MORTGAGES, MARKETS AND WHAT WE KNOW SO FAR

Detroit Chapter of the Institute of Internal

Auditors

Robert Van OrderUniversity of Michigan

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Basic Observation: Big increase in foreclosures. Why?

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Subprime ARM Defaults are Very Different

from Prime and Subprime FRM Loans 90 days or more delinquent or in foreclosure (percent of number)

Source: Mortgage Bankers Association(Quarterly data not seasonally adjusted;1998Q1-2007Q3)

Prime Conventional

FHA & VA

SubprimeFRM

– Recession SubprimeARM

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Stylized Facts and Gatherings from Various Data Sources

Credit Risk: A Few Propositions Recent History: Especially Large Early Payment

Defaults: Can it be rate adjustments? Changing Loan Characteristics: Hard vs. Soft Data,

Technical Change and the Two Decades. Economic Conditions Market Structure: The rise of subprime Securitization: The rise of non-agency securities

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Age of Loan in Number of Months From Origination Date

Cumulative REO Rates Are Showing Poor Performance of Recent Origination VintagesCould it have been ARMs?

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Alt-A Subprime

2002 2003 2004 2005 2006 2007

Source: Loan Performance, a subsidiary of First American Real Estate SolutionsNote: the last twelve points on each origination year cohort contain fewer loans progressively as loans issued at earlier dates always age faster. Data through December 2008.

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Credit Risk

Underwriting models and history suggested scorecards and diversification worked

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Relative Default ProbabilitiesNote the “Nonlinearity” as you move NortheastMore sensitive to mistakes.

　LTV <70 LTV 71-80 LTV 81-90 LTV 91-95

FICO <6200.96 4.8 11.04 19.68

FICO 620-6790.46 2.3 5.29 9.43

FICO 680-7200.2 1 2.3 4.1

FICO >7200.08 0.4 0.92 1.64

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Price Performance Matters. So Does (Did?) Diversification

Default Probability vs. House-Price AppreciationState/Origination Year and National/Origination Year Cohorts (1985-1995)

80% Loan-to-Value, 30-Year Fixed-Rate Home-Purchase Mortgage

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

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So looking back, you would have thought that controlling FICO and LTV was a big deal, you couldn’t have a credit problem without changes in FICO-LTV distribution, and a diversified portfolio would perform well.

But Performance Got Really Bad. Especially in Early Months

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Underwriting has changed over time, but not in ways you might have thought.

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High LTVs went up in 90s. Fell lately

LTV Trends

0.010.020.030.040.050.060.070.080.090.0

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

Average LTV

% LTV>90

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Recent observables haven’t changed all that much (Tales?)

Loan Characteristics at Origination for Different Vintages: Alt-A and Subprime Demyanyk, Yuliya and Otto Van Hemert, “Understanding the Subprime Mortgage Crisis”(2007)

2001 2002 2003 2004 2005 2006 Average Loan Size (*$1000) 151 168 180 201 234 259

FRM (%) 41:4 39:9 43:3 28:2 25:1 26:1

ARM (%) 0:9 1:9 1:3 4:3 10:3 12:8

Hybrid (%) 52:2 55:9 54:7 67:3 62:0 46:2

Balloon (%) 5:5 2:2 0:8 0:2 2:6 14:9

Refinancing (cash out) (%) 52:1 51:2 51:6 47:9 45:7 44:8

FICO Score 620 630 641 645 653 654

Loan-to-Value Ratio (%) 79:3 79:4 79:2 79:3 78:5 78:3

Debt-to-Income Ratio (%) 37:8 38:1 38:2 38:5 39:1 39:8

Documentation Dummy (%) 68:5 63:4 59:8 57:2 51:8 44:7

Initial Rate (%) 9:4 8:3 7:3 6:7 6:6 7:2

Margin for ARM and Hybrid (%) 6:2 6:3 5:9 5:3 5:0 4.9

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We Seem To Have Two Explanations Left

Economic Conditions. Structure and Moral Hazard

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The Case-Shiller Index

Single-family Construction

400

700

1,000

1,300

1,600

1,900

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

1- to 4-Family Housing Starts (thousands of units, SAAR)

Sources: Bureau of Census, Freddie Mac

– Recession

Third Quarter 2005 record: 1.8 million units

Forecast

Fourth Quarter 2007:

0.9 million units

Source: Freddie Mac Purchase-Only Conventional Mortgage Home Price Index (Annualized Quarterly Rates for 3rd Quarter 2007)

Price Changes by State: Third Quarter 2007

Pacific -5.8%

Mountain

0.4%

West South Central

4.9%

East South Central

-0.1%

South Atlantic -2.7%

Middle Atlantic

-0.9%

New England

-3.6%East North

Central

-3.8%

West North Central

-0.8%

> 5% Quarterly Change

< 0% Quarterly Change

0 – 5% Quarterly Change

< -5% Quarterly Change

DC

United States -2.2%(3rd Quarter Annualized Growth)

How favorable were economic conditions?

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The structure of the Market Has Changed

More Subprime and Alt-A Non Agency Securitization

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Subprime used to be about 10% of originations, but it’s share increased a lot after 2003

Market shares

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FHA/VA

Conforming

Subprime+Alt-A

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Securitization ChangesNote the nonagency share went up after the subprime share went up and around the time the vintages got worse.

Non Agency Share of MBS

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Non Agency Share ofMBS

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SUBPRIME SECURITIZATION

Credit risk is more important than for Agency securities. The risk has been handled (poorly) by structuring.

So securitization could have been a big part of the problem, because it is so susceptible of moral hazard/asymmetric information.

Recall that to some extent the recent subprime loans didn’t look that bad on paper. Hard vs. soft information.

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Subprime Foreclosures Started: 4-yr Distributed Lag of Multipliers

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As an aside there have been spillovers that don’t match with actual risk.

About half way through the eventual increases in defaults

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