Subprime Loans and the Crisis Overview

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Questions and Answers

What is the primary incentive for the servicer in the securitisation structure?

To minimize the number of loans on its books

To generate more fees by keeping defaulting loans (correct)

To ensure all loans are paid off quickly

To maximize the interest rates charged on loans

What issue arises due to overreliance on automatic credit scoring in the placement phase?

Improved loan performance for investors

Enhanced borrower trust in lenders

Structural mispricing by investors (correct)

Reduced risk for all parties involved

Which of the following is a key conflict of interest in the subprime lending structure?

Borrowers paying higher fees for subprime loans

The 'issuer-pay' model affecting credit rating agencies (correct)

Servicers being penalized for defaulting borrowers

Incentives for investors to retain high-risk loans

What type of bias may lead borrowers to enter mortgages with adjustable rates during periods of low interest?

Anchoring and adjustment bias Signup and view all the answers

What behavioral bias is characterized by borrowers walking away from perceived unfair contracts?

Self-serving bias Signup and view all the answers

What effect does bounded rationality have on borrowing decisions?

It creates potential judgment biases Signup and view all the answers

Which phenomenon could result from the combination of loss aversion and myopia during the mortgage signing process?

Short-sighted financial decisions Signup and view all the answers

What structural problem can arise from the moral hazard between the servicer and the investors?

Servicers may retain defaulting loans to collect fees Signup and view all the answers

What was a primary goal of the Federal Housing Program promoted by the US Government?

To increase the rate of homeownership Signup and view all the answers

Which of the following was a result of the Community Reinvestment Act (CRA)?

Facilitation of risky loans Signup and view all the answers

What was a significant factor contributing to the rise of the subprime lending market in the 1990s?

Government policies encouraging homeownership Signup and view all the answers

What negative impact did the privatization of Fannie Mae and Freddie Mac have?

Uncontrolled market guarantees Signup and view all the answers

What was a significant consequence of the securitization process in the mortgage market?

It shifted risk to low-income borrowers. Signup and view all the answers

What was one of the three reasons to support homeownership mentioned?

Wealth accumulation and economic self-sufficiency Signup and view all the answers

What economic condition contributed to the housing market's growth prior to the crisis?

Low interest rates and liquidity in financial markets Signup and view all the answers

Which statement best describes the state of homeownership in the US around spring 2004?

It peaked at 69.2% Signup and view all the answers

What was the leverage ratio of Fannie Mae and Freddie Mac during the financial crisis?

75 to 1 Signup and view all the answers

By how much did the amount of mortgage debt per household increase from 2001 to 2007?

63% Signup and view all the answers

What was one characteristic of 'option ARM' loans taken out by borrowers?

They allowed low early payments that increased mortgage balances. Signup and view all the answers

How much did the government commit to prevent the collapse of AIG?

$180 billion Signup and view all the answers

What trend was observed in suspicious activity reports related to mortgage fraud between 1996 and 2009?

20-fold increase followed by doubling Signup and view all the answers

What percentage of mortgage securities rated triple-A in 2007 were ultimately downgraded?

83% Signup and view all the answers

What was the total amount of commercial and residential real estate holdings and securities that Lehman Brothers amassed by the end of 2007?

$111 billion Signup and view all the answers

How much did nonprime lending surge to in 2005?

$730 billion Signup and view all the answers

What characterizes subprime loans?

Loans for borrowers with poor credit histories and reduced repayment capacity Signup and view all the answers

What was a significant factor in the increase of home refinancing between 2000 and 2003?

Sharp increase in average home prices throughout the country Signup and view all the answers

What was the delinquency rate for subprime mortgages by the end of 2006?

10 percent of subprime mortgages were more than 60 days delinquent or in foreclosure Signup and view all the answers

What does a leverage ratio of 40 to 1 imply for investment banks?

For every $40 in assets, there is only $1 in equity to cover losses Signup and view all the answers

Which of the following statements about home equity extraction is accurate?

Americans extracted $2 trillion in home equity between 2000 and 2007 Signup and view all the answers

What was the condition of adjustable-rate subprime mortgages in late 2007?

