Overview of the Subprime Mortgage Crisis

Overview of the Subprime Mortgage Crisis Steve Westley U.S. Government Accountability Office Financial Markets and Community Investment westleys@gao.gov Presentation at the Hudson Institute October 24, 2007 1 Objectives • Analyze the scope and magnitude of recent trends in home mortgage defaults and foreclosures, and how these trends compare with historical values. • Evaluate developments in economic conditions and the primary and secondary mortgage markets associated with recent default and foreclosure trends. 2 Background Note: Data exclude home equity loans. 3 Background Market Shares of the Minority Submarket for Home Purchase Mortgages (in terms of number of loans) Note: Percentages are for first-lien mortgages to owner-occupants. 4 Default and Foreclosure Trends 5 Default and Foreclosure Trends Note: The MBA data do not separately identify Alt-A loans but include them in the prime and subprime categories. 6 Default and Foreclosure Trends (Q2 2005 – Q2 2007) Note: Figures exclude government-insured or -guaranteed loans because they did not contribute to increases during the period examined. 7 Default and Foreclosure Trends 8 Default and Foreclosure Trends 9 Default and Foreclosure Trends 10 Developments Associated with Recent Trends • A combination of economic and market developments contributed to recent default and foreclosure trends, including: • the rapid decrease in home price appreciation throughout much of the nation beginning in 2005 and weak labor market conditions in certain states; • aggressive lending practices that reduced the likelihood that some borrowers would be able to meet their mortgage obligations; and • growth in the private mortgage-backed securities market, which provided liquidity to support these lending practices. • Other developments may have played a role, but additional information would be needed to fully assess their impact. 11 Developments Associated with Recent Trends Decline in House Price Appreciation Note: The HPI ratio is the ratio of (1) the projected OFHEO house price index for purchase transactions, assuming average Q3 2003 – Q1 2006 appreciation continued through Q2 2007 to (2) the actual OFHEO house price index as of Q2 2007. The figure covers the 25 states with the highest HPI ratio. 12 Developments Associated with Recent Trends Weak Regional Labor Market Conditions • Parts of the industrial midwest have experienced job losses, particularly in the manufacturing sector. • Michigan’s rate of non-farm employment growth was -4.6 percent from the fourth quarter of 2001 through the second quarter of 2007. • The corresponding figure for Ohio was -0.9 percent. • From the second quarter of 2005 through the second quarter of 2007, • Michigan had the third largest increase in the total number of foreclosure starts (behind California and Florida). • Ohio had sixth largest increase in the total number of foreclosure starts. 13 Developments Associated with Recent Trends Easing of Underwriting Standards and Wider Use of Certain Loan Features Note: Loan characteristics are for mortgages originated in the year indicated and pooled into private label securities. The CLTV figure reflects purchase loans only, while the piggyback loan figure reflects both purchase and refinance loans. The percentages in the figure on piggyback loans represent the dollar amount of first-lien mortgages with an associated piggyback loan. In dollar terms, jumbo, Alt-A, and subprime mortgages represented about 19, 16, and 24 percent of mortgage originations in 2006 (excluding home equity loans), respectively. 14 Developments Associated with Recent Trends Easing of Underwriting Standards and Wider Use of Certain Loan Features Note: Percentages represent the dollar amount of purchase and refinance mortgages originated in the year indicated and pooled into private label securities that have certain characteristics. In dollar terms, jumbo, Alt-A, and subprime mortgages represented about 19, 16, and 24 percent of mortgage originations in 2006 (excluding home equity loans), respectively. 15 Developments Associated with Recent Trends Easing of Underwriting Standards and Wider Use of Certain Loan Features Note: Percentages represent the dollar amount of purchase and refinance mortgages originated in the year indicated and pooled into private label securities that have certain characteristics. In dollar terms, jumbo, Alt-A, and subprime mortgages represented about 19, 16, and 24 percent of mortgage originations in 2006 (excluding home equity loans), respectively. 16 Developments Associated with Recent Trends Easing of Underwriting Standards and Wider Use of Certain Loan Features Note: Percentages represent the dollar amount of purchase and refinance mortgages originated in the year indicated and pooled into private label securities that have certain characteristics. In dollar terms, jumbo, Alt-A, and subprime mortgages represented about 19, 16, and 24 percent of mortgage originations in 2006 (excluding home equity loans), respectively. 17 Developments Associated with Recent Trends Easing of Underwriting Standards and Wider Use of Certain Loan Features • FitchRatings analysis of securitized subprime loans from 2005 shows the impact of risk layering on mortgage delinquency rates after 1 year of seasoning. 18 Developments Associated with Recent Trends Growth in Private Label RMBS Market 19 Developments Associated with Recent Trends Growth in Private Label RMBS Market • Role of investment banks and credit rating agencies • Officials acknowledged that they were surprised by the speed and severity of declines in house price appreciation and had underestimated the risks of certain loan features such as low documentation and high LTV ratios. • Recent credit rating downgrades for RMBS have affected a relatively small portion of total private label RMBS issuances and have largely been limited to lower-rated securities. • However, downgrades of second-lien subprime RMBS have been more extensive—for example, Moody’s has downgraded about 60 percent of the dollar volume of these types of securities that it rated in 2006. • Rating downgrades introduced uncertainty about the credit quality of subprime RMBS, contributing to financial market disruptions that reduced liquidity for borrowers seeking to refinance out of loans at risk of default or foreclosure 20 Developments Associated with Recent Trends Other Possible Factors • Misaligned incentives and lack of accountability in the origination and distribution of mortgages • Originators had financial incentives to increase loan volume, potentially at the expense of loan quality. • In 2005, brokers accounted for about 60 percent of originations in the subprime market (compared with about 25 percent in the prime market). • Some originators, particularly independent mortgage companies, lacked sufficient capital to make good on representations and warranties. 21 Developments Associated with Recent Trends Other Possible Factors • Federal regulation of lenders • In prior work, GAO raised concerns about nonbank lenders, noting that some have been targets of some of the most notable federal and state enforcement actions involving abusive lending. Top 25 Originators of Subprime and Alt-A Loans in 2006 22 Developments Associated with Recent Trends Other Possible Factors • Mortgage fraud • According to some industry researchers, growth in early payment defaults in recent years (i.e., defaults occurring within a few months of loan origination) are an indicator of increasing mortgage fraud. Suspicious Activity Report Submissions Citing Mortgage Fraud 23