The Rise and Fall of the U.S. Mortgage and Credit Markets Wednesday, April 29, 2009 11:00 AM - 12:15 PM Moderator: Rick Newman Chief Business Correspondent, U.S. News & World Report Speakers: James Barth, Senior Finance Fellow, Milken Institute; Lowder Eminent Scholar in Finance, Auburn University Alan Boyce, CEO, Absalon; President, Adecoagro Barry Eichengreen, George C. Pardee and Helen N. Pardee Professor of Economics and Political Science, University of California, Berkeley Glenn Yago, Director of Capital Studies, Milken Institute 1
Overview Factors that contributed to credit boom and bust Lax monetary policy and global imbalances led to low interest rates Reach for yield, reliance on short-term wholesale funding for relatively illiquid assets, small cash buffers, and risky/substantial leverage Financial innovation, such as securitization that weakened lending standards (e.g., mortgage originators) and credit default swaps that increased inter-connectivity (e.g., AIG), transferred risk broadly to others Opacity due to complexity of financial instruments (e.g., CDOs), riskier collateral for securities (e.g., subprime mortgages), heavy reliance on credit rating agencies, and overthe-counter trading of credit default swaps Procyclicality of regulation (capital requirements) and mark-to-market accounting, which contributed to forced asset sales and deleveraging Lack of a procedure to deal with deeply troubled big banks and non-bank financial institutions (too big to fail or too strategically important or too inter-connected) Incentive/compensation system that encouraged excessive risk taking, and poor corporate governance Public policy: gaps in regulatory structure and inconsistent asset management strategy Flight to safety due to uncertainty of asset values and solvency of financial institutions (hoarding of liquidity and/or calls for more collateral) 2
Overview of the housing market Total value of housing stock = $18.3 trillion Mortgage debt $10.5 trillion Subprime 7.3% Prime 92.7% Equity in housing stock $7.8 trillion Securitized 60% Non- Securitized 40% Governmentcontrolled 48% Private sectorcontrolled 52% Note: total residential and commercial mortgages = $14.6 trillion at year-end 2008. Sources: Federal Reserve, Milken Institute. 3
The mortgage problem in perspective 80 million houses 25 million or 31% are paid off 55 million have mortgages 49 million or 89% are paying on time 6 million are behind 11% of 55 million with 3% in foreclosure This compares to 50% seriously delinquent in the 1930s. Note: The data is at year-end 2008. Sources: U.S. Census, Freddie Mac, Mortgage Bankers Association, Milken Institute. 4
Low interest rates, credit boom and bust US$ trillions 4.0 Home price bubble, credit boom and bust Percent US$ trillions Index, January 2000 = 100 6.0 4.0 200 3.5 3.0 2.5 2.0 1.5 1.0 0.5 1-Year ARM mortgage rate (right axis) Home mortgage originations (left axis) 5.5 5.0 4.5 4.0 3.5 3.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 S&P/Case-Shiller National Home Price Index (right axis) Home mortgage originations (left axis) 175 150 125 100 75 0.0 2001 2002 2003 2004 2005 2006 2007 2008 2.5 0.0 2001 2002 2003 2004 2005 2006 2007 2008 50 Sources: Inside Mortgage Finance, Mortgage Bankers Association, Moody s Economy.com, S&P/Case-Shiller, Milken Institute. 5
All states had home price increases From 4Q 2001 to 4Q 2006 United States = 43% Sources: Moody s Economy.com, Milken Institute. 6
Forty-seven states had home price declines From 4Q 2006 to 4Q 2008 United States = -19% Sources: Moody s Economy.com, Milken Institute. 7
If you bought your house One year ago -14.0-14.3-15.0-16.4-19.0-19.3-19.4-20.4-22.6-23.3-24.9-25.8-29.4-32.4-32.5-35.0 Six years ago % change in price, January 2008-2009 % change in price, January 2003-2009 Sources: S&P/Case-Shiller, Milken Institute. -4.9-5.1-5.2-7.3-8.2-9.6 Dallas Denver Cleveland Boston Charlotte New York Portland Atlanta Seattle Chicago Composite-20 Washington Composite-10 Minneapolis Detroit Tampa San Diego Los Angeles Miami San Francisco Las Vegas Phoenix -32.9 23.7 18.4 15.4 12.3 12.0 10.6 10.6 7.9 3.2 3.0 2.7 0.0-1.0-2.0-4.6-4.9-6.6-12.4-13.3 35.3 33.3 Portland Seattle New York Washington Los Angeles Charlotte Tampa Composite-10 Miami Composite-20 Chicago Las Vegas Boston Phoenix Dallas Denver San Diego Atlanta Cleveland San Francisco Minneapolis Detroit 8
