FIS TERM PROJECT FACTORS THAT LED TO US HOUSING BUBBLE A REPORT SUBMITTED  TO                                                                                                      PROFESSOR  AMIT  PARAKH     IN PARTIAL FULFILLMENT OF THE REQUIREMENT OF THE COURSE                                                                                                                             FIXED INCOME SECURITIES                                                                                                                                                                          ON  6/9/2012                                                                                                                                                                                      BY                                                                                                                                                Anil  Nandyala  (B11005)                                                                                                                                              Jigar  Kotak  (B11023)                                                                                                                                              Richa  Daruka  (B11035)                                                                                                                                              Sonam  Keshri  (B11042)                                                                                                                                                                                  

American dream of owning a home was served well by the mortgage market but unfortunately a system borne with good intension brought trouble with poor risk management and too many assets funded with little owner contributed equity. The individuals and families deemed to be less credit worthy were also provided opportunity to own a home. Indeed, the homeownership rate reached a record high of 69.2 percent in the second quarter of 2004. In the past however terms to grant loan was more stringent but this move of mortgage market towards securitization led to greater liquidity in the mortgage market and what began as healthy growth in mortgage originations and housing starts swiftly became a home price bubble.

FACTORS THAT LED TO HOUSING BUBBLE: Abolition of Glass -Steagall Act: Glass-Steagall Act was passed in 1932, after the great depression, which was due to stock market crash. Banks speculated with depositor’s money. Banks were not only investing assets, but also buying new issues for resale to the public. Unsound loans were issued to companies in which the banks had invested and banks encouraged clients to invest in those stocks. Glass steagall was introduced to separate Commercial banks from Investment banks. Banks were given one-year time to decide on whether they would go for investment or commercial banking. Only 10% of commercial banks income could be generated from securities. The main aim behind passing this act was to stop banks from taking risky investments with depositor’s money and to prevent bank’s use of deposits in case of failed underwriting job. In November 1999 Glass-Steagall act was repealed with the establishment of Gramm-Leach-Bliley Act. The limitations of the GSA on the banking sector sparked a debate over how much restriction is good for healthy industry. Many argued that allowing banks to diversify in moderation offers banking industry the potential to reduce the risk. Many say that Gramm-Leach-Bliley Act was passed for CITI bank. CITI bank merged with Travelers, an insurance company. A deal that was not allowed because banks are not allowed to underwrite the insurance losses under Glass-Steagall Act. Many critics argue Gramm-Leach-Bliley Act’s permitted Wall Street investment banking firms to gamble their depositor’s money. Aggressive Lending: Sub prime Mortgage Lending: It is a type of mortgage that is normally given to borrowers with low credit ratings. Generally lending institutions charge higher interest rates than conventional mortgage in order to compensate the risk.

Subprime  8.4%  

Prime  91.6%  

Equity  in  Housing  units    $8.7  trillion  

Mortgage  debt  $10.6  trillion  

Securitized            59%  

Non  –  Securitized        41%  

During the housing bubble banks lent money at teaser rates that is rates below the prime lending rates for the first few years and then charged higher interest rates after two or three years. Banks average LTV (Loan to Value) during housing bubble was 99.3%. During the period between 2000 to 2004 banks lending to mortgage has increased from $1000 billion to $4000 billion and subprime loans as percentage of loans increased from 5% to 20% from year 2002 to 2006. Credit Default Swaps (CDS): Credit Default Swaps is a derivative instrument, it is used to arrest credit risk. Many of the securities issued through securitization were backed by CDS. AIG (American International Group) issued CDS worth $500 billion. Thus making all the securities get higher credit rating. Many CDS during the housing bubble were bought for speculative purpose. Many Investment banks took CDS not only for hedging, but also for speculation. Rating Agencies: All the big rating agencies Fitch, S&P and Moody’s gave high rating for securities backed by mortgages without checking the credibility of the CDS. The number of AAA rating bonds rose from few hundreds to thousands during the boom. Lax Regulatory Supervision: US Federal Reserve didn’t give any warnings to the banks regarding the Interest rates and Securitization. Debt equity ratio of investment banks reached as high as 33:1. There was no regulation to Derivative market at all; CDS were sold more for speculative purpose than hedging purpose. Thus making insurance companies like AIG give CDS of value of $500 billion whose revenue in the year 2010 is $77 billion. Shift From Originate to Hold Model to Originate to Distribute Model: Prior to 1980 vast majority of all home loans were made by savings and loans, which originated serviced and held the loans in their portfolios, in what is widely referred to as shift from originate model. But over time, home mortgages were increasingly securitized and sold in the secondary market; this process is called originate to distribute model. This business model allowed the mortgage market to tap into broader base of funding by opening doors for acceptance of riskier loan by originator, who could shift that risk to others. Not only this, this model lead to generation of three sources of revenue one derived for the originator who could handle the loan procedure, other firms could opt to service the mortgage and investors could receive the interest and principal payment for loans. SECURITIZATION: A Financial innovation came in that allowed the mortgage market into a broader base of funding. It is a process through which an issuer creates a financial instrument by combining other financial assets and then marketing different tiers of the repackaged instruments to investors. The process can encompass any type of financial asset and promotes liquidity in the marketplace. Mortgage backed securities is a good example, where the lender pools the mortgages from different borrowers and sells it to special purpose entity, who in turn issues the bonds in the market and pays cash to lender of the fund.

