My subprime lending crisis primer

[Biggus Piggus]

Here's a timeline of the subprime debt disaster, based on the Wharton timeline with other details added by me.

1985-91: More than 1,000 S&Ls failed.  S&Ls had specialized in mortgages.  Consumer and commercial loans got them in trouble.  Deregulation allowed them to compete with banks for those loans.  Rising interest rates caught them off guard, as their risk management was ill suited for the new types of loans.  Taxpayers paid for most of the failures, which reduced banks' aversion to take risks.  In the next cycle, a new set of lenders was making mortgage loans.

1998: The Federal Reserve led a rescue of Long-Term Capital Management, a hedge fund that was getting killed in bonds.  The life preserver kept LTCM from dumping $3.6 billion in bonds onto the market.  This set another precedent of the government acting as lifeguard when financial institutions took on too much risk.

2000: Tech stocks peaked in March, starting a 2-1/2 year freefall.  In May the Fed began cutting interest rates.  The Fed's key rate had been 6.5%.

2001: The United States entered recession in March.  The Fed's key interest rate hit 1.75% in December.

2002: Annual home price increases hit 10% in California, Florida and the Northeast.  Long-term average was 3-4%.  Low interest rates brought more people into the market.  Home appraisers began to bow to pressure to support rising home values.  Also in 2002, Wall Street began to take over the role, traditionally served by government-sponsored Fannie Mae and Freddie Mac, and the FHA, of packaging loans into securities.  Federal standards required Fannie, Freddie and the FHA to verify borrowers' income and take 15-20% downpayments.  New private mortgage lenders, with a growing private market hungry to buy their loans, had no such legal strictures.  Wall Street firms created new forms of high-yield, mortgage-backed securities with the intention of getting investment grades on them from independent debt rating agencies.

This new lending structure insulated the mortgage underwriters from the quality of their underwriting.  They were selling the loans; what did they care after that?  Wall Street was reselling all the mortgages it could get.

2003: In June, the Fed's rate cutting cycle bottomed at 1%.  After Gulf War II began in March, the stock market broke out of its three-year decline.  In my view, money flows into real estate got a big boost from the stock market's troubles.  A stock market recovery was destined to reverse that trend.  Economists later estimated that two-thirds of the decade's runup in home prices was due to low interest rates.

2004: In June, the Fed began raising rates again.  This move increased the public's participation in extremely low-rate, adjustable rate mortgages.  In 2004, about one-third of new mortgages were adjustable rate; they had been 10% of the market in 2001.  Home prices were up more than 20%, and 25% in California, Florida and other hot markets.  Ironically, despite the public's "get 'em while they're hot" mentality, the interest rate rising trend meant that when the ARMs were ready to reset to market interest rates, many people would not be able to afford the higher payments. 

2005: This was the peak year of subprime lending, with 22% of new mortgages falling in that category.  Just two years before, only 8% of new home loans were subprime.  When the mortgage market slowed, loan underwriting standards hit bottom with some lenders requiring no downpayment, no proof of income, and offering ARM teaser interest rates far below where they would reset.  Option loans allowed borrowers to pay variable amounts from month to month, with any shortage being added to the loan balance.  Home prices began to flatten, falling sequentially in the second half of the year.  National Association of Realtors agent/broker membership grew 15% in the year, fastest since the organization opened membership to agents in 1975.

Meanwhile, with interest rates still low, banks, corporations and other investors began bidding up asset-backed securities as a way to earn more on their cash than traditional debt investments would yield.  Wall Street had succeeded in getting their risky debt instruments rated as "investment grade," which most institutional investors require to buy them.  CDO underwriting experienced wild growth in 2005-06.

2006: In June, the Fed's rate raising cycle ended at 5.25%.  National average home prices peaked in Q2.  In Q3, home foreclosures began to accelerate.  This was when people with ARMs should have refinanced into fixed-rate mortgages, but with rates at a relative high point most waited.  Those loans issued in 2006 were, on average, of extremely low quality and would enter foreclosure at an alarming rate.  National Association of Realtors membership peaked in October at 1.37 million, up 90% from 1997, while preexisting home sales fell 8% Y/Y. 

2007: In January, the largest markets saw Y/Y falling home prices.  More than 25 subprime lenders were in trouble or bankrupt by the summer.  Lenders began to tighten standards, making it hard for people with ARMs to refinance.  In August, financial institutions began taking losses on their mortgage-backed securities as the market for them collapsed, and investors in asset-backed securities began to move out of them into cash.  The Fed opened $100 billion to prop up banks and started to cut interest rates again.  A group of banks formed a $100 billion fund to provide a source of demand for mortgage-backed securities. 

