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Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption The Subprime Crisis: Can problems in a small part of the mortgage market disrupt the entire economy? Paul Willen Federal Reserve Bank of Boston Boston Fed Regional Community and Banking Conference, October 25, 2007 The following reflects the views of the author and is neither the official position of the Federal Reserve Bank of Boston nor of the Federal Reserve System. c 2007 by Paul S. Willen. Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 1 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Disclaimer Forecast Overview of analysis Disclaimer The views expressed today are mine. The do not necessarily reflect the views of The Boston Fed Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 2 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Disclaimer Forecast Overview of analysis or the Federal Reserve System When I say “we”, I mean members of the research department. Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 3 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Disclaimer Forecast Overview of analysis Caveat Everything I’m about to say could be wrong: Example: Until [the depression], mortgages were not fully amortized, as they are now..., but were balloon instruments in which the principal was not amortized, or only partially amortized at maturity, leaving the debtor with the problem of refinancing the balance. Fabozzi and Modigliani (1992) Is this true? Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 4 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Disclaimer Forecast Overview of analysis Essentially no. By type of loan (1925-1929) Fully Amortized Partially Amortized Non-amortized Percentage of market (1929) As % of dollar value of all loans Mutual svgs banks Life Insurers Savings and Loans Commercial Banks Individuals and Other 10.5 14.3 61.5 24.1 11.8 94.6 0 5.1 40.3 10.1 38.3 50.3 12.1 25.2 Economists find a new theory... Old theory is “wrong”, new theory is “right” New theory will be old some day! Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 5 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Disclaimer Forecast Overview of analysis Figure: Theodoric of York, Medieval Barber (and intellectual) Why, just fifty years ago, they thought a disease like your daughter’s was caused by demonic possession or witchcraft. But nowadays we know that Isabelle is suffering from an imbalance of bodily humors, perhaps caused by a toad or a small dwarf living in her stomach. Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 6 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Disclaimer Forecast Overview of analysis Short answer Can problems in a small part of the mortgage market disrupt the entire economy? Answer: No. Because we have tools to address problems in the mortgage market. (Point 1) But... Problems in mortgage market are symptom of more serious problem: House prices (Point 2) House prices could derail the economy But we believe they probably won’t. (Point 3) Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 7 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Disclaimer Forecast Overview of analysis Forecast Component GDP Consumption Residential Inv Prod. Dur. Equip. Nonres. Struct. Contrib. of NX Exports Imports Unemployment Overall CPI Core PCE Paul Willen (Boston Fed) Share 100 70.3 5 7.3 3.3 11.5 -16.7 Q2 4 1.4 -11.6 4.2 27.7 1.3 7.6 -3.2 4.5 6 1.3 Quarterly Percent Changes, annual rate 2007 2008 Q3 (last) Q4 (last) Q1 (last) Q2 2.5 (2.2) 1.9 (2.5) 2.7 (2.4) 2 2.4 (2.4) 2.1 (2.3) 2.8 (2.4) 1.7 -15 (-12) -20.8 (-10.8) -3.3 (-0.3) -1.2 5.3 (4) 5.9 (4.6) 3.3 (3.8) 4.7 0 (0) 4 (4.7) 1.2 (1.4) 0.3 0.2 (0) 0.4 (0.3) 0.2 (0.1) 0.1 8.5 (6.5) 8.6 (8.3) 8.5 (8.2) 8.4 4 (4.5) 3.1 (3.6) 4.1 (5) 4.9 4.6 (4.5) 4.6 (4.5) 4.6 (4.5) 4.6 2.4 (2.5) 2.2 (2.2) 1.7 (2.3) 1.9 2 (2.1) 2.2 (2.3) 2.1 (2.2) 2 The Subprime Crisis: October 25, 2007 (last) (2.3) (2) (0.4) (4) (0.3) (0.1) (8.3) (4.5) (4.5) (2.1) (2) 8 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Disclaimer Forecast Overview of analysis Consumption House Prices Mortgage Market Problems Credit Crunch Investment Reckless lenders, new products, mortgage resets Problems spread Source of problems is stagnant or falling house prices Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 9 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Disclaimer Forecast Overview of analysis Consumption 3 House Prices 2 Mortgage Market Problems 1 Credit Crunch Investment We will focus on: 1 2 3 Addressing the credit crunch It’s the house prices... The housing wealth-consumption link Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 9 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Fed response The Credit Crunch Paul Krugman (NYT, 9/20/2007) It makes more funds available to depository institutions, a k a old-fashioned banks but old-fashioned banks arent where the crisis is centered. And the Fed doesnt have any clear way to deal with bank runs on institutions that arent called banks. Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 10 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Loans Fed response Non-Bank Lenders High Rated MBS Investors Low rated MBS Mortgage Borrowers Hedge Funds “New Housing Finance System” No banks necessary Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 11 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Fed response Non-Bank Lenders Loans Warehouse lines Mortgage Borrowers Loans Banks High Rated MBS Investors Low rated MBS Margin Credit Hedge Funds Banks still at the center of it all! 1 2 3 Margin Credit Warehouse lines Direct lending Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 11 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Fed response Non-Bank Lenders Loans Warehouse lines Mortgage Borrowers Loans Banks High Rated MBS Investors Low rated MBS Margin Credit Hedge Funds The Fed The Fed – the lender of last resort. 1 Can we get the ball rolling again? Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 11 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Fed response Figure: Rates on 30-year, fixed rate mortgages. Source: Bankrate.com. 7.4 7.2 տ Jumbo Contract interest rate, in % 7 6.8 6.6 տ Conforming 6.4 6.2 6 19 April Paul Willen (Boston Fed) 03 17 May 31 14 June 28 12 July The Subprime Crisis: 26 09 23 Aug 06 20 Sept October 25, 2007 12 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Fed response Forecasters have historically overestimated the impact of financial crises. Will we do that again? Global Insight’s Forecast of Real GDP q-o-q, annual rate. Forecast Date 2007:Q3 Aug. 2007 Sept. 2007 2007:Q4 2.3 2.3 Paul Willen (Boston Fed) 2008:Q1 2.3 1.7 2008:Q2 2.3 1.5 The Subprime Crisis: 2008:Q3 2.3 1.8 2008:Q4 2.7 2.6 3.2 2.7 October 25, 2007 13 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Fed response Some financial crises in the past 1 1970 Q2: Penn Central bankruptcy. 2 1982 Q3: Latin American defaults (e.g. Mexico) and crises in commercial banks and thrift institutions. 3 1987 Q4: Stock market crash (Black Monday). 4 1994 Q1: Bond Market Meltdown. 5 1998 Q3: Russian defaultand LTCM crisis. 6 2001 Q3: September 11th attacks in NYC and Washington DC. Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 14 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Fed response Figure: Forecasting experience with 9/11. Panel A Green Book Forecasts of Real GDP September 11th, 2001 Quarterly Percent Change, Annual Rate 6 5 Actuals 4 3 Pre Crisis, 8/16/01 2 1 Crisis, 9/27/01 0 -1 Post Crisis, 12/05/01 -2 -3 Q3:2001 Q4:2001 Q1:2002 Q2:2002 Q3:2002 Q2:2002 Q3:2002 Panel B DRI Forecasts of Real GDP September 11th, 2001 Quarterly Percent Change, Annual Rate 6 5 Actuals 4 Pre Crisis, 9/01 3 2 1 Crisis, 10/01 0 -1 Post Crisis, 12/01 -2 -3 Q3:2001 Q4:2001 Q1:2002 Sources: Bureau of Economic Analysis/Haver Analytics, Board of Governors, Data Resource Review/Global Insight Inc. Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 14 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Fed response Figure: Forecasting experience with the Russia Crisis in 1998. Panel A Green Book Forecasts of Real GDP LTCM Crisis Quarterly Percent Change, Annual Rate 7 6 Actuals 5 4 Post Crisis, 12/16/98 3 2 Pre Crisis, 8/13/98 1 Crisis, 9/23/98 0 Q3:1998 Q4:1998 Q1:1999 Q2:1999 Q3:1999 Panel B DRI Forecasts of Real GDP LTCM Crisis Quarterly Percent Change, Annual Rate 7 6 Actuals 5 4 Crisis, 10/98 3 Post Crisis, 12/98 2 Pre Crisis, 9/98 1 0 Q3:1998 Q4:1998 Q1:1999 Q2:1999 Q3:1999 Sources: Bureau of Economic Analysis/Haver Analytics, Board of Governors, Data Resource Review/Global Insight Inc. Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 14 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Fed response Figure: Forecasting experience with the 1987 stock market crash. Panel A Green Book Forecasts of Real GNP 1987 Stock Market Crash Quarterly Percent Change, Annual Rate 7 Actuals 6 5 4 Pre Crisis, 9/16/87 3 2 Post Crisis, 12/9/87 1 Crisis, 10/28/87 0 Q3:1987 Q4:1987 Q1:1988 Q2:1988 Q3:1988 Panel B DRI Forecasts of Real GNP 1987 Stock Market Crash Quarterly Percent Change, Annual Rate 7 Actuals 6 5 4 Pre Crisis, 10/87 3 2 Post Crisis, 12/87 1 Crisis, 11/87 0 Q3:1987 Q4:1987 Q1:1988 Q2:1988 Q3:1988 Sources: Bureau of Economic Analysis/Haver Analytics, Board of Governors, Data Resource Review/Global Insight Inc. Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 14 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Fed response Figure: Impulse Responses to a Liquidity Crisis GDP GDP Deflator 0.02 0.01 0.005 0.01 0 0 −0.005 −0.01 −0.01 −0.015 −0.02 0 5 10 15 20 −0.02 0 5 Commodity Price Index 10 15 20 Federal Funds Rate 0.1 1 0.05 0 0 −1 −0.05 −2 −0.1 0 Paul Willen (Boston Fed) 5 10 15 20 −3 0 The Subprime Crisis: 5 10 15 20 October 25, 2007 15 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Fed response Fed response Banks still matter! Fed policy tools still matter! Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 15 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption It’s not the products It’s not the resets It’s the house prices Subprime outcomes A theory (more of a story) Conventional wisdom right now: Lenders threw out 100 years of best practice and did stupid things: Reduced documentation “Exploding ARMs” Our theory: It’s house prices even if they had followed reasonable guidelines, we’d still have a problem, even if not as big as the problem that we now face. Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 16 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption It’s not the products It’s not the resets It’s the house prices Subprime outcomes It’s not the products... Loan Performance data for Middlesex county All securitized, non-agency mortgages Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 17 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption It’s not the products It’s not the resets It’s the house prices Subprime outcomes Divided up by documentation Composition doesn’t matter Delinq. Year Rate All mortgages 2006 Level 2005 Level 2004 Level 2003 Level Share 7.6 6.4 5.2 3.5 Paul Willen (Boston Fed) 38 43 49 58 Full Doc Delinq. Rate 7.6 6.7 5.7 3.0 Share Red. Doc Delinq. Rate 62 57 51 42 The Subprime Crisis: Share Overall Delinq. Rate 7.7 6.1 4.7 4.1 October 25, 2007 18 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption It’s not the products It’s not the resets It’s the house prices Subprime outcomes It’s not the resets There is no such thing as a low teaser on subprime loan Focus on 2/28s because More than half of all subprime loans Almost all the subprime ARMs Disproportionate delinquencies Source: LoanPerformance data 2003 2004 2005 2006 “Teaser” 7.5 6.96 7.3 8.35 Paul Willen (Boston Fed) 1-yr Prime ARM 3.76 3.90 4.49 5.54 The Subprime Crisis: Fully indexed rate at origination at reset 7.12 9.93 7.66 11.12 9.52 11.02 11.27 11.41 October 25, 2007 19 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption It’s not the products It’s not the resets It’s the house prices Subprime outcomes Subprime business model Extract high fees High interest rates prior to reset Borrowers refinances (or defaults) prior to reset. NOT the same as credit cards. Old vintages of 2/28s 2003 2004 Paul Willen (Boston Fed) Before the reset % prepaid % of all delinquencies 76 72 68 72 The Subprime Crisis: October 25, 2007 20 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption It’s not the products It’s not the resets It’s the house prices Subprime outcomes More recent vintages of 2/28s As of 3/2007 Origination 2005 2006 Paul Willen (Boston Fed) Reset 2007 2008 % prepaid 56 34 The Subprime Crisis: October 25, 2007 21 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption It’s not the products It’s not the resets It’s the house prices Subprime outcomes Figure: Foreclosures and house prices in Mass., 1989-present. Source: Boston Fed and The Warren Group. 0.6 0.4 ւ Foreclosure rate 0.2 0 15 10 5 0 -5 տ House price growth -10 % growth at annual rates % of homes foreclosed 0.8 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 Year Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 22 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption It’s not the products It’s not the resets It’s the house prices Subprime outcomes Subprime outcomes Do subprime loans lead to problems? Look at delinquency rates on subprime loans. Deceptive for two reasons 1 2 Most subprime loans are refinances – people are already in trouble when they get them. Causality goes the wrong way. Subprime purchase loans? Most end with refinance Look at whole homeownership experience How often do borrowers who buy houses with subprime loans get into trouble? We estimate that between 13% and 18% of subprime purchase experiences end in foreclosure. Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 23 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Credit channel and consumption Main difference with many others has to do with consumption. How does a change in wealth affect consumption? Some says $1 fall in housing wealth reduces spending by 5 cents We think it’s closer to 2 cents. Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 24 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Figure: Consumption to housing wealth relationship over time, based on NIPA data. 0.26 0.24 ↑ After 1/1/1996 0.22 0.2 log(C /Y ) 0.18 տ Before 1/1/1996 0.16 0.14 0.12 0.1 0.4 Paul Willen (Boston Fed) 0.5 0.6 0.7 0.8 Thelog(H/Y Subprime)Crisis: 0.9 1 1.1 1.2 October 25, 2007 26 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption We attempted to put some numbers on it. Essentially, we estimated that the wealth effect after 1996 is about half what it was before. A one-dollar increase in net worth led to a 5.4 cent long-run increase in consumption before 1/1/1996. led to a 2.2 cent long-run increase in consumption after 1/1/1996. A one-dollar increase in housing equity led to a 10 cent increase in consumption before 1/1/1996. led to a 0 cent increase in consumption after 1/1/1996. Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 27 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Financial Innovation and Credit Constraints “Financial innovations” have made it easier to borrow against your house since the 1990s No paperwork! No fees! So doesn’t this mean that spending should be more sensitive to house prices? No, just the opposite. Level of borrowing will go up. Sensitivity of borrowing goes down. Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 28 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Increased house prices relax a borrowing constraint Households have more debt... But the constraint matters to fewer consumers. For most consumers, borrowing self-limited. Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 29 / 30 Introduction 1. Credit Crunch 2. It’s the house prices 3. Housing wealth and consumption Conclusion Two key things to worry about: Can the Fed manage the liquidity squeeze? How much will house prices fall and how much will that affect consumption? Paul Willen (Boston Fed) The Subprime Crisis: October 25, 2007 30 / 30