AEI’s March 28, 2007 Subprime Seminar – V
For many of the people involved, the high point of AEI’s March 28th seminar on the Subprime Mortgage Crisis  was UBS researcher Tom Zimmerman’s 25 minute presentation and PowerPoint slide show. His two key points are simple enough.
- Eroding house prices, or House Price Appreciation (HPA) in Zimmerman’s talk, is the driving force behind rising delinquencies and defaults in the US housing market today.
- A sudden and unforeseen rise in Early Pay Defaults (EPDs) is what imploded the subprime sector, starting in late 2006.
The value in Zimmerman’s talk comes largely from his careful and detailed quantitative support for the first (now almost intuitively obvious ) assertion. As housing blogger Tanta helps point out in a recent post, a lot of industry players didn’t seem to get it at the time these events were unfolding.
His second assertion, that EPDs took down the whole subprime sector, is a bit more startling. His refreshing testimony that this event took him completely by surprise comes across as genuine.
The AEI event site  provides short summaries of Zimmerman’s and the others’ presentations, but no official transcript was produced. Doom is proud to present this unofficial annotated transcript of Zimmerman’s effort, and we trust it will prove a useful resource in studying this important talk.
Previous partial transcripts of the March 28th event:
- I – [1:37:18-1:43:44] A Slightly Off-Beat Question, April 5, 2007
- II – [1:54:05-1:56:30] Subprime Spillover Discussion – and a Bit of Business, April 7, 2007
- III – [1:20:30-1:25:40] Securitization on Trial – Bert’s First Question, May 7, 2007
- IV – [0:22:36-0:36:11] Roubini at the American Enterprise Institute, May 16, 2007
Zimmerman’s talk depends critically on his PPT slide deck. The reader will profit by opening up the slide deck and referring to the numbered slide when it’s reference pops up in the transcript. Many of the slides use acronyms and abbreviations. I’ve listed the abbreviated terms for each slide along with a numbered list of the slide’s titles.
As usual, I’ve taken the liberty of emphasizing some of the interesting bits. Corrections and suggested additions would be most welcome. Transcript times represent the audio recording of the seminar. The video times run about 20 seconds greater.
Chris Whelan (summing up) [0:50:43]: … I think the issue of liquidity is the issue I would want to leave you with today, because it really affects this entire market, from the homeowner on through to the end investor and the asset.
Alex Pollock [0:50:56]: Thank-you Chris, if you’ll remember Chris’s question — if the banks sold all this risk to somebody else, where did it go? — We’re hoping someone in the audience will tell us the answer to that. [laughter]
And we ended up on liquidity, which sounds a lot like the securities markets, so Tom, you get the last word here.
Tom Zimmerman [0:51:15]: Well, there’s always problems going last. Most of your thunder has been stolen one way or the other, including Alex’s first comments, because that’s what I was going to start out with, you know, bull markets are bull markets, you always know what’s going to happen at the end, and it’s not good. A lot of people love them when they are going up, and then when they come down we don’t like them. And in the subprime world there’s going to be a lot of victims. It’s not just the homeowners, there’s going to be a lot of guys who lose their jobs in these subprime originators. There’re all going out of business, they’re not going to be around. You’re going to see Wall Street operations shrink in size, the subprime market will be probably be half, going forward, half of what it was in the past few years, so we don’t need so many bankers or research people. Oh yeah, a lot of people are going to get hurt in this thing. [0:52:04]
And it’s not just the homeowner. So it’s a classic, classic, you know, bull market enthusiasm and classic bear market pain, so that’s where we’re at.
