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The Rise and Fall of the U.S. Mortgage and Credit Markets Wednesday, April 29, 200911:00 AM -
12:15 PM
Moderator: Rick NewmanChief Business Correspondent, U.S. News & World Report
Speakers:
James Barth,
Senior Finance Fellow, Milken Institute; Lowder
Eminent Scholar in Finance, Auburn University
Alan Boyce, CEO, Absalon; President, Adecoagro
Barry Eichengreen, George C. Pardee
and Helen N. Pardee
Professor of Economics and Political Science, University of California, Berkeley
Glenn Yago, Director of Capital Studies, Milken Institute
2
Overview
Factors that contributed to credit boom and
bust•
Lax monetary policy and global imbalances
led to low interest rates•
Reach for yield, reliance on short-term wholesale funding
for relatively illiquid assets, small cash buffers, and risky/substantial leverage
•
Financial innovation,
such as securitization that weakened lending standards (e.g., mortgage originators) and credit default swaps that increased inter-connectivity (e.g., AIG), transferred risk broadly to others
•
Opacity
due to complexity of financial instruments (e.g., CDOs), riskier collateral for securities (e.g., subprime mortgages), heavy reliance on credit rating agencies, and over-
the-counter trading of credit default swaps•
Procyclicality
of regulation
(capital requirements) and mark-to-market accounting, which contributed to forced asset sales and deleveraging
•
Lack of a procedure
to deal with deeply troubled big banks and non-bank financial institutions (too big to fail or too strategically important or too inter-connected)
•
Incentive/compensation system
that encouraged excessive risk taking, and poor corporate governance
•
Public policy: gaps in regulatory structure and inconsistent asset management
strategy•
Flight to safety
due to uncertainty of asset values and solvency of financial institutions (hoarding of liquidity and/or calls for more collateral)
3
Overview of the housing marketTotal value of housing stock = $18.3 trillion
Note:
total residential and commercial mortgages = $14.6 trillion at year-end 2008.Sources: Federal Reserve, Milken Institute.
Equity in housing stock$7.8 trillion
Mortgage debt $10.5 trillion Prime
92.7%
Subprime7.3% Securitized
60%Non-
Securitized40%
Government-controlled
48%
Privatesector-
controlled52%
4
The mortgage problem in perspective
Note: The data is at year-end 2008.Sources: U.S. Census, Freddie Mac, Mortgage Bankers Association, Milken
Institute.
25 million or 31% are paid off80 million houses
55 million have mortgages 49 million or 89% are paying on time
6 million are behind11% of 55 million with 3% in foreclosure
This compares to 50% seriously delinquent in the 1930s.
5
Home price bubble, credit boom and bust
Low interest rates, credit boom and bust
Sources: Inside Mortgage Finance, Mortgage Bankers Association, Moody’s Economy.com, S&P/Case-Shiller, Milken Institute.
US$ trillions
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
2001 2002 2003 2004 2005 2006 2007 20082.5
3.0
3.5
4.0
4.5
5.0
5.5
6.0
1-Year ARM mortgage rate
(right axis)
Home mortgage
originations (left axis)
Percent Index, January 2000 = 100
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
2001 2002 2003 2004 2005 2006 2007 200850
75
100
125
150
175
200US$ trillions
Home mortgage
originations (left axis)
S&P/Case-Shiller National Home
Price Index (right axis)
6
All states had home price increases
From 4Q 2001 to 4Q 2006
Sources: Moody’s Economy.com, Milken Institute.
United States = 43%
7
Forty-seven states had home price declines From 4Q 2006 to 4Q 2008
Sources: Moody’s Economy.com, Milken Institute.
United States = -19%
8
One year ago… Six years ago…
If you bought your house…
% change in price, January 2008-2009 % change in price, January 2003-2009Sources: S&P/Case-Shiller, Milken Institute.
-4.9-5.1-5.2
-7.3-8.2
-9.6-14.0-14.3
-15.0-16.4
-19.0-19.3-19.4
-20.4-22.6
-23.3-24.9
-25.8-29.4
-32.4-32.5
-35.0
DallasDenverClevelandBostonCharlotteNew YorkPortlandAtlantaSeattleChicagoComposite-20 WashingtonComposite-10MinneapolisDetroitTampaSan DiegoLos AngelesMiamiSan FranciscoLas VegasPhoenix
35.333.3
23.718.4
15.412.312.0
10.610.6
7.93.23.02.7
0.0-1.0
-2.0-4.6-4.9
-6.6-12.4
-13.3-32.9
PortlandSeattleNew YorkWashingtonLos AngelesCharlotteTampaComposite-10MiamiComposite-20 ChicagoLas VegasBostonPhoenixDallasDenverSan DiegoAtlantaClevelandSan FranciscoMinneapolisDetroit
9
Las Vegas housing market
Source: James Barth and Harris Hollans.