20 percent of them were delinquent or in foreclosure Signup and view all the answers

Which best describes the political and economic conditions surrounding the subprime lending crisis?

Low interest rates encouraging risky lending behavior Signup and view all the answers

Which factor contributed to the rise and fall of the subprime lending market?

The packaging and securitization of subprime loans Signup and view all the answers

What does the STSS regulation require from originators, sponsors, or original lenders in securitisation?

They must retain a minimum of 5% economic interest. Signup and view all the answers

Which of the following is NOT mentioned as a US response to the subprime lending crisis?

Implementation of loan packager liability. Signup and view all the answers

What is the purpose of separating fees in the lending process?

To avoid cross-subsidisation in the Annual Percentage Rate. Signup and view all the answers

Which statement about risk retention under the STSS regulation is accurate?

Retention must be measured at the origination of the securitisation. Signup and view all the answers

What aspect of securitisation does the transparency rule specifically address?

Underlying exposure and documentation. Signup and view all the answers

What may be required before state intervention according to US responses?

An appropriate bail-in. Signup and view all the answers

What incentive does 'skin in the game' refer to in the context of securitisation?

Elimination of volume-based incentives. Signup and view all the answers

What is 'assignee liability' in the context of loan origination?

Liability assigned to loan packagers for origination violations. Signup and view all the answers

What role does the independent body play in the revenue distribution process for issuers?

It selects the gatekeeper to facilitate the service. Signup and view all the answers

Which of the following readings primarily discusses the role of securities regulation?

The essential role of securities regulation Signup and view all the answers

What is one primary objective of the readings listed in the content regarding financial structures?

To examine the need for regulatory frameworks in securities. Signup and view all the answers

In the context of the content provided, which citation discusses empirical analysis related to companies going public?

'Why Do Companies Go Public? An Empirical Analysis' Signup and view all the answers

What is a significant focus of the mandatory corporate climate disclosures mentioned in the readings?

Requiring transparency in corporate environmental impacts. Signup and view all the answers

What is the primary benefit of mandated disclosure for liquidity traders?

It lowers asymmetric information among traders. Signup and view all the answers

Which consequence might result from a firm voluntarily disclosing information?

Increased risk of duplicative disclosure. Signup and view all the answers

How does reducing searching costs affect analysts?

It optimizes their analysis process. Signup and view all the answers

In what way does mandated disclosure improve market competitiveness?

By reducing the bid/ask spread. Signup and view all the answers

What impact does mandatory disclosure have on management monitoring?

It increases the appeal for institutional investors. Signup and view all the answers

Why might firms resist mandatory disclosure despite its benefits?

It reveals strategic information. Signup and view all the answers

What is a potential negative effect of increasing the availability of information through mandated disclosure?

It may incentivize noise trading. Signup and view all the answers

Which aspect of financial trading is improved by reducing transaction costs through mandated disclosure?

Enhanced competition among analysts. Signup and view all the answers

What is a significant benefit of mandatory company disclosure for public companies?

Improves market liquidity and pricing efficiency Signup and view all the answers

Which of the following is NOT a requirement during the Initial Public Offering (IPO) process?

Immediate listing on multiple exchanges Signup and view all the answers

Which of the following statements is true regarding ongoing disclosure for public companies?

It includes financial reporting requirements. Signup and view all the answers

Which action is typically taken first in the IPO process?

Selection of banks for underwriting Signup and view all the answers

What externality is associated with the optimal supply of information provided by listed companies?

Improved monitoring of management by stakeholders Signup and view all the answers

What type of offerings can accompany an Initial Public Offering (IPO)?

Follow-on offerings Signup and view all the answers

Why might mandatory disclosure increase litigation risks for companies?

It can expose inconsistencies in financial reporting. Signup and view all the answers

In the context of mandatory disclosure, which characteristic does NOT apply to public companies?

They have complete control over disclosure. Signup and view all the answers

What is the primary focus of the expected credit loss (ECL) model under IFRS 9?

To recognize expected credit losses continuously over the life of financial assets. Signup and view all the answers

What criterion determines if a lifetime expected credit loss allowance is required under IFRS 9?

If there has been a significant increase in credit risk since initial recognition. Signup and view all the answers

What is one of the primary roles of gatekeepers in financial transactions?

