Knowledge@Wharton Finance and Investment Research Article

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When mortgage default rates started to climb earlier this year, many experts thought the damage would be confined to the minority of issuers that had binged on subprime lending.

It's turning out much worse. Consumer spending is off, the credit crunch is spreading, the housing market is in a slump and the stock market has been shaken.

The economy is so threatened that the Federal Reserve set aside its worries about inflation and on September 18 cut short-term interest rates by half a percentage point for the first time in four years, hoping a shot of stimulus would head off a recession. The Fed pointed to worries about "tightening of credit conditions" that could deepen the drop in housing prices and the recent pullback in homebuilding.

Six or eight months ago, few experts thought the subprime fallout would be this bad. "It's the realization of my worst nightmares, the extent of the negative impacts on the rest of the economy," Susan M. Wachter, professor of real estate and finance at Wharton, said in an interview several days before the Fed action. "The degree and the extent of the harm done were not expected. It surprised me. But the fact that this would end badly was not surprising."

Downturns in the mortgage and housing markets have caused economic problems before, but the current situation is the first of its kind, underscoring the profound changes in these markets, she said. "In the past, these kinds of events have led to downturns in the overall economy through a credit crunch in the banking sector. This will be the first time it is through a credit crunch in the non-banking sector of finance, if it happens."

At the root of the subprime problem is a new class of specialized mortgage lender that has emerged in recent years to operate free of the regulations affecting traditional banks. In the mid-1970s, traditional institutions such as savings and loans had nearly 60% of the mortgage market. Now that stands at about 10%. Over the same period, commercial banks' share has grown from virtually nothing to about 40%.

Many of the new lenders specialize in loans to borrowers who could not qualify for traditional mortgages because of poor credit or low incomes. And they have passed the risk on to investors around the world who are eager to buy mortgage-backed securities carrying higher yields than those offered by safer investments such as U.S. Treasury bonds.

Mortgage-backed securities are created by assembling thousands of loans into bundles and creating a series of bonds that pass borrowers' principal and interest payments on to the bond owners. Typically, there is a series of bonds of increasing degrees of risk reflecting the borrowers' creditworthiness. The riskier bonds pay the highest yields but are the first to lose value if borrowers fall behind in payments.

Many subprime loans have adjustable interest rates: They typically change every year by adding a fixed margin to an underlying rate such as the yield on one-year U.S. Treasury bills. Between 2003 and early 2007, one-year Treasury rates rose to about 5% from just over 1.25%. As a result, borrowers are now facing steep increases in monthly payments as prevailing interest rates rise. That has led to growing defaults and losses for bondholders.

"Things are unraveling faster, and to a degree that we did not expect," Wachter said, adding, "It is clear that nobody knows who owns the toxic waste portion" -- a reference to the riskiest bonds. "The fact that it is so widely dispersed has made it even worse because many investment funds are suspect."

In a new paper, "The Housing Finance Revolution", Wachter traces the evolution of the home-financing market over the decades, explaining how technology, deregulation, globalization in financial markets and a world-wide decline in interest rates have produced the current crisis. Her co-author is Richard K. Green, professor of finance and economics at George Washington University.

A Global Tour of Mortgage Lending

Worldwide, the trend has been to move away from government control of mortgage lending and toward various systems of financing through the capital markets, Wachter and Green say.

Prior to the 1980s, for example, mortgages in the United Kingdom were provided through heavily regulated "building societies" which drew on depositors' savings and offered mortgages at below-market interest rates, shielding the mortgage market from changes in market rates. That changed with the Building Society Act of 1986, which leveled the playing field between the building societies and commercial banks. By 2000, building societies provided only 15% of mortgages, down from 70% in 1980.

Many other European countries opened their mortgage markets to competition in similar ways during the 1980s. "From heavily regulated and rationed systems, modern housing finance emerged with funding increasingly supplied through market-oriented commercial banks...," Wachter and Green write. "The result has been an explosion of mortgage growth throughout Europe...."

Falling interest rates contributed to the boom in mortgage lending by making homes more affordable. From 1980 through 2004, the average prime interest rate for 13 industrialized countries fell from 15% to 4.4%, Wachter and Green say. Low interest rates also allow people to borrow more, allowing them to bid up home prices.