In September, Realtor membership finally began to move contrary to seasonality, and by October it was down Y/Y.

By November, the Fed chipped in another $41 billion for banks to borrow.  The Q4 mortgage delinquency rate was 5.8%, highest since 1985, and a record 2% of loans were in foreclosure.  Adjustable-rate subprime loans were 7% of loans outstanding but 42% of foreclosures.  Another 20% were ARMs made to prime credit risks.  In December, the Fed created another mechanism to lend to banks/investors who wanted to swap their asset-backed securities for cash.

Q3 chargeoffs to recognize mortgage-related losses: $7.9 billion, Merrill Lynch; $4.4 billion, UBS (6x initial estimate); $3.4 billion, HSBC.

Q4 chargeoffs: $18.1 billion, Citigroup; $13.7 billion, UBS; $11.5 billion, Merrill Lynch.

2008: In March, J.P. Morgan works with the Fed to bail out Bear Stearns by buying the company for $2/share plus assumption of debt.  Fed guarantees $29 billion of credit to J.P. Morgan.  Q1 foreclosures were 650,000, up more than 100% Y/Y.  Fed interest rate cutting cycle likely bottomed in April at 2%.  FHA in June said it would lose $4.6 billion due to high default rates on home loans.  National Realtor count was 1.25 million in May, down 7% Y/Y.  That was the largest such drop since the 1990-91 recession.

[Biggus Piggus]

Thanks, PhillyHog, for the Wharton link btw.  The Web site has a popup timeline on which the above is based.

[Biggus Piggus]

I wanna say that the knee-jerk reaction would be to say that Republican deregulation of banking made this whole mess possible--the Wall Street-funded Internet bubble AND the Wall Street-funded mortgage calamity.

And I very much doubt that, had Republicans not sponsored the industry-sought idea of killing Glass-Steagall and other regs, the Democrats never would have thought of it.

But President Clinton and his New Dems went right along with the deregulation ideas.  Some Democrats in Congress can rightfully say they did not participate, but the heart of the party went along.

To me the crime was how they went about deregulating, pretty much opening the sluice gates rather than having any kind of new mechanism to check on what kind of business practices would go on in a deregulated environment.

The bubble made the SEC turn into a hardass, heavily business-unfriendly organization, and I suspect the same will have to happen to the FDIC.  Wouldn't be surprised to see a new kind of regulatory body emerge from this catastrophe.

Have to say this too, the hardening of the SEC (and the FDA too for that matter) took place under a Republican president (with an increasingly Democrat Congress, but the president kills what he doesn't like, and Congress has not the votes to override).  It's hard these days to paint anyone fairly with a political label.

[Oklahawg]

Thanks, Biggus. I am smarter.

[HotlantaHog]

The Federal Reserve had authority to regulate the subprime mortgage industry and chose not to. Ed Gramlich, a Fed governor, suggested in 2000 to Alan Greenspan that there was wild stuff going on in the mortgage industry, it was dangerous and perhaps the Fed should raise at least a mild alarm and take some action to avoid the worst abuses. Greenspan said, nah, let's not get involved. And as pointed out in the narrative, by cutting rates to 1 percent, he threw fuel on the fire.

http://www.nytimes.com/2007/12/18/business/18subprime.html

[Biggus Piggus]

The number of NAR members is down only 9% from its high, still more than 80% above the previous cycle low.  I wonder how many people are going to have to leave that business.

[Oklahawg]

http://www.motherjones.com/news/feature/2008/07/foreclosure-phil.html

A recent Mother Jones article talking about Gramm's role in this. I realize MJ is not typical fodder for investment types. A critique is encouraged.

[Biggus Piggus]

http://www.motherjones.com/news/feature/2008/07/foreclosure-phil.html

A recent Mother Jones article talking about Gramm's role in this. I realize MJ is not typical fodder for investment types. A critique is encouraged.

The story does a very sloppy job of trying to tie unregulated CDS's to the subprime calamity.

It's a real stretch.  Gramm-Leach-Bliley is better target practice.

CDS's may turn into a disaster of their own, because of the potential they have to magnify the significance of a default.

Hasn't happened yet.  Absolutely stupid for them to be unregulated, though.

[HognotinMemphis]

S&L's got into trouble in the late 80's/early 90's by borrowing short and loaning long at fixed rates. Greedy, dumbass bastards.

Anyone with a working brain saw this coming two years ago. Tell me again how "no doc" mortgage loans work? Getting an extra 50 basis points makes it safer for the lender? Hahahahahaha!

[PhillyHog]

I used to work at mortgage REIT in Philly that has since been delisted from the NYSE.

