Thread: Information On The Current Credit Market Crisis

I will provide an explanation for a question that the International Monetary Fund proposes in Finance and Development: “How could a modest increase in seriously delinquent subprime mortgages, which amounted to an additional $34 billion in troubled loans, so disrupt the $57 trillion U.S. financial system last summer that worldwide financial turmoil ensued[1]?” I will attempt to explain the drying up of the secondary market for mortgage backed securities using the concept of the “lemon phenomenon” as first explained in a paper by the Nobel Laureate, George Akerlof[6]. Due to the mortgage backed securities market being made up for the most part of three classes of paper quality and the subprime mortgages were securitized using derivatives into three similar classes of paper, I plan to model the entire market as the subprime securities. In order to understand how the main theme of this paper applies to these markets, we must first discuss how the subprime paper was divided. The subprime paper was divided up using CDOs.
The CDOs were split into three tiers of securities. The first form of security is referred to as the senior tier, which has the first claim on payments made on these mortgages. The senior portion has the highest credit rating and is frequently rated AAA[1]. This section of securities received the lowest interest rate. In our discussion, the second tier of the CDOs will be referred to as the mezzanine[1]. This section of securities would receive payment following the senior tier receiving its payment. The mezzanine has an substantial increase in risk, and so therefore, was given a below investment grade credit rating and has a higher rate of return[1]. The lowest tier security, which will be referenced as the equity tier, received payment only if both the senior and the mezzanine tiers were paid in full[1]. Now that there is an understanding of the CDO tiers, I am going to show how each play the roles, as described by Akerlof, in markets plagued with the lemon; the AAA CDOs represents the good product, the mezzanine the middle product, and equity represents the lemon[6].
Each of the classes of the subprime paper that were divided up using CDOs was treated separately in the secondary markets, and so prices were able to be discovered for each level of risk[1]. In the CDOs, approximately 80 percent of the securities was able to be resold to institutional investors as investment grade assets. The mezzanine tier usually found itself in the hands of investors who had a higher tolerance for risk and were chasing higher rate return fixed assets[1]. The lowest trenches were usually picked up by Hedge Funds and proprietary trading desks at Wall Street firms[1]. Credit rating agencies grades were initially sufficient indicators for investors as to the quality and risk of the rated tiers[1]. This meant that buyers believed that they knew the amount of each tier that was being sold in the secondary market. Values for all three tiers of the mortgage securities being found in separate auctions and all of the tiers being purchased up shows that buyers had values for each tier that exceeded that of the sellers.
In 1999 real estate prices started escalating rapidly in part to there being very limited investment options for speculators following the technology bust and was further fueled by historically low interests rates and expanded availability of capital for mortgage lending. In 2005, prices pushed to a point that buyers were having a difficult time affording the purchase of a home[2], especially in California, Arizona and Florida. In early 2006, demand for homeownership in these three states declined thanks to higher home prices[2] reducing affordability, rising long term interest rates[4], and higher property taxes.
This fall in demand was coupled with oversupply[5] and led to, at first, local modest declines in real estate values[3]. Rising costs to the consumer made it more difficult for many households to meet their mortgage payments and declining real estate values prevented them being able to sell their homes. This situation led to an increase in defaults. A rise in defaults and price reductions required Hedge Funds to write down the value of the equity. Due to Hedge Funds being heavily leveraged and the fact that they were forced to write down the values for the equity tiers that they held, margin calls were given and they had to sell off assets[1]. Since the Hedge Funds were the major purchasers of the equity tier and they now were demanding less of the equity tier, prices on the secondary market decreased. Decreases in value for the equity tier reduced the number of loan originations and these reductions led to further tightening in mortgage origination. This tightening in mortgage lending standards reduced the number of buyers who were available to purchase homes. This led to further declines in real estate values. As values of real estate continued to decline, some of the securities that investors thought were AAA grade securities and the mezzanine tier securities in essence became partially equivalent to their respective lower tier securities. This also led to a position where the buyers did not really have a good idea as to the amount of each tier of the securities that were being traded in the market. This led to a situation of asymmetric information in the markets where the sellers knew more about the quality of the securities that existed than the buyers did. The lack of knowledge on exactly how much of each tier of the securities was in the market left the remaining buyers that were willing to purchase these securities to develop an aggregate value for the securities rather than valuing the tiers of the securities individually. The aggregate valuation that these investors had for all three tiers together was than less than what the sellers were willing to sell the investment grade securities for. This led the investors to only sell what they viewed as the lower two tier securities. As more defaults occurred in the market, the investors started realizing that the sellers were no longer selling the high quality paper. So they in turn changed the aggregate valuation to only be for the mezzanine and the equity tiers. This new aggregate value was less than what the sellers valued the mezzanine tier securities to be. This new reduced valuation caused the sellers to quit selling what they viewed was mezzanine. This resulted in only the equity tier paper being traded in the market. Further declines in the real estate values increased the number of defaults in the market. This left both investors and sellers having values of zero for the equity tier securities. In essence, this removed any trading in the secondary market.
Akerlof explains that in markets that rely on trust upon participants, frequently have the opportunity to suffer the lemon phenomenon[6]. In the US credit markets, it is the credit agencies’ grades of securities that provides this trust. An inherited problem with using derivatives and splitting up mortgage-based securities is that in an event, of substantial declines in real estate, leaves higher tier securities turning into the equivalent of their lower tier counterparts. This undermines the credit rating agencies’ original ratings. Once these are brought into question and things change within the markets, buyers of securities are no longer trust the classifications that sellers place on the securities. This troubling scenario leads to the drying up of the securities market that is essential to our economy. This leads one to conclude that it is necessary to not only grade these securities, but also to find a way to insure them against losses. Therefore, Wall Street should not be allowed to simply pass on the risks associated with this onto investors, but rather pay the expenses of insuring these securities. It is my hope that any regulation that comes forth from our current credit crisis is held to only this. Otherwise, we risk raising the costs of homeownership to our populous, and multiple studies have shown that homeownership is very beneficial to neighborhoods and communities.

Cited Sources

1 Internal Monetary Fund. http://www.IMF.org/external/pubs/ft/fandd/2007/dodd.htm
2 S&P/Case-Shiller Metro Area Home Price Indices http://www2.standardandpoors.com/spf/pdf/index/SPCS_MetroArea_HomePrices_Methodology.pdf Standard & Poors. May 2006.
3 The S&P/Case-Shiller U.S. National Home Price Index Posts a Record Annual Decline in the 3rd Quarter of 2007 http://www2.standardandpoors.com/spf...ase_112766.pdf
4 EconoStats http://www.econstats.com/global/norgs2/AAORGS_oac_22.htm
5 Forecast for the Economy 2004-2006. http://gatton.uky.edu/CBER/Downloads/Thompson1-04.pdf
Thompson, Eric.
6 Akerlof, G. “The Market for Lemons”: Quality Uncertainty and the Market Mechanism. Quarterly Journal of Economics (1970) 84: 488-500