In terms of this topic of contagion – that’s kind of a funny word – in my view, and I’ll show you some slides  about this, for the last two or three years, when I appeared on mortgage panels around the country, I’ve always been way over there on the bearish side. And as the years went by I sort of got to the middle. And now I come to this group and I’m on the other side. It’s like I just [laughter] … so I agree with a lot of the comments made here today. I mean, I really think this is a big big problem, and I’ve been saying that for some time. [0:52:51]
I don’t know if it is quite as big as it’s been exagger- … said here. When you talk about some of the numbers. But clearly this is not a small issue, it’s a big issue. And I think, what I would like to do is spend a little bit of time with my slides and go in and drill down into the details of this subprime world itself and tell you sort of the way I see what happened here … and then maybe talk about extrapolations from that. And so most of my presentation is sort of focussed right on the subprime market sort of describing how I saw it unfold and what sort of happened here. [0:53:25]
Now here’s a slide [slide 1 at note  ] that I had, that I gave, the first slide at a seminar I was at and we talked about what’s happening in the subprime market. So if you read those questions you’d say, "yes, there’s obviously something going on here." Investors are asking these questions, they’re not naive. There’s an issue here, right? [0:53:46]
Is this growth unsustainable, aren’t these standards dropping, aren’t these new loan types going to beak, etc. etc. etc. So this was done, this was January 2005, right? [slide 2] So this is not a new story, this story has been out there for quite some time. We knew it was coming, we knew it was a problem, it was going to happen. This is September ’05. OK, here’s my forecast [slide 3] what’s going to happen when the market slows down. Subprime losses, which, let’s say, these scenarios are like our average subprime world of the last seven or eight years. Not the last two or three years, but the previous seven or eight years. Housing appreciation five to seven percent, total losses over the life of these loans four percent. [0:54:24]
In the never-never world of the last couple of years, these losses — I mean you’re talking low defaul
t rates — man there was nothing, nothing — you were golden in mortgage-land the last few years. And those cummulative losses dropped dramatically. And now of course when the housing market slows down, here’s what we thought was going to happen. We did this, you know, a couple of years ago. These numbers are going to go up by factors of two or three. You know, no question about that. This is subprime. [0:54:48]
These next couple of charts [slides 4 & 5] go beyond subprime and take a took at Alt-A, subprime and prime, and these next three charts [slides 6 & 7 & 8] show — these are default rates. and they’re linked to HPA. The higher the HPA, the lower the defaults, right across the board, bam-bam-bam. Loss severities, same thing. Loss severity is dramatically linked to HPA. That’s almost a no-brainer, right?
Alex Pollock [0:55:14]: You’re telling us that HPA is …
Tom Zimmerman: Oh, I’m sorry, Housing Price Appreciation, sorry … I’m coming out of a world where that’s … it’s … Three years ago, or four years ago that question would have been asked at the mortgage panels, but lately everybody knows that. OK, ah [laughter] … so — loss severities … same thing. And now you put them together … you take how many times people default times loss severity, you’ve got actual losses and here they are. So … If people think this is just a subprime problem, obviously it’s not, because, you know, this is the data, this is what’s been happening across the country in the last five or six years, and if you slow the housing market down, losses are going to go up. That’s almost physics and not economics. [0:55:58]
So we knew it was going to happen. Now … and take a look at this subprime number roughly — and this is historical data — at zero to five percent HPA we’re looking like, you know, eight percent kind of losses. [slide 6 – bottom chart rightmost bar] That’s an ugly number to a lot of CDO investors. That’s a bad number. That’s not good. The old numbers were three and four percent. So if the market slows down, if the housing market slows down — a flat market, forget going negative, then there’s a lot of problems. So … this is what we’ve been talking about for the last couple of years. [0:56:30]
Now this is longer history, this is, like, the cumulative defaults in the subprime market for the last ten years, [slides 7 & 8] and the real bad years were 2000 – 2001, really ugly stuff, and the last couple of years looks really great, which it was — ’03 ’04 really great.
