Econ 234 The Global Financial Crisis – Consumer Behaviour and Risk Assessment
Daryl L. Wright
The global financial crisis that occurred from 2007 to 2010 was largely affected by a risk assessment system that failed to recognize the level of risks involved in trading credit default swaps and asset backed securities. Particularly mortgage backed securities that contained sub-prime mortgages. The risk assessment failed to calculate the purchaser’s perception of home ownership which relied on the myopic expectation that housing prices would continue to increase. This false belief stems from a long history of steadily increasing house prices that aided to create a foundation for a market bubble. The largest market correction in housing values as a percentage since the great depression and the subsequent sell off that occurred fueled the downturn.
White securitization led to an increase in the supply of lendable funds a greater problem existed in the equation. Consumer behavior deviated from traditional models, the delinquency rates of the underlying assets held in MBSs resulted in a dramatic increase in overall risk.
The majority of financial instruments that failed during the financial crisis were considered low risk investments. However, the quality considerations of assets held in a given security was based on an extrapolation of historical home purchaser behavior. The entire process from mortgage underwriters to asset securitizers and security purchasers relied on the continuance of previous behavior expressed in one form or another.
Consumer Risk Increased
The chart below expresses credit default risk using a percentage of loans 90+ days delinquent. (FRBNY, 2011)
| Debt Type |
1999 Q1 |
2003 Q1 |
2007 Q1 |
2010 Q1 |
(%Δ) 2007 Q1 – 2010 Q1 |
Student Loans
Credit Cards
Auto Loans
Mortgage
HE Revolving |
13.1%
7.1%
2.6%
1.0%
0.7% |
6.5%
8.8%
2.3%
1.2%
0.4% |
8.0%
9.7%
2.6%
1.6%
0.7% |
10.4%
13.7%
5.0%
8.9%
4.1% |
+30%
+41%
+92%
+456%
+485% |
Between 2007 and 2009 the average house decreased in value dramatically and started dramatic increase in defaults. Once values began to drop sharply people simply stopped paying their mortgage, increasing risk to the lenders (Figure 2). Unlike other asset purchases where the purchaser expects a depreciation of value, a different relationship existed regarding home ownership. Previously, consumers would delay payments on credit cards, loans, and other forms of debt. However, in the recent crisis once the value of the asset stopped rising the mortgage owner started to delay payments, or not make them at all. [1]
Housing Bubble vs. 90+ Day Delinquency Rates
Once the market price reached a plateau between March and September 2006, before prices even decreased default rates began to skyrocket. As the homeowner stopped making mortgage payments, the purchasers of mortgage backed securities began to question the holdings and the risks involved.
Increased risk of default of the underlying loans as well as a flooded market of foreclosures would result in an increased risk assessment overall on mortgage backed securities.
As of the third quarter of 2007, 43 percent of foreclosures were on subprime ARMs, 19 percent on prime ARMs, 18 percent on prime fixed-rate mortgages, 12 percent on subprime fixed-rate mortgages, and 9 percent on loans with insurance protection from the Federal Housing Administration. (IMF, 2008 P.5)
While the high leverage positions of banks were most definitely the reason the crisis was so significant. It is important to understand the interpretation in the risk assessment of those purchasing the underlying asset. Considerations were not taken into account about the asset purchaser when determining the true risk associated with the loans.
Rating Agencies and Automated Risk Assessments
The Standard & Poor’s 500 Guide published two years before the crisis on November 5, 2005 includes an analysis of the Federal National Mortgage Association (Fannie Mae) Given the past market trends, the risk of mortgage backed securities was perceived as relatively low. Relatively few borrowers were in serious default when housing prices were increasing.
One of the primary benefits of securitization was that it reduced the risk of loss through diversification. However, the underlying relationship of the home purchaser and the price of the home continued to exist an evidently become reality. The market crash was caused by a number of statistically unlikely but significant events. Under traditional risk assessment models considerations were made based on the likelihood of default which did not account for a shift in consumer behavior. In a 1997 report entitled “Innovations in Mortgage Risk Assessment” Standard and Poor’s discusses the advantages to streamlining an electronic underwriting approval system that uses FICO scores to predict future performance from purchasers. Statements declaring the system as more sophisticated[2] because it relied less on the personal judgment of an underwriter and focused on the relationships between consumer credit scores and payment habits. (Standard and Poor’s, 1997 P.7)
A system that relies of credit scores generated from past performance should not have been a primary determinate in future performance. Ten years later this computer system may have been modified but it still generated risk assessments based on the same extrapolation of past performance. This system provided little opportunity for the mortgage underwriter to have input in the assessment. A representative from Moody’s explains:
“There has been a failure in some of the key assumptions which supported our analysis and modelling,” Mr McDaniel admits. “The information quality deteriorated in a way that was not appreciated by Moody’s or others.” Mortgage borrowers, in other words, did not behave as expected. (Krishna Guha, 2008 P.1)
Public Policy and Banking Standards
A major public policy push attempted to increase home ownership in the lower to middle class population who would not otherwise be granted loans under normal lending conditions. Changes to the “type” of mortgage holder played a large role in changing the relationship regarding debt.
