1 of 22

Subprime Mortgage Loans

Chapter 10 Additional Slides

2 of 22

Subprime Mortgage Loans�BACKGROUND: Prior to Great Recession (2007)

Subprime lenders provide higher-rate mortgages to borrowers who do not qualify for loans from mainstream lenders usually because of low credit scores.
Many of the riskiest mortgages were made by independent, non-bank lenders (now bankrupt) not overseen by federal regulators.
18% of all loan originations in 2006 were hybrid Adjustable Rate Mortgages (ARMs).

3 of 22

Subprime Mortgage Loans

In 2006, 1.2 million foreclosure filings were reported nationwide, up 42% from 2005. (not outside some historical averages)
Subprime loans constituted just 13% of outstanding mortgages, but over 60% of foreclosures.
Subprime lenders generally made hybrid ARMs without considering whether the borrowers could afford the loans past the initial teaser year.

4 of 22

Subprime Mortgage Loans

Holders of adjustable rate mortgages were more likely to be delinquent than those with fixed rates.

Teaser rate ARMs and other “exotic” adjustables so buyers could afford more house.
Payment shocks of 18% to 48% occurred.

5 of 22

Subprime Mortgage Loans

Subprime borrowers:

Financially stretched already - - loans were commonly underwritten to 50% to 55% debt-to-income ratios (traditional ratios are 30% to 33%).
In 50% of the cases, lenders used stated rather than documented income (stated income exaggerated 90% of the time.)
Many lenders failed to escrow property taxes and hazard insurance..

6 of 22

Subprime Mortgage Loans

Effect on minorities and poor:

More than half of the home loans made in 2005 to African American families were subprime loans,
40% of loans to Latin American families were subprime loans.
By contrast about 20% of loans made to white families were subprime loans.

7 of 22

Subprime Mortgage Loans

Economic risks (written before collapse):

Glut of housing
Slow-down in new construction
Negative wealth effect
Fewer loan options for many
Fed, more focused on inflation and not possible recession, will not want to cut interest rates.

8 of 22

Subprime Mortgage Loans

9 of 22

Banking, Leverage, and Financial Instability

Leverage is the use of borrowed money to magnify profits and losses
Modern banks use lots of leverage

A 10% return on investment can become a 100% return using leverage

Thus small losses can drive banks into insolvency

Lobbyists have successfully fought efforts to have banks reduce leverage

10 of 22

The Financial Crisis of 2007 and 2008

Mortgage Default Crisis
Many causes

Government programs that encouraged home ownership
Bad incentives provided by mortgage-backed bonds
Declining real estate values

LO5

14-10

The causes of the financial crisis of 2007-2008 are still being debated, but most authorities feel that the mortgage default crisis was a key component. Most banks and regulators had mistakenly believed that the innovation known as “mortgage-backed securities” had eliminated most of the bank’s exposure to mortgage defaults. Mortgage-backed securities are bonds backed by mortgage payments. It was thought that this was a smart business decision as these mortgage-backed securities transferred any future default risk on those mortgages to the buyer of the bond, instead of the bank. Unfortunately, the banks took the money that they received for the bonds and loaned it to other investors, and once the defaults started, it was like a house of cards. Once one card was removed, the whole house collapsed.

Visit http://crisisofcredit.com/ for a great video explanation.

11 of 22

The Financial Crisis of 2007 and 2008

Securitization- the process of slicing up and bundling groups of loans into new securities
Credit Default Swaps – Insurance on bonds

Started in late 1990’s
Grew to $60 trillion by the end of 2007

As loans defaulted, the system collapsed
“Underwater” homeowners abandoned homes and mortgages

LO5

14-11

12 of 22

The Financial Crisis of 2007 and 2008

Failures and near-failures of financial firms

Countrywide: second largest lender
Washington Mutual: largest lender
Wachovia

Other firms came close

General Motors

LO5

14-12

13 of 22

The Financial Crisis of 2007 and 2008

LO5

14-13

14 of 22

The Financial Crisis of 2007 and 2008

Troubled Asset Relief Program (TARP)

Treasury Department
Allocated $700 billion to make emergency loans
Saved several institutions from failure

AIG, Citibank, Bank of America, JPMorgan Chase, Goldman Sachs, GM, and Chrysler

LO6

14-14

15 of 22

The Financial Crisis of 2007 and 2008

The Fed’s lender-of-last-resort activities

Purchased AIG in September, 2008
Primary Dealer Credit Facility
Term Securities Lending Facility
Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility
Commercial Paper Funding Facility

Money Market Investor Funding Facility
Term Asset-Backed Securities Loan Facility
Interest Payments on Reserves

LO6

14-15

16 of 22

After the Great Recession

Slow recovery especially in terms of employment
Zero interest rate policy
Zero lower bound problem
Quantitative easing
Forward commitment
Operation Twist

LO6

To help stimulate the economy after the Great Recession, the Fed implemented the zero interest rate policy, quantitative easing, Operation Twist and forward guidance. Under the zero interest policy, the Fed aimed to keep short-term interest rates near zero to stimulate the economy. When growth remained weak the Fed had to find a way to deal with the zero lower bound policy under which a central bank is constrained in its ability to stimulate the economy through lower interest rates since you cannot have a negative interest rate. Their next response was quantitative easing which is similar to open-market operations but is not intended to lower interest rates but rather stimulate increased lending. In the second round the Fed engaged in forward commitment, preannouncing exactly how much it was going to buy. This continued until the Maturity Extension Program, better known as Operation Twist, was introduced in September 2011. This program was designed to reduce long-term interest rates.

17 of 22

18 of 22

$$ Money Trivia $$

19 of 22

$$ Money Trivia $$

What is the largest denomination of currency printed today?
What is the average life of a $1 bill?
a $50 bill?
a $100 bill?

20 of 22

$$ Money Trivia $$

The Bureau of Engraving and Printing, a Division of the US Treasury, prints Federal Reserve Notes in denominations of $1, $2, $5, $10, $20, $50, and $100.
Since 1946, no $500, $1,000, $5,000, and $10,000 denominations have been printed.
The average life of the $1 bill is 18 months. The $50 and $100 bills—handled less often—have average lives of 5 and 8 years, respectively.

21 of 22

$$ Money Trivia $$

Beginning in 1934 all U.S. paper currency was inscribed with “The United States of America Will Pay to the Bearer on Demand One [Five, Ten, etc.] Dollar [s] in Lawful Money.”
In 1964 the inscription was replaced with “This Note is Legal Tender for Debts, Public and Private.”

22 of 22

$$ Money Trivia $$

The Federal Reserve estimates that only 3/100ths of 1 percent of total currency in circulation is counterfeited. Authorities seize about 75 percent of all counterfeited money before it is circulated.
If you accept a counterfeit bill, you are stuck with the loss. Don’t try to pass a known counterfeit bill to someone else, or you can be fined up to $5,000.
As long as you present what is clearly more than one-half a bill, a bank will accept it for deposit or replace it. The bank then sends the bill to a Federal Reserve Bank, which destroys it and issues another bill in its place.