To offer verification and certification services for investors Signup and view all the answers

What was a primary goal of the change in approach under IFRS 9 regarding credit losses?

To minimize procyclicality and enhance risk management practices. Signup and view all the answers

Which of the following is a component of ongoing disclosure in financial reporting?

Details on major shareholders and their voting rights. Signup and view all the answers

Which of the following best describes the impact of activist hedge fund campaigns on firms?

They improve productivity, investment, and innovation Signup and view all the answers

What significant discretion exists among member states regarding credit risk assessment under IFRS 9?

The interpretation of significant deterioration in credit risk. Signup and view all the answers

Which category of risk management tools does the third-party assessment fall under?

Third-party assessments Signup and view all the answers

What challenge do gatekeepers pose in the financial industry after significant scandals like Enron?

Heightened self-regulation without sufficient oversight Signup and view all the answers

How did the ECB Asset Quality Review impact the definition of non-performing loans (NPLs)?

It established a uniform definition across all member states. Signup and view all the answers

What does the shift to an expected credit loss model aim to counter in financial practices?

Delayed recognition of credit losses in financial reporting. Signup and view all the answers

What is typically one of the reputational risks faced by gatekeepers?

Providing validation for inaccurate information Signup and view all the answers

What type of reports are vital for investment decisions as part of ongoing financial disclosure?

Periodic and event-driven regulated information. Signup and view all the answers

How do gatekeepers help in reducing monitoring costs in transactions?

By independently verifying company claims Signup and view all the answers

What is an example of market-based measures in risk management?

Credit ratings from an independent agency Signup and view all the answers

What aspect makes gatekeepers largely unregulated in the financial industry?

Reliance on reputation capital for compliance Signup and view all the answers

Study Notes

Subprime Loans

Subprime loans are offered to borrowers with a weakened credit history
These loans are often given to borrowers with payment delinquencies, charge-offs, judgments, and bankruptcies.
Borrowers often have reduced repayment capacity as measured by credit scores, debt-to-income ratios, and incomplete credit histories.

The Subprime Crisis

The Federal Reserve cut interest rates in the early 2000s, causing mortgage rates to fall.
This resulted in a surge of home refinancing, from 460billionin2000to460 billion in 2000 to 460billionin2000to2.8 trillion in 2003.
Home sales volume increased, and average home prices rose 67% in eight years
By refinancing homes, Americans extracted 2trillioninhomeequitybetween2000and2007,with2 trillion in home equity between 2000 and 2007, with 2trillioninhomeequitybetween2000and2007,with334 billion in 2006 alone.
By the end of 2006, approximately 10% of subprime mortgages in the United States were more than 60 days delinquent or in foreclosure, nearly double the 5.4% of subprime mortgages in this situation in December 2005.

Leverage Ratios

The leverage ratios of the top US investment banks were as high as 40 to 1, meaning for every 40inassetstheyhadonly40 in assets they had only 40inassetstheyhadonly1 in capital to cover losses.
Less than a 3% drop in asset values could wipe them out.
They were mostly leveraged with short-term loans in the overnight market.

Subprime Market Failure

The subprime market was born in the early 1990s and reached its peak in 2006, representing 20% of total mortgages.
Government policies encouraged homeownership, which reached a record 69.2% in the spring of 2004.
Three main reasons to support homeownership: wealth accumulation, positive social states, and community stability.

Key Political & Economic Conditions

The Federal Housing Program promoted by the US Government encouraged increased homeownership rates.
The Community Reinvestment Act (CRA), together with other regulations, facilitated high risky loans to increase financial inclusion.
The securitization process, freed up to 60% of overall mortgage markets.
The privatization of Fannie Mae and Freddy Mac provided uncontrolled guarantees to the market.

Securitization

This phase allows the transfer of risk to the market, including for 'non-conforming' loans.
The servicer helps the SPV to collect and make payments and borrowers to manage payments and their financial exposures.

EU Response & Regulation

The Simple Transparent and Standardised Securitisation (STSS) Regulation EU n. 2017/2402 applies to all securitization products.
Risk retention: the originator, sponsor, or original lender of a securitization shall retain a material net economic interest in the securitization of at least 5%.
The STSS regulation includes transparency and disclosure requirements for the underlying exposures, underlying documentation, and quarterly reports.

