Issue: 87
Sent: 30-10-2007 13:02:37
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The Sub Prime Debacle - Part 2 - Lester Wills
Last time I started to consider the sub prime debacle and examine how we got to this position. In order to understand how things came to pass it is necessary to backtrack slightly look at how the mortgage system used to work.
Professor Wachter from Wharton provides a very useful roadmap of the global mortgage system which I will use as a basis of my summary: As she explains, up until the 1980s, mortgages were heavily regulated as providers which drew on depositors' savings in order to offer mortgages. In the 1980s saw the freeing up of capital.
Many countries opened their mortgage markets and as a result modern housing finance emerged with funding increasingly supplied through market-oriented commercial banks. This occurred at a time when interest rates were on a massive downward trend as the average prime interest rate for 13 industrialized countries fell from 15% to 4.4%.
This meant that people were able to borrow more and bid up house prices contributing to the subsequent boom in house prices.
A similar approach developed in Australia as lenders flooded into the market during the 1990s. Such companies were able to borrow money cheaply and lend it again through mortgages at substantially higher rates. As Wachter points out mortgage backed securities were a good bet as Australian borrowers had very low default rates.
Strange as it may seem, the real basis of today's problems are to be found in the Depression of the 1930s.
As Wachter explains, before the 1930s, American mortgages had variable interest rates and down payments of at least 50%. Homeowners usually renegotiated their loans every 12 months. Borrowers' payments covered interest only, with principal paid off with balloon payments, usually after less than five years. Most of the loans were either funded by savings and loans that drew on savers' deposits, or by mortgage bankers using funds invested by insurance companies.
Unfortunately with the depression, many homeowners were unable to meet their balloon payments leading to large numbers of forced sales and foreclosures. The Federal Government helped out and set up the Federal Housing Administration (Fannie Mae) to insure long-term mortgages and the Home Owners Loan Corporation to sell government bonds tom purchase non-performing mortgages.
This was the early stages of securitization where lending risk was passed on to investors in mortgage backed bonds rather than being held by the institution that originated the loan.
The system worked well until the 1970s when short-term interest rates went through the roof causing the yield curve inverted. Some may recall the S&L crisis of the 70s where many such companies became insolvent as they were paying more to borrow than they were receiving on the long-term fixed rate loans they had already issued. Variable rate mortgages would have solved this problem but the Federal Government had previously banned such instruments in order 'to protect homeowners'. Needless to say, new laws were passed removing such restrictions.
Now the geeks and academia moved into the picture.
The new generation of computer whizzes (no doubt many of them MBAs) and academics used more and more powerful computers to analyse risk. Not only that they were able to accurately forecast the numbers of borrowers who would default if interest rates rose and how many would refinance if interest rates fell. This was important as these two events can undermine the value of mortgage-backed securities.
As a result, during the 1990s private label securities were issued by range of non-government backed entities. Whilst these were similar to government-backed securities, they of course did not have any government guarantee to protect against unexpectedly high default rates.
This meant that the pieces were almost all in place. The thirst for high returns provided the impetus for the final piece of the jigsaw.
These new mortgage back securities initially used 'prime' mortgages issued to low risk borrowers. However, seeing as how the system worked so well, it was not long before such securities were used to back jumbo loans that the more 'conventional' lenders would not consider. It was only a short step to using this approach to back sub-prime loans to borrowers with poor credit histories.
The move was on the generate loans almost at 'any cost'. In essence, low doc loans became no doc loans as the risk was being passed on to someone else. Meanwhile the originators happily pocketed their commissions (sounds a bit like the pension miss-selling debacle in the UK).
This market grew from half a billion in 2003 to well over a trillion in just 2 years as investors were eager to buy securities offering higher yields. Unfortunately there seems to have been little understanding of the credit risk, i.e. the risk that the borrowers would stop paying their mortgage as soaring house prices conveniently hid any such problem.
Remember what Gordon Geko said in the film Wall Street?
Sadly, just as the directors of Baring found out, when returns are good, it does not mean there is no risk something that once again seems to have been forgotten.
More next time.
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