Week 5 digital story josh kim

Digital Story
Global Financial Crisis and
Secondary Mortgage Market
ECONOMIC ANALYSIS FOR MANAGERS ECON 510
INDIANA WESLEYAN UNIVERSITY
JOSH KIM

Introduction
Background
•The financial crisis of 2007-2008 also known as the global financial crisis (GFC) was a severe worldwide financial
crisis due to excessive risks taking by banks that was combined with busting of the United States housing bubble.
•In March of 2009, Bear Stearns a global investment bank, a pillar of Wall Street dated to 1923 collapsed and was
acquired by JP Morgan Chase for pennies on the dollar.
•In summer of 2008, IndyMac Bank became one of the largest banks ever to fail in the U.S., and the country's two
biggest home lenders—Fannie Mae and Freddie Mac—had been seized by the U.S. government.
•In September 2008, another giant investment bank Lehman Brothers collapsed marking the largest bankruptcy in
U.S. history. U.S. economy has seen the greatest recession hence named “Great Recession”, since the Great
Depression.
•Although the Great Recession was officially over in the United States in 2009, among many people in America and
in other countries around the world, the effects of the downturn were felt for many more years.
•from 2010 through 2014, multiple European countries—including Ireland, Greece, Portugal and Cyprus—
defaulted on their national debts, forcing the European Union to provide them with “bailout” loans and other
cash investments.

Introduction
How did it affect me and my family?
•U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to
73% during 2008, reaching $10.5 trillion. The increase in cash out refinancing (occurs when a
loan is taken out on property already owned, and the loan amount is above and beyond the cost
of transaction, payoff of existing liens, and related expenses) , as home values rose, fueled an
increase in consumption that could no longer be sustained when home prices declined
◦ My family was living in Indianapolis at the time and I just got promoted and assigned to a new role in
Paris, IL, requiring relocation in September of 2009. The housing market was not hit in Indiana as
severely as some states like Florida and California, but the house we built in 2004 lost over $35,000 in
its value within the 12 months. I had to either give up my promotion or take the loss of the house value
to move to somewhere closer to Paris, IL.
◦ Secondarily, I lost over $20k in stock between 2008 and 2009 due to the wall street going to the “bear
market”.

Introduction
What was the outcome for my family affected by GFC?
•I explained the house situation to the company and the HR in the company headquarter had
reviewed the case and luckily made an exception to the relocation package to cover for the loss
on the housing value due to the financial crisis.
•The company covered the loss up to the 100% of the original purchase price so I didn’t have to
take on the burden to take on the new role within the company.

Introduction
How was I changed because of it?
•Biggest change was learning people’s behavior and how greed plays in financial market that
creates bubbles, bursting of bubble and repeating of that vicious cycle over again.
•The base of the root cause in which banks buying toxic securities and people being allowed to
borrow money from artificially inflated value of houses didn’t appear much different from the
.com bubble in early 2000s.
•During the .com crisis, money was borrowed or invested to many .com companies where
success was uncertain, yet stock prices skyrocketed with no logical reasons driven by greed and
hypes. Eventually the stock price of vast majority of them tanked out. There are high rewards for
high risks but when greed takes over, it is no longer investing but nothing shy of gambling.
•The painful learning from losing over $20k in stock market during the Great Recession was that
you need to be really nimble and fast in reacting to market. In Bear market, the sectors or the
companies you have stock with really do not matter. Everyone loses except the people shorting
stocks.

Focus companies profile
• Name
◦ Fannie Mae and Freddie Mac.
• Industry
◦ The secondary home mortgage market
• How long they have been in business
◦ Fannie Mae was first chartered by the U.S. government in 1938 to help boost the mortgage market.
Congress chartered Freddie Mac in 1970 as a private company.
• Economic viability
◦ They perform an important role in the nation’s housing finance system – to provide liquidity, stability
and affordability to the mortgage market. They provide liquidity (ready access to funds on reasonable
terms) to the thousands of banks, savings and loans, and mortgage companies that make loans to
finance housing.

Focus companies' profile
•Economic viability continued
◦ According to Fannie Mae and Freddie Mac's congressional charters, which gave them GSE (government-
sponsored enterprise) status, they operate with certain ties to the U.S. federal government which
provide a financial backstop. For instance, in September 2008, during the height of the financial crisis,
they were placed under the direct supervision of the federal government. By government’s takeover of
Fannie Mae and Freddie Mac, these two companies could survive through the Financial Crisis in 2008
with a bailout. It is the congress’ interests to make sure Fannie Mae and Freddie Mac continue to
function as they were created for.

