WHAT CAUSED THE MORTGAGE MARKET COLLAPSE OF 2008

WHAT CAUSED THE MORTGAGE MARKET COLLAPSE OF 2008
What can I expect to Learn about the Mortgage Market Collapse of 2008 Subject matter in no particular order What is an MBS, ABS, CDO Who were some of the players in the collapse How did the rating agencies like Moody play a part 5 Great books to read How did sub-prime loans play a part Why did this meltdown affect other countries How did the bailout work and why did it work

What can I expect to Learn about the Primary and Secondary Mortgage Market Today we will take a logical approach to the flow of money and mortgage loans between the primary and secondary mortgage market The Secondary Mortgage Market is NOT about second mortgages! We will learn how Wall Street played a major roll in the collapse.

What can I expect to Learn about the Primary and Secondary Mortgage Market Without getting too deep into an explanation, we all understand that an asset can be bought and sold many times. Sometimes for a profit and sometimes for a loss. Over time some assets will appreciate in value and others will lose value. No big surprise there.

Wall Street Gets Involved Let’s go back in time about 40 years. At that time the major players on the Secondary Mortgage Market were FANNIE MAE, FREDDIE MAC and GINNIE MAE. These GSE’s (Government Sponsored Entities) were created to “Create Liquidity in the Market Place” where mortgages could be bought from the primary market (Banks).

Wall Street Gets Involved Back in the day, wall street did not buy and sell mortgage assets like the GSE’s. Wall street for the most part would extend huge lines of credit to Mortgage Bankers and earn interest and fees when that line of credit was used. If a Mortgage Bank was making 100 million in loans every month, you can see that there might be some nice profits to Wall Street for extending that line of credit to the Mortgage Bankers.

Wall Street Gets Involved Wall Street, like any other company looks to increase profits and sometimes that means new revenue streams. Wall Street decided to enter the Secondary Mortgage Market and buy / sell loans like the GSE’s. Not a bad idea, just poorly executed. Allow me to explain.

How can a mortgage be SOLD? Mortgage instruments ARE assets that can be bought and sold just like any other asset. Basically, the parts of the mortgage that are sold are the note and mortgage. That changes NOTHING about the mortgage agreement the borrowers have with their original lender.

P&I is the part of a PITI payment that the investors are interested in purchasing Principal & Interest = $4,026 Taxes = $ 200 Insurance = $ 150 PMI (not accurate) = $ (Based on LTV and Credit score) TOTAL PITI Payment = $4,751

WHY was the Secondary Mortgage Market Created? Simple answer…… To create LIQUIDITY in the market place. Let’s take a trip down memory lane to the 70’s

Wall Street Gets Involved (Con’t) Wall Street is now looking to buy and sell loans… they know there can be large profits in this arena but they are not experts in this area. They also know that they want to expand the amount of loans being made so they have more loans to trade and profit from.

Wall Street Gets Involved (Con’t) In addition, they want to be similar too but different than the GSE’s. They know that the GSE’s in order to have cash to purchase more loans have to sell MBS’s (Mortgage Backed Securities) to pension funds / hedge funds, etc.

Wall Street Gets Involved (Con’t) Wall Street decides to create ABS’s. Asset Backed Securities. Wall street “believed” that ABS would never go down because the underlying asset (homes in the USA would always increase in value). They knew better, but that was their spin.

Wall Street Gets Involved (Con’t) In addition to selling ABS’s Wall Street also created a highly sophisticated financial instrument called a CDO. CDO was the acronym for Collateralized Debt Obligation. CDO’s were so complicated that many people on Wall Street could not fully explain them. CDO’s were sold to other Countries around the world.

Wall Street Gets Involved (Con’t) So what if other countries around the world purchased these things. They are smart and also understand risk. I agree, they are smart and understand risk, but this is where it gets interesting.

