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									THE GREAT CREDIT SQUEEZE:
    HOW IT HAPPENED,
 HOW TO PREVENT ANOTHER
   Martin Neil Baily, Douglas W. Elmendorf
             and Robert E. Litan
               May 16, 2008
         Declining Mortgage Interest Rates Fueled Strong Housing Demand.
         After the Dot-Com Bust, Real Estate was seen as a “Sure Thing.”
                             Real Home Prices and Real Household Income (1976=100); 30-year conventional mortgage rate
                       200                                                                                               18

                                                   Annualized 30-year Conventional
                                                   Mortgage Fixed Rate - right axis
                                                                                                                         16
                       180
                                                                                                                         14


                       160                                                                                               12
  Ind ex (1976= 100)




                                                                              Mean Real Household Income
                                                                                 (1976=100) – left axis                  10




                                                                                                                              P ercen t
                       140
                                                                                                                         8


                       120                                                                                               6

                                                                                  Real Home Price Index                  4
                                                                                   (1976=100) – left axis
                       100
                                                                                                                         2


                       80                                                                                                0
                             1976       1980       1984        1988        1992           1996            2000   2004
Source: OHFEO; Federal Reserve; Bureau of the Census. Home Prices and Income are deflated by CPI less Shelter.
  Conventional Mortgage Lending Grew Rapidly 2001-2003.
  Subprime and Home Equity Lending Exploded 2003-2006
  Total mortgage originations by type; with share of total originations by product: in Percent; billions US$
                                                                                                      1,800
Total=      2,215               2,885         3,945         2,920   3,120   2,980      2,430
                                                                                                   (annualized)

                                                 6
                                                       2
                                                 8


                                                16
                                                                     20
                                   6                                          20
                                                            11
                                          2
                                  7
                                                                     12
                                                                                               8
Subprime                                                     7                13
                                 20
                    5                                                                      11
 Alt-A                      2                               18
                    7                                                12
                                                                                                   3
  HEL                                                                         14           15
                    20                                                                                      6
 Jumbo                                                       18
                                                 62                  18                    14              13
                                                                              16
                                                                                                          10
                                  59

                    57                                       41
Conformin                                                                                  48
g                                                                    35       33                          61




FHA / VA                8             6          6           5        3        3           4                7
                2001             2002          2003         2004    2005     2006        2007            2007Q4
                                                                                                       (annualized)
Source: Inside Mortgage Finance. HEL is Home Equity Loan.
Starting in 2004 Lenders moved into Riskier Lending by Making Interest Only
and Negative Amortization Loans. Much of the Lending was Made not to Low-
Income Borrowers, but to those Seeking Cash for Other Spending, or Wanting
More Expensive Houses
      Interest-Only and Negative Amortization Share of Total Purchase Mortgage Originations: 2000-2006;
      percent
 35



 30                                                                                 29


                                                                      25
 25
                                                                                                   23


 20



 15



 10

                                                        6
 5                                         4
             2
                                 1
 0
            2000               2001       2002         2003          2004           2005          2006

 Source: Credit Suisse; LoanPerformance
   Securitization was Important in Expanding the Supply of Higher-
   Risk Loans
         Securitization Rates, percent. 2001 and 2006, by type of mortgage loan
  100

                                                                                         Subprime / Alt-A
                       Conforming



                                    81                                                            81


    75                72



                                                     Prime Jumbo



    50
                                                                   46               46



                                                     32


    25




     0
                  2001            2006             2001      2006                 2001          2006
Source: Inside Mortgage Finance
Since 2004, Delinquencies Have Increased Each Successive Vintage Year,
Reflecting the Erosion of Lending Standards as well as Low (and Subsequently
Negative) House Price Growth.
                                          90 Day Default Rate for Subprime Loans by Vintage

