Causes of Subprime Credit Crisis

    Causes of Subprime Credit Crisis Sanjai Bhagat Professor of Finance University of Colorado at Boulder Executive Summary Several conflicts of i...
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Causes of Subprime Credit Crisis

Sanjai Bhagat Professor of Finance University of Colorado at Boulder

Executive Summary Several conflicts of interest involving credit rating agencies, investment managers of institutional bond funds, mortgage originators/lenders, and the mortgage backed security sponsors are primarily responsible for the current subprime credit crisis. We note the following policy recommendations: Credit rating agencies should provide greater transparency of their valuation models and the process by which they arrive at the ratings of mortgage-backed bonds. To the extent their models and ratings have not been validated by extensive empirical data, they should note this prominently for the bond investors. If ratings are not comparable across asset classes (mortgage-backed, corporate), then alternative ratings should be considered. The compensation they receive from the issuer should be prominently noted, along with comparative data for corporate bonds. Greater equity participation by all key players: MBS sponsors should hold a portion of all bonds they issue. Mortgage originators/lenders should be required to have greater equity capitalization such that they incur economic costs if their R&W guarantees are not valid. Finally, going back to the tradition of requiring the ten percent down from home-buyers would permit greater alignment of the home-buyers’ interest with that of mortgage-backed bond investors.

June, 2008  

 

The current global credit crisis has its origins in the problems of the subprime mortgage market in the U.S. Until the turn of the millennium, most mortgage loans were made to borrowers with good credit histories conforming to underwriting standards set by government sponsored agencies; these loans are referred to as conforming loans. However, as noted in Table 1 and illustrated in Figure 1, subprime loans and Alt-A rapidly increased their market share. Subprime mortgages refer to borrowers that have poor credit histories. Alt-A loans are made to borrowers with good credit histories but with aggressive underwriting, such as, no documentation of income. Most lending institutions that issue mortgages to homeowners do not carry these mortgages on their balance sheets, but sell these mortgages to issuers who in turn sell them (eventually) to investors as fixed-income securities. As Table 2 and Figure 2 indicate, both subprime loans and Alt-A loans experienced significant increases in the securitization of the loans as a percentage of loans originated. The process of conversion of mortgages to risky fixed-income securities is known as securitization. There are several conflicts of interest in this securitization process that in tandem have led to the current subprime credit crisis. A simplified version of the securitization process is illustrated in Figure 3. The securitization process starts when a homeowner/mortgagor finances the purchase of a home or refinances the home. The originator/lender sells the mortgage to a government backed agency (like Fannie Mae, Freddie Mac) or an investment bank acting as a mortgage-backed security (MBS) sponsor. The MBS sponsor keeps only a 2   

 

small percentage of the mortgages, and pools the rest with similar mortgages and sells them to a bankruptcy-remote trust. The trust issues bonds to institutional investors (like pension funds, hedge funds). The issuer is bankruptcy-remote in the sense that if the MBS sponsor goes bankrupt, the assets of the trust/issuer will not be distributed to the creditors of the MBS sponsor. Marketability of the bonds is enhanced by the credit ratings from bond rating agencies (like Moodys, S&P, Fitch).

Conflict of interest between the Credit Rating Agencies and the MBS Sponsor The trust/issuer of the mortgage-backed bonds can be viewed as an investment company as defined in the Investment Company Act of 1940, hence would be subject to the extensive requirements of the Act; see Bethel, Ferrell, and Hu (2008). However, the trust/issuer can claim exemption from the Act if it issues only fixed-income securities that, at issue, received one of the four highest ratings from a nationally recognized rating agency (like, S&P, Moodys, and Fitch). The above situation has the potential to create a conflict of interest between the credit rating agencies and MBS sponsors that set up the trust/issuer, since the trust’s ability to claim exemption from the 1940 Act depends on the ratings provided by the rating agencies. Figure 4 notes Moodys revenues from rating various securities. While in the first quarter of 2001 Moodys quarterly revenue from rating structured securities (including MBS securities) was slightly greater than from rating corporate securities, by the fourth quarter of 2006 Moodys quarterly revenue from rating structured securities (including MBS securities) was about three times than from rating corporate securities. 3   

 

To the extent there was a conflict between the credit rating agencies and MBS sponsors, this was severely exacerbated by 2006. The above-mentioned conflict is similar to the conflict of interest noted in the accounting literature between the auditors and the shareholders of firms they were auditing, driven by the large non-audit fees the auditors were earning from the companies they were auditing in the pre-Sarbanes-Oxley era; see Dhaliwal, Gleason, Heizman, and Melendrez (2008), and Hoitash, Markelevich, and Barragato (2008).

