Case-Shiller Home Price Index

1. The Root Causes of the Crisis:What have We Learned?Bob DeYoungCapitol Federal ProfessorUniversity of Kansas School of BusinessSummer Teacher InstituteUniversity of ChicagoJune 2009

2. From 1997 to 2006, home prices increased at a 9.1% annual rate. Case-Shiller Home Price Index Home prices have declined more than 25% since 2006.

10. My talk today All recessions are different. This recession was caused by a collapse in residential real estate values. Real economy: Home prices fell  Housing sector collapsed  Aggregate spending declined. • This is a demand-side story. • Reduced spending on houses and related items. Financial sector: Mortgage defaults  Big losses on mortgage-backed securities  Investor uncertainty. • This is a supply-side story. • Less credit available for businesses and households.

11. My talk today 1. Root causes of the recession: • A bubble in the housing market. • A new lending model (which performed poorly). • A history of short-sighted economic, financial, and social policies. • Bad financial behavior by households. 2. What have we learned? • Have the responses of policymakers been appropriate? • Have households changed behavior?

12. Root Causes of the Crisis: • Housing bubble. • A new banking model. • Poor historical public policy. • Poor household finance.

13. GI Bill • Automobile/Suburbs • High income tax rates.

14. Affordable home policies. • Easier access to mortgage credit.

15. From 1997 to 2006, home prices increased at a 9.1% annual rate. Case-Shiller Home Price Index

16. Increased House Demand • Easy Federal Reserve monetary policy. • Mortgage interest tax deduction. • Policies to provide "affordable housing." • Ownership Society. • Originate-to-Securitize banking model.

17. Distribution of Assets held at Financial Intermediaries in the U.S. Banks were the center for: • Personal savings • Business credit • Payments

18. Distribution of Assets held at Financial Intermediaries in the U.S.

19. Bank profits as % of GDP Asset share of banks, thrifts, credit unions

20. Bank asset shares plunged, but bank profits soared. Why? • A new business model for large banks emerged. • The new model exploits post-1980s information technologies, financial products, and regulations. • Much activity at banks moved off the balance sheet. • Much income at banks now comes from fees, not from interest. • This new model is highly efficient, highly profitable, but riskier than most of us thought.

21. Traditional Mortgage Finance Agents that need funds Agents with excess funds Home Buyers Depositors $ funds $ $ funds $ Bank or Thrift Bank earns profits from interest margins. mortgages deposits

22. Innovation: technology and deregulation • Geographic deregulation (Riegle-Neal Act 1994) • Permitted inter-state branching. • Banks could exploit scale economies. • Product deregulation (Gramm-Leach-Bliley Act 1999) • Permitted commercial banks to engage in investment banking, securities brokerage, and insurance sales. • Largely fee-based, off-balance sheet activities. • New technologies • Credit bureaus and credit scores. • Automated loan underwriting. • Loan securitization. • Deeper capital markets.

23. Traditional Mortgage Finance Agents that need funds Agents with excess funds Home Buyers Depositors $ funds $ $ funds $ Bank or Thrift Bank earns profits from interest margins. mortgages deposits

24. Traditional Mortgage Finance Agents that need funds Agents with excess funds Home Buyers Depositors $ funds $ $ funds $ Bank or Thrift mortgages deposits

25. Mortgage Securitization

26. Mortgage Securitization cash $$$ mortgages Mortgage Pool (off-Balance Sheet) mortgages

27. Mortgage Securitization cash MBS $$$ $$$ mortgages MBS Mortgage Pool (off-Balance Sheet) mortgages mortgage-backed securities (MBS) mortgages

28. Mortgage Securitization cash MBS Mortgage payments from Households Loan servicer (often the bank or the securitizer) withholds a small fee from each mortgage payment. Payments go to investors based on terms of the MBS contract. Mortgage Pool (off-Balance Sheet) mortgages mortgage-backed securities (MBS) mortgages

29. Mortgage Securitization Bank earns profits from origination fees, securitization fees, servicing fees. cash MBS Investors get the principal & interest payments. $$$ $$$ mortgages MBS Mortgage Pool (off-Balance Sheet) MBS rated by Moody's, S&P or Fitch. Credit scoring allows a bank to make more loans faster. mortgages mortgage-backed securities (MBS) mortgages

30. This model increased risk at large banks. • Increasing reliance on fee income. • Fee income is often more volatile than interest income. • Fee-based activities require higher operating leverage. • Fee-based activities are off-balance sheet, allowing banks to use more financial leverage. • Fee income has not yielded expected diversification benefits. • Increasing reliance on third-party information. • All lenders have same information (credit bureaus). • Investors (firms and funds that own the MBS) rely on bond raters. • Fundamentally poor financial management. • A lack of diversification. • Excess reliance on financial leverage for earnings. • Too much interest rate risk. • Modeling risk without adequate historical data. • Why? Did large banks know they were Too-Big-To-Fail?