                            3.5%

                            3.0%

                            2.5%
 \90 D ay D efau lt R ate




                            2.0%

                            1.5%

                            1.0%

                            0.5%

                            0.0%
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                                   2004                  2005                  2006           2007
 Source: McDash Analytics
 The Rate of Growth of House Prices Began to Decline Starting in Mid-2004.
 Prices Began to Decline in 2007 as the Price Bubble Burst
        Case-Shiller 10-city Home Price Index; year-on-year monthly growth; percent
25%


20%
                                                              July 2004


15%


10%


 5%


 0%
  Jan-90         Jan-92         Jan-94   Jan-96   Jan-98   Jan-00     Jan-02    Jan-04   Jan-06   Jan-08
-5%


-10%


-15%
   Source: S&P / Case-Shiller Index
    Delinquency Rates Started to Rise for Mortgages starting in 2004Q4
    – immediately after house prices increases slowed. Delinquencies
    on most other financial assets also began to rise also.
      Seasonally adjusted Delinquency Rates on Loans at all Commercial Banks
6

                     Business loans                                               All consumer loans
                     Credit card loans                                            Single-family residential mortgages
                     Commercial real estate loans (excluding farmland)
5




4




3




2




1




0
    2000Q1          2001Q1           2002Q1           2003Q1             2004Q1    2005Q1           2006Q1              2007Q1
     Source: Federal Reserve Board of Governors
   The Risk Premium Spiked Up in the Summer of 2007

       TED Spread (3-month LIBOR - 3-month T-bill); basis points
250




200




150




100
                                                                                       July 2007




 50




   0
   Jan-02     Jul-02    Jan-03     Jul-03     Jan-04     Jul-04   Jan-05   Jul-05   Jan-06   Jul-06   Jan-07   Jul-07   Jan-08


Source: Federal Reserve; British Bankers Association (BBA)
When the defaults started, this made financial institutions reluctant to
lend to each other. Intermediaries could not roll over their borrowing.
  A VICIOUS CYCLE DROVE world-wide. There was
Markets started to freeze upFURTHER ILLIQUIDITY a vicious cycle,
which drove further illiquidity.

                       Rising losses in
                       sub- prime market
                                                                               Risk aversion
                                                                                of investors


                                       Banks/
                                       hedge funds
                                       need to
                                       liquidate                                                Falling asset
                                       positions                                                prices




                                  Investors avoid
                                  lending to banks
                                                                                               Announcement
                                                                                               of losses



                                                Banks without
                                                sufficient liquidity in
                                                squeeze-pay inflated      Banks reduce
                                                price for liquidity       funding to other
                                                                          banks




   Source: McKinsey & Company
  Summary of What Happened
• Americans became convinced that rising home prices were
  almost inevitable.

• Strong demand for homes was driven by falling interest
  rates, the increased availability of mortgages, and
  expectations of continuing capital gains.

• From 2001 to 2003 much of the mortgage growth was from
  prime conformable loans. After that the share of subprime
  and Alt-A mortgages increased. There appears to have
  been an erosion of mortgage lending standards.

• The “originate to distribute” model suffered from incentive
  problems because the mortgage originators often sold the
  mortgage quickly to another bank. The originators lacked
  an incentive to ensure the loan would be serviced, and the
  purchasing banks failed to check what they were buying.
  Summary of What Happened (continued)
• Securitization of mortgages expanded greatly, channeling
  funds into the market, including foreign capital. Structured
  securities, called CDOs, were developed of increasing
  complexity, many of which received high credit ratings from
  the ratings agencies despite the shaky mortgages
  underlying them.

• Some observers blame the Fed for keeping interest rates
  “too low” or blame foreign investors for flooding the US
  market with liquidity seeking high returns. These factors
  did play a role in sustaining the US housing boom, but do
  not, in our judgment, carry blame for what happened.

