The Asset Securitization Crisis - What went wrong?

In the beginning, the part that everyone has heard before…

The dotcom bubble burst marked the beginning of housing bubble The technology bubble bust of 2001 saw the US economy slip in to recession prompting the US Federal Reserve to cut interest rates. The dotcom bubble burst cleaned up US$5 trillion in market value of technology companies after the NASDAQ Composite Index peaked at 5,132 on March 10, 2000. The dotcom bubble burst also resulted in a large influx of funds fuelling interest in the real estate market. The equity investors having burnt their fingers in the dotcom crash saw real estate as an attractive alternative and a safer investment opportunity. Real estate’s share in total bank loans increased to 50% in 2002 as compared to 43% in 1999, and currently accounts for 56%. In addition, the real estate loans as a percentage of GDP increased to 20% in 2002 from 16% in 1999, and currently stand at 26%. The surge in realty loans and excessive focus on the real estate sector of the US banking industry laid the foundation of the housing bubble.

Historically low levels of interest rates supported growth in housing

The US economy battling recession in the aftermath of dotcom burst was brought back on the growth track through an aggressive monetary policy which also helped fuel growth in the real estate sector. The US Federal Reserve lowered interest rates significantly from 6.5% in May 2001 to 1.75% by the end of 2001. Consequently, the national average contract mortgage rates came down to 5.34% in July 2003 from 8.01% in March 2000 prompting the rise in mortgage loans. The mortgage rates having reached an all time low sparked a rise in the housing and construction activity and a surge in housing demand. The new housing annual starts grew at a CAGR of 5.7% from 2000-2005 depicting the increased construction activity during this period.

The US promoted consumer spending in order to bring the economy out of the technology crash. The US Federal Reserve not only made loans cheaper but also relaxed lending standards to drive the growth in the economy.

The rise in commercial and residential real estate loans resulted in construction and housing market boom

One of the primary reasons for the asset bubble creation is the increase in the loans toward the real estate sector which increased significantly during that period. Loans toward real estate in the US have grown at a CAGR of 11.7% in the period 1996-2006 to US$3,432 billion (during S&L crisis the real estate loan market had grown at a CAGR of 13.1% in 1976-1986). The construction and land development loan market has grown at a CAGR of 20.6% in the period 1996-2006 to US$499 billion in 2006. This implies the possibility that more supply was added to the market in this boom period than in that of the S&L crisis. The growth in construction loans saw an unprecedented rise in construction activity across the US attributable to the strong demand for housing. The increased construction activity and the housing boom along with low mortgage rates saw the US homeownership rates reach a peak of 69.2% in 2004, at levels not seen since 1965, as compared to 64% in 1994 – in the aftermath of the S&L crisis.

Source: FDIC

Increased speculative investments in the housing sector drove prices

The rising home prices and the cheap affordability and availability of mortgage loans saw real estate emerge as an attractive investment opportunity. The equity markets under the radid capital gains spell of the dot com era and crash saw speculators move toward the real estate markets and drove home prices across the US. US home prices appreciated significantly in the 2001-2005 period owing to increased housing demand and emergence of the housing sector as an alternative investment. The S&P Case Shiller home price index appreciated 106.5% to 206.52 in August 2006 from a base of 100 in January 2000.

Source: S&P/Case Shiller

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As Stephen G. Cecchetti from the Center for Economic Policy Research (CEPR) points out, the home prices have been in the range of 9 and 11 times the annual level of rent paid. This implies an average user cost of housing of around 10%. However since the beginning of 2000, home prices have appreciated significantly ahead of rents. In 2006, the price-to-rent ratio reached an extraordinary high level of 14 indicating creation of a bubble.

Source: Federal Reserve of New York and BEA

The bursting of the housing bubble

In Q2 2005 to Q4 2006 (depending on geographic location), the housing bubble burst with the onset of decline in home prices and fall in home sales resulting in housing inventory buildup. The decline in home prices saw the construction activity decline across the US in 2006 as prices continued to drop. The plunge in home sales witnessed in 2006-2007 has dwarfed the previous housing declines and continues to worsen reaching lower levels. In 2006, the US housing market faced the issues of rising inventories, declining home prices, and a sharp correction in home sales volumes. The rise in interest rates and tightening of terms also halted the housing demand as affordability went down. Furthermore, the speculative investors pulled out of the market leaving a hole in what was robust demand and home buyer’s confidence began to fade away.

