First Pres Van Order
Transcript of First Pres Van Order
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Paul Haran
Principal,UCD College of Business & Law
Welcome
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Tom Begley
Dean,UCD Schools of Business
Introduction
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Prof Robert Van Order
Professor of Finance,University of Michigan
Keynote Speaker
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TOPICS
Overview: Property Values in U.S. and Ireland
What are Subprime loans?
Role of Securitization and structuring.
How has the market changed?
Effects on Mortgage Markets and implications.
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Overview
Rapid house price growth has been a part of life for about adecade in most of Europe and North America. E.g., theU.S.. has had rapid growth; Ireland more so.
Ireland has also had a production boom. Production hasbeen around 15% of the economy.
There is evidence of decline now. Is this the bursting of abubble? Maybe, but not like the tech bubble in late 90s.
It has long been known that declining property values playa big role in mortgage default. There has been a very largeincrease in troubled (delinquent plus in foreclosure)subprime loans in the U.S., much more so than for primeloans.
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Overview
The market in which these are traded-viasecuritization- has more or less collapsed, and therehave been spillovers into seemingly unrelatedmarkets.
There is pressure for policy change. However, the
details of the problem are not clear, and precipitouspolicy changes are not a good idea
Ireland has a small sub prime market, but very bigprice increases. It is poised for a decline. But like theU.S. not a tech boom like bubble.
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Ireland had a Regime
Change in the mid 1990s
Prices of Used Houses: Ireland and Dublin
0
100,000
200,000
300,000
400,000
500,000
600,000
1978
Q1
1981
Q1
1984
Q1
1987
Q1
1990
Q1
1993
Q1
1996
Q1
1999
Q1
2002
Q1
2005
Q1
Ireland
Dublin
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The U.S. has had strong
growth, but not like Ireland
House Prices: Ireland and U.S. 1978-2007
0
5
10
15
20
25
1 13 25 37 49 61 73 85 97 109
Time
U.S.
Ireland
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WHAT IS A BUBBLE?
0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
1981
1984
1986
1988
1990
1993
1995
1997
1999
2002
2004
2006
NASDAQ
S&P 500
National HPI
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Subprime Loans
Borrowers with bad credit history
Used to be defined by lender (Money Store)
Now by FICO score and related credithistory
Quantifying credit history was a big deal in
securitizing high risk loans because ofagency problems
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Subprime Used To Be About 10%
Of The Market, But Its Share
Increased a Lot After 2003.
Should we be surprised in a market expandingthat fast that quality deteriorated?
Market shares
0
10
20
30
40
50
60
70
1 2 3 4 5
2001-2005
FHA/VA
Conforming
Subprime+Alt-
A
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0
1
2
3
4
5
6
7
8
9
1998
1999
2000
2001
2002
2003
2004
2005
2006Q1
Subprime and FHA Delinquency
Rates vs Those on Prime.Until recently subprime didnt look all that bad.
Loans 90 days or more delinquent or in foreclosure (percent of number)
Source: Mortgage Bankers Association and Loanperformance.com (through first quarter 2006)
Prime Conventional
VA
FHA
Subprime
Recession
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What Determines Credit Risk?
Here are some results from Freddie Mac data. Theloans are not really subprime but some have lowcredit scores.
Credit history matters, so does equity.
The problem of layering.
Everyone knew this stuff was risky, but it was riskierthan previously thought. (Getting caught with yourparameters down?). E.g., a small but significant shareof the 2007 originations didnt make the first payment.
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HOUSE PRICES AND DEFAULT:Equity Matters. So Does Diversification
Default Probability vs. House-Price Appreciation
State/Origination Year and National/Origination Year Cohorts (1985-1995)
80% Loan-to-Value, 30-Year Fixed-Rate Home-Purchase M ortgage
NV 1985
HI 1994
AZ 1985
CA 1989
CA 1990
DC 1995
AK 1986
0%
5%
10%
15%
20%
25%
-30% -10% 10% 30% 50% 70% 90% 110% 130%
5-Year Cumulative House-Price Appreciation
CumulativeDefau
ltRate
Individual States National
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Whats Going on Now?
Prices are FallingThough by how much is lessclear
Otherwise the economy is growing ok and theunemployment rate is relatively low.
So from the macro side its the price decline thatseems to be the problem.
But that probably doesnt explain the suddendivergence between prime and subprime.
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Securitization:
Is it the Problem? Securitization involves selling pools and shares of pools
loans into the bond market
Not new-Mainstay of the market for around 30 years
Nor is division of labor between servicer and investore.g.,Ginnie Mae
Ginnie Mae and FHA (substitute for subprime
Fannie Mae, Freddie Mac and Ginnie Mae provide credit
guarantees.
The non agency market is different.
THE ECONOMICS OF
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THE ECONOMICS OF
SECURITIZATION
Securitization involves packaging and selling pools ofloans in order to gain access to securities (bond) markets(e.g., rather than deposit markets). Mortgages, Car loans,David Bowie.