At work we were talking about the future of ARMs and fixed-rates.  A coworker told me that there was no way FRM would ever be prominent, as the CDO money would not be there for funding.  They were only interested in the profits offered by ARM.  That kind of thinking played a huge role in this mess.

Mortgages were no longer tools for getting people into houses but were raw material for greedy investors and the Wall Street underwriters that got fees for every deal they did.

[Masshog]

I almost got tired waiting for it to happen.  Started actually wondering if it was just me deluding myself (again) as underweight mortgage, financial, and anything related to mortgage bets failed to pay off.  I know a lot of really smart investor/trader types who just got worn out by their opinion and by management questioning what the hell they were thinking not participating.....   

[snoblind]

Good info.  I would add a couple of things.  At some point during the 90's (I don't have the article handy, but I can try to find the source) there was increased pressure from the government to increase the % of loans made to low income and minorities which contributed to relaxed standards in lending.  This also led to loans being made on properties and new construction in areas of cities that one could consider high risk.  The drumbeat of owning your own home drowns out the fact you don't own it as long as you are making mortgage

FHA loans only require 3% down not 10-15%.  The catch - the seller can pay the 3% for the buyer.  Another issue many cities have gift and grant programs which will pay all or part of closing costs and down payments.  So you have had many buyers over the past few years who couldn't write a $200-$500 earnest money check get into homes for $0.  For what it's worth I have noticed that every buyer I have come into contact with the past 6 months or so are going FHA under $200,000 with the exception of those who can get VA financing - no conventional loans.

I got into RE in 2004 so I speak as an "insider".  Multiple reasons for doing it at that time, but getting rich or easy money were not among them - but every day I think this is nuts and about going back to a real job, i.e. one with a steady paycheck.

I have written contracts for buyers that had no business buying a home.  So I guess if you want you can lump me in the greedy RE agent category, but you would be wrong.  More than once I asked, "are you sure you really want to this?" or "you understand if you get transferred/lose your job within a couple of years" there is now way you are going to come out of this without losing money.First the bank has already agreed to loan them the $ and if I didn't write the contract there were plenty of agents that would so I tried to counsel them the best I could, point out what could go wrong, and try to find them the best value for what they were spending.

I wrote the last paragraph to say this - the one part of the problem left out in the preceding posts were/are the buyers themselves.  To my knowledge no one held a gun to anyone's head to force them to buy a house.  The first group are those who don't have an understanding as to what they are agreeing to and what obligations they have to meet.  The second are investors/flippers who were out to make a quick buck.  Third, you have those who lied when applying for the no doc, stated income loan.
I have some sympathy for the first group, not the last two.

No question there are mortgage officers, appraisers, RE agents, and government officials who ought to be in jail after the fiasco of the past few years.

I will now step off the soap box...

[PhillyHog]

I am not trying to absolve the buyers of guilts, but I consider myself to be a fairly intelligent guy.  I was also the least educated on our trading desk. (I sat next to a MA from Stanford and a former Mechanical Engineer from China who had obtained an MA in Statistics and an MBA in the states).

But even we sometimes had difficulties defining the differences between various loan products when modeling.

Again I am NOT trying to cover-up for buyers bad behaviors such as lying about income and assets.  Shame on those people they know better.  But I do think that many people did not fully understand what they were getting into with recasts, negative amortization, LIBOR-and MTA-based floating rates.

Just my 2 pennies...

[snoblind]

Hey, Philly I didn't think you were...

Just seemed that no one had mentioned the buyers.  Like I said I'm a RE agent so I see the dark side of agents, builders, developers, etc.  You are correct about the products you mention - and I would bet my next commission check that most of the mortgage officers who sold them didn't/don't understand them either (I sure don't).  They were just trying to get the signature at the bottom of the page.

My counsel to buyers has always been if you cannot get the amount of the loan you want through a fixed rate product, you don't need to borrow that much.  In the case of an adjustable rate, make them give you a good faith estimate for the worse case scenario and how long before you can refinance (in writing).  If they can't or won't run like hades out the door and I will find you someone else.

I'm in Arkansas and since the prices here have not/are not as insane as in other parts of the country we didn't see a lot of the products you mentioned. 

[Ash]

snoblind you are absolutely right. everyone seems to want to absolve the buyer's of any guilt. it is their fault they didn't research and understand what they were doing before buying a house. it is shameful that we are going to push responsible taxpayers deeper into debt to bailout a bunch of folks who had no business buying the house they were in.

all this bailout will do is further distort the market and help hold RE prices at an unsustainable and unrealistic level.

[snoblind]

Here is an interesting take on why the government should be the bailout business.

http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2008/GCBF+July+2008.htm

Economics class was a long time ago for me so I will leave it those of you who understand this better than me to comment, but would I am interested to see what folks think about his view.