Category Archives: Subprime

2008’s new fad: “rating cliffs” and “credit cliffs”

Do you know what will be all the rage in 2008 in the wake of the subprime crisis? “Rating cliffs” and “credit cliffs” when firms that have seen a slow erosion of their credit will all of a sudden drop like a stone. As I devoted a whole chapter to the subject back in 2003 when drawing some lessons from Enron’s demise, I decided to revive it for your enlightenment. Here it is from
Paul Jorion, Investing in a Post-Enron World, McGraw-Hill, 2003.

Chapter 13: The perils of cliffs

Once upon a time, a company named Enron was a utility, of sorts. It owned pipelines, and fuels flowed through them. It thought of itself as a utility, and more or less behaved like one.

Then, in August 1999, Enron started trading contracts on future delivery of energy. A psychological shift accompanied the strategic shift. Enron began thinking of itself as a financial company. This was gratifying, because it meant the company had moved into the fast lane – where the drama, excitement, and money were. Goodbye to the plodding old days of being a regulated utility; hello to the Big Time.

One of the most successful divisions of Enron, it turns out, was a hedge fund called ECT Investments. “The hedge fund, the brainchild of Enron’s former chief executive officer, Jeffrey Skilling, did quite well,” according to a report in The Wall Street Journal, “averaging annual returns of more than 20% after it was launched in 1996. In that period, the Dow Jones Industrial Average had returns of 11%. The hedge fund’s gains amounted to as much as 8% of Enron’s overall earnings in recent years. . . ”

But the transformation to a financial company also meant that Enron became susceptible to all the fragilities to which financial companies are vulnerable. One of the most pernicious of these is the Confidence Factor: How much confidence do your clients and shareholders have in you today? How much will they have tomorrow? Absent a Three Mile Island-type disaster, the Confidence Factor doesn’t vary much for a utility. But it bounces all over the place for a high-flying financial company, especially if the main financial product that the company is trading in is its own stock.

The business depended, in large part, on the stock being constantly on the rise – or at least not losing value. The reason was leverage, which has the unpleasant capacity to go from positive to negative overnight. Enron was perched on the edge of what Standard & Poor’s calls a “credit cliff,” meaning that any drop in its credit rating would materialize in a deterioration of its debt, leading in no time to a further downgrading. Although Enron’s financial health was an exercise in brinkmanship, what actually brought it down in just over six weeks was little more than a glitch, which on its own merits should have been survivable. The rest, as its former CEO would say, was only a “run on the bank.”

So the point of this chapter is to help you, the investor, understand and recognize a credit cliff, as well as its equally daunting sibling, a “rating cliff.” I’m confident that when you spot a company living on these cliffs, you’ll decide to stay away.

Continue reading 2008’s new fad: “rating cliffs” and “credit cliffs”

The subprime crisis and the future of securitization

Echanges is a financial journal published monthly by DFCG, the French association of financial officers and auditors. I was asked by Jean-François Casanova who will be the editor of a special issue devoted to securitization to contribute a piece on securitization in the light of the subprime crisis. Here it is, in an English translation.

Has securitization played a role in the subprime crisis and in the
credit dislocation that followed? If not, did securitization emerge unscathed from the turmoil where the role it played has been rightly or wrongly questioned? These are two valuable questions that need to find an answer.

Securitization’s primary aim is that of creating for vast collections of debts of a relatively low dollar amount, a new debt instrument behaving like a classical bond tradable on a fluid secondary market. Liquidity is supposed to follow although in the absence of a true organized market with a clearing house and market makers this may amount to wishful thinking. Lacking securitization, an individual mortgage will be parked within a “held for investment” portfolio until maturity. Securitization seemed to have changed once and for all the rules of the game until the recent crisis emphasized that the existence of a reliable secondary market remained problematic for all Residential Mortgage-Backed Securities (RMBS) among which Mortgage-Backed Securities backed by “prime” mortgages granted to the
most creditworthy borrowers and Asset-Backed Securities backed by “subprime” granted to borrowers with a spotted credit history.

An RMBS is exposed to risk in a double manner: firstly, because of the potential default of each of the individual borrowers of one of the thousands of individual mortgages that are packaged into an RMBS and, secondly, because of possible prepayment of the loan. Although the latter doesn’t materialize in a true loss, it still impairs the security’s profitability because of the opportunity cost of those interest cash flows that will fail to materialize. In theory securitization allows dispersion of risk between a large number of investors. Alan Greenspan used to underline an additional factor: that risk is now optimally distributed among those best able to bear it. This year’s events have undermined such certainties. It turned out that, first, if securitization does indeed allow in principle to redistribute risk it is far from clear if such dispersion has truly occurred or whether, conversely, concentration has taken place within a restricted number of portfolios; second, while risk has no doubt migrated to those investors who intentionally chose to bear it, there is no guarantee that any of them valuated that risk correctly. Belong no doubt to that second category, all those investors who acquired Asset-Backed Securities backed by subprime mortgages for the only reason of their high yield, with little worry of how permanent the credit arbitrage of that high yield would remain, as it was clearly not sheltered from switching all of a sudden from a profitable situation of risk over-valuation to a hurting one of under-valuation. The real estate bubble bursting led as we know to such a reversal of circumstances.

