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The Subprime Panic

Working Paper by Gary B. GortonNational Bureau of Economic

ResearchOctober 2008

Presented by Rebekah Sundin

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Summary of Contents

1. Introduction

2. Executive Summary of working paper

3. Background of mortgage market in the U.S.A.

4. Key Points

5. Description of Terms (throughout presentation)

6. Conclusion

7. Pros/Cons of the Working Paper and other viewpoints

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Introduction

How the American Dream of home ownership turned into an international crisis

1.Economic boom that led to easy credit; housing boom stroked the demand for home ownership

2. “In fact, from March 1998 to March 2007, every rolling two year period displayed double digit house price appreciation.” (pg. 20)

3.Culture of easy credit, easy lending4. Increasingly sophisticated financial instruments 5. Increasing prevalence of subprime mortgages in

financial market6.Misunderstanding and misinformation of the subprime

mortgages impact on financial markets

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Executive SummaryGordon explains that intricate financial instruments created a chain of interlinked securities that served to inevitably hide the true value and weakness of subprime mortgages. The securitization design of the mortgages, cash flow triggers in the subprime market did not adequately protect against its exposure and even created incentives for further financial derivatives. Gordon argues that only after ABX indices began to estimate the true value of the subprime packages, did financial markets begin to realize the true risk of the bonds. As the subprime exposure began to be understood financial institutions discovered the far-reaching impact of the subprime bond trading and went into panic.

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Background

How did it all begin? Let’s start with Fannie Mae and Freddie Mac 1.government sponsored enterprises (GSEs): to

enhance the flow of credit to targeted sectors of the economy

2.GSEs create a secondary market for loans securitization that helps to provide household borrowers cheaper loans, removes credit risk from bank balance sheets and provides standardized instruments.

3.Lenders tend to provide GSEs with favorable interest rates, and the buyers of their securities offer them high prices because of implicit (perception of) a government guarantee.

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Fannie Mae

1. Federal National Mortgage Association (FNMA)

2. founded in 1938 during the Depression

3. chartered by Congress in 1968 as a GSE

4. does not make home loans directly to consumers, but uses secondary mortgage market to facilitate liquidity in the primary mortgage market thereby ensuring that funds are consistently available to the institutions that do lend money to home buyers

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Federal Home Loan Mortgage Corporation(FHLMC)

1.The FHLMC was created in 1970 to expand the secondary market for mortgages

2.buys mortgages on the secondary market, pools them, and sells them as mortgage-backed securities to investors on the open market

3.“Freddie Mac has made home possible for one in six homebuyers and more than five million renters.”

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What are subprime mortgages and why should we panic?

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Key Points

Section 2A: Growing prevalence of subprime and Alt-A in mortgage market (Table 1)

Section 2B: Subprime Mortgage Design1.How to lend to risky borrowers?2.Using house appreciation to leverage risk

over the short-term ; rolling over mortgage every 2-3 years thanks to accelerated house appreciation

3.What are Adjustable Rate Mortgages (ARM)?

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Prevalence of Subprime mortgages in MBS

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What are Subprime Mortgages

High risk, Short-term with high prepayment penalties; re-financing necessary

ARM• Hybrid mortgages with fixed and floating

rates• Step-up mortgage rate• Prepayment penalty not to re-finance early• More susceptible to house pricesWhat is predatory mortgage lending? – Possible U.S. criminal investigation

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Mortgage Brokers in the U.S.

1.75% of portfolio in subprime mortgages, lucrative, ability to establish control

2.No stated income; bank statements, no credit history, or missed previous mortgage payments, no down payment

3.Supplied interest-only, 50-year, option-arm, adjustable-rate, 90-100%LTV; 100% cash out, high premiums

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Section 3 and 4

Subprime securitization has dynamic tranching as a function of excess spread and prepayment and is sensitive to house prices as a result.

These sections also explains how the subprime residential mortgage-backed securities were sold to CDOs, how CDOs were issued to structured investment vehicles (SIVs: leveraged investment company that raises capital by issuing capital market securities ), and the synthetic creation of subprime RMBS risk.

