Originally Posted by donsutherland1

In an address to the New York Association for Business Economics, Federal Reserve Governor looked back at the financial scene on the eve of the explosion of defaults in the subprime mortgage market. “As recently as several months ago, some may have been tempted to believe that, in the realm of economic policy, we were on the precipice of the end of history,” he told his audience. After all, as he continued, “The seemingly benign financial and economic conditions of the past few years may have appeared to be approaching this nirvana.”

In August, the placid financial conditions gave way to a subprime mortgage-induced liquidity shock. Today, the ramifications of that event continue to play out in the form of reduced profit expectations for the financial sector, the prospect of slower economic growth, and the specter of widening exposure to the fallout of a continuing credit crunch. Its effects are likely to linger for another few years as adjustable rate mortgages continue to reset.

Upon closer examination of the issue, the emerging evidence reveals that a significant deterioration in lending practices was the primary cause of the subprime mortgage crisis. In the process, the cautionary lessons from past economic experience that might have limited the rapid growth in lending to subprime borrowers were ignored.

Four market principles are relevant:

• No market conditions are ever constant. Change is the norm. Assumptions and/or valuation models based on static market conditions increase one’s exposure to risk when market conditions change.
• Economic booms often give rise to bubbles. Prior to the 2000-2001 economic slowdown, a bubble developed in the Internet sector. On the eve of the subprime mortgage crisis, a bubble developed in the housing market with the sale price of homes rising well above the historic ratio to rents.
• A period of high returns can seduce investors and creditors into compromising their investing or lending standards.
• Market psychology can amplify market distortions, especially when marketplace reality increasingly diverges from previously rosy expectations.

The role of market psychology is particularly important. Robert Rubin explained:

Traders tend to assume that their positions will always be salable at very close to the last market price. When markets are doing reasonably well, they say, “Well, if I don’t like something I’ve bought, I’ll just kick it back out.” But when conditions deteriorate severely, liquidity diminishes enormously. Traders often can’t sell bad positions except at enormous discounts, and sometimes not at all. Then they may be forced to sell good positions to raise money. Thus, during periods of great market duress, investments can react in unexpected ways. Securities that have no logical relationship may suddenly move in tandem while securities that do have a logical relationship may diverge. Unexpected losses can develop rapidly and be huge.

As the housing bubble swelled with price-to-rent premiums exceeding historic valuations by more than 30% in numerous major markets, lenders and investors gave less and less thought to fundamental constraints such as risk and valuation. By 2006, almost two-thirds of all mortgage loans were made to individuals who previously would not have qualified for such loans. At the time, lenders and investors expected that housing prices would continue to rise and any borrowers who might face payments difficulties would readily be able to refinance under more favorable terms.

But what if the rise in housing prices slowed or even reversed? That scenario was seldom, if at all, considered by even some of the market’s most sophisticated financial institutions. Yet, to embrace such a posture required the fantastic assumption that housing prices could only head in one direction. That has never been the case in the U.S. or elsewhere. In all markets—equities, commodities, homes, etc.,—whenever prices have gotten far out of line with valuation fundamentals, either price increases slowed dramatically until over time the prices again reflected valuation fundamentals or “corrections” during which prices fell inevitably occurred. Given how out-of-line housing prices had soared, a “correction” would normally have had a fairly modest impact and would have been economically healthy for the long-run given that a volatile bubble would have been eliminated. But that was not the case. The “castle” of loans that had been constructed on the foundation of a bubble created a dangerous situation. As the bubble began to contract, that “castle” of loans crumbled and collapsed. Given the tendency of market psychology to sometimes swing to extremes, the subprime mortgage crisis induced a broader liquidity crunch.

A July 2007 IMF working paper authored by John Kiff and Paul Mills highlights the causes of the subprime mortgage crisis. In their paper entitled “Money for Nothing and Checks for Free: Recent Developments in U.S. Subprime Mortgage Markets,” they blame a combination of an “originate-to-distribute” lending model, deterioration in lending standards, and cooling of housing prices for inducing the subprime mortgage crisis.

The following excerpts highlight their assessment:

Until 2003, the majority of mortgage originations were “prime conforming” loans. These were then purchased by two government-sponsored housing enterprises (GSEs-Fannie Mae and Freddie Mac). However, by 2006, over hald of all originations did not meet the GSEs’ “conforming criteria.”

