Lecture notes - The US Subprime Mortgage Crisis: why, how and what

I attended a public lecture this evening at the University of Queensland given by Honorary Professor Allan Kleidon.

I have cut and pasted my notes typed at high speed below. They are not brilliant but I have done my best to capture the essence of what Professor Kleidon had to say.

Subprime lecture

Causes
Securitisation of markets
Something else going on?
Implications for Australia


What led up to crisis and related credit crisis?

What got us to where we are? Period in the US of low interest rates climbing over time. Movement into RE - started in early 2000s and continued. Particularly post dot com burst - lot of money looking for other investments. Home prices dramatically increased over this period.

Through 2006 rising substantially. A lot of people unable to get into market - rising faster than incomes. Large segment of economy disenfranchised. If you think about traditional banking, collecting deposits and using to make mortgage loans. Fed system allows some movement across the country.

What happened is people qualified for bank loan because sufficient credit to meet very high standards or just locked out. Pricing of mortgages did not reflect risk - just a go / no go system. So many people excluded.

Enter subprime lending. Enabled a pricing of risk for people who were not the highest credit quality. They would pay higher rates to reflect their credit risk but they were able to enter the market. Percentage of OO grew over this period.

Subprime completed the market by moving from go / no go situation to allowing other entrants. That’s a good thing but how to price and how to get correct.

What has happened is that events have occurred that people did not predict. The instruments very sensitive to assumptions made - ie default rates. With hindsight people got it wrong. Home prices fell and there’s a consensus that it’s the decline in house prices that has triggered what has gone on. Potentially a lot more to come.

Given that the price of homes fell - the more recent loans (2006) higher delinquency rate. More recent loans therefore defaulting at unexpectedly high rates. Early payment default way up. Default within 60- days of taking out a mortgage. Default almost immediately. Turns out be very important because someone who writes a book and then wants to sell it is under an obligation to take mortgage back if early payment default. Therefore rise of early payment defaults just killed mortgage originators - bad mortgages back onto their books and therefore hitting their LVRs. Being forced to buy back early defaults therefore unstuck. Add into mix rise in foreclosure rates.

Across US loans to sub prime default risen substantially and continue to rise in 2008. Even in 2006 / 2007 not seeing this yet - not enormously high. But in 2008 prime loans increasing in foreclosures higher than in the past.

Big implications for the future.

How do the securities markets work?

Origination whole loan sales. Prospective home owners, get loan from originator, make repayments to originator. They may move through mortgage servicer - different company (maybe maybe not). Original source of credit for securities market is a warehouse lender. Warehouse lender provides short term money to originator to go and fund the mortgages. Warehouse lender has short term loans so that house vendor can get paid. Oil that moves the system. Wants to securitise the mortgages and sell to the broader market and get their money back. Relying on being able to sell off in securities market.

Transferor buys the mortgages. Various legal entities own the mortgages they create mortgage backed securities. Mortgages held by 1 entity. Who will make payments to people who buy the securities. Interest payments and principal payments. Real issue is the principal repayment.

AAA paid off first - highest quality. Equity tranche paid off last. Often held by people setting up securititsation. Last in line.

What happens to the mortgage backed securities? They go through underwriter and transformed into other securities. There may be institutional investors buying higher rating, hedge funds buy risky tranches and CDOs additional layer backed by some tranches of mortgage backed securities. Taking risky levels and creating another set of securities. Those CDOs also have layers - cash cascade.

CDOs squared. They are repackaged themselves as a security with own cascade. CDO cubed multirepackage.

Further you get away from the underlying mortgage harder it is to value. Need to know what is happening to prepayment (early pay off). In US most mortgages fixed rate 30 years. But then you have default and mortgages flow out and not getting money in like being at the end of the Murray Darling. Is there a drop coming out the end?

If you are at the end of the line right now it is very dry. Put it all together legal issues in setting up structures so all of it works. Moreover insurers and rating agencies giving these ratings to theses securities as they work through the system and law firm and accountants are the subject of litigation when anything happens.