31. Model gives banks incentives to make riskier loans…that others will hold! • Credit underwriting separated from risk-bearing. • Incentives for lenders to make riskier loans. • Securitization separated from risk-bearing. • Incentives for investment banks to engineer riskier MBS. • Loan monitoring separated from risk-bearing. • Investors must rely on opinions of rating firms…and the rating firms get paid by the securitizing banks. • Control rights separated from risk-bearing. • Fractured ownership of mortgages impedes the modification of nonperforming mortgage loans.

32. Bad banking model? Or bad policy? • Regulation did not evolve with banking practices. • Bank moved activity off of their balance sheets. • This circumvented capital rules; increased leverage. • SEC reduced capital requirements for largest five investment banks in 2004. • Regulators did nothing to rein in "Too-Big-To-Fail." • SEC limits competition in securities rating business. • Only three main NRSROs (Moodys, S&P, Fitch) have been licensed to rate these securities.

33. Bad banking model? Or bad policy? • Congress made sure that OFHEO was a weak regulator of Fannie Mae and Freddie Mac. • Congress wanted more "affordable mortgages." • Pressured Fannie and Freddie into providing funds for subprime mortgage securitizations.

34. Many households also at fault. • Too much mortgage debt. • Bigger houses • Small down payments • Home equity loans

35. Household Financial Obligations(% of Disposable Income)

36. Subprime mortgage lending • A typical subprime mortgage scenario in mid-2000s: • Borrower cannot qualify for a conforming mortgage. • Gets a 3-year ARM: 0% down and a teaser rate. • Borrower can just afford the payments in years 1-3. • Borrower cannot afford the payments after year 3. • Deal works out only if home prices keep increasing. • As prices rise, borrower builds up equity in home. • Borrower builds credit rating with a good payment record during first 3 years. • At year 3, borrower refinances with a conforming loan at a low fixed rate. • But what if prices stop going up?

37. Home prices have declined more than 25% since 2006. A profound effect on the economy. Case-Shiller Home Price Index

38. Excess Supply Reduced House Demand • Prices stop rising… • Levered homeowners stop building equity. • Refinancing is no longer possible. • As these homeowners default on mortgages… • Investors wary and stop financing MBS. • Mortgage loans become scarce. • As prices fall, buyers wait for a good deal. Home Price Home Sales

39. NAHB estimates: Building one single-family home generates about 3.5 jobs. Rough calculation: The annual decline in starts since 2006 implies 4.2 million fewer jobs…an approximate 3% reduction in jobs.

40. (Annualized change from previous quarter, seasonally adjusted)

41. (Annualized change from previous quarter, seasonally adjusted)

42. (Annualized change from previous quarter, seasonally adjusted)

43. Impact on the Financial Sector • Large capital losses at banks. • U.S. banks will suffer at least $2 trillion from MBS losses. • About $1 trillion of these losses remain to be taken. • Based on estimates from IMF; Goldman Sachs; Nouriel Roubini. • Largest U.S. banks propped up by the tax payers. • Massive operating losses at mono-line mortgage firms. • Novastar, Countrywide, American Century, WAMU, IndyMac, and others have failed. • Lender losses created uncertainty in financial markets. • No new private mortgage securitizations in over a year. • BX 2007 AAA-rated subprime trading at 24¢.

45. Subprime Mortgage Delinquencies NOTE: Most subprime mortgages written by non-banks.

49. What Have We Learned? • Have the policy responses been appropriate? • Have households responded appropriately?

50. Congress • Silly populist legislation: • Tax AIG bonuses (ex post). • Limit executive pay (ex post). • Tank the corporate jet market. • Efforts to modify mortgages. • Gives households moral hazard incentives. • OCC study: High recidivism rate. • "TARP-plus" funding. • A $115 billion ransom payment to get bill passed. • Hair of the dog: • $8,000 tax credit for first-time home buyers. • 3% down payments for VA, FHA and FMHA loans.