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)

Blockchain and Securitization

image by  David Stankiewicz

Deloitte prepared a report on behalf of the Structured Finance Industry Group and the Chamber of Digital Commerce, Applying Blockchain in Securitization: Opportunities for Reinvention. It opens,

The global financial system is betting on blockchain to revolutionize many aspects of its business, and we (the Structured Finance Industry Group and the Chamber of Digital Commerce) believe that securitization is one of the areas in the capital markets that could most benefit from this transformation. Janet Yellen, Chair of the Board of Governors of the Federal Reserve System, recently called blockchain “a very important new technology” that “could make a big difference to the way in which transactions are cleared and settled in the global economy.” Financial services institutions have already invested over a billion dollars in the technology, with most big banks likely to have initiated blockchain projects by the end of 2017. There are already hundreds of use cases, ranging from international payments to securities processing, while technology firms including Amazon, Google, and IBM are offering a host of blockchain services aimed at the financial industry.

Why are all of these companies investing in blockchain? This new technology has the potential to dramatically disrupt the role of intermediaries—including that of banks—in financial transactions. Traditional activities performed by intermediaries might be changed or even replaced. Blockchain can also bring significant advances in efficiency, security, and transparency to many of the financial sector’s activities.

*     *     *

The Structured Finance Industry Group and the Chamber of Digital Commerce commissioned Deloitte & Touche LLP (Deloitte) to explore how blockchain might reinvent securitization—and how the securitization industry should consider preparing for this rapidly approaching future. This industry is exploring this nascent technology’s potential benefits and costs. Firm answers on blockchain’s likely use cases are not yet available, but discussions with securitization and blockchain experts have led to some key observations and insights about implications and possible paths forward. (1, footnotes omitted)

The report’s bottom line is that “[b]lockchain and smart contracts could catapult the securitization industry into a new digital age.” (2) It finds that

The technology’s potential to streamline processes, lower costs, increase the speed of transactions, enhance transparency, and fortify security could impact all participants in the securitization lifecycle—from originators, sponsors/issuers, and servicers to rating agencies, trustees, investors, and even regulators. (2)

The report provides a nice overview of blockchain basics for those who find distributed ledger technology to be mysterious. The real value of the report, however, is that it provides concrete guidance on how blockchain can be integrated in the securitization process. There is a chart on page 24 and an explanation of it on the following page that shows this in detail. This level of detail makes it much easier to visualize how blockchain can and most likely will change the nature of the business in years to come.

Another Housing Bubble?

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Trulia quoted me in Warning Signs: Another Housing Bubble Is Coming. It opens,

Signs show another bubble coming. Some experts have a different opinion.

When the housing market crashed in 2008, it caused what came to be known as ”The Great Recession.” When the bubble burst, it ”sent a shock through the entire financial system, increasing the perceived credit risk throughout the economy,” according to a report published in The Journal of Business Inquiry.

The crash caused homes to lose up to half their value. People became underwater, owing more than their home was worth. And who wants to pay on a mortgage that’s larger than what the home could sell for? Although some people did just that, many more opted to short sell their homes or to simply walk away and have the bank foreclose.

Present Day

Fast-forward to 2016, and we are seeing hot, even ” overheated,” housing markets; bidding wars; rising home prices; and house flippers – all the signs of a housing bubble that’s about to burst. Are we repeating the mistakes we made before? Yes and no. Let’s explore four reasons the housing bubble burst and whether we’re experiencing the same conditions today.

1. Easy Credit

Before the 2008 crash, credit was easy to get. Pretty much, if you were breathing, you could get a mortgage loan. This led to people getting mortgages who ultimately couldn’t afford to pay them back. They lost their homes, and this contributed in large part to the housing crisis. Today the situation is different. ”Credit is still much tighter than it was before the financial crisis,” says David Reiss, professor of law at Brooklyn Law School. ”This is particularly true for those with less-than-perfect credit scores.” He explains: ”There are almost no no-down-payment loans as there were in the early 2000s. Those defaulted at incredibly high rates.”

But what about Federal Housing Administration (FHA) loans? They feature ”low down payments, low closing costs, and easy credit qualifying.” Those are the very features that should sound some warning bells. But before you get too alarmed, keep in mind that the FHA has been making loans to people who do not qualify for a conventional mortgage since 1934. ”While there are low-down-payment loans available from Fannie, Freddie, and the FHA, their underwriting standards appear to be higher than those for low-down-payment products from the early 2000s,” says Reiss.

2. Low Interest Rates

Mortgage rates have been low for so long that you might not realize that was not always the case. In 1982, for example, mortgage rates were 18 percent. From 2002 to 2005, the rates stayed at about 6 percent, which enticed people to take out mortgage loans. And in 2016, we’re seeing historic lows of under 3.5 percent. If rates go up, we might see housing demand and housing prices fall.