You take these curves and you can standardize them, normalize them. What percentage of these losses occur when. You take a look, over here in the first year, into the second year — maybe you’ve got 15 percent of the losses have occurred, OK? So now, if you back up — and we knew this train wreck was coming some time, right? — so we figured, OK, not here, a year or two years from now we’re going to see lots and lots of problems. That’s always what happens, right? [0:57:15]
Well, we got surprised, right? [slide 9] We got surprised like everyone else did. A thing called "Early Pay Defaults." Out of the blue, no one expected them to be coming, I didn’t, nobody that I know in the industry did — a few journalists thought they knew, because they criticized some comments I made and said, "ah, everybody knew it was coming," right? No one knew [laughter] no one knew this was coming. [0:57:38]
We were out talking with some subprime guys early in ’06 and they were saying, "you know, one thing we’re worried about is EPDs are really creeping up fast — we don’t understand what it is." An Early Pay Default is when a person takes out a loan, and then doesn’t make the first payment. Or maybe the second or third payment. [0:57:53]
This used to be a small niggling little problem, like less than one percent of the loans. This thing soared to six or seven or eight percent by the middle of ’06. And that’s what knocked the subprime business out, it wasn’t these defaults that were going to happen down here — it wasn’t just normal default curve — it was the EPDs, that’s what knocked them out. It was not the regular default statistics we talk about, that’s what killed them. What happened, when these people originate these loans, typically they’ll sell half of them to The Street, keep half of them, securitize them, the ones they sell to The Street, they sell them with Reps and Warranties. And it says typically — when I sell this loan to you, if within the first two or three months, there is an Early Pay Default, guess what? You can put that loan back to me. [0:58:36]
And that’s what took down all these shops. They were selling loans to Wall Street, Wall Street took a look at them and said, "Heh! These guys … these are EPDs, take them back, guys!" …"But wait a minute, we don’t have the money to take them back! We have a cash flow system going here with securitized loans. We sell them — we don’t take them back!" OK, now you’re taking them back. So a lot of the smaller capitalized shops Ownit, First … a lot of these small guys … they’re gone, they just went out like that. [0:59:02]
These EPDs really hammered the big guys, whether it was New Century or Fremont or … even WaMu and CountryWide … all got hit with this stuff. But the bigger guys could survive it. They’ve got a lot of capital, they can handle it. The smaller guys, they’re gone. [0:59:16]
So what’s interesting to me — and we still don’t know — is what caused it exactly, and who these people are. Now we know part of what went on was this underwriting standards — we talk about how loose underwriting gets in this industry? These are the statistics for the subprime world for the last five or six years. [slide 10] You can take a look at a couple of things which really look pretty ugly … like the second liens — they went higher and that’s really bad … this I/O and 40 percent — these are affordability loans — they were zero they came to 30 or 40 percent of the market. Take a look at debt to income, it’s increasing. [0:59:51]
What’s really bad is these purchased … uh not purchased, the full doc loans, which went from 73 percent down to 56 percent. And on the far right are these seconds associated with the 80 percent firsts. So these were the 20 percent seconds. So by the end of, by ’06, like 25 percent of these loans out there — these 80/20s where you were actually getting a loan with no money down. [1:00:16]
So this is what, this is what created this perfect storm that we’re now seeing the fruits of. [slide 11] Now, here’s the breakdown of how many 2/28s and 3/27s were in the subprime product. And it’s like 60 percent is 2/28s and 12 percent are 3/27s. Now what is a 2/28? A 2/28 is a hybrid ARM. The first two years are fixed, usually at some rate linked off of two year swap rates. It runs maybe 200 basis points above a 30 year fixed rate loan. After the two year period, it will automatically reset to an ARM. And that ARM is six month LIBOR plus 6 percent. That’s now about 11 percent. [1:01:04]
So these 2/28s that were being created for this industry probably was the wrong product for a subprime borrower who was on the margin anyway in terms of income. Now you’ve got him into a 2/28, and now you’re going to give him an 80/20. These 80/20s are these 80 percent firsts / 20 percent seconds / no money down. And now you’re going to give him a low-doc loan wher
e he doesn’t have to identify who he is or what his income is, it’s just what he says. So this product, by the end of ’05 — early ’06, was really, really, really a very scary product waiting to blow up. It’s not surprising it blew up, but I still say it’s surprising it blew up so fast. [1:01:43]
