The Subprime Crisis...LTCM Crisis Sources: Bureau of Economic Analysis/Haver Analytics, Board of...

Introduction1. Credit Crunch

2. It’s the house prices3. Housing wealth and consumption

The Subprime Crisis:Can problems in a small part of the mortgage market disrupt the

entire economy?

Paul Willen

Federal Reserve Bank of Boston

REFA Meeting, December 6, 2007

The following reflects the views of the author and is neither the official position ofthe Federal Reserve Bank of Boston nor of the Federal Reserve System.

c©2007 by Paul S. Willen.

Paul Willen (Boston Fed) The Subprime Crisis: December 6, 2007 1 / 49



DisclaimerForecastOverview of analysis

Disclaimer

The views expressed today are mine.

The do not necessarily reflect the views of

The Boston Fed





or the Federal Reserve System

When I say “we”, I mean members of the researchdepartment.





Caveat

Everything I’m about to say could be wrong:

Example:

Until [the depression], mortgages were not fullyamortized, as they are now..., but were ballooninstruments in which the principal was notamortized, or only partially amortized at maturity,leaving the debtor with the problem of refinancingthe balance.

Fabozzi and Modigliani (1992)

Is this true?





Essentially no.

Mutual svgsbanks

LifeInsurers

Savingsand Loans

CommercialBanks

Individualsand Other

By type of loan (1925-1929)Fully Amortized 14.3 94.6 10.1Partially Amortized 61.5 0 38.3Non-amortized 24.1 5.1 50.3

Percentage of market (1929) 10.5 11.8 40.3 12.1 25.2As % of dollar value of all loans

Economists find a new theory...

Old theory is “wrong”, new theory is “right”

New theory will be old some day!





Figure: Theodoric of York, Medieval Barber (and intellectual)

Why, just fifty years ago, they thought a disease like yourdaughter’s was caused by demonic possession orwitchcraft. But nowadays we know that Isabelle issuffering from an imbalance of bodily humors, perhapscaused by a toad or a small dwarf living in her stomach.





Short answer

Can problems in a small part of the mortgage market disruptthe entire economy?

Answer: No.

Because we have tools to address problems in the mortgagemarket. (Point 1)

But...

Problems in mortgage market are symptom of more seriousproblem: House prices (Point 2)House prices could derail the economyBut we believe they probably won’t. (Point 3)





Forecast

From Macro Advisors (ours isn’t ready yet)

Percentage change at annual rates.

2007 2008Q3 Q4 Q1 Q2 Q3 Q4

Real GDP 4.9 0.1 1.8 3 2.9 3.1Consumption 2.7 1.1 1.9 2.1 2.3 2.5Nonres. investment 9.4 5.6 3.9 5.8 5.5 5.3Residential inv. -19.7 -24.7 -15 -5.3 3.7 5.1Change in inventories 32.9 22.9 25.3 35.4 32.6 33.2Exports 18.9 3.2 6.6 7.9 9 9Imports 4.3 3.6 2.9 3.1 4.6 5.5Gov’t spending 3.9 3.2 1.8 1.8 1.9 2.1Unemployment (%) 4.7 4.8 4.9 5 5.1 5.1Core CPI 2.5 2.2 2.3 2.4 2.3 2.3





HousePrices

2

3

Mortgage

MarketProblems

1CreditCrunch

Consumption

Investment

Reckless lenders, new products, mortgage resets

Problems spread

Source of problems is stagnant or falling house prices

We will focus on:1 Addressing the credit crunch2 It’s the house prices...3 The housing wealth-consumption link




Fed response

The Credit Crunch

Paul Krugman (NYT, 9/20/2007)

It makes more funds available to depositoryinstitutions, a k a old-fashioned banks butold-fashioned banks arent where the crisis iscentered. And the Fed doesnt have any clear way todeal with bank runs on institutions that arent calledbanks.