Wall Street Gets Involved (Con’t) Buyers of ANYTHING rely on the seller to be telling them a least close to the truth. The problem occurs when buyers think they are buying gold but instead are buying bronze. How can this happen you ask? Well, there are several players that are involved. Allow me to paint a picture for you.

Wall Street Gets Involved (Con’t) Wall Street wanted more loans to be made. They went to lenders like Country Wide Mortgage and asked them what can be done to make more loans. The simple answer is to reduce the qualifications. However, if they decide to lower the qualifications, then FANNIE MAE and others will not BUY the loans. Sounds like a problem until you realize that Wall Street did not really care, because THEY would be buying the loans and creating their own market to sell ABS and CDO’s.

POLLING QUESTION #1

Wall Street Gets Involved (Con’t) And the plot continues…… On the next few slides we will talk about RISK. Near the end of this class I will tie all the pieces of the puzzle into a tight knit summary. In the meantime, let’s learn about some of those puzzle pieces.

Different types of Risk in Mortgage Lending First up…… Credit Risk…..

HOW DOES THE FICO SCORE IMPACT MORTGAGE LOANS The HIGHER the RISK the borrower presents to the lender, the HIGHER the interest rate will be on the loan. Therefore, with all else being equal for two different borrowers EXCEPT for credit score, the borrower with the LOWER FICO score will pay a higher interest rate because they present a higher risk to the lender. Now for the full explanation of WHY they present a higher risk.

HOW DOES THE FICO SCORE IMPACT MORTGAGE LOANS For insurance and other forms of statistics you have a rule that is called “The Law of Large Numbers”. That means that the larger the sample is the closer you are to a perfect answer. In other words, if there were only 100 people that lived in the USA and we asked all 100 if they were Republican or Democrat and they all answered we would have a perfect % of each. Lets’ say 48 said Republican and 52 said Democrat. That would translate to 48% of the population is Republican and 52% of the population is Democrat.

HOW DOES THE FICO SCORE IMPACT MORTGAGE LOANS But the population in the USA is more like 350 MILLION. How do you get accurate numbers. Scientifically or mathematically you take a large enough SAMPLE of the population. The people at FICO have access to MILLIONS of credit reports and how they have performed for more than 50 years. They have a VERY LARGE sample so their margin of error is small. The example I am about to give you is not based on true and accurate numbers. It is just to give you an idea of how risk works in lending. Feel free to Google the true numbers if you like but the true numbers are not necessary for the EXAMPLE. It’s the CONCEPT that is important here.

HOW DOES THE FICO SCORE IMPACT MORTGAGE LOANS Let’s say that we are a lender. We have $300,000,000 to lend. We lend our money as follows: 800 FICO 700 FICO 600 FICO Question: What does the FICO score ACTUALLY mean? Statistics have shown that more borrowers in the lower score category will go 90 days late in the following year than those in the higher score category.

HOW DOES THE FICO SCORE IMPACT MORTGAGE LOANS All that the FICO score is saying is “What is the likelihood that a borrower will go 90 days late in the next year”. Let’s say that in the 800 category that only 1 person goes 90 days late next year and in the 700 it will be 3 and in the 600 FICO it will be 10 that go 90 days late. We are going to lend each score category 100 million dollars like this: 100 borrowers in each category borrow 1 million dollars each. That’s a total of 100 million per FICO category and a TOTAL of 300 million in loans. As the score goes down, the interest rate will increase.

HOW DOES THE FICO SCORE IMPACT MORTGAGE LOANS 800 FICO 700 FICO 600 FICO How many borrowers : Amount of each loan: 1 Million 1 Million 1 Million Total lent in each category: 100 Million 100 Million 100 Million Interest Rate for each FICO 5% 6% 7.5% After one year 90 day late: 1 Person 3 People 10 People (These are EXAMPLES and not actual #’s) Earning interest on: 99 Million 97 Million 90 Million

HOW DOES THE FICO SCORE IMPACT MORTGAGE LOANS 800 FICO 700 FICO 600 FICO Earning interest on: 99 Million 97 Million 90 Million Collection agents needed: Lawyers to Foreclose: As you can see, the lower 600 FICO score category may be EARNING a higher interest rate on the face, but after you take into account that so many people in the 600 category are not paying and the expense of hiring more collectors and attorneys to try to recouple that lost revenue, at the end of the day you make about the same as giving 5% interest to your 800 FICO category.

