter in this presentation.
Some Terminology

• Mortgage – to pledge property as security for a loan
• Collateral – the property that is pledged
• Liquidity – ease of conversion of an asset into cash
• Security – A certificate (paper or electronic) that gives
                         certain rights to the lender.

• Securitization –                  process involving pooling loans and creating
  securities backed by the loans.

• Bonds/Debt instrument –                        A security that gives
  the holder a right to receive a fixed amount (called “face value”) on a
  fixed date in the future (date of maturity) and right to receive
  periodic interest payments (called the “coupon rate” ).
Conventional Mortgage Process…

• …begins when a buyer wishing to buy a house,
  approaches a bank/financial institutions for a loan.
• Bank/Financial Institution checks borrower’s credit
  history, income, other financial data (such as other
  debts owed), and then decides whether to make the
  loan.
• Once the loan is made, the bank’s money is tied up
  for the duration of the loan (typically 30 years). This
  made traditional real estate loans very illiquid.
• Securitization of mortgages was meant to turn
  these illiquid loans into more liquid assets..
What is Securitization of Mortgages

• Mortgage securitization is the process in which
  several real estate loans are pooled together and
  then broken up into smaller pieces to be sold to
  investors.

• Just like stock ownership makes it possible for each
  one of us (no matter how wealthy or not wealthy) to
  own a piece of a company (instead of the whole),
  and enjoy shares of the profits, mortgage
  securitization, in theory, makes it possible for
  investors to hold a piece of the mortgage and enjoy
  shares of the interest (and principal) payments.
Securitization can be a good thing..

• ..because it allows money to flow from the savers
  (and investors who are willing to bear the risk), to
  the borrowers who do not have the money but want
  to use it.
• Obviously, the bank (or other financial institution)
  that made the original loan is also already
  performing this function. So why the securitization?
  • Answer: The bank may not be willing to make too many
    real estate loans if its money will be tied up for such long
    durations. By breaking the loans into pieces and selling it to
    investors, the bank turns an illiquid loan into a liquid asset.
    The money that is now freed up can be used to fund other
    productive activities..
Mortgage Securitization is not new..

• In 1968, GNMA (Ginnie May) was first authorized by
  Congress to issue Mortgage backed Securities to
  finance its home loans.

• FNMA (Fannie May) and FHMC (Freddie Mac) have
  been issuing Mortgage backed securities since the
  1980s.

• The mortgage backed securities created with pools
  of subprime loans are thought to be the culprits in
  the current financial crisis and these were issued
  starting in the mid-1990s.
•   Source: “Credit Crunch of 2008,” by Paul Mizen in Federal Reserve Bank of St. Louis Review,
    September/October 2008, 90(5), pp. 531-567.
                                            Mortgages
         Conventional Vs. Jumbo, Alt-A, and Subprime
• Conventional Mortgages adhered to certain
  standards.
      •Borrowers must have good credit rating
      •Income documentation required
      •Down payment required (typically 20%)
      •Principal balance could not be higher than a certain amount ($729,750 in 2008)

• Jumbo Loans
      •Made to borrowers with good credit (i.e., prime borrowers) but the principal
      balance is larger than the Agency (Fannie and Freddie) limits (729,750 in
      2008).

• Alt-A Loans
      •Made to prime borrowers but lax on other standards such as income
      documentation or down payment requirements

• Subprime Loans
      •Made to borrowers with bad credit ratings. Other standards may also be
      relaxed.
Source: “Understanding the Securitization of Subprime Mortgage Credit’” Ashcraft and Schuermann, Federal Reserve Bank of New
     York Staff Report 318, March 2008.
Subprime loans increased dramatically…




Source: “Money for Nothing and Checks for Free” by John Kiff and Paul Mills, IMF Working
Paper, July 2007.
But were still a small part of all mortages..




Source: “Money for Nothing and Checks for Free” by John Kiff and Paul Mills, IMF Working
Paper, July 2007.
   The Subprime Mortgage Securitization
   Process             Warehouse
                                                             Lender                          Credit
                                                             (makes short term
                                                             loans to Issuer for             Rating
                                                             purchase of
                                                             mortgages)
                                                                                             Agency

                    Requests
                    loan

  Mortgagor                   Bank/Financial                    Arranger/
                   Provides
                              Institution          Loan sold
  (Borrower)       loan
                                                                Issuer
                              (Originator)                                         Loans pooled
                                                                                   and sold to
                                                                                   Trust
Makes loan
payments
                Provides customer
                service to borrower
                                                                                                  SPV
                                                                                                  (Trust)
       Servicer
       (is employed by Trust                                                                issues
       to collect loan                        Remits loan payments to Trust                 securities
       payments etc.)                         and advances unpaid interest
                                              payments.
                                                                                            Investors