Las Vegas housing market US$ thousands 350 Median home sales price (left axis) 300 Flips/total transactions (right axis) 250 Foreclosures/total transactions (right axis) 200 150 100 50 Percent 80 70 60 50 40 30 20 10 0 1994 1996 1998 2000 2002 2004 2006 2008 Q3 Source: James Barth and Harris Hollans. 0 9
Percentage of homes purchased between 2004 and 2008 that now have negative equity United States = 41% Sources: Zillow.com, Milken Institute. 10
Leverage ratios of selected financial firms December 2008 Leverage ratio, total assets/common equity Freddie Mac Fannie Mae Federal Home Loan Banks Brokers/hedge funds 21.5 (June 2008) 26.2 31.6(June 2008) 67.9 (June 2008) Saving institutions Commercial banks Credit unions 10.6 9.3 11.1 0 10 20 30 40 50 60 70 80 Note: Leverage ratios for Freddie Mac and Fannie Mae are as of June 2008. The two institutions have negative common equities as of December 2008. Sources: FDIC, FHL Banks Office of Finance, National Credit Union Administration, Freddie Mac, Fannie Mae, Milken Institute. 11
Too much dependence on debt? Leverage ratios at biggest investment banks Total assets/total shareholder equity 40 33 34 35 31 32 33 34 30 28 27 25 20 15 10 5 0 22 13 19 19 26 2000 2005 2007 2008 31 Morgan Stanley Merrill Lynch Bear Stearns Lehman Brothers Goldman Sachs Sources: Bloomberg, Milken Institute. March 2008 24 24 June 2008 18 23 22 13 12
Too much dependence on debt? Leverage ratios at bank holding companies Total assets/total shareholder equity 25 20 15 10 13 13 19 14 13 13 12 2000 2005 2007 2008 17 11 13 10 13 5 0 Sources: Bloomberg, Milken Institute. Citigroup Bank of America JPMorgan Chase 13
Balance sheet information on FDIC-insured institutions Percent 25 20 15 10 5 0 1992 1994 1996 1998 2000 2002 2004 2006 2008 Sources: FDIC, Milken Institute. Borrowed funds-to-asset ratio (left axis) Insured deposits-to-asset ratio (right axis) Equity capital-to-asset ratio (right axis) Deposits-to-asset ratio (right axis) Cash-to-asset ratio(left axis) Percent 90 80 70 60 50 40 30 20 10 0 14
15 Reserve coverage ratio of all FDIC-insured institutions US$ billions 250 200 Coverage ratio (right axis) Loan-loss reserves (left axis) 150 100 50 Noncurrent loans (left axis) 0 2005 2006 2007 2008 Sources: Quarterly Banking Profile, FDIC, Milken Institute. Percent 200 180 160 140 120 100 80 60 40 20 0
The mortgage model switches from originate-to-hold to originate-to-distribute Household mortgage debt 1980=$958 billion Household mortgage debt 2008=$10.5 trillion Securitized 11% Securitized 60% Sources: Federal Reserve, Milken Institute. Held in portfolio 89% Held in portfolio 40% 16
The rise and fall of private-label securitizers Outstanding securities 1985 Total = $390B 6% 13% 55% 2001 Total = $3.3T 14% 18% 2006 Total = $5.9T 7% 35% 25% 2008 Total = $6.8T 9% 27% 27% 26% 39% 29% 37% 33% Ginnie Mae Freddie Mac Fannie Mae Private-label Sources: Inside Mortgage Finance, Milken Institute. 17
56 percent of MBS issued from 2005 to 2007 were eventually downgraded S&P Total Downgraded Downgraded/ Total AAA 1,032 156 15.1% AA(+/-) 3,495 1,330 38.1% A(+/-) 2,983 1,886 63.2% BBB(+/-) 2,954 2,248 76.1% BB(+/-) 789 683 86.6% B(+/-) 8 7 87.5% Total 11,261 6,310 56.0% Note: A bond is considered investment grade if its credit rating is BBB- or higher by S&P. The data is downgraded through October 2008. Sources: Inside Mortgage Finance, Milken Institute. 18
When is a AAA not a AAA? Multilayered mortgage products Origination of mortgage loans High-grade CDO Senior AAA 88% Junior AAA 5% Pool of mortgage AA 3% loans: prime or subprime A 2% BBB 1% Unrated 1% Mortgage bonds AAA 80% AA 11% A 4% Mezzanine CDO BBB 3% CDO-squared BB-unrated 2% Senior AAA 62% Junior AAA 14% Senior AAA 60% AA 8% Junior AAA 27% A 6% AA 4% CDO-cubed BBB 6% A 3% Unrated 4% BBB 3% Sources: International Monetary Fund, Milken Institute. Unrated 2% 19
