Origins and causes of the subprime mortgage crisis

Subprime Mortgage Crisis

Origin and Evolution

Sources of the Subprime Mortgage Crisis

Why Did Mortgage Lenders Lend to Subprime Customers?

What about the Ratings Agencies?

Buyers of the Securities -- why did they do it?

This paper covers the subprime mortgage crisis' key questions: why and how did it begin? Why didn't such a crisis occur in the past in this way? What exacerbated the subprime mortgage crisis once it started? Are we at a low point, and things will start to look better from now on, or are there additional shocks to our economic system which will continue to reverberate from the subprime mortgage crisis of recent years?

The primary thesis of this paper is that the subprime mortgage crisis is at or near the low point, and that the U.S. And OUS economies will improve over time. The secondary thesis is that the primary causes may continue to reverberate through the system as many of the lenders who contributed to the crisis have been bailed out through government action. As a result, the theory of "moral hazard" has come into play, and suggests that future such crises could erupt in the U.S. Or elsewhere, as not enough 'bad' investors have been cleaned out of the markets.

Literature Review

The Economist warned of an impending implosion of housing values for a number of years. By several measures, U.S. housing prices were rising faster than long-term inflation, incomes, rents and the ability of most Americans to pay for their mortgages. In 2005, the Economist reported in "The Global Housing Boom" that "Never before have real house prices risen so fast, for so long, in so many countries (Economist, 2005). This followed their warnings in 2003 that house prices are too high (Economist, Cracks in the Brickwork, 2003). The thesis advanced by the Economist is that Americans were living beyond their means, propped up by an unsustainable run-up in housing values, for which they could borrow against home equity with tax-advantaged equity loans.

The Wall Street Journal warned that housing prices and associated mortgages were growing at an alarming rate as far back as the late 1990's. The primary concern was that housing prices were climbing faster than incomes, which was clearly unsustainable over the long-term.

Greenspan stayed quiet after his retirement at the head of the Federal Reserve until late in 2007. He said that the subprime crisis was "an accident waiting to happen." He went on to say that the subprime mortgage crisis was only one of several potential housing-related crises just waiting to happen, and that if it weren't in the U.S. subprime market, it could be another housing-related crisis elsewhere in the world:

Sharply rising home prices erupted into major housing bubbles world-wide, Japan and Germany (for differing reasons) being the only principal exceptions. The Economist's surveys document the remarkable convergence of more than 20 individual nations' house price rises during the past decade. U.S. price gains, at their peak, were no more than average (Greenspan, 2007).

The roots of the subprime and related mortgage crises were laid in the 1990's. According to "The Global Financial System," issued by three Harvard Business School professors, the emerging securitization of home mortgages and the globalization of the investor base resulted in a divorcing of the link between the borrower and the lender (Froot, 1995). This book foresaw the future of the crises which was brought on by securitization.

The business press is particularly conscious of the need to expose excesses of the subprime mortgage crisis, but is relatively late to the game. Fortune and Forbes were early to explore the problems with "junk bonds" in the mid-1990's, but have come later to the game this time. Fortune explored "junk mortgages" late last year (Sloan, 2007), and Forbes referred to the "liquidity crisis" that was the longer-term concern of the subprime mortgage mess, meaning that there was a danger that lending institutions would close their doors to new loans, thus reducing liquidity and the pace of economic investment in a similar way that the Fed throttled back monetary supply by 1/3rd in the two years after the start of the Great Depression (Kaarlgard, 2007) (Friedman, 1961).

Sources of the Subprime Mortgage Crisis

What caused the subprime mortgage crisis, and how big a part of the overall picture is it? Subprime mortgages represented only 5.4% of the $2 trillion U.S. mortgage market, while by 2006, that amount climbed to over 20% for the year (Louis, 2007). By early 2007, about 10% of those subprime loans were delinquent (overdue by at least 60 days). That means that approximately 10% of the preceding 7 years' subprime mortgages, or about 1-2% of all mortgages, were delinquent. This is not a large number in a robust market, but the move was exacerbated by two concomitant events: the interest rates upon which ARM's (adjustable rate mortgages) were calculated were starting to hit below-market-rate mortgage loans made 2-3 years earlier, and the concern over lending started to hit the real estate market, causing a dip in housing prices.

