Financial crisis
Why was there no big increase in foreclosure rate before the great recession?
Because homes were typically in positive equity because people who didn't have the income to pay could sell their house and then pay off mortgage
CDO
Collateralized debt obligation. Type of security often composed of the riskier portions of mortgage-backed securities
Default
Your mortgages move into default when you fail to make three or more payments
Negative Amortization Loan
loan to allows a borrower to make monthly payments that do not fully cover the interest payment, with the unpaid interest added to the principal of the loan
Alt-A
loans made to borrowers with strong credit scores but which have other characteristics that make them riskier than prime (between subprime and prime) ♣ Limited or no documentation, investor owned property, low down payment - high LTV
Agency MBS
mortgage back security issued by a government sponsored enterprise, such as federal national mortgage association, Freddie, Frannie
Subprime
mortgage loans made to borrowers with relatively poor credit histories
Money market mutual funds
mutual funds that invest in short-term safe debt; a low-return liquid and safe place for investors to put their money
Market responses to bank runs
o 1. Suspend convertibility: temporarily halt withdrawals o 2. Interbank market: borrow from other banks
How large of an asset are homes for the middle class
o 25% of asset makeup for all households o But makes up 62% of assets for middle class o Only 7.1% for top one percent have more of their wealth in stocks, business equity, etc. o Next 19% it is 25.6%
Policy responses to bank runs
o 3. Deposit insurance o 4. Lender of last resort o 5. Confidence fairy
Concerns with teaser rates
o But concern that borrowers didn't understand the terms or put too much weight on short term costs relative to long-run costs ♣ Bucks and Pence found that borrowers understood broad terms of their mortgages but 35-40% of ARM borrowers didn't understand complex features - how much their rates could rise each year ♣ More vulnerable groups less likely to know their terms
One way the bank can still make money off of maturity transformation ...
o Buy GSE MBS - guaranteed so produced from credit risk, which means you don't have to hold as much capital o Note that the banks pay a g-fee as part of the purchase to fund the guarantee o All good as long as the GSEs don't go under (which requires that they price the g-fees right, don't take on too much from other activities)
How did run and run like events occur as the financial crisis unfolded?
o Credits began to doubt the solvency of an entity so they withdrew funds o To maintain leverage ratios, financial entities had to sell assets o Often assets were sold into illiquid markets inducing a loss spiral Also, ABCP outstanding fell and investors (MMF) stopped buying ABCP
What are the risks associated with homeownership?
o Default on payments - having bad credit score o Housing is not diversified - you are betting on a single neighborhood, unlike with stocks and bonds where you can buy them in different industries, countries, etc. The return on your home will be correlated with the performance of your local economy
Different reasons that home prices can rise:
o Economic factors - cost of capital, supply and demand, low interest rates o Bubble - people are willing to pay a certain price because they believe the price in the future will be higher o Asset price - ♣ infinitely live ♣ today pays dividend d ♣ d is expected to grow at g rate ♣ Alternative asset yields r% / year ♣ Value of asset today = d / r-g ♣ Small changes in r or g can lead to be value changes
Early stages financial policy response:
o Encourage banks to use discount window o But banks didn't really do this because they didn't want their creditors to find out because they were worried the creditors would cut lending o Then fed cut the discount rate and pressed larger banks to start borrowing - banks still didn't really borrow o Fed term auction facility - reduce stigma and banks were willing to borrow
What are the benefits associated with homeownership?
o Financial returns - investment o Tax benefits o Deduct property taxes o Homeownership as a savings commitment mechanism o Homeownership protects you from bad landlords - 18% of renters had difficulty getting landlords to fix problems
What 6 factors helped set up the economic crisis?
o Greater financial opportunities for households o The great moderation o Limited household income growth o Downtrend in the long-term interest rates o Long period of low bank losses o Migration of credit and risk outside of banking sector
A second way banks can still make money off of maturity transformation ...
o Hold PLS, CDOs in a SIV o Bank holding company sets up the SIV o SIV buys PLS, CDOs with the intent to hold them to security o SIV gets money by issuing ABCP (normally to money market mutual funds) against securities o Credit rating agencies have rated the ABCP to assure buyers they are getting what they want o When the ABCP comes due, SIV pays it off by taking out more ABCP ("rolling over") o The SIV profits because the return on long-term asset (CDO, PLS) is greater than the interest on ABCP o Return goes back to banks through the charging of fees o Banks don't have to hold as much capital if it holds these risk assets off balance sheet o All good as long as the SIV can keep rolling over the ABCP at reasonable rates which requires the underlying mortgage assets not to be reassessed as very risky
What are the positive externalities associated with subsidizing homeownership?
