Shortsighted About the Subprime Disaster

The end to house-price appreciation has caused turmoil in the subprime mortgage market, as I discussed last week. The rise in delinquencies, defaults and foreclosures has been concentrated among appreciation-dependent mortgages -- those that work for borrowers only if their property values increase. A large proportion, but not all, of such mortgages are subprime, meaning they were made to borrowers with imperfect credit or insufficient cash for standard mortgages.

It's easy to understand why borrowers became caught up in the belief that house prices always rise, but lenders are supposed to know better. Why was the mortgage lending industry willing to make loans that were workable for the borrowers only if their properties rose in value?

Disaster myopia. In 1986, with my Wharton School colleague Richard Herring, I published an academic paper called "Disaster Myopia in International Banking." The paper set out to explain the international banking crisis of the early 1980s, but on rereading it recently, I realized that it also goes a long way toward explaining the current crisis in the subprime market.

The disaster-myopia thesis is that if potential shocks that can cause major losses to lenders occur infrequently, they will not be fully reflected in loan prices and conditions. If the market is competitive and some lenders are willing to discount the likelihood of a shock altogether, other lenders who might be inclined to be more cautious are forced to go along or lose market share.

In the mortgage market, disaster myopia meant basing mortgage prices and underwriting rules on the assumption that because house prices had risen for a long period, they would continue to rise. The cessation of price increases was thus a shock for which lenders were no better prepared than borrowers.

Disaster myopia was especially prevalent among aggressive subprime lenders, who could make a lot of money in a very short time as long as house prices kept rising. Other subprime lenders who might not be disaster-myopic were forced to operate as if they were, to remain competitive.

Underwriting requirements in the subprime market are set by the investment banks that buy the loans and package them as securities. While the investment banks may or may not have been disaster-myopic, the ones that were willing to accommodate the more aggressive lenders did more business (as long as house prices were rising) than those who insisted on maintaining more restrictive underwriting rules.

Rapid spread of mortgage market shocks. Almost all subprime mortgages are converted into mortgage-backed securities that are sold to investors. These securities are actively traded and are therefore under constant surveillance by investors, traders and rating agencies. Bad news about defaults surfaces quickly and is quickly reflected in lower market prices of securities. The value of loans in the pipeline -- on the way to being made into securities but not there yet -- also drops.

The rapidity with which the current crisis in the subprime market has spread marks a very important difference with the international banking crisis of the 1980s. The international banks kept almost all the "bad" international loans in their portfolios and used various stratagems for keeping the original values on their books unchanged.

This avoided widespread failures, but it also shut down the market for new loans.

In the subprime crisis, by contrast, much lender blood has been spilled, but the market for new loans has remained open.

Failures of subprime lenders. As of May 1, National Mortgage News, a trade publication, counted 32 subprime lenders that had become "defunct" since early 2006. The immediate cause of most of these failures was the reduction in the market value of the loans in their pipelines -- loans they had already purchased but not yet sold.

Lenders originate mortgages in preparation for sale mainly with borrowed funds; their capital is usually quite small. Most borrowed funds come from what are called "warehouse lenders," mainly large commercial and investment banks that protect themselves by requiring that the unsold mortgages be posted as collateral. When the value of the collateral drops, the account becomes "undermargined" and the warehouse lender asks for more collateral. If the decline in the value of the mortgages exceeds the capital of the subprime lender, the lender will be unable to comply and probably will be forced to shut its operations.

A marked deterioration in the payment experience of subprime borrowers poses a second threat to the solvency of subprime lenders. Under their arrangements with investment banks, lenders are required to repurchase loans that become delinquent within a few months after sale. The more aggressive the lender in pushing through marginal cases, the more buybacks they are likely to face. Collateral calls and buybacks are the major causes of lender failures.

Next Saturday, I will discuss whether loans are still available to subprime borrowers.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site, http://www.mtgprofessor.com.

Copyright 2007, Jack Guttentag

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