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1
The Rise and Fall of the U.S. Mortgage and Credit Markets
Glenn YagoOctober 2009
2
Overview Factors that contributed to credit boom and bust• Lax monetary policy and global imbalances led to low interest rates• Reach for yield, reliance on short-term wholesale funding for relatively illiquid assets,
small cash buffers, and risky/substantial leverage• Financial innovation, such as securitization that weakened lending standards (e.g.,
mortgage originators) and credit default swaps that increased inter-connectivity (e.g., AIG), transferred risk broadly to others
• Opacity due to complexity of financial instruments (e.g., CDOs), riskier collateral for securities (e.g., subprime mortgages), heavy reliance on credit rating agencies, and over-the-counter trading of credit default swaps
• Procyclicality of regulation (capital requirements) and mark-to-market accounting, which contributed to forced asset sales and deleveraging
• Lack of a procedure to deal with deeply troubled big banks and non-bank financial institutions (too big to fail or too strategically important or too inter-connected)
• Incentive/compensation system that encouraged excessive risk taking, and poor corporate governance
• Public policy: gaps in regulatory structure and inconsistent asset management strategy• Flight to safety due to uncertainty of asset values and solvency of financial institutions
(hoarding of liquidity and/or calls for more collateral)
3
Overview of the housing market
Total value of housing stock = $18.3 trillion
Note: total residential and commercial mortgages = $14.6 trillion at year-end 2008.
Sources: Federal Reserve, Milken Institute.
Equity in housing stock$7.8 trillion
Mortgage debt $10.5 trillion Prime
92.7%
Subprime7.3%
Securitized60%
Non-Securitized
40%
Government-controlled
48%
Privatesector-
controlled52%
4
The mortgage problem in perspective
Note: The data is at year-end 2008.Sources: U.S. Census, Freddie Mac, Mortgage Bankers Association, Milken Institute.
25 million or 31% are paid off80 million houses
55 million have mortgages 49 million or 89% are paying on time
6 million are behind11% of 55 million with 3% in foreclosure
This compares to 50% seriously delinquent in the 1930s.
5
Home price bubble, credit boom and bust
Low interest rates, credit boom and bust
Sources: Inside Mortgage Finance, Mortgage Bankers Association, Moody’s Economy.com, S&P/Case-Shiller, Milken Institute.
US$ trillions
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
2001 2002 2003 2004 2005 2006 2007 2008
2.5
3.0
3.5
4.0
4.5
5.0
5.5
6.0
1-Year ARM mortgage rate
(right axis)
Home mortgage
originations (left axis)
Percent Index, January 2000 = 100
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
2001 2002 2003 2004 2005 2006 2007 2008
50
75
100
125
150
175
200
US$ trillions
Home mortgage
originations (left axis)
S&P/Case-Shiller National Home
Price Index (right axis)
6
All states had home price increases From 4Q 2001 to 4Q 2006
Sources: Moody’s Economy.com, Milken Institute.
United States = 43%
7
Forty-seven states had home price declines From 4Q 2006 to 4Q 2008
Sources: Moody’s Economy.com, Milken Institute.
United States = -19%
8
One year ago… Six years ago…
If you bought your house…
% change in price, January 2008-2009 % change in price, January 2003-2009Sources: S&P/Case-Shiller, Milken Institute.
-4.9-5.1-5.2
-7.3
-8.2-9.6
-14.0-14.3
-15.0-16.4
-19.0
-19.3-19.4
-20.4-22.6
-23.3-24.9
-25.8-29.4
-32.4-32.5
-35.0
DallasDenverClevelandBoston
CharlotteNew YorkPortlandAtlantaSeattleChicagoComposite-20
WashingtonComposite-10MinneapolisDetroitTampaSan DiegoLos Angeles
MiamiSan FranciscoLas VegasPhoenix
35.3
33.3
23.7
18.4
15.4
12.3
12.0
10.6
10.6
7.9
3.2
3.0
2.7
0.0
-1.0
-2.0
-4.6
-4.9
-6.6
-12.4
-13.3
-32.9
Portland
Seattle
New York
Washington
Los Angeles
Charlotte
Tampa
Composite-10
Miami
Composite-20
Chicago
Las Vegas
Boston
Phoenix
Dallas
Denver
San Diego
Atlanta
Cleveland
San Francisco
Minneapolis
Detroit
9
Las Vegas housing market
Source: James Barth and Harris Hollans.
