2008
Palisade Risk and Decision Analysis Conference
Simulating the Financial Consequences of the
Subprime Mortgage Crisis
Roy L. Nersesian
School of Business
Monmouth University
Once Upon a Time, In a Land Far, Far Away
Mortgage Bankers Practiced Sound Lending
Principles
20% Equity Investment in a House
Mortgage Payments Not to Exceed 25% of
Gross Income
Bankers Held the Mortgage
Personal Relationship Between Banker and
Mortgagee
Bankers Set Credit Standards
2
Institutions Wanted to Buy Mortgages For Income
Banks Began to Originate Mortgages and Sell
Them for Syndication
Intermediaries Stood Between Buyers and Sellers
Banks Earned Fees for Servicing the Mortgages
Intermediaries Earned Syndication Fees
Buyers such as Pension Funds Would Not Buy
Non-Creditworthy Mortgages
Third-Party Buyers Now Set the Credit Standards
3
The Road to Hell Is Paved With Good Intentions
Community Reinvestment Act
Intended to Counter Red-Lining
For Banks to Expand, Mortgages Must Be Made to
to Those Who Do Not Qualify in a Conventional
Sense
Fannie Mae and Freddie Mae Eventual Dumping
Ground For Substandard Mortgages as Guarantors
or Buyers
4
Collateralized Mortgage Obligation
(CMO)
First Step Slice
Tranch A
Tranch B
Tranch C
5
Tranch A
First Five Years of Amortization Payments
Plus All Prepayments
Carried Guarantee from Triple A Guarantor
Example: AIG
Had Reduced Interest Rate Reflecting
Short Term Maturity and Triple A Rating
Major Risk at Time of Issue:
Premature Repayment!
6
Tranch B
After Tranch A Paid Off, Tranch B Received all
Amortization Payments and All Prepayments
Without Prepayments, Would be Paid Off in
15 Years; Prepayments Hasten Maturity
Carried Interest Rate Equivalent to a B or C Rating
Could Have Credit Enhancers Such as Credit Default
Swap Agreement or an Investment Grade Credit
Rating from Rating Agencies such as Standard &
Poor, Moody or Fitch to Reduce Interest Rate and
Attract Buyers
7
Tranch C
After Tranch B Paid Off, Tranch C Received
All Interest and Amortization Payments
and Prepayments
With No Repayments, Would be Paid off in
30 Years (Most Mortgages Have a Much
Shorter Life from House Sales and Refinancing)
Longest Maturity and Highest Degree of Risk
Greatest Risk and Greatest Need for Credit
Default Swap or Investment Grade Rating
High Interest Rate to Compensate for Risk
8
Collateralized Mortgage Obligation (CMO)
First Step Slice – Second Step Dice
Tranch A
Tranch B
Tranch C
9
Investment Banker Held the Mortgages in
Escrow
Sold Bits & Pieces of Sliced and Diced
Mortgages As Collateralized Mortgage
Obligations
Buyers Had No Idea of Exactly What Bits
& Pieces They Were Buying in the CMOs
Creditworthiness Purely in Hands of
Intermediaries Who Did Not Hold a
Vested Interest
Buyers Depended on Credit Default
Swaps or Investment Grade Ratings
10
Pumping Air into a Bubble
Allowing People to Buy Homes Who
Were Otherwise Ineligible Added to
Housing Demand
House Prices Started to Rise
Homebuilders Started to Build
This Boosted Economic Activity
11
Government Support
Moral Good to Have Everyone a Homeowner
President Bush Applauded Rising Home
Prices Supported by Easy Mortgages
• Building Boom Adding to Economic Activity
• Refinancing Existing Homes at Higher
Levels of Debt Promoted Consumer Spending
• Increased Consumer Spending Good for
Economic Activity
12
TV Evangelists Pointing the Way to
Micro-Trump Fortunes
House Flipping
• Buy a House Fix it Up and Sell into Rising
Market Became Buy a House, Do Nothing,
and Sell into a Rising Market
• Order a New House for $X, Get 100%
Financing, Wait to Its Built and Sell for $X+Y
• Order 2,3,4,5 Houses for $2,3,4,5*X, Get 100%
Financing, Wait till They’re Built and
Sell for $2,3,4,5*(X+Y)
• A Veritable Ponzi Scheme – Continual