0
50
100
150
200
250
300
350
1994 1996 1998 2000 2002 2004 2006 2008 Q3
US$ thousands
0
10
20
30
40
50
60
70
80Median home sales price (left axis)Flips/total transactions (right axis)Foreclosures/total transactions (right axis)
Percent
10
Percentage of homes purchased between 2004 and 2008 that now have negative equity
Sources: Zillow.com, Milken Institute.
United States = 41%
11
Leverage ratios of selected financial firms December 2008
9.3
10.6
11.1
31.6
26.2
21.5
67.9
0 10 20 30 40 50 60 70 80
Credit unions
Commercial banks
Saving institutions
Brokers/hedge funds
Federal Home Loan Banks
Fannie Mae
Freddie Mac
Leverage ratio, total assets/common equity
Note: Leverage ratios for
Freddie Mac and Fannie Mae are as of June 2008. The two institutions have negative common equities as of December 2008.Sources: FDIC, FHL Banks Office of Finance, National Credit Union Administration, Freddie Mac, Fannie Mae, Milken Institute.
(June 2008)
(June 2008)(June 2008)
12
Too much dependence on debt?
Leverage ratios at biggest investment banks
2219
28 26
18
31
19
2724 23
33 32 3431
13
33 34
2422
13
0
5
10
15
20
25
30
35
40
Morgan Stanley Merrill Lynch Bear Stearns Lehman Brothers Goldman Sachs
2000 2005 2007 2008
Total assets/total shareholder equity
March 2008
June 2008
Sources: Bloomberg, Milken Institute.
13
Too much dependence on debt?
Leverage ratios at bank holding companies
Sources: Bloomberg, Milken Institute.
13
17
1311
19
14 13 13 12 1310
13
0
5
10
15
20
25
Citigroup Bank of America JPMorgan Chase
2000 2005 2007 2008
Total assets/total shareholder equity
14
Balance sheet information on FDIC-insured institutions
Sources:
FDIC, Milken Institute.
0
5
10
15
20
25
1992 1994 1996 1998 2000 2002 2004 2006 20080102030405060708090
Percent Percent
Equity capital-to-asset ratio (right axis)
Cash-to-asset ratio(left axis)
Deposits-to-asset ratio (right axis)
Insured deposits-to-asset ratio (right axis)
Borrowed funds-to-asset ratio (left axis)
15
Reserve coverage ratio of
all FDIC-insured institutions
Sources: Quarterly Banking Profile, FDIC, Milken Institute .
0
50
100
150
200
250
2005 2006 2007 2008020406080100120140160180200
US$ billions Percent
Noncurrent loans (left axis)
Loan-loss reserves (left axis)
Coverage ratio (right axis)
16
The mortgage model switches from
originate-to-hold to originate-to-distribute
Sources: Federal Reserve, Milken Institute.
Household mortgage debt2008=$10.5 trillion
Held in portfolio40%
Securitized60%
Household mortgage debt1980=$958 billion
Held in portfolio89%
Securitized11%
17
The rise and fall of private-label securitizers
Outstanding securities
Sources: Inside Mortgage Finance, Milken Institute.
26%
55%
6%
13%
1985Total = $390B
39%
14% 18%
29%
2001Total = $3.3T
33%
35%7%
25%
2006Total = $5.9T
37%
27% 9%
27%
2008Total = $6.8T
Ginnie Mae Freddie Mac Fannie Mae Private-label
26%
55%
6%
13%
1985Total = $390B
39%
14% 18%
29%
2001Total = $3.3T
33%
35%7%
25%
2006Total = $5.9T
37%
27% 9%
27%
2008Total = $6.8T
Ginnie Mae Freddie Mac Fannie Mae Private-label
18
S&P Total Downgraded Downgraded/ TotalAAA 1,032 156 15.1%AA(+/-) 3,495 1,330 38.1%A(+/-) 2,983 1,886 63.2%BBB(+/-) 2,954 2,248 76.1%BB(+/-) 789 683 86.6%B(+/-) 8 7 87.5%Total 11,261 6,310 56.0%
56 percent of MBS issued from 2005 to 2007 were eventually downgraded
Sources: Inside Mortgage Finance, Milken Institute.Note: A bond is considered investment grade if its credit rating
is BBB-
or higher by S&P. The data is downgraded through October 2008.
19
When is a AAA not a AAA?
Multilayered mortgage products
Sources:
International Monetary Fund, Milken Institute.