0
50
100
150
200
250
300
350
1994 1996 1998 2000 2002 2004 2006 2008 Q3
US$ thousands
0
10
20
30
40
50
60
70
80
Median home sales price (left axis)
Flips/total transactions (right axis)
Foreclosures/total transactions (right axis)
Percent
10
Percentage of homes purchased between 2004 and 2008 that now have negative equity
Sources: Zillow.com, Milken Institute.
United States = 41%
11
Leverage ratios of selected financial firms December 2008
9.3
10.6
11.1
31.6
26.2
21.5
67.9
0 10 20 30 40 50 60 70 80
Credit unions
Commercial banks
Saving institutions
Brokers/hedge funds
Federal Home Loan Banks
Fannie Mae
Freddie Mac
Leverage ratio, total assets/common equity
Note: Leverage ratios for Freddie Mac and Fannie Mae are as of June 2008. The two institutions have negative common equities as of December 2008.Sources: FDIC, FHL Banks Office of Finance, National Credit Union Administration, Freddie Mac, Fannie Mae, Milken Institute.
(June 2008)
(June 2008)(June 2008)
12
Too much dependence on debt? Leverage ratios at biggest investment banks
2219
2826
18
31
19
2724
23
33 32 3431
13
33 34
2422
13
0
5
10
15
20
25
30
35
40
Morgan Stanley Merrill Lynch Bear Stearns Lehman Brothers Goldman Sachs
2000 2005 2007 2008
Total assets/total shareholder equity
March 2008
June 2008
Sources: Bloomberg, Milken Institute.
13
Too much dependence on debt? Leverage ratios at bank holding companies
Sources: Bloomberg, Milken Institute.
13
17
1311
19
14 13 1312 13
10
13
0
5
10
15
20
25
Citigroup Bank of America JPMorgan Chase
2000 2005 2007 2008
Total assets/total shareholder equity
14
Balance sheet information on FDIC-insured institutions
Sources: FDIC, Milken Institute.
0
5
10
15
20
25
1992 1994 1996 1998 2000 2002 2004 2006 2008
0
10
20
30
40
50
60
70
80
90Percent Percent
Equity capital-to-asset ratio (right axis)
Cash-to-asset ratio(left axis)
Deposits-to-asset ratio (right axis)
Insured deposits-to-asset ratio (right axis)
Borrowed funds-to-asset ratio (left axis)
15
Reserve coverage ratio of all FDIC-insured institutions
Sources: Quarterly Banking Profile, FDIC, Milken Institute .
0
50
100
150
200
250
2005 2006 2007 2008
020406080100120140160180200
US$ billions Percent
Noncurrent loans (left axis)
Loan-loss reserves (left axis)
Coverage ratio (right axis)
16
The mortgage model switches fromoriginate-to-hold to originate-to-distribute
Sources: Federal Reserve, Milken Institute.
Household mortgage debt
2008=$10.5 trillion
Held in portfolio40%
Securitized60%
Household mortgage debt
1980=$958 billion
Held in portfolio89%
Securitized11%
17
The rise and fall of private-label securitizers Outstanding securities
Sources: Inside Mortgage Finance, Milken Institute.
26%
55%
6%
13%
1985Total = $390B
39%
14% 18%
29%
2001Total = $3.3T
33%
35%7%
25%
2006Total = $5.9T
37%
27%9%
27%
2008Total = $6.8T
Ginnie Mae Freddie Mac Fannie Mae Private-label
26%
55%
6%
13%
1985Total = $390B
39%
14% 18%
29%
2001Total = $3.3T
33%
35%7%
25%
2006Total = $5.9T
37%
27%9%
27%
2008Total = $6.8T
Ginnie Mae Freddie Mac Fannie Mae Private-label
18
S&P Total Downgraded Downgraded/ Total
AAA 1,032 156 15.1%
AA(+/-) 3,495 1,330 38.1%
A(+/-) 2,983 1,886 63.2%
BBB(+/-) 2,954 2,248 76.1%
BB(+/-) 789 683 86.6%
B(+/-) 8 7 87.5%
Total 11,261 6,310 56.0%
56 percent of MBS issued from 2005 to 2007 were eventually downgraded
Sources: Inside Mortgage Finance, Milken Institute.
Note: A bond is considered investment grade if its credit rating is BBB- or higher by S&P. The data is downgraded through October 2008.
19
When is a AAA not a AAA? Multilayered mortgage products
Sources: International Monetary Fund, Milken Institute.