Fed response

MortgageBorrowers

LoansNon-Bank

LendersHigh Rated

MBSInvestors

HedgeFunds

Low rated

MBS

BanksMarginCredit

Warehouselines

Loans

The Fed

“New Housing Finance System”

No banks necessary

Banks still at the center of it all!1 Margin Credit2 Warehouse lines3 Direct lending

Things came apart when sub prime borrowers stopped paying1 Cut off warehouse lines2 Cut off margin credit3 Whole system fell apart

The Fed – the lender of last resort.1 Can we get the ball rolling again?




Fed response

Forecasters have historically overestimated the impact offinancial crises.

Will we do that again?

Global Insight’s Forecast of Real GDP q-o-q, annual rate. Forecast Date

2007:Q3 2007:Q4 2008:Q1 2008:Q2 2008:Q3 2008:Q4

Aug. 2007 2.3 2.3 2.3 2.3 2.7 3.2Sept. 2007 2.3 1.7 1.5 1.8 2.6 2.7




Fed response

Some financial crises in the past

1 1970 Q2: Penn Central bankruptcy.

2 1982 Q3: Latin American defaults (e.g. Mexico) and crises incommercial banks and thrift institutions.

3 1987 Q4: Stock market crash (Black Monday).

4 1994 Q1: Bond Market Meltdown.

5 1998 Q3: Russian defaultand LTCM crisis.

6 2001 Q3: September 11th attacks in NYC and WashingtonDC.




Fed response

Figure: Forecasting experience with 9/11.

Q3:2001 Q4:2001 Q1:2002 Q2:2002 Q3:2002

-3

-2

-1

0

1

2

3

4

5

6

Quarterly Percent Change, Annual Rate

Panel B

DRI Forecasts of Real GDP September 11th, 2001

Q3:2001 Q4:2001 Q1:2002 Q2:2002 Q3:2002

-3

-2

-1

0

1

2

3

4

5

6


Panel A

Green Book Forecasts of Real GDP September 11th, 2001

Sources: Bureau of Economic Analysis/Haver Analytics, Board of Governors, Data Resource Review/Global Insight Inc.

Actuals

Pre Crisis, 8/16/01

Crisis, 9/27/01

Actuals

Pre Crisis, 9/01

Crisis, 10/01

Post Crisis, 12/05/01

Post Crisis, 12/01




Fed response

Figure: Forecasting experience with the Russia Crisis in 1998.

Q3:1998 Q4:1998 Q1:1999 Q2:1999 Q3:1999

0

1

2

3

4

5

6

7


Panel B

DRI Forecasts of Real GDP LTCM Crisis

Q3:1998 Q4:1998 Q1:1999 Q2:1999 Q3:1999

0

1

2

3

4

5

6

7


Panel A

Green Book Forecasts of Real GDP LTCM Crisis


Actuals

Crisis, 9/23/98

Pre Crisis, 8/13/98

Crisis, 10/98

Pre Crisis, 9/98

Actuals

Post Crisis, 12/98





Fed response

Figure: Forecasting experience with the 1987 stock market crash.

Q3:1987 Q4:1987 Q1:1988 Q2:1988 Q3:1988

0

1

2

3

4

5

6

7


Panel B

DRI Forecasts of Real GNP 1987 Stock Market Crash

Q3:1987 Q4:1987 Q1:1988 Q2:1988 Q3:1988

0

1

2

3

4

5

6

7


Panel A

Green Book Forecasts of Real GNP 1987 Stock Market Crash


Pre Crisis, 9/16/87

Actuals

Crisis, 10/28/87

Crisis, 11/87

Pre Crisis, 10/87

Actuals


Post Crisis, 12/87




Fed response

Figure: Impulse Responses to a Liquidity Crisis

0 5 10 15 20−0.02

−0.01

0

0.01

0.02GDP

0 5 10 15 20−0.02

−0.015

−0.01

−0.005

0

0.005

0.01GDP Deflator

0 5 10 15 20

−0.1

−0.05

0

0.05

0.1Commodity Price Index

0 5 10 15 20−3

−2

−1

0

1Federal Funds Rate




Fed response

Fed response

Banks still matter!

