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MORTGAGES, MARKETS AND WHAT WE KNOW SO FAR Detroit Chapter of the Institute of Internal Auditors. Robert Van Order University of Michigan. Basic Observation: Big increase in foreclosures. Why?. Subprime ARM Defaults are Very Different from Prime and Subprime FRM. – Recession.

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MORTGAGES, MARKETS AND WHAT WE KNOW SO FAR Detroit Chapter of the Institute of Internal Auditors

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MORTGAGES, MARKETS AND WHAT WE KNOW SO FARDetroit Chapter of the Institute of Internal Auditors

Robert Van Order

University of Michigan

Basic Observation: Big increase in foreclosures. Why?

Subprime ARM Defaults are Very Different from Prime and Subprime FRM

– Recession

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






Prime Conventional

Source: Mortgage Bankers Association

(Quarterly data not seasonally adjusted;1998Q1-2007Q3)

Stylized Facts and Gatherings from Various Data Sources

  • Credit Risk: A Few Propositions

  • Recent History: Especially Large Early Payment Defaults: Can it be rate adjustments?

  • Changing Loan Characteristics: Hard vs. Soft Data, Technical Change and the Two Decades.

  • Economic Conditions

  • Market Structure: The rise of subprime

  • Securitization: The rise of non-agency securities

2002 2003 2004 2005 2006 2007

Cumulative REO Rates Are Showing Poor Performance of Recent Origination VintagesCould it have been ARMs?



Cumulative REO Rate as a Share of Number of Loans Originated

Age of Loan in Number of Months From Origination Date

Source: Loan Performance, a subsidiary of First American Real Estate Solutions

Note: the last twelve points on each origination year cohort contain fewer loans progressively as loans issued at earlier dates always age faster. Data through December 2008.

Credit Risk

  • Underwriting models and history suggested scorecards and diversification worked

Relative Default ProbabilitiesNote the “Nonlinearity” as you move NortheastMore sensitive to mistakes.

Price Performance Matters. So Does (Did?) Diversification

  • So looking back, you would have thought that controlling FICO and LTV was a big deal, you couldn’t have a credit problem without changes in FICO-LTV distribution, and a diversified portfolio would perform well.

  • But Performance Got Really Bad.

  • Especially in Early Months

  • Underwriting has changed over time, but not in ways you might have thought.

High LTVs went up in 90s. Fell lately

Recent observables haven’t changed all that much (Tales?)

We Seem To Have Two Explanations Left

  • Economic Conditions.

  • Structure and Moral Hazard

The Case-Shiller Index

– Recession

Single-family Construction

1- to 4-Family Housing Starts (thousands of units, SAAR)


Third Quarter 2005 record: 1.8 million units

Fourth Quarter 2007:

0.9 million units

Sources: Bureau of Census, Freddie Mac

Price Changes by State: Third Quarter 2007

United States -2.2%

(3rd Quarter Annualized Growth)

New England


Pacific -5.8%

Middle Atlantic


West North Central




East North




> 5% Quarterly Change

East South Central


0 – 5% Quarterly Change

South Atlantic -2.7%

< 0% Quarterly Change

West South Central


< -5% Quarterly Change

Source: Freddie Mac Purchase-Only Conventional Mortgage Home Price Index (Annualized Quarterly Rates for 3rd Quarter 2007)

How favorable were economic conditions?

The structure of the Market Has Changed

  • More Subprime and Alt-A

  • Non Agency Securitization

Subprime used to be about 10% of originations, but it’s share increased a lot after 2003

Securitization ChangesNote the nonagency share went up after the subprime share went up and around the time the vintages got worse.


Credit risk is more important than for Agency securities. The risk has been handled (poorly) by structuring.

So securitization could have been a big part of the problem, because it is so susceptible of moral hazard/asymmetric information.

Recall that to some extent the recent subprime loans didn’t look that bad on paper. Hard vs. soft information.

Subprime Foreclosures Started: 4-yr Distributed Lag of Multipliers

As an aside there have been spillovers that don’t match with actual risk.

About half way through the eventual increases in defaults

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