From the Library of Melissa Wong FINANCIAL SHOCK From the Library of Melissa Wong This page intentionally left blank From the Library of Melissa Wong FINANCIAL SHOCK A 360º Look at the Subprime Mortgage Implosion, and How to Avoid the Next Financial Crisis MARK ZANDI From the Library of Melissa Wong Vice President, Publisher: Tim Moore Associate Publisher and Director of Marketing: Amy Neidlinger Executive Editor: Jim Boyd Editorial Assistant: Heather Luciano Development Editor: Russ Hall Digital Marketing Manager: Julie Phifer Publicity Manager: Laura Czaja Assistant Marketing Manager: Megan Colvin Marketing Assistant: Brandon Smith Cover Designer: Chuti Prasertsith Operations Manager: Gina Kanouse Managing Editor: Kristy Hart Project Editor: Chelsey Marti Copy Editor: Krista Hansing Editorial Services Proofreader: Water Crest Publishing, Inc Indexer: Lisa Stumpf Compositor: Jake McFarland Manufacturing Buyer: Dan Uhrig © 2009 by Pearson Education, Inc Publishing as FT Press Upper Saddle River, New Jersey 07458 FT Press offers excellent discounts on this book when ordered in quantity for bulk purchases or special sales For more information, please contact U.S Corporate and Government Sales, 1-800-382-3419, corpsales@pearsontechgroup.com For sales outside the U.S., please contact International Sales at international@pearson.com Company and product names mentioned herein are the trademarks or registered trademarks of their respective owners All rights reserved No part of this book may be reproduced, in any form or by any means, without permission in writing from the publisher Printed in the United States of America First Printing July 2008 ISBN-10: 0-13-714290-0 ISBN-13: 978-0-13-714290-3 Pearson Education LTD Pearson Education Australia PTY, Limited Pearson Education Singapore, Pte Ltd Pearson Education North Asia, Ltd Pearson Education Canada, Ltd Pearson Educatión de Mexico, S.A de C.V Pearson Education—Japan Pearson Education Malaysia, Pte Ltd Library of Congress Cataloging-in-Publication Data Zandi, Mark M Financial shock : a 360° look at the subprime mortgage implosion, and how to avoid the next financial crisis / Mark Zandi p cm ISBN 0-13-714290-0 (hardback : alk paper) Mortgage loans—United States Housing—United States—Finance I Title HG2040.5.U5Z36 2009 332.7’220973—dc22 2008024348 From the Library of Melissa Wong For Ava, Bill, Anna, and Lily From the Library of Melissa Wong This page intentionally left blank From the Library of Melissa Wong Contents Introduction Chapter 1: Subprime Précis Chapter 2: Sizing Up Subprime 29 Chapter 3: Everyone Should Own a Home 45 Chapter 4: Chairman Greenspan Counts on Housing 63 Chapter 5: Global Money Men Want a Piece 79 Chapter 6: Bad Lenders Drive Out the Good 95 Chapter 7: Financial Engineers and Their Creations 111 Chapter 8: Home Builders Run Aground 129 Chapter 9: As the Regulatory Cycle Turns 143 Chapter 10: Boom, Bubble, Bust, and Crash 159 Chapter 11: Credit Crunch 173 Chapter 12: Timid Policymakers Turn Bold 191 Chapter 13: Economic Fallout 213 Chapter 14: Back to the Future 229 Endnotes 245 Index 259 From the Library of Melissa Wong Acknowledgments This book would not have been possible without the support and help of a number of people Paul Getman, my friend, business partner, and sounding board for a quarter century, has been instrumental in guiding me through the tricky parts of putting this work together He taught me the basics of banking back in the 1980s when it wasn’t taught in graduate school His insights have been key to guiding my thinking on the topics addressed in this book Andy Cassel also deserves a substantial amount of credit for his tireless efforts turning my prosaic prose into something hopefully worth reading I had invaluable help from Zoltan