The 2008 Sub-Prime Crisis

Riccardo Rebonato

EDHEC Business School – EDHEC Risk Institute

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Outline of Lecture
Plan of the Lecture
How Mortgages Work
Honey, I shrunk the PTI
How Safe Is a Mortgage for the Lender?
How Is a Mortgage Made?
The Lender’s Due Diligence
Securitization
Capital Arbitrage
The Rating Agencies
The ABX Index
Fannie and Freddie: The Mortgage Agencies
Feeding the Beast
Food for Thought
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Plan of the Lecture

I The ‘sub-prime crisis’ of 2008-2009 has shown huge

limitations in how we measured and controlled maket risk.
I Furthermore, a large part of the current regulation has been
put in place as a response to what went wrong during
2008-2009.
I If we don’t understand the dynamics of what actually
happened, we will not understand how we can do better.
I As the crisis was intimately linked with mortgages, we must
understand how these work.

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How Mortgages Work

A standard mortgage has the following structure:

I advanced for a fixed sum of money;
I for a fixed term (eg, 30 years);
I pre-payable at any time;
I payments (which are due monthly) are made up of principal
repayment + interest – see Fig 1

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Figure: The principal and interest schedule for a standard (‘level’) US
mortgage.
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How Mortgages Work
What are the risks for the lender?
I If the borrower stops payments, the lender takes possession of
the house;
I foreclosure can take up to 1 year (and there are foreclosure
costs);
I the lender is exposed to house price risk over the foreclosure
period;
I in the US mortgages are non-recourse: the lender can get hold
of the house but nothing else;
I payments (which are due monthly) are made up of principal
repayment + interest – see Fig 1
I the cushion against all of this is the LTV (loan to value): for a
$250,000 a maximum LTV of 80% gives a maximum size for
the mortgage of $250,000 × 0.8 = $200,000.

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How Mortgages Work

Can the borrower repay?

I The key statistic is the PTI ratio (Payment to Income Ratio).
I A PTI of 40% is high; 50% is usually unsustainable;
I A PTI does not take explicit account of general economic
conditions (eg, level of unemployment).
I In a low rate environment large mortgages become
PTI-affordable – however they are very exposed to changes in
rates.
I The unstated name of the game for a mortgage broker:
find a structure such that the PTI becomes affordable.

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Honey, I shrunk the PTI

These are some ways to make a PTI ‘affordable’.

I ARMs: Adjustable Rate Mortgages
1. The borrower does not pay a fixed rate, but a rate linked to
LIBOR, or the Treasury Bill rate.
2. As short rates are typically lower than long rates, the headline
prepayment today is lower than for a level mortgage.
3. The PTI looks better.
4. Note that payers of ARMs lose the optionality embedded in
fixed-rate products.

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Honey, I shrunk the PTI

Here is another way to make a PTI ‘affordable’.

I PTI not low enough? Try Interest-Only Mortgages
1. With IO Mortgages the principal is not repaid
2. The idea is that, if house prices keep on going up, when the
house is sold there will be more than enough money to repay
the principal.
3. Since there is no principal repayment the headline PTI is now
lower – but you have paid down zero of your debt.

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Honey, I shrunk the PTI

Another idea to make a PTI ‘affordable’.

I PTI not low enough? Try a Hybrid ARM
1. The borrower starts with a low teaser rate (for 1 to 5 years).
2. When the teaser period is over, the borrower will move to a
higher ARM rate.
3. As before, the idea is that you will never get to this stage,
because house prices will go up forever, and you will sell your
house before the end of the teaser period.

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Honey, I shrunk the PTI

Another idea to make a PTI ‘affordable’.

I PTI not low enough? How about Option ARMs?
1. With Option ARMs the borrower has the option to vary the
payment (within certain bands).
2. The payment can get so low that you can even have negative
amortization: the notional of the mortgage increases over time
instead of decreasing.
3. This means that after a while you own more than you
originally borrowed.
I The ‘justification’ for all these structures?
I Teaser rates are ideal for speculating on house prices,
and for gaining a huge leverage: for a fixed PTI, the
same payment on a level mortgage on a $220,000 house
can correspond to a payment with teaser rate on a
$305,000 house!

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How Safe Is a Mortgage for the Lender?

I Prime Mortgage
1. LTV below 80%
2. FICO score for the borrower above 650;
3. PTI ratio below 40%;
4. Proof of income.
I Alt - A
1. relatively innocuous variations on the above (eg, self-employed,
slightly higher LTV. . . )
I Subprime
1. poor credit history
2. stated, not proven, income
3. stated, not proven, employment status
4. bankruptcy in the last 5 years
5. FICO score below 640
6. PTI above 50%.

