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Why Did Subprime Loans Become Such a Big Deal?

Abraham ParkIntelligent people, including my wife, have been asking me questions about the subprime mortgage crisis. The point that seems to stump them is why a relatively small percentage of subprime mortgage defaults has led to a spiraling national credit crisis, how it happened, and where do we go from here. They were good questions, and if you are wondering the same thing, read on…

So what’s the deal with the subprime mortgage meltdown?

Well, imagine that the markets involved are analogous to a house with three stories. Each of the floors represent an industry related to the housing market and each of the upper stories are dependent on the one right below it.

The first floor represents the primary mortgage market (homeowners and their banks or mortgage lenders)

The second level represents the secondary mortgage market (where government-enabled agencies and private lenders by bundled bank mortgages)

The third represents the credit derivatives market (where securities created in the secondary mortgage market are pooled again with other debts and with various risk preferences)

The primary mortgage market is huge, but the second and third levels are just as huge. It makes for a pretty big meltdown when it all starts to unravel.

When did they start lowering standards for homebuyers?

A lot of changes happened about twenty years ago, when the Tax Reform Act of 1986 introduced interest deductions on mortgages for homes, making mortgage debt cheaper than consumer debt for many homeowners. In addition, there was a concerted effort in economic policy to increase the share of homeownership in America. As a result, since 1986, the housing market has experienced 20 years of continued price increases. Even through the recession of 2001, while labor and stock markets weakened, the housing market continued to thrive with high volumes and steady price increases.

And along with the housing boom came the growth of the mortgage lending industry. Subprime lending was made possible because of laws such as the Depository Institutions Deregulation and Monetary Control Act (1980) and the Alternative Mortgage Transaction Parity Act (1982), which gave lenders the ability to charge high rates and fees, as well as variable interest rates and balloon payments.

However, it wasn’t until 1994, when an increase in interest rates caused a drop in prime mortgages, that brokers and mortgage companies turned to the subprime market to maintain the volume. During these times, subprime mortgages were relatively new and the long-term performances of these loans were unknown. In 1995, the size of the subprime loan market was estimated around $65 billion, but by 2007, subprime mortgages accounted for $1.3 trillion out of a total of $10 trillion in outstanding mortgages.

But how could so many lenders originate such huge volumes of mortgages? Where do they get their money?

From the secondary market, or the second floor of our imaginary house analogy. Mortgages, if you think of them as a consumer good, can actually be bundled and sold. And the government (and some private companies) bought them. After the savings and loan crisis of the 1980s, with the infamous “maturity mismatch” problem of lenders using short-term deposits to fund long-term mortgages, mortgages became tougher to acquire. So the government enabled agencies like Ginnie Mae, Fannie Mae, and Freddie Mac, to buy bank mortgages in the secondary mortgage market, which gave mortgage lenders a way to replenish their funds so that they could in turn originate more mortgages.

These government agencies (and some private companies also) then turned around and issued securities based on these mortgage debts as collaterals. And global investors, who wanted to participate in the U.S. housing market, bought a lot of these types of securities. And since 1980, the volume of government-sponsored mortgage-backed securities has risen from $200 billion to over $4 trillion. In addition, private mortgage insurers and mortgage pools (which include nonconforming loans) account for approximately $2 trillion.

The secondary market was an incentive, then, for banks to issue more loans?

Precisely. With the securitization of loans, banks and mortgage lenders effectively became mortgage originating and servicing business, which meant that mortgage lenders profits were based on the volume of mortgage originations. Since there was a huge growing secondary market willing to buy repackaged mortgage products that were ultimately based on these mortgages, the effective size of the mortgage market became much bigger than the size of the mortgage originations.

Then why would the secondary market buy the subprime loans? Don’t they have standards?

From the mid 1990s, the growth in securitization (10% of mortgages securitized in 1980 while 60% securitized now) led to dramatic growth in subprime lending as well, and by 2007, 75% of all subprime mortgages were securitized.

Now, the reason why subprime loans were able to be repackaged and sold in the secondary market , was entirely due to the existence of credit ratings agencies, such as Moody’s and Standard & Poors. Although they provide no guarantees, there is an overwhelming and even reckless reliance by investors on these agencies to give accurate ratings.

Rating agencies measure the credit risk, which is also referred to as default risk. Professional credit risk managers spend theirs careers developing credit risk models, but most models are based on two fundamental concepts: default probability and recovery rate. Together, the default probability and recovery rate give a good measurement of a debt’s quality and are often referred as credit spread. Combining these factors with a measurement of how much the creditor would lose if the counterparty defaulted (credit exposure) on a given debt, companies can calculate the expected loss of any given obligation. Now when the credit rating agency gives a stamp of approval, the tendency is for investors to not look at the quality of the underlying mortgages.