Change has reached even the most undeveloped economies. Wachter and Green note that in Bangladesh, mortgages were generally available only through the government-owned and funded Housing Building Finance Corp. until five or six years ago. Bureaucrats issued mortgages with little thought of borrowers' ability to pay, and typically 20% of borrowers were behind in payments at any given time, a very high rate.

A few years ago, the government stopped funding the BHBFC, and now three-quarters of the market has been taken over by private institutions that use underwriting standards and other modern loan-management techniques.

Similarly, mortgage lending stayed in government hands in South Korea through the middle of the 1990s, despite that country's growing economic size and sophistication. Loans were hard to get and usually covered only a portion of the cost of buying a home. Reform after the Asian financial crisis of 1998 introduced some market-driven features and led to a rapid growth of the mortgage market, though the system still has undesirable features. "Loans generally have very low loan-to-value ratios, variable rates of interest and balloon payments," the authors write. Some Korean policy makers think the solution is securitization -- creation of mortgage-backed-securities for sale to investors -- rather than relying on savers' deposits to fund mortgages.

That is the approach developed over the past decade in Australia. Lenders flooded into the market in the mid-1990s because they could borrow money cheaply and lend it out through mortgages at substantially higher rates. Mortgage-backed securities were a good bet because Australian borrowers had very low default rates. And there was a big appetite for these securities from pension-fund managers who had large sums to invest after a late-1980s law required employers to provide pensions.

Balloon Payments and Bailouts

The United States has been the leader in the move to securitization to provide mortgages, but it is a system that has taken decades to develop.

Before the 1930s, American mortgages featured variable interest rates and down payments of at least 50%, and homeowners generally 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 loans were funded by savings and loans, which drew on savers' deposits, or by mortgage bankers using funds invested by insurance companies.

As unemployment rose during the Depression, many homeowners could not make their balloon payments, causing a wave of sales and foreclosures. The federal government stepped in, creating the Federal Housing Administration (Fannie Mae) to insure long-term mortgages, and the Home Owners Loan Corporation to sell government-guaranteed bonds to purchase non-performing mortgages. This was the beginning of the securitization that is a central feature of today's mortgage market; lending risk is passed on to investors in mortgage-backed bonds rather than being held in the institution that originates the loans.

Essentially, the government bailed homeowners out by replacing their old mortgages with fixed-rate, 20-year loans they could afford. Borrowers could now borrow most of the money needed to buy a home, and instead of facing balloon payments homeowners amortized, or paid down principal gradually.

Under this system, savings and loans were the primary source of mortgages into the 1970s. S&Ls were federally insured and heavily regulated. The government set ceilings on interest rates paid to depositors, and S&L lending was limited to mortgages. Most mortgages carried fixed rates. In 1968, Fannie Mae was divided into The Government National Mortgage Association, or Ginnie Mae, and the new Fannie Mae, which was privately held and could buy and sell non-government-backed mortgages.

The system worked well so long as short-term interest rates paid to depositors were lower than long-term interest rates charged to borrowers. But in the late 1970s, interest rates soared and the yield curve inverted -- i.e., short-term rates were higher than long-term ones. Many S&Ls became insolvent because they were paying more to borrow money than they received on the long-term, fixed-rate loans they had previously issued. This kind of interest-rate risk can be avoided by issuing adjustable-rate mortgages, but the federal government had barred that to protect homeowners from "payment shock" when interest rates rose.

In response to the S&L crisis, Congress in 1980 lifted a regulation that had put a ceiling on the interest rate paid to depositors, helping S&Ls compete with the relatively new money market funds for the deposits needed to make loans. And regulators lifted the ban on adjustable-rate mortgages.

Technology and academic insights also helped the market evolve. Starting in the late 1970s, the mortgage industry and investors who bought and sold its securities began to use more powerful computers to analyze prices and risks in much the way sophisticated investors analyze the options market. Thus they could better predict the number of borrowers who would default if interest rates went up, and how many would refinance if rates fell -- events that can undermine the value of mortgage-backed securities.

