History, Status, and Implications of the Subprime Mortgage Market

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

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

Agenda

3

Subprime Mortgage Issuance Has Dominated ABS Supply in Recent Years

ABS IssuanceJanuary 2000 through August 2007

0

100

200

300

400

500

600

700

800

900

Credit Card Auto U.S.Mortgage

ManufacturedHousing

Equipment Student Loan Global RMBS Other Total

$ B

illio

ns

2000 2001 2002 2003 2004 2005 2006 2007-YTD

Data as of August 31, 2007

Source: JP Morgan. This information is taken from sources that w e deem reliable but no w arranty is made as to accuracy.

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.

Mortgage Debt Outstanding - $10.0 Trillion

Alt-A Fixed4%

Prime Adjustable

16%

Prime Fixed59%

Subprime Adjustable

10%

Alt-A Adjustable

7%

Subprime Fixed4%

Current composition of U.S. mortgage debt

3% 3%

5%

8%

11%

12% 13% 13%

33%

0%

5%

10%

15%

20%

25%

30%

35%

Up to 499 500-539 540-579 580-619 620-659 660-699 700-739 740-779 780+

FICO score range

% o

f p

op

ula

tio

n

FICO Score range for typical subprime mortgage borrowers

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)MSA

Mkt Value Rank

Subprime Mkt Value

($bb) Weighted Avg Price

Average Price Min Price Max Price

10th Percentile

Price

90th Percentile

Price 1 Qtr 1 Year 3 Year 5 YearRiverside-San Bernardino-Ontario, CA 1 47.68 410,749 390,859 56,000 1,450,000 257,000 598,237 0.6% 2.5% 46.6% 81.3%Los Angeles-Long Beach-Glendale, CA (MSAD) 2 46.61 521,613 552,479 175,000 2,125,022 350,000 741,500 0.3% 4.1% 44.1% 80.3%Chicago-Naperville-Joliet, IL (MSAD) 3 18.52 238,512 257,937 55,000 1,235,000 118,000 382,950 -0.6% 2.4% 23.2% 38.3%Atlanta-Sandy Springs-Marietta, GA 4 16.61 171,963 171,675 40,000 1,600,000 108,000 282,413 -4.3% -1.4% 6.2% 13.9%Sacramento-Arden-Arcade-Roseville, CA 5 16.44 381,136 399,871 150,000 1,400,000 256,500 635,000 0.8% -3.8% 27.3% 52.8%Oakland-Fremont-Hayward, CA (MSAD) 6 16.37 549,964 569,101 216,000 1,500,000 410,000 762,218 -0.6% -0.4% 33.5% 54.2%Nassau-Suffolk, NY (MSAD) 7 14.18 427,827 440,144 122,960 1,000,000 302,100 567,498 -0.8% 1.9% 24.6% 48.0%Miami-Miami Beach-Kendall, FL (MSAD) 8 13.97 363,651 370,273 97,000 1,350,000 206,000 530,000 1.0% 7.2% 55.1% 85.5%Phoenix-Mesa-Scottdale, AZ 9 12.49 243,733 254,669 76,000 1,300,000 175,000 350,478 0.7% 3.1% 50.9% 60.6%Washington-Arlington-Alexandria, DC-VA-MD-WV (MSAD) 10 12.33 397,791 400,536 125,000 1,200,000 250,000 600,000 -2.0% -2.7% 40.9% 65.4%Dallas-Plano-Irving, TX (MSAD) 11 11.72 152,060 154,176 52,649 1,025,000 81,560 265,495 1.1% 0.7% 3.4% 0.5%

