The US mortgage crisis: An overview of economic and policy causes, and a discussion of future approaches Russell N. James, J.D., Ph.D. Dept. of Housing & Consumer Economics University of Georgia Athens, Georgia, USA

Overview The mortgage crisis magnitude Underlying causes (government and private) Future policy discussion

The mortgage crisis magnitude

Underlying causes (government and private)

Future policy discussion

The nature and causes of the mortgage crisis Statistics on the US mortgage crisis Investigating causes of the US mortgage crisis Pushing excessive credit into the housing market and the hidden risk wave Rule changes for quasi-government mortgage insurers Hedge funds and the demand for risk Price stagnation and risk realization Price drop and excessive credit retraction

Statistics on the US mortgage crisis

Investigating causes of the US mortgage crisis

Pushing excessive credit into the housing market and the hidden risk wave

Rule changes for quasi-government mortgage insurers

Hedge funds and the demand for risk

Price stagnation and risk realization

Price drop and excessive credit retraction

Rising default rate for residential and commercial loans

Fannie Mae: Government-Supported Mortgage Insurer From $60/share to $.60/share in 12 months

From $60/share to $.60/share in 12 months

Housing price drops : A quarter by quarter visual walk through 2007 and 2009

2007 Quarter 2

2007 Quarter 3

2007 Quarter 4

2008 Quarter 1

2008 Quarter 2

2008 Quarter 3

2008 Quarter 4

2009 Quarter 1

Investigating causes of the US mortgage crisis A pictorial view

A pictorial view

This is old “free market” Savers Bank Borrower Deposits Interest Mortgage Loan Mortgage Payments

This is a “bad” loan Savers Bank Borrower Deposits Interest Mortgage Loan Mortgage Payments Foreclosure Sale: $ to bank (up to loan value)

This a bank with too many bad loans Savers Bank Borrower Deposits Interest Mortgage Loan Mortgage Payments

FDIC: Insures banks If a troubled bank’s assets get too low, it is taken over and sold to a healthy bank

This a bank with too many bad loans Savers Bank Borrower Deposits Interest Mortgage Loan Mortgage Payments

Smart bank takes over dumb bank Deposits Interest Mortgage Loan Mortgage Payments

Banks that survive and grow learn how to make loans that get repaid

Enter: Government Mortgage-Backed Securities Mortgage Loan Mortgage Payments Bank Sells the Loan Bank Gets Loan $ Returned Pools many loans Sells ownership shares in the pool

Government Mortgage-Backed Securities: Stage 2 Mortgage Payments Pools many loans Sells ownership shares in the pool

This is a bad loan Mortgage Payments Pools many loans Sells ownership shares in the pool Foreclosure Sale: $ to pool (up to loan value)

This is a bank with many bad loans Mortgage Payments Pools many loans Sells ownership shares in the pool

This is a banker with many bad loans The person making the loan doesn’t care if it is actually going to be paid or not.

This is a pool with many bad loans Mortgage Payments Pools many loans Sells ownership shares in the pool Government Backed Entity (GBE) Guarantees that investors still get paid

This is an investor who bought a pool with many bad loans The government-backed entity guarantees that the principal and interest will be paid anyway.

Solution: The GSE MUST Be Very Careful! Make sure to buy only good loans!

With Good Loans Everyone is Happy! Mortgage Payments Pools many loans Sells ownership shares in the pool

Why buy risky loans?

Government Mandate: Buy Low-Income Mortgages. December 1995, HUD Secretary mandated minimum 42% of GSE loans to lower income borrowers In 2000 the minimum was raised to 50% More requirements to buy in poor neighborhoods Must lend to more "very-low-income” borrowers Continued increases until 2007, minimum 55% Also, 38 percent of all purchases were to come from underserved areas (usually inner cities)

December 1995, HUD Secretary mandated minimum 42% of GSE loans to lower income borrowers

In 2000 the minimum was raised to 50%

More requirements to buy in poor neighborhoods

Must lend to more "very-low-income” borrowers

Continued increases until 2007, minimum 55%

Also, 38 percent of all purchases were to come from underserved areas (usually inner cities)

Government Order: Buy Loans to Low Income Borrowers (in Distressed Neighborhoods) Mortgage Payments? Pools many loans Sells ownership shares in the pool

Problems with Forcing Purchase of Low-Income Mortgages Low-income borrowers often don’t have down payment money. Low-income borrows often have poor credit history. In some cases, low-income borrowers don’t have much proof of income.

