Subprime Meltdown: From U.S. Liquidity Crisis to Global Recession

By Charles Brownell

What’s wrong?

• Too many people bought too many home that they couldn’t afford.

• Now those people are being foreclosed.– That is causing housing prices to fall, – which in turn in decreasing consumer confidence, – which in turn in decreasing consumer spending, – which in turn is causing a recession, – which in turn is causing layoffs, – which in turn is reducing consumer spending, – which in turn is causing layoffs, – which in turn is causing people to lose their homes to foreclosure, – which in turn is causing housing prices to fall, – which in turn is causing builders to stop building, – which in turn is causing a downward spiral– Go to the top of the list and repeat…

Definitions• What is Subprime

– ‘Subprime’ is a financial term used to identify borrowers who don’t qualify for a ‘prime’ loan.

• How do financial institutions distinguish between prime and subprime? – If you have a credit score below 620, you are a subprime borrower.

• So what’s a prime loan? – A prime loan is a loan that charges the prime interest rate, also known as the ‘prime

rate’. Typically the prime rate is the interest rate charged to financial institutions’ best, most credit-worthy customers. The prime rate is published in the business section of your local newspaper.

• So what can you expect if you are a subprime borrower? – You can expect to pay a higher interest rate and higher fees for a loan.

Background• Why would banks, the pillars of fiscal responsibility and risk aversion, lend

money to people who had bad credit ratings and possibly couldn’t afford to repay it? – The short answer is, they wouldn’t, and until thirty years ago they didn’t.

• Before Congressional legislation of the ‘70s required financial institutions to loan money to low and moderate-income borrowers, most financial institutions would make mortgage loans and hold onto them until maturity or they were paid off.

• In those days, the financial institutions had an incentive to be certain the people they loaned money to could repay it.

• The loan officer would meet with the borrower and get to know them. They would find out about their job, how long they’d worked there, how much money they made, etc.

• The advent of mortgage-backed securities (discussed later) removed the incentive for financial institutions to be certain loans would be repaid and gave them access to virtually unlimited amounts of capital.

So what changed?• Thirty years ago homebuyers who fell into today’s subprime category would

have been denied credit.

• Many of our Congressional leaders thought this was discriminatory and was directly responsible for the run-down housing in the inner city. – Congress wanted to give everyone the opportunity to own his or her own home, even

those who weren’t creditworthy.

– So Congress strongly encouraged and, in a sense, mandated that banks make loans to subprime borrowers through the Community Reinvestment Act (CRA).

• The CRA was intended to encourage depository institutions to help meet the credit needs of the communities in which they operate, including low- and moderate-income neighborhoods, consistent with safe and sound banking operations. It was enacted by the Congress in 1977 (12 U.S.C. 2901) and is implemented by Regulations 12 CFR parts 25, 228, 345, and 563e (2).

• If a bank didn’t have good CRA numbers they couldn’t expand or merge.

What did our leaders do to us?• Various Presidents and Congress enacted laws and issued orders that

dramatically increased the quantity, availability and use of subprime mortgages.

• 1980 - The Depository Institutions Deregulatory and Monetary Control Act, allowed financial institutions to charge a premium to subprime borrowers.

• 1982 - Alternative Mortgage Transaction Parity Act, allowed financial institutions to charge variable interest rates.

• 1994 – President Clinton (president from 1993-2001) unveiled his National Homeownership Strategy. Part of this strategy was to make it harder for banks to get a passing CRA grade, without which expansion and mergers were out of the question. The more minorities and low and middle-income borrowers a bank had, the better the CRA number. Banks dramatically increased their loans poor communities.

What did our leaders do to us?• 1996 – The Department of Housing and Urban Development (HUD) gave Fannie

Mae and Freddie Mac the explicit goal of 42% of their mortgages had to go to low and moderate-income borrowers & 12% had to go for ‘affordable housing’ to borrowers with incomes less than 60% of the median income for their area. To help accomplish these goals the percentage of capital required to back the mortgages was reduced to 2.5%. In other words, they had $2.50 for every $100.00 in loans. That’s a lot of leverage.

• 2000 – The Fannie Mae and Freddie Mac target for low and moderate-income borrowers was increased to 50% and 20% of all mortgages purchased by Fannie Mae and Freddie Mac had to go for ‘affordable housing’, once again defined as borrowers with incomes less than 60% of the median income for their area.

• 2005 – The Fannie Mae and Freddie Mac target for low and moderate-income borrowers was increased once again to 52% and 22% of all mortgages purchased by Fannie Mae and Freddie Mac had to go for ‘affordable housing’, borrowers with incomes less than 60% of the median income for their area.