If we go back to our 3-story house, the credit ratings agencies are like the columns that are holding up the building; the foundation on which the columns are grounded are the assumption, based on historical figures, that house prices will continue to rise as they have since 1986. So when the house prices fell….

Then the second floor came crashing down? What a mess!

But the second floor is nothing compared to the third floor. The third floor represents the credit derivatives market, in which securities created in the secondary mortgage market are in turn pooled again with other debts and sold as slices (known as tranches) with various risk preferences. Banks, securities houses, hedge funds, and insurance companies buy these credit derivative instruments, called structured finance products.

Everyone benefited from credit derivatives:

  1. Banks could transfer the credit risk of loans through these derivative products, while keeping the loan on its books
  2. Investors could enhance the credit risk of obligations by isolating the credit risk, pricing it, and transferring it to other investors; and
  3. Investors could diversify their risk with credit derivatives such as collateralized debt obligations (CDOs) or mortgages obligations (CMOs), which bundled together different types of credit risk and sold them as a portfolio product.

The frightening thing is that this third floor, though a relatively new development, is HUGE.

The credit derivatives market has had explosive growth only since the late 1990s. From $170 billion in 1997, currently the global credit derivatives market stands at estimated $20 trillion, surpassing the equity derivatives market and the corporate bond market. The CDO market alone is roughly $3 trillion—CDOs are useful because they can be used to dispose of high risk loans. Japanese banks used CDOs to clear up their loan books in the 1990s, as did Germany’s Dresdner Bank in 2003.

But who is holding this market together? You guessed it – the credit rating agency. It’s practically impossible for the investors in this market to understand or know the credit risk of the underlying securities when the underlying loans are pooled together from many different sources and are repackaged multiple times. So everyone just trusted the credit rating agencies to assign the appropriate risk rating.

How could they put so much trust in the rating agencies?

That is the biggest problem. Investors are interested in high returns, but only if they can trust the risk rating. Much of the global money has shifted away from the US stock market and into the real estate market since 2000 when the internet bubble burst. In the finance world, it’s all about risk-adjusted returns, and people don’t, or can’t, invest if risk can’t be accurately assessed.

So that is why the subprime debacle is a deeper problem than just these mortgages. It has revealed that the risk-pricing system by credit agencies is deeply suspect, which in turn has brought into suspicion not only subprime evaluations, but all other risk-based evaluations in the financial market.

Going back to the 3-story house analogy, imagine if the investors in the third floor realized that the columns have cracks in them (thus, risk of their investments were much higher than once believed). Not only would they want to shut down the third floor, they would want to exercise buyback provisions that permit investors to sell back loans that go bad within a specified period of time.

That’s how you get a case like Bear Sterns. Once everyone realizes that your underlying collateral is worth much less than expected because of the adjustments in credit ratings, the issuer is stuck with bad mortgages and the huge second and third floor activities suddenly freeze.

So what happens next? Are we going to buy a house this summer or not?

The problem was caused by credit rating agencies basing the credit risk of mortgages on the faulty assumption that the housing prices would continue to go up. So when house prices fell against expectations, all those industries we talked about suddenly found themselves on shaky foundations. Consequently, the secondary mortgage market participants are reducing mortgage purchases from the mortgage lenders, which means the mortgage lenders are stuck with bad mortgages. With liquidity dried up, mortgage lenders now have to tighten borrowing standards, which in turn causes house prices to fall even further. Potential disaster can be alleviated if the house prices start to go back up soon again. But I wouldn’t expect the house prices to turn up again any time soon, even though interest rates remain low.

The first order of priority, before expecting the house prices to rise, would be for the government and financial market participants to reevaluate the credit rating agencies, credit risk pricing models, and structured finance products in general. There is also the whole potential legal mess involving the mortgage insurers. It’s going to be a long road back.

As to buying a house, let’s wait.


Related in the Graziadio Business Report

Will the Sub-Prime Meltdown Burst the Housing Bubble? by Peggy J. Crawford, PhD, and Terry Young, PhD

Is the Real Estate Market a House of Cards? by Peggy J. Crawford, PhD, and Terry Young, PhD

The Book Corner Recommends: The Foreclosures.Com Guide to Making Huge Profits Investing in Preforeclosures without Selling Your Soul by Michael Kinsman, CPA, PhD

Author of the article
Abraham Park, PhD, Practitioner Faculty of Finance
Abraham Park, PhD, Practitioner Faculty of Finance
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