B ECON 420 Week 5

What problems existed with Mortgage-Backed Securities?

(1) AGENCY PROBLEMS --"OTD" model is subject to principal-(investor) agent (mortgage broker) problem --Borrowers had little incentive to disclose information about their ability to pay --Commercial and investment banks (as well as rating agencies) had weak incentives to assess the quality of securities (2) INFORMATION PROBLEMS

What caused the 2007-2009 Financial Crisis?

(1) Financial innovation in mortgage markets (2) Agency problems in mortgage markets (3) Role of asymmetric information in credit-rating (4) Housing prices bubble/burst

What caused the low interest rates which fueled the housing price bubble?

(1) Huge capital inflows into the US from countries like China and India (2) Congressional legislation that encouraged Fannie Mae and Freddie Mac to purchase trillions of dollars of mortgage-backed securities (3) Federal Reserve monetary policy which made it easy to lower interest rates

Stages of Financial Crises

(1) Initial Phase (2) Banking Crisis (3) Debt Deflation

Criteria Used to Measure Creditworthiness include

(1) Level of equity invested by the borrower (2) Borrower's income level (3) Borrower's credit history

Agency problems in mortgage markets

(1) Mortgage brokers didn't make a strong effort to evaluate the credit-worthiness of borrowers, because once they earned their fee, why would they care? Thus, ADVERSE SELECTION More volume = More money for boker (2) Commercial/investment banks also had weak incentives and could use risky financial instruments like financial derivatives and a credit default swap

Financial Crises are characterized by

-Declines in asset prices -Firm failures

Who was to blame for the financial crisis?

-Monetary policy -Mortgage originators -Credit-rating agencies -Financial institutions that packaged MBS -Institutional investors that purchased MBS -Financial institutions that insured MBS -Speculators of Credit Default Swaps

Explain how the credit crisis adversely affected many other people beyond homeowners and mortgage companies

-Mortgage insurers incurred expenses from foreclosures of the property they insured. -Individual investors whose investments were pooled by mutual funds, hedge funds, and pension funds and used to purchase MBS experienced loses. -Investors who invested in stocks of financial institutions experienced losses. -Several financial institutions went bankrupt, and many employees of financial institutions lost their jobs. -Financial institutions in other countries (e.g., the United Kingdom) had offered subprime loans, and they also experienced high delinquency and default rates

Financial innovations that emerged in the mortgage market

-Subprime mortgages -Mortgage-backed securities -Collateralized debt obligations (CDOs)

What happened with AIG during the 2007-2009 financial crisis?

-Suffered an extreme liquidity crisis when its credit rating was downgraded -AIG had written over $400 billion of insurance contracts (credit default swaps) that had to make payouts on possible losses from subprime mortgage securities -The Federal Reserve stepped in with a $85 billion loan to keep AIG afloat

Height of financial crisis

-Surging interest rates faced by borrowers led to sharp declines in consumer spending and investment -The unemployment rate shot up, going over the 10% level in late 2009 in the midst of the Great Recession

Fannie Mae / Freddie Mac funding problem

-With poor financial performance, Fannie Mae and Freddie Mac were incapable of raising capital -FNMA and FHLMC stock values had declined by more than 90 percent from the previous year.

Financial institutions as a result

-lost their funding, and some could not find anybody to buy them or to provide them with capital -were forced to sell their assets quickly -disrupted the financial markets

Describe how mortgage-backed securities are used.

A financial institution that purchases or originates a portfolio of mortgages can sell mortgages by packaging them and issuing mortgage-backed securities. The mortgages serve as collateral for the debt securities issued. The interest and principal payments on the mortgages are transferred (passed through) to the owners of the securities, after deducting fees for servicing.

What is a mortgage?

A mortgage is a form of debt to finance a real estate investment; the originator charges an origination fee when providing the mortgage The mortgage contract specifies: -Mortgage rate -Maturity (most 30-yr; 15-yr) -Collateral

AIG in financial crisis

AIG Financial Products Corporation (a division of AIG) used credit default swaps (CDS) to sell credit insurance to investors on complex financial instruments such as mortgage-backed securities, CMOs, CDOs (financial regulators were not overseeing the CDS) -For a premium, AIG was promising to make good if investors lost any money on CDOs. So AIG Financial Products Corporation was exposed to enormous losses when mortgages went bad.