To assume, as did Alan Greenspan, that the capacity securitization holds for dispersing risk would automatically materialize in its optimal distribution entails some degree of naivety. It amounts indeed to imagining that those who purchase these high yield securities intend to manage them conservatively “for the long haul.” One would have expected that a keen insider such as Chairman Greenspan would not have subscribed to the layman’s view of speculation as a pathological condition rarely encountered among market participants but rather as the markets’ essential component that it is in truth. It was of course the crucially speculative nature of these securities – due to a circumstantial credit arbitrage opportunity – that would lead Asset-Backed Securities to end up concentrated within the hands of a selected number of entities(insurance companies; pension funds; hedge funds; foreign banks) betting that such an arbitrage would persist, instead of getting “statistically” scattered among their optimal stakeholders.

Add another dimension, this time internal to the security’s machinery: the confidence held by the structurers of ABS in their ability of fully concentrating risk in the junior certificates of these securities so to exclude it entirely from the senior ones. From that trust derives its corollary that loans exposed to serious default risk could nonetheless be used as innocuous “stuffing” within CDOs (Collateralized Debt Obligations) assigned top rating. Such trust rests on the multipliers used in the stress tests of these securities’ credit enhancement structure, i.e. the waterfall reallocating cash flows from the subordinate certificates to the senior ones. The value of these multipliers is supposedly supported by statistical argument; e.g. Standard & Poor’s common “stress test” assumption that the probability of a loss 4.5 times higher than the highest historical loss is close to zero. There is in truth nothing to back that assumption which betrays a fatally flawed understanding of statistical inference, i.e. that the frequencies observed in a time-series of arbitrary length can be extrapolated as probabilities when the phenomenon observed is undoubtedly by nature cyclical (or at least unstable) as it is the case with Housing Price Appreciation.

Some have also debated the role played by securitization in severing the link between a lender’s financial responsibility and the individual loans finding their way into an RMBS. Fingers have been pointed at FASB 140 in particular as it allows recording an immediate gain on sale at securitization, encouraging therefore issuers to ignore how well-equipped a borrower is when paying interest and refunding principal over a number of years. Lenders relaxed underwriting standards as Wall Street’s capital markets showed infinite willingness to accept loans whatever the quality of both collateral and borrower. What lenders lost sight of in such a forgiving climate was that on the long term, quality only would
guarantee the survival of an active market for the product. Greenspan and others had envisaged that the man-in-the-street would represent the typical RMBS investor. What the crisis revealed was that RMBS investors would instead be savvy experts in their field, well-aware of risks incurred, who would briskly withdraw from the market as soon as the credit arbitrage had vanished. This is indeed what happened at the end of 2006 when foreclosures shot up as the real estate bubble burst
and the price of housing started to dive. The new context was one where the default risk premium in an ABS’ coupon would this time be under-evaluated.

Answering thus the first question: did securitization play a role in
the subprime crisis and in the credit crunch that followed?

The answer to that question is far from clear-cut. Let’s recap: MBS securitize mortgages where a portion of the coupon is risk-based and represents a premium reflecting – supposedly adequately – the default risk embodied by the individual borrower. If that premium is calculated in such way that a full business cycle has been encapsulated, there will necessarily be an alternation of times when there exists for the investor a potential credit arbitrage – as the risk premium is then over-valuated – and other times where the arbitrage will be absent – as the risk premium is then under-valuated. During periods of the first type, securities will be attractive due to the presence of such an arbitrage while in periods of the second type they will not. During the latter, the product’s appeal lies in the effectiveness of its credit enhancement: i.e. in the robustness of the waterfall redirecting cash flows from the junior certificates to the senior ones. Should that structure then be deficient, the product would lose its appeal and its market would dry up in no time – as the events of August 2007 convincingly confirmed.

As such, securitization is therefore not to blame in the subprime crisis. What is at stake however is an RMBS’ capacity at being at all times in the real estate’s business cycle a valuable product for both issuer and investor. To meet these ends, an RMBS needs to be correctly structured.

