Housing Crisis.ppt

7/27/2019 Housing Crisis.ppt

http://slidepdf.com/reader/full/housing-crisisppt 1/38

Slides by Frederica ShockleyCalifornia State University, Chico

Source: http://research.stlouisfed.org/publications/review/08/09/Mizen.pdf

The Credit Crunch of 2007-2008:

A Discussion of the Background,Market Reactions, and Policy

Responses

- Paul Mizen

http://research.stlouisfed.org/publications/review/08/09/Mizen.pdf




“Mispricing of Risk”

Crisis Due to “mispricing of risk” of new,

complicated assets based upon subprime & other mortgages.

High leverage contributed to risk.

House Prices ↓→ Foreclosures↑ → Bank

Failures

http://www.investorwords.com/1952/financial_leverage.html

http://www.investorwords.com/2039/foreclosure.html

http://www.answers.com/topic/bank-failure-2




http://www.investorwords.com/2039/foreclosure.html

http://www.investorwords.com/1952/financial_leverage.html



Background

The “Great Moderation” -years of macrostability

Low inflation

Low short-term interest rates

Steady growth

Global savings glut

Development of complex financial assets



Credit Boom

Fed dropped rates after dot com bust &again after 9/11.

Rising house prices

Stable economic conditions.

http://www.federalreserveeducation.org/fed101/index.htm?CFID=6800257&CFTOKEN=56137914

http://www.federalreserveeducation.org/fed101/index.htm?CFID=6800257&CFTOKEN=56137914



Disposable Income (DI) isincome after taxes that isavailable for consumption

& savings.



Savings Flowed into U.S.

After 1997 Asian Crisis many countriesbought U.S. treasuries & bonds.

Prices of Bonds ↑→ interest rates ↓→ Credit ↑

Savings from less developed countries fundedour deficits with growing imbalance.

1993 to 2005: U.S. savings as % of DI ↓

from 6% to 1%;Total debt to DI ↑ from 75% to 120%

http://www.imf.org/External/np/exr/facts/asia.htm








This is debt toDisposable Income (DI)which is income after

taxes that is availablefor consumption &savings.



U.S. Mortgages

Prime: borrowers have good credit & meetincome & house pricing requirements.

Jumbo: borrowers have good credit & meet

income requirements, but house price > amountset by Fannie & Freddie.

Alt-A have higher risk of default because theydo not conform to Fannie & Freddie

requirements.Sub-prime: most risky loans often made topeople with bad credit history.

http://www.yourdictionary.com/fannie-mae

http://www.yourdictionary.com/freddie-mac

http://www.investorwords.com/6734/alt_a.html




http://www.yourdictionary.com/freddie-mac

http://www.yourdictionary.com/fannie-mae



Mortgage

Originations



Sub-Prime Mortgages GrewRapidly

Late 90s increased to 13% of originations,but halted by dot com bust.

2002 – 2006: By 2006 Sub-Prime

mortgages = 20% of originations.Borrower faces higher upfront fees.

Lender faces higher probability of

prepayment or default.

http://www.investorwords.com/3793/prepayment.html

http://www.investorwords.com/3793/prepayment.html



Asset Backed Securities

Ginnie Mae & VA sold first securities backed by mortgages in 1968.

$10.7 T in global asset backed securitiesby 2006 (Bank of England).

Many purchased by off-balance sheetinstitutions owned by banks that originallysold securitized products.

http://www.answers.com/topic/government-national-mortgage-association

http://www.answers.com/topic/veterans-administration-va

http://www.investorwords.com/4446/security.html

http://www.thefreedictionary.com/securitized

http://www.thefreedictionary.com/securitized

http://www.investorwords.com/4446/security.html

http://www.answers.com/topic/veterans-administration-va

http://www.answers.com/topic/government-national-mortgage-association



Complex Securities

CDO’s, CDO’s Squared, CDO’s Cubed!

Great variation in characteristics of sub-primemortgages bundled together.