Fed policy tools still matter!




Defining a subprime mortgageResets aren’t the problemA profile of forecloseesSubprime outcomesIt’s the house prices

A theory (more of a story)

Conventional wisdom right now:

Lenders threw out 100 years of best practice and did stupidthings:

Reduced documentation“Exploding ARMs”

Our theory:

It’s house priceseven if they had followed reasonable guidelines, we’d still havea problem, even if not as big as the problem that we now face.





Some points

1 Defining a subprime mortgage

2 Resets aren’t the problem

3 Profile of foreclosees

4 Subprime outcomes

5 It’s the house prices





Defining a subprime mortage

What is a subprime mortgage?

Good question:

A “subprime borrower”

Has missed a mortgage payment in the last year or two yearsHas filed for bankruptcy in the last few yearsHas a “FICO score” less than 620





A “subprime lender”is the only type of lender who lends to subprime borrowers.but also lends to other borrowers who want to stretch

High LTV

High DTI

Low Doc

All of the above plus subprime borrower

has a reputation as honest, trustworthy. Puts interest ofborrower first.





A “subprime mortgage” is either

a loan made to a subprime borroweror a loan made by a subprime lender to any borrower.or some ill-defined combination of both.

Bottom line: Even defining subprime is a mess.





LoanPerformance data

Mortgage sold in MBSLabelled “Subprime”, “Alt-A” or “Prime”

HMDA

“High cost” loans300 basis points over treasury of equivalent maturity

Warren Data

Use HUD list of “Subprime Lenders”For small sample, we can see ARM rates93% of HUD-list loans had either

margin>350 basis points

initial rate >200 basis points over equivalent prime





Table: Subprime Lenders in Massachusetts, 1998-2007. HUD List.

# loans % of subprime statuspurchase mortgages

Option One Mtg. Corp. 11,243 18.6 operatingNew Century Financial Corp. 5,951 9.9 shutdownFreemont Investment & Loan 5,550 9.2 shutdownArgent Mtg. Co. 3,599 6.0 shutdownSummit Mtg. Co. 3,067 5.1 shutdownMortgage Lender Net 2,798 4.6 shutdownLong Beach Mtg. Co. 2,520 4.2 shutdownWMC Mtg. Corp. 2,316 3.8 shutdownAccredited Home Lenders 2,174 3.6 shutdownFirst Franklin Financial 1,896 3.1 operating

Total 41,114 68.1 -





Conventional wisdom

Story goes something like this:

Borrower lured in by “below-market teaser”Can afford the paymentsReset hitsPayment “explodes”Delinquency

Not accurate picture.





The “Teaser”

There is no such thing as a low teaser on subprime loan

Focus on 2/28s because

More than half of all subprime loansAlmost all the subprime ARMsDisproportionate delinquencies





Whole country

Subprime 2/28’s

Source: LP (Prepared by the BOG)

Initial 1-yearMargin

Fully Indexed Raterate prime arm at reset at origination

2001 9.7 5.8 6.2 7.5 10.02002 8.7 4.6 6.6 8.3 8.42003 7.8 3.8 6.3 10.0 7.52004 7.3 3.9 6.1 11.3 7.92005 7.5 4.5 5.9 10.7 9.72006 8.5 5.5 6.1 10.9 11.42007 8.6 5.7 6.1 10.8 10.8





Subprime Business Model

Extract high fees

High interest rates prior to reset

Borrowers refinances (or defaults) prior to reset.

NOT the same as credit cards.