Second question, this time in reverse: what is the future of Residential Mortgage-Backed Securities and more particularly of Asset-Backed Securities backed by subprime mortgages; are they likely to survive the crisis they are undergoing this year?

The teaching is straightforward: RMBS’ future is linked to the product getting immunized against the hazards of the real estate’s business cycle. Credit scoring reflects correctly the idiosyncratic differences between individual borrowers (and to that extent it ranks them satisfactorily) but it has no power for expressing the impact on their credit behavior of a full business cycle. This turns out to be a major defect of any credit scoring of individual consumers like with the all-pervasive FICO score. The scoring system turns out to be unable of assessing objectively the risk that the borrower imposes on the lender as the score conflates within a single number a consumer’s credit ability, the good health of the real estate sector as well as that of the global economy. To that extent, embedding in a mortgage’s note rate a risk premium reflecting mechanically a credit score will fail to ensure that a credit arbitrage is maintained for the security at all times in the business cycle. Should this difficulty reveal itself as being unsolvable, a different credit enhancement structure would be called for, possibly fully external as with insurance or a Letter of Credit. Residential Mortgage-Backed Securities‘ viability would then be determined by the capacity of insurers in that specialized field to absorb the shocks resulting from alternating phases of the business cycle. Recent news about the financial health of the companies occupying that niche is not particularly encouraging in that respect.

The ABS and Uncle Sam

Mr. Paul Schulten is asking me the following:

“It is true that delinquencies and losses in residential mortgage backed securities (RMBS) are strongly correlated with home price appreciation (HPA) or in the current environment home price depreciation (HPD).
As we enter a period of possible decline in home prices these losses accumulate first to the lowest rated tranche in an MBS or ABS security and subsequently in order to the next highest rated tranches. Those in the lowest rated tranches, the b piece, have presumably already experienced some discomfort if not some losses on their investment.
My question for you would be how far up the capital structure do you think losses will go? Will a single A investor incur losses? Does a triple A investor have reason for concern? Also, have the rating agencies done an adequate job in rating these securities? Specifically, a triple A security should carry a risk equivalent to that of US government debt. Is this the case or have the rating agencies misapplied their ratings and a triple A RMBS actually carries more risk than its supposed government security equivalent.“

I’ll start with the question at the end: “Have the rating agencies misapplied their ratings and a triple A RMBS actually carries more risk than its supposed government security equivalent?”

The answer is yes, there is more risk for an RMBS “AAA” but no, the rating agencies are not to blame. The reason is that an AAA on a Treasury and on an MBS or an ABS don’t compare. They don’t compare because the guarantee mechanism is of a different nature: the guarantee on a Treasury is a promise: it’s Uncle Sam’s word backing an IOU: it’s Uncle Sam saying: “I will pay you back!” Of course not every government has stuck to its word the way Uncle Sam intends to: Russia has defaulted, Thailand has and so has Argentina, among others. But it’s safe to say that if Uncle Sam says that he will pay you back then, for the foreseeable future, he will indeed do so. It’s a question of reputation: there is too much reputational risk at stake for Uncle Sam to renege on his word. An MBS or ABS “AAA” is altogether another kettle of fish: it’s the outcome of credit enhancement which is a mechanical process and it’s understood that there’s a possibility, however remote, that it may not work: the investor is warned in the deal’s prospectus that the borrower may default (credit risk) or choose to prepay if interest rates get lower (market risk) and that this may impact the bond’s returns. How? I’m going to show you in a highly simplified RMBS in the table below.
ABS simulation
In the first column, I’ve put the various values that the cash flow can take: from $10 to $100. These extreme values for monthly cash flows are rare outcomes; the most commonly found are in the $50-$60 interval. In the second column, you’ll find the probability of the various outcomes. I’ve chosen them so they represent the normal distribution of random fluctuations around a central value (here $55): if you build a histogram on the Probability column, you’ll see that it approximates the bell-shaped curve of the normal distribution. The five next columns represent the five tranches in my deal: the three “senior”: AAA, AA and A and the subordinated parts, the “Junior” tranche and the residuals. The subordination principle is elementary: Residuals take first loss; Junior takes second loss; etc. With a cash flow of at least $60, each of the senior tranches receives the $20 they’re entitled to by the bond’s waterfall. With less than $60 they incur losses, starting with A.

The price for each tranche has been calculated in the classical way of probability theory introduced by Girolamo Cardano (1501-1576) in his Liber de ludo aleae: the sum of the possible outcomes, each of them times the probability of its occurrence.