Origination ofmortgage loans High-grade CDO
Senior AAA 88%Junior AAA 5%
Pool of mortgage AA 3%loans: prime or subprime A 2%
BBB 1%Unrated 1%
Mortgage bonds
AAA 80%AA 11%A 4% Mezzanine CDO
BBB 3% CDO-squaredBB-unrated 2% Senior AAA 62%
Junior AAA 14% Senior AAA 60%AA 8% Junior AAA 27%A 6% AA 4% CDO-cubed…
BBB 6% A 3%Unrated 4% BBB 3%
Unrated 2%
20
National banks State commercial and savings banks
Federal savings banks
Insurance companies
Securities brokers/dealers
Other financial companies, including mortgage
companies and brokers
• Fed• OTS
• OCC• FDIC
• State bank regulators• FDIC• Fed--state member commerical banks
• OTS• FDIC
• 50 State insurance regulators plus District of Columbia and Puerto Rico
• FINRA• SEC• CFTC• State securities regulators
• Fed• State licensing (if needed)• U.S. Treasury for some products
• OCC• Host county regulator
• Fed• Host county regulator
• OTS• Host county regulator
Federal branch
Foreign branch
Limited foreign branch
Fed is the umbrella or consolidated regulator
Primary/secondaryfunctionalregulator
Notes:Justice Department: Assesses effects of mergers and acquisitions on competitionFederal Courts: Ultimate decider of banking, securities, and insurance productsCFTC: Commodity Futures Trading CommissionFDIC: Federal Deposit Insurance CorporationFed: Federal ReserveFINRA: Financial Industry Regulatory Authority GSEs: Government Sponsored Enterprises OCC: Comptroller of the CurrencyOTS: Office of Thrift SupervisionSEC: Securities and Exchange Commission
• Federal Housing Finance Agency
Fannie Mae, Freddie Mac, and Federal Home Loan Banks
Financial, bank and thrift holding companies
Justice Department• Assesses effects of mergers and acquisitions on competition
Federal courts• Ultimate decider of banking, securities, and insurance products
Sources: Financial Services Roundtable (2007), Milken Institute.
The U.S. regulatory regime: In need of reform?
commercial banks
21
How far do home prices have to fall?
Average = 100
Sources: Moody’s Economy.com, Milken Institute.
60
80
100
120
140
160
1981 1988 1995 2002 2009
OFHEO
Case-Shiller: 20-metro
Case-Shiller: 10-metro
Case-Shiller National
Price/rent
60
80
100
120
140
160
1981 1988 1995 2002 2009
OFHEO Case-Shiller: 20-metro Case-Shiller: 10-metro Case-Shiller National
Price/disposable income per capita
22
Alternative measures for the affordability of
mortgage debt for California
Mortgage payment assumptions:
* Home is purchased at median price
* Buyer takes out a 30-year
conforming, fixed-rate loan
* Payment also includes 1% property
tax per year, 0.1% property
insurance
Sources: Moody’s Economy.com, Milken Institute.
20%
30%
40%
50%
60%
70%
80%
2000 2002 2004 2006 2008
Estimated monthly payment / monthly household income
100% LTV
Maximum affordablility limit is 38%of median household income
90% LTV
80% LTV
23
Overview
Government responses to liquidity freeze and credit crunch•
Government/private sector purchases of toxic assets•
Guarantees for selected assets and liabilities •
Capital injections into financial institutions•
Subsidization of loan modifications by financial institutions •
Debt for equity swaps•
Easier monetary policies, including lowering interest rates and quantitative/ credit easing
•
Coordinated responses by countries (e.g., central bank currency swaps)•
Establish an RTC-like agency (?)•
Create good banks, bad banks (?)•
Nationalize deeply troubled financial institutions (?)
24
Federal government comes to the rescue of Main Street and Wall Street
Upper limit to total funds under these programsUpper limit to total funds under these programs……$9.8 trillion plus ?$9.8 trillion plus ?
Federal Reserve 6,048
Congress and White House 2,466
Federal Deposit Insurance Corporation 926Treasury, Federal Deposit Insurance Corporation and Federal Reserve 362
Total amount dispersed/committed (US$ billions) 9,802
Source: Milken Institute.