   Adapted from: “Understanding the Securitization of Subprime Mortgage Credit’” Ashcraft and Schuermann,
   Federal Reserve Bank of New York Staff Report 318, March 2008.
Source: “Understanding the Securitization of Subprime Mortgage Credit’” Ashcraft and
Schuermann, Federal Reserve Bank of New York Staff Report 318, March 2008.
Source: “Understanding the Securitization of Subprime Mortgage Credit’” Ashcraft and Schuermann,
Federal Reserve Bank of New York Staff Report 318, March 2008.
Source: “Money for Nothing and Checks for Free” by John Kiff and Paul Mills, IMF Working
Paper, July 2007.
Creation of the M.B.Securities- A Highly
Simplified illustration..

• Originator makes, lets say, a 100 loans adding up
  to, say, $80 million. The expected payback is $80
  million (Principal) plus the interest payments of,
  say, $5million (assuming no defaults).

• The originator pools the 100 loans and sells to the
  Arranger for, say, $82 million. (The Arranger is
  willing to pay more than $80 million because it
  expects to receive some interest payments).

• The Arranger then divides up the $80 million into
  several smaller pieces. Let’s say 1000 bonds each
  with a face value of 80,000 and some interest rate
  (called a coupon rate). Now it wants to sell these
  bonds to investors.
Securitization creates a distance between
the investor and the borrower..

• So how can an investor know whether the
  mortgages that secure its investment are
  healthy?

• Several checks and balances exist but also
  many problems also exist at each stage of
  the securitization process.

• Investors relied heavily on credit ratings
  provided by the Rating Agencies.
The Role of Credit Rating Agencies
• Credit rating agencies, such as Moody’s, Standard & Poor, and
  Fitch, are paid by financial institutions to provide easy to
  read/understand ratings of the risk associated with various
  debt instruments.

• Each Agency has its own scale of indicators and own models to
  determine default risk

A   sample scale of ratings
•    AAA – extremely safe, very low risk
•    AA – very strong credit, low risk
•    A – strong credit
•    BBB – Good credit
•    BB – good credit but vulnerable to economic conditions
Role of credit Rating Agencies- contd.

• In rating Mortgage Backed Securities (MBS), the rating
  agencies relied on information provided by the
  Issuer/Arranger.

• Their rating models were publicly available and Issuers often
  consulted with the rating agencies when constructing the loan
  pools and creating the MBS.

• The models used by the rating agencies relied on historical
  data (typically, 1992-2000) of mortgage default and
  foreclosure frequency rates. But the type of loans made during
  2001-2007 were very different from the types of loans made
  during 1992-2000. The later loans were much more risky.
Source: “Credit Crunch of 2008,” by Paul Mizen in Federal Reserve Bank of St. Louis
Review, September/October 2008, 90(5), pp. 531-567.
Structuring the Deal- the Devil in the
Details

• The potential investors in these mortgage
  backed securities were mainly institutions
  that were restricted by regulation to buying
  investment grade bonds. (Typically these are bonds that
  are rated BBB or better).

• So, for an Arranger to sell these mortgage
  backed bonds, a rating of BBB or better was
  essential.
• Working in consultation with the credit rating
  agencies, the deals were structured in a way
  that would give most of the bonds AAA
  (safe) rating.
Structured Deals – Converting Subprime
Loans into AAA bonds
• To convert a pool of loans to AAA securities, the Issuer had to
  provide Credit Enhancements (CE) in the form of
   • Over Collateralization: For example, $80 million loans are backed
     by real estate that is valued at more than $80 million. Or, more
     typically, the collective face value of the MBS is less than the
     underlying loan.

   • Excess Spread: The weighted average of the coupon rates on the
     MBS is less than the interest rate on the underlying home loan.

   • Subordination: In our example, the 1000 securities are divided
     into tranches (groups)- senior, mezzanine, equity, and residual
     tranches. Typically, about 80% of the bonds were designated
     senior tranche and were rated AAA, the rest were rated A, BBB
     and lower. The mezzanine, equity, and residual tranches are
     “subordinated” to the senior tranche. That means any money
     repaid by the borrower is first applied to the AAA tranche before
     any money is paid to the mezzanine, equity, and residual
     tranches.
• Additionally, the investors were assured of the safety of the
  bonds by the insurance provided by monoline insurers such as
  AMBAC, MBIA etc.
   Source: “Money for Nothing and Checks for Free” by John Kiff and Paul Mills, IMF
Collateralized Debt Obligations
(CDOs)

• No natural market for BB and C rated
  MBS.
• Repackaged into CDOs with other
  collateralized loans such as car loans.
• No natural market for lower tranches
  of CDOs. These are repackaged into
  CDO2. Lower tranches of CDO2 are
  repackaged into CDO3.
Source: “Money for Nothing and Checks for Free” by John Kiff and Paul Mills, IMF Working
   Paper, July 2007.
Structured Deals – Each MBS and CDO
is unique..

