Your SlideShare is downloading. ×
SmithBreeden Presentation on Subprime Market
Upcoming SlideShare
Loading in...5

Thanks for flagging this SlideShare!

Oops! An error has occurred.


Saving this for later?

Get the SlideShare app to save on your phone or tablet. Read anywhere, anytime - even offline.

Text the download link to your phone

Standard text messaging rates apply

SmithBreeden Presentation on Subprime Market


Published on

  • Be the first to comment

  • Be the first to like this

No Downloads
Total Views
On Slideshare
From Embeds
Number of Embeds
Embeds 0
No embeds

Report content
Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

No notes for slide
  • 1. Subprime defines the borrower NOT the house. Hence, houses for sale are not distinguishable by underlying mortgage type. 2. Homes are in all zip codes. 3. Average price is substantial. Recovery rates are not biased by the fact that the mortgage is subprime. 4. HPA since origination is important for credit risk evaluation (i.e., LTV)of current collateral pool at investment (i.e., prefer older collateral) 5. Substantial variability in 3 year HPA across MSAs. Important in collateral composition. 6. In evaluating future HPA, it only takes a 33% drop in price to offset a prior appreciation of 50%.
  • AAA- does not exist - removed from slide.
  • Transcript

    • 1. History, Status, and Implications of the Subprime Mortgage Market Doug Breeden, Mike Giarla, Pete Nolan, Tapas Panda, and B.J. Whisler A Presentation for The Fuqua School of Business at Duke University October 30, 2007
    • 2. Agenda
      • Creation and Evolution of the Subprime Mortgage Market
      • Subprime Impact on the Secondary Mortgage Market
      • Subprime Impact on Other Markets and the Broader Economy
      • Policy Issues and Implications
    • 3. Subprime Mortgage Issuance Has Dominated ABS Supply in Recent Years
    • 4. Subprime Mortgage Borrower Base Relative to General U.S. Population Source: MBA, Deutsche Bank Global Markets Research, Fair Isaac Corporation. Data as of: October 23, 2006. Note: All information is provided for informational purposes only and should not be deemed as a recommendation to buy or sell securities. This information is taken from sources that we deem reliable, but no warranty is made as to accuracy. Current composition of U.S. mortgage debt U.S. FICO score distribution
    • 5. Subprime Mortgages Cover Many High Value Homes
      • Smith Breeden Analysis includes zip code level geographic detail loan data.
      • Cost of foreclosure is less than many might expect (due to large average loan size).
      • Homes liquidated will be attractive to a wide range of homeowners.
      • Losses, given foreclosure, should be contained.
      Source: Smith Breeden Analytics. Data as of 1Q 2007. Subprime HPA Returns (Cumulative)
    • 6. Securitization Provides Opportunity for Investors of Various Risk Appetites Subprime Loans (1000s) AAA BBB+ AA+ AA- AA BBB BB+ BBB- BB Residual 8% Subordination Principal Payments losses 2% overcollateralization Source: Smith Breeden Analytics. Note: All information is provided for informational purposes only and should not be deemed as a recommendation to buy or sell securities. A- A A+
    • 7. Subprime ABS Yield Spreads Widened Dramatically in July and August
    • 8. Causes of Recent Subprime Troubles
      • Deterioration of loan underwriting standards
        • Low margins, high demand (CDOs).
      • Variable rate resets
        • 2/28 and 3/27 loans.
      • Softening employment
        • Local economies an important factor in subprime default.
      • Slowdown in home price appreciation
        • Previously erased effects from other factors.
      This presentation is provided for informational purposes only and should not be deemed as a recommendation to buy or sell securities.
    • 9. Opportunity Created by Subprime Woes
      • Systematic pricing of idiosyncratic markets
      • Liquidity providers to forced-sellers
      • Lack of necessary analytics in the investment community
      • Uncertain value
      This material has been prepared or is distributed solely for informational purposes only and is not a solicitation of offers to buy any security or instrument or to participate in any trading strategy. Past results are not necessarily indicative of future performance. No assurance can be made that profits will be achieved or that substantial losses will not be incurred. All investments involve risk including the loss of principal.
    • 10. Agenda