The situation at the onset of 2007:

• Home prices having appreciated between 2001- 2005, were at record levels.
• Home owners had more leverage than ever before (higher borrowing power on their appreciated home prices).
• Mortgage quality had declined significantly (Alt-A and subprime mortgages increased significantly).
• Asset-backed securitization had spread well beyond Fannie Mae and Freddie Mac (GSEs).

Housing bubble prior to Savings and Loan (S&L) crisis and the post dot-com bust asset bubble creation

This is not the first time the US regulatory authorities are facing the severe repercussions of a real property bubble bursting as the fiasco spreads to other credit markets. The current housing crisis is anticipated to drag on for a long time as witnessed during the S&L crisis of the 80s and 90s. The number of bankruptcy filings of mortgage lenders, hedge funds and large banks is similar to the number of the S&L institutions failing during the 80s and 90s. Both the S&L crisis and the current subprime crisis were preceded by a significant rise in commercial and residential real estate lending. Both the crises were primarily driven by imprudent real estate lending, and it appears both will share the trait of taking a long time to rectify. The S&L crisis was negatively impacted by the volatility in interest rates while significantly low interest rates in 2001-2002 helped create the housing bubble.

During the S&L crisis, the savings and loan institution experienced significant outflow of the low-rate deposits as depositors moved their money to the new high-interest money-market funds. During 1970s interest rates were driven up by the high inflation rate. In addition, the savings and loan institutions had their funds in long-term mortgage loans written at fixed interest rates, and in the rising interest rate scenario these loans were worth far less.

Change of lending preferences from financial institutions

In the S&L crisis of the 80s and 90s, most S&L institutions took to imprudent and risky lending to become profitable from loss-making entities. The primary reason for their losses was the erosion of their asset base, primarily mortgages. This was because in the late 1970s, interest rates in the US increased in line with the increases implemented by the Federal Reserve to control inflation. However, as most of the mortgages with S&L institutions were long term and fixed rate in nature, they were unable to take advantage of the current situation. Backed by several favorable reforms and deregulation measures by the US Government, these institutions began lending to the real estate sector, which posed a high demand for funds due to the concurrent boom in the sector. As a result, there was a change in the lending pattern across all the institutions in the US. Real estate loans comprised approximately 25.7% of total loans in 1980, which went up to 39.3% of the total loans in 1990.

Similarly in the current subprime crisis, based on an assumption of ever rising real estate prices and an expectation of refinancing the current loans later, most banks continued to lend to the residential and commercial real estate sector, despite historically imprudent concentrations. Moreover, the increasing ownership rates in the US fostered this demand. From approximately 64% in the 1980s, the home ownership rate in the US jumped to 69% in 2004, and was 68.1% at the end of 2007. Likewise, real estate loans, as a percentage of total loans of all commercial institutions in the US, increased to 61.2% in 2007 as compared to 58.8% in 2003, 25.7% in 1980 and 39.3% in 1990, the apex of the S&L crisis. Putting this in perspective, we have a 64% higher concentration of long term risky loans on the books now than we did during the worst credit crisis in US banking history.

Source: FDIC

Unrivaled growth in the real estate loans; both residential and commercial

Owing to a faster rate of growth in homeownership, the demand for real estate loans kept on increasing. This coupled with the readiness of commercial institutions to lend to the real estate sector led to shift in lending patterns. Consequently, there was unprecedented growth in the loans to the real estate sector during the S&L crisis. The real estate loans grew at a CAGR of 12.3% in the decade ending 1990.

More recently, in the context of the subprime crisis, a similar trend was observed in the growth in loans to real estate sector. The primary reasons for this were the favorable interest rates in the US coupled with the dot com bust in 2001-2004 which shifted the focus of investors to the real estate sector. This also led to increasing propensity of banks to lend to the real estate sector. Moreover, securitization helped inflate the already existing bubble in the real estate market. For the ten year period ending 2007, the real estate loans grew at a CAGR of 11.7%. As a result, real estate loans reached 26.3% of GDP in 2007 (an amount that is more than capable of affecting the economy) from 13.2% in 1988, a trend observed in both residential loans as well as commercial loans over the same period.

