Analysis of Financial Crisis

The Rise and Fall of the Housing Market and i= t's Impact on the U.S. Financial System

For 50 years after WWII, the U.S. housing market grew steadily with just= a few set backs as prices increased. The government policies during this era = had their roots in the agencies and government entities created in reaction to = the massive mortgage foreclosures that occurred during the great depression. Du= ring 1930's Great Depression the US had experienced a greater mortgage crisis th= an the one we are experiencing now. In 1933, about half of mortgage debt was in default, the unemployment rate had reached about 25 percent. Thousands of b= anks and savings and loans had failed. The amount of annual mortgage lending had dropped about 80 percent, as had private residential construction. States w= ere enacting moratoriums on foreclosures. In response to this, the Home Owners Lending Corporation (HOLC) was created in 1933. The average borrower that t= he HOLC eventually refinanced was two years' delinquent on the original mortga= ge and about three years behind on property taxes. The HOLC was a created to handle the immediate problem of mortgage foreclosures. Congress created the Federal Housing Administration (FHA) in 1933 as a long term solution for st= abilizing and managing the housing market and it chartered Fannie Mae in 1938 to facilitate the home mortgage lending market. In the post WWII era government policies continued to encourage homeownership. Primary among these policies= to facilitate home lending was establishment of two Government Sponsored Enterprises (GSEs). The U.S. Federal Government chartered two leading mortg= age institutions crisis, Fannie Mae (created as a government agency in 1938) which was charted as a pri= vate corporation in 1968 and Freddie Mac 1970.^[4] [[6]]

Fannie Mae operates in the U.S. secondary mortgage market. Rather than making home loans directly with consumers, Fannie works with mortgage banke= rs, brokers, and other primary mortgage market partners to help ensure they have funds to lend to home buyers at affordable rates. Fannie funds it's mortgage investments primarily by issuing debt securities in the domestic and international capital markets. Freddie Mac was charted by Congress in 1970 = by the “Federal Home Loan Mortgage Corporation Act.” Freddie Mac's= purpose is: (1) to provide stability in the secondary market for residential mortga= ges; (2) to respond appropriately to the private capital market; (3) to provide ongoing assistance to the secondary market for residential mortgages (inclu= ding activities relating to mortgages on housing for low- and moderate-income families involving a reasonable economic return that may be less than the return earned on other activities) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available = for residential mortgage financing; and (4) to promote access to mortgage credit throughout the Nation (including central cities, rural areas, and underserv= ed areas) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing. [[7]]

In the 1990s Congress urged the GSEs, particularly Fannie and Freddie, to acquire loans made to borrowers that we= re considered a bit more risky. By doing this it was hoped than an additional = 3% of borrowers could qualify for a Fannie and Freddie loan. The objective was= to take home ownership in the US from 66% of the populace to 70%. <ref> [ Holmes, Steven A. (September 30, 1999). "Fannie Mae Eases Credit To Aid Mortgage Lending". New York Times.] </ref> Originally backed by = the Democrats and the Clinton Administration this goal was further embraced by = the Bush Administration which continually emphasized that we were now an "Ownership Society". The Fed (under Alan Greenspan) abetted the availability of cheap money in the 2003-2006 time-frame by keeping the Fed Funds rate relatively low. As this environment developed, it should be noted that the foreclosure rate on a conforming Fannie and Freddie insured loan barely increased.

Fannie and Freddie’s impact on the financial market was significant. As they acquired more and more mortgages, they increased the securitization of the mortgages into AAA rated mortgage backed securities (MBS). The cash received from this securitization was use= d to support the purchase of even more mortgages, and more MBS. By the end of 20= 08 Fannie and Freddie held or guaranteed 5 trillion or about half the US mortg= age market.

ecuritization reflects innovation in= the financial markets at its best. Pooling assets and using the cash flows to b= ack securities allows originators to unlock the value of illiquid assets and provide consumers lower borrowing costs at the same time. MBS and ABS securities offer investors with an array of high quality fixed-income produ= cts with attractive yields. The popularity of this market among issuers and investors has grown dramatically since its inception 30 years ago to $6.6 t= rillion in outstanding MBS/ABS in 2003. By 2008 it was at 14 trillion. <= /span>

