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Mispricing of Risk
Crisis Due to mispricing of risk of new, complicated assets based upon subprime & other mortgages. High leverage contributed to risk. House Prices Foreclosures Bank Failures
Background
The Great Moderation -years of macro stability
Credit Boom
Fed dropped rates after dot com bust & again after 9/11. Rising house prices Stable economic conditions.
Disposable Income (DI) is income after taxes that is available for consumption & savings.
Prices of Bonds interest rates Credit Savings from less developed countries funded our deficits with growing imbalance.
1993 to 2005: U.S. savings as % of DI from 6% to 1%; Total debt to DI from 75% to 120%
This is debt to Disposable Income (DI) which is income after taxes that is available for consumption & savings.
U.S. Mortgages
Prime: borrowers have good credit & meet income & house pricing requirements. Jumbo: borrowers have good credit & meet income requirements, but house price > amount set by Fannie & Freddie. Alt-A have higher risk of default because they do not conform to Fannie & Freddie requirements. Sub-prime: most risky loans often made to people with bad credit history.
Mortgage Originations
Complex Securities
CDOs, CDOs Squared, CDOs Cubed! Great variation in characteristics of sub-prime mortgages bundled together. Not all low credit quality Many borrowers depended upon rising home value to allow refi. Many who bought securities did not understand risk.
Sub-Prime Trigger
The sub-prime mortgage market triggered the crisis. Default rates started increasing in 2006. Pooled mortgages risky because defaults positively correlated. Investors highly leveraged.
If 20 to 1 5% loss 100% capital Investors lose all with only low default rates.
Global Impact
Originator faced low risk even if borrower defaulted. Automated underwriting & outsourcing of credit scores helped originators sell more mortgages. With low interest rates throughout the world, investors reached for yield. Sales of securities went global.
Sub-Prime Assets
Subprime was trigger, but other high yielding assets, e.g. hedge funds, could have started the crisis. People bought risky, complicated assets because return was high. After sub-prime defaults increased, rating agencies downgraded many sub-prime backed securities.
Bear Stearns collapsed after hedge funds failed to rollover asset backed commercial paper.
Liquidity Crisis
Banks afraid to loan because they might have to cover losses on their conduits or SIVs. The Libor-OIS spread increased from a long-run 10 basis points to 364 in 10/08.
The London inter-bank offer rate indicates is the rate that banks charge each other for loans of 1 day to 5 years. The London inter-bank offer rate indicates is the rate that banks charge each other for loans of 1 day to 5 years.
The London inter-bank offer rate indicates is the rate that banks charge each other for loans of 1 day to 5 years.
Residential MSBs backed by sub-prime mortgages Steps between originator & holder
Often not employees of mortgage originators not subject to regulation. Fraud in some cases.
2. Originators had no more incentive to seek quality borrowers than did brokers.
Investors wanted more mortgages. Automated underwriting systems made mortgages loser & faster.
Quality of new borrowers Standards NINJA loans No Verified Income, Job, or Assets. Piggyback loans Over time Risk of default
Issuers paid up-front fees to rating agency. Rating agencies sold advice to issuers on how to get desired rating.
As long as the music is playing, youve got to get up and dance. Were still dancing. Chuck Prince, former CEO Citigroup. http://research.stlouisfed.org/publications/revie w/08/09/Mizen.pdf (page 22)
The Result
Incentives of brokers, originators, SPVs, rating agencies, & fund managers the same. No principal agent problem!
Escrow
First lien mortgage loans are the first or original mortgages taken out when someone buys a mortgage.
Conclusions
Reasons for credit crisis:
Period of macro stability with low inflation & low interest rates. Big increase in supply of loanable funds. Financial innovation resulted in complex instruments, e.g. MBSs.
Higher leverage; Sub-prime mortgages.
Conclusions
No one expected housing prices to fall nationwide. Nationwide falling housing prices & higher interest rates led to defaults. Other high yield assets, e.g. hedge funds, could have been trigger. Bank failures led to credit freeze in commercial paper.
Conclusions
Central bankers stepped in to provide liquidity. Regulation will need to increase if we are to prevent future crises.