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Section 3: The Design and Complexity of Subprime RMBS

Bonds SecuritizationSubprime lenders tended to rely on securitization of the mortgages

(see Table 2)“Note that in 2005 and 2006 originations were about $1.2 trillion of which 80 percent was

securitized.” (Gordon, pg. 6)

Cash inflowsBut unlike other securitizations, because of re-financing, there

were expectations of early cash inflows. Gordon explains the risk that this created:

“The credit enhancement for, and the size of, the tranches (and hence the degree of subordination) will depend on the incoming cash over time. The dynamics of this make the risk inherent in the securitization of subprime mortgages dependent on the refinancing of the mortgages, which in turn depends on house prices….The cash flow comes largely from prepayment of the underlying mortgages through refinancing….In some cases, this can lead to a leakage of protection for higher rated tranches. “(pg. 7)

Hence, the securitization design and early cash flows tended to subvert the risk inherent in the subprime loans. Yet expectations of increasing house prices allowed this risk to be manageable.

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Mortgage Originations and Subprime Securitization

(Table 1)

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Subprime RMBS (Figure 1)

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Subprime RMBSResidential mortgage-backed securities (RMBS) REMIC (Real Estate Mortgage Investment Conduit: an investment

vehicle that holds commercial and residential mortgages in trust, and issues securities representing undivided interests in these mortgages.

Two types of asset-backed securities (ABS) and mortgage-backed securities (MBS)

1. A senior/subordinate shifting of interest structure (“senior/sub”), sometimes called the “6-pack” structure (because there are 3 mezzanine bonds and 3 subordinate bonds junior to the AAA bonds), or

2. An excess spread/overcollateralization (“XS/OC”) structure. Over-collateralization means that the collateral balance exceeds the bond balance, that is, deal assets exceed deal liabilities.

Subprime RMBS bonds:3. additional layer of support from excess spread (the interest paid

minus the spread out on of RMBS bonds.4. initially more assets (collateral) than liabilities (bonds).

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Falling House Prices

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Falling house prices

Between 2001 and 2005 homeowners enjoyed an average increase of 54.4 percent in the value of their houses” (pg. 21)

But when housing prices began to drop, it became harder for families to refinance. Remember mortgage brokers have control over decision to refinance in the subprime market

Current state of mortgage market (underwriting)

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ABX Index

1.Launched in January 20062.Measured the risk of owning

subprime mortgage bonds.

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ABX index (figure 4)

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Subprime Subprime PanicPanic

1.Falling house prices, 2.the role of the ABX

indices 3.the runs on the SIVs

(structured investment vehicles: that raises capital by issuing capital market securities and/or asset-backed commercial paper (ABCP).

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Section C. Asymmetrical Information

The intricate chain of securitizations were susceptible to house prices. While there was general knowledge of a housing “bubble”, no one could determine the size of the bubble, its duration, or its impact. Hence investors continued to make bets on the housing bubble.

Gordon explains, “That is, there was a lack of common knowledge about the effects and timing of house price changes and about the appearance of increases in delinquencies. This explains why the interlinked chain of securities, structures, and derivatives, did not unravel for awhile.” (pg. 21)

“The implicit contractual arrangement between SIV sponsors and investors led sponsoring banks to take the off-balance sheet SIVs back onto their balance sheets, when there was no explicit obligation to do so.” (Pg 31)

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“The banking system was metamorphosing into an off-balance sheet and derivatives world—the shadow banking system…

The capital markets, through the sale of intermediary-originated loans via securitization, and the distribution of risk through derivatives, highlight the centrality of capital markets and illustrate the flexibility of structured products.…”

So what happened?

“Finally holders of short term liabilities (mostly commercial paper, but also repo) refused to fund “banks” due to rational fears of loss—in the current case, due to expected losses on subprime and subprime-related securities and subprime-linked derivatives. In the current case, the run started on off-balance sheet vehicles and led to a general sudden drying up of liquidity in the repo market, and a scramble for cash, as counterparties called collateral and refused to lend. As with the earlier panics, the problem at root is a lack of information.” (pg. 31)

Repo market: The repo market is one in which two participants agree that one will sell securities to another and make a commitment to repurchase equivalent securities on a future specified date, or on call, at a specified price. In effect, it is a way of borrowing or lending stock for cash, with the stock serving as collateral.