o Homeowners keep their home in better shape - increasing the value of neighboring homes o Children growing up in owners occupied dwellings do better o Homeowners are better citizens - they vote more o However, evidence as to whether there are casual relations between homeownership and these outcomes is view as weak o If homeownership facilitates wealth accumulation and financial security, then promoting homeownership may lead to less spending through social insurance programs (i.e. older households will be less likely to turn to Medicaid to pay long-term care costs)
How do banks facilitate the sharing of risk?
o Investors: can share the risk that their projects will fail with the saver who provided the funds o Savers: may be willing to accept these risks for the prospect of a higher return than they could earn otherwise
Why were F&F the big buyers of subprime and Alt-A loans?
o Subprime mortgages had higher returns o F/F had affordable housing goals, but also higher expected returns on their portfolio - policy had them finance some share of their housing on low-moderate income households
What are the negative externalities associated with subsidizing homeownership?
o Subsidizing homeownership is not just about subsidizing an asset class; it is also about subsidizing single-unit living, which tends to be away from the urban core o The way we subsidize homeownership promotes people living in larger homes o Leads to more energy use, causes road congestion, reduces other efficiencies and benefits associate with people living in cities
Traditional bank model
o Take in deposits o Use deposits to make mortgage loans
What can explain borrowers, lenders and investors exposing themselves to so much risk?
o The bubble was the main driver - the misguided belief that home prices wouldn't fall (and maybe go higher)
How do banks channel funds from savers to investors?
o Through financial markets - i.e. the stock market through which savers directly provide funds for investment o Through financial intermediaries - allow savers to indirectly provide funds for investment (via creation of credit) o Why financial intermediaries are so important: ♣ Borrowers have a wide range of needs - both businesses (expand, fund operations) and households (invest in education, to make bigger purchases) ♣ Savers have a wide range of goals - in terms of the return they want, the risk they are willing to take, and the time horizon for saving ♣ It would be very inefficient to try to match borrowers with savers in the absence of a financial system - matching borrowers to savers makes sure that scarce capital is allocated to its most efficient use
How is US homeownership rate versus other countries?
o We are not at very low end, but also not at very high end o Somewhere in the middle
Who accounted for the defaults?
o Zip codes where people tended to have low credit scores and typically low income were also the ZIP codes that saw the biggest increases in mortgage defaults o In absolute terms, the increase in defaults was biggest in low-income ZIP codes BUT in proportional terms, the increase in defaults in high-income zip codes was just as great or greater
credit repair mortgages
o allowed nonprime borrowers to make low payments, improve credit score, refinance into prime loan with lower rate
Teaser rates
o hybrids where rate was fixed for 2-3 years at some low level and then rose by 2 or more points Sometimes marketed as credit repair mortgages
Non-bank mortgage originators
rocket mortgage; these companies make loans and then sell them to someone else
tranches
securities that were ordered according to their priority in receiving distributions from the pool
Loan Securitization
securitization is the practice of pooling together loans and then selling the cash flow from the loans (the interest and principle payments) to financial investors as a security Pooling loans lowers the risk for the people buying the security / supplying the funds for the loans (i.e. investors) - if one loan defaults the package should still be worth something
ABCP
short term borrowing - CP is collateralized by financial assets
Bank run
the bank doesn't have enough funds to meet depositor withdrawals So then it needs to sell illiquid assets, possibly in a fire sale, in which case it won't receive full value, increasing the odds the banks cannot meet redemption requests and fail
Commercial banks and thrifts
(depository institutions) o More heavily regulated than other financial intermediates in their activities o Required to hold more capital - put in more of their own money when accumulating assets, lower leverage (but less return to capital)
Federal housing administration
- ensures low-down payment mortgages as a way of facilitating homeownership for low income family and first-time buyers
Was this a subprime crisis?
-Lending to lower-income households did not account for the bulk of the run up in mortgage debt -Subprime share of defaults shrank during the boom -More foreclosures among prime borrowers -researchers show that the largest counties with the largest home price booms had the largest declines in the subprime share of purchase mortgages
How did the great moderation contribute to the great recession?
-The great moderation was a period of reduced volatility in economic activity between mid 1980s and 2000s -Many components of GDP were also less volatile like consumption, investment, national income, etc. - Research suggests that factors that contributed to the great moderation were: o Better monetary policy o Improved inventory management o Lower sensitivity of the economy to oil-price shocks o Financial innovation
How were there changing attitudes about housing, risk, and debt around the time of the great recession?
