An Inquest into the Subprime Crisis

, image by Paul Townsend

Coroners Inquests in Gloucestershire from The Gloucester Journal 1814

Juan Ospina and Harald Uhlig have posted Mortgage-Backed Securities and the Financial Crisis of 2008: A Post-Mortem to SSRN. Given that the market for private-label MBS pretty much died by 2008, the title is apt. The paper presents a challenge to many of the standard narratives that have developed to explain the causes of the subprime crisis and the broader financial crisis that followed. Other researchers in this area will surely take up the gauntlet thrown down by this paper. Hopefully, we will collectively come up with the right narrative to explain the whole mess. The paper opens,

Gradually, the deep financial crisis of 2008 is in the rearview mirror. With that, standard narratives have emerged, which will inform and influence policy choices and public perception in the future for a long time to come. For that reason, it is all the more important to examine these narratives with the distance of time and available data, as many of these narratives were created in the heat of the moment.

One such standard narrative has it that the financial meltdown of 2008 was caused by an overextension of mortgages to weak borrowers, repackaged and then sold to willing lenders drawn in by faulty risk ratings for these mortgage back securities. To many, mortgage backed securities and rating agencies became the key villains of that financial crisis. In particular, rating agencies were blamed for assigning the coveted AAA rating to many securities, which did not deserve it, particularly in the subprime segment of the market, and that these ratings then lead to substantial losses for institutional investors, who needed to invest in safe assets and who mistakenly put their trust in these misguided ratings.

In this paper, we re-examine this narrative. We seek to address two questions in particular. First, were these mortgage backed securities bad investments? Second, were the ratings wrong? We answer these questions, using a new and detailed data set on the universe of non-agency residential mortgage backed securities (RMBS), obtained by devoting considerable work to carefully assembling data from Bloomberg and other sources. This data set allows us to examine the actual repayment stream and losses on principal on these securities up to 2014, and thus with a considerable distance since the crisis events. In essence, we provide a post-mortem on a market that many believe to have died in 2008. We find that the conventional narrative needs substantial rewriting: the ratings and the losses were not nearly as bad as this narrative would lead one to believe.

Specifically, we calculate the ex-post realized losses as well as ex-post realized return on investing on par in these mortgage backed securities, under various assumptions of the losses for the remaining life time of the securities. We compare these realized returns to their ratings in 2008 and their promised loss distributions, according to tables available from the rating agencies. We shall investigate, whether ratings were a sufficient statistic (to the degree that a discretized rating can be) or whether they were, essentially, just “noise”, given information already available to market participants at the time of investing such as ratings of borrowers.

We establish seven facts. First, the bulk of these securities was rated AAA. Second, AAA securities did ok: on average, their total cumulated losses up to 2013 are 2.3 percent. Third, the subprime AAA-rated segment did particularly well. Fourth, later vintages did worse than earlier vintages, except for subprime AAA securities. Fifth, the bulk of the losses were concentrated on a small share of all securities. Sixth, the misrating for AAA securities was modest. Seventh, controlling for a home price bust, a home price boom was good for the repayment on these securities. (1-2)

Monday’s Adjudication Roundup

  • BNY Mellon files a brief on writ for cert with the Supreme Court warning the potential for “warping” the residential mortgage-backed securities market if it overturns the Second Circuit’s decision finding that provisions of the Trust Indenture Act did not apply to the securities at issue.
  • Investors of Citibank file a class action in NY state court claiming that Citibank ignored toxic residential mortgage-backed securities causing $2.3 billion in losses.
  • Investors sue RAIT Financial Trust and its trustees alleging that the trust knew about subsidiary pocketing fees leading to a $21.5 million SEC settlement.

Monday’s Adjudication Roundup

FHA’s Net Cost of $15 Billion

The Congressional Budget Office posted FHA’s Single-Family Mortgage Guarantee Program: Budgetary Cost or Savings? In response to the question, “Has FHA’s Guarantee Program for Single-Family Mortgages Produced Net Savings to Taxpayers,” the CBO responds,

No. Collectively, the single-family mortgage guarantees made by FHA between 1992 and 2012 have had a net federal budgetary cost of about $15 billion, according to the most recent estimates by FHA. In contrast, FHA’s initial estimates of the budgetary impact of those guarantees sum to savings of $45 billion . . .. That swing of $60 billion from savings to cost primarily reflects higher-than-expected defaults by borrowers and lower-than-expected recoveries when the houses of defaulted borrowers have been sold—especially for loans made over the 2004-2009 period. (1)

The document contains a chart of estimates of the budgetary impact of the FHA’s single-family mortgage guarantees by year. It shows that the 2008 vintage was particularly bad, accounting for over $15 billion in losses by itself (the other years’ savings and costs would thus net out).

There are some disturbing aspects of this finding and some that are not. First, the disturbing ones. The FHA has not been transparent about its potential for losses and bailouts (see here for instance). Second, its own financial projections have been overly optimistic.

That being said, the mere fact that the FHA is expected to have losses is not in itself an indictment of the government’s strategy of using the FHA to provide liquidity to the mortgage markets during the financial crisis. If only this were done forthrightly . . . but perhaps that is too much to ask in the midst of the crisis itself.

Fannie and Freddie’s Unreported Billions of Losses

The Federal Housing Finance Agency’s Inspector General has warned FHFA Acting Director DeMarco that the FHFA has allowed Fannie and Freddie to defer acknowledgment of billions of dollars of losses relating to seriously delinquent singe-family residential mortgage loans for far too long.

The Office of the IG recommends that estimates of these losses be reported immediately, on an ongoing basis. There are all sorts of obvious good reasons to do this, including the fact that “[c]lassification of loans according to risk characteristics is a critical factor considered by financial regulators to evaluate a financial institution’s safety and soundness”  and that it accords with Generally Accepted Accounting Principles. (1)

directly through interest

Fannie and Freddie’s recent reports of billions of dollars of profits have caused a scrum to form around the two companies, as investors in preferred shares seek to get a slice of those profits through a series of lawsuits (here, here, here and here for example), as low-income advocates seek to fund the Housing Trust Fund through a lawsuit (here) and as some politicians forget the risks that these two companies present to the American taxpayer and seek to reanimate the two companies.

In a perfect world, we would ask what kind of residential housing finance infrastructure we want to implement for the next fifty years or so and what should happen to Fannie and Freddie should have little to nothing to do with their current profits or losses. But the political reality is that it does. With that as a given, we should at least have an honest assessment of their balance sheets. But the FHFA is keeping us in the dark. It needs to turn the lights on so that we can understand the true magnitude of these unreported losses so that the debate about Fannie and Freddie can be held with as much accurate information as possible.