Well as time passed residential mortgage backed securities were rated fairly highly by Fitch. July 2007 started to increase, Oct 2007 huge increase in number of downgrades by the agencies. Prior to that time did not have a lot of change even as resi houses prices falling and defaults rising. In August 2007 there was just a credit collapse. A spike in August 2007 spread between jumbo loans (above level Freddie Mac and Fanny Mae able to lend on) - if wanted to borrow above level cash could not get from them

Spread on Fannie May and Freddie Mac skyrocketed. Just a reflection of credit crisis of August 2007. Amount of commercial paper outstanding plummeted in Aug 2007. Worldwide down. Short term absolutely dried up.

Events only to happen in 10,000 years happened every day for 3 days. Things getting worse. Not right to think of this as a poor people problem. Issue much broader. Freddie Mac being hit by Alt A loans. Someone has good credit but uneven income (equivalent to low doc?). Indy Mac second largest collapse in US history. This is continuing. One of the big issues - US bankruptcy laws are no recourse. Big difference with Aus. Jingle mail. US only backing is the house therefore just send in the keys.

Very different from Australia. In US people not feel stigma in defaulting on mortgage. Eventually comes back on mortgage when banks dump on market. Further drives it down. Now getting through Alt As and into the prime. 30% drops in the US and some people predicting more to come. Prime housing affected. Remember it’s the money coming in from the borrowers there will be more defaults. Very little down the chain if at the end.

Worldwide markets affected. Global system dramatic downward spiral. IMF - systemic risks remain high. Multiple pressures on borrowers. Price of petrol hitting folks hard. Economies feeling the pinch. Credit closed up and frozen. US regulators stepped in to support Bear Stearns and Fannie and Freddie. Supported them. US Housing and Economic Recovery Act 2008 to come into force. Talking about credit markets fearful and frozen because people cannot value the securities (CDOs) because depends on how far prices will fall. Don’t know how much more jingle mail. Causing people to go to cash. Freezing up the system.

There is an interesting parallel with 19th century unregulated banks. Periodic credit crisis - hear of a rumor of run on bank therefore self perpetuating rumor. Even healthy banks forced to sell at fire sale prices to pay off depositors. Equivalent of selling your orchard as firewood.

Deposit insurance stepped in and ensured can get money out up to certain levels. Stops run ob banks but in return the banks have to accept capitalization limits. Securitisation is a shadow banking system. People in Perth can borrow money to, in effect, buy a house in Ohio through CDOs. What regulation is there in terms of risk?

Australia

Good news. There is much lower subprime / non conforming by Australian banks. 1 -2 % v 15% in US. Less inequality of income. Smaller pools of people disenfranchised. More of a speculative boom in the US than Australia. In the US lots of empty houses especially commuter suburbs - increases in petrol price killed being an hour away from work. More conservative banking standards in Aus. Less reliance on securitisation, some specialist mortgage companies securitising but not the banks. Most rates variable therefore banks able to increase rates in response to increases. But in the US locked for 30 years at 6%. No such thing as no recourse in Australia. Housing prices not falling in the same way - chances are they will not. Limited to some areas.

Bad news. Without belaboring the point there have been various entities in Australia directly exposed to US subprime problems. They have purchased securities in various points in the food chain. Basis capital, Absolute capital. What about our super funds?? Interesting question what they hold. Direct Australian bank investments in CDOs or other banks exposed to CDOs. First Milura Irrigation Trust bought (with Victorian govt money) bought CDOs. Princess Margaret Hospital in Perth through Basis Capital proud owner of CDOs on wrong end of the pipe. Lower priority mortgage backed securities likely to default. How low does low mean? Where does it end? No one knows. In part because a function of future RE prices. Function of number of foreclosures. Positive feedback loop.