My simulation is a very simple one and I was prepared to tweak it to make it comparable with what we’re talking about here. It turns out this is not even necessary. Indeed look at the table below where I’ve brought together the current prices for the ABX index, i.e. the way the market prices ABS backed by subprime mortgages. The actual prices for AAA, AA and A are close enough to those in my simple-minded simulation to suggest we’re dealing here with a very similar principle for pricing.
ABX Index 9-5-2007
Do these prices show what will happen in terms of losses on those ABSs? Maybe not, but in the current context of information about the product, this is where the market settles and in that respect the market – as always – is necessarily right. The conclusion is inescapable: yes, AA can incur losses; yes, even AAA can incur losses and in that respect no, an ABS’ AAA does not even come close to a Treasury’s own AAA which – as we’ve seen – is backed by Uncle Sam’s unwavering and dependable word.

The un-American solution to the subprime mess

Among the remedies mentioned for the subprime crisis, I haven’t seen listed the system I went through when getting a mortgage in England back in those days. Here is how it worked: the first step would be for you to open an account with a building society; then you would start saving, sending a check whenever you could in whatever amount; one month at a time your account would then accrue interest. Until one day, when the fateful 20% threshold was reached you would receive in the mail a letter saying: “Rejoice: the time has come, and we’re going to lend you the money you need to purchase the house of your dreams!”

This process could take a number of (gasp!) years! Shall I pronounce the P word? Yes: it required patience. But there was something more, something else that made it so… un-American.

You don’t see many comments at the bottom of my blogs but this is for one reason, it is because I carefully weed out most of the candidates. It always looks like this “Hi Paul! Cool site!” followed by a link reflecting one of the people’s most essential preoccupations. Here’s a list of them in ascending order: car dealerships, porn, rock concerts, recipes for weight loss and, outranking them all and by much, state lotteries.

Lotteries! And here lies the answer. At the end of the day, in the humdrum English system, you wouldn’t have made one more red penny than you knew already when you had opened, three years earlier, five years earlier, your building society account. The reason this doesn’t seem a fair proposition to the American mind is that the image of an ideal commercial transaction is based on that of the state lottery. If a deal doesn’t possess that special ingredient that can accidentally make you one day a multi-billionaire, just forget it!

It’s as simple as that!

Since we can’t fix the subprime mess can we at least make sure it doesn’t happen again?

One of the greatest American traditions is for families to get together at Christmas and watch with ever-renewed delight Frank Capra’s “It’s a Wonderful Life.” Recent events in the financial world, and in the mortgage business in particular, suggest that the movie should be introduced with this important disclaimer: “WARNING: The movie you’re about to watch is a work of FICTION. Although it is not unknown for a banker to be essentially driven by the altruistic desire to have every citizen own his own home – and will even contemplate suicide if prevented from doing so – such motivation CANNOT be expected from EVERY mortgage banker or broker. BEWARE: MORTGAGE BANKERS AND BROKERS ARE ENGAGED IN A COMMERCIAL PURSUIT AND MAY AT TIMES MAKE THEIR OWN INTEREST PREVAIL ON YOURS.”

So this is my solution to the subprime mess. It’s entirely consistent with the explanation given by a huge majority of subprime homeowners facing foreclosure: “The guy said it was OK. He said “That’s the loan for you!” Why wouldn’t I trust him? He wants his money back, right? Why would he give it to me if he thought I wouldn’t be able to pay it back?”

We know by now that the answer is that, no, in many cases – until recently that is – the banker didn’t care much if the loan was being repaid as it gets securitized and passed to Wall Street which then slices and dices it until it becomes part of the innocuous stuffing of a CDO – again, “innocuous” until recently. However, because it is only through the (three-year old) wizardry of contemporary finance that a mortgage with only a slight chance of being fully repaid may still be a valid commercial proposition, I fully support the borrower who assumes that as the banker wants his money back he won’t be foolish enough to lend money to someone who clearly won’t be able to pay it back. And this is why I stick to my proposal of a disclaimer for “It’s a Wonderful Life.”

I’m kidding of course but I’m half-serious too. Or said otherwise, I’m at least as serious as some of the commentators I’ve been reading recently who’ve come up with their own “solutions” to the subprime mess. Among the more thoughtful suggestions I’ve retained the following as worthwhile pondering about.

Representative Spencer Bacchus (Rep.) is introducing legislation that will require mortgage brokers and other persons selling home loans to be licensed. Loan originators “recently” convicted of fraud would not qualify. This is good because in 2006, 42% of subprime loans were sold by people under no regulatory supervision whatever. Predatory lending originates massively from these quarters.