Pozsar who culled through endless reports and documents and hunted down the most arcane of information His enthusiasm and interest in the topic made my job much more interesting I would also like to thank Jim Boyd, my editor, who gave me very kind encouragement throughout the entire process His cool demeanor was important to keeping my cool To my father, and my brothers and sister, Richard, Karl, Peter, and Meriam My father has been the proverbial, loving pain in the side, cajoling me to write a book; I surely wouldn’t have done it otherwise I haven’t lived with my brothers and sisters for almost thirty years, but I think of them every day, and their influence is enduring Finally, I must acknowledge my dear wife and children Their love and patience is key to anything I’m able to accomplish From the Library of Melissa Wong About the Author Mark Zandi is Chief Economist and co-founder of Moody’s Economy.com, Inc., where he directs the firm’s research and consulting activities Moody’s Economy.com is an independent subsidiary of the Moody’s Corporation and provides economic research and consulting services to global businesses, governments and other institutions His research interests include macroeconomic and financial economics, and his recent areas of research include an assessment of the economic impacts of various tax and government spending policies, the incorporation of economic information into credit risk analysis, and an assessment of the appropriate policy response to real estate and stock market bubbles He received his PhD from the University of Pennsylvania, where he did his PhD research with Gerard Adams and Nobel Laureate Lawrence Klein, and his BS degree from the Wharton School at the University of Pennsylvania From the Library of Melissa Wong This page intentionally left blank From the Library of Melissa Wong INDEX A aaa investors, 209 Aaa-rating, 181 ABS CDO (asset-backed security collateralized debt obligation), 117 ABX, leverage, 124 accountability, 238-239 lack of, acquisitions, home builders, 134 adjustable-rate mortgages, 16 alternative-A loans, 32 American Association of Residential Mortgage Regulators, 147 American Dream Downpayment Act, 151 American financial system, 111-114 responsibility, 126-127 appraisals, 17 ARMs (adjustable-rate mortgages), 16, 66-69 first-time home buyers, 54-55 interest-only ARMs, 38 option ARMs, 38 versus fixed-rate mortgages, 35-38 asset-backed conduits, 120 asset-backed security collateralized debt obligation (ABS CDO), 117 asset bubbles, controlling, 241-242 asset prices consumer spending, effect of, 222-225 effect of interest rates on, 223-225 rise in, 223 AU (automated underwriting) models, 107 auctions, 182 AVM (automated valuation models), 108 259 From the Library of Melissa Wong 260 INDEX B C Bair, Sheila, 156 banking, difficulties caused by subprime mortgage crisis, 24 banking industry, economic consequences of subprime mortgage crisis on, 229-231 banks, central banks, 87-89 Japan, 88 Basel Accords, 120 Basel II, 120, 153 Bear Stearns, 26, 167, 185, 204, 229, 231 Bear Stearns hedge funds, 124 benchmark lending rates, 69 Bernanke, Ben, 155 “Blueprint for Financial Regulatory Reform” (U.S Treasury Department), 240 bond insurance, 181 bond insurers, difficulties caused by subprime mortgage crisis, 25-26 borrowing home equity, 59 broker dealers, 26, 203-204 liquidity, 26-27 bubbles, 70 asset bubbles, 241-242 housing bubble, 161-163 overvalued houses, 163-164 busts, housing bust, 16, 132-134, 165-167 buying binges, 73-76 capital structure, 115 cash-out refinancing, 217 CDOs (collateralized debt obligations), 13, 117-119 CDOs-cubed, 119 CDOs-squared, 119 central banks, global investors, 87-89 Japan, 88 China, 10 global investors, 81-85 CMBS (commercial mortgagebacked