25
Overview
Reforms to prevent/mitigate credit booms and busts•
Macro-prudential regulation
(i.e., establish a systemic risk regulator or market stability regulator)•
A liquidity regulation
to take into account maturity mismatches due to short-term funding of longer-
term, illiquid assets•
Countercyclical regulation
(e.g., dynamic capital and/or provisioning regulations)•
A regulation that internalizes (taxes) a financial institution’s contribution to systemic risk (to address too-big-to-fail issue)
•
Greater transparency
by requiring clearing and settling of credit default swaps to be conducted through clearing houses or on exchanges, which provides for greater monitoring of exposures and posting of necessary collateral
•
Change fee structure for credit rating agencies, eliminate the Nationally Recognized Statistical Rating Organization (NRSRO) designation, and decrease use of ratings in regulatory system
•
Consider eliminating treatment of residential mortgages as non-recourse loans (i.e., secured only by the underlying property), merging Freddie Mac and Fannie Mae, and requiring mortgage originators to have “skin in the game”
•
Consider modifying incentive/compensation systems
to discourage excessive risk taking•
Reform structure of regulatory system•
Consider establishing greater co-operation among regulators in countries or establish centralized
supervision or deposit insurer in some regions
26
•
Barry Eichengreen’s
slides
27
And not only here:
It is a global slump in industrial production
6065
7075808590
95
5 10 15 20 25 30 35 40 45 50
Ju ne 1929= 100 A pril 2008=100
100
28
Not only here:
Trade is collapsing faster than in 1929
60
70
80
90
100
110
5 10 15 20 25 30 35 40 45 50
Ju ne 1929=100 A pril 2008=100
29
Not only here:
It is a global stock market crash
30
40
50
60
70
80
90
100
110
5 10 15 20 25 30 35 40 45 50
Ju ne 1929=100 A pril 2008=100
30
Grading the policy response
•
Monetary policy: A-•
Fiscal policy: B+•
Housing policy: B+•
Banking policy: Incomplete
31
Even then there is no instantaneous fix
•
Vertical line in figure at left is date of major bank recapitalization.
•
It still takes two years after that for lending to recover even in the Swedish case that is the benchmark of how to do it.
•
It took a long time to get into this mess. Alas it will take a long time to get out.
32
We will become more heavily indebted, but we have no choice
CBO forecasts now suggest that the US debt ratio
will rise from 40 to 80 percent of
GDP.
33
This is roughly what happened in Finland and Sweden
•
In resolving their banking crises, their debt ratios similarly rose by 40% of GDP.
•
Of course, you can make progress later, bringing this ratio back down, through surpluses and growth (if you fix the banking system and then show political resolve)
34
This is not to deny that there will be medium term consequences
•
There will be crowding out of capital investment, not now but once the economy is firing on all cylinders again.
•
But my point is that there is little choice.
•
We have dug ourselves a deep hole. The cost of preventing growth from collapsing now will be somewhat slower growth for several years going forward (until we normalize the budget balance).
35
•
Alan Boyce’s slides
36
U.S. Non-Agency MBS market died
Note:
2000-2005 assumed straight-line for quarterly comparison
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
$140,000
1Q00
3Q00
1Q01
3Q01
1Q02
3Q02
1Q03
3Q03
1Q04
3Q04
1Q05
3Q05
1Q06
3Q06
1Q07
3Q07
1Q08
3Q08
MB
S Is
suan
ce ($
mill
ions
)
0%
10%
20%
30%
40%
50%
60%
Non
-Age
ncy
Issu
ance
/ To
tal I
ssua
nce
Prime
Subprime
Alt-ANon-Agency / Total
37
Which reduces risk of negative equityTypical homeowner scenario:
–Borrower pays $100,000 for a house with an 80% LTV, loan originated at par–
Agency Loan, housing prices have fallen 10% and FN 5% mortgage bond prices have fallen to 94
–
Non-Agency Loan, housing prices have fallen 30% and mortgage bond prices have fallen to 75 At Origination
House 100
Loan 80Equity 20
Agency Loan:
Housing Prices Down 10%
Non-Agency Loan:
Housing Prices Down 30%Principle
of Balance
House 70
Loan 60Equity
10
Change in Equity: -50%
Existing System
House 90
Loan 80
Equity
10
Change in Equity: -50%
Existing System
House 70
Loan 80
Equity -10
Negative Equity
Principle
of Balance
House 90
Loan 75
Equity
15
Change in Equity: -25%
38
First lossLoan Originator
10%
Down payment 20%
Guaranty from GSE
90%Value
ofthe
loan
Value
ofthe
house
Credit enhancement structure for shared platformProvided by Originator and/or MI industryExpected Capital reserves of 20% Backup capital and industry skill to be provided by MI Reinsurance Industry
AAA rating flows from GSE guarantee The value of the house will serve as collateral Bond holder looks to GSE for full faith and credit guarantyGSE looks to Originator remove bad loans from the pool
Originator purchases parri passu amount of bonds from pool at lower of market or parIf originator fails to perform, GSE can seize servicing rights and margin and reassign to another servicer