Origination ofmortgage loans High-grade CDO
Senior AAA 88%Junior AAA 5%
Pool of mortgage AA 3%loans: prime or subprime A 2%
BBB 1%Unrated 1%
Mortgage bonds
AAA 80%AA 11%A 4% Mezzanine CDO
BBB 3% CDO-squaredBB-unrated 2% Senior AAA 62%
Junior AAA 14% Senior AAA 60%AA 8% Junior AAA 27%A 6% AA 4% CDO-cubed…
BBB 6% A 3%Unrated 4% BBB 3%
Unrated 2%
20
National banks State commercial and savings banks
Federal savings banks
Insurance companies
Securities brokers/dealers
Other financial companies, including mortgage
companies and brokers
• Fed• OTS
• OCC• FDIC
• State bank regulators• FDIC• Fed--state member commerical banks
• OTS• FDIC
• 50 State insurance regulators plus District of Columbia and Puerto Rico
• FINRA• SEC• CFTC• State securities regulators
• Fed• State licensing (if needed)• U.S. Treasury for some products
• OCC• Host county regulator
• Fed• Host county regulator
• OTS• Host county regulator
Federal branch
Foreign branch
Limited foreign branch
Fed is the umbrella or consolidated regulator
Primary/secondaryfunctionalregulator
Notes:Justice Department: Assesses effects of mergers and acquisitions on competitionFederal Courts: Ultimate decider of banking, securities, and insurance productsCFTC: Commodity Futures Trading CommissionFDIC: Federal Deposit Insurance CorporationFed: Federal ReserveFINRA: Financial Industry Regulatory Authority GSEs: Government Sponsored Enterprises OCC: Comptroller of the CurrencyOTS: Office of Thrift SupervisionSEC: Securities and Exchange Commission
• Federal Housing Finance Agency
Fannie Mae, Freddie Mac, and Federal Home Loan Banks
Financial, bank and thrift holding companies
Justice Department• Assesses effects of mergers and acquisitions on competition
Federal courts• Ultimate decider of banking, securities, and insurance products
Sources: Financial Services Roundtable (2007), Milken Institute.
The U.S. regulatory regime: In need of reform?
commercial banks
21
How far do home prices have to fall? Average = 100
Sources: Moody’s Economy.com, Milken Institute.
60
80
100
120
140
160
1981 1988 1995 2002 2009
OFHEO
Case-Shiller: 20-metro
Case-Shiller: 10-metro
Case-Shiller National
Price/rent
60
80
100
120
140
160
1981 1988 1995 2002 2009
OFHEO
Case-Shiller: 20-metro
Case-Shiller: 10-metro
Case-Shiller National
Price/disposable income per capita
22
Alternative measures for the affordability ofmortgage debt for California
Mortgage payment assumptions:
* Home is purchased at median price
* Buyer takes out a 30-year
conforming, fixed-rate loan
* Payment also includes 1% property
tax per year, 0.1% property
insurance
Sources: Moody’s Economy.com, Milken Institute.
20%
30%
40%
50%
60%
70%
80%
2000 2002 2004 2006 2008
Estimated monthly payment / monthly household income
100% LTV
Maximum affordablility limit is 38% of median household income
90% LTV
80% LTV
23
Overview Government responses to liquidity freeze and credit crunch
• Government/private sector purchases of toxic assets• Guarantees for selected assets and liabilities • Capital injections into financial institutions• Subsidization of loan modifications by financial institutions • Debt for equity swaps• Easier monetary policies, including lowering interest rates and quantitative/
credit easing• Coordinated responses by countries (e.g., central bank currency swaps)• Establish an RTC-like agency (?)• Create good banks, bad banks (?)• Nationalize deeply troubled financial institutions (?)
24
Federal government comes to the rescue of Main Street and Wall Street
Upper limit to total funds under these programsUpper limit to total funds under these programs
……$9.8 trillion plus ?$9.8 trillion plus ?
Federal Reserve 6,048
Congress and White House 2,466
Federal Deposit Insurance Corporation 926
Treasury, Federal Deposit Insurance Corporation and Federal Reserve 362
Total amount dispersed/committed (US$ billions) 9,802
Source: Milken Institute.