And here is this trap these guys are sort of getting themselves into. This is a good chart [slide 12] because it shows what these 2/28 individuals are faced with.individuals are faced with. The blue line, the most volatile line, is 6 month LIBOR plus 6 percent. The orange, no, the pink line is the actual loan rate for that two year part of the 2/28. That’s the loan rate these guys were paying for the first two years. And that’s the pink line. And the yellow line is just the pink line moved forward two years. So if you take a look at the yellow line, it tells you where you’re at today, so for instance in January uh March of ’07, we’re at about seven and a half percent. That means our loans, we’re getting ready for a two year reset — I’ve got a seven, I’ve had a seven and a half loan for the last two years … and now my choice is to reset into this current pink line, which is up about nine percent, or go to eleven percent. That’s the refinance choice these people have. [aside] — I get this backwards all the time — [1:02:50]
Now, in addition to that lousy underwriting we just talked about, of course you know what happened. The housing market slowed down. These are just the data showing the housing market slowing down. [slides 13 & 14 & 15] We all know that took place. The question is, who were these people? [slide 16] These six percent of these billion dollar loan packages, really six percent people who took out a loan — and then a month later or two months later didn’t make the first payment. I don’t know. No one knows exactly. [01:03:13]
My guess is some of them were speculators, who for the last several years have been taking a zero percent down loan and going out and speculating on houses? And all of a sudden, they took the loan out, they tried it one more time … "Wait a minute! The market is not going in my direction, I’ll just walk out of here." [01:03:29]
I don’t know. It could be one of these serial re-fi people. If you were back in here, look, if you were in ’02 ’03 ’04, and you had a subprime loan, and you were on that yellow line, [back to slide 12] heh, you can re-fi out. Go down to that pink line, lower you loan rate by 200 basis points, and by the way take cash out, because the market is going up 20 percent a year. That was a great trade for all of those poor people we’re now worried about. They had a pretty good time for a couple of years, by the way. [1:03:56]
Uh, they were doing very well. They were rolling out of those loans into lower rate loans and taking cash out of their houses. It was, as we say, it was a win-win-win for everybody during that period. [1:04:05]
So, I think some of those people got caught. They just re-fi’d one too many times. And who knows, you know, if you don’t charge anyone a down payment, maybe some young person just decided to take out a loan to live in a house for a year and then walk away. I don’t know, I don’t know who these people are. But there’s a lot of them, and that’s what put the industry down. It’s wasn’t this default rate we’re going to expect to see in the coming years. [1:04:27]
Now, the other thing that hurt the industry of course, was that already this gross profitability that they’d had the past four or five years had already disappeared. [slide 17] When LIBOR dropped dramatically back in ’01 ’02, and their loan rate, which is this 2/28 WAC rate on the top — that light blue line, that net margin they have just exploded during this period of ’02 ’03 and ’04. There were companies like Ameriquest that were taking a billion dollars a year out of this market. They just took just took a billion out and went home. It was like boom boom boom boom. [1:04:58]
So there was enormous amounts of money being made in this industry during that period. Then of course LIBOR rises, their rates rise a little bit, but not nearly as fast, and it’s just you go back to a normal environment, or close to a break-even kind of a situation. [1:05:12]
And now what happened, these early pay defaults, it really pushes them over the edge. [slide 18] So by early ’06, their margins, which were enormous, had shrunk to a pretty small amount — and these are like, rough numbers — but we see these early pay defaults are always there, but they come in at a very low number. Now you go to, by early ’07 or late ’06, you calculate what those early pay defaults are 8 percent of you packages — you’re gone. This is … so it’s not a profitable industry — it’s time out. [1:05:42]
So the originators, they have all these early pay defaults going on from their prime product. [slide 19] So how do you get rid of your early pay defaults. They’re sinking you. You’ve got to reduce what you’re doing. You’ve got to shrink it. But one of these large companies reduced their production by 25 percent, and their early pay defaults went from 6 to 3 percent. They’re still getting killed. So you have to really, really change the product that you’re producing to get rid of these early pay defaults. And when you do it, you shrink your volume dramatically. [1:06:14]