Santa Ana-Anaheim-Irvine, CA (MSAD) 12 11.68 630,883 649,406 283,600 1,600,000 530,000 797,000 0.0% -0.4% 32.6% 70.5%San Diego-Carlsbad-San Marcos, CA 13 10.77 513,536 539,334 121,000 1,350,000 350,000 728,500 1.4% -0.3% 22.1% 58.0%New York-White Plains-Wayne, NY-NJ (MSAD) 14 10.60 449,803 449,180 158,000 1,500,000 315,000 605,500 -0.7% 3.1% 30.1% 54.5%Las Vegas-Paradise, NV 15 9.99 296,086 311,086 155,000 950,000 224,000 417,000 0.3% 0.7% 42.9% 58.0%Minneapolis-St. Paul-Bloomington, MN-WI 16 8.25 247,047 256,847 81,000 2,980,000 161,000 414,176 -0.3% -0.2% 14.0% 29.5%San Jose-Sunnyvale-Santa Clara, CA 17 8.16 675,550 709,313 300,000 2,449,780 550,000 865,000 0.8% 3.1% 32.7% 47.9%Houston-Sugar Land-Baytown, TX 18 8.13 142,319 136,634 42,000 1,479,947 74,500 247,950 1.0% 4.3% 12.3% 16.9%Tampa-St. Petersburg-Clearwater, FL 19 7.96 200,436 213,217 75,000 1,255,000 120,000 304,500 -1.8% 2.6% 44.5% 62.7%Stockton, CA 20 7.87 419,196 404,042 169,004 1,225,000 258,500 634,500 -3.2% -3.5% 37.6% 58.4%Seattle-Bellevue-Everett, WA (MSAD) 21 7.54 378,263 397,126 82,503 1,532,619 254,500 610,000 4.3% 13.7% 40.7% 50.6%Detroit-Livonia-Dearborn, MI (MSAD) 22 7.24 109,828 116,151 28,999 638,000 62,500 162,500 -4.0% -3.4% -1.8% 3.2%Fort Lauderdale-Pompano Beach-Deerfield Beach, FL (M 23 6.99 323,288 349,631 99,000 1,150,000 220,000 485,000 2.3% 5.8% 49.1% 76.3%Portland-Vancouver-Beaverton, OR-WA 24 6.75 274,440 284,518 104,000 1,360,000 182,500 444,475 2.2% 10.8% 40.2% 49.9%Denver-Aurora, CO 25 6.73 201,531 217,349 73,000 1,300,000 131,000 335,000 -3.5% -5.1% -4.6% -5.5%

Market Index 345.59 378,097 359,822 28,999 2,980,000 254,163 3 550,365 3 -0.1% 1.9% 32.2% 53.3%

6

Subprime Loans(1000s)

AAA

BBB+

AA+

AA-

AA

BBB

BB+BBB-

BBResidual

8% Subordination

PrincipalPayments

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+

Securitization Provides Opportunity for Investors of Various Risk Appetites

7

Subprime ABS Yield Spreads Widened Dramatically in July and August

Data as of September 21, 2007

Source: J P Morgan. This information is taken from sources that w e deem reliable but no w arranty is made as to accuracy.

Subprime ABS Yield SpreadsFebruary 1998 through September 21, 2007

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200

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1000

1200F

eb-9

8

Jun-9

8

Oct-

98

Feb-9

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Jun-9

9

Oct-

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Feb-0

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Jun-0

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Oct-

00

Feb-0

1

Jun-0

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Oct-

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Feb-0

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Jun-0

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Feb-0

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sis

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ints

AAA AA A BBB

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• 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.

Causes of Recent Subprime Troubles

9

• Systematic pricing of idiosyncratic markets

• Liquidity providers to forced-sellers

• Lack of necessary analytics in the investment community

• Uncertain value

Opportunity Created by Subprime Woes

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

11

Rating Agency Mass Downgrade Action

•June 15th: Moody’s announced the first mass scale downgrade action (267 bonds). Since then, rating agency downgrades have been running at full steam.

Rating Transition of 2006 Subprime Bonds through Oct 2007

New Rating

Original Rating A Baa Ba B Caa

A 21% 43% 27% 9% 1%

Baa 12% 32% 23% 32%

Ba 4% 14% 82%

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

Spread (1M LIBOR - 1M T-Bill)

-50

0

50

100

150

200

250

300

350

9/2

3/1

999

3/2

3/2

000

9/2

3/2

000

3/2

3/2

001

9/2

3/2

001

3/2

3/2

002

9/2

3/2

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3/2

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005

3/2

3/2

006

9/2

3/2

006

3/2

3/2

007

9/2

3/2

007

Source: Bloomberg

15

Asset Backed Commercial Paper Spreads Widen

Source: Bloomberg

Spread (1M ABCP - 1M T-Bill)

-50

0

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9/23

/199

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3/23

/200

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9/23

/200

7

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Unwinding of ABCP

•Asset Backed Commercial Paper unwinds and ends up on liquidity provider’s balance sheet…

Asset Backed Commercial Paper Outstanding

500

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700

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1000

1100

1200

1300

9/2

9/2

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11/2

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1/2

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11/2

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1/2

9/2

007

3/2

9/2

007

5/2

9/2

007

7/2

9/2

007

9/2

9/2

007

Source: Bloomberg

17

Jumbo Mortgages Squeezed

•… As originators faced with a liquidity crunch increased rates on Jumbo mortgages.