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How Is a Mortgage Made?

I A mortgage broker assesses a borrower’s circumstances, and

suggests a loan type, and a lender.
I Brokers market their services actively: in 2006 over 50% of
mortgages were introduced by a mortgage broker.
I This means that to be competitive in the mortgage market a
lending bank must offer loans that a broker will recommend.
I Brokers get paid by the lender for each mortgage they
originate.
I The fee varies with the type of product – the more complex
the product, the higher the fee.

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How Is a Mortgage Made?

I So brokers are incentivized tend to recommend complex

mortgages with a higher fee.
I So lenders are in turn incentivized to create complex
mortgages.
I Brokers have an incentive to make sure that the mortgage is
made, not that the mortgage will be repaid
I Therefore they ‘present’ a borrower to the lender in the best
possible light
I They can ‘optimize’ applications to increase the chance that
they will be accepted by the lender.

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The Lender’s Due Diligence
Surely the lenders will be very careful about the mortgages they
advance – or will they?
I Traditionally mortgages were funded by a bank via deposits.
I However, deposits have ceased for quite some time to be
enough to cover the demand for mortgages.
I Mortgage banks1 filled this gap by funding mortgages via
short-term funding in the capital market – see in the UK
Northern Rock.
I Once lots of mortgages are made, they are packaged together
and sold on, freeing up cash for more lending.
I Therefore mortgages do not stay on the balance sheet of
mortgage banks (for long).
I This is the ODM (originate to distribute) model. Compare
with the loans authorized by the old-fashioned loan officer.
1
which are NOT banks, despite the name, because they are not licensed to
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The Lender’s Due Diligence

Some observations:
I The rise of subprime (or, feeding the beast): too many lenders
chasing too few prime borrowers.
I To create more mortgages lenders had to move to subprime.
I Subprime borrowers borrowed $100 bn in 2001 and $600bn in
2006.
I Brokers, appraisers and ODM lenders are all encouraged to
ensures that mortgages – any mortgages – are made, not that
the mortgages are repaid.

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The Lender’s Due Diligence

Some observations:
I The possibly dodgy loans do not stay on the lender’s balance
sheet, so little due diligence was performed by the banks.
I As more borrowers who had never had access to the housing
market began to bid for houses, house prices sky-rocketed,
creating an apparently virtuous circle.
I What could possibly go wrong?

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Securitization

Securitization played a key role in the next phase of the crisis.

I Suppose that a firm has a pool of assets, perhaps mortgages,
that it has originated, or acquired.
I These assets (should) pay regular, predictable payments.
I The firm can set up a Special Purpose Vehicle (SPV), that
buys the assets (say, the mortgages).
I Where does the SPV get the money from? From investors to
whom bonds are sold.
I The bonds pass-through to the investors the receivables from
the mortgages.

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Securitization

I The investor is comfortable to buy the bonds because, for

instance, out of $100 of mortgage, $95 of bonds are
originated, which take the first payments.
I What happened to the remaining $5?
I This is issued as shares, which are bought by the mortgage
bank (skin in the game) or by external investors.
I If the loss on the mortgage is $3, the bond holders are repaid
in full; the equity holder only gets $2.
I The SPV is bankruptcy removed: the mortgage lender does
not have to hold capital against the assets in the SPV, and the
SPV’s debt does not count among the liabilities of the bank.
I (Reputational aspects.)

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Securitization

I What can be securitized?

1. commercial mortgages
2. bonds
3. corporate loans
4. credit card receivables . . . (name a few other)
I What common characteristic do these assets share?
1. self-liquidating (unlike a painting by Velasquez, if everything
goes well, the assets turn into cash without having to make a
sale)
2. diversification
3. history available
4. statistics (eg ratings of underlying bonds)

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Securitization

Tranching is key to securitization. This is how it works.

I Take a notional of $100m.
I The receivables from a pool of assets can be channelled via a
waterfall to different classes of ‘tranches’, each with a
different ‘thickness’:
1. the first losses are absorbed by the equity tranche, which may
be 5% of the total notional;
2. the next losses are absorbed by the mezzanine tranches, which
may be the next 5% of the total notional;
3. next we have the senior tranche;
4. sometimes we have the super-senior tranche, which is
protected by all the underlying tranches.
I See Figs 2 and 3

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Figure: A simple securitization structure.

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Figure: A simple waterfall structure.