The problem is in the last five years you’ve built overhead dramatically. So now you’ve got a really lose-lose situation. And that’s where they are right now. That’s why these guys are going down. So the early pay defaults were the mechanism that just triggered it. But it was the larger problem of having underwritten these really lousy loans and having a profit margin already squeezed. [1:06:33]
So you put them together and you’ve got massive defaults across this industry. What’s going to happen? The industry is going to create a new product. They have to. It’s going to be a new product. It’s not going to be a 2/28, it’s going to be a … what? a 5/1, it’s going to be a 15 year fixed rate loan — I don’t have a clue what it is, but they’re right now trying to figure it out. [1:06:47]
We’re in the middle of this transition. No one knows what it’s going to be, but it ain’t going to be a 2/28 80/20 low-doc. We know that. It’s not working. [1:06:55]
The industry, you know, is in a shambles. The only people who will survive are the very large companies who are part of a major commercial bank or investment bank. The rest of them will be gone. That’s basically it. [1:07:07]
Here’s a list [slide 20] — I’m not going to go through it. But all the problem childs and what’s happened to them. They’re now … the government steps in — right? [slide 21] So the government was onto this, right? early December ’05 came out with the new rules … not regulations … new rules about how you should underwrite certain types of loans. And there was a big discussion. Do we include language that says: "every loan you write must be written, must be to a fully amortizing –" you must fully qualify the person at a fully amortized fully indexed rate. [1:07:45]
There was some sort of logic to that. If you’re going to qualify a person for a loan — I don’t know about anything else, but at least you should take a look at this loan — what are the features of it are? But once you fully index it, and you fully amortize it, they should be able to carry
that loan. [1:07:58]
So that language didn’t get in. That language did not get into the first set of rules that went out in October. The first set of rules that went out only said — if it’s an I/O, or an option ARM do those rules apply. So the subprime industry thought … we’re off the hook … right? They didn’t get us. [1:08:18]
But a month later — comments, you started seeing it in the press, etc. etc. that guess what, some people think that maybe a 2/28 is also a pretty risky loan — it is inappropriate — now we know what’s going to happen, within a month the new rules will be out, and the 2/28s and 3/27s will now have to be qualified at a fully indexed fully amortized number, for which that’s 11 percent now, and as one executive from WMC said at a recent conference, "that is 75 percent of my business." [1:08:45]
So it’s a whole new world, it’s a whole new ball game, it’s not like it used to be, and the borrowers who are out there now — going forward in six months — we’re going to have a new industry. Right? half the volume or sixty percent of the volume. The new loan — same players — damaged a little bit, beaten up a little bit, but they’ll still be there. CountryWide will be there, WaMu will be there, other banks will still be there. But the problem are these guys. [slide 22] These are the guys that took out the loans in the last two or three years. And this goes back to some questions and comments made earlier. These are the guys we’re concerned about and who Congress is concerned about. [1:09:23]
These are the people who took out these 2/28s, and now what’s going to happen is — the capital markets can’t originate them because nobody wants them, these loans. The bank raters won’t let them do it. So what’s going to happen is these guys in the ’04 ’05 ’06 vintages, mostly ’05 and ’06, when it comes time for them to refinance in two years, there’s no where to go. There’s none of those nice 2/28s left, teaser 2/28s sitting out there. There’s going to be something else, there’s going to be a very, very different world. There’s going to be a higher loan rate, by far, 100 200 basis points, I don’t know what the number is, but it’s going to be big. It will be a lot more than these old 2/28s. And, you’ve got to put some money down. [1:10:01]
No more of this zero financing. That’s gone, that’s history. So, they may be able to deal with this higher loan rate, but they’re not going to be able to deal with this … 10 percent down? I don’t know what the number is … whatever it is. It’s going to be created in the open market. They can’t deal with it. For instance, back to Congressional legislation, the question is — do we have a bailout for these subprime guys — I don’t know. I have no idea how this will go, how you’re going to deal with … and how you are going to figure out whether or not the person who you bail out is the people you who see on the front page of the Wall Street Journal and the New York Times — and there’s clearly a lot of agony about this stuff — or those 6 percent EPDs who decided to take a flyer on the housing market and decided to jump out. [1:10:43]
Now are you going to save them all together, or how do you decide which ones you’re going to save and you don’t save … or where the money comes from to do the saving, I don’t know? So that’s beyond me.