• 2007 – Fannie Mae and Freddie Mac had approximately 50% of the $12 trillion in U.S. mortgages.

Mortgage-Backed Securities - Securitization

• When financial institutions were required to loan money to those high-risk borrowers who in all likelihood would have difficulty repaying the loan, the financial institution needed to get those loans off their books by selling them to someone else.

• So they either sold them to Fannie Mae and Freddie Mac (discussed later) or bundled them up and worked with credit rating agencies to determine the overall level of risk associated with a bundle of mortgages and sold them as bonds.

• Bundling the mortgages together and selling them as bonds is known as securitization. – The product of securitization of mortgages is a mortgage-backed security.

Fannie Mae & Freddie Mac• The banks were loaning money to people who probably wouldn’t be able

to pay it back. They needed to sell those loans so they could make more loans.

• But who is going to buy bad loans?

• Congress sends Fannie Mae and Freddie Mac to the rescue.

• Fannie Mae & Freddie Mac buy up all the subprime loans and sell them as bonds.

• Why would anyone buy the subprime bonds from Fannie Mae and Freddie Mac?– Because Fannie Mae and Freddie Mac are ‘Government Sponsored

Enterprises’ and as such gave the impression that their junk bonds were backed by the ‘full faith and credit’ of the U.S. Government. Investors, thinking the U.S, government was backing the subprime loans, bought them up by the trillions.

The Long Answer• Why would banks lend money to people who had bad credit ratings and possibly

couldn’t afford to repay it?

• Ultimately, the financial institutions that loaned the money to the subprime borrowers wouldn’t be held liable if the borrower didn’t repay the loan. – The loan would be sold to Fannie Mae & Freddie Mac who in turn would package it

up into a bond and sell it around the world.

• So banks sold as many loans as they could. – You may argue that the banks must have known or at least suspected that the

borrowers couldn’t repay the loan. – That may or may not be true.

• Banks didn’t have anything at risk, they didn’t have anything to lose by loaning money to subprime borrowers as long as Fannie Mae and Freddie Mac would buy those subprime loans from the bank.

Subprime Example• What does it mean to give a loan to someone making 60% of the median income?

• Say the median income in an area is $40,000. Fannie Mae and Freddie Mac were directed to purchase 22% of their mortgages from people making less than $24,000.

– Using the 28% rule that means the house payment (principal, interest, taxes, insurance) had to be $560 or less.

– Most of these loans were low/no money down, low/no documentation, adjustable rate loans.

– For a $560 per month loan at 6% with a 30-year amortization you can afford a $70,000 home if your taxes are $1,000 per year and your insurance is $500 per year.

• Here’s how the math works. – Taxes are $1,000 per year or $83 per month. – The insurance is $500 per year or $41 per month. – The taxes and insurance together cost $125 per month. – If they can afford $560 per month then their house payment can’t exceed $435 per

month ($560 less $125 is $435). Remember they need to spend $125 on taxes and insurance.

Two typical scenarios

• First, what happens if the loan was an adjustable rate loan and the rate goes up?

• And second, what if they got a much lower rate to start with and bought a much more expensive home?

• These are the typical situations that subprime borrowers faced. There are many, many others.

• I believe banks structured these loans so that subprime borrowers would HAVE TO refinance. – That way the bank could reap another round of fees.

• Let’s look at each of these two scenarios in detail.

First, what happens when rates go up?• What happens when the rate on the loan and it adjusts say from 6%

to 10%. – The payment increases to $614 per month. – The old payment was $435 per month. – That means they would see their payment increase 41%. – To be able to afford that they would need a 41% increase in their income. – Because they make less than 60% of the median income chances are they

won’t be able to afford a 41% increase in their house payment.

• The $70,000 home was simply unaffordable. While it is an admirable goal to provide affordable housing the current method simply fails to achieve that goal.

• This family will lose their home.

• Not only has this family lost their home, but now their credit rating is ruined. Thank you Congress.

What if they bought a more expensive home?• Suppose that instead getting a 6% mortgage they chose the ‘Exploding ARM’

with a 2% interest rate for the first two years.

• How much home could they afford for that same $435 payment? – They could’ve purchased a $115,000 home for $435 per month at 2% interest.

• So how much does their payment increase when the loan adjusts to 10%? – The new payment for a $115,000 mortgage at 10% is $1,009 per month or an

increase of 132%.

• Their income would have to increase 132% to be able to afford the $115,000 home.

• How much is a 132% increase in income if you make $24,000 per year? – It is $55,680.