The 1990s saw the development of "private-label securities" issued by commercial banks and other entities generally free of the regulations governing ordinary banks. These were similar to the mortgage-backed securities sold to investors by government-authorized entities like Fannie Mae, but they did not carry the same implicit government guarantee that investors would be protected against unexpectedly high default rates.

Initially, private-label securities involved only "prime" mortgages issued to low-risk borrowers, but then lenders used them to back jumbo loans that the government-authorized lenders were not permitted to make. Finally, lenders used them to back subprime loans to borrowers with poor credit histories and Alt-A loans to ones deemed safer than subprime but not as good as prime.

The private-label market mushroomed from $586 billion in 2003 to $1.2 trillion in 2005, as subprime and Alt-A loans grew from 41% of the private-label market to 76%, Wachter and Green say. Investors were eager to buy these securities because the higher mortgage rates charged to riskier borrowers meant higher yields on the mortgage-backed securities.

"For a time, capital markets seemed to have an appetite for almost any kind of risk, so long as it received sufficiently large yield in exchange," Wachter and Green write. But, they add, there was little understanding of the credit risk -- the risk that borrowers would stop making payments -- in the new, fast-growing market. "Many subprime loans had essentially no underwriting, and insufficient data were available to calibrate default risk for subprime mortgages."

Because home prices had soared between 1997 and 2005, homeowners who ran into financial trouble could easily sell their homes for more than they owed, avoiding default and foreclosure. That period therefore provided no insight into what would happen if home prices leveled off or fell while rising interest rates saddled homeowners with bigger payments -- the situation that has developed in the past year or so.

'No Skin in the Game'

The looser credit standards of the past decade brought a mortgage boom, with Americans holding 2.5 times as much mortgage debt in 2005 as in 1997, a period when gross domestic product grew by just 50%, Wachter and Green say. Subprime mortgages made up 22% of new loans in 2005, compared to 8% in 2003, and in 2004 more than 30% of all mortgages carried adjustable rates, up from about 10% in 2001.

"At the same time, the subprime market developed new products whose features had never faced a market test," Wachter and Green write. This included 2/28 and 3/27 loans, which have 30-year terms but begin annual rate adjustments after the first two or three years.  They carried prepayment penalties making it prohibitively expensive for borrowers to refinance when their payments got too high. Buyers qualified based on the initial low "teaser" rate, even though they might not be able to shoulder the higher payments that could come if the rate adjusted upward.

"The apparent mistake the industry made was to offer a loss-leader price in the early years of a loan in order to get borrowers into the market, in the hope that they would make up the difference in later years," Wachter and Green write. "They attempted to enforce the higher price in the future through the use of prepayment penalties. Prima facie evidence suggests that this did not work."

Many borrowers, Wachter and Green say, did not understand how high their monthly payments could rise if interest rates went up. They note that "even under the best of circumstances, disclosing true costs and risks to even well-informed borrowers is difficult; to a borrower without financial literacy, it is nearly impossible."

Investors who bought securities backed by subprime loans apparently did not understand the risks either. "Mortgage originators had powerful incentives to originate loans, regardless of quality: every mortgage that was successfully originated and sold to an investor produced a fee for the originator." These firms often assured investors that loans met minimum standards, and they often promised to make good in case of unexpectedly large number of defaults. But they did not have the capital to honor those promises.

It is puzzling, Wachter and Green say, why investors did not understand this. Nor did they seem to understand the risks inherent in the housing market; from time to time, prices have dropped in various regions of the U.S.

The evidence from the U.S. and around the world clearly shows, Wachter and Green say, that the public benefits when market-based mortgage systems replace ones controlled by government: Loans become easier to get and homeownership rates rise. Investors benefit as well, from access to new types of securities. It is not so clear, they say, that any one way of providing market funding is best -- through savers' deposits, bonds guaranteed by government or securities that have no guarantees.

Wachter and Green argue, however, that there is a way to minimize a repeat of the problems recently experienced in the subprime market: Make sure that the firms that originate these and other loans continue to have a financial stake in the loans even after they are securitized and sold to investors.

That could be done by requiring that they keep enough funding on hand to cover a portion of investors' losses if borrowers default at higher-than-expected rates. "The problem is that the originators have no skin in the game, or there's some misunderstanding about whether they have skin in the game," Wachter said. "It needs to be made explicit that they do."

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