March 2007

Mortgage Credit and Subprime Lending: Implications of a Deflating Bubble

Cosponsored by Professional Risk Managers' International Association

Over the last decade, the U.S. housing market has experienced an unprecedented increase in housing values and credit availability, particularly in the area known as "subprime" lending for buyers with less-than-perfect credit. In the last two years, according to the comptroller of the currency, 20 percent of all mortgage originations have been subprime. In 2006, 40 percent of all interest-only and payment-option adjustable-rate mortgages (ARMs) were also subprime. Furthermore, many of these subprime loans have been packaged into collateralized debt instruments and sold to investors, often with banks and hedge funds providing enhancements regarding loan defaults.
 
What are the trends in the mortgage-credit sector, and what will their implications be for the U.S. economy? What will happen to credit markets, particularly to securities originating from subprime loans, and to the U.S. economy if even moderately pessimistic predictions about the real-estate sector come to pass? Did the "democratization of credit" over the past decade go too far? What are the credit and market-risk implications--to banks, hedge funds, and investors--of a sharp correction in residential real-estate values in the United States?

At a March 28 AEI conference, Nouriel Roubini, Desmond Lachman, Thomas Zimmerman, and R. Christopher Whalen discussed these and other questions. Alex J. Pollock was the moderator.

Desmond Lachman
AEI

While many commentators have suggested that the worst of the subprime lending crisis is behind us, it is more likely that the problem is just beginning, and the situation will probably have negative repercussions for the U.S. economy. Several factors contributed to the housing bubble and increase in subprime lending. First, after the NASDAQ bubble burst in 2000, the Federal Reserve lowered interest rates to 1 percent by 2003 and held rates at abnormally low levels for a sustained amount of time. There was an increase in the use of exotic instruments like ARMs and negative amortization loans, and lenders reduced their credit standards, permitting a boom in subprime and "Alt-A" mortgages, which in 2006 accounted for around 35 percent of new mortgages, up from 10 percent in 2002. In addition, more people began to speculate on real estate. In 2005, 28 percent of home purchases were done for investment purposes, well above the historical average of 12 percent. Yet as a result of this rapid housing expansion, the U.S. housing market now faces an excess supply, and prices have begun to fall. Also, the Fed has normalized interest rates at 5.25 percent, and demand for housing has fallen. The result of all this has been an increase in mortgage delinquencies and foreclosures, and thirty mortgage lenders have been forced to shut down. This housing downturn will affect the economy directly through a decrease in housing construction, and indirectly by reducing household savings and consumption. A high number of defaults on housing loans could also create problems for the financial sector.

Nouriel Roubini
New York University

Commentators have claimed that the ills of the subprime housing market will be contained to that sector of the economy and that there will be no effect on other sectors. Experience and data, however, show that these predictions are likely false. First, there has been an increase in subprime lending beyond the housing market, including millions of subprime credit cards and auto loans, with the latter now experiencing an increase in default rates. In a typical housing recession, housing starts tend to drop by 50 to 60 percent, but currently they have only dropped by 30 percent so far. There is a glut of houses and prices are going down. This could be the worse housing recession in over forty years. Moreover, it will go beyond the subprime loans, since exotic instruments like zero down-payment loans, "liar loans," interest-payment-only loans, and negative amortization have been used for non-subprime mortgages. Lenders are becoming stricter about their standards, which will cause a credit crunch. Also, massive losses in the collateralized debt obligation market mean that the financing basis of the mortgage market could collapse. Furthermore, the recession will be made worse by a fall in aggregate consumption, caused by job losses in housing construction, manufacturing, and the automobile industry, and the fact that for the past several years, many Americans have consumed by borrowing against their homes. But now that prices are falling, this option is no longer available. Finally, until the economy works through the oversupply of houses, intervention by the Fed will not prompt a recovery, and the economy therefore cannot avoid a hard landing.

R. Christopher Whalen
Institutional Risk Analytics

For the past decade, mortgage default rates have been well below the long-term average; in fact, it is likely that 2006 will be at the trough for default rates for the following years. During the past several years, the major subprime lenders have indicated that their mortgage portfolios contain little risk. This is alarming because it implies that these lenders have sold many of these subprime mortgages to hedge funds and other investors, thereby disseminating the risk throughout the market. Therefore, while certain commentators have claimed that pending subprime defaults will only impact the housing finance sector of the economy, the reality is that these mortgage defaults will affect the U.S. financial system.

Thomas Zimmerman
UBS Investment Bank

Today, we are seeing the beginnings of the painful correction that always follows bull market enthusiasm, a correction foreseeable since 2005. Not only will homeowners be hurt by the depreciation in housing prices, but the subprime originators and banks will too, and the effects of this housing bust will spread to other sectors of the economy. During the past seven or eight years, housing appreciation has been strong and default rates have been exceptionally low, but now that appreciation rates are falling, defaults will increase substantially. By mid-2006, early pay defaults, in which a borrower fails to make either his first, second, or third payment, went from accounting for one percent of loans to seven or eight percent, and this is what finally brought on the subprime bust. ARMs, like 2/28s and 3/27s, when rates go up after the first two or three years, were not well suited for subprime borrowers, many of whom could not afford the adjusted interest rates Moreover, many lenders who approved subprime mortgages required little documentation of the borrowers' income (low-doc or "liar" loans). Finally, although there is a downside of the subprime debt being spread throughout the economy--affecting more people than those directly involved in the housing market--the good news is that the debt is spread very widely. Furthermore, about half the subprime debt such as that bought by Fannie Mae and Freddie Mac is in securities which will retain a triple-A rating. People owning these mortgage-backed securities will not suffer the consequences of the higher default rates.

AEI research assistant Daniel Geary prepared this summary.