Low-income borrowers often don’t have down payment money.

Low-income borrows often have poor credit history.

In some cases, low-income borrowers don’t have much proof of income.

Government Solution: Ignore the problems, buy risky loans! Problems with many low-income borrowers. They don’t have money for down payment Solution: Fannie Mae developed a "flexible" product line, providing up to 100 percent financing and requiring borrowers to make as little as a $500 contribution They can‘t prove they have income Solution: GSE’s bought into the “Alt-A” market, for borrowers who were unwilling to provide financial full documentation. They don’t have good credit Solution: GSE’s were not required to report credit risk to the U.S. Government

Problems with many low-income borrowers.

They don’t have money for down payment

Solution: Fannie Mae developed a "flexible" product line, providing up to 100 percent financing and requiring borrowers to make as little as a $500 contribution

They can‘t prove they have income

Solution: GSE’s bought into the “Alt-A” market, for borrowers who were unwilling to provide financial full documentation.

They don’t have good credit

Solution: GSE’s were not required to report credit risk to the U.S. Government

GSE purchasing risky loans From 2001 through 2006 sub-prime loans rose from 7.2% to 18.8% of all mortgages and Alt-A loans rose from 2.5% to 13.9% of all mortgages. From 2005 to 2007, Fannie and Freddie bought approximately $1 trillion in sub-prime and Alt-A loans. 40% of their mortgage purchases during this time

From 2001 through 2006 sub-prime loans rose from 7.2% to 18.8% of all mortgages and Alt-A loans rose from 2.5% to 13.9% of all mortgages.

From 2005 to 2007, Fannie and Freddie bought approximately $1 trillion in sub-prime and Alt-A loans.

40% of their mortgage purchases during this time

Other supporting actions Federal Housing Administration created down-payment and closing-cost assistance programs that allowed FHA borrowers to buy a home without spending any of their own money up front. Changes to the Community Reinvestment Act increase mandatory issuance of low income loans by banks.

Federal Housing Administration created down-payment and closing-cost assistance programs that allowed FHA borrowers to buy a home without spending any of their own money up front.

Changes to the Community Reinvestment Act increase mandatory issuance of low income loans by banks.

The rise of mortgage companies

In this world, the “Bank” doesn’t need any depositors Mortgage Loan Mortgage Payments Bank Sells the Loan Bank Gets Loan $ Returned Pools many loans Sells ownership shares in the pool

Mortgage companies Mortgage Loan Mortgage Loan Banks required to buy low-income loans by CRA GSE’s required to buy low-income loans

Mortgage companies: Yield Spread Premiums Expensive, High Interest, High Fee Mortgage Loan Standard Mortgage Loan Banks required to buy low-income loans by CRA GSE’s required to buy low-income loans Some mortgage companies became abusive and made more money by charging higher fees or rates. This increased default rates, but they weren’t going to hold the loan anyway.

Part II: The Rise of Hedge Funds 50 years ago, the first hedge fund started with $100,000 Recent estimates showed a peak growth to well over 1 Trillion Dollars.

50 years ago, the first hedge fund started with $100,000

Recent estimates showed a peak growth to well over 1 Trillion Dollars.

What is a hedge fund? A typical manager may charge fees of "2 and 20", which refers to a management fee of 2% of the fund's net value each year and a performance fee of 20% of the fund's profit This sharing in profits makes it a “hedge fund” instead of a “mutual fund”

A typical manager may charge fees of "2 and 20", which refers to a management fee of 2% of the fund's net value each year and a performance fee of 20% of the fund's profit

This sharing in profits makes it a “hedge fund” instead of a “mutual fund”

Why hedge funds seek risk If the manager receives 20% of the profit, but pay 0% of the loss, what risk level most benefits the manager?

If the manager receives 20% of the profit, but pay 0% of the loss, what risk level most benefits the manager?

If I share profits, but not loss, I benefit from greater risk

Why hedge funds seek risk Allowing manager's to take a share of profit but providing no mechanism for manager's to share the risk of any loss, gives managers an incentive to take excessive risk rather than targeting high long-term returns.

Allowing manager's to take a share of profit but providing no mechanism for manager's to share the risk of any loss, gives managers an incentive to take excessive risk rather than targeting high long-term returns.

