Paul Haran

Principal,

UCD College of Business & Law

Welcome

Tom Begley

Dean,

UCD Schools of Business

Introduction

Prof Robert Van Order

Professor of Finance,

University of Michigan

Keynote Speaker

PROPERTY VALUES, SUB PRIME MARKETS AND SECURITIZATION:

THE U.S. MARKET AND IMPLICATIONS FOR

IRELAND

TOPICS

• Overview: Property Values in U.S. and Ireland

• What are Subprime loans?

• Role of Securitization and structuring.

• How has the market changed?

• Effects on Mortgage Markets and implications.

Overview• Rapid house price growth has been a part of life for about a

decade in most of Europe and North America. E.g., the U.S.. has had rapid growth; Ireland more so.

• Ireland has also had a production boom. Production has been around 15% of the economy.

• There is evidence of decline now. Is this the bursting of a “bubble”? Maybe, but not like the tech bubble in late 90s.

• It has long been known that declining property values play a big role in mortgage default. There has been a very large increase in troubled (delinquent plus in foreclosure) subprime loans in the U.S., much more so than for prime loans.

Overview• The market in which these are traded-via

securitization- has more or less collapsed, and there have been “spillovers” into seemingly unrelated markets.

• There is pressure for policy change. However, the details of the problem are not clear, and precipitous policy changes are not a good idea

• Ireland has a small sub prime market, but very big price increases. It is poised for a decline. But like the U.S. not a tech boom like bubble.

Ireland had a “Regime Change” in the mid 1990s

Prices of Used Houses: Ireland and Dublin

0

100,000

200,000

300,000

400,000

500,000

600,000

1978Q

1

1981Q

1

1984Q

1

1987Q

1

1990Q

1

1993Q

1

1996Q

1

1999Q

1

2002Q

1

2005Q

1

Ireland

Dublin

The U.S. has had strong growth, but not like Ireland

House Prices: Ireland and U.S. 1978-2007

0

5

10

15

20

25

1 13 25 37 49 61 73 85 97 109

Time

U.S.

Ireland

WHAT IS A BUBBLE?

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

1981

1984

1986

1988

1990

1993

1995

1997

1999

2002

2004

2006

NASDAQ

S&P 500

National HPI

Subprime Loans• Borrowers with bad credit history

• Used to be defined by lender (Money Store)

• Now by “FICO” score and related credit history

• Quantifying credit history was a big deal in securitizing high risk loans because of agency problems

Subprime Used To Be About 10% Of The Market, But It’s Share Increased a Lot After 2003.

Should we be surprised in a market expanding that fast that quality deteriorated?

Market shares

0

10

20

30

40

50

60

70

1 2 3 4 5

2001-2005

FHA/VA

Conforming

Subprime+Alt-A

0

1

2

3

4

5

6

7

8

9

1998

1999

2000

2001

2002

2003

2004

2005

2006

Q1

Subprime and FHA Delinquency Rates vs Those on Prime.

Until recently subprime didn’t look all that bad.

Loans 90 days or more delinquent or in foreclosure (percent of number)

Source: Mortgage Bankers Association and Loanperformance.com (through first quarter 2006)

Prime Conventional

VA

FHA

Subprime

– Recession

What Determines Credit Risk?

• Here are some results from Freddie Mac data. The loans are not really subprime but some have low credit scores.

• Credit history matters, so does equity.

• The problem of layering.

• Everyone knew this stuff was risky, but it was riskier than previously thought. (Getting caught with your parameters down?). E.g., a small but significant share of the 2007 originations didn’t make the first payment.

Relative Default ProbabilitiesRecent history is movement to

the Northeast of the Chart

　LTV <70 LTV 71-80 LTV 81-90 LTV 91-95

FICO <6200.96 4.8 11.04 19.68

FICO 620-6790.46 2.3 5.29 9.43

FICO 680-7200.2 1 2.3 4.1

FICO >7200.08 0.4 0.92 1.64

HOUSE PRICES AND DEFAULT: Equity Matters. So Does Diversification

Default Probability vs. House-Price AppreciationState/Origination Year and National/Origination Year Cohorts (1985-1995)

80% Loan-to-Value, 30-Year Fixed-Rate Home-Purchase Mortgage

NV 1985

HI 1994

AZ 1985

CA 1989

CA 1990

DC 1995

AK 1986

0%

5%

10%

15%

20%

25%

-30% -10% 10% 30% 50% 70% 90% 110% 130%

5-Year Cumulative House-Price Appreciation

Cum

ulat

ive

Defa

ult R

ate

Individual States National

What’s Going on Now?

• Prices are Falling—Though by how much is less clear

• Otherwise the economy is growing ok and the unemployment rate is relatively low.

• So from the macro side it’s the price decline that seems to be the problem.

• But that probably doesn’t explain the sudden divergence between prime and subprime.

Securitization: Is it the Problem?

• Securitization involves selling pools and shares of pools loans into the bond market

• Not new-Mainstay of the market for around 30 years

• Nor is division of labor between servicer and investor—e.g., Ginnie Mae

• Ginnie Mae and FHA (substitute for subprime

• Fannie Mae, Freddie Mac and Ginnie Mae provide credit guarantees.