Demand for New Houses by More and More
Micro-Trump Fortune Seekers
13
Ballooning Demand for CMO Paper
Lots of Global Excess U.S. Dollars from
Perennial Trade Deficits by U.S. Consumers
Sinking into Credit Card and Mortgage
Debt to Buy Chinese Imports and Oil Imports
at Record High Prices
Low Interest on U.S. Government Bonds
Not Compensating for Inflation
CMO Tranch C Very Attractive Interest Rates
Sovereign Wealth Funds
Norwegian Teachers’ Pension Funds
Virtual Infinite Demand
14
The New Paradigm
It Does Not Matter Who the Mortgagee Is
House Prices Continually Rising
If Mortgagee Falls Behind in Payments:
1. Foreclose on the House
2. Sell House for Higher Price
3. Foreclosure Losses Minimized
Liar’s Mortgages
Pay Slight Premium to Avoid Checks on
Income, Debt, and Net Worth
Example: Illegal Alien with No Visible
Means of Support Got $300,000 Mortgage
15
Adjustable Rate Mortgages
Teaser Rates for First 2-5 Years Followed
By Steep Step-up in Interest Rate
Low Rate Permitted Even Larger Sized
Mortgages to be Granted
Mortgagees Intended to Refinance
Mortgage Before Step-up Occurred
16
Infinite Supply – Infinite Demand
Investment Banker Only Interested
In Bonuses of 7, 8, and 9 Figures
Garbage Mortgages Held in Escrow
Sold on a Global Scale
Investment Banker Zero Credit Standards
CMO Buyers Asked No Questions – Depended
On Credit Rating Agencies Who “Sold Their
Soul” for the Rating Fees
Critics Silenced or Ignored
Not Unlike the 1920sStock Market Boom
17
Then One Day, The Birds Came Home to Roost
Homebuilders Built More Houses Than House
Flippers and Liars’ Mortgages Could Absorb
House Prices Stabilized
First Group to Walk
House Flippers Dead
Could Not Hold on to Houses to Await Upturn
Mortgage Payments
Insurance (Florida $18,000 for Hurricane
Insurance on Upscale Houses)
Property Tax Payments
18
Second Group to Walk
Those Who Intended to Refinance Mortgages
Before Teaser Rates Ended
Banks Got Religion and Reinstated Traditional
Credit Standards
Mortgagees Unable to Put up 20% Equity
Value of Homes Declining
Economic Activity Down From Housing Bust
Lower Income, High Fuel and Food Costs, and
Steep Step-up in Mortgage Interest Costs
Snapped Already Stressed Budgets
19
Third Group to Walk
You Own a $1 Million MacMansion
It Is Now Worth $700,000
Do You Continue to Make Payments With
Negative Equity of $300,000?
Or Do You Walk?
Personal Credit Rating Ruined – Can Always Rent
A $1 Million MacMansion in Foreclosure!
1930’s Law Prohibits Banks from Pursuing
Defaulter – Maximum Loss is Loss of Home
(A Free Put)
20
The Third Group Is the Big Unknown
Creating the Simulation
Dividing Nominal $100,000 Mortgage
Into Tranches A, B, and C
Principal
Total Interest
First 5 Years
$34,000
Total Interest
6-15 Years
$60,000
Total Interest
Over 15 Years
$45,000
Total
Interest &
Principal
Tranch A
$6,000
$1,000
-
-
$7,000
Tranch B
$20,000
$7,000
$15,000
-
$42,000
Tranch C
$74,000
$26,000
$45,000
$45,000
$190,000
Total
$100,000
$139,000
21
Simulated CMO
Made up of 1,000 Mortgages Face
Amount Between $400,000 and $1 Million
Total Value Around $700 Million
CMO Created Several Years Ago
• Group 1 Has Already Walked
• Group 2 Has Already Walked
Tranch 1 Holders Reimbursed From Losses
by Triple A Guarantor Who Today Is Ward
of the Government or No Longer Triple A
22
Group 1 and 2 Make Up Between 20-30%
of 1,000 Mortgage Portfolio
=1000*RiskPert(0.2,0.25,0.3)
Group 3
Depends on Duration of Housing Crisis
& Nature of Home Price Declines
Duration of Decline (Years)
% Probability
Cumulative
% Defaults
1
5%
0‐3%
2
20%
2‐8%
3
30%
7‐12%
4 or more
45%
10‐15%
23
Duration of Housing Depression
=RiskDiscrete({1,2,3,4},{0.05,0.2,0.3,0.45},RiskName("Duration of Housing
Depression"))
Duration
Year
Group 3
of Housing
1
1
1
Depression
2
1
36
3
3
1