…The transformation of the market was such that, of 2006 originations, only 36 percent were conforming loans…

Recent subprime lending growth was boosted by more highly leveraged lending against a background of rapidly rising house prices. Housing affordability dropped to the point where a significant proportion of borrowers were financially overstretching via risky “affordability products,” with many apparently lying about their financial resources to get loans. Also, speculative borrowers obtained loans on the basis of expected collateral appreciation, with little account taken of their ability to make the requisite mortgage payments…

At the same time, strong investor appetite for higher-yielding securities in 2005-06 probably contributed to looser underwriting standards. Safeguards ensuring prudent lending were weakened by the combination of fee-driven remuneration at each stage of the securitization process and the dispersion of credit risk which weakened monitoring incentives. Hence, intermediaries were remunerated primarily by generation loan volume rather than quality, even as the credit spreads on the resulting securities shrank…

However, as interest rates rose and house prices flattened and then turned negative in a number of regions, many stretched borrowers were left with no choice but to default as prepayment and refinancing options were not feasible with little or no housing equity.

The working paper also explained how the “originate-to-distribute” model undermines lending quality:

The originate-to-distribute model is driven by fee generation, facilitated by risk dispersion and compartmentalization. The pursuit of fee income along the entire origination-to-funding chain brings with it potential incentive conflicts. For example, because few lenders retain the mortgages they originate, incentives for diligent underwriting and monitoring are diminished.

Finally, the working paper explains that additional subprime mortgages are likely to face interest rate “resets” through 2009. Hence, more subprime mortgage defaults are likely over the next few years.

This leaves policy makers with some crucial decisions:

• Should assistance be lent to affected homeowners who face foreclosure?
• Should a bailout package be prepared for affected lenders?
• Should the Federal Reserve preemptively seek to mitigate a broader liquidity crunch?
• Should new regulations be designed?

In my opinion, unless the situation reaches the point where it poses a genuine risk of a significant and prolonged economic shock (as opposed to a modest but temporary slowdown), the federal government should avoid direct intervention aimed at assisting either the affected homeowners or lenders and investors. To do so would only undermine the incentive for lenders and investors who are facing losses from defaults to renegotiate the terms of the loans with affected homeowners so as to limit the expected short-term losses. It is in the mutual interest of borrowers, lenders, and investors to work together to address the consequences of the bad lending that had taken place. For the longer-term, such assistance would merely lay the foundation for future bad lending practices. After having been insulated from marketplace risks, borrowers, lenders, and investors would come to expect future government intervention. Hence, as happened with the subprime mortgage crisis, they would pay insufficient attention to marketplace realities and tend to adopt the most favorable assumptions. In turn, borrowing and lending discipline would again deteriorate.

The Federal Reserve should consider the probability of a possible subprime mortgage-induced credit crunch, along with myriad other economic risks within its purview. Such an outlining of possible scenarios, estimating their likelihood, consideration of relevant historical events, and weighing of tradeoffs for possible policy options improves the quality of decision making and preparedness for possible contingencies that might emerge. The Fed’s assuring that broader financial markets remain sufficiently liquid is important to sustaining the nation’s economic growth. Considering the tradeoffs of policy approaches to achieving that outcome is essential to policy choices and implementation.

In past financial crises in Mexico and South Korea, market confidence was not fully restored unless robust structural reforms accompanied financial assistance. Structural reforms that address the insidious effects on lending quality posed by the “originate-to-distribute” model might be beneficial. For example, the “originate” angle might be tied to loan quality. Loans could be capped to reflect valuations of homes that are reasonably consistent with the historic price-to-rent relationship with increased down payments (from one’s assets not additional loans) being required to cover excessive price-to-rent differences. Those capable of making higher down payments are those who are less likely to default. New rules to ensure greater transparency and enhanced protection from unfair or deceptive lending practices could also facilitate better decision making.

To be sure, the more rigorous lending criteria would likely reduce the growth in U.S. homeownership. Yet, once the subprime mortgage crisis comes to a close, homeownership rates might well be where they would have been, but at the much higher price of the economic costs associated with the defaults and liquidity crunch that followed the collapse of the subprime mortgage market. In the long-run, prudent efforts to preclude bubble-based leverage could reduce overall economic risks and the spread of financial contagion through the increasingly integrated global financial marketplace.