Demystifying the Mortgage Meltdown: What It Means for Main Street, - PowerPoint PPT Presentation

Demystifying the Mortgage Meltdown: What It Means for Main Street, Wall Street and the U.S. Financial System James R. Barth James R. Barth Glenn Yago Glenn Yago Senior Fellow Director of Capital Studies Milken Institute October 2, 2008 1

“ I have great, great confidence in our capital markets and in our financial institutions. Our financial institutions, banks and investment banks are strong.” Treasury Secretary Henry Paulson March 16, 2008 CNN 2

… but just six months later… “The financial security of all Americans … depends on our ability to restore our financial institutions to a sound footing.” Treasury Secretary Henry Paulson September 19, 2008 Press release 3

“Any real estate investment is a good investment … ” 4

“Any real estate investment is a good investment … ” … Really?! 5

Subprime mortgage meltdown timeline December 2006–September 2008 Dow Jones U.S. Financial Index Aug. 1, Aug. 16, 2007: Sept. 30, 2007: Oct. 24, 2007: Mar. 11, 2008: Fed Mar. 16, 2008: Mar. 18, 2008: Countrywide gets 2008: First NetBank goes Merrill announces offers troubled JP Morgan Fed cuts 650 Priority Feburary–March 2007: More than 25 emergency loan of bankrupt. $7.9 billion in banks as much as Chase offers to discount rate subprime lenders declare $11 billion from a Bank subprime write- $200 billion in buy Bear to 2.4%; Fed bankruptcy. group of banks. closes. downs, surpassing loans; Fed Stearns; Fed funds rate to Citi’s $6.5 billion. introduces Term introduces 2.25%. Sept. 14, 2008: Securities Primary Dealer Lehman files for Lending Facility. Credit Facility. 550 bankruptcy. July 30, 2008: Dec. 2006: Apr. 2007: New Sept. 16, 2008: Feb. 2007: President Ownit Mortgage, Ownit Mortgage, Century, a Century, a Fed loans AIG Fed loans AIG HSBC sets HSBC sets Bush signs a Bush signs a a subprime mortgage $85 billion. aside $10.6 Dec. 12, 2007: housing lender, files for broker, files billion for Fed introduces rescue law. 450 bankruptcy. for bad loans, Aug. 6, 2007: Sept. 23, 2008: Term Auction bankruptcy. including American Home Washington Facility. subprime. Mortgage files Mutual is seized Jan. 11, 2008: for bankruptcy. July 31, 2007: by FDIC. Bank of Two Bear America agrees June 9, 2008: Stearns Feb. 13, 2008: 350 to buy Sept. 29, 2008: Lehman hedge funds President Bush Countrywide. Aug. 17, 2007: Fed cuts announces a $2.8 Citigroup file for introduces tax discount rate to 5.75%; billion loss. agrees to buy bankruptcy. Sept. 7, 2008: U.S. rebate stimulus Jan. 30, 2008: Fed Fed introduces Term Wachovia bank. seizes Fannie Mae program of $168 cuts discount rate Discount Window July 11, 2008: IndyMac and Freddie Mac. billion. to 3.5%. Program. is seized by FDIC. 250 Sources : BusinessWeek, S&P, Global Insight, Milken Institute. 6

Overview 7

Home mortgages: Who borrows, how much has been borrowed, and who funds them? Total value of housing stock = $19.3 trillion Subprime Securitized 8.4% Government- 58% Mortgage debt controlled $10.6 trillion 46% Prime 91.6% 91.6% Non-securitized Private sector- 42% controlled 54% Equity in housing stock $8.7 trillion Note: total residential and commercial mortgages = $14.7 trillion; 5 percent = $700 billion Sources: Federal Reserve, Milken Institute. 8

The mortgage problem in perspective 80 million houses 27 million are paid off 53 million have mortgages 48 million are paying on time 48 million are paying on time This compares to 50% seriously delinquent in the 5 million are behind 1930s. (9.2% of 53 million with 2.8% in foreclosure) Sources : U.S. Treasury, Milken Institute. 9

I. Low interest rates and a lending boom 10 10

Did the Fed lower interest rates too much and for too long? Federal funds rate vs. rates on FRMs and ARMs Percent 8 30-year FRM rate 7 6 5 4 Target federal funds rate 3 1-year ARM rate 2 Record low from June 25, 1 2003, to June 30, 2004: 1% 0 2001 2002 2003 2004 2005 2006 2007 2008 Sources : Federal Reserve, Mortgage Bankers Association, Moody’s Economy.com, Milken Institute. 11 11

Home price bubble Low interest rates and credit boom and credit boom Index, January 2000 = 100 US$ trillions Percent US$ trillions 4.5 6.0 4.0 250 4.0 3.5 5.5 200 3.5 3.0 3.0 5.0 2.5 150 2.5 2.5 Home Home 4.5 2.0 Home mortgage 2.0 mortgage 100 originations 1.5 S&P/Case-Shiller 1.5 4.0 originations (left axis) National Home (left axis) 1.0 1.0 Price Index 1-Year ARM rate 50 3.5 (right axis) (right axis) 0.5 0.5 0.0 3.0 0.0 0 2001 2003 2005 2007 2001 2003 2005 2007 Sources : Inside Mortgage Finance, Mortgage Bankers Association, Moody’s Economy.com, S&P/Case-Shiller, Milken Institute. 12 12