Hedge fund managers great returns Hedge fund managers produced very high returns. But, in efficient markets, producing high returns requires accepting high risk. Managers sought risk through creation of new financial instruments, such as derivatives.

Hedge fund managers produced very high returns. But, in efficient markets, producing high returns requires accepting high risk.

Managers sought risk through creation of new financial instruments, such as derivatives.

CDO's (Collateralized Debt Obligations) Repackaged collections of debts Often repackaged low-quality mortgage debt CDOs and derivatives provide high levels of risk desired by hedge fund managers Also high levels if return (at first) Old bank rules still classified residential mortgages as relatively lower risk for capitalization requirements Therefore, risky loans had a buyer

Repackaged collections of debts

Often repackaged low-quality mortgage debt

CDOs and derivatives provide high levels of risk desired by hedge fund managers

Also high levels if return (at first)

Old bank rules still classified residential mortgages as relatively lower risk for capitalization requirements

Therefore, risky loans had a buyer

Part III: Basel I and Mortgages Basel I, a 1988 international protocol to ensure that banks are adequately capitalized, assigns bank assets to different risk categories. AAA asset-backed securities are less than half as risky as residential mortgages. Residential mortgages are half as risky as commercial loans. Holding mortgages instead of commercial loans reduces capital requirements Holding AAA-rated mortgage backed securities (CDO) instead of whole mortgages reduces capital requirements.

Basel I, a 1988 international protocol to ensure that banks are adequately capitalized, assigns bank assets to different risk categories.

AAA asset-backed securities are less than half as risky as residential mortgages.

Residential mortgages are half as risky as commercial loans.

Holding mortgages instead of commercial loans reduces capital requirements

Holding AAA-rated mortgage backed securities (CDO) instead of whole mortgages reduces capital requirements.

Basel I and Changing Risk Basel I works if mortgages are high quality or AAA-rating was accurate Problem: Mortgage qualities gradually eroded (standards lowered) Problem: Excessive capital pushed into housing ballooned prices, making mortgages riskier The Basel capital requirements became increasingly inadequate the reality of the new, riskier mortgage products and mortgage environment.

Basel I works if mortgages are high quality or AAA-rating was accurate

Problem: Mortgage qualities gradually eroded (standards lowered)

Problem: Excessive capital pushed into housing ballooned prices, making mortgages riskier

The Basel capital requirements became increasingly inadequate the reality of the new, riskier mortgage products and mortgage environment.

The big question With all of this increase in mortgage risk From government policy From hedge funds Why didn’t it fall apart sooner?

With all of this increase in mortgage risk

From government policy

From hedge funds

Why didn’t it fall apart sooner?

Why didn’t this fall apart sooner? If you make risky loans to people who can’t pay, why did it take so many years to crash? Answer: There are no bad loans when house prices are skyrocketing.

If you make risky loans to people who can’t pay, why did it take so many years to crash?

Answer: There are no bad loans when house prices are skyrocketing.

Defaulting on the mortgage: Standard Version Foreclosure: $ to bank (up to loan value) Mortgage Loan Mortgage Payments Mortgage Payments Stop

Defaulting on the mortgage: Rapid appreciation version Mortgage Loan Mortgage Payments Mortgage Payments Stop Home has gone up in value. Home is resold by owner at a profit.

No such thing as bad loans I buy a $200,000 house with no down payment and payments I can’t afford. I will default in 12 months. Bad Loan? By the time I default, the house is worth $230,000 Instead, I sell the house and make a profit. No foreclosure. No bad loans.

I buy a $200,000 house with no down payment and payments I can’t afford.

I will default in 12 months.

Bad Loan?

By the time I default, the house is worth $230,000

Instead, I sell the house and make a profit.

No foreclosure. No bad loans.

Building risk wave As the GSE risk increased more and more, there were no repercussions because of rapidly appreciated house prices. The GSE’s created the rapidly appreciating house prices through the extreme expansion of credit to those who would not previously have been able to qualify.

As the GSE risk increased more and more, there were no repercussions because of rapidly appreciated house prices.

The GSE’s created the rapidly appreciating house prices through the extreme expansion of credit to those who would not previously have been able to qualify.