Like investors, purchasers of homes perceived the market to consistently increase and purchasing decisions were based on market momentum as a prime determinate. In the case of the recent housing crisis at an unrealistic forecast. Some surveys showed a projected increase median of 10% regarding future increases in home values. At this rate a “2000-fold increase” would have occurred that would result in no one being able to afford a home if continued for a long period of time (Shiller, 2009 P.2).
Combined with banking standards and loan options such as no-recourse, Adjustable Rate Mortgages(ARM), negative equity or high leveraged mortgages, and very low down payment requirements the borrower was able to reduce their own risks and solidify a price related behavior which ultimately deviated from risk assessment projections.
Systems built around the assumptions that past behavior will continue into the future are used to project future outcomes. It appears that past performance does not guarantee future success.
[1] Figure 2 indicates in March 2007 the Case-Shiller composite 10 and 20 indices both move downwards from 2007 Q1 – 2009 Q1 for a total loss of -30% (Point A to B) while at the same time 90+ day mortgage delinquency rates moved from 1.56% in March 2007 to peak at 8.89% in March 2010. (Point A to Point C). The peak mortgage delinquency rate occurs 5 months after the peak unemployment rate which occurred in October 2009. (USDL, 2011)
[2] A more descriptive analysis of Standard & Poor’s 500 article Appendix A
Appendix B provides an excerpt and brief analysis of Washington Mutual’s 2006 annual report filed with SEC. The report indicates that the risk was recognized in the report yet reaffirmed increasing average FICO scores. In a sense the company recognized the risk but assumed the FICO based risk assessment was compensating for increased delinquencies. Holding true to Standard and Poor’s statement that the system was more “sophisticated”.
References
Federal Reserve Bank of New York. (2011). U.S. credit conditions – Percent of balance 90+ days delinquent by loan type. Retrieved from http://www.newyorkfed.org/creditconditions/
Technical Notes: http://www.newyorkfed.org/creditconditions/technical_notes.pdf
International Monetary Fund. (2008). Assessing Risks To Global Financial Stability. Retrieved from http://www.imf.org/external/pubs/ft/gfsr/2008/01/pdf/text.pdf
Krishna Guha and Gillian Tett. (2008, January). Stricken US homeowners confound predictions. FT.com,1. Retrieved March 27, 2011, from ABI/INFORM Global. (Document ID: 1422426641).
Securities and Exchange Commission – SEC EDGAR (2007, March 01). Annual report pursuant to section 13 or 15(d) of the securities exchange act of 1934 for the fiscal year ended December 31, 2006. Retrieved from http://www.secinfo.com/d11MXs.uF79.htm#2fkw
Shiller, Robert. (2009). Unlearned lessons from the housing bubble. The Economists’ Voice, 1-2.
Standard & Poor’s. (2005). The Standard & Poor’s 500 Guide, 2006 Edition. McGraw-Hill Companies. Federal National Mortgage Association Page 345.
Standard & Poor’s (1997). Innovations in mortgage risk management. Structured Finance Ratings, Retrieved from http://www2.standardandpoors.com/spf/pdf/events/mortriskmgmt.pdf
United States Department of Labor – Bureau of Labor Statistics. (2011) Labor Force Statistics from the Current Population Survey. Retrieved from http://data.bls.gov/pdq/SurveyOutputServlet?request_action=wh&graph_name=LN_cpsbref3’
Appendix A
Standard & Poor’s 2005 Page 345. The recommendation sets a tone for the risk assessment of Mortgage backed securities and the companies that are issuing them.
In 2003 it [Fannie Mae] issued $850 billion in MBSs for other investors, versus $478 billion in 2002 and $345 billion in 2001. Congress is constantly concerned about the government’s risk exposure on over $1 trillion of mortgages and mortgage-backed securities outstanding, since the U.S. government might have to ultimately make good on large-scale defaults. Congress has therefore established capital standards, which the company meets… (Standard & Poor’s, 2005)
Standard & Poor’s recommendation at the time:
S&P Investability Quotient Percentile: FNM scored higher than 81% of all companies for which an S&P Report is available.