securities), 179 collateralized debt obligations (CDOs), 13, 117-119 diversification, 125-126 commercial mortgage-backed securities (CMBS), 179 commercial paper, 22 commodity prices, rise of, 220-221 Community Reinvestment Act (CRA), 150 competition to mortgage brokerage firms, 106 Conference of State Bank Supervisors, 147 conforming loans, 31 construction of new houses, reduction of, 216 consumer spending decline of, 213 effect on asset pricing, 222-225 From the Library of Melissa Wong INDEX corporate bonds, 178-179 Countrywide, 100 covenant-lite bonds, 178 CRA (Community Reinvestment Act), 150 credit, 28 credit cards, securitization, 113 credit crunch, 188-189, 199-200 leverage, 183-184, 189 liquidity, 185 credit default swap market, 25 credit default swaps, 230 credit rating agencies, role in subprime mortgage crisis, credit scores, 32 D data collection, expansion of, 234-235 debt rise of, of United States, deed in lieu, 170 deficiency judgments, 236 deflation, 64, 72-73 depositories, 102 discount window borrowing, 199 diversification, 125 CDOs (collateralized debt obligations), 125-126 dollar (U.S.), weakening of, 219-221 dotcom firms, 137 down payments, 39 261 E economic stimulus, 205-208 emerging economies effect of, 3-4 global investors, 85-87 equity, 49 borrowing, 59 reduction of, 218 equity tranches, securitization, 116 F failure, Federal Reserve’s regulatory failure, 152-153 Fannie Mae (Federal National Mortgage Association), 31 economic stimulus, 206-207 FDIC (Federal Deposit Insurance Corporation), 145 Federal Home Loan Bank (FHLB), 51 Federal Housing Administration (FHA), 45 Federal Housing Administration (FHA) Secure, 194 Federal Open Market Committee (FOMC), 200 Federal Reserve, 18, 52, 145 asset bubbles, role in, 241-242 cracking down on nontraditional mortgage lending, 155-157 discount window, 199 From the Library of Melissa Wong 262 interest rate cuts from, 231 monetary toolbox, 200-205 regulatory failure, 152-153 regulatory oversight by, 240 Federal Trade Commission, 147 FHA (Federal Housing Administration), 45 FHA (Federal Housing Administration) Secure, 194 FHCs (financial holding companies), 145 FHLB (Federal Home Loan Bank), 51 FICO scores, 32 finance companies, 113 financial accountability, 238-239 lack of, financial crisis, preparation for, 242-243 financial guarantors, 180-183 financial holding companies (FHCs), 145 financial innovation, 10-11, 13 financial literacy, need for, 236-237 financial regulation, regulatory oversight, lack of, 4-5 reformation of, 239-241 financial systems American financial system, 111-114 responsibility, 126-127 complexity of, INDEX financial transparency, 238-239 first-time home buyers, 52-54 ARMs, 54-55 Fitch, fixed-rate mortgages, versus ARMs, 35-38 flippers, 14, 46, 59-61, 141 FOMC (Federal Open Market Committee), 200 food prices, rise of, 220-221 foreclosure process, reformation of, 235-236 foreclosures, 27 programs to alleviate, 232 foreign investors, 79 Frank/Dodd plan, 211 Freddie Mac (Federal Home Loan Mortgage Corp.), 31 economic stimulus, 206-207 G gasoline prices, rise of, 231 See also oil prices GDP (gross domestic product), effect of subprime mortgage crisis on, 216 gilts (gilt-edged securities), 177 global emerging economies, effect of, 3-4 global investors, 79-81 central banks, 87-89 China, 81-85 emerging economies, 85-87 liquidity, 89-92 From the Library of Melissa Wong INDEX global money markets, difficulties caused by subprime mortgage crisis, 22-23 government intervention, 208-212 government mortgages, versus private mortgages, 30-31 government-supported mortgage lenders, 106-107 government tax receipts, reduction of, 216-217 Gramlich, Edward, 153 Gramm-Leach-Bliley bill, 152 Great Moderation, 91 Greenspan put, 69-72 Greenspan, Alan, 64, 152 ARMs, 36, 