Download The Subprime Crisis:

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