Why did subprime mortgages climb so quickly in this decade? The securitization trend, which started in the 1980's, accelerated in the 1990's and in this decade. Securitization was done in two steps: (1) local banks and savings and loans, which had been the primary mortgage-holder in past booms, decided that they could make more money by bundling the mortgage obligations which they contracted and giving them to money-center investment bankers to create a grouping of like mortgages as "securitized assets" with the underlying mortgage payments and asset values of the houses as collateral. The (2) next event was the 'stripping' of mortgages into their component parts, some with higher risk but higher potential returns, others supposedly less risky (Lehnert, 2005). Interest volatility could be captured in higher-risk interest-only instruments, while underlying mortgage payments could be sold at some small risk premium below the underlying net present value of their future cash flows.

While U.S. housing prices were increasing, many of the mortgages which were offered were 'rescued' by the higher underlying value of the mortgaged asset. If a homeowner was unable to keep up with his/her payments (lost job, income lower than expected), he/she could go back to the mortgage well with a refinancing or an equity loan against the increased value of the house.

The subprime portion of the mortgage market meanwhile grew at a faster pace than the overall market. Mortgages are "subprime" due to several factors, but chiefly because the mortgagees are poor credit risks due to (1) self-declared (but not verified) income, (2) lower credit ratings than those usually able to get mortgages, or (3) not qualifying according to their income to the amount that they were borrowing. The last of these three factors -- inability to cover mortgages with income -- was dealt with through "teaser" rates which gave the mortgagees two to three years of below-market mortgage rates through what was termed a "reverse" mortgage. In a traditional mortgage, the principal declines every month, as full interest and a small but increasing portion of the principal is included in the monthly payment. In a reverse mortgage, the principal owed actually increases, as the monthly mortgage payment is less than the total interest at market rates. As a result, the principal in the home increases.

These rates are called "teaser" rates because no mortgagor can maintain a below-market rate for more than two or three years. At some point, the mortgage payment must rise to market rates. The typical terms were 2 to 3 years at below-market interest rates, or with "negative equity" payments, then a 'catch-up' provision which brought the interest and principal payments back to a market level. Many subprime mortgages included ARM's -- adjustable rate mortgages -- which were tied typically to the Federal Funds Rate or the Prime Rate at the time of the resetting of interest rates. Since the Fed started raising rates from historically low rates in 2004, many of the rates set at that time were "time bombs," which would increase after the two- to three-year time delay.

Federal Funds Rate: Climbing since 2004 (Hewitt, 2007)

Three elements therefore combined in 2007 to create a 'perfect storm' for the 10-20% of those who had taken out subprime mortgages:

1. The ARM mortgages were reset at much higher interest rates. This is because many of the mortgages which had been set in 2004 finally came due for a reevaluation, and mortgage rates in the interim had climbed significantly.

2. Negative equity loans were converted to market terms. As mortgage brokers, builders and banks had aggressively pursued a hot mortgage market in 2002-2005, they had offered many below-market 'teaser' rates which persuaded those who could not truly afford the level of house to sign mortgage documents and commit to 'balloon' or rising house payments.

3. Those that were unable or unwilling to pay were revealed when their costs rose significantly. Since subprime mortgagees were, by definition, self-declared income earners (meaning that there was a greater chance that their incomes were below that which they declared) and were generally poor credit risks based on previous history, they were the first likely defaulters on mortgages.

Existing Home Sales

These sales peaked in 2005, however, and started to decline. This led to the opposite of the home sales expansion, with a subsequent decline in revenues for mortgage brokers, bankers and investment bankers.