Crashing risk wave When appreciation slowed, the risk started to generate foreclosures Foreclosures generated forced sales Forced sales depressed prices Depressed prices generated more foreclosures Banks realized the assets were mispriced and capital reserves were insufficient Forced sales of mortgage backed CDOs Further lowering their value and creating more need for capital reservs

When appreciation slowed, the risk started to generate foreclosures

Foreclosures generated forced sales

Forced sales depressed prices

Depressed prices generated more foreclosures

Banks realized the assets were mispriced and capital reserves were insufficient

Forced sales of mortgage backed CDOs

Further lowering their value and creating more need for capital reservs

So, now what do we do? What was the core problem? Mispriced asset. Unrealized risk. Did government regulation help or hurt? GSE’s, following government mandate, caused much of the problem. GSE’s could keep risk “off the books” of US Government Basel I did not change regulations as assets changed

What was the core problem?

Mispriced asset. Unrealized risk.

Did government regulation help or hurt?

GSE’s, following government mandate, caused much of the problem.

GSE’s could keep risk “off the books” of US Government

Basel I did not change regulations as assets changed

Putting decision-makers at risk In ANY system, when the decision-maker does not bear the outcome risk, bad decisions will result. Long-term, returning to a system where the decision-makers are at risk could return rationality. Essentially, returning the asset class to its previous definitions

In ANY system, when the decision-maker does not bear the outcome risk, bad decisions will result.

Long-term, returning to a system where the decision-makers are at risk could return rationality.

Essentially, returning the asset class to its previous definitions

1: Requiring 10% cash down-payments (no second mortgages) A zero down payment mortgage is a purchase decision where the buyer is not at risk. Borrowers who are at risk are less likely to make risky investment decisions. Analogy: After the 1929 stock market crash regulations changed margin requirements from 10% to 50%, calming the potential for leveraged speculation. Limit the leverage.

A zero down payment mortgage is a purchase decision where the buyer is not at risk.

Borrowers who are at risk are less likely to make risky investment decisions.

Analogy: After the 1929 stock market crash regulations changed margin requirements from 10% to 50%, calming the potential for leveraged speculation.

Limit the leverage.

2: Requiring originator risk Originating lenders must be at risk for the quality of loans made. May come in the form of delayed payments based on performance, partial ownership, or another system.

Originating lenders must be at risk for the quality of loans made.

May come in the form of delayed payments based on performance, partial ownership, or another system.

3: Requiring government to count guarantee risk Allowing “off the books” risk accumulation in the GSE gave congressional decision-makers a “free” decision. Simply ordered more low-income loans without any consequences on government budget.

Allowing “off the books” risk accumulation in the GSE gave congressional decision-makers a “free” decision.

Simply ordered more low-income loans without any consequences on government budget.

4: Limit government guarantee percentage for mortgage investors Previous system, GSE guaranteed 100% principal and interest payments If GSE’s had guaranteed, e.g., 90% of principal and interest payments, then investors would care about the risk of the pool.

Previous system, GSE guaranteed 100% principal and interest payments

If GSE’s had guaranteed, e.g., 90% of principal and interest payments, then investors would care about the risk of the pool.

5: Rewarding banks that correctly perceived risk Government intervention rewarding banks that misperceived risk, simply because it was a common error encourages simultaneous industry movement in future decisions. Bank strategies become less diversified. This clustering behavior increases risk of systemic defaults due to single events. Instead support a failing bank by aid and resale to a stronger bank.

Government intervention rewarding banks that misperceived risk, simply because it was a common error encourages simultaneous industry movement in future decisions.

Bank strategies become less diversified.

This clustering behavior increases risk of systemic defaults due to single events.

Instead support a failing bank by aid and resale to a stronger bank.

Returning the risk Upside Essentially returns the asset class to it previous definitions, making Basel I realistic No “cost free” government orders generating huge future liabilities Downside Amounts to a dramatic credit retraction in housing Credit retraction will negatively impact house prices

Upside

Essentially returns the asset class to it previous definitions, making Basel I realistic

No “cost free” government orders generating huge future liabilities

Downside

Amounts to a dramatic credit retraction in housing

Credit retraction will negatively impact house prices

Alternative strategies Reignite house appreciation by generating inflation through printing money. This will build equity in existing mortgages and slow default. Upside: May provide time to return to reasonable mortgage credit standards. Downside: Could devastate banks holding lower interest rate mortgages and risks rampant inflation and political instability

Reignite house appreciation by generating inflation through printing money.

This will build equity in existing mortgages and slow default.

Upside: May provide time to return to reasonable mortgage credit standards.

Downside: Could devastate banks holding lower interest rate mortgages and risks rampant inflation and political instability