The U.S. regulatory regime: In need of reform? Justice Department Assesses effects of mergers and acquisitions on competition Financial, bank and thrift holding companies Fed OTS Fannie Mae, Freddie Mac, and Federal Home Loan Banks Federal Housing Finance Agency Federal courts Ultimate decider of banking, securities, and insurance products Fed is the umbrella or consolidated regulator Primary/ secondary functional regulator National banks OCC FDIC Federal branch OCC Host county regulator State commercial Federal savings and savings banks banks State bank regulators FDIC Fed--state member commerical commercial banks Foreign branch Fed Host county regulator Sources: Financial Services Roundtable (2007), Milken Institute. OTS FDIC Limited foreign branch OTS Host county regulator Insurance companies 50 State insurance regulators plus District of Columbia and Puerto Rico Securities brokers/dealers FINRA SEC CFTC State securities regulators Other financial companies, including mortgage companies and brokers Fed State licensing (if needed) U.S. Treasury for some products Notes: Justice Department: Assesses effects of mergers and acquisitions on competition Federal Courts: Ultimate decider of banking, securities, and insurance products CFTC: Commodity Futures Trading Commission FDIC: Federal Deposit Insurance Corporation Fed: Federal Reserve FINRA: Financial Industry Regulatory Authority GSEs: Government Sponsored Enterprises OCC: Comptroller of the Currency OTS: Office of Thrift Supervision SEC: Securities and Exchange Commission 20
How far do home prices have to fall? Average = 100 Price/disposable income per capita 160 140 120 OFHEO Case-Shiller: 20-metro Case-Shiller: 10-metro Case-Shiller National Price/rent 160 140 120 OFHEO Case-Shiller: 20-metro Case-Shiller: 10-metro Case-Shiller National 100 80 100 80 60 1981 1988 1995 2002 2009 Sources: Moody s Economy.com, Milken Institute. 60 1981 1988 1995 2002 2009 21
Alternative measures for the affordability of mortgage debt for California Mortgage payment assumptions: * Home is purchased at median price 70% Estimated monthly payment / monthly household income 80% 100% LTV 90% LTV * Buyer takes out a 30-year 60% 80% LTV conforming, fixed-rate loan 50% * Payment also includes 1% property 40% tax per year, 0.1% property 30% insurance 20% Sources: Moody s Economy.com, Milken Institute. Maximum affordablility limit is 38% of median household income 2000 2002 2004 2006 2008 22
Overview Government responses to liquidity freeze and credit crunch Government/private sector purchases of toxic assets Guarantees for selected assets and liabilities Capital injections into financial institutions Subsidization of loan modifications by financial institutions Debt for equity swaps Easier monetary policies, including lowering interest rates and quantitative/ credit easing Coordinated responses by countries (e.g., central bank currency swaps) Establish an RTC-like agency (?) Create good banks, bad banks (?) Nationalize deeply troubled financial institutions (?) 23
Federal government comes to the rescue of Main Street and Wall Street Federal Reserve 6,048 Congress and White House 2,466 Federal Deposit Insurance Corporation 926 Treasury, Federal Deposit Insurance Corporation and Federal Reserve 362 Total amount dispersed/committed (US$ billions) 9,802 Upper limit to total funds under these programs $9.8 trillion plus? Source: Milken Institute. 24
Overview Reforms to prevent/mitigate credit booms and busts Macro-prudential regulation (i.e., establish a systemic risk regulator or market stability regulator) A liquidity regulation to take into account maturity mismatches due to short-term funding of longerterm, illiquid assets Countercyclical regulation (e.g., dynamic capital and/or provisioning regulations) A regulation that internalizes (taxes) a financial institution s contribution to systemic risk (to address too-big-to-fail issue) Greater transparency by requiring clearing and settling of credit default swaps to be conducted through clearing houses or on exchanges, which provides for greater monitoring of exposures and posting of necessary collateral Change fee structure for credit rating agencies, eliminate the Nationally Recognized Statistical Rating Organization (NRSRO) designation, and decrease use of ratings in regulatory system Consider eliminating treatment of residential mortgages as non-recourse loans (i.e., secured only by the underlying property), merging Freddie Mac and Fannie Mae, and requiring mortgage originators to have skin in the game Consider modifying incentive/compensation systems to discourage excessive risk taking Reform structure of regulatory system Consider establishing greater co-operation among regulators in countries or establish centralized supervision or deposit insurer in some regions 25
