Subprime: Playing with Risky Assets

By:

Sean Neary

Brandon Zears

Manuel Gutierrez

Abstract

In this paper, we will go into how subprime mortgages came to be and the history behind their creation. Then we will discuss how they positively and negatively affected the US economy. We will also look at how subprime mortgages relate with other markets, and then examine where we are now and what might have helped or hindered our current crisis. Last, we will discuss how actions being taken might affect the future.

Large risks reap even larger rewards. This mentality played a key role in the birth of sub-prime loans during the final months of 2001. How long can such a strategy be practiced before risks increase to become clearly more evident than any rewards? An analysis of the current economic conditions of the United States financial markets depicts the brutal answer. In particular, sub-prime loans have become the subject of various financial arguments, as the source of the ever-growing woes of the existing economic situation being faced in the United States.

To begin, we will look at the progression that led to the situation we are currently facing. On September 16th, 2001; months after the “dot.com” bubble had burst and just five days following the terrorist attack that demolished the world trade center towers, the Fed along with government officials needed to do something to aid an economy that was already on the brink of recession. The strategy that the Federal Reserve chairman, Alan Greenspan, chose to enact was sharp cuts in the Fed Funds Rate. Their hopes were to increase consumer confidence by increasing individuals’ abilities to spend, through more financial liquidity. The Fed’s decision was followed quickly with President George W. Bush making a public address encouraging the people of the United States to not let terrorists succeed in destroying our economy by cutting off the normal flow of business. Bush proposed that we could stay strong as a nation if citizens would go out and spend money as they normally would, rather than hold onto it in fear of what was yet to come.

A drop in interest rates, making them lower than had been seen in a generation, succeeded in encouraging renewed consumer spending. Opportunities for individuals to borrow vast amounts of money at minor costs did not take long to emerge. A large percentage of the money borrowed during this time was reinvested into home mortgages; essentially due to home equity rising at more than generous rates. This situation only becomes a problem when housing prices increase so much that individual’s incomes are no longer capable of purchasing new homes, thus creating decreased demand and declines in housing prices. Many mortgage brokers were hard at work attempting to derive a solution to this and to provide the opportunity to each and every individual who wanted to get a loan.

The answer to the problem was seen through the involvement of Congress with the birth of Fannie Mae and Freddie Mac. The two companies were in essence a warehouse of loans bundled up and sold by mortgage brokers. Fannie and Freddie helped increase the volume of loans by purchasing housing loans from brokers, who then had larger cash flows to lend out to other potential borrowers. Fannie and Freddie gained on this through the inflow of monthly payments by homeowners. These monthly payments then are bundled up and sold in shares. This is where mortgage backed securities were first developed. These securities were particularly low risk investments since Fannie and Freddie almost monopolized the market and had stringent terms as to who qualifies for a loan. It was not until large accounting scandals hit Fannie andFreddie that other mortgage brokers attempted to break into the trillion-dollar market and change some of the stern lending terms that were currently in place.

The investor that these brokers had in mind to aid their entrance to the market came in the form of Wall Street. The plan was for Wall Street to sell shares of securities comprised of American homes,to borrowers. These securities were seen as great investments’, not only by individuals in the United States, but also by many other countries. The big problem arose once mortgage brokers began to convince Wall Street into purchasing securities that were of tremendously high risk. These high-risk securities were comprised of sub-prime loans.

Subprime refers to lending practices in which loans are given to high-risk borrowers with questionable credit. These loans are similar to normal everyday loans with the difference of much higher interest rates as well as higher fees associated with the loan. The increased rates and fees compensated the issuers for additional risk of lending to high-risk individuals or companies. Many of the individuals that were given subprime loans would not qualify for a prime loan because their credit score and past borrowing history is not one that would merit a loan. Many banks and loan officers use FICO scores to help determine the interest rate for the loans. Chart 1 shows a breakdown of FICO scores by percentile, percentof population, and delinquency rates.

PERCENTILE / % OF PEOPLE / SCORE / DELINQUENCY RATE
2nd / 2% / 300-499 / 87%
7th / 5% / 500-549 / 71%
15th / 8% / 550-599 / 51%
27th / 12% / 600-649 / 31%
42nd / 15% / 650-699 / 15%
60th / 18% / 700-749 / 5%
87th / 27% / 750-799 / 2%
100th / 13% / 800-850 / 1%

Chart 1

The delinquency rates by FICO score can be seen clearer in Table 1. For example, of individuals’ with a FICO score between 550-599, approximately thirty-one out of every hundred loans will result in loan default, bankruptcy or longstanding overdue debts. Therefore, the risks associated with credit scores of 700+ have incredibly minimal risk associated with them due to lower delinquency rates.

