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The Definition of Subprime: At the Center of the Storm

The Definition of Subprime: At the Center of the Storm. Examination and Risk Management Implications of Recent Market Turbulence and Liquidity Conditions. Remarks by: Jeff Curry, Director Financial and Risk Management Practice The Secura Group/LECG. Contact at: (703) 749-1588

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The Definition of Subprime: At the Center of the Storm

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  1. The Definition of Subprime: At the Center of the Storm Examination and Risk Management Implications of Recent Market Turbulence and Liquidity Conditions Remarks by: Jeff Curry, Director Financial and Risk Management Practice The Secura Group/LECG Contact at: (703) 749-1588 jcurry@lecg.com October 29, 2007

  2. The Definition of Subprime Relies Primarily on the Use of FICO Scores Subprime FICO Threshold Banking Regulators 660 and under Mortgage Industry 620 and under Myfico.com 650 and under

  3. FICO Scores as a Predictor of Default Likelihood – Not Enough History • FICO scores were first developed in 1989, and didn’t gain wide acceptance and use until the late 1990s. • Therefore, the use of FICO scores as a predictor of default has not been tested in a truly adverse credit/economic scenario. • Even Fair Isaac now admits: The average FICO score of a portfolio of loans is not an accurate predictor of risk -- a huge problem because that's exactly what many investors assumed it was. • "FICO scores an individual's risk over time. It's not an assessment of the riskiness of the loan made." (Fair Isaac) • A recent study by Fair Isaac and DBRS (a bond rating service) concluded: “that a borrower with a high credit score is just as likely to default on a no-money-down mortgage as a lower-scoring borrower who puts down 40%. So two portfolios with identical average FICOs can behave very differently.” (Forbes)

  4. Factors Considered in FICO Scoring Payment History 35% Amounts Owed 30 Length of Credit History 15 New Credit 10 Types of Credit Used 10 100%

  5. The Capital Markets were Geared to Keep Subprime Mortgages Flowing • Due in large part to confidence in FICO scores as predictors of default. • Mortgage brokers, mortgage originators, investment bankers, rating agencies, institutional investors – the common denominator for credit/investment decisions right up the chain was the FICO score. • From the investor standpoint, rating agency ratings and deal structures, including credit enhancements, also played an important role in the decision process. However, the ability to sell subprime loans as investment grade assets, rated by the rating agencies, clearly fueled enormous growth in the subprime loan industry. • This in turn created greater access to credit for potential homebuyers, which in turn cause home prices to rise, which allowed the mortgage pools to show a very low default rate, which reinforced the apparent validity of the framework that transformed subprime loans into investment grade securities. • A house of cards built on FICO scores and the capital markets “subprime machine.”

  6. So, Where are We Today? • Subprime mortgages represent $1.5 trillion (15%) of the $10 trillion residential mortgage market. • Alt-A represents another $500 billion (5%). • The prime market is 80% of the total residential mortgage market. • 50% of subprime mortgages are in ARMs, many of which reset in the next few years. • $600 billion to reset by the end of 2008 • Subprime mortgages are 5-6 times more likely to default than prime mortgages, even without considering the impact of resets to higher interest rate levels (on ARMs). • Subprime mortgage securitizations represent 42% of the U.S. ABS market – the largest chunk. • $600 billion in subprime originations in 2006, despite obvious signs of weakness in the housing market. Most of this (60%) was securitized. • Not easy to gear the capital markets machine down (previous slide)

  7. Total Subprime Originations

  8. Monthly ARM Resets – Next Few Years

  9. Mortgage Delinquency Rates Source: Federal Reserve Bank of Chicago

  10. Adjustable Rate Mortgage (ARM) Delinquency Rates Source: Federal Reserve Bank of Chicago

  11. Lessons? • Let the buyer beware – always! • At all levels of the food chain. • Be prepared for renewed regulatory/examination emphasis on credit quality standards. • Due in part (perhaps in large part) to the lax discipline on credit standards in recent years and the influence of the subprime capital markets machine in the last few years, we will be searching for the bottom in the housing and mortgage markets for some time to come. • Enhance your risk management (ERM) capability: make it more proactive, to foresee developments like the subprime meltdown coming, to identify and evaluate their impact on multiple risk categories, and to be a force for implementing evasive action.

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