If Bernanke isn’t worried about subprime mortgages, should you be?
Federal Reserve Chair Ben Bernanke this week laid out his analysis of the subprime mortgage situation:
Let me begin with some background. Subprime mortgages are loans made to borrowers who are perceived to have high credit risk, often because they lack a strong credit history or have other characteristics that are associated with high probabilities of default. Having emerged more than two decades ago, subprime mortgage lending began to expand in earnest in the mid-1990s, the expansion spurred in large part by innovations that reduced the costs for lenders of assessing and pricing risks. In particular, technological advances facilitated credit scoring by making it easier for lenders to collect and disseminate information on the creditworthiness of prospective borrowers. In addition, lenders developed new techniques for using this information to determine underwriting standards, set interest rates, and manage their risks….
The expansion of subprime mortgage lending has made homeownership possible for households that in the past might not have qualified for a mortgage and has thereby contributed to the rise in the homeownership rate since the mid-1990s. In 2006, 69 percent of households owned their homes; in 1995, 65 percent did. The increase in homeownership has been broadly based, but minority households and households in lower-income census tracts have recorded some of the largest gains in percentage terms. Not only the new homeowners but also their communities have benefited from these trends. Studies point to various ways in which homeownership helps strengthen neighborhoods. For example, homeowners are more likely than renters to maintain their properties and to participate in civic organizations.
If it were true, as Bernanke suggests, that the primary factor responsible for the increase in these loans has been technological advances in information collection, then I would have expected the default rates on such loans to have decreased rather than increased. But the Fed Chair himself acknowledges:
For these mortgages, the rate of serious delinquencies–corresponding to mortgages in foreclosure or with payments ninety days or more overdue–rose sharply during 2006 and recently stood at about 11 percent, about double the recent low seen in mid-2005.
Forget that 13% subprime delinquency number you heard about so much in the press … I quizzed the MBA and got this in response from Jay Brinkmann, vice president of research and economics:
… our latest subprime numbers are 14.4% delinquent by at least one payment, plus another 4.5% in foreclosure, for a total of 18.9% either delinquent or in foreclosure. For just subprime ARMs that number is 21.1%…
And that is in an environment in which the unemployment rate remains below the historical average. What would we see in a full-blown recession?
Bernanke believes these problems will be self-correcting, since there would seem to be little incentive for the creditor to extend a loan with an insufficiently high probability of repayment. He acknowledges that these incentives may not provide adequate discipline for the originators of the loans themselves, since the originators quickly resell the loans to other investors:
The ongoing growth and development of the secondary mortgage market has reinforced the effect of these innovations. Whereas once most lenders held mortgages on their books until the loans were repaid, regulatory changes and other developments have permitted lenders to more easily sell mortgages to financial intermediaries, who in turn pool mortgages and sell the cash flows as structured securities….
Although the development of the secondary market has had great benefits for mortgage-market participants, as I noted earlier, in this episode the practice of selling mortgages to investors may have contributed to the weakening of underwriting standards. Depending on the terms of the sale, when an originator sells a loan and its servicing rights, the risks (including, of course, any risks associated with poor underwriting) are largely passed on to the investors rather than being borne primarily by the company that originated the loan. In addition, incentive structures that tied originator revenue to the number of loans closed made increasing loan volume, rather than ensuring quality, the objective of some lenders. Investors normally have the right to put early-payment-default loans back to the originator, and one might expect such provisions to exert some discipline on the underwriting process. However, in the most recent episode, some originators had little capital at stake and did not meet their buy-back obligations after the sharp rise in delinquencies. Intense competition for subprime mortgage business–in part the result of the excess capacity in the lending industry left over from the refinancing boom earlier in the decade–may also have led to a weakening of standards. In sum, some misalignment of incentives, together with a highly competitive lending environment and, perhaps, the fact that industry experience with subprime mortgage lending is relatively short, likely compromised the quality of underwriting.
The ultimate discipline, then, must come from these final holders of the mortgages. I have two concerns about whether the incentives have indeed been structured to work in society’s best interests here. The first is whether these final holders of the loans perceive them to be insured through implicit government guarantees, for example through Fannie Mae and Freddie Mac or the too big to fail doctrine. If so, then there may be a serious moral hazard problem here that has promoted excessive risk-taking behavior from these final investors
My second concern is whether certain institutions such as public pension funds (, ) may in fact desire assets with low probabilities of catastrophic outcomes, with the technological advances to which Bernanke refers giving them new opportunities to assume risks that may not be desirable from the perspective of broader social goals.
For this reason, the number one question in my mind that we should be asking here is, Who is the residual holder of this risk?
And that is not a question that was addressed in Bernanke’s remarks.