Table 1(Source:

Risk compensation can also be seen from another point of view with the analysis of average interest rates for different ranges of credit scores. This can be seen in the Table 2. Using this it is clear to see that individuals’ with lower credit scores receive higher interest rates since they necessitate much higher risk than individuals with higher credit scores. Borrowers’ had previously assumed that it would be much more difficult to pay back high interest loans until the true theory behind subprime surfaced.

Table 2(Source:

The theory behind subprime loans is that even when borrowing at higher interest rates, individuals may still benefit as long as housing prices continue to appreciate at the same rate or greater than the amount of debt accumulated in a certain period. This allows for refinancing to pay off the debt accumulated on the original loan with some possible profit even though new principle values are higher. Table 3 illustrates housing price indexes from 1976 – 2007.

This thinking alluredmany prospective homebuyers’ into loans in which they knew they would not be able to pay off if anything happened to their incomes or if housing prices declined. However, loan officers performed questionable procedures to convince prospective homebuyers’ that there was little to no risk involved. Loan officers stressed that housing prices had been continuously climbing year after year. The loan officers instructed their clients to take on these loans and then refinance each year in order to keep up with payments of debts. Many loan officers would sell their clients the idea that this was the way for them to achieve the so-called “American Dream.”

In 2007, the Housing Price Index reached a negative rate for the first time ever. This means that the value of homes deflated and the value of mortgages were greater than the market value of homes. This limited the ability for homeowners’ to refinance their mortgages. Homeowners were also limited when it came to selling their homes to pay off their mortgages since their equity has been diminished. Most of the sub-prime borrowers were counting on the ability to refinance their mortgages so that they could pay off debt that had accumulated, and cover missed payments on their mortgages. Once the value of homes started to fall, many of the borrowers started to default on their mortgages. Borrowers’ did not feel it was necessary to pay off a mortgage valued at more than the market value of their home. Most of the homeowners that held sub-prime mortgages already had the mentality to not pay off their debt with out of pocket capital and this made the situation even worse.

Many issues as of late have discredited the legitimacy of subprime loans. The current mortgage crisis that the United States is experiencing is the number one example. Simply stated, too many loans were processed for unworthy borrowers who had little chance of successfully repaying their debt. Most, if not all of the lending facilities knew prior to lending to these people that they were assuming control of very high-risk investments as well as dealing with high-riskindividuals whom have defaulted on previous liabilities. These risks are illustrated in Table 4.

Table 4shows mortgage delinquency rates for sub-prime loans in comparison to prime loans. The graphs can be interprited with the subprime having a higher default rate compared to that of prime loans. There is also

greater variance in the default rate for subprime, where the prime loans are consistent. Much of the variance and higher default rates could possibly be described by the types of borrowers that are being lent to. The risk that was assumed should account for the higher default rates.

Although these risks should have been assumed, many of the financial institutions did not expect such a high rate of default to occur. Some underlying qualities that subprime borrowers possess are:

  • Two or more loan payments paid past 30 days due in the last 12 months, or one or more loan payments paid past 90 days due the last 36 months,
  • Judgment, foreclosure, repossession, or non-payment of a loan in the past,
  • Bankruptcy in the last 5 years,
  • Relatively high default probability as evidenced by the credit score,
  • Overextension of credit.

The prime loans are consistent due to the type of individuals that are given loans having a higher credit score along with a history of repayment of their debts. A prime loan typically consists of a borrower putting down 20 percent or more of the value of the loan for a down payment in order to purchase a home. With a sub-prime borrower, the down payment was much lower (between zero and 10 percent). Subprime borrowers were also more susceptible to unconventional loan practices due to lack of other lending options. A few of the new types of loans created that were targeted towards sub-prime borrows include, but not limited to:

  • Options - Entitles borrowers to defer some of their monthly payments, which would result in increased loan balances due to negative amortization of the interest.
  • Convertible - Starts out with a fixed rate and then converts to an adjustable rate at a specified date addressed on the loan.
  • Low documentation/no documentation - The borrower does not have to provide paperwork to prove income, employment, or control of assets. This is also known as “stated income” since lenders do not require documentation of any information regarding credit worthiness.