Mark Adelson, a researcher at Nomura, considers that the only truly innocent victims of the current subprime crisis are precisely the victims of predatory lending who at least “are borrowers who did not lie about their incomes, bet on the housing bubble, or choose to live beyond their means” (p. 5). He seems to be hinting though at their partial guilt when he adds: “Innocent victims of predatory lending also must have been ignorant about the terms of the loans that they were taking. They must have signed papers without understanding them”(ibid.). Unless of course he only has illiteracy in mind.

Adelson is also adept of licensing (*), but licensing of borrowers in his case. I quote: “An alternative to outlawing or restricting (directly or indirectly) certain loan products might be to create a licensing system for borrowers who want to use them. For example, a possible system might work as follows: Basic loan products such as fixed-rate fully amortizing loans would require no license. Riskier products such as ARMs, interest-only loans and negative amortization loans could require successively higher levels of licenses – roughly similar to the various classes of drivers licenses based on different types of vehicles (i.e., car, bus, medium truck, heavy truck, hazardous material, etc.)” (p. 7).

I personally never believed ARMs were such a bad deal: interest rates rise usually as a reflection of growth in the economy. It’s no unreasonable assumption then that people can pay more for housing when the economy is expanding. Maybe I don’t mind ARMs so much because that was the only option open to borrowers when I had a mortgage in England. Of course, in those days in England, teaser rates would have been regarded as an indecent proposition. The only advantage teaser rates seem to present is of introducing confusion and allowing an unscrupulous mortgage seller to make them pass for the real thing. So a gentler alternative to requiring bureaucratic stamps to obtain an ARM would be banning teaser rates.

Some other suggestions seem helpful: the Regulators in their joint statement of a couple of weeks ago proposed lifting prepayment penalties within a window period on both sides of the time when an ARM resets (**); or former Fed Governor Edward M. Gramlich’s idea of lowering HOEPA’s 8% above Treasury threshold, down to 5% to cover 50% of all subprime loans instead of the current 1% (***).

The fact remains however, as I’ve written in a number of past blogs, that all actors, from the individual borrower down to Wall Street, adapted in a perfectly rational way to a context of constantly rising housing prices, i.e. adapted to the real estate bubble. Now the doctors come all with remedies that will ease the symptoms but no one tackles the very root of the epidemics: what caused that bubble in the first place. The cause of the bubble lies in the permanent subsidy that the Government feeds in the housing industry, a subsidy helping the wealthy much more considerably than it does the underprivileged. The one provision feeding residential bubbles is the tax deductibility of interest payments relative to housing. However, as the people’s Representatives are among those high-bracket citizens who would have most to lose from withdrawing that clause…

(*) Mark Adelson, Sub-prime Surprise … Not!, Nomura Fixed Income Research, April 18, 2007

(**) OCC, Federal Reserve, FDIC, OTS, National Credit Union Administration, Statement on Subprime Mortgage Lending, June 29, 2007

(***) Edward M. Gramlich, Subprime Mortgages. America’s Latest Boom and Bust, The Urban Institute Press, 2007

Now that the housing bubble has burst, who’s to blame?

Blame is flying in all directions: mortgage lenders had stopped bothering whether or not borrowers could repay as they were passing the buck to Wall Street anyway; Wall Street firms were using subprime mortgages of any denomination as innocuous stuffing in Collateralized Debt Obligations (CDOs); regulators failed to curb the worst forms of abuse – that were no longer restricted to unregulated mortgage companies but had become rampant in the whole industry; homeowners, driven by greed, couldn’t be bothered with reading their loan contracts before signing them.

I’ve got an alternative explanation: each party was following its own well-conceived best interest in a way that was plainly rational within the existing environment. Think of it: if the value of homes goes up every year by a large amount, it makes perfect sense for some to ask for – and for others to grant – a 125% Loan To Value mortgage. Indeed, with an annual housing price appreciation of 13.7% (as it was at its peak in the spring of 2005) it takes only one year and nine months for the house to be worth 125% of its value at purchase time. The same reasoning applies to Pay Option ARMs with monthly payments lower than the interest accrued, pushing the loan into negative amortization; the more it goes, the more you owe but who cares as the home value shoots up even faster! This doesn’t make a prudent strategy but everyone will tell you – even nowadays – that mortgage is still and by far the cheapest form of consumer credit.

What all parties involved failed to notice was that the circumstances were changing. Every one of the characters in the play had adapted to an environment where price appreciation in residential housing had gained the certainty of a natural law. What escaped everyone was that the housing market requires a constant flow of new recruits to come in at entry level, popping all those ahead of them one notch up. When the bubble was about to burst, lenders became aware of at least that aspect and did all within their power to push the heavy payments as far away into the future as was feasible, promoting rock-bottom teaser rates, Interest Only mortgages and Pay Option ARMs with negative amortization.

