the sub-prime mortgage situation: causes and · pdf filethe sub-prime mortgage situation:...

Adelson & Jacob Consulting, LLC

The Sub-prime Mortgage Situation:

Causes and Lessons

Mark Adelson Adelson & Jacob Consulting, LLC

New York State Bar Association

Derivatives & Structured Products Law Committee

ABN AMRO, 49 East 52nd Street, 5th Floor, NY, NY

Wednesday, 13 February 2008


2

Agenda

The context of the situation

What is a sub-prime mortgage?

Basics of origination and servicing

Measures of mortgage loan credit risk

Understanding ABS deal structures

Cash flow triggers, sequential vs. pro rata distributions

Performance outlook, uncertainty, and challenges

Public policy initiatives

13 February 2008


Fed Funds Target Rate, NASDAQ Composite Index, and

Annual Rate of U.S. Home Price Appreciation

3 13 February 2008

Source: Federal Reserve, Yahoo

0

2

4

6

8

10

12

14

16

1990 1992 1994 1996 1998 2000 2002 2004 2006

Fed Funds Target Rate (%)

NASDAQ (1990=1)

U.S. HPA (%)


U.S. Mortgage Originations

4 13 February 2008

Source: Inside Mortgage Finance, Mortgage Bankers Associations

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.01990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008P

2009P

($ t

rilli

ons)


U.S. Public Home Equity ABS Issuance

5 13 February 2008

Source: Moody's, Bloomberg, Asset Securitization Report

0

20

40

60

80

100

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

($ b

illio

ns)

0

100

200

300

400

500

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

P


Insured Portion of U.S. Home Equity ABS Issuance

6 13 February 2008

Sources: Asset-Backed Alert Database (insured portion), Moody's, Bloomberg, Asset Securitization Report

0%

20%

40%

60%

80%

100%1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Insu

red P

ort

ion

0

100

200

300

400

500

Issu

ance

Vo

l ($

bill

ion

s)

Insured Portion

Issuance Volume


50

100

150

200

250

300

350

400

450

2001 2002 2003 2004 2005 2006 2007

Sp

rea

ds (

ba

sis

po

ints

)

0

30

60

90

120

150

180

210

240

Issu

ance

($

bill

ion

s)

SF CDO Issuance

ARM BBB- Spread

ARM BBB Spread

Fixed BBB Spread

Home Equity ABS Yield Spreads over Swaps/LIBOR and

Annual Structured Finance CDO Funded Issuance Volume

7 13 February 2008

Source: JPMorgan


Sub-prime Performance (12/2007)

8 13 February 2008

Source: Moody's


Sub-prime Performance (12/2007)

9 13 February 2008

Source: Moody's


10

The ABS "Home Equity" Euphemism

In securitization, "home equity loan" means any loan

secured by residential real estate other than

1. prime-quality, first lien mortgage loans

2. manufactured housing loans

Types of "home equity" loans include:

sub-prime mortgage loans (biggest category)

second lien mortgage loans (traditional home equity loans)

home improvement loans

HELOCs

"high LTV" mortgage loans

Reperforming and non-performing loans (sometimes)

13 February 2008


11

The Sub-prime Mortgage Market in Context

Collateral

Cre

dit R

ep

uta

tion &

R

epaym

ent

Capacity "A"

traditional

seconds

HELOCS High

LTV

sub-prime

M

13 February 2008


12

Sub-prime Mortgage Loan Basics

Usually either

Delinquent in past 12 months

FICO below 620

Common features

high DTI

low or no reserves

no escrows

no MI if LTV over 80

hybrid ARM 2/28 or 3/27 (>80%)

limited documentation

investor properties.

Delinquency Odds by FICO®

0%

5%

10%

15%

20%

25%

30%

580 620 660 700 740 780

Source: Realestateabc.com

13 February 2008


Other Old Definitions

Prime Loans

Conforming in all respects to

standard Fannie/Freddie

program criteria

Typical features

Clean payment record: 0x30x12

LTV ≤ 80% or with MI

DTI ≤ 28% inside, 36% outside

Full documentation

Reserves and escrows

Owner occupied

Alt-A Loans

Borrower has clean credit

But … one or more of

LTV > 80% w/o MI

temporary resident alien

non-owner occupied property

high DTI

high LTV w/ other factors (e.g.

cashout)

less than full documentation

13 13 February 2008


14

New Definitions

Spectrum of quality

Prime: top ~70%

Alt-A: next: ~15%

Sub-prime: bottom ~15%

New non-traditional products complicate classification

Option ARMs

Interest-only

Hybrid ARMs

Piggy-back seconds

Stated income to W-2 borrowers

Risk layering !!!

13 February 2008


15

Origination Basics

Originate to sell

Generate profits on origination

Underwriting criteria

Pricing tiers, rate sheets

Underwriting "matrix"

doc level pay history FICO/LTV grid max loan amount & DTI

product type pay history doc level/property type grid max LTV & size

Exceptions

documented (e.g., LTV upgrades for good pay history but weak FICO)

undocumented

13 February 2008


16

Origination Basics (cont.)

