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Adelson & Jacob Consulting, LLC
The Sub-prime Mortgage Situation:
Causes and Lessons
Mark Adelson Adelson & Jacob Consulting, LLC
New York State Bar Association
Derivatives & Structured Products Law Committee
ABN AMRO, 49 East 52nd Street, 5th Floor, NY, NY
Wednesday, 13 February 2008
Adelson & Jacob Consulting, LLC
2
Agenda
The context of the situation
What is a sub-prime mortgage?
Basics of origination and servicing
Measures of mortgage loan credit risk
Understanding ABS deal structures
Cash flow triggers, sequential vs. pro rata distributions
Performance outlook, uncertainty, and challenges
Public policy initiatives
13 February 2008
Adelson & Jacob Consulting, LLC
Fed Funds Target Rate, NASDAQ Composite Index, and
Annual Rate of U.S. Home Price Appreciation
3 13 February 2008
Source: Federal Reserve, Yahoo
0
2
4
6
8
10
12
14
16
1990 1992 1994 1996 1998 2000 2002 2004 2006
Fed Funds Target Rate (%)
NASDAQ (1990=1)
U.S. HPA (%)
Adelson & Jacob Consulting, LLC
U.S. Mortgage Originations
4 13 February 2008
Source: Inside Mortgage Finance, Mortgage Bankers Associations
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.01990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008P
2009P
($ t
rilli
ons)
Adelson & Jacob Consulting, LLC
U.S. Public Home Equity ABS Issuance
5 13 February 2008
Source: Moody's, Bloomberg, Asset Securitization Report
0
20
40
60
80
100
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
($ b
illio
ns)
0
100
200
300
400
500
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
P
Adelson & Jacob Consulting, LLC
Insured Portion of U.S. Home Equity ABS Issuance
6 13 February 2008
Sources: Asset-Backed Alert Database (insured portion), Moody's, Bloomberg, Asset Securitization Report
0%
20%
40%
60%
80%
100%1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Insu
red P
ort
ion
0
100
200
300
400
500
Issu
ance
Vo
l ($
bill
ion
s)
Insured Portion
Issuance Volume
Adelson & Jacob Consulting, LLC
50
100
150
200
250
300
350
400
450
2001 2002 2003 2004 2005 2006 2007
Sp
rea
ds (
ba
sis
po
ints
)
0
30
60
90
120
150
180
210
240
Issu
ance
($
bill
ion
s)
SF CDO Issuance
ARM BBB- Spread
ARM BBB Spread
Fixed BBB Spread
Home Equity ABS Yield Spreads over Swaps/LIBOR and
Annual Structured Finance CDO Funded Issuance Volume
7 13 February 2008
Source: JPMorgan
Adelson & Jacob Consulting, LLC
Sub-prime Performance (12/2007)
8 13 February 2008
Source: Moody's
Adelson & Jacob Consulting, LLC
Sub-prime Performance (12/2007)
9 13 February 2008
Source: Moody's
Adelson & Jacob Consulting, LLC
10
The ABS "Home Equity" Euphemism
In securitization, "home equity loan" means any loan
secured by residential real estate other than
1. prime-quality, first lien mortgage loans
2. manufactured housing loans
Types of "home equity" loans include:
sub-prime mortgage loans (biggest category)
second lien mortgage loans (traditional home equity loans)
home improvement loans
HELOCs
"high LTV" mortgage loans
Reperforming and non-performing loans (sometimes)
13 February 2008
Adelson & Jacob Consulting, LLC
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The Sub-prime Mortgage Market in Context
Collateral
Cre
dit R
ep
uta
tion &
R
epaym
ent
Capacity "A"
traditional
seconds
HELOCS High
LTV
sub-prime
M
13 February 2008
Adelson & Jacob Consulting, LLC
12
Sub-prime Mortgage Loan Basics
Usually either
Delinquent in past 12 months
FICO below 620
Common features
high DTI
low or no reserves
no escrows
no MI if LTV over 80
hybrid ARM 2/28 or 3/27 (>80%)
limited documentation
investor properties.