Nouriel Roubini [1:10:51]: You could exclude all those EPDs, right? If you exclude the EPDs from the bailout you’re going to throw them over the wall, essentially right out of the system.
Tom Zimmerman: yeah, yeah, that’s one way, you could do that. But an EPD could be — I don’t know, maybe you could have had an accident. I don’t know, maybe he got sick. I don’t know either. There are other ways to do it, right? So that’s the trap that these … the trap that the government is in right now … trying to deal with, and it’s not easy to figure out how to solve this particular problem, but it is a big problem. [1:11:23]
How much time do I have?
Alex Pollack: Your time is up, but it’s been so good, I’ve been letting you go. We ought to wrap up.
Tom Zimmerman [1:11:31]: OK, we’ll wrap up, OK. Ah, numbers, [slides 23 & 24 & 25] this is just some data that showed what percentage of the market was subprime. 12 Percent by this measure, 13 and some percent by the MBA’s numbers of loans, but they really underestimate it because you’re only covering like 60 percent of the subprime market, so they’re numbers are something like 17 or 18 percent. Let’s say it’s 15 percent of the world is subprime markets. Let’s say that the old numbers were 15 or 20 percent default and the other 25 or 30, say it’s 20 percent or so default, 3 percent of the loans are going to go bad, so 3 percent of the loans in the country go bad, something like that — 3 percent is the number. [1:12:12]
That’s why some people say it’s not a great big problem, because we’re talking about 3 percent of the mortgages out there. There are 10 million mortgages, 17 billion [note: probably meant "trillion"] dollars worth of assets, so not everybody has a mortgage, right? So it’s less that 3 percent of the homes in America are effected by this. 2 or 3 percent are effected by this. So, by that measure, yeah, it’s going to hurt those people in certain sections of the country, but it’s not a great big deal from that point of view. I agree that — well, here’s another point. This is the delinquencies, [slide 26] subprime delinquencies are going up, right? Look at the prime numbers, they’re going up just as fast. All these prime, Alt-A, everything, everything’s going up. [1:12:50]
It’s just that subprime — look at the Y scale over here — these are big numbers. You know, in the subprime world, you have delinquencies and default rates that are, like, 4 or 5 or 10 times what they are in the prime world. So that’s why the numbers are so difficult to deal with. It’s not that the rate of increase of defaults are worse, it’s just that they’re starting, it’s just such a big number. [1:13:15]
And finally I think I agree here with some of the comments that were made earlier. Even though only 3 percent of the houses might be at risk of a default from this process we’re talking about in subprime world, in the last 3 or 4 years it accounts for 40 percent — between Alt-A and subprime — between 40 percent of the market. [slide 27] [1:13:34]
You take that out of the housing market and that’s a big vacuum. That’s really going to hurt the new home sales, the new home sales and the whole housing market, so I agree with that, it’s really, we’ve really just begun to see the pain from this part of it. It’s not really the subprime default rates that are going to kill us, it’s going to be the lack of subprime funding that’s going to go out there to fund those loans — and it’s been going out there the last 2 or 3 years. [1:13:56]
What that number is and how that impacts the overall economy. You’re a better judge of that, I don’t have a good idea what [inaudible] One last comment. In terms of the impact on two other groups of people. The impact on the banks is marginal. The only big banks who are involved in it, it’s just a small part of their business. Even HSBC, it doesn’t bother them. It’s too small. The independent investment banks claim that it’s like 3 percent, right? Goldman 3, Bear 3 Lehman 3, something. The most, you know, 2 or 3 percent of their revenue is coming from this business. You shrink it
in half, it’s not going to be a big deal. [1:14:32]
So Wall Street is going to take some hits here and there — trading desks will get hit, but it’s not going to be a serious systemic problem. [1:14:39]
