"And then the Roof Caved In" Notes

massive rise in subprime industry between 2002 and 2006
southern california, nevada, arizona, florida
caused by push for greater home ownership rate - especially among people lacking the 3 C’s
- character
- credit history
- collateral
- also: lower interest rates, loose regulations
piggyback loans - risky for the second bank (the piggyback) who didn’t get priority on the collateral
alt-A loans - between subprime and prime, often used to refinance houses - lower down payment, less background checks
- interest Alt-A loans - regular
- hybrid ARM - fixed interest period, then variable - ie. 2/28
- negative amortization - borrower pays less than interest value - principal goes up
- option ARM - buyer can choose how much they pay - often ends up with neg. amort.

Dr. Edward Gramlich and Sheila Bair noticed fragility of bubble, but Greenspan didn’t listen
- gramlich wanted to apply rules, but greenspan refused because weren’t enforceable
independent loan companies: Quick Loan, Ameriquest - no regulation
many lenders couldn’t afford to make safer policies - would simply lose out on business
“eyes wide shut” - wilfull ignorance - people refused to believe what was right in front of them
in 2005, more than half of subprime loans were originated by unincorporated businesses - UNREGULATED!

1938 - Fannie Mae founded as part of New Deal to purchase mortgages from lenders to free up capital
- didn’t start with much money but sold bonds to raise capital
- 1970 - Freddie Mac founded, introduced MBS (mortgage backed securities). used payments collected from mortgages to pay off MBS, and used MBS payments to buy more mortgages
- MBS’s cut into tranches - different groups with different risk levels - more risk → higher interest rate from Freddie
- many international investors got involved in US mortgage market thru this
- Fannie + Freddie had a ton of power - CONFORMING mortgages
2003 - Freddie Mac caught understating … Fannie caught overstating. reputation destroyed, Wall Street took over, less regulation.

rating agencies: Moody’s, Standard & Poor’s, Fitch
- Lou Ranieri → Congress in 1970s, passed ERISA to allow MBS’s to be rated
corruption of rating agencies - tried to market themselves to banks by offering inflated ratings - ISSUER PAYS model
- “rating shopping” became a thing
no historical standards for rating MBS’s - rating agencies could basically do whatever
- analysts encouraged to ignore accuracy of unregulated mortgage applications, so they could give higher ratings
Moody’s went public - more profit focused, less controlled by parent Dun & Bradstreet

globalization of US housing + financial markets - willingness of banks to peddle securities across the world to fund more mortgages
investors were willing to invest in US assets because of large trade deficits
- complexity
- ignorance
- trust
rise of unconscious buyer
narvik needed money to fund public services
bought into synthetic CDO triple A tranche (actually shit)
- group of diversified loans gathered together, even though they were bad, were given higher rating bc unlikely to all default at once
even Terra (broker) didn’t understand what they were saying

investment banks behaved very riskily in the lead up to 2008 - Merrill Lynch’s implostion (in part due to Stan O’Neal)
- O’Neal raised profit margins by reducing costs through risky business practices
- merrill originated, bought, and pacakged more mortgages into CDOs
- very dependent on mortgage securitizations because they were profitable while the market was going up
- eventually, Merrill assets equaled more than 27 times their equity - not stable - a decline in assets would erase all their capital
private partnerships → public around time of structured products - thus, shareholders responsible for losses, so corporations were riskier - higher leverage ratio
- business’s assets/equity given

short selling: borrow stock from a lender, sell right away, expecting price will go down and you can repurchase and give stock back at a lower price, making money in the process
- possibility of infinite loss, unlike regular speculation (where loss is maximum amount purchased)
- ie. shorting Bre-X stock and shorting CDOs - US housing market
- Cui Bono?
Bass figured out housing market instability by:
- disparate housing price and income ratio to history
- large number unsold homes
- lack of regulation
- bass went to Bear Stearns, who didn’t agree. found they were leveraged 38 times - 38:1 asset:equity ratio
a lot of people borrowing beyond their means ex: Arturo Trevilla

Feb 25, 2007: first major warning sign - remittance data to owners of mortgage securities (how many ppl late on payments/in default)
- many subprime lenders forced to close, as Wall Street stopped buying - tightened standards for everyone
less home mortgages given → less home buyers, home prices began to drop
- too many houses, not enough buyers
- many people had believed that home prices would never go down - kept refinancing (to their peril in 2008)
july 10, 2007 - Standard & Poor’s announced downgrades on MBSs and CDOs
- foreign investors quickly sold off assets
- triple A’s never defaulted - would be downgraded first!

2006: more than 25% mortgages considered subprime - UNDERESTIMATE because people who refinanced subprimes were no longer subprime!
2008 crash: banks lost 1.2 trillion globally, millions of ppl forcolsed on
700 billion bailout by US government - on the TAXPAYER DOLLAR
- “Too big to fail” - AIG (treasury stepped in + bought about 80% of shares) , Fannie, Freddie
- merrill lynch sold self to bank of america
- without bailout, liquidity crisis most likely prolonged, banks insolvent
more regulations imposed - however, greed, major cause, left unaddressed
boom and bust cycle continues
- FTX DISASTER!
many ppl left below poverty lines for rest of their lives
- spectacular gains for a select few

2009: Obama’s Financial Crisis Inquiry Commission
- Feb 2011 published report - 9 major reasons they believed crisis occured - 3 of them were:
- crisis was avoidable
- gov was unprepared
- over-the-counter derivatives contributed greatly
CDOs and CLOs have returned in recent years
most likely currently in growth or deregulation phase
issuer pays model for rating agencies still in existence at many agencies
high national unemployment of almost 10%
modest spending by consumers → slower recovery
JP Morgan Chase considered one of the few “winners” - generally stayed away from CDOs, and was able to buy up a lot of investment firms at a low price