67 benchmark lending rates, 69 bubbles, 70 deflation, 72-73 Gresham’s law, 106 H hedge funds, leverage, 124 HMDA(Home Mortgage Disclosure Act), 234 HOEPA (Home Ownership and Equity Protection Act), 153 home appraisers, 17 home builders, 130-132 acquisitions, 134 booms and busts, 132-134 financing homes they sold, 139 263 optimism, 137-139 part in housing boom, 19-20 public builders, 134-136 surplus homes, 139-142 home building, 129 flippers, 141 manufactured housing, 130 home-equity line of credit, 75, 113, 217 Home Mortgage Disclosure Act (HMDA), 234 home ownership, 45-47 first-time home buyers, 52-54 ARMs (adjustable-rate mortgages), 54-55 flippers, 59-61 incentives for, 50-52 investors, 57-59 rates for, 47-48 spending on, 48-49 trade-up buyers, 55-57 Home Ownership and Equity Protection Act (HOEPA), 153 home sales prices, reduction of, 215-216 homeowners’ net worth, reduction of, 217-219 homeownership, politics of, 149-151 Hope Now, 232 response of policymakers to financial shock, 194-195 household debt, rise of, 225-227 From the Library of Melissa Wong 264 household spending, 222 decline of, 213 effect on asset pricing, 222-225 housing, foreclosures (government intervention), 208-212 housing boom, 13-15, 132-134, 159-161 underwriting collapses, 16-18 housing bubble, 161-163 overvalued houses, 163-164 housing bust, 16, 132-134, 165-167 housing crash, 167-170 bottom of, 169-170, 172 housing crisis See subprime mortgage crisis housing market, stock market compared, housing prices, reduction of, 229 housing starts, reduction of, 216 housing valuation, 163-164 hubris, I immigration, housing boom, 160 incentives for home ownership, 50-52 inflation, risk of in 2007, 193 innovation, financial innovation, 10-13 INDEX insurance bond insurance, 181 for insurers, 180-183 insurers, mortgage insurers, 99 interest on mortgages, taxes, 51 interest rates cuts from Federal Reserve, 231 effect on asset prices, 223-225 interest-only ARMs, 38 Internet, effect on mortgage brokerage firms, 104 investors, 102 emerging investors, 85-87 global investors, 80 home ownership, 57-59 J–K Japan, central banks, 88 JPMorgan Chase, 26 JPMorgan Chase, purchase of Bear Stearns, 204 judicial form of foreclosure, 236 junior liens, 209 junk bonds, 178-179 L lenders government-supported mortgage lenders, 106-107 models for lending, 107-110 mortgage bankers or brokers, 98-99 From the Library of Melissa Wong INDEX mortgage brokerage firms, 103-105 competition, 106 Internet, 104 mortgage insurers, 99 mortgage lenders, 100-103 mortgage servicers, 99 mortgage underwriters, 99 part in housing bust, 20-21 residential mortgage lending, 95-97 leverage, 13, 91, 123-125 ABX, 124 credit crunch, 183-184, 189 reducing, 186-187 liars’ loans, 17 LIBOR (London Interbank Offered Rate), 175 licensing mortgage lenders, 234 liquidity broker dealers, 26-27 credit crunch, 185 global investors, 89-92 loan defaults, 170 loans conforming loans, 31 liars’ loans, 17 piggyback second loans, 39 securitized or not securitized, 41-43 stated income loans, 40 local government tax receipts, reduction of, 216-217 London Interbank Offered Rate (LIBOR), 175 265 Long-Term Capital Management, 71 Losses from subprime financial shock, 173-174 M manufactured-home loans, 113 manufactured housing, 130 margin calls, 184 mark to market, 186 mark-to-market accounting rules, 237-238 mark to model, 187 mezzanine tranches, securitization, 115 models automated underwriting (AU) models, 107 automated valuation models (AVM), 108 models for lending, 107-110 monetary toolbox (Federal Reserve), 200-205 monoline insurers, 180 Moody’s, moral hazard, 197 mortgage bankers, 98-99 mortgage brokerage firms, 103-105 competition, 106 Internet, 104 mortgage brokers, 98-99 mortgage crisis See subprime mortgage crisis