Excessive Risk Taking Led to Nonprime Mortgage Boom

by bkrigbaum@solagroup.com





CAMBRIDGE, MA – The boom and
then bust of nonprime mortgage lending in the
United States caused enormous damage to individuals, communities, the
national
economy, and the global financial system.  In a report
released today,
researchers at the Joint Center for Housing Studies of Harvard
University
conclude that the origination of excess risk in the primary mortgage
market was
inextricably linked to demand on the secondary capital markets for
mortgages
with higher yields than prime mortgages, as well as the multiplication
and
magnification of this risk through actions taken in the capital
markets. 

“The
combination of a glut of global liquidity, low interest
rates, high leverage, and regulatory laxity in the context of initially
tight
and then overvalued housing markets triggered staggering risk
taking,” says
Eric S. Belsky, managing director of the Joint Center and one of the
study’s
authors. “Capital markets supplied credit through Wall Street
in large volumes
for risky loans to risky borrowers and then multiplied these risks by
issuing
derivatives that exposed investors to risks in amounts much larger than
the
face amount of all the loans.”

Many
other nations, the report points out, saw booms in home
prices during the first half of the 2000s as mortgage interest rates
globally
fell sharply and stayed there for a time.  In deciding how
much to bid for
a home, homebuyers tend to focus on monthly payments, and lower
mortgage rates
allowed them to chase prices higher in the context of housing markets
that were
tight—at least at first. Once house price appreciation took
off, the report
suggests, backward looking price expectations led both homebuyers and
mortgage
investors to count on rapidly rising prices, which further fuelled a
bubble.
But the riskier nature of the loans tolerated in the US, the sheer
volume of
them, the share of them made to speculators,  and the way they
were
bundled into securities and written into credit default swaps caused
much more
damage to the US economy and global financial markets than did mortgage
loans
originated in these other nations.

The report finds that
regulatory failures allowed the market to
chase higher returns through excessive leverage and risk taking.
Regulatory
lapses included the failure to closely supervise nonbank financial
intermediaries, prevent unprecedented layering of risk in mortgage
underwriting, adequately supervise the credit ratings agencies, and
impose
stiff enough counterparty risk controls, such as insisting on greater
transparency in the capital markets and requiring higher reserves
against
risks.

“One
of the biggest problems,” states report co-author Nela
Richardson, “is that the whole system created the illusion
that risks were being
adequately managed.  This is because rating agencies assigned
AAA-ratings
to large portions of securities backed by subprime and Alt-A loan pools
and
synthetic derivatives based on them.” Many of the securities
were also
overcollateralized—issuing a smaller face amount of
securities than the total
face value of loans in the pools—to hold aside reserves
against losses. 
In addition, monoline insurance could be purchased and credit default
swaps
entered into to further hedge against risk.  Yet the
fundamental
underpinnings of the models used to rate these securities were deeply
flawed
and the capacity of third-party insurers and credit default swaps to
make good
on claims was inadequate.

As
for the role of Fannie Mae and Freddie Mac in the crisis, the
report finds that Alt-A loans contributed disproportionately to their
losses
and that AAA-rated securities backed by subprime mortgages they
purchased may
have helped support the market for these securities. However, the vast
majority
of nonprime mortgages that were securitized went through private
conduits on
Wall Street, not Fannie Mae and Freddie Mac. Investors others than
Fannie Mae
and Freddie Mac mostly bore the risk of defaults of these loans. In
addition,
the demand for exposure to the risk and returns on underlying nonprime
mortgages was so great that credit default swaps and synthetic
Collateralized
Debt Obligations made up of these swaps were issued in amounts over and
above
the mortgages themselves. 

The
report also finds that while high price loans as reported
under the Home Mortgage Disclosure Act were disproportionately
concentrated in
low-income, predominantly minority
census tracts, the vast majority of
high-priced loans were issued to homeowners outside these communities.
It also
finds that loans made by financial institutions regulated under the
Community
Reinvestment Act in areas where they were assessed for meeting the
credit needs
of low and moderate income communities constituted less than five
percent of
all high-price loans at the peak in 2005.

“Looking
forward, it is encouraging that actions have been taken
within the past two years intended to address many of the regulatory
problems
we found,” commented Belsky.  “But many of
the details are left for
regulators to work out and how they do so will determine the balance
achieved
between consumer protection and management of systemic risk on the one
hand and
financial innovation, efficiencies, and consumer access on the
other.”  A
central issue – the role of the federal government moving
forward in backing
mortgages through guarantees—has not yet been tackled and
will matter to cost,
availability, and access to mortgage credit in the years
ahead.  Yet, the
report argues, the housing market would have struggled even more to
recover
absent federal guarantees of mortgages and mortgage-backed securities,
and both
the cost and availability of mortgage credit moving forward would be
negatively
affected by any curtailment in the scope of the guarantees. However, it
notes
the importance of government charging for these guarantees rather than
allowing
unfunded implicit guarantees of the kind Fannie Mae and Freddie Mac
offered. 

 Harvard
University’s Joint Center for Housing Studies is a
leading center for information and research on housing in the United
States.
Established in 1959, the Joint Center is a collaborative unit
affiliated with
the Harvard Graduate School of Design and the Kennedy School of
Government.  The
report Understanding the Boom
and Bust in Nonprime
Mortgage Lending
is available
at http://www.jchs.harvard.edu/publications/finance/UBB10-1.pdf.


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