1. The Subprime Mortgage Industry: A reporter’s view Saskia Scholtes Financial Times Saskia.Scholtes@ft.com (212) 641 6605

2. The human side of the story: Skewed incentives drive bad decisions

3. The Actors Borrowers Lenders (originators & their brokers) Securitization bankers Rating agencies Investors Policymakers & regulators

4. The Borrowers INCENTIVES 1.“Flexible” mortgage products made it possible to stretch for the American Dream – owning your own home. 2.Speculation on rising house prices 3.Keeping up with the Jones

5. Borrowers made bad decisions: Believing that rising house prices would bail them out, some overextended Some chose the low teaser rates of ARM loans, believing they could refinance before the rate reset Some inflated their incomes on low or no-doc loans

6. But house prices can fall… Source: Office of Federal Housing Enterprise Oversight house price index

7. The price: losing your home

8. The Lenders (originators & their brokers) INCENTIVES 1.Brokers paid with yield-spread premiums 2.Higher origination volumes meant higher earnings 3.Competition (aka: Keeping up with the Jones)

9. Riding the lending boom…

10. …without a crash helmet The emphasis on volumes encouraged lenders to ignore “The Three Cs”: 1.Character 2.Capacity 3.Collateral & rely instead on automated underwriting based on FICO scores and zip codes

11. The price: EPDs & Bankruptcy When house price appreciation stalled, 1.borrowers began to default in the first few months of the loan 2.lenders faced repurchase demands for bad loans from Wall Street 3.Poorly capitalized lenders were forced out of business

12. New Century collapse

13. The Securitization Bankers INCENTIVES 1.Higher RMBS & CDO deal volumes meant higher earnings… and bigger bonuses 2.Originate & distribute model in theory meant that banks could avoid holding the risk 3.Competition (aka: Keeping up with the Jones)

14. Bear Stearns: Riding the lending boom…

15. Bankers made bad decisions 1.Banks did not closely examine the loans. When originators folded, bankers held “warehouses” of unsecuritized and poorly underwritten mortgages 2.As mortgage loans turned sour, and buyers for new bonds disappeared, so did the revenue stream 3.They didn’t distribute everything: >$150bn of writedowns so far

16. Credit crunch consequences: Bear Stearns for $2 a share

17. The Rating Agencies INCENTIVES 1.Higher RMBS & CDO deal rating volumes meant higher earnings 2.Rating agencies had an incentive to “help” deal structurers obtain the highest ratings 3.Competition (aka: Keeping up with the Jones)

18. A boon for the rating agencies

19. Rating agencies made bad decisions Over-reliance on historical data. “Flexible” mortgage products had never been offered to this group of borrowers before – the data was irrelevant Over-reliance on modeling, eg. continued house price appreciation was “baked into the cake”

20. The Investors INCENTIVES 1.Subprime MBS and CDO products provided yield in a low-yield world 2.And often came with AAA ratings 3.Competition (aka: Keeping up with the Jones)

21. Investors made bad decisions Over-reliance on ratings… 1.As a substitute for credit analysis 2.As a way to reach for yield, but maintain a “high quality” portfolio 3.In the belief that AAA also means “liquid trading instrument” that will not lose market value

22. Policymakers & regulators INCENTIVES Boosting home ownership regarded as good public policy

23. But it granted home loans to those who could not afford to repay

24. “The reality is that too aggressively pursuing a goal is perverse. It’s not good public policy to put people in homes they’re going to end up losing.” Dick Syron - CEO, Freddie Mac March 12, 2008