Who owns this stuff? The subprime … first of all, 75 percent of the subprime securitized product in subprime, 75 percent is triple-A. You’re home free, not a problem. I can stress these numbers as much as I want and that triple-A guy is not going to get hit. His spreads might widen out a bit but he isn’t going to lose a dollar or principal. [1:15:01]
That’s good, because Freddie and Fannie owns about half of that. So they’ve got about half of that risk. It’s triple-A, it’s not going to go anywhere. So 75 percent of the subprime market is not a problem. [1:15:11]
The lower rated tranches triple-B minus, those guys, they’ve got problems — they’ll get hit. Some of them will go down, half of them will go down. People who own the equity pieces will down, but that’s spread all around the world. It’s spread out into private money coming out of Central America, it’s State money coming out of China, it’s Hedge Fund money coming out of Europe and America, it’s all over the place. [1:15:35]
So the guys who are going to get hit with this in the capital markets from losses in here and losses in the CDO market, are all around the world. It’s really spread out, and this is back to your question about who’s got the risk, it’s just all over, so in a way that’s good, not bad, right? It’s not concentrated it’s all over the place. So I don’t see that as a systemic problem. Whether or not the corporate side starts to get the same things, then you realize that the corporate risk is of a different magnitude. [1:16:03]
If it all happened together, yes that would be a different issue. Just the subprime world itself, and its Alt-A cousin, together is not going to be the kind of numbers which would create this systemic financial kind of crisis. It’s going to weigh heavily on the housing market in the next few years.
Alex Pollock [1:16:21]: Maybe on that relatively hopeful note we’ll end, Tom, Thanks very much. And thanks very much to the panel for excellent presentations. [1:16:28] … [there followed a few minutes of general discussion by the panelists, after which the general Q&A started]
Notes and References
: "Mortgage Credit and Subprime Lending: Implications of a Deflating Bubble", Event, American Enterprise Institute & Professional Risk Managers’ International Association, March 28, 2007.
: "The U.S. Subprime Market: An Industry in Turmoil", by Thomas Zimmerman, Managing Director, U.S. Securitized Products Strategy Group, UBS, March 2007. (PPT slide deck found under "Zimmerman Presentation" at , the first slide is a title page; numbers in the following list of slides reflects slide page number — browser number will be one more). Big thank-you to Doom’s Admin for contributing the direct link to the PDF of the slide show. Twist and I are still puzzling out the exact placement of the slides in the presentation above — opinions from Doomers on the correct spots would be most helpful.
- Questions Investors Ask – some tough questions …
- Isn’t the rapid growth in subprime unsustainable and highly risky?
- Aren’t underwriting standards dropping? (Higher LTVs and larger number of no docs.)
- Aren’t the new loan types (IOs, 80/20s, etc.) raising the risk profile?
- Won’t the housing bubble collapse and carry us all with it?
- With spreads so tight, does it make sense to play in this market at all?
- Subprime Home Equities: On the Brink or Safe For Another Year? – title of January 2005 presentation
- Impact of Prepayments & HPA on Subprime Losses—September 2005 – terms (defined at , etc.) CPR – conditional prepayment rate, HPA – home price appreciation, CDR – conditional default rate, LS – loss severity, ARM – adjustable rate mortgage, CUM – cummulative
- Impact of Slower HPA: Higher Defaults – These two charts separate out 2002 loans into color-coded cohorts based on HPA experienced where the loans are; note the bigger Y-axis numbers for subprime compared to Alt-A, but similar shaped curves. HPA – home price appreciation, OTS – Office of Thrift Supervision, MBA – Mortgage Bankers Association, 60+ – 60 or more days (in arrears)
- Higher Loss Severities – The x-axis grouping labels are house price appreciation (HPA) percentages for the cohorts — the message: less HPA, greater loss experience across all types of loan
- The Impact of HPA on Losses – this is the same material as slide 5 grouped differently (mortgage types broken out into three separate graphs)
- Timing of Collateral Losses—1 – HEL – home equity loan, % OB – percentage of base amount?