Borrowing backed by securities or the transforming of debt into securities concept was present from the early 20th century. Samuel W. Straus is credited with originating the first mortgage security with a senior claim, circa 1909. Over the next two decades (1910-1929) the securitization of mortgages became quite popular. The Great Depression made these instruments remove from table.

Securitization of mortgages began anew in the 1970s, with the US government-sponsored National Mortgage Association and their “Ginnie Mae passthrough.” These mortgage-back securities (MBS) have grown enormously since then, as evidenced by recent years’ publicity correlating to the economic meltdown. Why SECURITIZATION? Borrowers are at benefit as they are getting easy loans. The originators have various advantages from this phenomenon that are as follows: Balance sheet Management: This helps the originator to free their balance sheet and bring in more cash which makes the balance sheet more robust, the ratio improves. The proceeds from securitization can be further used for creating new assets, thus the assets throughput of originators balance sheet increases. Funding Alternative: A well-structured credit ABS (Asset Backed Securities) stands on its own credit rating and thus generates genuine incremental funding. This is so as the originator's existing creditors may invest in the asset backed securities in addition to providing lines of credit to the originator. Further, there may also be other investors in the Asset backed security who do not have a lending relationship with the originator Reallocation of risk: Securitization transfers much of the credit risk in the portfolio to the ABS investors and helps to quantify the residual credit risk that the originator is exposed to. This is very useful, as the originator can take larger exposure to individual obligators as well as provide a higher degree of comfort to his creditors. Operating process efficiency: Securitization demands detailed portfolio analysis and information that lead to serious reexamination and consequent re –engineering of operating process within the organization.

Securitization of auto loans, credit card receivables, computer leases, unsecured computer loans, residential and commercial mortgages, franchise/royalty payment, trade, toll road, future export have gained prominence. Securitization can also be created by pooling asset portfolios that are homogeneous with regard to credit, maturity and interest rate risk. But in general all the assets generating predictable and stable cash flow can be taken up for securitization. Mortgage backed securities are classified in to different grades of bonds and issued in to the market. The bonds, which were not subscribed, stayed with the banks. Many of the securities are backed by Credit Default Swaps, thus making the bonds high credit worthy. Whose Money is Invested in Securities? It was the deposits in the banks & pension fund money that made the whole system liquid. All the bank and financial institution had become risk adverse and had started taking greater risk. Banks stopped worrying about collateral, because they can recover money through Securitization. There were huge incentives on sales of home loan and even the appraisal where decided on the basis of number of Mortgages sold by them. Who Lost the Race? After the bankruptcy of Lehman Brothers, Many of the banks & other financial institutions were on the same verge. Government was left with no option other than bail out. It was the taxpayer’s money that was used for the bail out and they were the biggest losers of the crisis. Government started taking austerity measures & people lost jobs because of sudden economic crunch. Who Gained out Of it? All the credit rating agencies earned lump sum amount to rate the bonds(low quality) issued out of securitization as triple A rated bonds. Other than this all the investment bankers also gained as they got huge incentive by selling even the low quality mortgages. Consequences of US Housing Bubble: Prior to 2005 housing price of houses are skyrocketing. Due to which most of the people started investing in real estate keeping in mind that the house price will go up in near future. In 2005 housing price in US grew at its peak after which the economic bubble burst. Due to this bond prices go up. So, people started buying more houses, either on credit or by taking loan from banks and other financial institutions. By providing loan banks were left with no liquid cash and therefore went into bankruptcy. This caused the global financial crises.

• Large drop in consumption in US economy • GDP dropped by 4.1% below US’s Baseline • Unemployment rates in the following sectors

o Residential construction: 36.6% o Entire construction: 21.5% o Mortgage brokers: 54.5% o Non-Mortgage brokers: 44.0% o Wood product manufacturing: 35% o Cement & concrete product manufacturing: 24.4%

Bibliography: invetopedia.com Wikipedia.com Inside Job Economicpopulist.org Bond Markets, Analysis and Strategies Article:  The Rise and Fall of the US mortgage and credit market by MILKEN INSTITUTE