Cumulative terminations of Subprime 2/28’s

Source: LP (prepared by BOG)

2001 2002 2003 2004 2005 2006

Still active 4.5 2.4 6.0 14.0 47.9 77.3

6 months or less 6.2 5.4 6.3 8.6 9.0 9.37 to 12 months 21.0 20.4 24.3 26.8 25.2 20.313 to 18 months 37.1 37.4 40.1 41.8 38.0 22.719 to 24 months 56.8 59.6 64.9 67.3 50.125 to 30 months 69.8 73.5 80.6 81.6 52.131 to 36 months 77.5 81.9 87.5 85.5





Exotic Mortgages

You may have heard about exotic mortgagesInterest only and Neg-AMDo have exploding payments

Are NOT the problem right now.

Source: McDash

1 mo. 2 mo. 3+ mo. Total FICO

Option ARM 3.2% 1.2% 1.2% 5.7% 7072/28 10.0% 5.2% 6.7% 21.9% 6243/1 5.1% 2.1% 2.6% 9.9% 6845/1 1.5% 0.5% 0.5% 2.5% 7297/1 1.1% 0.3% 0.3% 1.7% 73210/1 1.0% 0.3% 0.2% 1.5% 738All IO ARMS 2.0% 0.8% 0.8% 3.6% 726All Non-IO ARMs 4.1% 1.7% 2.1% 7.9% 696





Reset Freeze

Freeze rates at initial level for borrowers who:

can afford the initial rate.cannot afford the fully indexed rate.

Two problems:not many people

Reset is small – raises payment by 20%.

Presence of second liens means that effect on total mortgage

payment is even smaller.

Equivalent to a < 10% fall in income even for highly indebted

borrowers.

very difficult to identify these people

especially if loan was low-doc to begin with...

To me, it’s useful because it shifts the debate.

Even if we could implement it, it wouldn’t help much.Forces people to accept that resets aren’t the problem!





A profile of foreclosees

Actual foreclosures (not petitions)

Three facts1 Many put nothing down.2 Many owned the house for a short time3 Concentrated in LMI communities, not new construction.

Source: Warren Group.





(.0227192,.0969305](.015261,.0227192](.0113314,.015261](.0086207,.0113314](.0066026,.0086207](.0043716,.0066026](.0025099,.0043716](0,.0025099][0,0]No data





(.0158353,.0551181](.0110619,.0158353](.0071971,.0110619](.0056657,.0071971](.0037559,.0056657](.0028694,.0037559](.0018939,.0028694](.0007305,.0018939][0,.0007305]No data





Communities

Disproportionately LMI

Minority

More so than last time

LMI % of Minority Zip CodeForeclosure Ownerships Foreclosure Ownerships

2006 43.8 16.8 25 14.22007 44.2 17 25.6 14.3

1991 34.1 17.7 21.8 14.81992 38.8 17.6 23.3 14.7





Tenure

Percentage of foreclosees with who owned the house for...

< 1 year < 2 years <3 years >3 years ≥5 years ≥ 10 years

2006 4.0 26.9 42.4 57.5 42.3 21.82007 3.1 25.8 45.1 54.9 38.8 21.1

1991 5.8 11.7 24.8 75.1 . .1992 3.2 6.6 15.3 84.6 . .





Purchase equity

Percentage of foreclosees with LTV at purchase of...

≤ 80% 80%–95% 95%–100% ≥ 100%

2006 8.6 41.1 15.7 34.52007 8.0 38.4 13.4 40.01991 35.9 53.9 1.9 8.21992 30.4 58.0 2.7 8.8





Role of subprime

Almost half the foreclosures involved a subprime mortgage,

But less than a third involved a house purchased with asubprime mortgage.

I.e. 70% of foreclosed properties were purchased with primemortgages.

Subprimepurchase

Subprimedefault

Default onpurchase

2006 28.7 45.6 38.62007 30.4 43.9 39.7





Subprime outcomes

Gerardi, Shapiro and Willen (2007)

Do subprime loans lead to problems?

Look at delinquency rates on subprime loans.

Deceptive for two reasons1 Most subprime loans are refinances – people are already in

trouble when they get them. Causality goes the wrong way.2 Subprime purchase loans? Most end with refinance

Look at whole homeownership experience

How often do borrowers who buy houses with subprime loansget into trouble?