Conflict of interest between the Credit Rating Agencies and the Investment Manager Until now credit rating agencies have used the same rating system to rate mortgage-backed bonds as they do to rate corporate bonds. The methodology to rate corporate bonds is well-understood and has been validated by empirical data going back to almost a century. Credit rating agencies are required to and do disclose their criteria and methodology for rating mortgage-backed bonds. However, there are concerns about the complexity and transparency of the models used by the rating agencies; see Mason and Rosner (2007). Perhaps, even more importantly, given the brief existence (less than a decade in some cases) of the ever more complex mortgagebased securities, we do not have the empirical validity of these models to the same level of statistical confidence as for corporate debt. In 2007, Moodys downgraded several AAA mortgage-backed bonds to junk status within a matter of weeks; see Crouhy and Turnbull (2008). Such a significant 4   

 

drop in rating in such a short period is almost unheard of for corporate bonds; see Hirsch and Bannier (2008). This suggests that AAA mortgage-backed bonds implied higher credit risk than AAA corporate bonds. Pension funds, hedge funds and other institutional investors that invest in mortgage-backed bonds usually do so via an investment manager(s) who has discretion on which and how much of various mortgage-backed securities to hold. Part of the incentive compensation of these fund managers depends on the extent to which their portfolio’s return exceeds a benchmark. A mortgage-backed bond portfolio invested in AAA bonds would usually have the AAA return (from investing in a representative basket of AAA corporate and mortgage-backed bonds) as the benchmark. However, as noted above, AAA mortgage-bonds are riskier than AAA corporate bonds. Hence, a portfolio of AAA mortgage-backed bonds would have a higher expected return than a representative basket of AAA corporate and mortgage-backed bonds.

Conflict of interest between the Homeowner/Mortgagor and Originator/Lender Mian and Sufi (2008) document a dramatic increase in the fraction of mortgages sold by mortgage originators shortly after origination to non-mortgage agency institutions during 2001-2005; see figure 5. They refer to the above sale of mortgages by mortgage originators shortly after origination as “disintermediation.” As noted earlier, these non-mortgage agency institutions purchased these mortgages and issued mortgage-backed securities to institutional investors. The effect of this was a significant expansion in credit supply for the mortgage originator/lender. 5   

 

The mortgage originator/lender is compensated through fees paid by the homeowner (points and closing costs), and by the premium, if any, from the sale of loans to the MBS sponsor. The mortgage originators/lenders responded to the increased supply of credit by engaging in predatory lending practices; see Ashcraft and Schuermann (2007). Predatory lending is defined as lending practices that leave the borrower worse-off from the loan. Loan-flipping or inducing a borrower to repeatedly refinance a loan and pay high fees and points each time the loan is refinanced, is an example of a predatory lending practice. The disntermediation and predatory lending practices led to rapid deterioration in the quality of mortgage loans in the first half of this decade, ultimately leading to significant increase in defaults during 2006-2007; see figure 6, and Keys, Mukherjee, Seru and Vig (2008), and Demyank and Van Hemert (2008).

Conflict of interest between the Originator/Lender and MBS Sponsor As noted above, the mortgage originator/lender is compensated through fees paid by the homeowner (points and closing costs), and by the premium, if any, from the sale of loans to the MBS sponsor. The mortgage originator/lender’s compensation increases with every loan they can close, regardless of the quality of the loan or eventual default. The mortgage originator/lender is responsible for documenting the credit worthiness and income of the borrower. Indeed the originator/lender has to provide representations and warranties (R&W) to the MBS sponsor about the borrower and their own underwriting process. The originator/lender is required to repurchase the 6   

 

problem loans from the MBS sponsor if the R&W are not valid. However, for this R&W provision to have a disciplining effect on the originator/lender, two conditions have to be met. First, the MBS sponsors have to do their own due diligence to determine if the R&W terms are being honored. Second, the originator/lender would need to have enough (equity) capital to purchase the problem loans. A wave of recent lawsuits suggest that neither of the above two conditions were met in many cases during the first half of this decade; see Nielsen (2008).