-View that housing was an easy way to build wealth -attitude world was safer than it was, deregulation, lax supervision, outdated regulation -Less stigma toward having debt
What are the three critical roles of financial institutions?
1) Channel funds from savers to investors 2) Facilitate the sharing of risk 3) mitigates the effects of asymmetric information:
What were vulnerabilities in shadow banking
1) High leveraged 2) reliance on short term funding 3) Didn't have backing of government
What are the two methods of Cash-out refinancing?
1) people often refinance their fixed-rate mortgage because interest rates have fallen and they can save on their mortgage payments 2) They can also refinance to extract some of the equity that they have built in their homes (either through home price appreciation or by paying down their mortgages) -With a cash-out refinancing, you take out a new mortgage that is larger than your old mortgage, use some of the proceeds to pay down your old mortgage and you keep the rest this is a good option if interest rates are low -Example: you had a mortgage of 100K, you take out a new mortgage of 150K and use some of it to repay whatever's left from the first mortgage you had, and then you get the rest as cash when in need of quick equity -You only want to do this when interest rates are low, because you need to repay that second big mortgage and it wouldn't make sense to take out a bigger mortgage if the interest rate is higher than on your initial mortgage
Fixed rate mortgages
interest rate fixed for entire term and borrower required to make a series of equal payments
Synthetic CDO
A CDO that holds credit default swaps that reference assets, allowing investors to make bets for or against those referenced assets
Adjustable-rate mortgage
interest rate specified in terms of a margin above some index, adjusts at regular rate
CDS
A type of credit derivative allowing a purchaser of the swap to transfer loan default risk to a seller of the swap. The seller agrees to pay the purchaser if a default event occurs.
originate-to-hold model
Before the 1970s, banks and S&Ls originated mortgage loans to the households and generally held them until they were repaid
Ruthless/Strategic default:
Borrowers default only because the value of their home has declined well below their mortgage (they default even though they can afford to make their payments) o Even assuming some later recovery in prices, it doesn't make economic sense to keep owning the home because prices won't recover enough such that they earn sufficient return on their investment o Example: You bought a house for $300K, put down $50K and took out a mortgage of $250K. House prices go down to 100K. You could either just default and lose your 50K, or you could pay back your $250K mortgage (+interest) and then sell the house for 100K, losing 200K ($300K-$100K). Smarter to just default.
Love risk?
Buy the lower tranches with higher scheduled payments but subject to being reduced if underlying mortgages defaulted
Hate risk?
Buy the top tranches, which had lowered scheduled payments but you were highly likely to get them
Investment banks
issue securities, can serve as broker and dealers, trade for their own accounts o Securitized loans, create PLS and CDO
What are harmful foreclosure-related outcomes for families?
Credit scores become damaged harder to get new credit to buy another home, to smooth consumption, higher rates on loans you do get, harder to get new apartment, credit scores sometimes required on job applications but empirical evidence that this effect isn't significant Credit score recovers over time but very slowly because people who have been foreclosed upon go delinquent on other debts because life is just financially harder - don't have credit card to use when car breaks down, so you can't go to your job, etc. etc. Displacement
What were people using the extracted equity for?
Evidence suggests homeowners used extracted equity to fund consumption
Derivative
Financial contract whose price is determined (derived) from the value of an underlying asset, rate, index, or event. E.g., futures, options, swaps
the originate-to-distribute model
Growth in securitization starting in the 1970s led the mortgage system to shift from depository based funding to capital markets based funding
How did downtrend in long-term interest rates contribute to the great recession?
In a low interest rate environment ... o Investors will generally be willing to take on more risk as they search for yield
Home equity lines of credit (HELOCs)
just take out loans against your house, better to do if interest rates are high, as it is less than taking out another whole mortgage which would be bigger and costlier to take out
Example of a SIV
Investment bank borrows money from the money market and issues them commercial paper (promise) to repay them in 90 days. Then the investment bank uses this money to buy long-term assists, like mortgage backed securities. However, if the MBS defaults or people don't repay their mortgages when they are supposed to, then the investment bank won't have the money to pay back the money market after 90 days. This is an example of the issuance of short-term liabilities to fund long term assets (i.e. bank taking deposits to fund mortgages)
How did greater financial opportunities for households contribute to the great recession?