Not all low credit qualityMany borrowers depended upon rising homevalue to allow refi.

Many who bought securities did not understand

risk.

http://encyclopedia.thefreedictionary.com/Collateralized+debt+obligation

http://www.math.ust.hk/~maykwok/courses/MAFS521_07/CDO-Squared_Nomura.pdf

http://www.math.ust.hk/~maykwok/courses/MAFS521_07/CDO-Squared_Nomura.pdf

http://encyclopedia.thefreedictionary.com/Collateralized+debt+obligation



Sub-Prime Trigger

The sub-prime mortgage market triggeredthe crisis.

Default rates started increasing in 2006.

Pooled mortgages risky because defaultspositively correlated.

Investors highly leveraged. If 20 to 1 → 5% loss → 100% capital ↓

Investors lose all with only low default rates.

http://www.investorwords.com/3140/mortgage_pool.html








Global Impact

Originator faced low risk even if borrower defaulted.

Automated underwriting & outsourcing of

credit scores helped originators sell more mortgages.

With low interest rates throughout the world,investors “reached for yield.”

Sales of securities went global.

http://www.mortgageqna.com/qualifying-for-mortgage/what-is-automated-mortgage-underwriting.html


http://www.investorwords.com/5491/credit_score.html


http://www.mortgageqna.com/qualifying-for-mortgage/pros-and-cons-of-automatic-underwriting.html

http://www.mortgageqna.com/qualifying-for-mortgage/pros-and-cons-of-automatic-underwriting.html







Sub-Prime Assets

Subprime was trigger, but other highyielding assets, e.g. hedge funds, couldhave started the crisis.

People bought risky, complicated assetsbecause return was high.

After sub-prime defaults increased, rating

agencies downgraded many sub-primebacked securities.

http://www.investorwords.com/2296/hedge_fund.html

http://www.yourdictionary.com/business/rating-agencies






http://www.investorwords.com/2296/hedge_fund.html



Corporations Lost Billions

Assets difficult toassess → Uncertainty↑ →banks stopped

loaning to other banks.

A write down is the amount by which an asset’s

value is reduced.



Bear Stearns collapsed after hedgefunds failed to rollover asset

backed commercial paper .



Structured Investment Vehicle(SIV)

Funds that borrowed in short termcommercial paper market to financeassets that they held long term.

Borrowed at low rate & bought long-termsecurities that paid high interest.

Some intended to run indefinitely, but all

gone by Oct. 2008.

http://en.wikipedia.org/wiki/Structured_investment_vehicles

http://en.wikipedia.org/wiki/Structured_investment_vehicles



Liquidity Crisis

Banks afraid to loan because they might have tocover losses on their conduits or SIV’s.

The Libor-OIS spread increased from a long-run

10 basis points to 364 in 10/08. The London inter-bank offer rate indicates is the rate

that banks charge each other for loans of 1 day to 5years.

The London inter-bank offer rate indicates is the rate

that banks charge each other for loans of 1 day to 5years.

http://www.answers.com/topic/overnight-index-swap-1

http://www.answers.com/topic/overnight-index-swap-1



The London inter-bank offer rate indicates isthe rate that banks charge each other for

loans of 1 day to 5 years.



Three Month LIBOR – OIS Spread

Indicator of confidence bankshave in other banks.

Usually about 10basis points, butpeaked at 364 on10/10/08.

Greenspan saysTARP decreasedspread. Source:

http://www.microcappress.com/blog/credit-re-freeze-nipped-in-the-bud/641/

http://www.economist.com/finance/displaystory.cfm?story_id=12813430

http://www.economist.com/finance/displaystory.cfm?story_id=12813430



Credit Markets Froze



Cost of Insurance Increased

LCFI = Large Complex Financial Institution

http://www.bankofengland.co.uk/publications/fsr/2003/fsr15art3.pdf

http://www.bankofengland.co.uk/publications/fsr/2003/fsr15art3.pdf



Originate & Distribute Baking

In use for 40 years, but opacity ↑ →mispricing of risk:

Residential MSB’s backed by sub-prime

mortgages ↑

Steps between originator & holder ↑

Distorted incentives.