Source: Bloomberg

Spread (Jumbo FRM 30Y - Conventional FRM 30Y)

-20

0

20

40

60

80

100

120

3/2

3/2

000

7/2

3/2

000

11/2

3/2

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3/2

3/2

001

7/2

3/2

001

11/2

3/2

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3/2

3/2

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11/2

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3/2

3/2

007

7/2

3/2

007

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

May 2007 Current

Haircut Funding Haircut Funding

AAA 5% LIBOR + 4 10% LIBOR + 20

AA 7% LIBOR + 6 20% LIBOR + 30

A 10% LIBOR + 10 25% LIBOR + 40

Agency 3% LIBOR – 3 4% LIBOR – 12

19

Trading Volume Depressed

•Trading volume shrunk, making price discovery difficult.

Trading Volume(% of normal volume)

Agency Pass-Throughs 80-90%

CMOs (both Agency and Non-Agency) 10%

ARMs (Agency) 70%

ABS 10%

CDOs 10%

Source: UBS

20

Non-Agency Hybrid Spreads

Source: Morgan Stanley

21

Investment Advice

“Be fearful when others are greedy and be greedy when others are fearful”

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Portfolio Ramp-up

Purchases by Asset Class ($MM Par)

Class AGCY AAA AA A Total % of Tot

Corp Bond 2.50 11.50 14.00 16.5%

Fixed MBS 2.13 2.13 2.5%

Hybrid MBS 14.42 16.16 2.91 0.68 34.17 40.2%

Float MBS 28.14 3.26 31.40 36.9%

MMP 1.40 1.90 3.30 3.9%

Total 17.95 44.30 8.67 14.08 85.00

% of Tot 21% 52% 10% 17%

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.

Mortgage Market Share by Issuance

Agency Alt-A Jumbo Subprime Others Tot. Non-Agency

End 2006 44.7% 17.7% 10.6% 21.7% 5.4% 55.3%

Expected by 2009

77% 4% 11% 6% 2% 23%

Source: UBS

26





Agenda

27

•General corporate bond spreads wider

Response in Corporate Bonds: Overall

Data Sources: Moody’s Investors Service Long-Term Single-A Corporate Bond Yields; Bloomberg US Treasuries Indices

Single-A Minus Treasury Spread

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150

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250

300

350

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Year

Sp

rea

d (

ba

sis

po

ints

)

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•Financial institution bonds wider

Response in Corporate Bonds: Financials

Data Source: Bloomberg

Financial Institution Bonds Minus Treasury

020406080

100120140160180

Jan Feb Mar Apr May Jun Jul Aug Sep Oct

Month

Sp

read

(b

asis

po

ints

)

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Housing Economics: Overview

Rising Home Inventories

Home Prices Decline

Construction Declines

Mid-term Impact on EmploymentEquilibrium

Restored in time

Reduced DemandIncreased

Foreclosures

30

Housing Economics: Supply and Demand

Source: The Bank Credit Analyst, Volume 59, Number 4

31

•Recent increases in the unemployment rate

Economics: Unemployment Rate

Data Source: Bureau of Labor Statistics

US Unemployment Rate

0%

1%2%

3%4%

5%

6%7%

8%

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

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•The brunt of the effect is in construction and manufacturing

Economics: Construction Payrolls

Data Source: Bureau of Labor Statistics

-500

-400

-300

-200

-100

0

100

200

300

400

500

1991

1992

1993

1994

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1997

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2006

2007

*

Ch

an

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in C

on

str

uc

tio

n P

ay

rolls

(0

00

s)

*2007 figures are through Q3

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•Wealth-based spending source at risk

Economics: Consumption

Data Sources: Federal Reserve Estimates based on Bureau of Economic Analysis data

US Home Equity Extraction Net of Costs

0

30

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120

150

1991

1992

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1994

1995

1996

1997

1998

1999

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2001

2002

2003

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2007

$ B

illi

on

s

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•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.

