Lecture 3.2 Valiante: The Rise and Fall of Subprime Lending PDF

The rise and fall of the subprime lending market: the key role of securitisation (case study) Diego Valiante, Ph.D. O...

The rise and fall of the subprime lending market: the key role of securitisation (case study) Diego Valiante, Ph.D. Opinions expressed are strictly personal and cannot be LEIF Master Programme attributed in any way to the European Commission.  Agenda Some key facts about the subprime crisis and related GFC Key political and economic conditions Subprime lending and packaging structure Key market failures Potential remedies and the EU response © Valiante Diego - 2  What are subprime loans? Subprime loans are loans given to borrowers with: – “weakened credit histories that include payment delinquencies, and possibly more severe problems such as charge-offs, judgments, and bankruptcies. – They may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that many encompass borrowers with incomplete credit histories.” (OCC, Fed, FDIC, OTS) © Valiante Diego - 3  Some stats from Financial Crisis Inquiry Commission Report The Federal Reserve cut interest rates early in the new century and mortgage rates fell, home refinancing surged, climbing from $460 billion in 2000 to $2.8 trillion in 2003. Home sales volume started to increase, and average home prices nationwide climbed, rising 67% in eight years By refinancing their homes, Americans extracted $2 trillion in home equity between 2000 and 2007, including $334 billion in 2006 alone, more than seven times the amount they took out in 1996. By the end of 2006, approximately 10 percent of subprime mortgages in the United States were more than 60 days delinquent or in foreclosure, nearly double the 5.4 percent of subprime mortgages in this situation in December 2005. – 20 percent of the entire outstanding stock of adjustable-rate subprime mortgages in late 2007. © Valiante Diego - 4  Some stats from the Financial Crisis Inquiry Commission Report (2) Leverage ratios of top US investment banks were as high as 40 to 1, meaning for every $40 in assets, there was only $1 in capital to cover losses. Less than a 3% drop in asset values could wipe them out. They were also mostly leveraged with short-term loans in the overnight market. – For example, at the end of 2017, Bear Stearns had $11.8 billion in equity and $383.6 billion in liabilities and was borrowing as much as $70 billion in the overnight market. It was the equivalent of a small business with $50,000 in equity borrowing $1.6 million, with $296,750 of that due each and every day. Fannie Mae and Freddie Mac (Government-sponsored entities) were leveraged 75 to 1 From 2001 to 2007, national mortgage debt almost doubled, and the amount of mortgage debt per household rose more than 63% from $91,500 to $149,500. – Nonprime lending surged to $730 billion in 2004 and then $1 trillion in 2005 By the end of 2007, Lehman had amassed $111 billion in commercial and residential real estate holdings and securities, which was almost twice what it held just two years before, and more than four times its total equity. © Valiante Diego - 5  Some stats from the Financial Crisis Inquiry Commission Report (3) Nearly one in 10 mortgage borrowers in 2005 and 2006 took out “option ARM” loans, which meant they could choose to make early payments so low that their mortgage balances rose every month. Lehman held more than 900,000 derivatives contracts, of which many linked to RMBS. The number of suspicious activity reports—reports of possible financial crimes filed by depository banks and their affiliates—related to mortgage fraud grew 20-fold between 1996 and 2005 and then more than doubled again between 2005 and 2009. – One study places the losses resulting from fraud on mortgage loans made between 2005 and 2007 at $112 billion. 68% of “option ARM” loans originated by Countrywide and Washington Mutual had low- or no-documentation requirements. The government ultimately committed more than $180 billion because of concerns that AIG’s collapse would trigger cascading losses throughout the global financial system. From 2000 to 2007, Moody’s rated nearly 45,000 mortgage-related securities as triple-A. – The results were disastrous: 83% of the mortgage securities rated triple-A that year ultimately were downgraded. © Valiante Diego - 6  What is this crisis about? Frauds? A story of frauds and misconduct hidden behind a complex financial structure fed by subprime loans… (from min. 45:22 to 54:25) https://www.c-span.org/video/?281763- 1/role-derivatives-current-financial-crisis © Valiante Diego - 7  What is this crisis about? Failure of public policies? A story of failed public policies… https://youtu.be/XMKKHUIwmNw © Valiante Diego - 8  Some history of the subprime lending market Born in early 1990s, this market reached its peak in 2006 (20% of total mortgages origination in the US) Encouraged by government policies, homeownership reached a record 69.2. in the spring of 2004. Three main reasons to support homeownership: 1. Wealth accumulation and economic self-sufficiency; 2. Positive social-psychological states; and 3. Stability of neighbourhoods and communities. © Valiante Diego - 9  The rise and fall of the market for subprime lending (3) © Valiante Diego - 10  Key political and economic conditions 1. The Federal Housing Program promoted by the US Government to increase the homeownership rate (including tax deductions of interest rates via Federal Tax Reform of 1986); 2. The long-run positive trend of house appreciation linked to low interest rates and to the large availability of liquidity in financial markets; 3. The Community Reinvestment Act (CRA), together with other regulations, to facilitate high risky loans (including balloon payments) by trying to increase financial inclusion (and so homeownership rate) for racial and ethnic minorities. 