Difficult to evaluate risk.



Six Bad Incentive Mechanisms

1. Mortgage brokers motivated by up-front feesindependent of borrower quality.

Often not employees of mortgage originators → not

subject to regulation. Fraud in some cases.

2. Originators had no more incentive to seekquality borrowers than did brokers.

Investors wanted more mortgages.

Automated underwriting systems made mortgagesloser & faster.



More Bad Incentives

3. Mortgages ↑→Securitization profits for originators ↑

Quality of new borrowers ↓ → Standards ↓ →

NINJA loans – No Verified Income, Job, or Assets.

Piggyback loans ↑

Over time Risk of default ↑



More Bad Incentives

4. Tranching allowed financial entities totailor securities for varying levels of riskpreference.

5. Rating agencies made income ratingthese financial products.

Issuers paid up-front fees to rating agency.

Rating agencies sold advice to issuers onhow to get desired rating.



More Bad Incentives

6. CDO’s ↑ → Return↑→ Fund manager

bonuses ↑

“As long as the music is playing, you’ve got to

get up and dance. We’re still dancing.” Chuck

Prince, former CEO Citigroup.http://research.stlouisfed.org/publications/review/08/09/Mizen.pdf (page 22)







The Result

Incentives of brokers, originators, SPV’s,rating agencies, & fund managers thesame.

No principal agent problem!

http://www.businessdictionary.com/definition/special-purpose-vehicle-SPV.html

http://economics.about.com/od/economicsglossary/g/principalag.htm

http://economics.about.com/od/economicsglossary/g/principalag.htm

http://www.businessdictionary.com/definition/special-purpose-vehicle-SPV.html



Regulation, Supervision, & Accounting Practices

Originators often ignored the quality of borrowers & Fed & state agencies did nothing.

Originators may have engaged in predatorylending.

Consumer protection legislation not enforced.



CRA Regs Encourage Risky Loans

HUD required Freddie & Fannie to buymortgage securities for low incomehomeowners mid 90s.

HUD expected originators to imposehigher standards on such lenders, butFreddie & Fannie bought the mortgagesanyway.

Such securities increased 2004 to 2006.

http://www.ffiec.gov/CRA/

http://www.hud.gov/

http://www.hud.gov/

http://www.ffiec.gov/CRA/



New Fed Rules for “Higher Priced” Mortgages

Source: http://research.stlouisfed.org/publications/review/08/09/Mizen.pdf (Page 30)

Escrow

First lien mortgage loansare the first or originalmortgages taken outwhen someone buys a

mortgage.


http://hubpages.com/hub/Escrow-Definition_and_Description

http://hubpages.com/hub/Escrow-Definition_and_Description




Other Potential Changes

Require banks to hold same capitalrequirements for “off -balance-sheet”

entities, e.g. SIV’s & conduits.

Regulators need to evaluate the “big

picture” in order to reduce the externality cost of excessive risk taking.



Regulation of Rating Agencies

Rating agencies should be single productfirms.

They need to use models that take intoconsideration longer spans of data.

They need to be subject to regulation.



Conclusions

Reasons for credit crisis:

Period of macro stability with low inflation &low interest rates.

Big increase in supply of loanable funds.

Financial innovation resulted in complexinstruments, e.g. MBS’s.

Higher leverage;Sub-prime mortgages.

Risk assessment failed.



Conclusions

No one expected housing prices to fallnationwide.

Nationwide falling housing prices & higher interest rates led to defaults.

Other high yield assets, e.g. hedge funds,could have been trigger.

Bank failures led to credit freeze incommercial paper.



Conclusions

Central bankers stepped in to provideliquidity.

Regulation will need to increase if we areto prevent future crises.

Documents

Housing Crisis.ppt