Delinquency Odds by FICO®
0%
5%
10%
15%
20%
25%
30%
580 620 660 700 740 780
Source: Realestateabc.com
13 February 2008
Adelson & Jacob Consulting, LLC
Other Old Definitions
Prime Loans
Conforming in all respects to
standard Fannie/Freddie
program criteria
Typical features
Clean payment record: 0x30x12
LTV ≤ 80% or with MI
DTI ≤ 28% inside, 36% outside
Full documentation
Reserves and escrows
Owner occupied
Alt-A Loans
Borrower has clean credit
But … one or more of
LTV > 80% w/o MI
temporary resident alien
non-owner occupied property
high DTI
high LTV w/ other factors (e.g.
cashout)
less than full documentation
13 13 February 2008
Adelson & Jacob Consulting, LLC
14
New Definitions
Spectrum of quality
Prime: top ~70%
Alt-A: next: ~15%
Sub-prime: bottom ~15%
New non-traditional products complicate classification
Option ARMs
Interest-only
Hybrid ARMs
Piggy-back seconds
Stated income to W-2 borrowers
Risk layering !!!
13 February 2008
Adelson & Jacob Consulting, LLC
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Origination Basics
Originate to sell
Generate profits on origination
Underwriting criteria
Pricing tiers, rate sheets
Underwriting "matrix"
doc level pay history FICO/LTV grid max loan amount & DTI
product type pay history doc level/property type grid max LTV & size
Exceptions
documented (e.g., LTV upgrades for good pay history but weak FICO)
undocumented
13 February 2008
Adelson & Jacob Consulting, LLC
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Origination Basics (cont.)
Channels
Retail
Wholesale – correspondents, brokers
Origination process – quality control, staffing, risk
modeling, pricing, strategy
Pedigree – performance history of the originator's loans
13 February 2008
Adelson & Jacob Consulting, LLC
17
Measures of Mortgage Loan Credit Risk
Traditional view: 3 "C"s
Collateral – loan-to-value ratio (LTV)
Credit – credit score (FICO)
Capacity – debt-to-income ratio (DTI)
Other factors
13 February 2008
Adelson & Jacob Consulting, LLC
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Measures of Mortgage Loan Credit Risk (cont.)
Modern (Fannie Mae) view:
Primary risk factors (Part X, §, 3.01)
Equity investment (LTV)
Credit history (FICO score)
Contributory Risk Factors (Part X, § 3.02)
Liquid financial reserves
Employment classification
Mortgage term (15, 30, 40)
Product type (FRM, ARM, hybrid, etc.)
Property type (SFR, condo, 2-4)
Transaction type (PMM, RTR, CO)
Co-borrowers
DTI ratio
Previous delinquency
Previous bankruptcy
13 February 2008
Adelson & Jacob Consulting, LLC
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Loan Documentation – Common Permutations
Documentation Type
Fu
ll or A
ltern
ativ
e
Docu
me
nta
tion
Reduced Documentation
No R
atio
No D
oc (N
INA
)
Sta
ted
Inco
me
Sta
ted
Asse
ts
Sta
ted
Inco
me
/
Sta
ted
Asse
ts
No In
co
me
No A
sse
ts
Income Disclosed
Source of Income Verified 1
2
Amount of Income Verified
Qualifying Ratios Calculated from Income
Assets Disclosed
Assets Verified
1 "No Income" loans usually have a verbal verification of employment (VVOE) 2 "No ratio" loans rarely (but sometimes) have a VVOE
13 February 2008
Adelson & Jacob Consulting, LLC
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Processing & QC: Automation
Pros
Speed
Certainty
Convenience
Consistency
Cons
False precision
Invites manipulation
G.I.G.O.