mortgage fees, 104 From the Library of Melissa Wong 266 mortgage insurers, 99 mortgage lenders, 100-103 licensing, 234 mortgage lending rules, 234 mortgage rates, 65-66 ARMs (adjustable-rate mortgages), 66-69 mortgage refinancing, 74 mortgage securities markets, fall of, 21 mortgage servicers, 99, 210 mortgage underwriters, 99 mortgage write-down plan, 233 mortgages government versus private mortgages, 30-31 residential mortgage lending, 95-97 N NCUA (National Credit Union Association), 145 negative equity, 156 housing crash, 169-171 nest eggs, reduction of, 222-225 net worth of homeowners, reduction of, 217-219 New Century Financial, 147 new home construction, reduction of, 216 non-traditional mortgage products, 144 nontraditional mortgage lending, cracking down on, 155-157 INDEX O OCC (Office of Comptroller of the Currency), 145 Office of Housing Enterprise Oversight (OFHEO), 147 Office of Thrift Supervision (OTS), 145 OFHEO (Office of Housing Enterprise Oversight), 147 oil prices, rise of, 220-221, 231 See also gasoline prices optimism, home builders, 137-139 option ARMs, 38 originate-to-distribute model, 114 OTS (Office of Thrift Supervision), 145 overbuilding See surplus homes overvalued houses, 163-164 ownership society, 151 P PDCF (Primary Dealer Credit Facility), 201, 205 piggyback second loans, 39 policymakers’ responses to subprime mortgage crisis, 191-192, 231-233 asset bubbles, controlling, 241-242 changing the rules for the mortgage industry, 106-107 data collection, expansion of, 234-235 From the Library of Melissa Wong INDEX economic stimulus, 205-208 FHA Secure, 194 financial literacy, need for, 236-237 financial transparency and accountability, 238-239 foreclosure process, reformation of, 235-236 Hope Now, 194-195 mark-to-market accounting rules, 237-238 mortgage lender licensing, 234 mortgage lending rules, 234 mortgage write-down plan, 233 regulatory oversight, reformation of, 239-241 reluctance to act, 195-198 positive carry, 125 predatory lending, 144 trying to prevent, 151 preparation for financial crisis, 242-243 prepayment penalties, 155 price-earnings (PE) ratio, 92 price-to-rent ratio, 164 Primary Dealer Credit Facility (PDCF), 201 prime versus subprime, 31, 33-35 private mortgage securities market, 232 private mortgages, versus government mortgages, 30-31 Project Lifeline, 232 267 property taxes, tax deductions, 51 public home builders, 134-136 put option, 71 Q–R rating agencies, 18-19 re-evaluating risk, 177-180 real estate investment trusts (REITs), 18, 106 recession, 27-28 as consequence of subprime mortgage crisis, 213-214 redlining, 150 reducing leverage, 186-187 refinancing, 74 Regulation Q, 133-134 regulators, 18-19, 146 difficulties in restraining aggressive lenders, 154-155 Federal Reserve, failure of, 152-153 home ownership politics, 149-151 non-traditional mortgage products, 144 of bankrupt mortgage lenders, 148-149 predatory lending, 143 states role in, 146 subprime lending, 145 who is responsibile for what, 145-147 regulators of bankrupt mortgage lenders, 149 From the Library of Melissa Wong 268 regulatory oversight lack of, 4-5 reformation of, 239-241 Reich, John, 157 REITs (real estate investment trusts), 18, 106 renters, 46 reporting requirements, expansion of, 235 residential mortgage lending, 95-97 residential mortgage-backed security (RMBS), 115 Resolution Trust Corporation (RTC), 112 response of policymakers to financial shock, 191-192 FHA Secure, 194 Hope Now, 194-195 reluctance to act, 195-198 responsibility, financial system, 126-127 right of redemption, 236 risk, re-evaluating, 177-180 risk-based pricing model, 96 risk layering, 38-41 risk-weighting, 120 RMBS (residential mortgagebacked security), 115 RTC (Resolution Trust Corporation), 112 rules, changing rules for the