Policy Recommendations In light of our discussion of the above conflicts of interest, we note the following policy recommendations: Credit rating agencies should provide greater transparency of their valuation models and the process by which they arrive at the ratings of mortgage-backed bonds. To the extent their models and ratings have not been validated by extensive empirical data, they should note this prominently for the bond investors. If ratings are not comparable across asset classes (mortgage-backed, corporate), then alternative ratings should be considered. The compensation they receive from the issuer should be prominently noted, along with comparative data for corporate bonds. Greater equity participation by all key players: MBS sponsors should hold a portion of all bonds they issue. Mortgage originator/lenders should be required to have greater equity capitalization such that they incur economic costs if their R&W 7   

 

guarantees are not valid. Finally, going back to the tradition of requiring the ten percent down from home-buyers would permit greater alignment of the home-buyers’ interest with that of mortgage-backed bond investors.

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References Ashcraft, A.B. and T. Schuermann, 2007, Understanding The securitization of Subprime Mortgage Credit, Federal Reserve Bank of New York paper. Bethel, J.E., A. Ferrell and G. Hu, 2008, Law and Economic Issues in Subprime Litigation, Harvard Law School paper. Crouhy, M. and S. M. Turnbull, 2008, The Subprime Credit Crisis of 07, University of Houston paper. Demyank, Y. and O. Van Hemert, 2008, Understanding the Subprime Mortgage Crisis, Federal Reserve Bank of St. Louis paper. Dhaliwal, D.S., C. A. Gleason, S. Heitzman, and K. Melendrez, 2008, Auditor Fees and Cost of Debt, Journal of Accounting, Auditing and Finance. Hirsch, C. and C.E. Bannier, 2008, The Economics of Rating Watchlists: Evidence from Rating Changes, Frankfurt School of Finance & Management paper. Hoitash, R., A. Markelevich and C. Barragato, 2007, Auditor Fees and Audit Quality, Managerial Accounting Journal. Keys, B., T. Mukherjee, A. seru and V. Vig, 2008, securitization and Screening: Evidence From Subprime Mortgage Backed Securities, University of Chicago paper. Mason, J.R. and J. Rosner, 2007, Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions, Drexel University paper. Mian, A. and A. Sufi, 2008, The Consequences of mortgage Credit Expansion: Evidence from the 2007 Mortgage Default Crisis, University of Chicago paper. Nielsen, J., 2008, 2007: Looking Back at What’s Ahead, Navigant Consulting report.

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Table 1: Origination of Mortgage Loans in Billions of Dollars Year 

Subprime 

Conforming 

Alt‐A 

2001 

190 

1433 

60 

2002 

231 

1898 

68 

2003 

335 

2690 

85 

2004 

540 

1345 

200 

2005 

625 

1180 

380 

2006 

600 

1040 

400 

Source: Inside Mortgage Finance (2007)     

Figure 1: Origination of Mortgage Loans

 

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Table 2: Securitization of Mortgage Loans as % of Loans Originated Year 

Subprime 

Conforming 

Alt‐A 

2001 

46 

76 

19 

2002 

53 

76 

79 

2003 

58 

79 

87 

2004 

67 

76 

79 

2005 

74 

82 

87 

2006 

75 

87 

91 

Source: Inside Mortgage Finance (2007)   

Figure 2: Securitization of Mortgage Loans as % of Loans Originated

   

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Figure 3: Mortgage Securitization Process Trustee   

Homeowner/ Mortgagor 

MBS  Sponsor

Originator /Lender 

TRUST  /Issuer

Rating Agencies 

Servicer 

                 

represents flow of dollars.

 

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Bond  Underwriter 

Institutional  Investors 

 

Figure 4: Moodys Quarterly Revenues From Rating Various Securities

  Source: Moodys (2007)

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Figure 5: Fraction of Mortgages Sold to Non-Mortgage Agency Institutions. Source: Mian and Sufi (2008)

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Figure 6: Default Rates for Mortgage and non-Mortgage Debt, Indexed to 1996. Source: Mian and Sufi (2008) 

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