• Financial institutions are regulated and supervised by a
  bewildering array of federal and state authorities. None of
  them acted forcefully to stop or mitigate the erosion of
  lending standards or to warn of serious problems brewing
  in the mortgage market.
  Summary of What Happened (continued)
• Price increases eventually slowed. Delinquencies began to
  rise as early as 2004. As delinquencies rose, this burned
  through the cushion built into the structured securities and
  some defaulted. The risk premium jumped in the summer
  of 2007 and there was chill on borrowing world wide
  between financial institutions. Central banks acted
  promptly to provide liquidity to ease the crisis and the Fed
  started lowering rates.

• The boom in residential housing turned into a severe slump
  as new single family starts fell in half over the next few
  months. The drop in construction, together with soaring oil
  prices and the tightening of lending standards, has pushed
  the US economy into a recession or at least a period of
  very weak growth. Although we believe the US economy
  will weather this storm and resume at least slow growth, a
  deeper recession is possible.
  Summary of What Happened (continued)

• Risk management practices in financial institutions failed.
  The models that were used to assess risk had not factored
  in the possibility of a broad downturn in the housing
  market. Further, several institutions reported that they had
  not followed their own internal rules for risk management.
  Departments within these companies that were making
  huge profits developing and trading the new securities
  were allowed to take large risks without adequate internal
  monitoring.
    Short-Run Policies

•   Fiscal stimulus
•   Sharp reduction in federal funds rate
•   Federal Reserve as lender of last resort
•   Policies toward Fannie Mae and Freddie Mac
•   Mortgage foreclosure policy
 Federal Reserve as Lender of Last Resort

• Lending from the discount window
  – Encourage use (narrower spread to funds rate,
    anonymous auctions)
  – Expand collateral accepted (for loans, swapped directly
    for Treasuries)
  – Expand institutions with access (primary dealers)
• Rescue of Bear Stearns
  – Shareholders get very little, but creditors made whole
• What next?
  – Risk of further crises
  – More capital needed
 Policies toward Fannie Mae and Freddie Mac


• Encourage capital raising and do not push them to
  do much more lending
• Risk of insolvency
• Possible policy actions
  – Forbearance
  – Government equity investment?
  – Nationalization?
Mortgage Foreclosure Policy

• What is the appropriate role for government?
• Key actions to date
  –   Expanded reach of FHA
  –   Additional mortgage counseling
  –   Hope Now agreement for borrowers facing rate resets
  –   Project Lifeline
• Recommended further actions
  – Clarify servicers’ fiduciary responsibilities
  – Change bankruptcy law in limited way
  – Further expand eligibility for FHA-guaranteed loans
    Long-Run Reforms,
    By Stage of Process (or Actor)

•   Improve mortgage origination
•   Improve commercial bank regulation
•   Investment bank regulation?
•   Toward improvement in credit ratings
•   Improve the pricing of derivatives
•   Improve bond insurer regulation
•   Hedge funds
•   Regulatory restructuring
 Long-Run Reforms,
 By Theme

• Financial institutions should be more transparent.
• Financial institutions should be less leveraged and
  more liquid.
• Financial institutions should be supervised more
  effectively.
 Financial Institutions Should Be More
 Transparent

• Mortgages:
   – simpler disclosures and counseling in advance
   – broader and stronger restrictions under HOEPA
   – federal oversight of state regulation of originators
• Asset-backed securities: report on underlying assets
• Credit ratings agencies:
   – greater clarity in comparing ratings across asset classes
   – report on agencies’ track records
   – disclose limitations of ratings for newer instruments
• Commercial banks: clearer off-balance-sheet accting
• Derivatives: standardize and trade on exchanges
 Financial Institutions Should Be Less
 Leveraged and More Liquid

• Commercial banks:
  – capital requirements for off-balance-sheet liabilities
  – required issuance of uninsured subordinated debt
• Investment banks:
  – regulation and supervision of capital, liquidity, and risk
    management
• Bond insurers:
  – higher capital requirements
 Financial Institutions Should Be Supervised
 More Effectively

• Commercial banks:
  – closer supervision of risk-management practices
  – consolidation of federal regulation and supervision

• Bond insurers:
  – closer supervision of underwriting standards for new
    products

								
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