Welcome
Paul Haran
Principal,
UCD College of Business & Law
Introduction
Tom Begley
Dean,
UCD Schools of Business
Keynote Speaker
Prof Robert Van Order
Professor of Finance,
University of Michigan
PROPERTY VALUES,
SUB PRIME MARKETS
AND SECURITIZATION:
THE U.S. MARKET AND
IMPLICATIONS FOR
IRELAND
TOPICS
• Overview: Property Values in U.S. and Ireland
• What are Subprime loans?
• Role of Securitization and structuring.
• How has the market changed?
• Effects on Mortgage Markets and implications.
Overview
•
Rapid house price growth has been a part of life for about a
decade in most of Europe and North America. E.g., the
U.S.. has had rapid growth; Ireland more so.
•
Ireland has also had a production boom. Production has
been around 15% of the economy.
•
There is evidence of decline now. Is this the bursting of a
“bubble”? Maybe, but not like the tech bubble in late 90s.
•
It has long been known that declining property values play
a big role in mortgage default. There has been a very large
increase in troubled (delinquent plus in foreclosure)
subprime loans in the U.S., much more so than for prime
loans.
Overview
• The market in which these are traded-via
securitization- has more or less collapsed, and there
have been “spillovers” into seemingly unrelated
markets.
• There is pressure for policy change. However, the
details of the problem are not clear, and precipitous
policy changes are not a good idea
• Ireland has a small sub prime market, but very big
price increases. It is poised for a decline. But like the
U.S. not a tech boom like bubble.
Ireland had a “Regime
Change” in the mid 1990s
Prices of Used Houses: Ireland and Dublin
600,000
500,000
Ireland
400,000
Dublin
300,000
200,000
100,000
2005Q1
2002Q1
1999Q1
1996Q1
1993Q1
1990Q1
1987Q1
1984Q1
1981Q1
1978Q1
0
The U.S. has had strong
growth, but not like Ireland
House Prices: Ireland and U.S. 1978-2007
25
20
15
U.S.
10
Ireland
5
0
1
13
25 37
49 61
Time
73 85 97 109
WHAT IS A BUBBLE?
5000
NASDAQ
4500
S&P 500
National HPI
4000
3500
3000
2500
2000
1500
1000
500
2006
2004
2002
1999
1997
1995
1993
1990
1988
1986
1984
1981
0
Subprime Loans
• Borrowers with bad credit history
• Used to be defined by lender (Money Store)
• Now by “FICO” score and related credit
history
• Quantifying credit history was a big deal in
securitizing high risk loans because of
agency problems
Subprime Used To Be About 10%
Of The Market, But It’s Share
Increased a Lot After 2003.
Should we be surprised in a market expanding
that fast that quality deteriorated?
Market shares
70
60
FHA/VA
50
40
Conform ing
30
20
Subprim e+AltA
10
0
1
2
3
2001-2005
4
5
Subprime and FHA Delinquency
Rates vs Those on Prime.
Until recently subprime didn’t look all that bad.
9
Loans 90 days or more delinquent or in foreclosure (percent of number)
– Recession
8
Subprime
7
FHA
6
5
4
VA
3
2
Prime Conventional
1
Source: Mortgage Bankers Association and Loanperformance.com (through first quarter 2006)
2006Q1
2005
2004
2003
2002
2001
2000
1999
1998
0
What Determines Credit Risk?
• Here are some results from Freddie Mac data. The
loans are not really subprime but some have low
credit scores.
• Credit history matters, so does equity.
• The problem of layering.
• Everyone knew this stuff was risky, but it was riskier
than previously thought. (Getting caught with your
parameters down?). E.g., a small but significant share
of the 2007 originations didn’t make the first payment.
Relative Default Probabilities
Recent history is movement to
the Northeast of the Chart
LTV <70
LTV 71-80
LTV 81-90
LTV 91-95
FICO <620
0.96
4.8
11.04
19.68
0.46
2.3
5.29
9.43
0.2
1
2.3
4.1
0.08
0.4
0.92
1.64
FICO 620-679
FICO 680-720
FICO >720
HOUSE PRICES AND DEFAULT:
Equity Matters. So Does Diversification
Default Probability vs. House-Price Appreciation
State/Origination Year and National/Origination Year Cohorts (1985-1995)
80% Loan-to-Value, 30-Year Fixed-Rate Home-Purchase Mortgage
Cumulative Default Rate
25%
Individual States
AK 1986
National
20%
15%
CA 1990
AZ 1985
10%
CA 1989
NV 1985
5%
HI 1994
DC 1995
0%
-30%
-10%
10%
30%
50%
70%
90%
5-Year Cumulative House-Price Appreciation
110%
130%
What’s Going on Now?
• Prices are Falling—Though by how much is less
clear
• Otherwise the economy is growing ok and the
unemployment rate is relatively low.
• So from the macro side it’s the price decline that
seems to be the problem.
• But that probably doesn’t explain the sudden
divergence between prime and subprime.
Securitization:
Is it the Problem?
•
Securitization involves selling pools and shares of pools
loans into the bond market
•
Not new-Mainstay of the market for around 30 years
•
Nor is division of labor between servicer and investor—e.g.,
Ginnie Mae
•
Ginnie Mae and FHA (substitute for subprime
•
Fannie Mae, Freddie Mac and Ginnie Mae provide credit
guarantees.
•
The non agency market is different.