II. Homeownership, prices, starts and sales take off 13 13

Credit boom pushes Home price bubble California and national homeownership rate peaks in 2006 home prices reach to historic high record highs Percent Index, January 1987 = 100 US$ thousands 70 Q2 2008: 68.1% 380 700 S&P/ Q2 2004: 69.2% Case-Shiller California m edian 69 330 600 hom e price National Hom e Price Index 500 California 68 280 average 400 400 1987-2008 1987-2008 U.S. m edian U.S. m edian 230 67 hom e price $229,748 300 180 66 200 130 OFHEO Hom e Price Index 65 100 Average, 1965–Q2 2008: 65.2% U.S. average, 1987-2008: $121,280 80 64 0 1998 2000 2002 2004 2006 2008 1998 2000 2002 2004 2006 2008 1998 2000 2002 2004 2006 2008 Sources : U.S. Census Bureau, OFHEO, Moody’s Economy.com, S&P/Case-Shiller, California Association of Realtors, Milken Institute. 14 14

Housing starts hit Homes sales reach Homes for sale a record in 2005 a new high Millions Millions Millions Millions Housing units, millions 4 0.8 7.0 1.5 2.0 Existing homes for Existing hom e January 2006: 1.8 m illion sale (left axis) sales (left axis) 5.6 1.2 3 0.6 1.5 4.2 0.9 2 2 0.4 0.4 1.0 Average starts, 2.8 0.6 1959–July 2008: 1.1 m illion New hom e sales (right axis) 1 0.2 0.5 1.4 0.3 New homes for July 2008: 641,000 sale (right axis) 0.0 0.0 0 0.0 0.0 1998 2000 2002 2004 2006 2008 1998 2000 2002 2004 2006 2008 1998 2000 2002 2004 2006 2008 Sources : U.S. Census Bureau, OFHEO, Moody’s Economy.com, Milken Institute. 15 15

III. Subprime borrowers and subprime mortgages 16 16

Who is a subprime borrower? National FICO scores display wide distribution What goes into a FICO score? Percentage of population 40 Types of credit in use Prime = 79% 10% New credit 30 27 Payment history 10% 35% Subprime = 21% Subprime = 21% 18 18 20 15 Length of 13 12 credit history 8 10 5 15% 2 0 Amounts owed up to 500- 550- 600- 650- 700- 750- 800+ 499 549 599 649 699 749 799 30% Sources : myFICO.com, Milken Institute. 17 17

Prime and subprime mortgage originations by FICO score reveal substantial overlaps Percent of total originations FICO below 620 FICO above 620 20 Prime: 6.6% Prime: 93.4% Subprime: 45.2% Subprime: 54.8% 16 Prime 12 Subprime 8 4 0 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 0 5 7 9 1 3 5 7 9 1 3 5 7 9 1 3 5 7 9 0 4 4 4 5 5 5 5 5 6 6 6 6 6 7 7 7 7 7 9 - - - - - - - - - - - - - - - - - - - 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 6 8 0 2 4 6 8 0 2 4 6 8 0 2 4 6 8 0 4 4 5 5 5 5 5 6 6 6 6 6 7 7 7 7 7 8 FICO score Sources : LoanPerformance, Milken Institute. 18 18

ARMs look attractive to many borrowers Percent 8.0 7.0 30-year FRM rate 6.0 5.0 5.0 4.0 1-year ARM rate 3.0 2.0 2001 2002 2003 2004 2005 2006 2007 2008 Sources : Mortgage Bankers Association, Moody’s Economy.com, Milken Institute. 19 19

ARM share grows, following low interest rates Percent of all outstanding home mortgages 25 20 15 10 5 0 2001 2002 2003 2004 2005 2006 2007 2008 Sources : Mortgage Bankers Association, Moody’s Economy.com, Milken Institute. 20 20

Largest share of ARMs go to subprime borrowers Percent of mortgage type 60 FHA ARM Prime ARM Subprime ARM 50 40 30 30 20 10 0 2001 2002 2003 2004 2005 2006 2007 2008 Sources : Mortgage Bankers Association, Moody’s Economy.com, Milken Institute. 21 21

Subprimes take an increasing share of all home mortgage originations US$ trillions 8.4% 4.0 Subprime 21.3% Prime 7.4% 20.1% 18.2% 3.0 Subprime's share: 7.9% 7.8% 7.8% 2.0 1.0 0.9% 0.0 2001 2002 2003 2004 2005 2006 2007 Q2 2008 Sources : Inside Mortgage Finance, Milken Institute. 22 22

Subprime mortgages increase rapidly before big decline Originations Outstandings US$ billions US$ billions 1,400 Average annual growth rates 700 1,200 1,240 1995–2006: 14% 625 600 1,200 2006–Q1 2008: -23% 600 540 973 940 1,000 895 500 800 699 400 400 310 574 600 300 479 200 191 400 200 160 200 100 14 0 0 2001 2002 2003 2004 2005 2006 2007 Q1 2001 2002 2003 2004 2005 2006 2007 Q2 H2 2008 2008 2008 Sources : Inside Mortgage Finance, Milken Institute. 23 23

IV. Mortgage product innovation 24 24