understanding the sources and way out of the ongoing financial upheaval

Understanding the Sources and Way Out of theOngoing Financial Upheaval

Susan M. WachterRichard B. Worley Professor of Financial Management

The Wharton SchoolUniversity of Pennsylvania

Bank for International Settlements Hong Kong Institute for Monetary Research

University of Pennsylvania

April 23, 2009

PASEF

Global Downturn• The economy is in the worst downturn since the Great

Depression.• Capital market crisis—more than a “recession” credit flow

ended, globally and global economy is withering.• A self-reinforcing adverse cycle:

– The financial system crisis is upending the economy, putting further pressure on the financial system

• US public policy response without precedent.– Fiscal stimulus package– Federal Reserve has vastly expanded its role– What more is needed: for private credit flows to resume,

confidence in the financial system itself must be restored– This requires understanding what went wrong and

rebuilding the architecture of the financial system

The Economic Backdrop• Economy in “Great Recession”

– Unemployment at 8.5%– 4th quarter decline in GDP at 6.2%, global

decline 1.5%• Volatility in global stock markets

– US and global stock prices are more than 40% down

• Angst in the banking system and credit markets remain badly shaken– Banks still not lending

The Economic Backdrop-Capital Markets

Source: Moody’s Economy.com

The Damage Is Not Over• Real GDP began to fall in Q4 of 2007- fall continuing.• 2.6 million jobs have already been lost and the

unemployment rate is still rising. • Consumer confidence has crashed to its lowest reading

ever

Source: Mark Zandi, Moody’s Economy.com

Response to the Crisis• Fiscal Stimulus

– Unprecedented stimulus ($1 trillion)

• Monetary Stimulus– Federal Funds Rate near zero– Quantitative easing

• Banking Bailout– TARP

• Missing: New Financial Architecture

– Need to understand what went wrong

Impact of Stimulus Measures


Monetary Stimulus


The state and local impacts


March, 2007 January, 2008 September, 2008

The Collapse-from housing to financial markets: still missing, the new financial architecture

Global Financial Crisis: Made in the USA• Triggered by actual and prospective losses on

US mortgages-leveraged losses far greater• Global meltdown: Bad luck or inevitable?• Boom-bust housing price cycle: Why?• Reckless decline in mortgage lending standards

(followed by credit crisis and no private lending)• Increased housing prices beyond sustainable

heights• Unprecedented house price rises hid problem

loans-teaser rates, no doc/low doc, option arm’s, NINJA loans

• Loans made that could not be repaid-betting on ever increasing house price to rescue loans

A Severe National Housing Downturn

Figure 6: Price Appreciation Controlled for Volatility

-2

-1.5

-1

-0.5

0

0.5

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1.5

2An

nual

Per

cent

Cha

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US Home Price Canada Home Price

Australia Home Price UK Home Price

France Home Price Thailand Home Price

Japan Home Price Hong Kong Home Price

WHY?• Private label securitized mortgages, backed

leveraged derivatives, synthetics• Decades of securitization—not the problem• Interest rate risk securitized historically• PLS securitized default risk, relied on

diversification—not Marked-to-Market, but rather Marked-to-Model

• Expansion of toxic debt as asset, based on collateral, and ever increasing house prices

0%

50%

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400%

1975 1980 1985 1990 1995 2000 2005

Chronic imbalances

15

0%

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40%

60%

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100%

120%

140%

1975 1985 1995 2005

NonfinancialCompanies

Government

FinancialCompanies

Gross debt by U.S. sectorPercentage of GDP

Source: U.S. Federal Reserve, Bureau of Economic Analysis

Sectoral contribution to U.S. gross debtPercentage of GDP

NonfinancialCompanies

FinancialCompanies

Household

Government

Households

Increased use of non-traditional products

FHA/VA Conv/Conf Jumbo Subprime Alt A HEL

2001 8% 57% 20% 7% 2% 5%

2002 7% 63% 21% 1% 2% 6%

2003 6% 62% 16% 8% 2% 6%

2004 4% 41% 17% 18% 6% 12%

2005 3% 35% 18% 20% 12% 12%

2006 3% 33% 16% 20% 13% 14%

2007 4% 48% 14% 8% 11% 15%

Mortgage originations by product

18

Deterioration of lending standards, 2002 to 2006: Leverage w/out Docs Table 3

ARMS

Orig Yr CLTV CLTV>80 Seconds Full Doc IO% DTI FICO<700 Investor WAC SpdtoWAC

Prime 2002 66.4 4.1 1.9 56.0 46 31.0 20.7 0.7 5.5 - 2003 68.2 10.1 10.9 48.6 53 31.8 21.8 1.6 4.6 - 2004 73.5 20.7 23.1 51.2 71 33.5 22.0 2.1 4.5 - 2005 74.1 21.7 26.8 47.3 81 33.6 18.9 1.9 5.4 - 2006 75.3 26.2 35.3 33.6 91 37.2 19.5 2.3 6.2 -