We estimate that between 13% and 18% of subprimepurchase experiences end in foreclosure.

Very sensitive to house prices





It’s the house prices

Our analysis shows that falling house prices are the driver offoreclosure activity.

Let me first present the evidence.





2 4 6 8

9

10 12 1400

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

Quar

terly

def

ault

haz

ard,in

%

Years after purchaseHPA>20%

0% < HPA ≤ 20% ց

ւ −20% < HPA ≤ 0%

ւ HPA ≤ −20%





Figure: Foreclosures and house prices in Mass., 1989-present. Source:Boston Fed and The Warren Group.

-10

-5

5

0

0

0.2

0.4

0.6

0.8

88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

10

15

38

%of

hom

esfo

recl

osed

Year

ւ Foreclosure rate

%grow

that

annual

rates

տ House price growth





Figure: Foreclosures and 30-day delinquency rates in Mass.,1989-present. Source: Boston Fed, the MBA and The Warren Group.

00

0.20.2

0.40.4

0.60.6

0.80.8

2

2.2

2.4

2.6

2.8

8888 8989 9090 9191 9292 9393 9494 9595 9696 9797 9898 9999 0000 0101 0202 0303 0404 0505 0606 0707

38

%of

hom

esfo

recl

osed

%of

hom

esfo

recl

osed

YearYear

ւ Foreclosure rateւ Foreclosure rate

%of

borrow

ersdelin

quen

t

ւ 30-day Delinquency rate





What we are saying?

Negative equity is necessary but not sufficient for foreclosures

In other words:

If equity is positive, almost no one defaults (because they cansell at a profit.If equity is negative, then default may make sense, but itdepends on other things.

Why should you hold on to a house when you have negativeequity?

You will eventually make moneyDepends on whether you can wait that longPatience, financial resources





Figure: Cumulative appreciation for Massachusetts homeowner whobought in Q3, 1988.

-20

20

40

60

80

88 90 92 94 96 98

100

124

0

00 02 04 06 08




3. Housing wealth and consumption

Main difference with many others has to do with consumption.

How does a change in wealth affect consumption?

Some says $1 fall in housing wealth reduces spending by 5cents

We think it’s closer to 2 cents.




Figure: Consumption to wealth relationship over time, based on NIPAdata.

0.1

0.12

0.14

0.16

0.18

0.2

0.22

1.7 1.75 1.8 1.85 1.9 1.95 2 2.05 2.1

9.55

log(C

/Y)

log(W /Y )

տ Before 1/1/1996

↑ After 1/1/1996




Figure: Consumption to housing wealth relationship over time, based onNIPA data.

0.1

0.12

0.14

0.16

0.18

0.2

0.22

0.24

0.26

0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2

9.55

log(C

/Y)

log(H/Y )

տ Before 1/1/1996

↑ After 1/1/1996




We attempted to put some numbers on it.

Essentially, we estimated that the wealth effect after 1996 isabout half what it was before.

A one-dollar increase in net worth

led to a 5.4 cent long-run increase in consumption before1/1/1996.led to a 2.2 cent long-run increase in consumption after1/1/1996.

A one-dollar increase in housing equity

led to a 10 cent increase in consumption before 1/1/1996.led to a 0 cent increase in consumption after 1/1/1996.




Financial Innovation and Credit Constraints

“Financial innovations” have made it easier to borrow againstyour house since the 1990s

No paperwork!No fees!

So doesn’t this mean that spending should be more sensitiveto house prices?

No, just the opposite.

Level of borrowing will go up.Sensitivity of borrowing goes down.




Increased house prices relax a borrowing constraint

Households have more debt...But the constraint matters to fewer consumers.

For most consumers, borrowing self-limited.




Conclusion

Two key things to worry about:

Can the Fed manage the liquidity squeeze?How much will house prices fall and how much will that affectconsumption?


The Subprime Crisis...LTCM Crisis Sources: Bureau of Economic Analysis/Haver Analytics, Board of...

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