3. ARMS

Before the housing crash when home prices were rising fast, many people were priced out of the market with a fixed-rate mortgage because they couldn’t afford the monthly mortgage payments. But they could afford lower payments that were possible with an adjustable-rate mortgage – until that rate adjusted up. In 2005, 38.5 percent of the mortgage market was ARMs. But in 2015, that amount has dropped considerably to 5.3 percent.

4. A Buying Frenzy

There’s an old story that before the stock market crash of 1929, Joseph Kennedy, Sr., sold his shares. Why? Because he received a stock tip from a shoeshine boy. Kennedy figured, the story goes, that if the stock market was popular enough for a shoeshine boy to be interested, the speculative bubble had become too big.

Before the housing crash, this country saw a home buying frenzy similar to what happened before the stock market crash. Everyone from lenders to rating agencies to investors (foreign and American) to investment bankers to home buyers was eager to get into the mortgage game because house values kept rising. Today, we are seeing a similar buying frenzy in some markets, such as San Francisco, New York, and Miami . Some experts think that the price increases of homes in those areas are not sustainable. They say that because heavy foreign investment in those areas is part of what’s driving up prices, if those investments slow or stop, we could see a bubble burst.

So what do some experts think?

David Ranish, owner/broker for The Coastline Real Estate Group in Laguna Beach, CA, says: ”There are concerns about another housing bubble, but I do not see it. The market could stabilize, but a complete collapse is highly unlikely.”

Bruce Ailion, an Atlanta, GA, real estate expert, says,” ”Five to six years ago, I was a buyer of homes. Today I am a seller.”

David Reiss says, ”It is probably a fool’s game to predict the future of the housing market or whether we are in a bubble that is soon to burst.”

Why Credit Rating Agencies Exist

image: www.solvencyiiwire.com

Robert Rhee has posted Why Credit Rating Agencies Exist to SSRN. The abstract reads,

Although credit rating agencies exist and are important to the capital markets, there remains a question of why they should exist. Two standard theories are that rating agencies correct a problem of information asymmetry and that they de facto regulate investments. These theories do not fully answer the question. This paper suggests an alternative explanation. While rating agencies produce little new information, they sort information available in the credit market. This sorting function is needed due to the large volume of information in the credit market. Sorting facilitates better credit analysis and investment selection, but bond investors or a cooperative of them cannot easily replicate this function. Outside of their information intermediary and regulatory roles, rating agencies serve a useful market purpose even if credit ratings inherently provide little new information. This alternative explanation has policy implications for the regulation of the industry.

I do not think that there is much new in this short paper, but it does summarize recent research on the function of rating agencies. Rhee’s takeaway is that, “given their dominant public function, rating agencies should be subject to greater regulatory scrutiny and supervision qualitatively on levels similar to the regulation of auditors and securities exchanges.” (15) Amen to that.

Treasury Gives RMBS a Workout

The Treasury has undertaken a Credit Rating Agency Exercise. According to Michael Stegman, Treasury

recognized that the PLS market has been dormant since the financial crisis partly because of a “chicken-and-egg” phenomenon between rating agencies and originator-aggregators. Rating agencies will not rate mortgage pools without loan-level data, yet originator-aggregators will not originate pools of mortgage bonds without an idea of what it would take for the bond to receive a AAA rating.

Using our convening authority, Treasury invited six credit rating agencies to participate in an exercise over the last several months intended to provide market participants with greater transparency into their credit rating methodologies for residential mortgage loans.

By increasing clarity around loss expectations and required subordination levels for more diverse pools of collateral, the credit rating agencies can stimulate a constructive market dialogue around post-crisis underwriting and securitization practices and foster greater confidence in the credit rating process for private label mortgage-backed securities (MBS). The information obtained through this exercise may also give mortgage originators and aggregators greater insight into the potential economics of financing mortgage loans in the private label channel and the consequent implications for borrowing costs.

While this exercise is very technical, it contains some interesting nuggets for a broad range of readers. For instance,

The housing market, regulatory environment, and loan performance have evolved significantly from pre-crisis to present day. Credit rating agency models appear to account for these changes in varying ways. All credit rating agency models incorporate the performance of loans originated prior to, during, and after the crisis to the degree they believe best informs the nature of credit and prepayment risk reflected in the market. Credit rating agency model stress scenarios may be influenced by loans originated at the peak of the housing market, given the macroeconomic stress and home price declines they experienced. The credit rating agencies differ, however, in how their models adjust for the post-crisis regime of improved underwriting practices and operational controls. Some credit rating agencies capture these changes directly in their models, while other credit rating agencies rely on qualitative adjustments outside of their models. (10)

It is important for non-specialists to realize how much subjectivity can be built into rating agency models. Every model will make inferences based on past performance. The exercise highlights how different rating agencies address post-crisis loan performance in significantly different ways. Time will tell which ones got it right.