The success of the securit= ization industry has helped many individuals with subprime credit histories obtain credit. The Investment community believes securitization allowed more subpr= ime loans to be made because it provides lenders an efficient way to manage cre= dit risk. Secondary market purchasers of loans, traders of securitized bonds and investors are not in a position to control origination practices loan-by-lo= an. The investment community in 2003 urged Congress = to move with great care as it addressed the problem of predatory lending. They believed the secondary markets were a tremendous success story that helped democratize credit. <ref>[http= ://www.house.gov/financialservices/media/pdf/110503cc.pdf<= span style=3D'font-size:10.0pt;mso-fareast-font-family:"\30D2\30E9\30AE\30CE\89D= 2\30B4 Pro W3"'>] </ref>

As securitization = of mortgages increased the Investment banks urged the mortgage lending industry (Countrywide, Washington Mutual, New Century Financial, Wells Fargo, Househ= old Finance, Quikloans and many others), to increase their loan volumes. They d= id this by embracing the sub-prime borrower and issuing Alt-A (limited documentation) loans. And why not? The investment banks appetite for loans = to securitize was ravenous.

<ref> [<= span class=3Dgl1>At Washington Mutual, A Relentless Urge to Lend, International Herald Tribune, Dec 28, 2008.
http://www.iht.com/articles/2008/12/28/business/wamu.php?page=3D2= -64k ] </ref> =

<= /span>

The mortgage and investment banking community continued to believe in securitization as way = to reduce risk. The share of MBSs backed by subprime and Alt-A loans increased dramatically in the last decade. From 1996 to 2006 the share of subprime and Alt-A MBSs rose from 47% to 71% of total private sector MBS issuances. <ref> [http://www.chicagofed.org/publications/fedletter/cf= lnovember2007_244.pdf ] </ref>

<= /span>

Mortgages were further dispersed into securitization structures called Collateral Debt Obligations (CDO’s). These were complicated securities designed to further reduce the risk of mortgage debt as well as consumer credit debt into slices of securities cal= led “tranches”. A description of a CDO in a 2004 article describes = the complicated nature of CDO’s:

“Even though the motives behind the creation of ea= ch CDO differ widely, the principles underlying the structuring of a transacti= on remain similar. At the heart of these principles is the division or slicing= of the credit risk of the reference portfolio into different classes, known as tranches. In accordance with its seniority, each tranche enjoys rights and priorities concerning payments generated by its collateral. Alternatively k= nown as a waterfall structure, this is the process whereby in bankruptcy the proceeds from liquidated cash CDO assets will first be used to meet the cla= ims of the most senior, triple-A rated debt tranche. Only then will proceeds fl= ow to the next most senior tranche of notes, and so on.

The most junior tranche within this waterfall structure = is the equity piece, sometimes referred to as the ‘first-loss piece̵= 7;, which is generally unrated and will account for anything between 2% and 15%= of a CDO’s total capital structure. To compensate for their subordination within the cash waterfall, investors in the equity class of CDOs generally = look for returns of between 15% and 20%.

Equity tranches of CDOs can be placed with investors attracted by the high returns available. Indeed, a Fitch report published in February 2004 comments: “As markets have developed and the number of potential investors has grown, the markets have become more capable of absorbing the riskier pieces of an issue.” In practice, however, the equity tranches of CDOs are still often bought and held by originators.

A key component of the tranching structure of CDOs is the use of coverage tests embedded into the covenants of deals and aimed at maintaining a minimum level of credit quality and therefore protection for note-holders. Coverage tests can include rate coverage ratios, over-collateralisation (OC) ratios and par ratios. In the event of these thresholds not being maintained on a payment date, the manager would genera= lly be required to liquidate sufficient collateral to ensure that the ratios are satisfied.

Ther= e are no predetermined rules on how many tranches an individual CDO may contain. The minimum is usually three, and although there is no maximum, the Aria CDO launched in June 2004 by Axa Investment Managers, which references a pool of 140 corporate names, is exceptional in that it is divided into 28 tranches denominated in five currencies – Swiss francs, sterling, dollars, eur= os and yen – and incorporating fixed, floating and inflation-linked tranches. “

&= nbsp;

The article also provided the above graphic to illustrate the structure of a typical CDO. Of interest is that the “AAA” r= ated tranche of the CDO was no doubt comprised of a significant amount of sub-pr= ime and Alt-A mortgages.