Unhealthy status of Fannie Mae and Freddie Mac during the
financial crisis
•Government regulations prohibited Fannie and Freddie from buying high-risk mortgages. But as
the mortgage market changed, so did their business.
•Between 2005 and 2007, they acquired few conventional, fixed-interest loans with 20% down.
They loaded up on subprime, interest-only, or negative amortization mortgages—loans more
typical of banks and unregulated mortgage brokers.
•Fannie and Freddie made things worse by their use of derivatives to hedge the interest-rate risk
of their portfolios. But as private-sector companies with shareholders to please, they were doing
this to remain competitive with other banks. They were all doing the same thing.

financial crisis
• Fannie Mae's loan acquisitions were:
◦ 62% negative amortization
◦ 84% interest-only
◦ 58% subprime
◦ 62% required less than 10% down payment
• Freddie Mac's loans were even more risky, consisting of:
◦ 72% negative amortization
◦ 97% interest-only
◦ 67% subprime
◦ 68% required less than 10% down payment

financial crisis
• These exotic subprime mortgages made Fannie and Freddie's loan acquisitions toxic. Banks
were going out of business and houses defaulting on mortgages. There have been serious losses
to Fannie Mae and Freddie Mac.
• It was critical for Fannie Mae and Freddie Mac to figure out how to minimize the loss and what
kind of help is needed from the government to survive the economic crisis. Cutting the loss and
receiving the aid from the government was the most important and effective strategy.

Secondary Mortgage Market –
Fannie Mae, Freddie Mac in GFC
•Few people who decide to purchase a home have the necessary savings or available financial
resources to make the purchase on their own. Most need to take out a loan. A loan that uses
real estate as collateral is typically referred to as a mortgage.
•A potential borrower applies for a loan from a lender in what is called the primary market. The
lender underwrites, or evaluates, the borrower and decides whether and under what terms to
extend a loan. Different types of lenders, including banks, credit unions, and finance companies
(institutions that lend money but do not accept deposits), make home loans.
•After a mortgage is made, the borrower sends the required payments to an entity known as a
mortgage servicer, which then remits the payments to the mortgage holder (the mortgage
holder can be the original lender or, if the mortgage is sold, an investor).

•The secondary market is the market for buying and selling mortgages. If a mortgage originator
sells the mortgage in the secondary market, the purchaser of the mortgage can choose to hold
the mortgage itself or to securitize it.
•When a mortgage is securitized, it is pooled into a security with other mortgages, and the
payment streams associated with the mortgages are sold to investors.
•These are called Mortgage-Backed Securities (MBS). Fannie Mae and Freddie Mac securitize
mortgages and resell them to other investors who would are seeking to generate profit by taking
interests from mortgage payers.
•Before the secondary market was established in 1960s, only larger banks had the extensive
funds necessary to provide the funds for the life of the loan, usually for 15 to 30 years.
•Because of this, potential homebuyers had a more difficult time finding mortgage lenders.
Because there was less competition between mortgage lenders, they were able to charge higher
interest rates.

•The 1968 Charter Act solved this problem by creating Fannie Mae and Freddie Mac. These
government-sponsored enterprises (GSE) function as aggregators, able to buy bank mortgages
and resell them to other investors.
•Instead of reselling the loans individually, they are bundled into mortgage-backed securities, in
which their value is secured or backed by the value of the bundle of underlying loans.
•The 2008-2009 subprime mortgage crisis saw the two entities owning or guaranteeing 40% of all
U.S. mortgages. This portfolio amounted to nearly $5 trillion U.S. as it teetered on the brink of
default.
•Other financial institutions like Lehman Brothers and Bear Stearns were capsized by mortgage-
backed securities and other high-risk derivatives during the 2008 financial crisis.
•There was a rush to the exits as private banks deserted the mortgage market that was in a mess.
As a result, Fannie and Freddie became responsible for almost 100% of home loans in the
secondary mortgage market.