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Notably, while the growth in residential loans was higher in the earlier crisis period, the growth in commercial loans has outstripped the residential loan growth in the recent times. In the decade from 1988-1997, residential loans have expanded at a CAGR of 10.1% as compared to 3.5% for commercial loans. However, in the following decade i.e. 1998-2007, residential loans grew at a lower CAGR of 11.2% as compared to 12.4% for commercial loans, mainly because of small and mid-size banks lent more in commercial real estate during the period. Although commercial real estate loans were higher paying, they also bore higher risk in the form of liquidity, valuation, market risk - which affected the risk profile of these banks that were incapable of bearing such a level of complexity in risk in the first place.

Source: FDIC

Shift from traditional banking activities

With major opportunities of revenue generation being offered by trading and other investment activities, as well as the lifting of the Glass-Steagal Act in the US (which allowed commercial banks and investment banks to compete directely), banks across the globe shifted from traditional banking activities to other sources of income, leading to better revenue diversification. The ratio of non-interest income to a bank’s total income has more than doubled from 20% in 1980 to approximately 44% in 2006.

Source: FDIC

To take advantage of the upcoming subprime mortgage markets, most financial institutions indirectly participated in the subprime market through investments in mortgage backed securities. Investment banks, for example, having moved from their traditional fee income to trading income, also invested in these securities. They not only invested as a principle, but also created complex products which included asset backed securities, mortgage backed securities as well as collateralized debt obligations to sell through agency arrangements to other entities, many of whom were ill suited to value and assess the risk/reward proposition of such complex instruments.

These products were based on the securitization of mortgages. Poor quality loans were clubbed together to create an asset base, which was rated in tranches (slices of prospective cash flows) by credit rating agencies according to their level of risk. With an anticipation that the real estate prices would continue to rise in perpetuity, investment banks invested in the riskier securities to reap profits. However, as the incapability to pay back high interest loans began to surface against the back drop of depreciating real estate prices, there were a large number of defaults leading to a degradation of value of such securities. Hence, the performance of investment, mortgage and commercial banks were significantly affected during the process.

Lax lending practices saw the emergence of the subprime and other lending crises

The rising home prices and the relaxed lending standards saw the mortgage lenders expand their subprime lending activities. The lenders overlooked the credit history and financial wherewithal of the borrowers and distributed mortgage finance incessantly. In addition, the decline in mortgage denial rate to 14% in 2002-2003, half of 1997 levels denoted the easy mortgage availability. Mortgage loans were disbursed overlooking the credit quality of the borrower, low FICO scores and the ability of the borrower to repay in a rising interest rate scenario. Furthermore, the rise in home prices saw the homeowners leveraging their capacity to borrow using home equity credit. As the subprime borrowers began to default and the home prices started declining, a number of mortgage lenders witnessed higher defaults and rising foreclosures. The rise in payment defaults and the foreclosure activity coupled with the correction in the home prices negatively impacted the mortgage lenders. Consequently, the number of subprime mortgage lenders filing bankruptcies begun to increase marking the advent of the US subprime mortgage crisis.

The share of subprime mortgages to total originations has increased to 20% or approximately US$600 billion in 2006 from 5% in 1994 and 13% in 1999. The problem faced is not primarily excessive subprime lending but the excesses of the banking industry which created the newer asset categories like the leveraged loans, Mortgage Backed Securities (MBS) and the Collateralized Debt Obligations (CDOs) on these subprime assets. The new found ability of the banking industry to cheaply and easily slice and dice the risk created newer forms of risks in the industry. The financial engineers not only pooled mortgages together, they took a variety of mortgage backed securities and repooled them into new pools. These investment products classified as collateralized debt obligations are assembled not only from home mortgages, but also include other portfolios of credit card debt and student loans. These CDOs are then sliced up into tranches with different credit ratings primarily the AAA-rated, or senior, BBB rated tranche and the equity tranche which suffers the first default. The senior tranches are paid first followed by BBB-rated tranche and last to the equity tranche. The new found liquidity aided by these vehicles combined with the fact that the risk was often transferred off balance sheet allowed the OPM (other people’s money) factor to creep into underwriting standards – or lack thereof. By separating the responsibility for asset maintenance from the asset origination, a time bomb waiting to get bailed out was created!