- Timing of Collateral Losses—2 –
- Surge in EPDs Caught Industry by Surprise –
- Changing Subprime Collateral Characterisitcs – ARM – adjustable rate mortgage, IO – interest only, LTV – loan-to-value ratio, CLTV – combined loan To value ratio, DTI – debt to (annual) income ratio, FICO – Fair Isaac Corporation credit score, WAC – Weighted Average Mortgage Coupon
- 2/28, 80/20, Low Doc: Ideal Loan for the Perfect “Credit” Storm. – 2/28 – ARM with 2 year teaser rate, then 28 years of fully amortizing payments, 80/20 – 80% mortgage, but "downpayment" is actually a second mortgage (avoids PMI – private mortage insurance)
- 2/28 Refis— No Easy Choice – 2/28 & WAC see above, ReFi – refinance, 6mo L – 6 month LIBOR == London Interbank Offered Rate
- Existing Home Sales Down –
- Existing Home Inventory Up –
- Existing Home Prices Have Stalled –
- EPDs? Who Are Those People? – EPD – early payment default
- Speculators taking advantage of a free option in the form of 0% down payment?
- Serial cash-out refiers, refing for one last time?
- Renters looking for a years free rent?
- Rough Measure of Subprime Profitability – 2/28 & HEL & WAC & LIBOR – see above
- Impact of EPDs on Economics of Subprime Origination – EPD – early payment default
- Subprime Trap—For Originators –
- Subprime Originations ($ million) – Rankings & Current Status – detailed list of situation with major subprimers as of March 2007 (heaven knows how the audience could have absorbed this one!)
- Government Regs Will Reduce Subprime Refi Options –
- Subprime Trap—For Borr
owers – RMBS – residential mortgage backed security, 3/27 – like 2/28 but teaser rate runs 3 years
- Outstanding Mortgage Securities (Dollars in Millions) – another big detailed chart
- Non-Agency Sector Break Down –
- Mortgage Sector Share by Number of Loans –
- Loan Delinquencies—Prime vs. Subprime – note radical difference in y-axis scales
- Why Did Subprime & Alt-A Capture Such a Large Market Share? –
: "Mortgage-Backed Security", RiskGlossary.com, undated.
: "Housing Prices: Up was more fun", Editorial, Seattle Post-Intelligencer, June 5, 2007.
… We think there is more to the housing story, one that the Fed chairman articulated well. "Subprime mortgage borrowing nearly tripled during the housing boom years of 2004 and 2005," Bernanke said. "But decelerating house prices, higher interest rates, and slower economic growth have contributed to an increased rate of delinquency among subprime borrowers."
The most telling part of the story is that so many loose loans were written just last year that there is now a substantial increase in "early payment defaults." In other words, banks or mortgage companies could not even count on more than a few months of payments from a new "homeowner."
: "Fitch Report on Loan Modifications", anonymous poster Tanta, CalculatedRisk blog, June 4, 2007.
Let us be clear. Foreclosure waves create additional losses just by being foreclosure waves. You can try to rush for the exits all you want; it takes too long to get out of this door if there are too many people in line. This has always been true. I read things like the above and wonder whether Fitch’s loss models ever considered that when declining home values (a key element in the loss severity calculation) get to a certain point, the foreclosure volume gets to a point such that the operational risk explodes, which drives those loss severities even deeper. The beginning of that paragraph, "servicers have also noted that they believe," quite honestly makes me wonder whether this is news to Fitch.