Even that could only delay the inevitable: with sufficient stretching the elastic band would pop and aspiring first-time buyers at the FHA and subprime entry level: young couples, immigrants, would be left at the gates. Those who got into buying their home by the skin of their teeth were the first to be washed out when the tide reversed and the price of housing started to drop. As industry insiders noted recently, those late-comers have been so roughed up in the process that it will be a challenge getting them back in once things have settled:

Subprime loans sped up and burned a class of future homeowners, said Frank Nothaft, chief economist for mortgage finance company Freddie Mac. “If they had delayed their initial decision to buy, they would have had a higher likelihood of transitioning,” he said. “Now they’ve had a taste of (homeownership) and are back in the tenant pool — maybe forever.” (…) “We knew that we were borrowing forward by bringing in young people at ages that we had not seen in past years,” said Jay Brinkmann, an economist with the Mortgage Bankers Association. “We can see a decline in terms of future home buyers because we have brought forward a certain cohort of the age.” (1)

The regulators no doubt should have known better: while it is understandably nearly impossible for an individual borrower to hold a comprehensive view of the macro-economic landscape and still difficult to grasp it entirely for financial services like mortgage banks, the Fed, the Office of the Comptroller of the Currency (the OCC is the regulator of federal banks) the Office of Thrift Supervision (the OTS monitors Savings & Loans), Fannie Mae and Freddie Mac employ scores of economists who should have seen coming the widening gap at the first-time buyer entry level. The trouble with economists is that a large number of them don’t believe in financial bubbles altogether; others are disastrously slow at recognizing them even when they get as big as the 2005 housing bubble: it wasn’t before June 2005 that Fed’s Chairman Alan Greenspan admitted he saw “froth” in the housing sector. Remember what the press had to say at the time:

The chairman of the Federal Reserve wanted to make one thing perfectly clear: There is no housing bubble. No sirree. What’s going on in the overheating housing market right now is properly described as “froth.” “There do appear to be, at a minimum, signs of froth in some local markets,” Alan Greenspan said. (2)

How come? Because for a bubble to exist, price has to become “speculative,” meaning that it is higher than the sum of its “fundamentals,” the building blocks of value and therefore the benchmark for price. Unfortunately, ways can be found for decomposing whatever price into some fundamentals that make perfect sense. What’s been lacking in financial theory is an infallible model of price formation that recognizes a bubble when there is one. Fed’s researcher Refet S. Gurkaynak writes:

Can asset price bubbles be detected? (…) despite recent advances, econometric detection of asset price bubbles cannot be achieved with a satisfactory degree of certainty. For each paper that finds evidence of bubbles, there is another one that fits the data equally well without allowing for a bubble. We are still unable to distinguish bubbles from time-varying or regime switching fundamentals, while many small sample econometrics problems of bubble tests remain unresolved. (3)

The inescapable conclusion is that if anyone is to blame for the bubble having popped to some eminent economists’ amazement, it is precisely the economists and them only. A Nobel Prize in economy is awarded every year, how come we’re still unable to tell there is a bubble even when it’s about to pop straight in our face with a mega-bang?

(1) Patrick Rucker, “Home market took a costly subprime advance,” Reuters, Friday May 4, 2007.

(2) Dana Milbank, “Lawmakers Struggle to See Beneath the ‘Froth’ in Greenspan’s Testimony,” Washington Post, Friday, June 10, 2005.

(3) Refet S. Gurkaynak, Econometric Tests of Asset Price Bubbles : Taking Stock, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C.2005-04.