Borrowings in residential real estate loans

Source: Federal Reserve

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Increased disbursement to low quality loans like NINJA loans and liar loans

Apart from subprime lending, most banks increased their lending to Alt-A borrowers, or liar loans in anticipation of realizing higher income in the rising interest rate scenario. Alt-A loans are ones which were thought to be better in quality than subprime loans, but do not have traditional income and asset verification, thus alternate documentation for verification of their ability to pay back the loan was used. According to Standard & Poor’s, the total Alt-A loans disbursed increased approximately 23% in 2006, higher than that for the subprime loans. These loans, like subprime loans, were widely disbursed to take advantage of the higher interest rates, with an assumption of ever rising property prices.

Since Alt-A loans were easy to avail due to lax requirements of documentation supporting the level of income; significant growth was witnessed in the disbursement of these loans. As a result, they formed approximately 46% of all subprime mortgages in 2006 which amounted to US$276 billion (from US$30 billion in 2001), according to Credit Suisse Group. However, people who bought houses on Alt-A loans recorded a default rate of 12.6% in February 2007, against a figure of 1.5% for prime mortgages, according to First American Loan Performance, a mortgage consulting group based in San Francisco. This again highlights the lax lending standards as well as lack of due diligence in the lending activities by the financial institutions.

In context of the S&L crisis, loan were carelessly disbursed in a similar fashion, as continuous deregulation measures taken by the U.S. Government led to the S&L institutions taking uninformed decisions in order to push up their declining bottom-line as well as their flagging net worth. This enabled them to diversify their activities. Some of the other initiatives taken by the US Government which favored the S&L institutions were:

• Elimination of deposit interest rate ceilings
• Elimination of the previous statutory limit on loan to value ratio
• Expansion of the asset powers of federal S&Ls
  • Permitting up to 40% of assets in commercial mortgages,
  • Permitting 30% of assets in consumer loans,
  • Permitting 10% of assets in commercial loans, and
  • Permitting 10% of assets in commercial leases.

Lending above capacity and risk appetite

A common mistake in both the crises was the over lending by banks, both above their true lending capacity as well as prudent risk appetite. As banks continued to increase lending to the real estate market without proper discretion and informed decision about the borrower’s repayment ability, credit became available to all borrowers who otherwise would not have qualified for such loans.

According to the FDIC, the number of insured institutions where construction loans exceed total capital has more than doubled from 1,179 in 1Q 03 to 2,368 in 4Q 07. This indicates that financial institutions have relied on external finance to achieve the level of growth in lending, which multiplied the concerns at the time of the crisis.

Source: FDIC

Securitization and credit ratings – adding fuel to fire

Securitization, a process by which banks could offload the subprime loans from their balance sheet, was a primary catalyst in spreading the effects of the subprime crisis. Banks bundled the subprime loans and recut them to create mortgage backed securities, and often rebundled to have their cash flows redistributed, and in certain instances again rebundled and redistributed several times over (ex. CDO squared and cubed). These “assets” were imprudently rated by the credit rating agencies as investment grade securities based primarily on the highly faulty concept of perpetual HPA (house price appreciation that would rise forever), due to which such securities were readily purchased by investors. Banks, with the anticipation of a never-falling housing market, had hoped to pay interest on these securities through the mortgage payments to be realized on the underlying mortgages.