      • Creation and Evolution of the Subprime Mortgage Market
      • Subprime Impact on the Secondary Mortgage Market
      • Subprime Impact on Other Markets and the Broader Economy
      • Policy Issues and Implications
    • 11. Rating Agency Mass Downgrade Action
      • June 15 th : Moody’s announced the first mass scale downgrade action (267 bonds). Since then, rating agency downgrades have been running at full steam.
      Caa B Ba Baa A Original Rating New Rating 21% 82% 14% 4% Ba 32% 23% 32% 12% Baa 1% 9% 27% 43% A Rating Transition of 2006 Subprime Bonds through Oct 2007
    • 12. Risk Repricing in Subprime MBS
      • Investors re-priced risk in subprime mortgage-backed bonds, leading to severe marked-to-market losses.
      • BSAM funds liquidation aggravated the death spiral: Two hedge funds of Bear Stearns Asset Management (BSAM) liquidated
        • High Grade Structured Credit Strategies Enhanced Leverage Fund
        • High Grade Structured Credit Strategies Fund
    • 13. Liquidity Crunch
      • Liquidity crunch manifested in four market components
      • A: LIBOR rates
      • B: ABCP rates
      • C: Jumbo rates
      • D: Funding rates for levered players
    • 14. Inter-bank Lending Suffers, LIBOR Spikes Source: Bloomberg
    • 15. Asset Backed Commercial Paper Spreads Widen Source: Bloomberg
    • 16. Unwinding of ABCP
      • Asset Backed Commercial Paper unwinds and ends up on liquidity provider’s balance sheet…
      Source: Bloomberg
    • 17. Jumbo Mortgages Squeezed
      • … As originators faced with a liquidity crunch increased rates on Jumbo mortgages.
      Source: Bloomberg
    • 18. Deleveraging of Portfolios
      • Funding became less attractive for levered players to carry non-agency products, leading to more deleveraging.
      Haircut and Funding Rates for Agency and Non-Agency Mortgages LIBOR + 20 10% LIBOR + 4 5% AAA Funding Haircut Funding Haircut LIBOR – 12 4% LIBOR – 3 3% Agency LIBOR + 40 25% LIBOR + 10 10% A LIBOR + 30 20% LIBOR + 6 7% AA Current May 2007
    • 19. Trading Volume Depressed
      • Trading volume shrunk, making price discovery difficult.
      Source: UBS 10% CMOs (both Agency and Non-Agency) 80-90% Agency Pass-Throughs Trading Volume (% of normal volume) 10% CDOs 10% ABS 70% ARMs (Agency)
    • 20. Non-Agency Hybrid Spreads Source: Morgan Stanley
    • 21. Investment Advice
      • “ Be fearful when others are greedy and be greedy when others are fearful”
    • 22. Portfolio Ramp-up 16.5% 14.00 11.50 2.50 Corp Bond % of Tot Total A AA AAA AGCY Class 2.5% 2.13 2.13 Fixed MBS 36.9% 31.40 3.26 28.14 Float MBS 40.2% 34.17 0.68 2.91 16.16 14.42 Hybrid MBS 52% 44.30 21% 17.95 1.40 17% 10% % of Tot 85.00 14.08 8.67 Total 3.9% 3.30 1.90 MMP Purchases by Asset Class ($MM Par)
    • 23. ABCP Unwinding and/or Revaluation
      • Citigroup, J.P. Morgan and Bank of America formation of super-conduit (Master Liquidity Enhancement Conduit) will impact spreads in the short term.
      • Rate reset will add pressure to the housing market until affordability improves.
      • Supply of non-agency to shrink and spreads to tighten on high-rated bonds in the long-term.
    • 24. Subprime ARM Resets Pending
      • High volume of subprime resets over the next 18 – 24 months
      Source: PIMCO
    • 25. Future Mortgage Market Composition
      • The mortgage market composition will change dramatically.
      Source: UBS 4% 17.7% Alt-A 77% 44.7% Agency Mortgage Market Share by Issuance 23% 2% 6% 11% Expected by 2009 55.3% 5.4% 21.7% 10.6% End 2006 Tot. Non-Agency Others Subprime Jumbo
    • 26. Agenda
      • Creation and Evolution of the Subprime Mortgage Market
      • Subprime Impact on the Secondary Mortgage Market
      • Subprime Impact on Other Markets and the Broader Economy
      • Policy Issues and Implications
    • 27. Response in Corporate Bonds: Overall
      • General corporate bond spreads wider
      Data Sources: Moody’s Investors Service Long-Term Single-A Corporate Bond Yields; Bloomberg US Treasuries Indices
    • 28. Response in Corporate Bonds: Financials
      • Financial institution bonds wider
      Data Source: Bloomberg
    • 29. Housing Economics: Overview Rising Home Inventories Home Prices Decline Construction Declines Mid-term Impact on Employment Equilibrium Restored in time Reduced Demand Increased Foreclosures
    • 30. Housing Economics: Supply and Demand Source: The Bank Credit Analyst, Volume 59, Number 4
    • 31. Economics: Unemployment Rate
      • Recent increases in the unemployment rate
      Data Source: Bureau of Labor Statistics