How did the bankruptcy of Lehman Brothers reduce the liquidity of the commercial paper market?

Because Lehman relied on mortgage-backed securities (MBS) for collateral for its commercial paper, Lehman was forced into bankruptcy when its MBS values declined. As a result of Lehman's failure, investors became more concerned that commercial paper issued by other financial institutions might also be backed by assets of questionable quality.

Subprime Mortgage

Borrower does not quality for prime loan -Relatively lower income -High existing debt -Can make only a small down payment

Prime Mortgage

Borrower meets traditional lending standards

Commercial Paper Collateral

Commercial paper can be backed by assets (like MBS) of the issuer and offers lower yield than unsecured commercial paper

Blame: Financial institutions that packaged MBS

Could have verified the credit ratings assigned by the credit rating agencies by making their own assessment of the risks involved

What was the role of credit rating agencies during the 2007-2009 financial crisis?

Credit rating agencies rate the tranches of mortgage-backed securities based on the mortgages they represent. The rating agencies, which are paid by the issuers that want their mortgage-backed securities rated, were criticized for being too lenient in their ratings shortly before the credit crisis

Stage One: Initial Phase

Crises can begin the following ways: -Credit Boom/Bust -Asset-Price Boom/Bust -Increase in Uncertainty

Credit Boom/Bust

Economy introduces new types of financial products or eliminate restrictions on financial institutions, prompting financial institutions to go on a lending spree (CREDIT BOOM), which leads to overly risky lending This leads to losses, and fewer funds means fewer loans, so lending boom turns into lending crash

Why did Fannie Mae and Freddie Mac experience mortgage problems?

Fannie Mae and Freddie Mac purchased trillions of dollars of mortgage-backed securities. They made poor investment decisions by using funds to invest in many mortgages that involved high risk By 2008, many subprime mortgages defaulted, so Fannie Mae and Freddie Mac were left with properties (the collateral) that had a market value substantially below the amount owed on the mortgages that they held.

Increase in Uncertainty

Financial crises happen in high periods of uncertainty like just after the start of a recession, a crash in the stock market, or failure of a major financial institution

Asymmetric information problems are often described as

Financial frictions

Commercial Paper Placement

Firms place commercial paper directly with investors or rely on commercial paper dealers to sell their commercial paper

Yield on Commercial Paper

Higher than the yield on a T-bill with the same maturity because of credit risk and less liquidity

Housing Price Bubble

Hosing prices boomed, fueling the market for subprime mortgages and formed an asset-price bubble, which burst, then prices declined and led to defaults by subprime mortgage holders

Stage Three: Debt Deflation

If an unanticipated decline in price level occurs, firms' REAL net worth deteriorates further which creates an increase in asymmetric information problems (adverse selection/moral hazard)

Insured Mortgages

Loan is insured by the Federal Housing Administration (FHA) or the Veterans Administration (VA)

Conventional Mortgages

Loan is not insured by FHA or VA but can be privately insured

Blame: Speculators of Credit Default Swaps

Many buyers of CDS contracts on MNS were not holding any mortgages of MBS that they needed to hedge

How did banks use the criteria to measure creditworthiness before the great recession?

Many didn't even check income level or credit history

What were the effects of the declining housing prices on the debt market?

Many subprime borrowers found their mortgages "underwater" -- that is, the value was below the amount of the mortgage Defaults on mortgages shot up, leading to foreclosures on millions

Explain how mortgage lenders can be affected by interest rate movements. Also explain how they can insulate against interest rate movements.

Mortgage lenders that provide fixed-rate mortgages could be adversely affected by rising interest rates, because their cost of financing the mortgages would increase while the interest revenues received on mortgages is unchanged. The lenders could reduce their exposure to interest rate risk by offering adjustable-rate mortgages, so that the revenues received from mortgages could change in the same direction as the cost of financing as interest rates change.

What are Mortgage-Backed Securities?

Mortgages that are repackaged into securities

What is a financial crisis?