However, increased defaults in the subprime loans led to the depletion in the value of these underlying loans, which led to a significant drop in demand for these securities, which in turn dramatically affected both the value and liquidity of the securities. Consequently, the investors in these securities faced a loss. The widespread and rampant increase in mortgage backed securities had attracted many investors to these incorrectly rated “investment grade” securities. The total exposure of the US financial institutions to mortgage backed securities was US$1,236 bn in FY 2007, representing a 2.4% y-o-y growth. Mortgage backed securities constituted 9.5% of the total assets of US institutions in 2007 from 11.0% in 2004, 10.5% in 2005 and 10.2% in 2006 (the reduction in these numbers over time can be attributed in large part to the reduction in value). The share of subprime mortgages passed to third-party investors though securitization increased from 54% in 2001, to 75% in 2006. This helped the spreading of the crisis to investors who were not directly linked to subprime loans.

The lax lending cum subprime cum asset securitization fiasco bursts into the credit markets

The bursting of the housing bubble spiraled into the much bigger problem of the subprime mortgage crisis with the rising defaults and increasing foreclosures resulting in significant housing price correction. This could have been restricted had the financial engineering and regulatory arbitrage (in the form of balance sheet shenanigans) at the investment and commercial banks been checked. The creation of asset-backed securities (ABS) and mortgage-backed securities (MBS) through securitization saw the loans gravitate from the banks to capital markets across the globe.

In addition, the securitization phenomenon meant that the lenders ceased to worry about loan quality and focused on generating fee quantity. The mortgage pools primarily sponsored by the Government Sponsored Entities like Fannie Mae and Freddie Mac increased the maximum loan value to US$727,750 in March 2008 form US$417,000. Fannie Mae and Freddie Mac’s main business was to insure mortgages, so buyers of these securities issued by them can make claims in case of default on the underlying mortgages. Mortgage backed securities issued by other financial intermediaries are called ABS issuers and does not provide any government sponsored insurance. In 1996 Fannie Mae and Freddie Mac accounted for approximately 70% of the assets being purchased and pooled and its share fell to less than 10% in 2004. At the same time, the alternative issuers’ share increased to around 40%. The primary reason for the decline in the GSE’s share was the large mortgages exceeding the maximum size or the credit quality of the borrower was lower for the inclusion. The GSEs losing their hold in the asset backed securitizations has seen the emergence of new ABS issuers taking control of securitization market. Consequently, the financial system produced a multitude of products that helped the origination of these alternative mortgages. In the last few years, the mortgage standards continue to deteriorate as each entity in the chain focused on revenue over risk and believed that it was passing the risk to the next entity in the chain – very much like the American child game of musical chairs. Then one day, the music stopped!

Increased dependence on external borrowing over the years

Over the years, banks in the U.S., in order to cater to the ever increasing demand for credit shifted from their traditional source of funds – the deposit base - to external borrowing. This became necessary to match the unparalleled and unsustainable growth in their loan books and led to unprecedented amounts of leverage being utilized. This leverage left the banks open to wide swings in earnings volatility and RISK!

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In the ten year period of 1993-2002, the average annual growth rate in gross loans and leases was 6.5%, while total deposits in the system grew at a much lesser 4.7%. As a result, banks opted for other borrowings, which increased at an average annual growth rate of 13.9% in the same period. Consequently, banks resorted to external funds to maintain liquidity. This led to increased leverage and hence increased the inherent risk associated with them. Reflecting rampant growth in loans as well as increased risk, the loan-to-deposit ratio for financial institutions in the US advanced significantly from 79.2% in 1993 to 91.2% at the end of 2002.

Source: FDIC

The trend has continued in a similar fashion in the last five years as well. In the five year period ending in 2007, net loans and leases have registered an average annual growth rate of 9.4%, while deposits have grown at a slower 8.6%. As a result, other borrowings have grown at a much higher average annual growth rate of 13.2% in the same period.

Source: FDIC

Higher Loan-to-Value ratios led to easy credit availability

The increasing loan-to-value ratios played an important part in increasing the risk associated with loans in both the S&L crisis as well as the asset securitization/subprime mortgage crisis. During the S&L crisis, the Garn - St Germain Depository Institutions Act of December 1982 significantly expanded the powers of the S&L institutions in terms of lending ability and volumes. Among the many favorable moves, one was the demolition of the statutory limit on the LTV ratio. However, this inherently meant higher risk as well, which intensified the effects of the housing market bust on the S&L institutions.