Governments Bad Social Agenda

• How realistic is it for someone making $24,000 one year to jump up to $55,680 the next year? – In most cases it is impossible.

• Now tell me that these financial institutions that put these people into these loans didn’t understand all of this.

• They are professionals in the financial world. Of course they understood it. – All of them from the CEOs all the way down to the mortgage brokers.

• Even Congressional leaders understood is was a house of cards waiting to fall. There were warning bells going off loud & clear.

What did Congress say or do about the warnings?

• The short answer is nothing.

• In 2004 Fannie Mae was caught cooking the books so the Fannie executives could get big fat bonuses. – Franklin Raines, CEO of Fannie Mae, walked away with over $50 million.

Some have reported his take as high as $90 million.

• After having been caught cooking the books it was a perfect opportunity to try and put some controls on Fannie Mae and Freddie Mac.

• Unfortunately when the Fannie Mae regulator tried to put some controls in place to limit the risk to the American taxpayer, Representatives Barney Frank, Maxine Waters and others stopped it.

The Congressional ‘Supervision’• Representatives responded by saying things like, ‘They’ve hit all their goals. What’s the

problem? “ – That’s like asking someone to drive to the store and back in 5 minutes. It’s a 10-mile trip so they

would have to drive 100 miles per hour. If they got pulled over by the police they would say, ‘But officer I was hitting my goal.’ Just because it’s a goal doesn’t make it right or legal.

• Barney Frank said the taxpayer’s money isn’t at risk. Obviously that was wrong!

• During the Congressional investigation our Congressional leaders asked Franklin Raines if he thought he was under supervised.

– He said, no he didn’t. That’s like asking the man who escapes from jail a hundred times if he thinks he’s under supervised. What kind of an idiot asks that kind of a question? A politician.

• They asked Franklin Raines if he thought Fannie Mae was over leveraged at 100 to 1. – He said, no in fact Fannie Mae could be leveraged at 200 to 1 and still be sound. That’s insane!

Bears Stearns was leveraged 30 to 1 and they went under. I believe banks can’t be leveraged more than 10 to 1 and they’re going under.

• Either Franklin Raines doesn’t understand the mortgage business (he was CEO so you’d think he’d understand mortgages) or he wasn’t being completely honest. You decide. Either way he walked away with a fortune!

Sniper Fire Revisited• Someone was going to get burned on these loans. Didn’t anyone try to

stop this madness?

• Yes the Republicans tried desperately but were blocked by the Democrats again and again.

• But don’t take my word for it. Listen to our Representatives in their owns words on video…

– http://www.youtube.com/watch?v=_MGT_cSi7Rs

– http://www.youtube.com/watch?v=63siCHvuGFg&feature=related

– http://www.youtube.com/watch?v=YGnZMGDG4k4&feature=related

How can we allow this?

• It has recently been revealed that the biggest Fannie Mae and Freddie Mae defenders got enormous political contributions from Fannie Mae and Freddie Mac. – Barney Frank, Chris Dodd, etc.

– Barack Obama was #2 on the list of total political contributions and he’s a freshman.

• Why are we allowing Government Sponsored Enterprises GSEs to donate to politicians!? – Talk about the fox watching the henhouse.

The details behind the crisis.• How did subprime loans create a worldwide crisis?

– Fannie Mae and Freddie Mac securitized trillions of dollars in mortgages, many of those securities included subprime mortgages. Those securitized mortgages ended up in banks and financial institutions around the world. When the mortgages defaults started to increase no one really knew how much subprime exposure they had. So they tried to sell the CDOs. Because there were many sellers and no buyers for these CDOs it drove the price down for all CDOs, which in turn drove the price down further.

• So there was a lot of bad mortgage bonds out there. How does that translate into a liquidity crisis?– Banks and other financial institutions have reserve requirements. That means they

have to have a certain amount of cash on hand. Since banks don’t make money on the cash they have in the bank (they have to loan it out to make money) they tend to keep as little cash on hand as possible. To meet their reserve requirements they usually borrow money from other banks. They do this every night just before the close of business so that they’ll meet the reserve requirements for the federal bank regulators in the morning. Since no one knew how much subprime junks bonds anyone held, banks were concerned about loaning money to a bank that might fail in which case they’d lose their money.

How does 5% cause a crisis?• If only 5% of the bonds were subprime that cause a crisis?