Subprime, CDOs and the threat to home ownership

In a well-documented recent paper (*), Joseph R. Mason of Drexel University and Joshua Rosner of Graham Fisher & Co. ask if a chain of events has not begun unfolding that will end up in a situation where funding for the mortgage industry is massively curtailed. In their paper, Mason and Rosner draw a parallel between the role played presently by subprime loans within Collateralized Debt Obligations (CDOs) and a situation that arose in 2003 leading to the demise of the main collateral types used in those days to enhance CDO credit. These sectors were: manufactured housing, aircraft leases, franchise business loans and 12-b1 mutual fund fees. Should Mason and Rosner’s parallel be justified, then securitization of subprime loans will similarly be in for a major setback in the years to come, the effects of which would ripple through the whole mortgage capital markets and dry up their current main source of funding.
Collateralized Debt Obligations which, as the authors show, were issued in 2006 at a volume nearly equal to that of the three prior years, provide investors with access to high-yield debt, bypassing through the packaging inherent to securitization their otherwise lack of liquidity. CDOs often simply re-securitize low-grade certificates belonging to Asset-Backed Securities (ABSs). CDOs allow putting to their best possible use as credit enhancers these low-grade certificates. A Moody’s analysis in October 2006 reported collateral for outstanding CDOs comprising 28% of subprime and home equity loans and 12% of prime loans. Unlike what is the case with MBSs or ABSs, CDOs are managed, with the Collateral Manager free to populate the security dynamically during its lifetime.
The reason why subprime loans played recently in CDOs the role held in earlier days by manufactured housing et al. is easy to grasp: what makes their attraction is that until the end of 2006 they were undervalued as their high yield – supposedly reflecting their embedded default risk premium – was more conservative than the risk actually incurred, providing investors with a possible arbitrage.
The reason for this opportunity for arbitrage is obvious: in the absence of any safe method for assessing the market risk component of future losses (as opposed to the credit risk component that can be estimated with the help of an individual “credit score”), risk premiums are calculated to mitigate business cycles in their entirety. The implication is that in low default times, the risk premium, i.e. the high yield, will be overvalued, constituting for the investor an attractive proposition. Conversely, in the depressed part of the business cycle, the risk premium is undervalued and fails to cover the actual financial risk appropriately, or in any case with a too thin profit spread. Collateral types like subprime mortgages, manufactured housing et al. will out of necessity only be of interest to CDO Collateral Managers during their periods of risk overvaluation and may meet their doom or at least their periodic eclipse whenever they enter the depressed part of their business cycle as demand then essentially vanishes.
In Milken’s glory days, junk bonds’ embedded risk premiums were overvalued compared to their actual default risk, making the market an attractive one. When their high yield ceased to reflect adequately their rising default rate, the market evaporated, swallowing with it its protagonists. Manufactured housing, aircraft leases, franchise business loans and 12-b1 mutual fund fees met the same fate in 2003 as far as CDOs are concerned: “We argue that the shrinkage in those sectors arose from decreased funding by the CDO markets” (p. 33), contend Mason and Rosner. They add that the exact same phenomenon is currently taking place with subprime certificates carved out from ABSs: “We therefore maintain that the shrinkage in Residential Mortgage Backed-Securities’ sector is likely to arise from decreased funding by the CDO markets as defaults accumulate. (This) could set off a downward spiral in credit availability that can deprive individuals of home ownership and substantially hurt the U.S. economy” (p. 33).
Their argument is too complex to be faithfully reflected in a short note like this but it is in my view flawless. The only reproach I would make is that they mix two considerations about subprime, introducing an unnecessary distraction in their demonstration. The first consideration about subprime is legitimately relevant to their argument: a borrower’s capacity at making monthly payments which is now lacking with the defaults recently observed in the subprime sector. The second consideration, crucial for the mortgage industry as a whole, but extraneous when discussing CDOs, is the borrower being “underwater,” i.e. owing debt on the house larger than the potential net proceeds of selling the house. The first consideration impacts any type of mortgage-backed security as it affects directly the capacity of recovering a loan’s principal. The second consideration is but a looming threat as long as the homeowner stays put; its effects are complex and spread out necessarily over the long term.
By contrast, the discussion by the authors of the role played by the rating agencies is at the core of their demonstration. Will these be able to do any better at rating in a time of crisis than they did in November 2001 with Enron when the public became wary at their methods? The authors’ reminder that rating agencies claim they need anywhere between three and seven weeks for “notching” i.e. for reflecting in their own rating a change of grade by another agency, casts here a giant question mark. That they promptly put their act together is no luxury but a must: as Mason and Rosner state it, here lies reputational risk for the U.S. capital markets.

(*) Joseph R. Mason and Joshua Rosner, “How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation market Disruptions?” presented at the Hudson Institute on February 15th, 2007

Where did the housing bubble come from?

In today’s Wall Street Journal, Andy Laperrière, a managing director of the Washington office of the ISI Group, wrote a piece on the crisis in the mortgage industry, I wrote to the Journal’s editor, the following letter:

In his “Mortgage Meltdown” (Wall Street Journal, March 21, 2007), Andy Laperrière assigns the residential real estate bubble to the boost to home prices that the subprime market has provided “at the margin.” By that he ignores that housing is segmented and although easier access to the lower part of the market has no doubt contributed at raising prices at that particular end of the range, it is unlikely to have had any impact on housing higher up on the ladder where Alt-A and prime borrowers do shop for a home.

If this is so, what are then the factors that contributed to lifting the price of housing? The Agencies, Fannie Mae and Freddie Mac, have claimed part of the responsibility, saying that their active securitization of individual loans into Mortgage-Backed Securities has resulted in lowering the interest rates charged to borrowers. Wayne Passmore, a researcher at the Federal Reserve, has shown convincingly that this was not the case and that the Agencies’ favorable impact for the borrower amounts to a negligible 7 basis points (0.07 %) (1). Fannie and Freddie come out thus clean in that respect.

