# Presentation: 409166

## Securitization of Subprime MortgagesAn Empirical Analysis of the Loan Sale Decisions of Depository Institutions

**Paul Calem and Jonathan Liles**
**Freddie Mac**
**and**
**Christopher Henderson**
**Federal Reserve Bank of Philadelphia**
**August 20, 2008**
- The views expressed are those of the authors and do not represent official views of Freddie Mac, the Federal Reserve Bank of Philadelphia, or the Federal Reserve System
** **

## Securitization of Subprime Mortgages

- Banks have an incentive to securitize loans to reduce regulatory capital requirements, diversify funding sources, and limit concentrations of risk in the asset portfolio
- The prevailing view is that regulatory capital requirements are too high for most mortgage loans, giving financial institutions incentive to sell less risky loans to investors
- However, agency problems may impede the functioning of securitization markets
- Lenders may have private information enabling them to sell riskier loans into public markets

## Securitization of Subprime Mortgages

- This classic “lemons problem” may have been a factor affecting subprime (ABS) securitization
- The lemons problem, exacerbated by overly optimistic assessments by investors of the outlook for house prices and of credit risk, likely contributed to the recent subprime market collapse
- It may be a key factor influencing the extent and form of future recovery of the subprime market
- Such problems are mitigated in the prime (MBS) market due to:
- Standardized products
- Lower risk, less heterogeneous borrowers

## Research Objectives

- Explore the decision of depository institutions to sell or retain subprime mortgages during 2004-2006
- Use HMDA data merged with data from *LoanPerformance *on characteristics of the subprime market at the neighborhood (ZIP code) level
- Seek evidence on the extent to which regulatory arbitrage was a driver of subprime mortgage securitization
- Did banking institutions tend to sell higher-yield subprime mortgages, contrary to the conventional view?
- Seek evidence on “euphoria”  in the ABS market fueled by rapid house price appreciation in 2005 and 2006
- Did loan sale behavior change?

## Research Objectives

- Seek evidence on information asymmetries in the subprime securitization market
- Did banks sell higher risk subprime mortgages without fully signaling increased risk through higher asset yields?
- Explore the dimensions along which securitization transactions costs vary
- Are certain loan categories or types of institutions associated with greater likelihood of loan sale?

## Preview of Findings

- During 2004, banks were less likely to sell the higher risk subprime loans they originated (those with larger APR spread), consistent with regulatory capital arbitrage
- Subsequently, we observe a reversal of this relationship, consistent with euphoria-driven undervaluing of credit risk in ABS markets
- We obtain evidence suggestive of informational advantages of depository institutions
- For example, banks were more likely to sell loans associated with neighborhoods with high future default rates

## Preview of Findings

- Loan categories associated with higher transactions costs, such as very small loan sizes, exhibit reduced likelihood of loan sale
- HOEPA loans were comparatively likely to be retained

## Relevant Prior Literature

- Securitization and Agency Problems
- Akerlof (1970)
- Hill (1996)
- Demarzo and Duffie (1999)
- DeMarzo (2005)
- Loan Sales
- Samolyk (1989)
- Drucker and Puri (2007)

## Relevant Prior Literature

- Regulatory Capital Arbitrage and Mortgage Securitization
- Picker (1996)
- Jones (2000)
- Calem and LaCour-Little (2004)
- Ambrose, LaCour-Little, and Sanders (2004)
- Calem and Follain (2007)
- Subprime Mortgage Lending: General
- Apgar and Herbert (2006)
- Avery, Brevoort, and Canner (2006)
- Chomsisengphet and Pennington-Cross (2006)
- Smith (2007)

## Relevant Prior Literature

- Recent Developments in the Subprime Mortgage Market
- DiMartino and Duca (2007)
- Doms, Furlong, and Krainer (2007)
- Edmiston and Zalneraitis (2007)
- Federal Reserve Bank of San Francisco (2007)
- Gerardi, Shapiro, and Willen (2007)
- President’s Working Group on Financial Markets (2008)

## Relevant Prior Literature

- Subprime Mortgage Lending: Agency and Information Problems
- Alexander, Grimshaw, McQueen, and Slade (2002)
- Courchane, Surette, and Zorn (2004)
- Crews-Cutts and Van Order (2005)
- An and Bostic (2006)
- Golding, Green, and McManus (2008)
- Securitization of Subprime Mortgages
- DiMartino, Duca, and Rosenblum (2007)
- Ashcraft and Schuermann (2008)
- Keys, Mukherjee, Seru, and Vig (2008)
- Mian and Sufi (2008)

## Economic Factors Influencing the Loan Sale/Securitization Decision

- Regulatory capital
- Funding and liquidity
- Informational advantages of depository institutions
- Transactions costs
- Risk diversification
- Predatory lending risk

## Regulatory Capital Arbitrage

- Required regulatory capital exceeds economic capital for the credit risk of prime mortgages
- This creates an incentive to retain higher risk, subprime mortgages
- Regulatory supervision may bring some restraint to this incentive