Similarly, in the subprime mortgage crisis, loan-to-value ratios of subprime as well as Alt-A loans went up significantly. Though a higher LTV ratio had ensured increased credit availability at the time of availing the loan, poor loan repayment ability coupled with declining values of the underlying properties as an effect of the slowdown in the market led to a rise in the already high LTV ratio. This has further increased the risk associated with these loans.

Credit quality (and credibility) of the banking sector suffered in the process

In both the S&L crisis as well as the subprime crisis, improper and inadequate assessment of the borrower’s credit worthiness and imprudent lending led to a severe hit on the credit quality of the entire banking sector. While the banks continued to charge-off bad loans from their books, non-current loans as a percentage of total loans continued to increase in both the cases. This not only impacted overall growth prospects of the banks, but also aggravated the prevalent concerns in the subprime and asset securitization markets.

In addition, both the S&L crisis and the recent asset securitization crisis are characterized by banks attempting to underwriting commercial real estate risks they were ill-equipped to value – both from a manpower and expertise perspective. The BoomBustBlog.com analysis of General Growth Properties and the Commercial Real Estate sector showcases the likelihood of failing to appreciate the complexity of the CRE valuation in detail. In analyzing the value prospects of GGP, we valued each and every property of the REIT using localized data and info, then folded the valuations into a master entity and measured cash flows into the REIT structure, as well as development expenses and revenues, taking into consideration contingent liabilities, local economic conditions, the macroeconomic environment, etc. The effort took several man-months of resources and we ended up with over 2 gigabytes of valuation data on over 260 properties. This is the effort that was necessary to effectively loan money to GGP, for their current condition puts every loan made to them at risk. Very, very few, if any lending institutions made any effort approaching this level of effort, and the risk level of their mortgages now reflect it. Very similar occurrences happened in commercial real estate lending in the S&L crisis just two decades ago.

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During the S&L crisis, total charge-offs as a percentage of total loans increased from 1.04% in 1Q 90 to 1.56% by the end of 1991, reflecting concerns over declining credit quality in the system toward the end of the crisis. In the last five years, there has been a stability in the quarterly net charge-off rate compared to earlier years, as it declined from 0.98% in 4Q 02 to 0.83% in 4Q 07. However, in the more recent two–year period, the quarterly net charge-off rate has started to show an increasing trend, rising from 0.60% in 4Q 05 to 0.83% at the end of 4Q 07. This reflects the negative impact of the asset securitization crisis on the credit quality of the banks.

Source: FDIC

In terms of non-current loan rate, the numbers reveal a similar story. While the non-current loan rate increased from 2.94% in 1Q 90 to 3.58% at the end of 1991, it has increased marginally from 1.36% in 4Q 02 to 1.39% in 2007. However, once again it is on a rise since 4Q 05, when it was 0.74%, and has increased drastically to 1.39% at the end of 4Q 07. The lull in this rate from ’02 to ’07 is due to the lax lending environment tha allowed weak credits to refinance their way out of trouble. As the lending markets tightened significantly, in the 2^nd half of ’06 and the particularly the summer of ’07, the non-current loan rate has spiked at a rate sharper than that of the S&L crisis, which portends a potentially more drastic fallout than that of the S&L crisis.

Delinquency Rates

Source: FDIC

In comparison, total delinquent real estate loans as a percentage of total real estate loans had risen from 4.96% in 1Q 90 to 5.94% in 4Q 91, declined from 2.69% in 4Q 02 to 2.40% in 2.13% in 4Q 07. However, they have increased in the more recent period from 1.56% in 4Q 05 to 2.13% in 4Q 07. It is imperative that interested observers take note of where we are in this particular real asset correction, in terms of chronology and completion. This allows a more appropriate comparison to the S&L crisis.