THE ECONOMICS OF
SECURITIZATION
•
Securitization involves packaging and selling pools of
loans in order to gain access to securities (bond) markets
(e.g., rather than deposit markets). Mortgages, Car loans,
David Bowie.
•
The major contribution of securitization is that it opens the
mortgage (or other) market to bond markets and long term
lending.
•
This is in contrast with traditional depositories (banks),
which tend to be forced into short term funding and do not
usually have an elastic source of funds.
THE ECONOMICS OF
SECURITIZATION
•
But there is cost. Bond market investors are at an
informational disadvantage relative to those selling them
the bonds: asymmetric information.
•
The key is understanding and managing the tradeoff
between the greater efficiency of funding in capital markets
and the asymmetric information. The balance does not
always fall on the side of securitization. Bank funding (via
deposits or bonds) may be the way to go.
•
Even if securitization is the way to go, it may need
significant “structuring” to work.
STRUCTURING
(AKA slicing and dicing)
•
The idea is get access to the bond market—vs the deposit
market—getting around banks.
•
But there are agency problems because investors aren’t
sure of what they’re getting: Both adverse selection and
moral hazard.
•
For the “Agencies” this is done via Agency guarantees and
back up form their charters.
•
For others (e.g., commercial and nonconforming
mortgages, like subprime) some enhancement is needed.
•
Typically this is done by structuring.
Senior/Subordinated Structures
• Senior/Sub structures are the most popular. They
allow most of the credit risk to remain with originator
and/or specialists and get intuitional investors
interested in the senior part.
• The trick is prioritize the cash flows so that there is a
queue and originators or specialists take the bulk of
the credit risk’
• This means that a pool of B type securities can have
most of it funded with AAA paper.
• That there were AAA pieces is consistent with the
loans in the pool being junk bonds.
A TYPICAL STRUCTURE:
FOCUS ON SUBORDINATION
Loan 1
Loan 2
Loan 3
Loan 4
…..
$1 Billion
Total Loans
Trust
$850m
AAA Rated
$1 Billion
Subprime
Structured Deal
$100m, A Rated,
$50m, NR,
24
A Commercial Deal (Courtesy: Davidson, Sanders etc)
Bonds for GMAC 1997-C1 Deal
Class
Bonds:
A-1
A-2
A-3
B
C
D
E
F
G
H
J
K
X
Total
Securities
Initial Cert.
Balance or
Notional Amt.
Spread
$261, 582,000
48
$227, 661,000
62
$724,100,000
65
$67,879,000
70
$50,909,000
75
$50,909,000
85
$93,334,000
100
$25,454,000
118
$84,849,000
$59,394,000
$16,969,000
$33,944,278
$1,696,984,278 Notional Amt
$1,696,984,278
Rating
(Moody's/
Fitch)
Ass/AAA
Aaa/AAA
Aaa/AAA
Aa2/AA+
A1/AA
A2/A+
Baa2/BBB
Baa3/BBBBB/BB
B
BUnrated
Aaa/AAA
Percent of
Initial Pass- Weighted
Initial Pool
Through Rate Average Life
Balance Sub-ordination
(approx.)
(yrs)
15.4%
13.4%
42.7%
4.0%
3.0%
3.0%
5.5%
1.5%
5.0%
3.5%
1.0%
2.0%
N/A
28.5%
28.5%
28.5%
24.5%
21.5%
18.5%
13.0%
11.5%
6.5%
3.0%
2.0%
0.0%
N/A
6.830%
6.853%
6.869%
6.918%
6.898%
6.997%
7.085%
7.222%
7.414%
6.600%
6.600%
6.600%
1.629%
4.00
7.50
9.71
9.94
9.96
10.01
11.45
13.53
14.93
17.99
19.78
22.0
N/A
Payment
Window
1 - 75
75-108
108-119
119-120
120-120
120-125
125-158
158-170
170-195
195-235
235-242
242-358
1-358
Quality Deterioration
•
Why Did The Defaults Increase?
•
Recent paper by Yuliya Demyanyk (FRB St. Louis) and
Otto Van Hemert (NYU) suggests very mixed reasons
•
It looks like it was not Adjustable rates or low
documentation especially.
•
High LTV loans
•
A prime candidate is that agency costs went up—(Lying
and cheating by loan originators). Loan originators working
at the margine of what is allowed in the contract.
•
Appraisals probably got worse.
•
Who is holding the bag? Representations and warranties.
Effects: Trading Drying UpSpillover into Unrelated Markets
<>
So What?
We don’t know much about the contributions
of the things the media seem sure are evil
• Rate adjustments?
• Predatory Lending?
• Documentation?
• Government pushing banks into risky
areas?
Some Bad Ideas.
Remember the Subprime market is very private and very
competitive- Exit is easy and the only thing
lenders/investors have is pricing and equity in the property.
• Forced restructuring.
• Making lenders/investors responsible for
borrowers risk-taking
• Restricting terms like prepayment
penalties.
IRELAND
• Bubble Candidate, but not like tech
stocks
• Subprime market is small
• Looking forward: Securitization isn’t all
bad and has been manageable.
IRELAND
• It’s not easy expanding loan markets to
riskier borrowers. You can’t expect to do it
without mistakes and lots of defaults.
• How far are you willing to let consenting
adults go?
• How do you know if consent is informed?
• Watch speed of market growth and loan to
value ratios.