The Subprime
Panic
Working Paper by Gary B. Gorton
National Bureau of Economic
Research
October 2008
Presented by Rebekah Sundin
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Summary of Contents
1.
2.
3.
4.
5.
6.
7.
Introduction
Executive Summary of working paper
Background of mortgage market in the U.S.A.
Key Points
Description of Terms (throughout presentation)
Conclusion
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 lending
4. Increasingly sophisticated financial instruments
5. Increasing prevalence of subprime mortgages in financial
market
6. Misunderstanding and misinformation of the subprime
mortgages impact on financial markets
3
Executive Summary
1. Gordon 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
1.How did it all begin?
2.Let’s start with Fannie Mae and Freddie
Mac
3. government sponsored enterprises (GSEs): to
enhance the flow of credit to targeted sectors of the
economy
4. 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.
5. 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 5
guarantee.
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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1.Federal Home Loan Mortgage
Corporation(FHLMC)
2.The FHLMC was created in 1970 to expand the
secondary market for mortgages
3.buys mortgages on the secondary market, pools
them, and sells them as mortgage-backed
securities to investors on the open market
4.“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
1.Section 2A: Growing prevalence of
subprime and Alt-A in mortgage market
(Table 1)
2.Section 2B: Subprime Mortgage Design
3.How to lend to risky borrowers?
4.Using house appreciation to leverage risk
over the short-term ; rolling over mortgage
every 2-3 years thanks to accelerated
house appreciation
5.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 prices
• What 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
1.Subprime securitization has dynamic tranching
as a function of excess spread and prepayment
and is sensitive to house prices as a result.
2.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
1. Securitization
2. Subprime lenders tended to rely on securitization of the mortgages (see
Table 2)
3. “Note that in 2005 and 2006 originations were about $1.2 trillion of which 80 percent was
securitized.” (Gordon, pg. 6)
4. Cash inflows
5. But unlike other securitizations, because of re-financing, there were
expectations of early cash inflows. Gordon explains the risk that this
created:
6. “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)
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 RMBS
1. Residential mortgage-backed securities (RMBS)
2. 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.
3. Two types of asset-backed securities (ABS) and mortgage-backed
securities (MBS)
4. 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
5. An excess spread/overcollateralization (“XS/OC”) structure. Overcollateralization means that the collateral balance exceeds the bond
balance, that is, deal assets exceed deal liabilities.
6. 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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18
Falling House Prices
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Falling house prices
1.Between 2001 and 2005 homeowners
enjoyed an average increase of 54.4
percent in the value of their houses” (pg.
21)
2.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
3.Current state of mortgage market
(underwriting)
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21
ABX Index
1.Launched in January 2006
2.Measured the risk of owning subprime
mortgage bonds
3..
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ABX index (figure 4)
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Subprime Panic
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 assetbacked commercial
paper (ABCP).
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Section C. Asymmetrical Information
1.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.
2. 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)
3. “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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“Shadow Banking System”
1. “The banking system was metamorphosing into an off-balance sheet and
derivatives world—the shadow banking system…
2. 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.…”
3. So what happened?
4. “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)
5. 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 26
serving as collateral.
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)
1.“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.
2.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.
32
Residential Mortgage-Related Net
Exposures and Losses ($
millions)
33
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
1.Offer deposit insurance
2.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 risk
6. Ensure risks are understood.
7. Prevent shift of assets of off-balance sheets - banks had incentive to
move to structured investment vehicles
8. 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 details
1. US $700bn rescue package signed on October 3, 2008
2. The 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.
3. 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.
4. 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.
5. 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
1.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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1.Thank you
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More cartoons, anyone?
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Future of U.S. Housing Market?
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