It is understandable then that FNM was not in the business of being greedy but making a premium for the “collateralized debt swap” to enable lenders to gain liquidity and reduce risk in exchange for a return or premium.
In securitization operations, which account for much of FNM’s remaining profits, the company swaps mortgage-backed securities (MBSs) for mortgages with various lending institutions, and in the process earns a fee of about 0.20%. One reason the lenders swap loans for MBSs is that the latter add to liquidity. FNM functions as a mortgage insurer in that it accepts the risk of default on the mortgage in exchange for a fee or a premium. (Standard & Poor’s, 2005 P.345)
Fannie Mae and most companies in the securitization business at the time had myopic expectations about how the market would perform. As it had always done in the past a steady gain in the price of housing would continue to allow the MBS market to flourish. However, Fannie Mae, Standard and Poor’s and almost every financial institution failed to recognize the purchaser’s relationship to housing and their vulnerability in the event of a housing downturn. More importantly the snowballing effect after the reduced demand increases the supply and drives the price down.
Appendix B
Because mortgage underwriters relied on a risk assessment system that relied on historical data they believed the consumer credit was stable while delinquency rates on mortgages were already starting to increase. Data indicated in their SEC EDGAR filing shows a slide indicating improved consumer credit while at the same time 90+ day delinquency rate had already began an upward trend for over one quarter.
Retrieved from SEC, 2007: http://www.secinfo.com/DB/SEC/2007-000/1277/277-0000/55-022.gif
However, in the 2006 Annual report Washington Mutual states that risks have already increased and provides fairly clear indication of what is causing it. Subprime lending increasing delinquencies leading to increased risk in the securitization sale process, ARM loans and Interest only loans as well as high loan to value loans. The following statement is an excerpt from the report with bolded fields of interest.
The Company originates and purchases from third-party lenders loans to higher risk borrowers through its subprime mortgage channel. The Company either holds such loans in portfolio or securitizes and sells them. Borrowers in the subprime mortgage channel tend to have greater vulnerability to changes in economic factors, such as increases in unemployment, a slowdown in housing price appreciation or declines in housing prices, than do other borrowers. Overcapacity and competitive market conditions in the subprime mortgage industry have negatively impacted the Company’s business and could continue to do so in the future. The Company’s subprime mortgage channel portfolio has performed within the Company’s expectations in recent periods. The future performance of this loan portfolio could be negatively impacted by a variety of factors, including changes in the economic factors noted above, which negatively impact borrowers, as well as deterioration in the ability of third-party lenders who sold loans to the Company to continue to service or repurchase loans as required under the terms of their loan sale and servicing agreements with the Company. At December 31, 2006, loans in the subprime mortgage channel with an unpaid principal balance of $8.78 billion were serviced by a single third-party lender. By value, this $8.78 billion represented a majority of the balance of loans in the Company’s subprime mortgage channel portfolio that were not serviced by the Company. In addition, as a seller of subprime mortgage channel loans, the Company began experiencing, in the fourth quarter of 2006, increased incidents in the absolute number of repurchase requests. Increased delinquencies of such loans could negatively impact the Company’s ability to securitize and sell such loans. (SEC, 2007)
Retrieved from: http://www.secinfo.com/d11MXs.uF79.htm#2fkw Page 3 (Credit Risk)
50.411859
-104.604737
and some “flare”.
Managing Rental Properties for Maximum Profit Review
After reading Managing Rental Properties for Maximum Profit by Greg Perry I understand that there is a sea of published material that provides little substance. I think the book would have provided useful information for small scale landlords conducting business in the late 1950s. That being said, I didn’t walk away from the book thinking it was a complete waste of time. Perry provides some useful information regarding client relationships and sales strategies. He suggests that by forming a relationship with the client a number of benefits can be realized including fewer midnight phone calls about leaky taps.
Going into the book I was seeking material that was focused on structure, finance and medium/large scale operations. I think the book should probably have been named “First time Landlords” as it was geared towards land lording more than property management or even profit maximization. In Perry’s view profit maximization comes from reducing “inefficiencies” which he indicates a large part being the time of the landlord. Of course, in a corporate structure the landlord usually isn’t the Property Manager and is therefore 90% fixed cost.
From a landlord perspective building relationships is a great asset. Having people tell you when something is wrong prior to additional damage is a great cost savings strategy. Better yet if they fix it themselves and are qualified to do so. Perry’s suggestion for reducing sales cost (or the cost of locating good tenants) was to hold an open house rather than phone interviews because questions can be answered as a group rather than multiple times by phone. Another benefit to doing so is you can compare candidates immediately and understand which ones might be better for the property.
All in all, I’d give this book 1.5/5 and not suggest it for anyone who wants to get more than a few pages of solid learning material.
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