New technologies developed in the decades preceding the crisis, along with some types of deregulation meant that: o More households had access to credit o Interest rates were lower o Households who already had access could get larger loans Credit was cheaper and easier to get Credit score allowed banks to assess risk and base interest rates off that - more risky --> higher interest rate, and they would give riskier loans since they felt that they could price the risk accurately Also, the shift towards automation meant that the costs of originating loans declined, resulting in a decline in the cost of credit (the interest rate) for borrowers Loan securitization
Libor
Lending rate among banks
SIV
legal entities set up by bank holding companies that held mortgage related securities
PLS
Private-label (or non-agency) mortgage-backed securities. Sponsored by a private company rather than a government sponsored enterprise, such as Fannie Mae or Freddie Mac.
What happened to refinanced loans in the years leading up to the recession?
Refinance loans increased greatly in 2003 - occurred because interest rates had dropped
The community reinvestment act
Required banks to make loans available in low income, minority communities
credit supply view
The credit supply view of the US housing boom argues that the expansion of subprime credit was a key driver of the bubble
funding liquidity risk
The maturity mismatch associated with short term funding creates funding liquidity risk - this is the risk that a financial institution will not be able to raise the cash to meet demand from depositors withdrawing their money
What is the biggest homeownership tax expenditure?
The mortgage interest deduction (MID) o If you itemize, you get to deduct your mortgage interest payments up to some threshold from your taxable income
Network effects - counterparty risk
The risk that the party on one side of the contractual agreement won't fulfill its obligations o Multiple counterparties can restrict funding for financial institutions through network effects o Bank A may be reluctant to provide funding to bank B because it knows bank B is also doing business with bank C
delinquent
You become delinquent when you fail to make payments
Repurchase agreement
a different way to effectively do short borrowing using the securities that you own - you sell some securities but have an agreement you will repurchase them at some a later date
Commercial paper
a form of bond, short-term uninsured debt; only want buy CP from a high quality rating institution if you're a money market mutual fund since there is no collateral
Emergency lending under section 13(3)
allowed fed to lend to any individual, corporation, etc. in unusual exigent circumstances provided the borrower is unable to secure adequate credit accommodation from other banking institutions hard because didn't have much experience using this tool, didn't have resources to channel liquidity outside traditional banking section, risk adverse
Credit Default Swaps
are contracts insuring against the default of a particular bond or tranche - if you're worried about bonds defaulting, you can buy CDS • But you need to pay a fee if the bond doesn't default •And you get a payment in the event the bond default
Double trigger model
borrowers default on a mortgage only if they have both negative equity and an income shock How do you get here? Costs of damaged credit record, fear of lender coming after you for more money, costs of moving, moral obligation, you really like your home
Displacement
costs of moving, more difficulty getting to job, negative impact on health, children who switch schools may perform more poorly
Credit ratings agencies
created rating indicating the risk of securities for use by people wanting to buy them
ABS
debt instruments secured by assets such as mortgages, credit car loans or auto loans
deposit insurance
guarantees that a bank's depositors will be paid even if the bank can't come up with the funds, up to a maximum amount per account - shadow banks don't have this
AIG, other insurers
provided insurance on securities or tranches of securities, including by being the counter-party on credit default swap
Hybrids mortgages
rate is fixed for some period then starts to adjust
Shadow banking
refers to bank-like financial activities conducted outside the traditional banking system ... shadow banking activities are more lightly regulated than banks, lower capital requirements
discount window
through which eligible banks could borrow on a short term basis to address shortages of liquidity
FHA loans
traditionally the most common path for riskier borrowers to get mortgages o Made by private lenders o Borrowers typically low and moderate income, often with weaker credit histories, smaller down payments o The FHA provided insurance on these loans; Ginnie Mae securitized these loans
Fire sale
when a financially distressed institution sells goods or assets into an illiquid market, leading to heavily discounted prices relative to their fundamental value
repurchase agreement
with repo, a firm borrows money to fund its activities by selling a collateral asset today and promising to repurchase at some later date
Is homeownership a diversified investment
you are betting on a single neighborhood, unlike with stocks and bonds where you can buy them in different industries, countries, etc.
Frannie and Freddie
• Bought mortgages as a way of creating more liquidity in the mortgage market • They funded these purchases either by issuing bonds or by securitizing mortgages into guaranteed MBS • Guarantees meant that payments continued even if underlying mortgages went bad •Created a perception that GSE debt had the backings of the federal government o Known as an implicit subsidy - allowed GSEs to borrow at lower interest rates than other big financial institutions • This allowed GSE to dominate the market and to accumulate huge portfolios of risk mortgage portfolios
maturity transformation
♣ the issuance of short-term liabilities to fund long term assets (i.e. bank taking deposits to fund mortgages) - if you can't get funding "rolled over" and keep it going then you risk not having enough liquidity to meet depositor demands
How did migration of credit and risk outside of banking sector contribute to the great recession?