mortgage industry, 106-107 INDEX S S&L (savings and loan) crisis, 112 sales prices for homes, 215-216 saving rate See also nest eggs effect on home owners’ net worth, 218-219 reduction of, 214-215 savings and loan (S&L) crisis, 112 SEC (Securities and Exchange Commission), 18, 106, 147 second mortgages, 209 securitization, 12-13, 41-43, 112-113 credit cards, 113 overview of, 115-116 senior tranches, securitization, 115 shadow banking systems, 119-121 short sales, 170, 194 shorting, 124 simultaneous seconds, 209 SIVs (structured investment vehicles), 22, 121-123 sovereign wealth funds, 189 speculation, 59, 162 spending See also consumer spending buying binges, 73-76 on homes, 48-49 stagflation, 222 From the Library of Melissa Wong INDEX Standard & Poor’s, state government tax receipts, reduction of, 216-217 stated income loans, 40 stock market, housing market compared, structured investment vehicles (SIVs), 22, 121-123 subprime, versus prime, 31-35 subprime financial shock, 21-22, 173 government intervention, 208-212 length of, 175 losses from, 173-174 triggers of, 176 subprime lending, 145 subprime mortgage crisis economic consequences of banking industry, effect on, 229-231 consumer spending, effect on asset prices, 222-225 debt, rise of, 225-227 dollar (U.S.), weakening of, 219-221 home sales prices, reduction of, 215-216 home owners’ net worth, reduction of, 217-219 new home construction, reduction of, 216 recession, 213-214 saving rate, reduction of, 214-215 state/local government tax receipts, reduction of, 216-217 269 policymakers’ responses to, 231-233 asset bubbles, controlling, 241-242 data collection, expansion of, 234-235 financial literacy, need for, 236-237 financial transparency and accountability, 238-239 foreclosure process, reformation of, 235-236 mark-to-market accounting rules, 237-238 mortgage lender licensing, 234 mortgage lending rules, 234 mortgage write-down plan, 233 regulatory oversight, reformation of, 239-241 reasons for, 1-2 accountability, lack of, credit rating agencies, role of, emerging economies, effect of, 3-4 financial system complexity, hubris, regulatory oversight, lack of, 4-5 From the Library of Melissa Wong 270 subprime mortgages defined, outstanding debt, 44 sizing up, 43-44 surplus homes, 139-142 T TAF (Term Auction Facility), 200 tax rebates, economic effect of, 231 tax receipts for state/local government, reduction of, 216-217 taxes, 51 teaser rates, 16 tech-stock bubble, 69 Term Auction Facility (TAF), 200 Term Securities Lending Facility (TSLF), 201 terrorism, trade-up buyers, 56 trade deficit (U.S.), 220 trade-up buyers, 46, 55-57 trading down, 76 tranches, securitization, 115 transparency, 238-239 triggers of subprime financial shock, 176 trust, 23 TSLF (Term Securities Lending Facility), 201, 205 INDEX U–Z U.S debt, U.S dollar, 219-221 underwriters, 99 weakening of dollar (U.S.), 219-221 “the wealth effect,” 73 Wells Fargo & Company, 147 World Trade Organization (WTO), 81 write-downs, of major banks, 187-188 yen carry trade, 89 From the Library of Melissa Wong This page intentionally left blank From the Library of Melissa Wong From the Library of Melissa Wong ... storm-prone coastal areas Mortgages grew more complex, evolving from plain-vanilla fixedrate loans into myriad adjustable-rate and variable-payment form loans Adjustable-rate mortgages (ARMs) that included... Education Canada, Ltd Pearson Educatión de Mexico, S .A de C.V Pearson Education—Japan Pearson Education Malaysia, Pte Ltd Library of Congress Cataloging-in-Publication Data Zandi, Mark M Financial shock... shock : a 360° look at the subprime mortgage implosion, and how to avoid the next financial crisis / Mark Zandi p cm ISBN 0-1 3-7 1429 0-0 (hardback : alk paper) Mortgage loans—United States Housing—United