The major contribution of securitization is that it opens the
mortgage (or other) market to bond markets and long termlending.
This is in contrast with traditional depositories (banks),which tend to be forced into short term funding and do notusually have an elastic source of funds.
THE ECONOMICS OF
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THE ECONOMICS OF
SECURITIZATION
But there is cost. Bond market investors are at aninformational disadvantage relative to those selling themthe bonds: asymmetric information.
The key is understanding and managing the tradeoffbetween the greater efficiency of funding in capital
markets and the asymmetric information. The balancedoes not always fall on the side of securitization. Bankfunding (via deposits or bonds) may be the way to go.
Even if securitization is the way to go, it may needsignificant structuring to work.
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STRUCTURING
(AKA slicing and dicing)
The idea is get access to the bond marketvs the depositmarketgetting around banks.
But there are agency problems because investors arentsure of what theyre getting: Both adverse selection andmoral hazard.
For the Agencies this is done via Agency guarantees andback up form their charters.
For others (e.g., commercial and nonconformingmortgages, like subprime) some enhancement is needed.
Typically this is done by structuring.
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Senior/Subordinated Structures
Senior/Sub structures are the most popular. They
allow most of the credit risk to remain with originatorand/or specialists and get intuitional investorsinterested in the senior part.
The trick is prioritize the cash flows so that there is aqueue and originators or specialists take the bulk of
the credit risk
This means that a pool of B type securities can havemost of it funded with AAA paper.
That there were AAA pieces is consistent with theloans in the pool being junk bonds.
A TYPICAL STRUCTURE
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A TYPICAL STRUCTURE:
FOCUS ON SUBORDINATION
Loan 1 Loan 2 Loan 3 Loan 4$1 BillionTotal Loans..
Trust
$850mAAA Rated
$100m, A Rated,
$50m, NR,
$1 BillionSubprime
Structured Deal
A C i l D l (C t D id S d t )
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Class
Initial Cert.
Balance or
Notional Amt. Spread
Rating
(Moody's/
Fitch)
Percent of
Initial Pool
Balance Sub-ordination
Initial Pass-
Through Rate
(approx.)
Weighted
Average Life
(yrs)
Payment
Window
A-1 $261, 582,000 48 Ass/AAA 15.4% 28.5% 6.830% 4.00 1 - 75
A-2 $227, 661,000 62 Aaa/AAA 13.4% 28.5% 6.853% 7.50 75-108
A-3 $724,100,000 65 Aaa/AAA 42.7% 28.5% 6.869% 9.71 108-119
B $67,879,000 70 Aa2/AA+ 4.0% 24.5% 6.918% 9.94 119-120
C $50,909,000 75 A1/AA 3.0% 21.5% 6.898% 9.96 120-120
D $50,909,000 85 A2/A+ 3.0% 18.5% 6.997% 10.01 120-125E $93,334,000 100 Baa2/BBB 5.5% 13.0% 7.085% 11.45 125-158
F $25,454,000 118 Baa3/BBB- 1.5% 11.5% 7.222% 13.53 158-170
G $84,849,000 BB/BB 5.0% 6.5% 7.414% 14.93 170-195
H $59,394,000 B 3.5% 3.0% 6.600% 17.99 195-235
J $16,969,000 B- 1.0% 2.0% 6.600% 19.78 235-242
K $33,944,278 Unrated 2.0% 0.0% 6.600% 22.0 242-358
X $1,696,984,278 Notional Amt Aaa/AAA N/A N/A 1.629% N/A 1-358
Total $1,696,984,278
Securities
Bonds:
A Commercial Deal (Courtesy: Davidson, Sanders etc)Bonds for GMAC 1997-C1 Deal
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Quality Deterioration
Why Did The Defaults Increase?
Recent paper by Yuliya Demyanyk (FRB St. Louis) andOtto Van Hemert (NYU) suggests very mixed reasons
It looks like it was not Adjustable rates or lowdocumentation especially.
High LTV loans
A prime candidate is that agency costs went up(Lyingand cheating by loan originators). Loan originators workingat the margine of what is allowed in the contract.
Appraisals probably got worse.
Who is holding the bag? Representations and warranties.
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Effects: Trading Drying Up-
Spillover into Unrelated Markets
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So What?We dont know much about the contributions
of the things the media seem sure are evil
Rate adjustments?
Predatory Lending?
Documentation?
Government pushing banks into riskyareas?
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Some Bad Ideas.Remember the Subprime market is very private and very
competitive- Exit is easy and the only thing
lenders/investors have is pricing and equity in the property.
Forced restructuring.
Making lenders/investors responsible forborrowers risk-taking
Restricting terms like prepayment
penalties.
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IRELAND
Bubble Candidate, but not like techstocks
Subprime market is small
Looking forward: Securitization isnt allbad and has been manageable.
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IRELAND
Its not easy expanding loan markets toriskier borrowers. You cant expect to do itwithout mistakes and lots of defaults.
How far are you willing to let consenting
adults go?
How do you know if consent is informed?
Watch speed of market growth and loan tovalue ratios.
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