• Credit market debt outstanding by holders other than banks increased - i.e. insurers, GSEs, ABS, Money market mutual funds all borrowing debt • Banks and non-banks are different in that banks have certain protections for their depositors, resolution process when bank fails • Banks more heavily regulated than other financial entities • The migration meant that there was more risk-taking generally • And more risk-taking outside of the banking system where panics and runs are more likely ♣ The pre-crisis regulatory regime was not designed to deal with the migration of credit and risk outside of the financial system
How did limited household income growth contribute to the great recession?
• Stagnant income growth in lower and middle parts of the US • Measures of middle class income growth exclude taxes and transfers • Middle growth was a lot less than the top growth • Top 1% - income was up 240% • Why might limited income growth matter for households? o According to standard theory, utility is just a function of absolute consumption o So households should be better off with any increase in their consumption even if limited But what if utility is a function of consumption compared with some benchmark? o Like your neighbor's consumption o Or yesterday's consumption o Or your expectations for consumptions given how fast your parents' consumption grew -Government was happy to reward constituents wealth in form of home-ownership if income couldn't increase
How did a long period of low bank losses contribute to the great recession?
• There had been a nearly 70-year quiet period in American finance • The decade long period of financial stability created a false sense of strength
Negative equity
• when asset value is less than the loan amount
Benefits of greater financial opportunities for households?
♣ Increased credit means lower borrowing costs - easier to smooth consumption ♣ Easier to buy a home, start a business ♣ Easier to refinance your mortgage to take advantage of a drop in interest rates or to get cash out ♣ Allowed households to skip buying a starter home and go right to the home consistent with lifetime income ♣ Financial innovation also had benefits on the asset side of the balance sheet - households had access to the stock market via mutual funds
How did subprime and Alt-A mortgages became riskier over time
♣ Loan to value ratio went up to 100% ♣ Loans with piggyback loans went up
Costs of greater financial opportunities
♣ Net financial opportunities also allowed households to choose to take more risk in pursuit of higher utility ♣ You might borrow to fund lots more consumption if you think your income is going to increase ♣ You might borrow to buy riskier assets
How is homeownership a financial investment? How does it compare to renting?
♣ Real prices rise over time on net ♣ Large low-frequency fluctuations ♣ But the average return isn't that high - average annual return for last 60 years is only .7% ♣ However, this perspective ignores many features of the real world like the tax benefits of homeownership, costs of maintenance, transaction cost of buying a home ♣ Thought experiment: What if you bought a house in 2002 and sold it in 2016? How would you fair financially compared with renting and investing the down payment you would have used in something else? ♣ How to test this: Take the net cash flow benefit (saving rent and getting tax deduction minus the cost of maintenance, property taxes, improvements and mortgage payments) and capital gains (less transactions costs) as a fraction of your down payment to calculate an internal rate of return • IRR on home without tax benefits - 10% • IRR on home with tax benefits - 14% • Apartment index after tax - 9% • S&P 500 index - 5.9% • Bond index - 2.8% ♣ Take away: you get return on investing in and buying a home than you would if you rented and invested down payment in the S&P 500 index or bond index ♣ However, depends on when and where you bought your home ♣ Unless homebuyers can correctly time when and where they buy a home, there is no guarantee the return on investment from buying a home will do better than other investments
How does Homeownership act as a savings commitment mechanism?
♣ We know from behavioral economics that many people find it difficult to save and are not very responsive to traditional saving incentives ♣ A house is a commitment device that makes it easier or more automatic to save ♣ Limited share of workers has access to a workplace retirement saving plan that could serve as a savings commitment mechanism - a house is an alternative savings commitment mechanism because you have to make the down payment and you save as you pay down mortgage principle through your monthly payments ♣ You can get your money out through a home equity line of credit, cash-out refinancing, or selling your home (but there is a cost of doing so)
structured investment vehicle (SIV)
♣ shadow bank's off-balance funds that use of short term liabilities to fund long-term asset ♣ Designed to profit from the difference between lower short-term and higher long-term interest rates ♣ SIVS were funded by short-term asset backed commercial paper so bank holding companies profited from the spread between the rates of ABCP and the mortgage securities