Governor Alan Greenspan had a different culprit in mind when he was assigning the blame to new construction: the lower progress in productivity in that sector compared to the rest of the economy, he explained, meant that the price of new construction would necessarily rise, forcing that of existing homes to align on them (2). But the 1% yearly increment credited to that cause was a far cry from the 28% rise in home prices observed over the period 1997 to 2002.

Tax deductibility of interest payments is another likely candidate as the government subsidy may erase up to a third of the amount of a mortgage’s monthly payment. It is reckoned that in 2004 borrowers saved 61.5 billion dollars through tax-deductibility of interest. In the first years of an amortizing mortgage, the best part of a monthly payment is interest, with only a small part of principal being repaid. On a typical 30 year fixed rate mortgage, it takes nearly twenty years before the monthly payment contains a larger portion of principal than of interest due. Laperrière reminds us also that in 2006, Interest Only loans represented about one third of all mortgages, with here of course, tax deductibility applying to the entire payment.

The “causes of the current housing bust” may not be that mysterious after all.

(1) Passmore, Wayne, The GSE Implicit Subsidy and the Value of Government Ambiguity, Board of Governors of the Federal Reserve System, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C., 2003 et 2005.

(2) Alan Greenspan, Home Mortgage Market, Remarks by Chairman Alan Greenspan At the annual convention of the Independent Community Bankers of America, Orlando, Florida, , 4 mars 2003.

Malaise in the subprime sector

In today’s Wall Street Journal, Alex J. Pollock a former President and Chief Executive Officer of the Federal Home Loan Bank of Chicago wrote a piece on the subprime industry, I wrote to the Journal’s editor, the following letter:

“In his “Credit Crack-Up” (March 12, 2007), Alex J. Pollock offers a perceptive summary of the current malaise in the subprime mortgage industry. Some of his comments however call for qualification.

1. The risk of “punishing of the innocent along with the guilty”

Some segment of the subprime industry falls unfortunately under the category of “predatory lending” where the lender seeks his profit not, as in normal circumstances, in the interest being charged but in the equity locked in the property and attempts in fact to force repossession. In a speech he made in 2004, Edward M. Gramlich, a Governor of the Federal Reserve, complained that “despite […] actions by the Fed and other bank regulators, we still have no obvious way to monitor the lending behavior of independent mortgage companies” (*), which at the time represented 12% of originations in that sector.

2. “How could all these problems arise […] given our massive computer power manipulating mortgage data with sophisticated models built by mathematical experts?”

No amount of computer power and mathematical expertise will ever allow to bridge safely from observations of the past to prediction of the future. A majority of the mortgage products currently offered to the consumer are of recent invention and have only a short track-record from which to extrapolate. The FICO score has shown a remarkable efficacy at predicting borrower default. Its power derives from assuming that consumers’ past credit behavior along with the current servicing of their debt predicts accurately their future credit behavior. This simple assumption neglects however that the wider economic context, such as the current level of interest rates or of unemployment, has an influence on consumer creditworthiness and the fact remains that the FICO score has never been tested over a full business-cycle including a recession. The “traditional” threshold of 620 FICO points that the industry had adopted as marking the border between subprime and prime has in the past few weeks been raised by lenders to 660; the move is no doubt prudent but it is not based on any objective measurement: new developments only will eventually reveal if the new value was too conservative or still too low.

3. “The belief that the economy has changed in some fundamental way, and that a ‘new era’ is beginning”

The single true danger lies here precisely. Because it has no choice but to extrapolate from historical data, the mortgage industry is bound to develop new scenarios whenever new circumstances dictate. If we keep in mind that what we see now may only reflect the favorable part of the business cycle, we will envisage consumer behavior within that context and remember that a downside remains possible in the future. If on the contrary we assume that a “new era” has opened where business cycles are a thing of the past or, which amounts to the same, that the favorable part will last forever, then we haven’t seen the end of our troubles.
But are we justified to blame mortgage bankers for having trumpeted the arrival of a “new era” in consumer credit? In its most recent guise, the “new era” theme was once again reborn from its ashes as the “optimal allocation of financial risk,” where risk migrates automatically to those parties ideally suited to take it. Its advocate was of course no less an authority on these matters than the former Chairman of the Federal Reserve, Alan Greenspan.”

(*) Edward M. Gramlich, “Subprime Mortgage Lending: Benefits, Costs, and Challenges”, May 21, 2004