– Banks and other financial institutions have to value their assets using a method called ‘mark-to-market’. The way this works is companies have to change the value of the assets they own on their books according to whatever they could sell them for on the open market. Now that may sound like a good idea but there are two things wrong with it. First, the idea of mark-to-market is to get a ‘true valuation’ for the asset. In the case of CDO’s the underlying asset, the home is still valuable. Additionally, just because someone doesn’t want to buy the CDO doesn’t mean the majority homeowners are going to stop paying their mortgages. If you held onto those CDOs until maturity you might only lose 5% - the amount represented by foreclosure. But if no one is buying CDOs then you have to mark them down to whatever value someone is willing to pay. When no one wants to buy the CDOs the value can drop by 40%, 50%, 60%, 70%, 80% or more even though the underlying asset still retains 95% of the value. This is a crazy rule and one that encourages a downward spiral in asset values. The second thing wrong with mark-to-market is it doesn’t take into account the cash flow associated with those assets. If I used cash flow to value the CDOs they might drop by only 5% because 95% of the homeowners in the CDO are still going to pay their mortgage.

Mark-to-market Example• Yesterday Big Bank had $1 trillion in assets and $900 billion in liabilities. They were in great shape. They had

$100 billion in equity. They were leveraged 9 to 1. They had $9 of debt for every $1 in equity and everyone wanted to loan them money. Sounds great, everyone’s happy, Big Bank has $100 billion in equity.

• Unfortunately, today they had to use the mark-to-market rule to adjust the value of their assets. All of their assets were in CDOs and they had to market them down by 20%. Suddenly they have assets of $800 billion and liabilities of $900 billion. They are $100 billion in the hole. To use an accounting term, they are technically insolvent. They are bankrupt. In this case the FDIC will seize Big Bank.

• Lets examine those CDOs. If we use the discounted cash flow method to value those assets we find that yes 5% of those loans are bad, but the rest are still good. That means that in reality Big Bank’s asset value has declined only 5% from $1 trillion to $950 billion. They should still be in business. But because they had to value assets that no one wants to buy it drives the price of those assets down further as people try to sell them to raise the needed capital to run their business.

• Do you see the obvious flaw in using the price someone is willing to pay right now to value assets that have cash flow associated with them?

• There’s another thing wrong with mark-to-market besides the inherent flaw in valuing assets at the price someone is willing to pay right now, mark-to-market uses indexes to determine the current value. Indexes may contain bias. For example, suppose you want to determine current values of homes vs. the price of homes five years ago but you only included homes that had been sold and re-sold. It sounds good that you’ll get true market value but that is bias. High-end homes are typically bought and held for a long period of time. It means that you’ll probably get more homes that have been flipped. Because you’ve excluded high-end homes you may get more homes that have been purchased with a subprime mortgage and if the original buyer couldn’t afford the mortgage you’ll get a higher number of foreclosures.

• Here’s how that bias translates into skewed data for home prices. When home prices are going up they appear to be going up much faster than they actually are. Why? Because the low-end homes will be turned over more often either because the subprime mortgage needs to be refinanced and the homeowner decides to sell and move up to a bigger home rather than refinance or because more low end homes tend to be sold with subprime mortgages the payments are more affordable and therefore there is higher demand for the ‘starter’ home. On the other hand when there are a lot foreclosures in the low-end homes and there’s a lot of supply without much demand the prices of those homes will fall faster than a high-end home. But those situations won’t be reflected in the index because the index excludes homes that haven’t been sold and re-sold in the last five years.

Linking the credit crisis to Main Street• How does a downward spiral in asset values translate into a credit crisis?

– When banks and other financial institutions have to write down the value of their assets they have less assets that they can borrow against. If the value of a companies assets decline because they’ve marked them down for mark-to-market rules who is going to loan them money? No one. If the company is a bank and other banks won’t loan them money to meet their reserve requirements they are going to be seized by the FDIC. That’s why we’ve seen so many banks being seized by the FDIC.

• How does that translate into other businesses?– Businesses that don’t have reserve requirements still need money on a short-term basis to run their business.

These short-term loans to business are called ‘commercial paper’. For example, GE uses a lot of commercial paper. They used to pay less than the prime-lending rate for a commercial paper loan. With everyone having to mark down assets the asset to liability ratio suddenly looked pretty bad. It made it appear that many companies were getting close to bankruptcy. No one wants to loan someone money who is close to bankruptcy. But, as in the above example, the mark-to-market rule has greatly exaggerated the problem.

• So we have a lot of companies that can’t borrow money. How does that translate into a 5,000 point decline in the stock market?