“Shadow Banking System”

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Over-liquidity of low interest rates submerges the housing

market

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Asymmetric Information (cont’d)

1.“In the current crisis there was a loss of information due to the complexity of the chain. it is not possible to penetrate the chain backwards and value the chain based on the underlying mortgages. The structure itself does not allow for valuation based on the underlying mortgages, as a practical matter. There are (at least) two layers of structured products in CDOs. Information is lost because of the difficulty of penetrating to the core assets. Nor is it possible for those at the start of the chain to use their information to value the chain “upwards” so to speak.”

2.Agency relationships were also substituted for actual information.

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Asymmetric information (cont’d)

“Economists think of information as a “signal” about the future payoff of a security. Agents obtain signals by expending resources. The costs of learning the signal are recovered by trading on this private information. In the process the asset price aggregates the information.

The initial “signal” concerns the underwriting standards for the mortgages…as different portfolios are formed, each requires multiple signals. Essentially incentive-compatible arrangements are substituted for the actual signals, which are too complex to be transmitted. (pg. 26)

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Exposure of ABS

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Who is at risk?

1.Investors (trading or investing in securities or derivatives)

2.Banks and financial institutions that warehouse the securities or RMBS (exposed to market risk during this time); and that hold interest-only securities, principal-only securities and residual securities.

3.Mortgage companies (hold on to servicing rights up to 10% of total assets)

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Section 6 Alternative Hypothesis and Incentives

1.“Originate-to-distribute” view, incentives have been fundamentally altered – blames rating agencies; originators and underwriters of loans that no longer have an incentive to pay attention to the risks of loans they originate, since they are not residual claimants on these loans.

2.Another problem in the securitization design is that financial institutions earned fees on transferring credit risk in the short-term with supposedly little exposure due to short-term nature of holding the bond; this incentivized increasing amount of CDS.

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Residential Mortgage-Related Net Exposures and

Losses ($ millions)

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Gordon’s Conclusion

1.Current crisis can be described as a bank panic

2.The lack of details in both the financial institutional setting and the security design of subprime mortgages have created a banking panic

3.Lack of information of expected losses on subprime and subprime-related securities and subprime-linked derivatives has lead to drying up of credit markets

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Gordon’s Rescue Plan

Offer deposit insurance

Use Clearinghouse loan certificates to allow markets to fix the problem of asymmetrical information. The process of the auction would create transparency with respect to the prices of these securities. The markets will then provide a clearinghouse price for the contaminated securities. This information and guarantees will help lending institutions to continue lending.

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Critiques and Personal Reflection

1. House price bubble; Greenspan bubble; 2. Regulators – demand banks increase capital in times of

boom to prepare for downturn; 3. Balcerowicz: monetary policy was too loose; cut too much,

too low interest rates. prices inflated; banks provide cheap loans. Increased demand for houses and stocks.

4. Governments to blame : create easy credit; incentives for home owners to have access to financing.

5. Failure of private sector to manage risk6. Ensure risks are understood. 7. Prevent shift of assets of off-balance sheets - banks had

incentive to move to structured investment vehicles8. Credit rating agencies wrong in estimating the value of

instruments: triple A ; models of risk management were flawed. Using historical data covered good times.

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U.S. Bailout detailsUS $700bn rescue package signed on October 3, 2008The US Treasury is to invest $250bn in a number of banks as part of a

package of measures aimed at restoring confidence in its financial sector.

1. US Treasury will also issue blanket guarantee all bank deposits and new debt issues by banks for a period of three years; and an additional guarantee on new debt issued by banks will be put in place for a period of three years.

2. At least $125bn is to go to nine of America's largest banks, including Citigroup, JPMorgan Chase and Bank of America, in exchange for capital under the rescue plan.

Additional funds: The Fed said it would provide up to $540 billion in financing to money market mutual funds in a new program called the Money Market Investor Funding Facility, that will buy from money market mutual funds certificates of deposit, bank notes and commercial paper, which is short-term debt companies issue to raise money for payroll or supplies.

3. Money market funds hold about one-third of commercial paper.4. Fed officials said that about $500 billion has flowed out of prime

money market funds since August as investors worried about their ability to redeem shares.

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Government Bailout

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Bailout difficulties

But how will Treasury structure the pricing and purchase of the troubled assets, which are troubled precisely because they're difficult-to-value. Challenges from holding illiquid mortgage backed securities, to illiquid whole loans, to raising needed capital, to simply facing a crisis of confidence.

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Thank you

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More cartoons, anyone?

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Future of U.S. Housing Market?

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