Misses nuances
13 February 2008
Adelson & Jacob Consulting, LLC
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Example – Appraisals
Regular Appraiser Automated Appraiser
13 February 2008
Adelson & Jacob Consulting, LLC
Example – FICO® Score
Includes
Payment history 35%
Outstanding debt 30%
Credit history length 15%
Pursuit of new credit 10%
Credit mix 10%
Excludes
Income
Employment
Collateral
Address
Age
Sex
Race
Religion
Marital status
22 13 February 2008
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When Things That Seem
Alike Really Aren’t
HEL/B&C Underwriting Guidelines
Description of delinquencies
Debt-to-income ratio
13 February 2008
Adelson & Jacob Consulting, LLC
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Description of Delinquencies
Jan
$1,000
Feb
$0
Mar
$1,000
Apr
$1,000
May
$1,000
Jun
$1,000
Which history suggests more risk?:
Jan
$1,000
Feb
$0
Mar
$2,000
Apr
$1,000
May
$1,000
Jun
$1,000
13 February 2008
Adelson & Jacob Consulting, LLC
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Description of Delinquencies
As of June 1, the borrower is:
120 days delinquent one time (1x120)
30 days delinquent four times in a row (4x30)
30 days delinquent once on a “rolling” basis (1x30)
Jan
$1,000
Feb
$0
Mar
$1,000
Apr
$1,000
May
$1,000
Jun
$1,000
Borrower’s payment history:
? 13 February 2008
Adelson & Jacob Consulting, LLC
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Debt-to-Income Ratio
Income
Regular job
Investment income
Second job
Home business
Gifts
Debt
Fully indexed rate
Teaser rate
Included debts
13 February 2008
Adelson & Jacob Consulting, LLC
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HEL ABS Deal Structure – Tranching
0
20
40
60
80
100
0 20 40 60 80 100
Pool Losses
Tra
nch
e L
osse
s
BBB A
AA AAA
Assets
13 February 2008
Adelson & Jacob Consulting, LLC
28
HEL ABS Deal Structure – Cash Flow
Senior-sub, O/C (not like prime MBS six pack)
Sequential / pro-rata / reverse sequential, with triggers
Spreadsheet examples
0 12 24 36 48 60 72 84 96 108 120
A Prin. M Prin.
B Prin. Residual
13 February 2008
Adelson & Jacob Consulting, LLC
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Performance Uncertainty
Resets for 2006 vintage in 2008 and 2009
HPA outlook – wide range of views
Interest rates levels
Availability of credit
Models running outside range of their development
samples
Emotional and psychological factors
13 February 2008
Adelson & Jacob Consulting, LLC
Policy Initiatives
Non-traditional Mortgage Products (71 Fed. Reg. 58609, 10/4/06)
interest-only loans and option ARMs
must qualify at fully-indexed rate
avoid collateral dependent loans (unsafe & unsound)
Sub-prime Mortgage Loans (72 Fed. Reg. 37569, 7/10/07)
must qualify at fully-indexed rate
making loan based on collateral rather than borrower's repayment
ability may be a "predatory" lending practice
Reg Z proposal (73 Fed. Reg. 1671 1/9/08)
must consider ability to repay
must verify income
must collect escrows
restrict prepayment penalties
30 13 February 2008
Adelson & Jacob Consulting, LLC
Policy Initiatives (2)
FHASecure Program
Economic Stimulus Act of 2008 (HR 5140)
Mortgage Forgiveness Debt Relief Act of 2007 (Pub. L. No. 110-142)
Mortgage Reform and Anti-Predatory Lending Act of 2007 (H.R. 3915 12/3/07)
Home Ownership Preservation and Protection Act of 2007, (S. 2452 12/12/07)
Emergency Mortgage Loan Modification Act of 2007 (H.R. 4178 11/14/07)
State actions
Hope Now Alliance
ASF streamlined loan modification framework
31 13 February 2008