– Most of the large companies listed on the stock market have CDOs. Because CDOs were viewed almost as safe a U.S. government T-bills. As the asset values of those CDOs declined so did the asset values of the companies that owned them. The companies that owned the most CDOs and had the least cash were the one to go out of business first. Some were rescued but some were not. Because of the uncertainty about which bank or company would fail next, would they get a bailout, would it be enough, how long will this last, etc. companies began to sell the stock. They needed to raise money to shore up their financial position. There were many, many more sellers than there were buyers and the prices began to decline. When the bailout didn’t instantly turn things around people panicked, selling more and more. The result was all sellers and no buyers. When you have that situation the prices of stocks fall dramatically.

• When big companies go out of business so do a lot of small companies. It rolls downhill.

The Role of Credit Rating Agencies• The role of credit rating agencies in the subprime market is interesting. There can be no question that

some of the burden of blame for the current crisis rests with the credit rating agencies.

• I’m not suggesting this crisis is entirely their fault. But they were handing out triple A rating for subprime bonds like candy. They seriously underestimated the risk involved with these loans and securities.

• In their defense, when the Mortgage Backed Securities were carved up and the worst performing loans placed in the Special Purpose Vehicles it became nearly impossible to accurately predict the overall performance of the loan portfolio.

• In August 2007 as the credit problems came to a head, many investors saw the rating on their investments go from the very best credit rating to default in a day or two.

• Investments that were sold as low risk went into default without warning. There are many money managers who purchased these investments because they carried an excellent rating and appeared to be low risk.

• Many investors are asking how their investments could go from excellent to default in such a short period of time. They are also asking how insured bonds become worthless.

• The answer goes back to the complexity of the investment. Because of the separation between the asset and the mortgage-backed securities, it is possible for the bonds to become worthless even as the underlying asset maintained most of its value.

• We also had bonds downgraded which results in immediate devaluation. The losses for downgraded bonds are also enormous.

• One thing is for certain. The credit rating business will never be the same again.

How long will it last?• The recession will last until we turn around the housing market.

• We are now in a situation where we have approximately 21% of all buyers effectively out of the market. 21% is the number of Alt-A and Subprime borrowers who will no longer be able to get a loan. http://www.irvinehousingblog.com/blog/comments/why-the-sub-prime-meltdown-is-a-problem/

• With 12-15 months of housing inventory for sale and 21% of the demand gone we're actually looking at 15-18 months of inventory. Add to that the decline in the value of existing homes http://www2.standardandpoors.com/spf/pdf/index/CSHomePrice_Release_082653.pdf and you can see we have a serious problem. The decline in home values is a long way from over. We'll need to work through that inventory but who is going to buy the inventory when they can't get a loan.

• To add fuel to the fire, the ARMs, Hybrid ARMs etc. that were written during the boom won't finish adjusting until 2012. We still have a long way to go before we've seen the end of the massive quantities foreclosures.

• But wait, the bad news continues. We are now looking at a situation where everyone who purchased a home in the last 2 years, and put less than 20% down, owes more than their home is worth. What is the incentive for those people to hang onto those homes? Have you heard of 'jingle-mail' that's when you send the keys back to the lender in the mail.

• We have to work off the excess home inventory and that will take time.

What’s wrong with the current plan?

• What's wrong with buying the distressed assets?

• Everything– You can't reasonably value them. – If you pay too much the taxpayer doesn't get their money

back. – If you pay too little you cause downward pressure on

housing prices.

• Even Congressional leaders should be able to understand that.

My Bailout Plan

• Have a government sponsored loan available for every homeowner up to $100,000 - provided the outstanding mortgage is more than $100,000.

• The loan would be available at 0% interest plus the rate of inflation.– The catch is that the loan would be personally guaranteed and would

survive foreclosure and bankruptcy.

• As part of this deal the lending institution would agree to reset the balance of the loan to the prime rate.

• The $100,000 would go to the bank to pay off part of the mortgage.

How much would this cost?• How much would this cost?

– Well we have 70 million homeowners and 50 million with a mortgage.

– Since this isn't limited to subprime it may be that all 50 million would take advantage of this offer.

– However, those who have a lower interest than prime probably wouldn't take advantage.

– Also those who have nearly paid off their mortgage probably wouldn't take advantage.

– Let's say 50% of of the 50 million homeowners take the government up on the deal.

– That would cost $2.5 trillion.

– Three thoughts on that $2.5 trillion.• First it would immediately solve the liquidity crisis because it would flow back into

the banking system immediately.• Second, since the $2.5 trillion would be a loan it would eventually be repaid. • Third, the original value of the mortgage wouldn't change. This is an important

point. Only those people who truly want to keep their homes would take advantage of this plan.There's no uncertainty of how to value the bad loans.There's no buying distressed loans.There's no threat of the bailout causing housing prices to spiral downward like the existing plan.

In the end…

It’s all about

money.