    • 32. Economics: Construction Payrolls
      • The brunt of the effect is in construction and manufacturing
      Data Source: Bureau of Labor Statistics *2007 figures are through Q3
    • 33. Economics: Consumption
      • Wealth-based spending source at risk
      Data Sources: Federal Reserve Estimates based on Bureau of Economic Analysis data
    • 34. Economics: Global Response
      • Personal consumption represents 70% of US Gross Domestic Product.
      • US consumption represents 19% of global GDP.
      • Global economies arguably highly dependent on US consumer spending.
    • 35. Agenda
      • Creation and Evolution of the Subprime Mortgage Market
      • Subprime Impact on the Secondary Mortgage Market
      • Subprime Impact on Other Markets and the Broader Economy
      • Policy Issues and Implications
    • 36. Subprime “Pain” is Not Limited to Institutional Investors
      • Financial and psychological damage is being felt by individuals and families (and entire communities) as foreclosures mount.
      • Without major intervention, more than 1 million of the subprime loans (est. 20%) made in 2005 and 2006 are headed for foreclosure.
      • A disproportionate share of the pain is felt by minority borrowers.
    • 37. Subprime “Woes” Disproportionately Affect Minorities “ Higher Cost” 1st Lien Loans (2005 HMDA) Source: FFIEC. Data reported by Lenders Under the Home Mortgage Disclosure Act. See p. 23 of “ Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowners ” – Center for Responsible Lending. as % of total loans made to each group # Higher Cost (000) 19 1,214 White 40 376 Latino 52 388 African American
    • 38. Even After Adjusting for Risk Factors, Minority Borrowers Are More Likely to Have a Subprime Loan
      • 2006 Study Found that African-American and Latino borrowers are at greater risk of receiving high-rate loans than white borrowers, even after controlling for legitimate risk factors.
      Source: “Unfair Lending: The Effect of Race and Ethnicity on the Price of Subprime Mortgages”, Center for Responsible Lending, May 31, 2006)
    • 39. About The Center For Responsible Lending (“CRL”)
      • Non-profit, non-partisan research and policy organization dedicated to protecting homeownership and family wealth by working to eliminate abusive lending practices.
      • Affiliated with Self-Help, headquartered in Durham, one of the nation’s largest community development financial institutions.
          • Self-Help Credit Union
          • Self-Help Ventures Fund
          • Self-Help Community Development Corporation
    • 40. Is Subprime = “Evil”?
      • All subprime loans are not inherently “bad” – only a subset will default. Subprime loans have helped many people achieve their dream of home ownership.
      • Not all subprime lenders are “scrupulous”. Unscrupulous lenders often hide behind “we help people realize their home ownership dreams” statement.
      • Unfortunately, predatory practices were common in the subprime lending business.
    • 41. The Market Is Self Correcting, Right?
      • Normal market forces are not correcting problems.
      • Subprime mortgage market does not have adequate incentives to police itself. Example – economic incentives for subprime lenders to make harmful loans:
            • Mortgage brokers not required to offer loans that are in borrowers’ best interests (although many claim they do) and compensation policies are designed to encourage exactly the opposite).
            • Some lenders provide incentives to brokers to put people into higher interest loans, loans with excessive fees and penalties when they could qualify for better economic terms.
            • Until recently, investor demand made it easy to avoid accountability - from a moral and credit quality standpoint.
    • 42. What Needs To Be Done and What Is Likely To Happen?
      • There are two major policy areas on which to focus. CRL is actively involved in fashioning policy in these two areas:
            • Helping to keep people in their houses – protecting homeowners threatened with foreclosure.
            • Protecting Borrowers in the Future
    • 43. Protecting People Threatened With Foreclosure – Ballast or Bailout?
      • Who should/will bear the losses that are occurring?
            • Taxpayers
            • Investors
            • Homeowners
      • Taxpayer sponsored “bailout” of borrowers not needed. Would create a moral hazard and encourage a repeat. Sensible strategies needed to minimize economic impact of large scale foreclosures on families, communities and national economy. Lenders/investors better off as a result – fewer loans in foreclosure, less REO, higher home prices, etc.