81
4
0
0
118
Year
Group 3
1
=IF($F$6>=1,1,0)
=H4*1000*RiskPert(0,0.015,0.03)
2
=IF($F$6>=2,1,0)
=H5*1000*RiskPert(0.02,0.04,0.08)
3
=IF($F$6>=3,1,0)
=H6*1000*RiskPert(0.07,0.09,0.12)
4
=IF($F$6=4,1,0)
=H7*1000*RiskPert(0.1,0.12,0.15)
=SUM(I4:I7)
24
Below Calculates Number of Defaults and
Amount of Mortgages In Default and
Not in Default
1
2
3
4
5
6
7
8
9
10
11
12
A
B
C
D
Subprime CMO Financial Loss Calculator
Number of Mortgages in Default
Amount of Mortgages in Default
E
F
G
H
I
J
Group
1&2
Duration
of Housing
Depression
4
Year
1
2
3
4
1
1
1
1
Group 3
17
53
88
128
286
Total
513
227
$157,870
$198,259
Amount of Mortgages Not in Default
$356,129
$343,871
The Total Loss in Cell J10 Is Calculated By:
=RiskCompound(J8,RiskPert(400,700,1000))
25
The Shortfall Reflects a Foreclosed House
Eventually Recouping 40-70% of its Original Value
A
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
B
C
D
Portfolio Size
E
F
Scaling up to
Portfolio of:
$100,000
$700,000
G
H
Money
Collected
Mortgages
not in
Default
Interest Payments of CMO to Tranch A
Principal Payments of CMO to Tranch A
Total to be Paid to Tranch A
$1,000
$6,000
$7,000
$7,000
$42,000
$49,000
$3,439
$20,632
$24,071
Interest Payments of CMO to Tranch B
Principal Payments of CMO to Tranch B
Total to be Paid to Tranch B
$22,000
$20,000
$42,000
$154,000
$140,000
$294,000
$75,652
$68,774
$144,426
I
Shortfall
0
($21,368)
Remaining Proceeds
($71,226)
Remaining Proceeds
Interest Payments of CMO to Tranch C
Principal Payments of CMO to Tranch C
Total to be Paid to Tranch C
$116,000
$74,000
$190,000
$812,000
$518,000
$1,330,000
$398,890
$254,464
$653,354
($263,536)
26
Tranch A Holders Made Whole by Guarantor
Tranch B and C Holders Suffer Shortfalls
I
15
16
17
18
Shortfall
19
20
21
0
22
($21,368)
23
24
25 Remaining Proceeds
26
($71,226)
27
28
29 Remaining Proceeds
30
($263,536)
31
32
J
Proceeds From
Liquidation of
Foreclosed
Properties
$214,027
$21,368
K
L
M
N
Total
Collected
Financial
Loss
As % of
Expectations
$7,000
$42,000
$49,000
$192,659
$71,226
$75,652
$140,000
$215,652
$78,348
27%
$398,890
$375,897
$774,787
$555,213
42%
$121,433
$121,433
27
Tranch B Holders Suffer Losses
Trimodal Appearance From Varying
Length of Housing Depression
Tranch B Loss Expectation
0.1442
5.0%
14
0.2905
90.0%
5.0%
12
10
Tranch B Loss E xpectation
8
M inimum
M aximum
M ean
S td D ev
V alues
6
4
0.1126
0.3194
0.2248
0.0500
10000
2
0.35
0.30
0.25
0.20
0.15
0.10
0
28
Tranch C Holders
Loss Expectation Based on
Total Principal and Interest for
No Prepayments and No Foreclosures
Tranch C Loss Expectation
0.2364
0.4855
5.0%
7
90.0%
5.0%
6
5
Tranch C Loss E xpectation
4
M inimum
M aximum
M ean
S td D ev
V alues
3
2
0.1784
0.5542
0.3712
0.0834
10000
1
0.60
0.55
0.50
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0
29
Why Did Financial Intermediaries Suffer?
When Housing Prices Initially Stabilized,
They Believed That This Was Only a Brief
Lapse Before Prices Would Resume
Climbing Bringing Life Back to CMO Market.
They Built up Their Inventory of Mortgages
In Anticipation of Future CMO Sales
When Houses Prices Began to Fall, the CMO
Market Died and the Investment Bankers
Were Stuck With Unsold Inventory (Toxic
Waste)
30
Another Reason: Napoleonic Complex
Fall of Napoleon Can Be Traced to the Day
He Started to Believe His Own Propaganda
Of Invincibility
Investment Bankers Bought High Yield
Tranch C Securities to Improve Corporate
Earnings and Take-Home Bonuses – They
Actually Believed Their Own Lies!
31
Epilogue
Full Scale Crisis in Banking Confidence
Trillions to Reliquefy Credit Facilities
Collapse of World Stock and Commodity Markets
Aided and Abetted by Hedge Fund Liquidations
What about $700 Trillion Derivatives Market?
(Global Cash and Securities $80 Trillion)
32