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Securitization – Capital Arbitrage

I Almost all the risk of a pool of tranched assets is in the equity

/ mezzanine tranches.
I Suppose that the lender has kept the equity and mezzanine –
let’s take a very generous 9%.
I For 1bnofassetsthiscorrespondstoanotionalof 90m.
I Take the capital charge on risky assets to be 8%.
I If the loans had not been securitized,
1bnofmortgageswouldhaveattractedacapitalof 80m.
I After selling the senior tranches, the same capital now attracts
only 90mx8% =7.2m, less than a tenth of the original capital.
I But the risk retained is almost the same! The 8% capital
rule had been devised with an average pool of mortgages in
mind, not with toxic waste.

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Securitization – The Rating Agencies

How can the SPV (ultimately, the lender) convince investors that
the senior tranches are really safe? Enter the rating agencies.
I Given a pool of assets (with geographical diversification and
other features) the rating agencies rate the different tranches.
I They only get paid if a pool gets rated!
I They “work with” the lender/SPV to structure the tranches in
such a way that they will pass the rating test.
I Note that in this process of refinement some assets are
chucked out.
I This may be because of poor geographical diversification, but
also because they are really bad.
I These rejected assets remain available for the next
securitization.

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Securitization – The Rating Agencies

I The six-pack: the mezzanine is divided into six tranches

1. AA
2. A+
3. A-
4. BBB
5. BB
6. B
I If the mortgages perform well, tranches become better quickly.
I For instance, most of the mortgages were 2/28 or 3/27 ARMs,
so there is a huge wave of prepayment after years 2 and 3.
I These cashflows go to the senior tranches, which may have a
life of only 2 years, and (should ) therefore have little
exposure to default risk.

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Securitization

How can you enhance the rating of your pool: enter the Monolines
I Traditionally monoline insurers were in the business of writing
financial guarantees on municipal bonds.
I These stable and rather stodgy business model began to
change with the advent of mortgage-backed ABSs.
I To increase their revenues, monoline insurers began to ‘wrap‘
(ie, to guarantee against losses from) the tranches of
securitization.
I Monoline insurers did not even have to raise money to get
exposure to subprime risk.
I They are paid a financial guarantee fees upfront, and they
only have to pay if and when the protected asset does not
pay: it is all good money upfront.

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Securitization – Monolines

How can you enhance the rating of your pool: enter the Monolines
I Monoline insurers were sough after because often charged less
to protect a tranche than credit default swaps
I They could do so partly because MLIs do not have to pledge
collateral (or, rather, they only have to pledge it if they get
downgraded).
I So, a A-rated tranche of an MBS would cost 40 bp/annum to
protect with a credit swap, but only 20 bp to have it
protected by a MLI.
I After the kiss of wrapping, the A-rated frog has become a
AAA-rated prince.

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Securitization – The ABX Index

How can you enhance the rating of your pool: enter the Monolines
I There are many ABX indices.
I Each one is referenced to a vintage of a tranche
sub-prime-backed bonds of a given rating.
I So, for instance, ABX 0602 BBB is the index of the
BBB-rated sub-prime backed bonds issued in the second half
of 2006.
I The indices gave visibility to the price risk.
I House prices fell → defaults rose → credit enhancement
becomes less effective → various tranches become riskier →
everybody could see their prices falling as ABX prices were
widely distributed.

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Fannie and Freddie: The Mortgage Agencies

I These Government Sponsored Entities (GSEs) were created by

L Johnson to facilitate home ownership in the States.
I They had private shareholders, but an ‘implicit’ government
guarantee, which allowed them to raise funds at extremely
attractive rates.
I Originally they would hold (conforming) mortgages on their
books. But this quickly increased their balance sheet.
I Therefore the GSEs played a leading role in the invention of
MBSs.

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Fannie and Freddie: The Mortgage Agencies

I Issuing pass-throughs with their repayment (not

pre-payment!) guaranteed by the Agencies allowed them to
free their balance sheet, raise more capital, and lend more.
I The GSEs would retain the (low) default risk, but pass on
prepayment risk and balance sheet funding to the bond
market.
I Note: the GSEs were only allowed to buy conforming
(high-quality mortgages).
I Most sub-prime were non conforming, so the GSEs could not
buy them.
I While everyone else was printing money, the shareholders of
the GSEs become impatient and clamoured for a piece of the
action.

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Fannie and Freddie: The Mortgage Agencies
I The first response of the agencies was to increase the riskiness
of their mortgages.
I For instance, Freddie Mac’s exposure to loans with LTV over
90% double from 2001 to 2007, but they were still
constrained by the rule that they could only buy whole loans if
they conformed.
I Therefore they argued that they should be allowed to buy not
just whole loans, but also private-label (not GSE-sponsored)
highly-rated MBSs.
I Thanks to the magic of securitization, the loans behind these
MBSs did not have to conform.
I The Agencies had finally engineered a synthetic exposure to
subprime.
I By late 2007 Fannie and Freddie’s portfolio of MBSs grew to
an astonishing $1.5 trillion (the GDP of the US is
approximately $9 trillion)!
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Feeding the Beast

I By late 2006 everybody wanted a piece of the subprime action.