## Funding and Liquidity

- A liquid securities market is a dependable source of funds for loan originations
- Euphoria among investors may bring “too much” liquidity into the market
- Particular risks may be unrecognized or undervalued by the market, generating increased loan sales by banks
- Euphoria fueled by rapid house price acceleration may have contributed to growth in subprime mortgage securitization during 2005-2006

## Informational Advantages of Depository Institutions

- Ties to local markets and relationships with borrowers
- Community banks are attentive to neighborhood conditions that could influence mortgage credit risk
- Even large, centralized organizations may develop such ties
- They monitor the profitability of branch networks and correspondent relationships
- They engage in community reinvestment activities
- More efficient use of information that is potentially also available to the securities market
- Banks may incorporate more local and regional economic data into their decision processes than aggregators/asset managers/investors

## Informational Advantages of Depository Institutions

- Superior controls around information processes due to better aligned incentives and regulatory supervision
- Model risk and other operational risks may receive greater attention from banks
- Banks may more consistently apply overrides to models in fast-growing segments for which the models may not be representative
- Hybrid ARM loans with initial, “teaser” margins
- Non-traditional products
- Loans with piggyback second liens
- ABS investors generally rely on rating agencies or other third parties, who may face conflicting incentives

## Transactions Costs

- Transactions costs include due diligence and legal expenses; costs associated with structuring and negotiating contract terms; and costs associated with sale of the security
- Fixed costs per loan included in an issue and fixed costs per issue imply higher transactions costs for smaller loans and smaller institutions

## Other Factors Influencing the Loan Sale/Securitization Decision

- Risk diversification
- Banking institutions, particularly smaller institutions, may sell loans to reduce concentrations of credit risk in the asset portfolio
- Banks may sell loans with particular duration characteristics as an interest rate risk management strategy
- Predatory lending risk
- Investors may be reluctant to touch HOEPA loans or other loans with very high interest rates or fees due to legal risks

## Data and Empirical Approach

- We analyze the disposition (retention vs. sale) of subprime loans originated during 2004-2006, using loan-level HMDA data
- The population is limited to loans originated by commercial banks, savings banks, and credit unions (depository institutions)
- Loans sold to an affiliated institution are excluded
- The population is limited to first lien, home purchase or refinance mortgages (amounts < $1,000,000)
- Subprime loans are defined to be “high cost” (having a HMDA-reported APR spread), or originated or purchased by a HUD-identified subprime specialist

## Data and Empirical Approach

- These data are merged at the tract-level with housing and mortgage market variables from several sources
- Aggregated tract-level characteristics from HMDA, such as percent of loans that are high cost
- Aggregate ZIP code level subprime market characteristics from LoanPerformance, such as percent of loans that are high LTV
- The data are transformed to tract-level by weighting proportionately across ZIP codes that overlap each Census tract
- Data are from the LoanPerformance Servicing (not Securities) database
- MSA house price appreciation (OFHEO index), and MSA housing starts (from economy.com)
- The number of owner-occupied units in the Census tract, from the 2000 U.S. Census

## Data and Empirical Approach

- We analyze the disposition of the loan in relation to the size of the APR spread and proxies for various dimensions of credit risk, along with a number of control variables
- The APR spread provides a direct test of regulatory capital arbitrage
- Regulatory capital arbitrage implies an inverse relationship between the APR spread (priced risk) and likelihood of sale
- A reversal of this relationship during 2005-2006 would suggest an impact of euphoria in the securitization market

## Data and Empirical Approach

- Along particular dimensions where banks have informational advantages, we expect likelihood of sale to increase with risk
- Variables used to assess bank informational advantages include:
- Loan for non-primary residence
- Ratio of loan amount to borrower income
- Local area house price appreciation rate

## Data and Empirical Approach

- Model 1: we test for bank informational advantages using a number of local mortgage and housing market variables
- Percent of loans in the Census tract that are subprime
- Percent of loans in the Census tract that are non-primary residence (investment property or second home)
- Percent of the Census tract’s subprime loans that are originated by subprime specialists
- Housing market depth (log number of tract owner occupied units)
- Local area percent change in housing starts
- Model 2: we test for informational advantages using the the future (third quarter 2007) default rate in the Census tract (in place of the above)

## Data and Empirical Approach

- We distinguish between home purchase and refinance
- Control variables include:
- Loan size
- Institution size
- Type of depository institution
- Thrift vs. commercial bank
- HUD-identified subprime specialist
- Metropolitan area dummy variable
- Percent of tract subprime loans that are junior lien
- Percent of tract subprime loans that are high LTV (LTV  90)

