First Pres Van Order

7/27/2019 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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First Pres Van Order

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