The S&L crisis and its direct effects ranged from the mid 80’s to the early nineties, as is illustrated by the upward spike in the same time frame in the chart above. Notice that prices leapt upward even though building costs waned, due primarily to the stimulus of easy money from the banking system. Now, compare and contrast this residential spike to that of the recent real asset boom starting in late 90’s. By putting these two spikes in appreciation into perspective, we can see there is much, much more pain to be had in a residential real estate correction off of the most recent boom than was experienced during the S&L crisis, or that of any other period for the last 115 years. This correction is bound to be exacerbated by the amount of leverage utilized in the securitization products described earlier, and the wide net cast by these potential time bombs that are the very core of the concept of securitization – the wide spread dispersion of risk – extreme risk due to the combination of extreme negative price movement, extreme leverage, and opacity in asset structure, legal precedent and distressed pricing.

An important difference in the effects of credit quality in the S&L crisis and the subprime crisis are the type of real estate loans affected. In the S&L crisis, commercial loans were most affected while in the asset securitization crisis, many classes of loans were affected – with a cascading effect moving through subprime, Alt-A and prime residential loans, consumer loans secured and unsecured), leveraged loans (ex. LBO loans) and commercial real estate loans. The commercial real estate loan, CMBS and leveraged loan market has started deteriorating rapidly over the last fiscal quarter, and as you can see in the chart above, we are still in the early innings of the residential housing led correction.

Growth in frauds contributed to the subprime crisis

Apart from poor discretion when generating loans, the subprime crisis was aggravated by various frauds which led to misrepresentation of the applicants’ information. According to Mortgage Bankers Association and the Federal Bureau of Investigation, borrowers and brokers fraudulently over-stated the applicant's income which led to the borrower qualifying for a home which was actually unaffordable. This led to an estimated US$1 bn worth of fraudulent lending in 2007 alone. According to a study by the Mortgage Asset Research Institute, approximately 60% of stated income loans (or Alt-A loans) were exaggerated by at least 50%.

The alarming rise of mortgage frauds are also reflected in the increasing mortgage fraud complaints. According to the Financial Crimes Enforcement Network (U.S. Treasury Department), mortgage fraud complaints more than doubled in the U.S. from 2003 to 2006, while suspicious activity reports related to mortgage fraud increased 14 times from 1997 to 2005.

Source: Fannie Mae

According to Fannie Mae Mortgage Fraud Update, frauds related to credit related misrepresentation (including credit, social security numbers and liabilities) constituted 47% of the total mortgage frauds at the end of 2007, while income related frauds constituted 22% of total mortgage frauds during the year.

Subprime crisis’ impact on financial performance

In the times of the S&L crisis as well as the asset securitization crisis, the performance of the US financial institutions was dismal. Return on equity (ROE) touched a historical low of (1.07%) declining over 10 percentage points, while Return on Assets (ROA) suffered a 55 bps decline to (0.06%) in 1987. This reflects the severe impact of the S&L crisis which led to the closure of 262 financial institutions across the US, pushing most of the remaining into losses during the period.

A similar phenomenon was observed in 2007, as financial institutions faced the negative impacts of the decline in the subprime mortgage market.

Source: Fannie Mae

In 2007, net interest income increased 6.9% y-o-y to US$352.8 bn on the back of expansion in the loan portfolio, primarily led by commercial loans. However, the top-line growth could not percolate down to the bottom-line as a result of increase in the non-interest expenses as well as rise in provisions for loan losses. The aforementioned increases in commercial loan revenue and interest has come back to bite the lenders in the form of a sharply declining CRE market and a dearth of demand for CRE loans and related securities. This binging on CRE lending is leading to extreme concentrations and stress in local and regional lending institutions.

Provisions for loan losses increased 130.7% y-o-y to US$68.1 bn in 2007, as credit quality continued to decline in 2007. Consequently, non-current loans as a percentage of total loans increased 60 bps y-o-y to 1.39% during the period. As a result, the total non-current loans increased 91.5% y-o-y to US$109.9 bn at the end of 2007.

A shrinking bottom-line during 2007 drove down the profitability ratios, as ROA fell 42 bps y-o-y to 0.86% while ROE plummeted to 8.17%, a fall of 143 bps y-o-y in 2007. In 2007, combined net income of all financial institutions declined 27.4% y-o-y to US$105.5 bn - the lowest level since 2002 – as 11.6% of the institutions registered a loss during the year. This was the highest percentage of losses in the industry in the last 26 years.

Next: Securitization and the housing bubble bust...