Rise in interest rates August 2007. Centro Properties. Just not expected this short term crunches. Credit tighter globally - affecting commercial borrowing. Impact starting to be felt all over the place. Europe and Britain have problems with CDOs but also more generally. Talk of slowdowns in China, Japan and India. Australia and NZ - NZ talk of moving into recession. Gloom re: Australian economy. Commodity prices and AUD falling dramatically. In July 98 cents to US. Dropped as low as 82 cents within that time.

Banks in various places - some suggestions in UK, Australia credit rationing for good borrowers. IN the US company doing very well, 2 big contracts and the bank said sorry only enough money for 1. If that continues they cannot employ same numbers hits consumer confidence and spending - create further downturns. Affect whole stream of asset classes.

How far will problems extend? More mortgage backed securities defaults to come. a lot of securities at risk. Almost certain more will go. Very difficult to say how deep will go. Rapid changes in loan loss reserves in Australian banks. Saw NAB increase provisions in July for exposure to CDOs. And then it announced that it held some money, not huge, half a billion in Fannie and Freddie bonds. No immediate default but exposure.

What has changed a lot - and it will continue to change. Changes in underlying economies will see dramatic revaluation of these securities. Lower value tranches drop off to nothing.

In Australia prices falling. More decreases over time. Not uniform. More affects on more outlying commuter communities given the increase in the price of oil. Dropped a bit recently but will not stay down in the long run. What is the impact in Australia? Key question. Protection of full recourse loans but ultimately may occur.

Audit 2008 - some Australian loans made not subject normal credit checks. Rumored may increase prospect of more defaults. Last weekend Australian talking about ST George substantial low doc in outlying suburbs. May be some issues through particular portfolios in Australia.

Political and regulatory issues

In August in an attempt to respond ASIC looked at 3 basic areas: credit rating agencies (failed to respond in the US to changing environment), activist hedge funds, market manipulation. They should also think about Senator Obama targeting wild west Wall Street. Turns out that his senior economic advisor faculty of Uni of Chicago, known for free market support. Suggestion may need to be some focus on Wall st firms that are outside the parent regulation of the banks - forcing them to increase their capital to lending regulations. Raises the question of whether link to 19th C unregulated banking. Bear Stearns bail out akin to deposit insurance. Pro quid pro quo is tougher capitalization rules. Apply this lesson to Australia.

Aussie Mac? Make loans and securities - not occurred. Some political criticism of bank lending rates. Need to match RBA. Suggestions that something funny going on. RBA said that there is competition - if cost of funds drop we can expect to see mortgage specialists reenter and start up securitisation again. Question is when will it be profitable. Right now not palatable because don’t know how deep crisis will go - now not really right time to develop it. Needs time so people can figure out how to price these instruments.

One suggestion is that we should push for more securitisation and push super funds to buy the securities. Long term investors therefore best to hold these securities. But at what price? Needs to be worked through. Again the Australian full recourse environment - more security for securitisation in Australia than US because no jingle mail but still need to value them.

Litigation

Lots of people suing lots of people. Anyone who has had a bank failing is chasing deep pockets. Criminal, SEC, contractual bankruptcy etc. Less in Australia. More an issue of who owns the collateral? Increase in significance of class actions in Australia suggested. Some class actions v Centro - sort of issues not told vulnerable to liquidity squeeze therefore overpaid for securities.

Nice capsule of all works - look at subprime crisis on google.

Q: Why is tail wagging dog - drop in subprime affecting prime?
A: Any negative equity a lot of people will just hand in the keys. A whole class of people just pulling out of the market. Price of housing falls by 20% - people borrowed on an 80% LVR at peak will walk.

Q: What about affordability in Aus?

Its true some commentators point out that subprime allowed some people to get into that could not otherwise afford it. This is completing a market for people that couldn’t get in. Large number of people seeing housing prices up faster than incomes rise - if foot in the door can get a start therefore very attractive. There is a big difference between how pain spread in US and Australia. Lots of 30 year fixed mortgages in US - rates go up and people not affected. People hit in Australia much more due to use of variable rate mortgages. Protects the banks because as face higher funding interest rates able to pass it on. Good for protecting stability of the banks. But for ordinary folk, petrol up, mortgage costs up, other consumer credit up in price. If things slow down, at what stage are people going to get squeezed into default. Important question both at security level and personal level.