• For any given pool of loans the rating agency, (or its publicly
  available rating model), told the Issuer how much credit
  enhancement would be necessary for the MBS tranches to
  receive AAA rating.

• The Issuers often bundled car loans and credit card loans with
  subprime mortgages to get the desired credit enhancements
  (especially for the CDOs).

• This turned the previously standardized MBS market (with
  virtually no chance of default) into a market with high risk.
  And, especially, into a market with risk that was very difficult
  to price.

• Compounding the risk pricing problems, were falling housing
  prices and several incentive and information problems at each
  stage of the securitization process.
Incentive Problems in the Securitization
Process
                                                               Warehouse
                                                               Lender                          Credit
                                                               (Makes short term
                                                               loans to Issuer for             Rating
                                                               funding mortgage
                                                               purchases)                      Agency

                     Predatory                                     Adverse Selection
                     Borrowing   Originator
                                 (gets closing costs,               Arranger/
  Mortgagor                                             Mortgage
                    Predatory    points paid by                     Issuer
  (Borrower)        Lending      borrower PLUS sale     Fraud
                                                                    (gets fees paid
                                 proceeds of loan)                  by investors plus   Adverse
                                 Makes warranties to                any premium         Selection
                                 Arranger                           paid over the par
 Moral Hazard                                                       value)                            SPV
                                                                                                    (Trust)
        Servicer
                                                                                           Principal
        (gets paid fixed fee based
        on outstanding loan
                                                                                           Agent
        value)
                                                Moral Hazard             Model Error       problem



                                                                                                    Investors

Adapted from: “Understanding the Securitization of Subprime Mortgage Credit’” Ashcraft and Schuermann,
Source: “Understanding the Securitization of Subprime Mortgage Credit’” Ashcraft and Schuermann,
Federal Reserve Bank of New York Staff Report 318, March 2008.
Source: “Understanding the Securitization of Subprime Mortgage Credit’” Ashcraft and Schuermann,
Federal Reserve Bank of New York Staff Report 318, March 2008.
What triggered the credit crunch?

• Falling housing prices increased defaults.
• Investors began to exercise “put back” options that
  put the Originators on the hook for the bad loans.
• High leverage meant that a small loss on subprime
  loans translated into huge losses of capital.
• The run on the banks started a chain reaction that
  resulted in the failure of several stand-alone
  (monoline) banks and insurers.
• Doubts about the extent of losses suffered by each
  institution created large scale uncertainty that froze
  the credit market.
What Now?

• Credit Crisis is real. But what is the
  solution?
• Is a bailout necessary? If so, what
  should a good bailout do?
  • Depends on whether the credit crisis is
    due to
    • Inadequate capital, or
    • Lack of confidence, or
    • Both inadequate capital and lack of confidence
The current bailout/rescue plan

• Mainly addresses the problem of lack
  of confidence. Seeks to restore
  confidence by:
  • Govt. buying up the “toxic” assets
• Critical question is “at what price?”
  • Seeks to find the price through a reverse
    auction.
Reverse Auctions

• Problems with using reverse auctions
  in this case
  • Each “toxic” asset is different. The CDOs
    and MBS are not all alike.
  • Asymmetric Information - Banks know
    more about the quality of the securities
    than the government.
  • Adverse Selection - Banks are likely to
    offer the worst securities for sale at the
    auction and keep the good (more
    valuable, profitable) ones to themselves.
Alternatives to bailout plan

• Why not simply help the homeowners
  who are in foreclosure?
  • Curing current foreclosures is not enough.
  • Future defaults will have to be picked up by taxpayers as
    well for this to work.
  • Estimated $6 trillion of potentially problematic loans made.
    Very expensive to bailout homeowners..
  • Moral hazard issue – more are likely to default is
    government bails out. This is also a problem with current
    plan to directly help banks.
  • Problematic loans were made in other markets (car loans,
    credit cards) as well. Curing defaults in housing markets
    may not be enough to avert deeper recession.
Alternatives to Bailout plan

• Demanding stock (share in profits) in
  return for providing capital to troubled
  banks.
• Good idea from taxpayer’s perspective
  but not likely to help if bankers do not
  participate.
No easy answers..

• Rules of auction and other details of bailout
  are critical for
  • preventing a deeper and longer recession, as well
    as,
  • Not enriching banks at the expense of tax payers.
Treasury Secretary has 45 days to come up
  with the details of the plan to buy toxic
  assets.
Watch for more details..
Meanwhile, time is running out as evidenced
  by the deepening of the crisis.

				
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