“The Subprime Crisis: You Should Live in Interesting Times”: “The Subprime Crisis: You Should Live in Interesting Times” Susan M. Wachter Richard B. Worley Professor of Financial Management Professor of Real Estate and Finance The Wharton School University of Pennsylvania Presented at The Evolving Housing Finance Marketplace Roundtable New York January 16th 2008


The good, the bad, the ugly: The good, the bad, the ugly 1993-2006: Subprime (high cost) mortgages grew on average 26% annually (Gramlich) 1994-2005: Homeownership increased 2006- 2007: Homeownership fell


U.S. Homeownership Rates,1994 through 2007: Source: Census Bureau U.S. Homeownership Rates, 1994 through 2007


Underwriting Standards Deteriorated: Underwriting Standards Deteriorated Layering of risk 2/28 & 3/27 hybrid ARMs, low & no documentation, little or no equity, low credit scores Lenders and investors expected that housing prices would continue to rise and borrowers would be able to refinance; otherwise, most would default (for subprime hybrid ARMs, up to 97% following initial rate reset)


Slide5: Source : U.S. Census Bureau


Foreclosure Rate Adjustable Rate Mortgages: Foreclosure Rate Adjustable Rate Mortgages MBAA data


Global Contagion: Global Contagion


Slide10: Borrowers Originators / Brokers Secondary Market Regulators Investors The Weak Links Passing the Buck


Slide11: Originators / Brokers Secondary Market Investors Passing the Buck Borrowed at teaser rates-not able/expected(?) to pay at reset Borrowers Regulators Originate to distribute Securities marked to models not to market/assignee liability exemption Agency incentives misaligned- “current conditions” out Lack of short sales Where does the buck stop?


Slide12: Subprime Share and House Price Appreciation - 2002 Changes in House Price in 2002


Mortgage delinquency rate, % of $ volume, 05Q4-07Q2: Mortgage delinquency rate, % of $ volume, 05Q4-07Q2 > 1.45% .85% - 1.45% < .85% U.S. = 1.12% Source: CreditForecast.com


Slide14: > 11.6% Sub-prime Share of Originations, HMDA 2006 8.0%>x>11.6% =<8.0% U.S. = 10.0% Source: HMDA, Moody's Economy.com


Mortgage Loan Defaults: Mortgage Loan Defaults


Questions from Korea: Questions from Korea Last year the subprime crisis gave big shocks to the global economy as well as American economy. How do you expect the future of subprime crisis in 2008 and what is the reason of your expectation? What about the housing market of the U.S. in 2008? More possibility of dropping down? If yes, why? If subprime crisis continues and the recession of American economy realizes, how does it influence the global economy? What would be the worst scenario? Last December, the Bush’s administration announced a deal to freeze the mortage rate. Do you believe this would be effective? Could you explain the process of the subprime crisis? Many people around the world are curious of how such a financial crisis could have happened in the U.S. which has the highest technology in financial industry. How could this happen? The previous cases of financial crisis in many other countries did not spread out to the world, but this subprime crisis in the U.S. already had effected many other countries’ economy. Why? What is the lesson that we can learn from the current subprime crisis?


Slide21: Friday's agreement for Bank of America Corp. to buy Countrywide Financial Corp. for $4 billion shows how size and financial solidity are trumping everything else in mortgage lending. With the heft to withstand rising defaults and falling home prices, these big companies are helping prevent a total shutdown of mortgage lending. "Bank of America stepping in right now is a very good thing for the market" because it signals confidence in an eventual revival of the housing and mortgage markets from what appears to be the worst slump since the Great Depression, said Susan M. Wachter, a finance and real-estate professor at the University of Pennsylvania's Wharton School. Now, defaults are forcing lenders to tighten their standards, and mortgage volume has been plunging, along with home sales. The Mortgage Bankers Association has projected home mortgage originations of about $1.86 trillion this year, down from a peak of $3.95 trillion in 2003. Mortgage Markets Get a Hand By JAMES R. HAGERTY January 12, 2008; Page A5