Barry Eichengreen s slides 26
27 And not only here: It is a global slump in industrial production 100 95 90 85 80 75 70 65 60 Ju ne 1929= 100 A pril 2008= 100 5 10 15 20 25 30 35 40 45 50
28 Not only here: Trade is collapsing faster than in 1929 110 100 Ju ne 1929=100 A pril 2008=100 90 80 70 60 5 10 15 20 25 30 35 40 45 50
29 Not only here: It is a global stock market crash 110 100 90 80 70 60 50 40 30 Ju ne 1929=100 A pril 2008=100 5 10 15 20 25 30 35 40 45 50
Grading the policy response Monetary policy: A- Fiscal policy: B+ Housing policy: B+ Banking policy: Incomplete 30
Even then there is no instantaneous fix Vertical line in figure at left is date of major bank recapitalization. It still takes two years after that for lending to recover even in the Swedish case that is the benchmark of how to do it. It took a long time to get into this mess. Alas it will take a long time to get out. 31
32 We will become more heavily indebted, but we have no choice CBO forecasts now suggest that the US debt ratio will rise from 40 to 80 percent of GDP.
This is roughly what happened in Finland and Sweden In resolving their banking crises, their debt ratios similarly rose by 40% of GDP. Of course, you can make progress later, bringing this ratio back down, through surpluses and growth (if you fix the banking system and then show political resolve) 33
This is not to deny that there will be medium term consequences There will be crowding out of capital investment, not now but once the economy is firing on all cylinders again. But my point is that there is little choice. We have dug ourselves a deep hole. The cost of preventing growth from collapsing now will be somewhat slower growth for several years going forward (until we normalize the budget balance). 34
Alan Boyce s slides 35
U.S. Non-Agency MBS market died $140,000 $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 $0 Note: 2000-2005 assumed straight-line for quarterly comparison 60% 50% 40% 30% 20% 10% 0% 1Q06 3Q06 1Q07 3Q07 1Q08 3Q08 36 MBS Issuance ($ millions) Non-Agency Issuance / Total Issuance Prime Subprime Alt-A Non-Agency / Total 1Q00 3Q00 1Q01 3Q01 1Q02 3Q02 1Q03 3Q03 1Q04 3Q04 1Q05 3Q05
Which reduces risk of negative equity Typical homeowner scenario: Borrower pays $100,000 for a house with an 80% LTV, loan originated at par Agency Loan, housing prices have fallen 10% and FN 5% mortgage bond prices have fallen to 94 Non-Agency Loan, housing prices have fallen 30% and mortgage bond prices have fallen to 75 At Origination Existing System House 90 Agency Loan: Housing Prices Down 10% Loan 80 Equity 10 House 90 Principle of Balance House 100 Loan 75 Equity 15 Loan 80 Non-Agency Loan: Equity 20 Housing Prices Down 30% Principle Existing System of Balance House 70 Loan 80 Equity -10 House 70 Loan 60 Equity 10 Change in Equity: -50% Change in Equity: -25% Negative Equity Change in Equity: -50% 37
38 Credit enhancement structure for shared platform Value of the house Value of the loan Down payment 20% First loss Loan Originator 10% Guaranty from GSE 90% Provided by Originator and/or MI industry Expected Capital reserves of 20% Backup capital and industry skill to be provided by MI Reinsurance Industry AAA rating flows from GSE guarantee The value of the house will serve as collateral Bond holder looks to GSE for full faith and credit guaranty GSE looks to Originator remove bad loans from the pool Originator purchases parri passu amount of bonds from pool at lower of market or par If originator fails to perform, GSE can seize servicing rights and margin and reassign to another servicer