Occurs when there is a particularly large disruption to information flows in financial markets, resulting in financial frictions (asymmetric information problems) that increase sharply and financial markets which stop functioning

OTD for Mortgages

Once a mortgage is originated, banks must receive payments (principal and interest) and create securities (securitization) based on this -Banks can sell mortgages as securities -Use value of mortgage for collateral for securities and sell to investors

Asset-Price Boom/Bust

Prices of assets such as equity shares and real estate are driven well above their fundamental economic values, creating a bubble When bubble bursts and asset prices realign with fundamental economic value, companie see net worth decline and make more risky investments, which contributes to economic contraction EX: Tech stock market bubble, housing price bubble

Asymmetric Information & Credit-Rating Agencies

Rating agencies advised clients on how to structure financial instruments like CDOS, while rating them at the same time (i.e., CONFLICT OF INTEREST) Result = Wildly inflated ratings

Blame: Institutional investors that purchased MBS

Relied heavily on the ratings assigned to MBS by credit rating agencies without the due diligence of performing their own independent assessment.

Repurchase Agreements in recession

Rising concern about quality of financial institution's balance sheet and rising defaults on mortgages (which led to fall in value of MBS) led lenders to require larger amounts of collateral Thus financial institutions could only borrow half as much with the same amount of collateral -To raise funds, financial institutions had to engage in fire sales and sell off assets rapidly (lowering price), which lowered the value of collateral further (similar to bank runs during the Great Depression)

Commercial Paper

Short-term debt instrument issued by well-known, creditworthy firms that is normally issued to provide liquidity or to finance a firm's investment in inventory and accounts receivable. -Minimum denomination of commercial paper is usually $100,000. -Maturities are normally between 20 and 45 days but can be as short as 1 day or as long as 270 days. -Commercial paper does not pay interest and is priced at a discount from par value

Repurchase Agreements

Short-term loan that uses assets (like mortgage-backed securities) as collateral -One party sells securities to another with an agreement to repurchase the securities at a specified date and price -The most common maturities are from 1 day to 15 days and for one, three, and six months

Blame: Mortgage Originators

Some mortgage originators were aggressively seeking new business without exercising adequate control over quality

Stages of 2007-2009 Financial Crisis

Stage One: Housing Price Boom/Bust Stage Two: Run on the Shadow-Banking System Stage Three: Credit Crisis

How did the Great Depression occur?

Stage One: Stock Market Crash -Bubble in stock market (stocks were overvalued; it was too easy to borrow money) -Stock prices kept falling, increased uncertainty and worse adverse selection/moral hazard Stage Two: Bank Panics -One-third of US commercial banks failed Stage Three: Debt Deflation (gold standard) -Ongoing deflation led to 25% decline in price level, which greater indebted firms -Led to prolonged economic contraction

Why were subprime mortgages offered aggressively?

Technology made it easier to securitize subprime mortgages, which led to an explosion in subprime mortgage-backed securities

What were the effects of the declining housing prices on financial institutions?

The decline in prices led to rising defaults on mortgages. As a result, the value of mortgage-backed securities and CDOs collapsed, leaving financial institutions with deteriorated net worth This created financial friction in markets as they began to deleverage, sell off assets and restrict credit availability

Securitization

The pooling and repackaging of loans into securities -Securities are then sold to investors, who become the owners of the loans represented by those securities

AIG

The world's largest insurance company, but in fact a multinational financial services company

Stage Two: Banking Crisis

Tougher business conditions and deteriorated balance sheets which bankrupt certain financial institutions, leading to more uncertainty, bank runs, and greater asymmetric information (increasingly severe moral hazard/adverse selection)

Mortgage lenders with fixed-rate mortgages should benefit when interest rates decline, yet research has shown that this favorable impact is dampened. By what?

When interest rates decline, a large proportion of mortgages are refinanced. Therefore, the benefits to lenders that offer fixed-rate mortgages are limited.

Why did the housing bubble burst?

When interest rates increased, subprime mortgage loans stopped working because people couldn't afford new payments and defaulted

Blame: Credit-Rating Agencies

he rating agencies, which are paid by the issuers that want their MBS rated, were criticized for being too lenient in their ratings shortly before the credit crisis

Blame: Financial institutions that insured MBS

presumed, incorrectly, that the MBS would not default