•The two Government Sponsored Enterprises (GSEs) were basically holding together the entire
housing industry. This large holding of toxic home loan securities was how Fannie Mae and
Freddie Mac were implicated in the subprime mortgage crisis.
•The secondary mortgage industry is an oligopoly market where there are a few sellers such as
Fannie Mae, Freddie Mac and other aggregators selling MBS products and buyers are large
investors on financial securities.
•For the GSEs, the opportunity costs would be when buying and selling higher risk MBS in which
the mortgage payers have lower credit score than the lower risk MBS which may be comprised
of mortgages from higher credit scores. They guarantee timely payments of principal and
interest on these mortgage-backed securities. Even if the original borrowers fail to make timely
payments, both institutions still make payments to their investors. Therefore, low quality MBS
can create risks for Fannie Mac and Freddie Mac.

Fannie Mae/Freddie Mac
Pricing Model
• Secondary markets are the money people that purchase loans from mortgage companies. They
do not deal with borrowers directly, but they do want to make money from the transaction and
are willing to take on the risk of the borrower paying them back.
• In a two-tiered system like this, companies in both tiers need to make a profit or the whole
system will collapse. Pricing strategy and types can be incredibly complex for the mortgage
industry. Here are some of the basic pricing terms.
◦ Price: This is the percent of the loan amount that investors are willing to purchase. A price of 100 means
the investor will pay 100 percent of the loan amount. If the mortgage company wants to make a profit
on the loan, they must charge a higher price to the consumer than what the secondary market is willing
to pay for that loan, or charge borrowers points to make up the difference. Most borrowers do not want
to pay points, so mortgage companies typically raise the interest rate offered. (Note: this is how
companies mark up the pricing, not how mortgage originators should mark up the pricing.)

Pricing Model
◦ Raw price: This is the price that investors are willing to pay for a loan. Typically, they offer a price (as
above) along with an associated interest rate. This is called the raw price instead of price because it
denotes the starting point before any mark-ups or mark-downs are made to a company’s distribution
channels.
◦ Basis points (bps): This is a common unit of measure for interest rates. It is equal to one one-hundredth
of one percentage point.
◦ Par pricing: Pricing is measured on a scale with par equaling 100. At par a lender pays no money and
makes no money. When originators offer borrowers par price for their loans, the borrowers pay no
points — with one point equaling 1 percent of the loan amount — and get no lender credit. If mortgage
companies have raw par pricing from investors, they must mark up the pricing by increasing the interest
rate to make a profit before they offer par pricing to borrowers.

Pricing Model
◦ Above par pricing: This is anything above 100. A price of 101 would be 1 percent of the loan amount
above par. If a lender is offered above-par pricing, then the investor is willing to pay the lender a
premium for this loan. When a mortgage company gives a borrower above-par pricing, most pass on
that premium to the borrower as a lender credit to help offset closing costs — normally in exchange for
a higher interest rate.
◦ Below par pricing: This is when an investor is not willing to pay a lender 100 percent for the loan. A
price of 99, for example, means the investor will only pay the lender 99 percent of the value of the loan.
Borrowers would then need to pay 1 percent of the loan amount, or one point, to get the lower rate at
the par price. This is referred to as a discount point because the borrower is paying to discount the
interest rate.

Margins
•Margins in any industry are simply add-ons to the cost to produce something. Product
manufacturers, for example, sell their wares to wholesalers, who then distribute that product to
stores. As the pricing gets marked up through the supply chain, each part of that chain needs to
add their profit to the price.
•Corporate margin is the money mortgage companies need to make on loans to pay the bills
needed to run the company and turn a profit. Otherwise, when they sell the price, or rate, to the
borrower, that company will not make any money on the loan.
•Regional offices have staffs to manage a national mortgage company’s region, for example.
Mortgage branches have overhead costs and staff as well. Even wholesale lenders, who resell
money to brokers, must pay overhead and try to make a profit. All of these offices need to be
considered when adding margins so the bills of the entire supply chain can be paid.

Margins
• Today, most mortgage companies have pricing engines that make the process of building in
margins simple. These engines are configured by the secondary market teams to build in all of
the margins per entity, which is any line of business as defined by the company. An entity could
be a branch or call center. It could be retail only, or wholesale or include many other groups.
Configuration tells the engine to group and price all loans within an entity the same way.
• The secondary market team will look at each line of business, decide on margins and add those
to the pricing engine. The team also must be careful about how they structure the margins to
make sure the company complies with all regulatory guidance regarding pricing. When the
pricing engine pulls in raw pricing for the day, it adds those margins and then displays the rate
and price with the margins already built in.
• Most simply put, the way GSEs generate profit is by the difference in the price that they pay for
mortgages and the price for which they can sell the MBS backed by those mortgages, contingent
upon their hedge effectiveness.