<= ref> [ht= tp://www.creditmag.com/public/showPage.html?page=3D168502 ] </ref>

A key question in the securitization process was how did almost all the securities being issued get rated AAA? Particularly, when as cited previous= ly, 71% of all mortgages issued by the private mortgage industry in 2006 were sub-prime or Alt-A loans. The debt rating companies such as Moody’s, = McGraw Hill’s Standard and Poor’s and Fitch were the leading agencies providing the ratings on the various asset backed securities being produced= by the investment banks. And high rated securities were essential to the entire system: For every dollar of equity that financial companies are required to hold for bonds rated AAA, $3 is needed for bonds rated BBB, and $11 is needed for bonds rated just below investment grade (BB). For banks, the sensitivity of capital requirements to ratings is generally even more extreme.=

Since the ratings determine required capital, they have a profound influence on how financial institutions inves= t. And every actor in the financial system has every incentive to group and slice assets in ways that maximize not their fundamental soundness but their rati= ng. Indee= d, that is the entire rationale behind the $6 trillion structured-finance business. Subprime mortgages (and all manner of other risky loans) held dir= ectly by financial institutions are questionable assets with high associated capi= tal charges. Each one alone would deserve a "junk" rating. Structured finance simply piles such risky assets into bundles and slices the bundles = into tranches. The rating agencies deemed some 85% of the tranches by value as A= AA, and nearly 99% as investment grade.

<ref> [http://online.wsj.com/= article/SB123086073738348053.html ] </ref>

= By their own admission the ratings companies have an inherent contradiction in their business model: they have a need to accomplish accurate ratings but t= hey also have a need to gain and maintain market share. If their ratings came in consistently low (not AAA) for an issuer’s credit securities they wou= ld be in danger of losing that issuer as a customer. In other words, there is = an inherent conflict of interest between bond issuers (who pay to get their is= sues rated) and the ratings agencies (who receive fees from the issuer to rate t= he issuers bonds). The problem was further exacerbated by the fact that the ratings agencies frequently had to evaluate an issue based on data provided= by the issuer. The securitization process had become so complicated and opaque that the ratings agency had to rely on the issuer’s data. There was a= lso the fact that the mortgage securitization process was so successful. As hou= sing prices kept rising through the 1990’s into the 2000’s, mortgages rarely went into foreclosure and when they did their impact inside an MBS or CDO was mitigated thereby “proving” the ratings were accurate.<= o:p>

<ref> [http:/= /oversight.house.gov/documents/20081022102906.pdf ] </ref>

This system worked= as long as housing prices increased. Systemic risk was ignored as more and more sub-prime and Alt A loans were securitized. The “triple A” securities were purchased by many diverse institutions with debt as if they were AAA bonds (they were, that is how they were rated). As long as the security’s mo= rtgage interest cash flow was maintained this was a successful strategy but as more and more mortgages went into foreclosure, the value of the securities dropp= ed requiring assets to be sold to maintain capital ratios while at the same ti= me cash flows that paid the debt dropped, placing the owners of the securities close to or in default. It first hit Bear Stearns, then Lehmann Brothers

The housing bubble fueled by the success of = the mortgage securitization process soon got another boost due to a major chang= e in the leverage rules. At a key meeting of the SEC in 2004, at the request of = the investment banking industry, debt to capital ratios were increased. Until t= hen Investment Banks as well as regular banks were allowed to use 1 dollar of capital to borrow 10 dollars. Banks are still limited to 10 to 1. The decis= ion allowed the brokerage entities of the largest investment banks (Bear Stearn= s, Lehmann Brothers, Merrill Lynch, Citicorp, Goldman Sachs) as well as many l= arge hedge funds to use 1 dollar of capital to accumulate up to 40 dollars of de= bt. <ref> [http://www.nytimes.com/2008/10/03/business/03sec.html?pagewanted=3D3&_= r=3D1&ref=3Dbusiness&adxnnlx=3D1223025677-rFwtkDCegwA3KpS nYcctA] </ref>

At the end of 2007, Lehman Brothers was leveraged 31:1. Bear Stearns turned $1 into $33 th= rough the magic of leverage. What this meant that was that with the advent of mar= k to market accounting (for a discussion of mark to market accounting see= the following: <ref> [ http://en.wikipedia.org/wiki/Mark-to-market ] </ref>), on a mark to mark= et basis, every bank with exposure to MBS, complex CDO and derivatives was pro= ne to an amazing loss of value at staggering speeds.

