Econ 101 M. SalemiThe Sub-Prime Mortgage Crisis Econ 101 M. SalemiThe Sub-Prime Mortgage Crisis1. Sub-prime mortgages and derivatives2. What accounts for growth in sub-prime mortgages and CDOs?3. What caused the sub-prime mortgage crisis?4. Why did the mortgage crisis spread?5. What steps have been taken to remedy the crisis? Are they adequate?What is a Sub-Prime Mortgage?A mortgage is the pledge of a property to a lender as security for a loan to purchase the property.A sub-prime mortgage is a mortgage by a borrower who has a FICO credit score below 620, limited credit history or some other credit impairment (Coval, Jurek and Stafford, p. 18).What is a Collateralized Debt Obligation (CDO)?A CDO is a derivative security that is issued against a portfolio of underlying securities, such as mortgages.Under certain assumptions, CDOs are much less risky than the underlying mortgages.An simple example explains how a CDO can lower risk.CDO ExampleSuppose: There are two $1.00 IOU’s with two payment outcomes--$1.00 and zero. The probability of full payment is 90 percent for each IOU.Payments are independent events.CDO ExampleCreate two new securities:The senior security pays $1.00 unless both IOU’s default.The junior security pays zero if either IOU defaults.Default probabilities are:1 percent for the senior security19 percent for the junior securityActual Mortgage Securitization is More ComplicatedThe initial pool has many mortgages.There are more than two tranches.The securitization process is repeated by pooling and tranching the CDO’s to create a new security called a CDO2.A form of insurance (credit default swap) may be bundled with the lower tranches of the CDOs to lower their risk.Rating Agencies Played a Crucial Role in the Issuance of CDOs.Investors wanted safe assets.Moody’s, Standard and Poors, and Fitch gave their AAA rating to a high fraction of mortgage backed CDOs.The rating agencies were earning more from rating CDOs than from rating traditional corporate bonds.What Accounts for the Growth of Sub-prime Mortgages and CDOs?Sub-prime Mortgages$96.8 Billion in 1996$600 Billion in 2006CDO Products in 1997 $9,000 Billion of which$5,000 Billion were rated AAA by rating agencies (Coval, Jurek and Stafford, p. 2-4). Demand for CDOsOne part of the story is willingness of individuals to buy real estate secured by non-standard mortgages.That willingness was at least in part fueled by a desire to participate in the boom in real estate. Composite Case Shiller Home Price Index0.0050.00100.00150.00200.00250.00Jan-87Jul-87Jan-88Jul-88Jan-89Jul-89Jan-90Jul-90Jan-91Jul-91Jan-92Jul-92Jan-93Jul-93Jan-94Jul-94Jan-95Jul-95Jan-96Jul-96Jan-97Jul-97Jan-98Jul-98Jan-99Jul-99Jan-00Jul-00Jan-01Jul-01Jan-02Jul-02Jan-03Jul-03Jan-04Jul-04Jan-05Jul-05Jan-06Real Estate Speculation Explains Some of the Growth in Sub-prime MortgagesDemand for CDOsA second part of the story is the large demand for low-risk, dollar-denominated securities.The demand is related to the international debt position of the US.In recent year, US Treasury Securities have had low yields.U.S. Current Account Deficits Create A Demand for Dollar SecuritiesUS Balance of Payments on Current Account-250-200-150-100-50050Jan-60Jan-62Jan-64Jan-66Jan-68Jan-70Jan-72Jan-74Jan-76Jan-78Jan-80Jan-82Jan-84Jan-86Jan-88Jan-90Jan-92Jan-94Jan-96Jan-98Jan-00Jan-02Jan-04Jan-06Jan-08DateBillions of USDTotal Foreign Demand for U.S. Securities Can Be Measured by the Cumulated Current AccountCumulated Current Account-8000-7000-6000-5000-4000-3000-2000-100001000Jan-60Jan-62Jan-64Jan-66Jan-68Jan-70Jan-72Jan-74Jan-76Jan-78Jan-80Jan-82Jan-84Jan-86Jan-88Jan-90Jan-92Jan-94Jan-96Jan-98Jan-00Jan-02Jan-04Jan-06Jan-08DateBillions of USDFed Policy Has Kept Yields on Treasury Securities LowFederal Funds Rate0.001.002.003.004.005.006.007.00Jan-95Jan-96Jan-97Jan-98Jan-99Jan-00Jan-01Jan-02Jan-03Jan-04Jan-05Jan-06Jan-07Jan-08DateForeign Governments were urged to Buy Mortgage Backed CDOsWhat Caused the Sub-prime Mortgages Crisis?The Performance of CDOs is very sensitive to assumed correlation in the performance of the underlying mortgages. The correlation estimates were too small.The performance of CDOs is very sensitive to the price of housing. Rating Agencies assumed house prices would continue to rise rapidly.Rating Agencies Underestimated CorrelationsAs correlations rise the CDOs become riskier.In our example, if the underlying securities have a positive payout (instead of zero) correlation, then the default probability of the senior tranche can rise as high as 20 (rather than 1) percent.The Housing Bubble BurstHousing Prices Fell After June 2006Composite Case Shiller Home Price Index0.0050.00100.00150.00200.00250.00Jan-87Jan-88Jan-89Jan-90Jan-91Jan-92Jan-93Jan-94Jan-95Jan-96Jan-97Jan-98Jan-99Jan-00Jan-01Jan-02Jan-03Jan-04Jan-05Jan-06Jan-07Jan-08As Housing Prices Fell, So Did the Value of Sub-Prime Mortgages andMortgage-Backed CDOs.In March 2007, First Pacific Advisers discovered that Fitch used a ratings model that assumed constantly appreciating home prices.FPC: “What if home prices were to decline by 1% to 2% per year for an extended period of time?”Fitch: “The models would break down completely”FPC: “…how far up the rating scale would it harm?”Fitch: “It might go as high as the AA or AAA tranches.”(Coval, Jurek and Stafford, p. 25)Why Did the Crisis Spread to Other Financial Institutions?All financial firms use borrowed funds to make investments.All financial firms are illiquid.No financial firm can survive a run unassisted.Why Did the Crisis Spread to Other Financial Institutions? Potential lenders were afraid to lend to financial institutions whether or not they had substantial balances of mortgage-backed securities among their assets.Potential lenders realized that they might not be repaid if others refused to lend.In a sense, the crisis moved lenders from “we all lend” equilibrium to a “none of us lend”equilibrium.The Ted Spread Shows that Credit Markets Were Breaking DownThe Ted Spread is the difference between the 3 month London interbank rate and the 3 month T Bill rate.Why Did the Crisis Spread to Stock Markets?The sub-prime crisis morphed into a lending crisis.Lending is the life blood of investment.Without lending, many firms cannot raise funds to finance their operations, to install new capital, or to purchase new technology.Stock prices fell because the lending crisis threatened lower firm earnings in the future.What