Channels

Retail

Wholesale – correspondents, brokers

Origination process – quality control, staffing, risk

modeling, pricing, strategy

Pedigree – performance history of the originator's loans

13 February 2008


17

Measures of Mortgage Loan Credit Risk

Traditional view: 3 "C"s

Collateral – loan-to-value ratio (LTV)

Credit – credit score (FICO)

Capacity – debt-to-income ratio (DTI)

Other factors

13 February 2008


18

Measures of Mortgage Loan Credit Risk (cont.)

Modern (Fannie Mae) view:

Primary risk factors (Part X, §, 3.01)

Equity investment (LTV)

Credit history (FICO score)

Contributory Risk Factors (Part X, § 3.02)

Liquid financial reserves

Employment classification

Mortgage term (15, 30, 40)

Product type (FRM, ARM, hybrid, etc.)

Property type (SFR, condo, 2-4)

Transaction type (PMM, RTR, CO)

Co-borrowers

DTI ratio

Previous delinquency

Previous bankruptcy

13 February 2008


19

Loan Documentation – Common Permutations

Documentation Type

Fu

ll or A

ltern

ativ

e

Docu

me

nta

tion

Reduced Documentation

No R

atio

No D

oc (N

INA

)

Sta

ted

Inco

me

Sta

ted

Asse

ts

Sta

ted

Inco

me

/

Sta

ted

Asse

ts

No In

co

me

No A

sse

ts

Income Disclosed

Source of Income Verified 1

2

Amount of Income Verified

Qualifying Ratios Calculated from Income

Assets Disclosed

Assets Verified

1 "No Income" loans usually have a verbal verification of employment (VVOE) 2 "No ratio" loans rarely (but sometimes) have a VVOE

13 February 2008


20

Processing & QC: Automation

Pros

Speed

Certainty

Convenience

Consistency

Cons

False precision

Invites manipulation

G.I.G.O.

Misses nuances

13 February 2008


21

Example – Appraisals

Regular Appraiser Automated Appraiser

13 February 2008


Example – FICO® Score

Includes

Payment history 35%

Outstanding debt 30%

Credit history length 15%

Pursuit of new credit 10%

Credit mix 10%

Excludes

Income

Employment

Collateral

Address

Age

Sex

Race

Religion

Marital status

22 13 February 2008


23

When Things That Seem

Alike Really Aren’t

HEL/B&C Underwriting Guidelines

Description of delinquencies

Debt-to-income ratio

13 February 2008


24

Description of Delinquencies

Jan

$1,000

Feb

$0

Mar

$1,000

Apr

$1,000

May

$1,000

Jun

$1,000

Which history suggests more risk?:

Jan

$1,000

Feb

$0

Mar

$2,000

Apr

$1,000

May

$1,000

Jun

$1,000

13 February 2008


25

Description of Delinquencies

As of June 1, the borrower is:

120 days delinquent one time (1x120)

30 days delinquent four times in a row (4x30)

30 days delinquent once on a “rolling” basis (1x30)

Jan

$1,000

Feb

$0

Mar

$1,000

Apr

$1,000

May

$1,000

Jun

$1,000

Borrower’s payment history:

? 13 February 2008


26

Debt-to-Income Ratio

Income

Regular job

Investment income

Second job

Home business

Gifts

Debt

Fully indexed rate

Teaser rate

Included debts

13 February 2008


27

HEL ABS Deal Structure – Tranching

0

20

40

60

80

100

0 20 40 60 80 100

Pool Losses

Tra

nch

e L

osse

s

BBB A

AA AAA

Assets

13 February 2008


28

HEL ABS Deal Structure – Cash Flow

Senior-sub, O/C (not like prime MBS six pack)

Sequential / pro-rata / reverse sequential, with triggers

Spreadsheet examples

0 12 24 36 48 60 72 84 96 108 120

A Prin. M Prin.

B Prin. Residual

13 February 2008


29

Performance Uncertainty

Resets for 2006 vintage in 2008 and 2009

HPA outlook – wide range of views

Interest rates levels

Availability of credit

Models running outside range of their development

samples

Emotional and psychological factors

13 February 2008


Policy Initiatives

Non-traditional Mortgage Products (71 Fed. Reg. 58609, 10/4/06)

interest-only loans and option ARMs

must qualify at fully-indexed rate

avoid collateral dependent loans (unsafe & unsound)

Sub-prime Mortgage Loans (72 Fed. Reg. 37569, 7/10/07)

must qualify at fully-indexed rate

making loan based on collateral rather than borrower's repayment

ability may be a "predatory" lending practice

Reg Z proposal (73 Fed. Reg. 1671 1/9/08)

must consider ability to repay

must verify income

must collect escrows

restrict prepayment penalties

30 13 February 2008


Policy Initiatives (2)

FHASecure Program

Economic Stimulus Act of 2008 (HR 5140)

Mortgage Forgiveness Debt Relief Act of 2007 (Pub. L. No. 110-142)

Mortgage Reform and Anti-Predatory Lending Act of 2007 (H.R. 3915 12/3/07)

Home Ownership Preservation and Protection Act of 2007, (S. 2452 12/12/07)

Emergency Mortgage Loan Modification Act of 2007 (H.R. 4178 11/14/07)

State actions

Hope Now Alliance

ASF streamlined loan modification framework

31 13 February 2008

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