4. The volume-based incentives created by the securitisation process (firstly appeared in the 1930s) freed up to 60% of overall mortgages markets; 5. The privatisation of Fannie Mae and Freddy Mac that provided uncontrolled guarantees to the market; Creating a conflict between two interests: the long-run financial stability of the securitisation process and the short-termism of preserving profitability (shareholders’ value). © Valiante Diego - 11  The subprime lending & packaging structure © Valiante Diego - 12  The subprime lending & packaging structure (origination) 1. Many players involved: 1. Low-income borrowers 2. Originating bank (e.g. Washington Mutual among the big ones [only 20% were banks], but mostly small non - depository institutions due to the reputational risks attached to it) 3. Brokers 4. Appraisers 5. Warehouse lenders (big banks providing liquidity to these small originating financial companies) 6. Servicers 2. The credit score model for risk assessment is based on an automatic system (first introduced in 1989) Fair Isaac Corporation (FICO) scores are the most used and are based on payment history (35%), current level of indebtedness (30%), types of credit used (10%), length of credit history (15%) and new credit accounts (10%). Weights are those used in 2008-2009. 3. Subprime mortgage were mostly non-recourse loans (if borrower defaults, bank can only seize the collateral) Increase perception of low delinquency cost in a house price collapse led to more origination too. © Valiante Diego - 13  The subprime lending & packaging structure (origination) 1. Adverse selection and predatory lending practices between borrower and lender – Automated scoring system (FICO credit scores) accentuated misevaluation of risk Overreliance on past data Reference value bias reduces ability to check relativity of risk [below 620 was subprime], such as biases affecting individual’s decisions Borrowers’ opportunistic behaviour to get a higher score by withholding information. – Subprime loans became so widespread that were given to NINJA(No Income No Jobs & Assets) borrowers too. – Recourse nature of the debt also fostered inability for borrowers to signal their real risk. 2. Moral Hazard between appraiser/broker and borrower – They are on the lender’s payroll. – Broker may even get a volume-based fee. 3. Moral Hazard between originator and purchasing bank/arranger of the securitisation (originate- to-distribute model) – Subprime mortgages were mostly non-recourse loans (higher chance housing bubbles due to Originate-To-Distribute incentives models; Nam & Oh 2016). – These volume-based incentives also implied higher chance of securitised portfolio to default (20% more likely; Keys et al. 2008). © Valiante Diego - 14  The subprime lending & packaging structure (securitisation) This phase allows 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 their payments and their financial exposures. – Its incentive is to keep the loan on its books for long time, even though it is defaulting, in order to generate more fees. © Valiante Diego - 15  The subprime lending & packaging structure (securitisation) More risk shifting to the bottom of the chain takes place (with multiple iterations, e.g. CDOs2) © Valiante Diego - 16  The subprime lending & packaging structure (placement) 1. Adverse selection between the arranger/purchasing bank and investors – Overreliance on automatic credit scoring, coupled with incentives to push risk down the chain, created structural mispricing by investors. 2. Moral hazard between servicer and investors – Interest in keeping defaulting loans on the books (fees), even though they could have defaulted event before packaging them. 3. Conflict of interests and moral hazard of credit rating agencies over final investors – ‘Issuer-pay’ model – Overloaded by issuance, but no incentive to reduce new rating issuance to preserve quality (because of fees) © Valiante Diego - 17  The subprime lending & packaging structure © Valiante Diego - 18  Bounded rationality failures On the judgment side, it is possible to identify several potential biases (Ulen and Korobkin 2000; Sunstein 2000; Jolls 2007). – Anchoring and adjustment bias The borrowers’ choice to get in a mortgage with adjustable rates (ARMs) may be “anchored” to a long period of low interest rates and home price appreciation. – Overconfidence bias boosted by the house value bubble – Self-serving bias (own view of ‘credit morality’) Leading to walking away from (perceived) ‘unfair’ contracts or leading to irresponsible borrowing (led by low short-term default costs and constant house value appreciation) On the decision-making side, there is loss aversion (combined with myopia) in at least two instances: – At signature. More attractive homeownership for low income (high risk) borrowers (rent-to-own behaviour for consumer durables) – At default. Risk seeking subprime borrowers choosing delinquency (likely future loss, due to bad credit rating) over repayment of underwater home equity (certain short-term loss). © Valiante Diego - 19  To recap 1. Fee-based compensation scheme (brokers, servicers, appraisers, origination