• The non agency market is different.

THE ECONOMICS OF SECURITIZATION

• Securitization involves packaging and selling pools of loans in order to gain access to securities (bond) markets (e.g., rather than deposit markets). Mortgages, Car loans, David Bowie.

• The major contribution of securitization is that it opens the mortgage (or other) market to bond markets and long term lending.

• This is in contrast with traditional depositories (banks), which tend to be forced into short term funding and do not usually have an elastic source of funds.

THE ECONOMICS OF SECURITIZATION

• But there is cost. Bond market investors are at an informational disadvantage relative to those selling them the bonds: asymmetric information.

• The key is understanding and managing the tradeoff between the greater efficiency of funding in capital markets and the asymmetric information. The balance does not always fall on the side of securitization. Bank funding (via deposits or bonds) may be the way to go.

• Even if securitization is the way to go, it may need significant “structuring” to work.

STRUCTURING (AKA slicing and dicing)

• The idea is get access to the bond market—vs the deposit market—getting around banks.

• But there are agency problems because investors aren’t sure of what they’re getting: Both adverse selection and moral hazard.

• For the “Agencies” this is done via Agency guarantees and back up form their charters.

• For others (e.g., commercial and nonconforming mortgages, like subprime) some enhancement is needed.

• Typically this is done by structuring.

Senior/Subordinated Structures

• Senior/Sub structures are the most popular. They allow most of the credit risk to remain with originator and/or specialists and get intuitional investors interested in the senior part.

• The trick is prioritize the cash flows so that there is a queue and originators or specialists take the bulk of the credit risk’

• This means that a pool of B type securities can have most of it funded with AAA paper.

• That there were AAA pieces is consistent with the loans in the pool being junk bonds.

24

A TYPICAL STRUCTURE: FOCUS ON SUBORDINATION

Loan 1 Loan 2 Loan 3 Loan 4 $1 BillionTotal Loans…..

Trust

$850mAAA Rated

$100m, A Rated,

$50m, NR,

$1 BillionSubprimeStructured Deal

Class

Initial Cert.Balance or

Notional Amt. Spread

Rating(Moody's/

Fitch)

Percent of Initial Pool Balance Sub-ordination

Initial Pass-Through Rate

(approx.)

WeightedAverage Life

(yrs) Payment Window

A-1 $261, 582,000 48 Ass/AAA 15.4% 28.5% 6.830% 4.00 1 - 75A-2 $227, 661,000 62 Aaa/AAA 13.4% 28.5% 6.853% 7.50 75-108A-3 $724,100,000 65 Aaa/AAA 42.7% 28.5% 6.869% 9.71 108-119B $67,879,000 70 Aa2/AA+ 4.0% 24.5% 6.918% 9.94 119-120C $50,909,000 75 A1/AA 3.0% 21.5% 6.898% 9.96 120-120D $50,909,000 85 A2/A+ 3.0% 18.5% 6.997% 10.01 120-125E $93,334,000 100 Baa2/BBB 5.5% 13.0% 7.085% 11.45 125-158F $25,454,000 118 Baa3/BBB- 1.5% 11.5% 7.222% 13.53 158-170G $84,849,000 BB/BB 5.0% 6.5% 7.414% 14.93 170-195H $59,394,000 B 3.5% 3.0% 6.600% 17.99 195-235J $16,969,000 B- 1.0% 2.0% 6.600% 19.78 235-242K $33,944,278 Unrated 2.0% 0.0% 6.600% 22.0 242-358

X $1,696,984,278 Notional Amt Aaa/AAA N/A N/A 1.629% N/A 1-358

Total $1,696,984,278 Securities

Bonds:

A Commercial Deal (Courtesy: Davidson, Sanders etc) Bonds for GMAC 1997-C1 Deal

Quality Deterioration• Why Did The Defaults Increase?

• Recent paper by Yuliya Demyanyk (FRB St. Louis) and Otto Van Hemert (NYU) suggests very mixed reasons

• It looks like it was not Adjustable rates or low documentation especially.

• High LTV loans

• A prime candidate is that agency costs went up—(Lying and cheating by loan originators). Loan originators working at the margine of what is allowed in the contract.

• Appraisals probably got worse.

• Who is holding the bag? Representations and warranties.

Effects: Trading Drying Up-Spillover into Unrelated Markets

                                         <>

So What? We don’t know much about the contributions of the things the media seem sure are evil

• Rate adjustments?

• Predatory Lending?

• Documentation?

• Government pushing banks into risky areas?

Some Bad Ideas. Remember the Subprime market is very private and very

competitive- Exit is easy and the only thing lenders/investors have is pricing and equity in the property.

• Forced restructuring.

• Making lenders/investors responsible for borrowers risk-taking

• Restricting terms like prepayment penalties.

IRELAND

• Bubble Candidate, but not like tech stocks

• Subprime market is small

• Looking forward: Securitization isn’t all bad and has been manageable.

IRELAND

• It’s not easy expanding loan markets to riskier borrowers. You can’t expect to do it without mistakes and lots of defaults.

• How far are you willing to let consenting adults go?

• How do you know if consent is informed?

• Watch speed of market growth and loan to value ratios.