Credit Mortgage Markets Subprime Mortgages Subprime mortgages making loans to people who may have difficulty maintaining the repayment schedule These loans have higher interest rates and less favorable terms in order to compensate for higher credit risk The subprime mortgages crisis was one of the first indicators of the financial crisis with a rise in subprime mortgage delinquincies and foreclosures and the resulting decline of MBS Easy credit in most bubbles bubbles happen where credit is important Housing stocks auto s get special attention Credit eased 2000 2005 Aftermath of dotcom federal funds rate mortgage rates and ARM rates fell sharply 2 major effects of plummeting interest rates 1 automatically raised value of existing housing stock house prices rose and homeowners felt wealthier housing became locus of household savings refinancing released cash to consumers innovation of home equity loans large wealth effect spurred recovery 2 expanded mortgage borrowing lending 1 Easy Credit Policy Greenspan was architect of this policy made sense in 2000 1 but would not let up Resulted in 42 increase in debt between 2002 2006 Increase in bank debt by 6T Merrill Lynch liabilities rose by 90 Housing prices rising by 10 12 a year Greenspan convinced risks were properly assessed He declared it impossible to detect bubble anyway and announced Fed would stand ready to fix any post bubble problems Many cautioned this was a bad policy 2 Mortgage Products rate mortgages Market for risk bearing depends on free and informed choices Solution Mortgage alternatives Products differ w r t interest rate risk on 30 year fixed rate mortgage and on ARM Adjustable Interest only loans Option ARMs Hybrid ARMs such as 2 28 hybrids Stated income loans New Borrowers New instruments drew in new borrowers some were legitimate candidates from ARM others were flipping houses many were lured in by predatory practices Many of these people were elderly minorities less educated and less sophisticated Predatory Practices How mortgages went bad Unreasonable unnecessary costs and conditions Prepayment penalties short term balloon payments Outright fraud and deception loan flipping bait and switch promising something is true then when signed its not true forged signatures and falsified statements paper system failed so was hard to even find loan documents Consumer Protection Economics Most markets were ok Intervene when Information problems due to complexity and uncertainty Transaction subject to pressure duress Competitive forces are weak Lots of these problems affect mortgages Any policy action scaled to problem cooling off period standardization of products disclosure Always has been regulatory role in mortgage markets Patchwork of agencies but one at top Federal Reserve Board Feds response to consumer issues Will not routinely conduct consumer compliance examinations of nonbank subsidiaries Reluctant to support substantive limitation on market behavior Does not advocate any particular approach to these problems Greenspan If there is fraud one doesn t need supervision and regulation one needs law enforcement But legal action is expensive and cumbersome and not available to all Under Greenspan Fed even opposed action by others Securitization Why did housing bubble spilling into the real economy Because of the nature of the food It is housing everyone has it and it is a big part of peoples income which goes to housing Securitization involves further hand off of mortgages Originate to distribute becomes further distribution creates further information incentive issues Problems minimized when GSEs did securitization Problems in information and incentives Frannie and Freddie succeeded because they were over watched but Government Secured Entities GSE s were not regulated and limited Wall St Investment banks got involved in securitization in 2000 They were not considered banks at all No deposits no reserves no regulation no constraints on types of mortgages no restraints on what they can invest in money is not protexted These banks mostly make money by Fees and IPO s will be underwritten by these banks financial engineering They got involved in securitization because it was a means to collect fees 03 08 banks doubled or tripled in size and this was due to adopting of securitization Different types of securitization RMBS residential mortgage backed securities CDO s Collateralized debt obligations CDO s Suppose you have 100 mortgages each work 100k 10 default risk Options 1 Sell entire group for 9M 2 Divide into 5 identical groups of 20 3 Separate into risk categories sell each off at appropriate price 4 Pool and tranche pool of income streams of all 100 mortgages Pool collecting income from all mortgages Tranche From single pool create security with first claim on income stream 1st tranche Senior tranche 2nd tranche mezzanine 3rd tranche Equity tranche Riskiest residual claim has highest interest rate Why would CDO be worth more than parts 1 Diversification of mortgage default risk correlation 2 Customization to buyers hedge funds To satisfy people with different preferences for risk hedge funds 3 Liquidity Frannie and Freddie Mac took local mortgages and sold them as securities to people in other states internationally widened range to who can buy Hedge Funds Appetite for high risk they hedge funds Ensure player against nasty outcome create insurance contracts for people who are willing to pay against nasty outcomes Ex Airline is afraid fueld cost will rise a lot investors usually put in 1 5 million dollars into fund in 2007 hedge funds accounted for 3 trillion dollars they were buying a lot of CDOs in 2010 in went down to 1 5 trillion due to asset collapse Role of Credit Agencies Made enormous amounts of money on CDOs They played crucial role since CDOs were relatively novel They had problems of information and incentives Clearly erroneous ratings continued to rate securities highly even as mortgage default rates rose These agencies could have prevented crash from happening because they had a lot of info They were very corrupt and failed to do their jobs hence they let the crash happen Did banks know any better Probably not Used value at Risk var models not adequate for out of sample experience and have behavioral error They held onto some CDOs themselves because of 1 poor governance no one was paying attention to these guys 2 low funding costs access to capital was cheaper than to other players so they have 3 lack of