Q; inaudible

A: Not everyone in US has 30 year fixed rate mortgage. Other products low rates to start but resets over time. Resets for some of these. People looking at housing prices rising - thought could get in and not have run away over time. Qualify to get into a better mortgage before the balloon hit. Where things went wrong was prices of houses declined. Some people came in as flippers. Buying condos at baseball parks. When you see ads for buying condos good sign that the market has hit its peak. But when the price fell people not able to establish higher equity - could not refi. Interest rates up and when balloon hit just astronomical costs.

Q: inaudible

A: Maybe. You have to put in the context of no recourse loans. If choice is to have a chance to get foot in door and lose or never have a chance - rational people will give it a go.

End.
 
Great typing skills

Kudos to you for this Boomtown.

Is this what you do you for "happy hour?" :D

Seriously, thanks for sharing the gist of the situation. It's a nice summary.
 
Excellent

Thanks Boomtown,

Well worth the effort.
I liked the comment about selling Condos at baseball parks.
JTW
 
Eeenteresting.

Im trying to think of an Australian stadium that allows 20+ story residential next door. Whenever there is the opportunity to repeat the excesses of the US here we should seize it!
 
Eeenteresting.

Im trying to think of an Australian stadium that allows 20+ story residential next door. Whenever there is the opportunity to repeat the excesses of the US here we should seize it!

I am looking at it now from my office. Docklands Stadium aka Telstra Dome in Melbourne. Surrounded by apartment buildings! ;)
 
hi boomtown
sorry to say that the guy needs to go back and understand the reason before trying to work out the effect.
and before I start a 5 page post the reasons are not as he has said.
the reasons behind subprime are a lot more then just a simple product comming into a market.
my advice is to understand what it is before trying to explain why or how it happened or for that matter what effect is still to happen.
there seems to be alot of people that seem to say how or why it has happened without understand the product and why or who promoted it.
and then trying to understand who back the security and again why or who.
and on top of that.
trying to work out who will lose money when the whole thing has not unravelled as yet.
tyhe more information the better but you do need to read up on the product first
 
Planet Wall Street

Anybody wanting to follow this issue (....and if you're an IP investor I suggest that's maybe a good move !)....good reading is the Planet Wall Street articles in the Age. Just Google on "The Age Planet Wall Street" and you'll get there.

Sub-prime is pretty old news now. The situation has moved on to AA- and prime mortgages. The numbers just keep going up... from billions to trillions ...and now quadrillion.
LL
 
the problem is like deregulation of currency markets earlier and FX risks. Basically there is innovation, new open marekts and mispricing of risk because that market has never existed in a free form before.

In this case, mortgage backed securities working it's way back to credit swaps and derivatives.
 
Litigation

Lots of people suing lots of people. Anyone who has had a bank failing is chasing deep pockets. Criminal, SEC, contractual bankruptcy etc. Less in Australia. More an issue of who owns the collateral? Increase in significance of class actions in Australia suggested. Some class actions v Centro - sort of issues not told vulnerable to liquidity squeeze therefore overpaid for securities.
Well done,just have to ask how do you find out about when these people speak,i would just like to go along and have a listen,from what i have been told in the US,is that the Mortgagee can not chased up what left after the proceeds after the fire sale are set,the mortgage is discharged from the debt makes you have a quick think about who ends up holding the can,it's a bit different in the banking system we have in this country where the banks will hound you for ever cent..willair..
 
My girlfriend is studying finance at UQ so she told me about it. Membership has its benefits :D

I only found out about in 45 minutes beforehand but Ill try to post up here if I see anything else interesting.
 
I wonder when they will start suing the credit rating agencies for false rating?
Are the US mortagage system entirely to blame?
 
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