Reducing Price/Value Deviation

Reduces information asymmetry and creates a competitive market for analysts improving price accuracy and market liquidity.
Lowers risk in corporate acquisitions.
Helps monitor management, increasing institutional investor interest in relational investments.

Mandatory Disclosure for Liquidity

Mandated disclosure reduces searching and analysis costs by analysts.
Standardized formats for financial information make firms more comparable.
Reduces opportunities for insider trading and increases the availability of information to reduce the price/value gap.
Encourages firms to disclose more information to attract analysts.
Stimulates analysts to market their analyses, further reducing analysis costs.
Benefits liquidity traders by lowering asymmetric information and reducing the risk of trading against better-informed traders.

Argument for Mandatory Disclosure

Despite firms hypothetically having incentive to disclose information voluntarily to reduce their cost of capital, firms may not disclose information due to:
- Fear of revealing commercial strategies.
- Providing stakeholders with valuable information that can improve their negotiating positions.
- Reducing the firm's ability to exclude other interested parties from using information against the firm.
- Increased risk of litigation.
Optimal provision of information by listed companies is a public good with important positive externalities, including:
- Improved market liquidity.
- More efficient public pricing.
- More effective monitoring of management.

Disclosure Systems

Public Companies:
- Disclosure at Issuance:
  - Prospectus rules.
  - Admission to listing/trading requirements.
- Ongoing Disclosure:
  - Accounting rules.
  - Financial reporting.
  - Trading data.
Private Companies:
- Limited Information disclosure:
  - Limited accounting rules.

Mandatory Disclosure - Going Public

Three types of primary market issuances:
- Initial Public Offerings (IPOs):
  - Beauty contest for investment banks.
  - Due diligence and document preparation, including prospectus.
  - Research preparation by analysts.
  - Investor education.
  - Management roadshow.
  - Bookbuilding and price agreement.
  - Pricing and admission to trading.
  - Stabilization.
- Captive Issuance: Private placement to selected investors.
- Fringe Direct Offerings: Direct listing with allowances for impaired exposures.

IFRS 9 Impairment

Moves from incurred loss to expected credit loss (ECL) recognition.
ECLs should be recognized regularly over the lifetime of a financial asset from its initial recognition.
Expected credit losses are measured through a loss allowance equal to:
- 12-month expected credit losses.
- Lifetime expected credit losses if credit risk on the financial instrument has increased significantly.

Accounting Standards - IFRS 9 Impairment

Change in approach aims to reduce procyclicality.
Significant step for banks reliant on standardized risk evaluation models.

Ongoing Disclosure - Financial Reporting

Regular flow of disclosure of periodic and event-driven regulated information is essential for investment decisions.
Includes:
- Financial reports.
- Information on major holdings of voting rights.
- Information disclosed under market abuse rules.
Shareholder pressure:
- Inflow of short-term institutional investors can lead firms to cut R&D.
- Activist hedge fund campaigns can lead to improved productivity, investment, and innovation.

Gatekeepers and Information Intermediaries

Gatekeepers verify and certify information for investors.
Examples:
- Independent auditors: Verify financial statements.
- Debt rating agencies: Evaluate creditworthiness.
- Securities analysts: Assess business and financial prospects.
- Investment bankers: Appraise the fairness of transactions.
- Lawyers: Validate the legality of financial transactions.
Information intermediaries:
- Financial press.
- Data providers.

Gatekeeper Functions

Provide third-party assessments to reduce adverse selection and monitoring costs.
Examples:
- Credit ratings, due diligence.
Entities largely unregulated, relying on reputation capital.
Failures have occurred due to inadequate regulation in the aftermath of the Enron scandal and the 2008 financial crisis.
Recommended regulation:
- Independent body should redistribute revenues from issuers to gatekeepers.

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Description

This quiz explores the concept of subprime loans and the factors leading to the subprime mortgage crisis. It delves into borrower characteristics, market trends, and the significant rise in home refinancing during the early 2000s. Test your knowledge on this critical economic topic!