    • 44. Helping Borrowers Keep Their Homes – The Landscape
            • 40% - Refinance existing loans to prime, fixed rate loans (GSEs, FHA…)
            • 20% - Loan modification – extend initial rate (programs are appearing).
            • 20% - Loan modification – reduce rate or loan balance up to 50% - to
              • between fair value and liquidation cost. Avoid Bankruptcy.
            • 10% - Speculative or investor loans. (Not much sympathy for this
              • group.)
            • 10% - Borrowers where feasible assistance will not be enough to avoid
              • bankruptcy.
    • 45. Targeted Approach To Help Borrowers Keep Their Homes
      • Direct servicers to make meaningful and sustainable modifications to existing loans. President, Treasury Secretary, FDIC all speaking out. More action is needed and forthcoming.
      • Eliminate anomaly in the bankruptcy code (Chapter 13), which allows judges to modify unaffordable mortgages on vacation homes and investment properties but not on borrower’s primary residence.
    • 46. Aren’t Loan Modifications “Un-American”?
      • Who owns my loan, anyway? It was sliced and diced and sold. Must deal with a servicer – not lender.
      • Servicers fear investor lawsuits.
      • Servicers are overwhelmed – set up mainly to process payments.
      • “ Piggyback” seconds on 30+% of recent subprime loans – neither first nor second lien holder has incentive to help the other.
      No…but loan modifications are often difficult to obtain because:
    • 47. Possible Standards For Modifying Loans in Bankruptcy Court
      • Bifurcate into two classes:
          • First – secured by appraised value of property. If necessary, modify interest rate to a fixed rate and amortize over the remaining life.
          • Second – remainder of loan – on par with other unsecured debt.
      • Overall plan structured so borrower emerges with manageable payments, debt load and can sustain further drop in price of house.
      • Bankruptcy law change will reduce servicers’ fears of being sued and establish standards for sustainable loan modifications .
    • 48. Protecting Future Subprime Borrowers Expect significant regulation – perhaps “over-regulation”
      • Joint Banking (Regulatory) Guidance for Non-traditional (’06) and Subprime (’07) Mortgage Loans
      • Federal Reserve rules under review – Fall 2007 – (FRB has authority to prohibit mortgage loans and refis that FRB finds to be abusive, unfair, deceptive, or not in the interest of the borrower)
      • Federal legislation – likely to focus on the following items:
            • Prepayment penalties and payment of yield spread premiums
            • Escrows for taxes and insurance
            • Underwriting to fully indexed rate – w/ reasonable debt/income
            • Income verification/documentation
            • “ Flipping” when net tangible benefit of refi is less than fees charged
            • Availability of credit counseling
    • 49. Other Suggestions To Protect Borrowers
      • Enhance documentation
          • Less is more – who reads all this “stuff”?
          • Plain English
      • Self Defense:
            • Responsibility of families and educational system to increase level of financial literacy. Knowledge = power!
      • Conclusion: There is much that can and will be done to help borrowers stay in their homes. Expect quite a bit of government/regulatory/
        • legislative action in the next 6 months as well as overreaction.
      • Stay tuned!
    • 50. Q&A
    • 51. Backup: Global Stock Market Correlation Source: Community First Investments and Risk Evaluation Analytics 0.72 0.91 0.87 0.88 0.91 0.76 0.70 US 0.99 0.86 0.81 0.49 0.58 0.98 Mexico 0.60 0.81 0.8 0.98 UK 0.98 0.90 0.83 0.52 0.61 Brazil 0.52 0.76 0.84 Germany Mex. UK Braz. 0.89 Hong Kong 0.84 0.90 Japan India H.K. Japan Ger. 2001-2006 0.59 0.45 -0.55 0.95 0.98 0.81 0.86 US 0.80 0.71 -0.24 0.89 0.84 0.96 Mexico 0.55 0.37 -0.59 0.93 UK 0.79 0.76 -0.22 0.88 0.79 Brazil 0.63 0.49 -0.49 Germany Mex. UK Braz. 0.74 Hong Kong 0.63 0.49 Japan India H.K. Japan Ger. 1996-2000
    • 52. Backup: US GDP Growth Contributors Source: Federal Reserve Bank of St. Louis “National Economic Trends” October, 2007
    • 53. Backup: Fed Funds Expectations Data Source: Bloomberg Futures Pricing
    • 54. Backup: US Dollar Weakening Data Source: Bloomberg