Market Place
• Fannie Mae, Freddie Mac and other aggregators – who are large mortgage originators with ties
to Wall Street firms – create MBS (private-label mortgage-backed securities by working with
Wall Street firms or agency mortgage-backed securities by working through GSEs.
◦ Securities Dealers
After an MBS has been formed (and sometimes before it is formed, depending upon the type of the MBS),
it is sold to a securities dealer. Most Wall Street brokerage firms have MBS trading desks. Dealers on these
desks do all kinds of creative things with MBS and mortgage whole loans; the end goal is to sell them as
securities to investors. Dealers frequently use MBSs to structure CMO, ABS, and CDOs. These deals can be
structured to have different and somewhat definite prepayment characteristics and enhanced credit
ratings compared to the underlying MBS or whole loans. Dealers make a spread in the price at which they
buy and sell MBS, and look to make arbitrage profits in the way they structure the particular CMO, ABS,
and CDO packages.

Market Place
◦ Investors
Investors are the end-users of mortgages. Foreign governments, pension funds, insurance companies,
banks, GSEs and hedge funds are all big investors in mortgages. MBS, CMOs, ABS, and CDOs offer
investors a wide range of potential yields based on varying credit quality and interest rate risks.
Foreign governments, pension funds, insurance companies and banks typically invest in highly rated
mortgage products. Certain tranches of the various structured mortgage deals are sought after by these
investors for their prepayment and interest rate risk profiles. Hedge funds are typically big investors in
mortgage products with low credit ratings and structured mortgage products that have greater interest
rate risk.
Of all the mortgage investors, the GSEs have the largest portfolios.

Trends
Trends for mortgage before the financial crisis and current.
◦ If you were house hunting before the crash, you could choose between an array of loan products to
keep your payments low such as an interest-only loan, a “choose-your-own-payment” loan, a balloon
payment loan or an adjustable-rate mortgage (ARM) with an extremely high cap. If your credit score was
low, you didn’t have money for a down payment or your income was erratic, you could get around all
those obstacles with a no-documentation loan, sometimes for as much as 125 percent of the home
value.

Trends
• The pre-crash loan products are mostly gone. You can choose between a fixed-rate loan or an ARM that
meets “Qualified Mortgage” (QM) standards established by the Consumer Financial Protection Bureau
(CFPB). That ARM will have caps so the interest rate can’t jump too high too quickly — and you’ll have to
qualify based on the worst-case scenario of the highest possible mortgage rate.
• You’ll also need to fully document everything and make a down payment of at least three or 3.5
percent with most loan programs.

Trends
o If your credit score is less than 620, you’re not likely to qualify for a loan at all and unless your score is
760 or above, you’ll pay a little extra in interest on a conventional loan.
o Pre-crash, buyers saw a good-faith estimate of their loan costs and, at the closing, a Truth-in-Lending
statement and a HUD-1 statement that showed the financial terms of their purchase. Yet many buyers
found the entire purchase process mysterious and often didn’t understand their loan terms. Pre-crash,
buyers saw a good-faith estimate of their loan costs and, at the closing, a Truth-in-Lending statement
and a HUD-1 statement that showed the financial terms of their purchase. Yet many buyers found the
entire purchase process mysterious and often didn’t understand their loan terms.

Trends
Trends that people still want to buy homes
◦ During the financial crisis U.S. lost $16 trillion of net worth for homeowners and 10 million people lost
their homes to foreclosure during the crash, but one reality hasn’t changed: the majority of Americans
want to own a home. Prices across the U.S., which fell 33 percent during the recession, have rebounded
and are now up more than 50 percent since hitting the bottom. Among those homeowners who lost
their home to a short sale or foreclosure, about 35 percent have now purchased another home.

Correction Implementation
• Lenders and policymakers learned the hard way that easy credit and the erosion of
underwriting standards are not the solution to higher demand for loans.
• About one-third of all mortgages in 2006 were low or no-documentation loans or subprime
loans. Now people understand that loans must be sustainable, otherwise everyone loses. People
learned that a foreclosure hurts families, communities, lenders and investors.
• While regulations such as Dodd-Frank changed the financial world, lenders and investors also
lost their appetite for risk and have changed their behavior. Sam Khater, chief economist of
Freddie Mac in McLean, Va. As a result, he says, mortgage performance is better than it has
been in 20 years.