While the housing market bubble inflated (starting in the 1990’s, = the investment banks and stock market participants valued portfolios of mortgage securities and other derivatives far greater than their book value. The mortgage backed securities proc= ess worked extremely as well as long as the underlying mortgages were primarily prime loans. The risk significantly increased in the early 2000s as sub-pri= me loans became the primary mortgage used in securitization. As the housing bu= bble deflated, many portfolios of these securities fell below book value. Since = the big investment banks and large hedge funds were allowed to borrow excessive= ly on the huge margin described in the previous paragraph, the drop in value due = to mark to market accounting forced the investment banks to write down the val= ue of the security or portfolio as a defensive measure against even greater losses. The rapid drop in value of securitized assets also forced margin ca= lls as some hedge funds, for example, did not have sufficient additional collat= eral to protect against the margin call. Creditors who lent money to investment banks required certain margin and capital ratios and refused to extend additional credit to funds or investment banks as the value of their assets dwindled. This is what happened to Bear Stearns (it had to be taken over by= JP Morgan with the assistance of the government) and to Lehmann Brothers (which was forced into bankruptcy). It’s also what forced Merrill Lynch to m= erge with Bank of America and Goldman Sachs and Citigroup to cease to exist as Investment Banks. The credit crisis dramatically collapsed the market cap values of many of the key players in the mortgage industry (whether they ma= de risky loans or not) and in the investment banking community which had successfully securitized all forms of credit for so long. As the following table illustrates investors in these stockss lost over $1 trillion of market cap value (these stocks dropped 92% from their mid 2000 value) as a result = of the mortgage securitization process based on securitizing risky loans and allowing excessive leverage to acquire such assets.

M= ortgage Companies	m= id 2000s	&= nbsp;	&= nbsp;	e= arly 2009	&= nbsp;	&= nbsp;
C= ompany	P= rice	S= hares (millions)	M= kt Cap millions	P= rice	M= kt Cap millions	&= nbsp;
F= annie Mae	$80.00	1000	$80,000	$0.40	$400	&= nbsp;
F= reddie Mac	$50.00	1400	$70,000	$0.17	$238	&= nbsp;
W= AMU	$45.00	1700	$76,500	$0.05	$85	&= nbsp;
C= ountrywide	$52.00	580	$30,160	$6.00	$3,480	&= nbsp;
N= ew Century	&= nbsp;	&= nbsp;	$1,750	&= nbsp;	$55	&= nbsp;
&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;
&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;
I= nvestment Bankers	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;
G= oldman Sachs	$240.00	460	$110,400	$100.00	$46,000	&= nbsp;
B= ear Stearns	$133.00	135	$17,955	$2.00	$270	&= nbsp;
C= itigroup	$52.00	5450	$283,400	$2.00	$10,900	&= nbsp;
M= errill Lynch	$92.00	2000	$184,000	$6.00	$12,000	&= nbsp;
L= ehmann Brothers	&= nbsp;$60.00	&= nbsp; &nbs= p; 689	&= nbsp; 41,340 <= o:p>	&= nbsp; .04=	&= nbsp; &nbs= p; &= nbsp; &nbs= p; &nbs= p; 27	&= nbsp;
&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;
O= ther Financial Institutions	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;
B= ank of America	$52.00	5000	$260,000	$6.00	$30,000	&= nbsp;
A= IG	$72.00	2500	$180,000	$0.35	$875	&= nbsp;
&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;
&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;	&= nbsp;
&= nbsp;	&= nbsp;	&= nbsp;	$1,294,165=	&= nbsp;	$104,303	&= nbsp;

Excellent summary reviews of this cycle of risky lending followed by securitization of sub-prime debt in conjunction with the use of excessive leverage can viewed= in the CNBC documentary “House of Cards” <ref> [ http= ://www.cnbc.com/id/28892719 ]</ref> = &nb= sp; <ref>= [http://online.wsj.com/video/end-of-wall-street-what= -happened/1F02EFEC-569A-4FED-9BF9-D89CD6E57AD0.html ]</ref> .