Economics: Global Response

35





Agenda

36

• 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.

Subprime “Pain” is Not Limited to Institutional Investors

37

Subprime “Woes” Disproportionately Affect Minorities

# Higher Cost (000)

as % of total loans made to each group

African American 388 52

Latino 376 40

White 1,214 19

“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.

38

• 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.

Even After Adjusting for Risk Factors, Minority Borrowers Are More Likely to Have a Subprime Loan

Source: “Unfair Lending: The Effect of Race and Ethnicity on the Price of Subprime Mortgages”, Center for Responsible Lending, May 31, 2006)

39

• 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.

o Self-Help Credit Union

o Self-Help Ventures Fund

o Self-Help Community Development Corporation

About The Center For Responsible Lending (“CRL”)

40

• 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.

Is Subprime = “Evil”?

41

• 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:

o 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).

o 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.

o Until recently, investor demand made it easy to avoid accountability - from a moral and credit quality standpoint.

The Market Is Self Correcting, Right?

42

• There are two major policy areas on which to focus. CRL is actively involved in fashioning policy in these two areas:

o Helping to keep people in their houses – protecting homeowners threatened with foreclosure.

o Protecting Borrowers in the Future

What Needs To Be Done and What Is Likely To Happen?

43

• Who should/will bear the losses that are occurring?o Taxpayerso Investorso 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.

Protecting People Threatened With Foreclosure –Ballast or Bailout?

44

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.

Helping Borrowers Keep Their Homes – The Landscape

45

• 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.

Targeted Approach To Help Borrowers Keep Their Homes

46

• 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.

Aren’t Loan Modifications “Un-American”?

No…but loan modifications are often difficult to obtain because:

47

• Bifurcate into two classes:

o First – secured by appraised value of property. If necessary, modify interest rate to a fixed rate and amortize over the remaining life.

o 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.

Possible Standards For Modifying Loans in Bankruptcy Court

48

• 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:o Prepayment penalties and payment of yield spread premiumso Escrows for taxes and insuranceo Underwriting to fully indexed rate – w/ reasonable debt/incomeo Income verification/documentationo “Flipping” when net tangible benefit of refi is less than fees chargedo Availability of credit counseling

Protecting Future Subprime BorrowersExpect significant regulation – perhaps “over-regulation”

49

• Enhance documentationo Less is more – who reads all this “stuff”?o Plain English

• Self Defense:o 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!

Other Suggestions To Protect Borrowers

50

Q&A

51

Backup: Global Stock Market Correlation

Source: Community First Investments and Risk Evaluation Analytics

2001-2006 Mex. Braz. UK Ger. Japan H.K. India

US 0.70 0.76 0.91 0.88 0.87 0.91 0.72Mexico 0.98 0.58 0.49 0.81 0.86 0.99Brazil 0.61 0.52 0.83 0.90 0.98UK 0.98 0.8 0.81 0.60Germany 0.84 0.76 0.52Japan 0.90 0.84Hong Kong 0.89

1996-2000 Mex. Braz. UK Ger. Japan H.K. India

US 0.86 0.81 0.98 0.95 -0.55 0.45 0.59Mexico 0.96 0.84 0.89 -0.24 0.71 0.80Brazil 0.79 0.88 -0.22 0.76 0.79UK 0.93 -0.59 0.37 0.55Germany -0.49 0.49 0.63Japan 0.49 0.63Hong Kong 0.74

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Backup: US GDP Growth Contributors

Source: Federal Reserve Bank of St. Louis “National Economic Trends” October, 2007

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Backup: Fed Funds Expectations

Data Source: Bloomberg Futures Pricing

3.7

3.8

3.9

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4.4

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4.6

NovDec

Jan

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May Ju

n Jul

Aug Sep Oct

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Backup: US Dollar Weakening

Data Source: Bloomberg

US Dollar Index

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History, Status, and Implications of the Subprime Mortgage Market

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Transcript of History, Status, and Implications of the Subprime Mortgage Market