Reiss on $1.5B S&P Settlement

Westlaw Journal Derivatives quoted me in S&P Settles Fraud Suits for $1.5 Billion. The story reads in part,

Standard & Poor’s has agreed to pay $1.5 billion to settle lawsuits filed by the U.S. Department of Justice, 19 states and a pension fund that accused the ratings agency of damaging the economy by inflating credit ratings in the years leading up to the 2008 financial crisis.

According to a statement issued Feb. 3 by S&P, a subsidiary of McGraw-Hill Cos, the ratings agency will pay $687.5 million each to the DOJ and the states. It also will pay $125 million to settle a lawsuit filed by California Public Employees’ Retirement System. Cal. Pub. Employees’ Ret. Sys. Moody’s Corp. et al., No. CGC-09-490241, complaint filed (Cal. Super. Ct., S.F. County July 9, 2009).

The parties filed a joint stipulation of dismissal with the U.S. District Court for the Central District of California on Feb. 4.

“After careful consideration, the company determined that entering into the settlement agreement is in the best interests of the company and its shareholders and is pleased to resolve these matters,” McGraw-Hill said in the statement.

S&P did not admit to any wrongdoing in agreeing to settle.

U.S. Attorney General Eric Holder announced the settlement for the Justice Department and states.

“On more than one occasion, the company’s leadership ignored senior analysts who warned that the company had given top ratings to financial products that were failing to perform as advertised,” he said in a statement.

*     *     *

David Reiss, a professor at Brooklyn Law School, also said the settlement closes an important chapter of the crisis.

“S&P would have faced a lot of unquantifiable risk if it had to admit wrongdoing in the settlement,” he said. “It is unclear that the Justice Department would have wanted to expose one of the three major rating agencies to such a risk because it could have destabilized the rating agency industry.”

Reiss added that the $1.5 billion settlement should have a deterrent effect.

”[It] likely gives ratings analysts some firm ground to stand on if they are pressured to lower their standards by others in their organizations,” he said. (1, 18-19)

The article also has a sidebar that reads,

Ratings agencies had avoided liability for their actions for quite some time based on the theory that they were First Amendment actors who dealt in opinions.

Recent cases have held that the rating agencies can be held liable for some of their ratings notwithstanding the First Amendment. United States v. McGraw-Hill Cos. et al., No. 13-CV-0779, 2013 WL 3762259 (C.D. Cal. July 16, 2013) and Federal Home Loan Bank of Boston v. Ally Financial Inc. et al., No. 11-10952, 2013 WL 5466631 (D. Mass. Sept. 30, 2013).

For instance, if the rating agency did not follow its own rating procedures, it could be held liable for fraud.

David Reiss, Brooklyn Law School (18)

Does Morningstar Speak with Forked Tongue?

Morningstar Credit Ratings, a small Nationally Recognized Statistical Rating Organization (albeit a subsidiary of Morningstar, the large investment research firm), has issued a Structured Credit Ratings Commentary on Rating Shopping in Asset Securitization Markets. It finds that

Rating shopping is alive and well in the U.S. securitization markets notwithstanding the implementation of regulatory and legislative actions intended to curb the practice and promote competition among credit rating agencies, or CRAs. It is important to note, however, that the rating shopping following the financial crisis has not led to a “race to the bottom” scenario with respect to rating standards that some congressional lawmakers and other critics of the issuer-paid model believe was prevalent during the years leading up to the crisis. (1)

I have to say that I find Morningstar’s analysis perplexing. The commentary highlights a number of structural problems in the ratings agency industry. It then goes on to say that everything is fine and that there is no race to the bottom to worry about, to lead us into another financial crisis.

The commentary goes on to state that while

it is rational for issuers and arrangers to choose the CRA with the least onerous terms, CRAs generally have held their ground by adhering to their analytical methodologies notwithstanding the constant threat of losing business. . . . The CRAs’ unwillingness to lower their standards in the midst of reviewing a transaction is attributable in part to strong regulatory oversight from the SEC, which has focused heavily on holding nationally recognized statistical rating organizations, or NRSROs, accountable for following their published methodologies. (1-2)

I find it odd that the commentary does not consider where we are in the business cycle as part of the explanation. Once the market becomes sufficiently frothy, rating agencies will be more tempted to compromise their standards in order to win market share. I wouldn’t accuse Morningstar of speaking with a forked tongue, but its explanation of the current state of affairs seems self-serving: move on folks, we rating agencies have everything under control for we have tamed the profit motive once and for all!