bank) – Predatory Lending practices – Complex interest rate structures (lack of transparency) 2. Volume-based incentive through the securitisation process (GSEs, borrowers, all players in the securitisation process except investors) – Shifting risk down to investors – Lack of transparency – Overreliance on public guarantees 3. Cognitive biases at point of sale (borrowers, brokers, originating banks, appraisers) – Self serving bias, anchoring, overconfidence and loss aversion 4. Excessive public intervention (GSEs, borrowers, monoline insurers) 5. Policy failures (unnecessary accommodative monetary policies) © Valiante Diego - 20  The subprime lending market – Some potential remedies Mandatory disclosure of hidden costs and alternative scenarios (incl. simplified disclosure of Annual Percentage Rate and Adjustable Rates Mechanisms). Fiduciary relationship between subprime borrowers and lender/brokers (due to the characteristics of the borrower) – Lack of education and economic vulnerability – This is specially true for brokers (using their personal relationship with clients) Remuneration linked to the interest rates that they were able to charge (no skin in the game) – As a result, a suitability assessment on the lender may lead it to care more about who it is lending to. Lender would then look at: Ability to repay (affordability) Product design in the borrower’s best interest, after the borrower’s declaration of the aim of its purchase Consumer’s understanding and absence of predatory practices – Suitability should be withdrawn if the borrower voluntarily and explicitly retained information at the signing of the contract. © Valiante Diego - 21  The subprime lending market – Some potential remedies Overreliance on fees also by lenders – Separation of fees may help to avoid cross-subsidisation (not pooling in the Annual Percentage Rate) ’Skin in the game’ incentives for the securitisation process (to eliminate volume-based incentives) Lliability on loan packagers for violations in the origination of the loans, also called ‘assignee liability’ (Peterson 2007) The actual US response – Direct control over GSEs and increase limits for their mortgage purchases – Massive public intervention to refinance loans ($300 bn) – Enhancements to mortgage disclosures – Help local governments to buy and renovate foreclosed properties – Ensure appropriate bail-in before state intervention (for the future) © Valiante Diego - 22  A key EU response – Simple, Transparent and Standardised Securitisation (STSS Regulation EU n. 2017/2402) The STSS regulation applies to all securitisation products: – Risk retention (does not apply to securitisation of public debt) The originator, sponsor or original lender of a securitisation shall retain on an ongoing basis a material net economic interest in the securitisation of not less than 5 %. That interest shall be measured at the origination and shall be determined by the notional value for off- balance-sheet items. Where the originator, sponsor or original lender have not agreed between them who will retain the material net economic interest, the originator shall retain the material net economic interest. (art. 6) – Transparency rules on: Underlying exposure, underlying documentation of the transaction, a transaction summary (if no prospectus), quarterly reports. © Valiante Diego - 23  A key EU response – Simple, Transparent and Standardised Securitisation (STSS Regulation EU n. 2017/2402) – Additional criteria (on top of the above) to be marketed as simple, transparent and standardised (STS) securitisations (different if commercial paper securitisation or ABCP) Simplicity (art. 20; including no clawback provisions to challenge securitisations in case of insolvency of the seller of the exposure, no other securitised products as underlying) Standardisation (art. 21; including mitigating currency and interest rate risks, use standard market rates, cash buffer, disclosure of remedies and actions in case of default, debt restructuring and so on, provision to facilitate resolution of conflicts between classes of investors and so on) Transparency (art. 22; data on historical default and loss performance, such as delinquency and default data, sample of exposure subject to external verification prior to issuance) – Verification and due diligence rules on institutional investors to assess all the risks arising from different types of securitisation (also verify that originators in third countries apply risk retention). The STSS Regulation came with an amendment to the regulation on capital requirements to make the capital treatment of STS securitisations for banks and investment firms more risk-sensitive. © Valiante Diego - 24  Recommended readings The Financial Crisis Inquiry Report, US Financial Crisis Inquiry Commission available at https://www.govinfo.gov/content/pkg/GPO-FCIC/pdf/GPO- FCIC.pdf (Chapters 3 and 5) Additional readings – IOSCO, Report on the Subprime Crisis, available at https://www.iosco.org/library/pubdocs/pdf/IOSCOPD273.pdf – Valiante, Diego, The Market for Subprime Lending: A Law and Economics Analysis of Market Failures and Policy Responses (August 20, 2008). Available at SSRN: https://ssrn.com/abstract=1956463 or http://dx.doi.org/10.213 9/ssrn.1956463 – Engel K. C. and P. A. McCoy, “A Tale of Three Markets: The L&E of Predatory Lending”, Texas Law Review, Vol. 80, No. 6, May 2002, p. 1263. © Valiante Diego - 25  Diego Valiante LEIF Master Programme [email protected] www.unibo.it