Additional Types of Risk In mortgage lending there are multiple layers of risk. Combine all of these different risks into one overall risk for the borrower. Here are just a few of the risks considered in mortgage lending: Credit (We already looked at that) Job stability Income stability Type of property DTI (Debt to Income Ratio) LTV (Loan to Value Ratio)

Additional Types of Risk Consider each factor as if they were individual stilts holding up a home at the edge of the ocean. Picture a home where the waves come onshore and roll under the home on the stilts. You would want your home to be built on STRONG stilts. And you would also want there to be MANY strong stilts to support that home. Mortgage lending is the same. Each risk item is a stilt. For example, a HIGH credit score is an example of a STRONG stilt and a LOW credit score is an example of a rotten stilt.

Additional Types of Risk If one stilt is rotten it may not be the end of the deal because the other stilts or compensating factors may be strong enough to make the loan work. Take a look at this home with stilts. We want STONG stilts like: GREAT CREDIT / BIG DOWN PAYMENT / LOW DTI … ETC…

Additional Types of Risk

Additional Types of Risk Without dissecting each type of risk we understand that there needs to be a minimum level of risk that a lender will accept. If the risk is too great, the lender will deny the loan. So at the TOP of the RISK level we have the A paper loans. These are the loans made to the BEST borrowers. These borrowers have stable income, lot’s of down payment money, low risk properties, very high credit scores, etc. They receive the lowest interest rates on their loans. On the other end of the spectrum we have HIGH risk loans. These are made to individuals that can not prove everything or have banged up credit.

Additional Types of Risk We may have to different borrowers borrowing the same amount of money on similar properties but each loan will have a different interest rate. It could be as simple as all factors are equal EXCEPT for their credit scores. If one borrower has a 700 FICO and the other borrower is at 640 they will receive different interest rates just based on that risk facto alone. Let’s now move into the world of sub-prime loans.

Additional Types of Risk If we were to ask most people what they thought of sub-prime loans, most would say they are BAD loans. That answer would be untrue. Sub-Prime loans can be GREAT loans for the right people. The problem was that many of these loans were made to the wrong people because no one cared as there were tremendous profits being realized.

Additional Types of Risk Time for a little breakdown of a few types of sub-prime loans. Here are 4 types that were made: NINA SISA Option Arm / Pick a Pay NINJA (my favorite! --- I’m being sarcastic)

Additional Types of Risk Time for a little breakdown of a few types of sub-prime loans. NINA = NO INCOME NO ASSETS SISA = STATED INCOME STATED ASSETS Option Arm / Pick a Payment = The borrower can choose their payment every month from 4 options ranging from a 15year amortization with the highest payment, next is a 30 year payment then an interest only option and finally a minimum payment that was way lower than the interest only payment. (These loans were usually NEGATIVLY AMORTIZED! NINJA = NO INCOME NO ASSTS NO JOB --- I never saw one of these, but I bet they were made!

Additional Types of Risk Now there is NOTHING wrong with these loans. They have their place. They are great loans for the RIGHT borrowers. This course is not about training you on these loans but how they played a part in the mortgage collapse. However, keep this in mind as it was a contributor to the collapse. These loans were more risky than A paper loans. Every time there is something a lender can not verify or does not look at makes the loan more risky. That is not the problem. The problem is:

Additional Types of Risk The problem is: The rates being charged on these loans was NOT in line with the amount of RISK they presented to the lenders. For example, let’s say we have a loan on a property with an A borrower. Let’s also say that the BEST interest rate for that loan for that day is 5%. On that same day another borrower with everything the same EXCEPT that they have a much lower credit score will receive a higher interest rate. We all agree with that.