I But even after granting loans to the most NINJA borrowers,
there were not enough subprime mortgages to keep the pace.
I The first response was to use as ‘underlying assets’ not
mortgages (dodgy as they may be), but tranches of mortgage
securitization.
I An ordinary CDO uses, say, corporate bonds or mortgages as
underlying assets.
I A CDO of ABSs uses ABSs as ‘collateral’, producing tranches
backed by tranches backed by assets.

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Feeding the Beast

I So an originator could collect lots of BBB tranches from

securitization, pool them together, re-tranche them, and have
them rated by the always helpful Rating Agencies.
I So, you can create a AAA tranche using only BBB tranches.
I The Agencies had little experience with pools of mortgages,
and zero experience with polls of tranches originated from
pools of mortgages.
I But they would still only get their fee if they rated the
structure!

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Feeding the Beast
A very important point:
I If you have a AAA-rate “first-order” tranche, you need some
8% of losses for you to begin to suffer.
I Even if you have 15% of losses in the underlying pool, your
bond is still worth 93.
I But consider now a AAA-rated tranche created from
BBB-tranches.
I As generalized defaults mount to 6-7%, all the BBB-tranches
get depleted
I Each tranche goes to zero very quickly. item And it doesn’t
matter how many assets worth zero you pool together: once
losses reach around 10% there are no cashflows to reach a
AAA-rated tranche of BBB-tranches!
I The AAA is 100% wiped out!

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Feeding the Beast

A quote from Michael Lewis’s The Big Short

“. . . A CDO [. . . ] was essentially just a pile of triple-B
rated mortgage bonds. Wall Street firms had conspired
with the rating agencies to represent the pile as a diversi-
fied collection of assets, but everyone with eyes could see
that if one triple-B subprime mortgage bond went bad,
most would go bad, as they were all vulnerable to the same
economic forces. Subprime loans in Florida would default
for the same reasons, and at the same time, as subprime
mortgages in California. And yet fully 80% of the CDO
composed of nothing but triple-B bonds was rated higher
than triple-B. [. . . ] To wipe out any triple-B bond – the
ground floor of the building – all that was needed was a
7% loss in the underlying pool of home loans. . . ”

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Feeding the Beast

Also from Michael Lewis’s The Big Short

“. . . [This also created] a stunning opportunity. The mar-
ket appeared to believe its own lie. It charged a lot less
for insurance on a putatively safe AA-rated slice of a CDO
than it did for insurance on the openly risky BBB-rated
bonds. Why pay 2% a year to bet directly against BBB-
rated bonds when [you] could pay 0.5% a year to make
effectively the same bet against the AA-rated slice of the
CDO?”

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Feeding the Beast

How else can we create assets out of thin air? Enter portfolio
credit default swaps.
I A portfolio credit default swaps is a CDS written not on a
single asset, but on a portfolio.
I This portfolio can be pool of subprime mortgages.
I So, for instance, the junior portfolio credit default swap on a
given pool of $1bn of mortgages can pay out on the first
$40m of losses, but no more.
I The mezzanine portfolio credit default swap on the same pool
of $1bn of mortgages can pay out on the next $50m losses
I The senior portfolio credit default swap protects the residual
$190m of the pool.
I The three swaps together protect the whole pool.

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Feeding the Beast

Also from Michael Lewis’s The Big Short

“ They didn’t realize that the bonds inside their CDOs
[the bonds on which they had bought protection] were
actually credit default swaps on the bonds, and so their
CDOs weren’t ordinary CDOs but synthetic CDOs.”
See Fig 4

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Figure: An old structure revisited.

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Feeding the Beast

The ‘magic’ of portfolio credit derivatives

I With physical assets, I ultimately have to find someone to
take a loan.
I CDOs of ABSs are a pyramid way to get around this.
I Portfolio Credit Default Swaps are another way to create
synthetic assets: given a reference pool of assets, an infinite
number of originators can write protection on the same pool.

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Food for Thought

The ‘magic’ of portfolio credit derivatives

I If you were the regulator after 2008 what would you have
done?
I Here are some thoughts:
1. “Skin in the game would solve the problem.”
2. “This is just a game of pass-the-parcel. I just have to make
sure that there is a back-stop to put an end to all this. The
back-stop should be the rating agencies / the monoline
insurers.”
3. “We just need to put good effective rules at each link in the
chain to prevent stupid things happening.”
I Given the situation just described, how do losses become
‘systemic’ ?
I Any thoughts about the measurement of market risk?

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