I take a close look at the history of subprime mortgage loans between 2001 and 2007 to see if there was any pattern evident that could have led people to foresee, and thus forestall, the crisis that occurred in 2007. Sadly, using standard econometric tools I find that by as early as 2005 it was possible to detect a serious deterioration of subprime loan quality.
This finding is detailed in joint work with Yuliya Demyanyk from the FRB St. Louis, which was presented at the Fed, IMF, SEC, FDIC, S&P, Lehman Brothers, among many other places, and can be downloaded at http://ssrn.com/abstract=1020396. Below I provide an executive summary.
The subprime market grew dramatically starting with 2001. Based on our database, which covered roughly half of the subprime mortgage market, the number of new loans more than quadrupled, and the average loan size almost doubled over the sample period. We did a number of regressions of differing complexity before the answers began to emerge. We detected that during the dramatic increase of the subprime mortgage market, the quality of the market also dramatically deteriorated, vis à vis the performance of the loans adjusted for differences in borrower characteristics, loan characteristics, and subsequent house appreciation.
The degeneration of the loan quality has been unvarying and steady, but not equally so among different types of borrowers. Over time, borrowers with a high loan-to-value (LTV) ratio became increasingly risky compared to low-LTV borrowers. Securitizers seem to have been aware of this particular pattern in the relative riskiness of borrowers: We demonstrated that over time they made the mortgage interest rate more sensitive to the LTV ratio of borrowers. Specifically, in 2001, a borrower was hardly charged a higher interest rate for the higher LTV ratio. In contrast, in 2006, a borrower with a one-standard deviation above-average LTV ratio was charged an interest rate higher by 30 basis points.
Were problems in the subprime mortgage market imminent long before the actual crisis showed signs in 2007? Our answer is yes, at least by the end of 2005. By excluding the data for 2006 from our analysis, we showed that the steady degradation of the subprime market was already clear, with the worsening of loan quality already in progress for five consecutive years. The main challenge in detecting this deterioration was the steep appreciation in housing prices that masked the true riskiness of the subprime mortgage loans.
Vintage 2006 loans stood out in terms of high delinquencies and foreclosures. Further, the bad performance of that vintage was not confined to a particular segment of the subprime market, but rather reflected a market-wide phenomenon. It is important to note that, at first sight, our finding that the crisis also worsened the performance of fixed-rate mortgages (FRMs) seems at odds with remarks in 2007 by Federal Reserve Chairman Ben Bernanke, who said that serious delinquencies in that sector had been “fairly stable at about 5.5 percent.” The discrepancy occurred because we compared FRMs of the same age that originated in different years. If just the outstanding mortgages altogether were analyzed, the picture more closely resembles Bernanke’s observation. We plotted exactly this for both FRMs and hybrid mortgages and found that the delinquency rate of outstanding FRMs did remain fairly constant as of 2005, as the Fed chairman observed. But the result is affected by an aging of the FRM pool caused by a decrease in the popularity of FRMs. FRMs that originated in 2006 performed unusually badly.
In another exercise, we explored the behavior of the subprime-prime rate spread. In general, the mortgage rate on subprime mortgages is higher than on prime mortgages in order to compensate the lender for the additional default risk associated with subprime mortgages. To explore the rate spread pattern, we focused on FRMs, not hybrid mortgages, because the price of hybrids is determined by both the initial teaser rate and the margin over the index rate, which complicates the comparison of subprime and prime rates. We used data on subprime rates from the LoanPerformance database, and for the prime rate, we used the contract rate on FRMs reported by the Federal Housing Finance Board in its Monthly Interest Rate Survey. We found that the subprime-prime rate spread declined over time, both with and without adjustment for changes in loan and borrower characteristics. At the same time, the riskiness of loans has increased, implying that on a per-unit basis, the subprime-prime spread declined even more. Investing in securities backed by subprime loans was an increasingly bad deal, and the handful hedge funds that aggressively and timely bet on the fall of the subprime market are among the few winners of the crisis.
Originally published at Stern on Finance blog and reproduced here with the author’s permission.