## Overview of the Data: Sample Size

## Overview of the Data: Disposition of Home Purchase Loans

## Overview of the Data: Disposition of Refinance Loans

## Overview of the Data: Structure of the Loan Origination Market

## Overview of the Data: Structure of the Loan Origination Market

## Overview of the Data: Structure of the Loan Origination Market

## Overview of the Data: APR Spreads

## Market Context: Interest Rate Trends

**Source: Federal Reserve Bank of St. Louis**

## Overview of the Data: APR Spreads

## Overview of the Data: Product Type

## Overview of the Data: Documentation Level, LTV, and FICO

## Market Context: Piggyback Lending Trends

**Source: HMDA data with matched first/second liens obtained from Federal Reserve Board**

## Overview of the Data: Ratio of Loan Amount to Income

## Overview of the Data: Average Loan Size

## Overview of the Data: Investor Loans (non-primary residence)

## Overview of the Data: Housing Market Conditions

## Empirical Results

- Model 1: tract-level variables proxy for localized informational advantages
- Model 2: future default rate in tract proxies for localized informational advantages
- Estimated separately for home purchase and refinance in 2004, 2005, and 2006

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## Slide 43

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## Slide 45

## Empirical Results: Shifting Relationship to APR Spread

- Likelihood of sale declines with APR spread in 2004, consistent with regulatory capital arbitrage
- Likelihood of sale generally increases with APR spread in 2005 and 2006, consistent with undervaluing of credit risk in ABS markets

## Empirical Results: Shifting Relationship to APR Spread

## Empirical Results: Bank Informational Advantages

- Likelihood of sale is inversely related to local area house price appreciation and percent change in housing starts
- Suggests that banks may incorporate more local and regional economic data into their decision processes than aggregators/asset managers/investors
- Home purchase in 2006 is exception

## Empirical Results: Bank Informational Advantages

- Loans for non-primary residence are less likely to be sold
- Consistent with relationship lending or with specialized  information regarding local investment opportunities
- Refinance in 2006 is exception
- Likelihood of sale increases with ratio of loan amount to borrower income
- Consistent with more cautious assessment of debt payment capacity (model overrides)

## Empirical Results: Bank Informational Advantages

- Likelihood of sale increases with:
- Percent of tract loans that are subprime
- Percent of tract loans that are non-primary residence
- Percent of tract subprime loans that are originated by subprime specialists
- Consistent with asymmetric information concerning neighborhood risk factors
- Alternatively, to the extent that borrowers with similar risk profiles tend to cluster geographically, may reflect asymmetric information concerning borrower-specific risks

## Empirical Results: Bank Informational Advantages

- For home purchase loans, likelihood of sale is inversely related to number of owner occupied units in neighborhood
- Consistent with superior information regarding appraisal accuracy
- In model 2, a higher neighborhood delinquency rate *ex-post *(in Q3 2007) is associated with increased likelihood of sale

## Other Empirical Results

- Likelihood of sale increases with percent of tract subprime loans that are junior lien
- Likelihood of sale increases with percent of tract subprime loans that are high LTV (only for home purchase loans)
- Likelihood of sale reduced for HOEPA loans and those in the highest APR spread category
- Consistent with legal risks

## Other Empirical Results

- Large home purchase loans are less likely to be sold
- Very small loans are less likely to be sold
- Fixed transactions costs per securitization
- Very small institutions tend not to sell
- Fixed costs associated with access to securities market or other loan sale channels
- Loans outside metro areas less likely to be sold

## Other Empirical Results

- Purchase and refinance loans exhibit somewhat different patterns of loan disposition in relation to type and size of institution
- May reflect differing diversification requirements; differing roles of  relationship lending

## Robustness

- Results (models 1 and 2) are robust to:
- Adding dummy variables for Census Divisions
- Including observations with missing income (setting the loan-to-income ratio=0 and using a dummy variable)
- Excluding loans sold to other depository institutions
- Any of these changes has little impact on sign, magnitude, or statistical significance of other variables

## Robustness

- Model 1 is robust to inclusion of additional ZIP-code level measures of subprime market composition
- Product mix
- Percent of tract subprime loans that are to lower FICO borrowers (FICO score < 620)
- Including these has little impact on sign, magnitude, or statistical significance of other variables
- No consistent relationship to loan disposition observed for any of these

## Robustness

- Model 1 is robust to excluding the measures of subprime market composition from LoanPerformance data
- Using either the full HMDA sample before merging with LoanPerformance data, or the smaller merged sample
- Model 2 is robust to excluding the tract-level control variables

## Conclusions

- We obtain evidence suggestive of euphoria-driven undervaluing of credit risk in ABS markets during 2005-06
- In 2004, depository institutions were less likely to sell subprime loans with larger APR spreads, consistent with regulatory capital arbitrage
- In 2005-06, we observe a reversal of this relationship
- We also obtain evidence suggestive of informational advantages of depository institutions
- Likelihood of sale increases with ratio of loan amount to borrower income
- Likelihood of sale related to a variety of neighborhood risk factors

## Conclusions

- Some caveats apply
- Relationship between loan disposition and APR spread may have been affected by shifting yield curve
- We  cannot observe whether banks offered greater credit enhancements on riskier loans