Alt A 2002 74.3 20.8 2.7 29.3 26 35.4 46.4 9.9 6.3 0.82003 78.0 33.3 23.4 28.1 56 35.3 44.7 12.9 5.6 1.02004 82.6 46.9 39.1 32.6 75 36.2 44.3 15.3 5.5 1.02005 83.5 49.6 46.9 28.3 83 37.0 40.5 16.5 6.0 0.62006 85.0 55.4 55.4 19.0 87 38.3 44.2 13.5 6.8 0.6

Subprime 2002 81.2 46.8 3.7 66.9 1 40.0 93.4 4.7 8.5 3.02003 83.5 55.6 9.9 63.5 5 40.2 91.6 4.9 7.5 2.92004 85.3 61.1 19.1 59.9 20 40.6 90.6 5.3 7.1 2.62005 86.6 64.4 28.1 55.9 32 41.2 89.7 5.4 7.3 1.92006 86.7 64.0 31.0 54.6 20 42.1 91.8 5.7 8.2 2.0

Source: Loan Performance data as of November 2006. UBS, April 16, 2007, Thomas Zimmerman, "How Did We Get Here and What Lies Ahead"

Spreads declined

CLTV (leverage) increases

% Full Doc declined

Nonprime mortgage lending replaced the

“American Mortgage”: where and why?

February 13, 2009 Susan M. Wachter 2020

A Housing Bubble Starting in 2003, Especially in the “Sand States”

Prices by City (Case-Shiller)

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phnxlamiamitampalvchicagomnpls

ar m_p 0% t o 25% >25% t o 50% >50% t o 75% >75% t o 100%ar m_ p 0% t o 25% >25% t o 50% >50% t o 75% >75% t o 100%


Percent of All Loans—Adjustable Rate

1999 2006


Percent of All Loans—Low Documentation- by 2006, 25% of loans

l owdoc_ p 0% t o 25% >25% t o 50% >50% t o 75% >75% t o 100% l owdoc_p 0% t o 25% >25% t o 50% >50% t o 75% >75% t o 100%

1999 2006

t easer _ p 0% t o 25% >25% t o 50% >50% t o 75% >75% t o 100%


Percent of Adjustable Rate Loans—Teaser (2006)

Source: www.newyorkfed.org/mortgagemaps

Number of Subprime Loans

Source: www.newyorkfed.org/mortgagemaps

Increase in House Price Index

-20<-10%

No correction

>-20%

-10%<0%

Sources: Fiserv Lending Solutions, Moody's Economy.com, OFHEO

Projected Peak-to-Trough House Price Decline, %

Originators / Brokers

Secondary Market

Investors• Borrowed at teaser rates-

not able/expected(?) to pay at reset

Borrowers

Rating Agencies• Originate to

distribute

• Securities marked to models not to market/assignee liability exemption

• Agency incentives misaligned- “current conditions” out

• Lack of short sales, CDS

Where does the

buck stop?

How did we get here?


Deregulation and Regulatory Arbitrage: “Competitive Regulation”• Charter competition fueled a race to

the bottom in underwriting standards

• Migration to federal bank and thrift charters

• At the federal level, regulation and examinations of nonbank mortgage lending subsidiaries were lax


Deregulation• The proposed Federal Reserve Board

Regulatory Oversight of mortgages not implemented until 2008, HOEPA (Home Ownership and Equity Protection Act, 1994) irrelevant,<1% loans

• 2004 act SEC allowed investment firms to – increase leverage to 40 to 1 – to voluntarily measure their capital, and – decrease SEC oversight

• 2000 State reserving for CDS issued by insurance companies, Fed govt precludes

Market and Regulatory Failure• Risk taking without accountability

– Too big to fail, too small to sue• Underpriced risk is inevitable,

compensation for generating risk without accountability

WHY?• Decades of securitization, 1980-2000—no problem• Historically-interest rate risk securitized, default

risk controlled for and not priced, only prime mortgages securitized

• “Innovation:” Private label securitization of default risk

• Private label mortgage backed securities did not trade

• Priced based on Marked-to-Model paradigm Not Marked-to-Market,

• Market and regulatory discipline absent


New Financial Architecture• Replace Basel II

– Basel II: regime of self-regulation

• End “Competitive Regulation”– Race to the bottom

• Single Regulator

• Asset Bubbles– What is a single regulator regulating?– How do we regulate asset bubbles?

PerspectiveThe events of the past year or two have highlighted regulatory gaps and deficiencies that we must address to improve the structure of our markets and the resiliency of our economy. As we recover from the current crisis, it will be important to address these issues as soon as possible, to develop a regulatory structure that will better respond to future economic challenges.--Ben Bernanke

Thank You

Susan M. WachterRichard B. Worley Professor of Financial

ManagementProfessor of Real Estate and Finance

The Wharton SchoolUniversity of Pennsylvania

[email protected]

understanding the sources and way out of the ongoing financial upheaval

Documents

moodys economy

financial markets

global economy

financial system crisis

new financial architectureneed

mark zandi

credit crisis

credit markets