Due to these questionable loan practices, it should not have come as surprise to any lender that mass defaults would occur.

One strategy lenders use to distance themselves from the obligation of holding these loans is by bundling them and then reselling the bundles to larger financial institutions; as we had briefly touched on previously in our paper. These financial institutions then re-bundle the previous bundles with ones from other banks and resell them to other institutions as securities on Wall Street. The creation of these bundled form mortgage backed securities (MBS) and certified debt obligations (CDO). They are then traded in the open market as investments. With this process, the party responsible for paying off the defaulted loans is uncertain to investors since so many banks and institutions are involved. This process leads to a decreased realization of the risk that has been assumed by the original lenders that gave out the risky loans. Defaulted loans thus not only affect the banking intuitions but also consumers whom have invested in the securities. When many defaults occur, the value of the securities can diminish at rapid paces. The bundling of loans was mainly done by larger Wall Street banks, which bought loans from smaller firms knowing that they were subprime and of high default risk. This helped increase liquidity to smaller banks with by supplying them with constant flow of funds.

When new investments join the market they have to be graded based on volatility of risk by a rating facility. The rating scale for investment grade bonds and securities range from “AAA” to “BBB” with “AAA” being the least risky investment with consistent returns. The ranking “BBB” is ranked as being the most risky of investment grade. Due to increased risk associated with “BBB” investments, higher yields are received. This providing incentives to purchase riskier rated assets over virtually risk free assets that have significantly lower returns. The CDOs would have normally been under a “BBB” rating because of what they were composed of (subprime loans).

The major rating agencies were Moody’s & Fitch, Standard, and Poor’s. CDOs were the focus of these major rating agencies. CDOs are very well thought-out products that are seen to be highly complex and difficult investments to understand. A lot of the time, buyers did not have the slightest idea as to whatthey were really purchasing. Even though buyers did not really know what they were getting their hands on, they knew that with homebuyers not defaulting, their investment would be a wise one. For the duration of the housing boom of the 2000’s, housing prices surged and a limited number of borrowers defaulted. The riskier “BBB” rated securities made from mortgages looked just as good as the safer “AAA” that did not consist of mortgages, but with much higher returns. Agencies were said to have been paid for their appraisals by the same banks that issued the securities to be rated. With this, the agencies had the incentive to give better ratings to securities for the purpose of repeat business. This would give the rating companies a terrible reputation if they were caught overrating numerous amounts of bonds and not justifying doing so. This leads to investors not trusting the rating system, making ratings inadequate and leading to the rating companies going out of business. With some ingenious math and possibly some collusion since the rating agencies depended largely on Wall Street banks to bring them repeat business these CDOs received “AAA” ratings. The rating of “AAA” meant that universities and foreign investors were willing to invest in these CDOs because they were very secure. About 50% of all CDOs created were sent to Asian investors who were sure that with a “AAA” rating, securities backed by American homes would be a safe investment. There was little to no regulation of the creation of the CDOs, much less the issuing or sale of the original subprime loans that were issued out by lenders.

Sub-prime loans received sudden attention and grew at rapid rates. Subprime loans have been said to be in the right place at the right time for Wall Street. Wall Street saw an opportunity to gain from large returns on investments without internalizing the true risk behind the loans. In the late 1990’s the quasi-private institutions known as Fannie Mae and Freddie Mac were under large scandals with the CEOs departing and some business practices were under scrutiny. With the lenders having no place to turn for securing their mortgages and maintaining liquidity, Wall Street became an opportunity that the lenders could not wait to get their hands on.

With Wall Street now being in charge of providing mortgage backed securitiesand having a seemingly infinite amount of money to continue to purchase more mortgages, lenders saw this as an opportunity to make huge profits. Wall Street took advantage of this and capitalized on the bundles of mortgage backed securities by selling to investors overseas. Banks on Wall Street took advantage of the West Coast housing markets and decided that it would obtain their supply of mortgages mostly out of the West Coast. Bankers decided that in order to obtain the greatest amount of mortgages, the majority of them dropped their standards and regulations. Michael Francis, a major player on a popular Wall Street bank firm, goes on to say, “We removed the litmus test. No income, no asset. Not verifying incomes… breathe on a mirror and if there's fog you sort of get a loan." (House of Cards)