25
Overview Reforms to prevent/mitigate credit booms and busts
• Macro-prudential regulation (i.e., establish a systemic risk regulator or market stability regulator)• A liquidity regulation to take into account maturity mismatches due to short-term funding of longer-
term, illiquid assets• Countercyclical regulation (e.g., dynamic capital and/or provisioning regulations)• A regulation that internalizes (taxes) a financial institution’s contribution to systemic risk (to address
too-big-to-fail issue)• Greater transparency by requiring clearing and settling of credit default swaps to be conducted
through clearing houses or on exchanges, which provides for greater monitoring of exposures and posting of necessary collateral
• Change fee structure for credit rating agencies, eliminate the Nationally Recognized Statistical Rating Organization (NRSRO) designation, and decrease use of ratings in regulatory system
• Consider eliminating treatment of residential mortgages as non-recourse loans (i.e., secured only by the underlying property), merging Freddie Mac and Fannie Mae, and requiring mortgage originators to have “skin in the game”
• Consider modifying incentive/compensation systems to discourage excessive risk taking• Reform structure of regulatory system • Consider establishing greater co-operation among regulators in countries or establish centralized
supervision or deposit insurer in some regions
26
• Barry Eichengreen’s slides
27
And not only here: It is a global slump in industrial production
60
65
70
75
80
85
90
95
5 10 15 20 25 30 35 40 45 50
Ju ne 1929= 100 A pril 2008=100
100
28
Not only here:Trade is collapsing faster than in 1929
60
70
80
90
100
110
5 10 15 20 25 30 35 40 45 50
Ju ne 1929=100 A pril 2008=100
29
Not only here:It is a global stock market crash
30
40
50
60
70
80
90
100
110
5 10 15 20 25 30 35 40 45 50
Ju ne 1929=100 A pril 2008=100
30
Grading the policy response
• Monetary policy: A-• Fiscal policy: B+• Housing policy: B+• Banking policy: Incomplete
31
Even then there is no instantaneous fix
• Vertical line in figure at left is date of major bank recapitalization.
• It still takes two years after that for lending to recover even in the Swedish case that is the benchmark of how to do it.
• It took a long time to get into this mess. Alas it will take a long time to get out.
32
We will become more heavily indebted, but we have no choice
CBO forecasts now suggest that the US debt ratio will rise from 40 to 80 percent of GDP.
33
This is roughly what happened in Finland and Sweden
• In resolving their banking crises, their debt ratios similarly rose by 40% of GDP.
• Of course, you can make progress later, bringing this ratio back down, through surpluses and growth (if you fix the banking system and then show political resolve)
34
This is not to deny that there will be medium term consequences
• There will be crowding out of capital investment, not now but once the economy is firing on all cylinders again.
• But my point is that there is little choice.
• We have dug ourselves a deep hole. The cost of preventing growth from collapsing now will be somewhat slower growth for several years going forward (until we normalize the budget balance).
35
• Alan Boyce’s slides
36
U.S. Non-Agency MBS market died
Note: 2000-2005 assumed straight-line for quarterly comparison
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
$140,000
1Q00
3Q00
1Q01
3Q01
1Q02
3Q02
1Q03
3Q03
1Q04
3Q04
1Q05
3Q05
1Q06
3Q06
1Q07
3Q07
1Q08
3Q08
MB
S Is
suan
ce (
$ m
illio
ns)
0%
10%
20%
30%
40%
50%
60%
No
n-A
gen
cy Is
suan
ce /
To
tal I
ssu
ance
Prime
Subprime
Alt-A
Non-Agency / Total
37
Which reduces risk of negative equityTypical homeowner scenario:
–Borrower pays $100,000 for a house with an 80% LTV, loan originated at par–Agency Loan, housing prices have fallen 10% and FN 5% mortgage bond prices have fallen to 94
–Non-Agency Loan, housing prices have fallen 30% and mortgage bond prices have fallen to 75
At Origination
House 100
Loan 80
Equity 20
Agency Loan:
Housing Prices Down 10%
Non-Agency Loan:
Housing Prices Down 30%
Principleof Balance
House 70
Loan 60
Equity10
Change in Equity: -50%
Existing System
House 90
Loan 80
Equity10
Change in Equity: -50%
Existing System
House 70
Loan 80
Equity -10
Negative Equity
Principleof Balance
House 90
Loan 75
Equity15
Change in Equity: -25%
38
First lossLoan Originator
10%
Down payment 20%
Guaranty from GSE
90%Value
of the
loan
Value of
the house
Credit enhancement structure for shared platform
Provided by Originator and/or MI industry Expected Capital reserves of 20% Backup capital and industry skill to be provided
by MI Reinsurance Industry
AAA rating flows from GSE guarantee The value of the house will serve as collateral Bond holder looks to GSE for full faith and credit
guaranty GSE looks to Originator remove bad loans from
the pool Originator purchases parri passu amount of bonds
from pool at lower of market or par If originator fails to perform, GSE can seize servicing
rights and margin and reassign to another servicer