Correction Implementation
• Appraisers shared some of the blame for overinflated home values during the housing boom, in
part because lenders were able to directly communicate with appraisers their expectations for a
home valuation to match escalating prices. Regulations are in place now to put a firewall
between the appraisal process and the underwriting process
• At the peak of the housing boom, borrowers with a credit score of 620 to 640 qualified for the
lowest interest rates on conventional loans. Credit scores for FHA borrowers were in the mid-
500s. By contrast, in July 2018, according to Ellie Mae, a mortgage analytics company, 70 percent
of borrowers had a FICO score more than 700. The average FICO score for conventional loans for
a home purchase in July 2018 was 751, more than 100 points higher than what was considered
worthy of the best mortgage rates from 2004 to 2006.

Regulatory responses to the subprime mortgage crisis
• Presidents George W. Bush and Barack Obama signed into law several major legislative
responses to the financial crisis of 2008.
•The most influential and controversial of these was the Dodd-Frank Wall Street Reform and
Consumer Protection Act, which introduced a raft of measures designed to regulate the
activities of the financial sector and protect consumers.
•Another notable law was also the Emergency Economic Stabilization Act, which created the
Troubled Asset Relief Program (TARP). Moreover, the Federal Reserve took up many new and
additional measures of its own.

• Dodd-Frank, the Emergency Economic Stabilization Act, and steps taken by the Federal Reserve were
key components in responding to the 2008 financial crisis.
• Dodd-Frank amended many existing legislations and created many new standalone provisions.
• The Emergency Economic Stabilization Act provided $700 billion in bailout relief.
• Post-Dodd-Frank, many new committees and the Federal Reserve were tasked with the
responsibilities of greater financial market oversight.
•The Financial Stability Oversight Council (FSOC) is created.
•The establishment of the FSOC was focused on improving systemic risks. The FSOC’s primary purpose
is to monitor designated Systemically Important Financial Institutions (SIFIs) deemed “too big to fail.“
•The FSOC has authority to require testing and documentation of the business operations of SIFIs. It
can also decide to take action for dividing or reorganizing these institutions in such a way that reduces
the overall risk to the economy.

• Federal Reserve
The Federal Reserve took extraneous steps to support the economy and the financial markets
during and after the 2008 financial crisis. In addition to its authority to designate monetary
policy, primarily the federal funds rate, the Fed also setup many special purpose vehicles for
lending to various sectors of the market. These special purpose facilities have become
somewhat of a new standard for the Fed in regular and emergency lending activities.
In addition to its own actions, the Federal Reserve was also directed by Dodd-Frank to carry out
regular stress testing on banks in the banking sector. Provisions in the Dodd-Frank Act pertaining
to Federal Reserve stress testing are primarily found in Title XI. Post-Dodd-Frank, the Federal
Reserve conducts two types of stress testing annually: Comprehensive Capital Analysis and
Review (CCAR) and Dodd–Frank Act supervisory stress testing (DFAST).

• Further legal changes due to the Great Financial Crisis
◦ In 2018, President Donald Trump passed the Economic Growth, Regulatory Relief, and Consumer
Protection Act. This Act eased a great deal of the regulatory burdens created for banks through Dodd-
Frank, primarily by increasing the threshold at which banks are subject to greater regulatory
documentation obligations. The threshold was increased from $50 million to $250 million.

• Regulations aimed to enhance capital and liquidity
◦ The Federal Reserve has since enforced regulations to enhance the capital strength and liquidity of 16
systematically important financial institutions. A bank’s liquidity enables it to meet its current and future
obligations, whereas capital refers to the funds within a bank that help it to absorb unexpected losses.
◦ Banks are required to maintain adequate levels of capital and liquidity. Capital and liquidity standards
are set by internationally accepted Basel III norms, but the Fed has raised these standards even higher
for larger banks.
◦ Banks are also required to conduct “stress tests,” which are designed to verify whether they can operate
in conditions similar to those that occurred during the financial crisis. At the same time, large banks are
required to develop resolution plans to manage failure and reduce their chances under the Dodd-Frank
Wall Street Reform and Consumer Protection Act.
◦ The Act also gives the Fed responsibilities for safeguarding the stability of the financial system. For this
purpose, the Fed created the Financial Stability Oversight Council, which has been designed to help US
regulators work together more effectively to better promote the stability of the financial system.

Week 5 digital story josh kim

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