What, Who, Where and Why of the Subprime Crisis By: Ken Cyree, University of Mississippi Presented to Carroll University

What are Subprime Loans “High-cost lending to high risk customers” Customers typically have poor or no credit history and little or no down payment Often have high debt-to-income ratios (> 50% in many cases)

How were they made? 1.Mortgage Brokers, receiving commission for loan volume, make subprime loans 2.Loans packaged together and sold to a large bank or Wall St. firm 3.The Wall St. Firms re-package as a CDO and sells to Hedge Funds 4.Hedge funds buy using debt and also create derivative securities against these CDOs, selling these derivatives to others

How were they made? 5.Rates reset or economic conditions worsen for the original loan borrowers who cannot pay timely or default 6.As borrowers default, foreclosures rise, banks are less willing to lend slowing housing demand, so home prices fall 7.Even banks who made NO subprime mortgages have collateral values fall and less business as willingness to lend falls

Who are Subprime Borrowers Credit FICO ScoreCharacteristicsRate A> 620No late payments.Prime B late payments in 2 years +1.75% to % C late payments, some > 60 Days +3.0% to +4.25% D< 520Frequently late+4.5 or more

Who are the lenders? Largely, non-bank mortgage lenders like Countrywide and American Century –Proportions of subprime lending by non-banks: 2004 = 51%; 2005 = 52%, 2006 = 46% –In % of all home loans originated were subprime and by 2006 it was 28% In 2007, 64% of foreclosures were subprime –In 2003 there were $332 billion subprime loans outstanding and in 2007 there were $1.3 trillion, a 292% increase in four years.

Why make subprime loans? 70% of subprime loans have prepayment penalties, compared to 2% of prime loans From 2004 to 2006, about 90% had “exploding” payments with the average payment increasing 30-50% Mortgage lenders could package them and sell them as mortgage backed securities with no recourse to FNMA and FHLMC. –Lots of fee income and no risk = disaster

When did it start? Some believe it started with CRA in the late 1970s, but there is plenty of blame to go around: –Fannie Mae… has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits. (NY Times, Sept. 30, 1999)

Who’s to blame? The Bush Administration touted home ownership, especially among minority borrowers

Who’s to Blame? –The Federal Reserve, which cut interest rates after the dot-com bubble burst, made credit cheap fueling the housing bubble. –Home buyers, who took advantage of easy credit to buy more house than they could afford. –Credit Rating Agencies who believed diversification across geography would avoid systemic failure, and took fees from investment banks compromising their rating independence –Alan Greenspan who encouraged Americans to take out adjustable rate mortgages near the peak of the housing bubble –Wall Street firms who paid too little attention to the quality of the risky loans that they bundled and sold.

More blame to spread around –The Bush administration failed to provide needed government oversight of the increasingly dicey mortgage-backed securities market –Mark-to-market accounting rules which require “exit price” adjustments and worsen losses in crises. –Democrats opposed the Federal Housing Enterprise Regulatory Reform Act of 2005, which would have established a single, independent regulatory body with jurisdiction over Fannie and Freddie – a move that the Government Accountability Office had recommended in a 2004 report. –Current House Banking Committee chairman Rep. Barney Frank of Massachusetts opposed legislation to reorganize oversight in 2000 (when Clinton was still president), 2003 and 2004, saying of the 2000 legislation that concern about Fannie and Freddie was "overblown." –In 2008, Senate Banking Committee chairman Chris Dodd called a Bush proposal for an independent agency to regulate the two entities "ill-advised."

More blame to spread around –The Credit Default Swap (CDS) market was essentially zero in 2000 and peaked at $62 Trillion in 2008, almost the value of the entire world economy –These guarantees allowed selling of Structured Investment Vehicles (SIV) or Collateralized Debt Obligations (CDOs) since the CDS “insured” them from default, so there was no incentive to investigate the mortgages or other bonds in the CDO or SIV.

What do we do to fix it? No one knows for sure. TARP added capital to banks so they could write off the losses. –Encourages future bad loans –We may not have enough to save the largest banks The “bad bank” concept might work, but at what price does the government buy or guarantee the bad loans? If we do nothing, the banking system will fail.