Additional Types of Risk Let’s agree that the interest rate for borrower 2 will be 5.5%. Now borrower 3 comes to us. Same property, same low credit score and in addition instead of putting down 20%, they only put down 10%. Again, this adds another layer of RISK and the interest rate MUST go up. No one disagrees with this logic. As long as the rate reflects the true risk we are good to go. This is known as the law of diminishing returns. There comes a point where the risk is so great that the loan is denied.

Additional Types of Risk So far, this all makes sense. But here is where problems arose in the sub-prime market. Wall Street wanted as many loans as possible. How do you do that? First, lower the standards to qualify. Second, keep the interest rates artificially LOW. More people qualify and for MORE house! BOOM!

Additional Types of Risk Wall Street is now BUYING record amount of Sub-Prime loans and making a FORTUNE on them. They are packaging them and selling ABS’s and CDO’s like candy to a baby. But wait, it gets better.

Additional Types of Risk In order for Wall Street to sell these ABS’s and CDO they must first have them RATED by places like Moody and Standard and Poor. In my opinion, these institutions dropped the ball. They gave much better ratings to these securities than they should have. Many of these securities probably deserved a rating of CRAP and instead received AAA.

Additional Types of Risk Let’s take a look at how the secondary market pays lenders first. The next two slides are how a wholesale rate sheet works. Allow me to explain:

POLLING QUESTION #2

Example Borrower

Please tell me how much money in dollars that this loan would earn for the lender: Loan Amount: $100,000 Interest Rate: % Lock Period: 15 Days Type of Loan: 30 Year FIXED Property: Investment – Single Family Purchase or Refi: Purchase LTV: LTV >80% <= 90% NOO

Please tell me how much money in dollars that this loan would earn for the lender: Loan Amount: $100,000 Interest Rate: % Lock Period: 15 Days Type of Loan: 30 Year FIXED Property: Investment – Single Family Purchase or Refi: Purchase LTV: LTV >80% <= 90% NOO Did you guess ZERO? ZERO is the correct answer!

POLLING QUESTION #3

Tying it all Together So we have borrower getting loans for interest rates FAR below what the real risk is. Many of these loans should NEVER have been made to certain types of borrowers, but millions of them were made because of greed and competition. Wall Street was buying these CRAPPY loans and bundling them into ABS and CDO securities with excellent ratings from the companies that give risk ratings. Many pension funds / hedge funds / and Countries invested in these securities that were all baked by millions of CRAPPY loans on houses that were probably on the street you lives on.

Tying it all Together So, if you’re an investor buying a security where you hope to earn a certain because it’s rated say AAA but it really should have been rated CCCrap and the security goes belly up…. YOU LOSE BIG TIME. Basically, this is a trickle UP problem. The foundation is made up of crappy loans that the average American should not have been in in the first place. When they can no longer make the payments on these loans for various reasons…. The WHOLE house of cards comes down. The Wall Street bankers no longer have the cash flow to pay the interest to their investors.

Tying it all Together And that my friend… Is the rest of the story. Here are 5 books to read: Too Big to Fail (Movie was ok, but book was better) Chain of Blame (Talks about Countrywide Mortgage and ties in nicely with 1st book) The Devils Casino (About the collapse of Bear Sterns and Lehman Brothers) Stress Test (Timothy Giethner – awesome book) The Big Short (The movie was EXCELLENT – I have not yet read the book!)

TELL US ONE THING YOU LEARNED TODAY As I go around the room, please tell the class one thing that you learned today about the mortgage market collapse that you did not know before you got here!

You can order a copy of Doug Vairos book on Amazon Kindle for $2.95 so you can send a copy to anyone you want as a gift! THANK YOU for your time today.

Doug Vairo Cell:

WHAT CAUSED THE MORTGAGE MARKET COLLAPSE OF 2008

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WHAT CAUSED THE MORTGAGE MARKET COLLAPSE OF 2008

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