Since the brokers and bankers made their money on the transaction, they held no responsibility longer-term to assure the continued quality of the underlying assets -- the homes and the mortgage payments -- would remain high.

What about the Ratings Agencies?

The three major ratings agencies, Fitch, Moody's and S&P, were competing for a share of the credit rating business. These firms had chiefly made their money in the past by rating municipal bonds. This was a lucrative but low-margin, low-growth business. Each of the credit rating agencies saw mortgages -- particularly subprime mortgage aggregates -- as a way to earn increased margins in a growing industry. These are private institutions, however, which generate revenue by the number of ratings that they issue. Their bills are paid as a part of the issuance of the collateralized mortgage securities: i.e. The more securities they rated, the more money they made. Since the investment bankers (who had an incentive to increase their number of transactions) rewarded the ratings agency contracts, they would not go to a ratings agency that gave relatively few "investment grade" ratings to their securities. If any of the three were to suddenly grow more conservative, that ratings group would quickly lose market share and revenues.

That these ratings agencies were too lax is evident in their recent statements that they did not cause the 'mortgage mess.' They are under fire from Congress for their inability to give objective ratings of their securities:

Democratic and Republican senators said they were particularly concerned with a key aspect of the agencies' business models: they get paid by the companies whose bonds they rate. That's like a film production company paying a critic to review a movie, and then using that review in its advertising, Sen. Jim Bunning, R-Ky., said. (AP, 2007)

At the same hearing, Michael Kanef, a managing director at Moody's, agreed with the senators that their employees should not be allowed to go directly to mortgage investment banking houses. This is a clear statement that conflicts of interest have existed for some period of time.

Buyers of the Securities -- why did they do it?

The buyers also changed over time. In the days when banks and S&L have held the 'paper,' they knew their customers. The mortgage-backed securities were generally sold to U.S. investment houses which understood the risks and were able to judge the quality of the loan packages. In this decade, a decided increase in foreign buyers changed the ability of the buyers to judge the quality of what they were buying. Relative interest rates and returns on investment were low in Europe and Far East Asia; subprime mortgages in the U.S. seemed to offer a higher premium for a low perceived risk. Splitting the mortgages into discreet elements -- some higher-risk interest-related securities and some cash-flow oriented securities, seemed to give those foreign investors an even better return. The world was awash in dollars as the U.S. continued to run a significant balance-of-trade deficit, which meant that a lot of governments and foreign individuals held dollar assets. The combination of readily-available dollars and a relatively low perception of risk for high-return subprime securities in the U.S. combined with a lack of knowledge of the marketplace and the quality of the underlying assets to create an opportunity for fraud or incompetence.

Conclusion

Was the present subprime mortgage crisis a one-time 'perfect storm,' which will never occur again? Part of the answer relies on what structural changes will be made to the U.S. And international markets for housing mortgages. One can make a pessimistic scenario:

Moral hazard' has not hit this market in the way that it would if the U.S. And other sovereign treasuries had not intervened to pour in liquidity. Thus many investors who should have learned their lessons were bailed out by government action.

Packaging of mortgages has not abated, although it has fallen back with the current skittishness of global markets related to subprime and other mortgage prices. Once housing prices start to rise again, there is no assurance that mortgage packages won't again flood the market.

The world is still awash in cash -- and the U.S. still offers outsize returns as compared to other areas in the world.

On the other hand, there may be some cause for a rethinking of the mortgage crisis. If politicians in the U.S. decide to impose conditions on rating agencies, or instill SEC-like oversight, they could create a fairer judgment of the underlying credit quality of the mortgage-backed securities.

One could argue that mortgages and housing prices are cyclical, and each new generation must learn the lessons of valuing assets. If the U.S. And other governments step in to 'clean up' the market that does not mean that the enterprising global markets won't find another way to hit a depressive period in the future.