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31,1
The subprime mortgage market:
familiar lessons in a new context
Lewis D. Johnson and Edwin H. Neave
School of Business, Queen’s University, Kingston, Canada
12 Abstract
Purpose – The purpose of this paper is to examine the recent subprime mortgage market meltdown
from a theoretical and practical perspective.
Design/methodology/approach – The authors apply the principles of transaction costs economics
to critically evaluate the roles of lenders, borrowers, institutions, and investors.
Findings – It is found that a combination of need, greed, perverse incentives, inadequate risk
controls, lax regulation, and lax oversight caused a bubble in the subprime mortgage market which
has inevitably burst. The principles of transaction cost economics provide a template for analysis and
corrective action.
Research limitations/implications – The subprime mortgage market provides a useful example
of where theory can provide helpful insights. The example has implications for future research in
other financial market settings.
Practical implications – The results provide insight and guidance to lenders, borrowers,
institutions, investors, regulators, and central bankers in how to identify and handle potentially toxic
financial scenarios.
Originality/value – The theoretical perspective has not been applied to the subprime market or
other similar financial settings. It offers both academic and practical contributions.
Keywords Governance, Risk management, Mortgage default
Paper type Research paper
Figure 1.
Distribution of risks
lenders, insurers, and investors, monitoring incentives are attenuated and defaults Subprime
inadequately supervised. The most obvious signs of this kind of dynamic evolution are mortgage
high and rising profits, evidence of competitive pressures, and the use of new
instruments that, while merely redistributing risks, give the illusion of eliminating market
them.
To develop the main concept underlying our analysis, we first outline the static
relations between lenders’ risk control capabilities and the default risks of the loans 19
they place on their books[11]. We then outline the dynamics of adjusting capabilities to
align them with increasing risk. Finally, we consider the effects of redistributing the
default risks beyond the original lenders.
Consider a portfolio whose average risk is indicated by point A in Figure 2. The
straight line in the diagram, the Capital Market line, indicates the risk–return tradeoffs
available in the securities market. The portfolio of original mortgages, however, is
administered by an intermediary and is not at this point regarded as a marketable
security[12]. The left-hand curve indicates the effective rates of return obtainable on a
mortgage portfolio by a lender whose capabilities for risk control are matched against
the average risk shown by point A. The effective rate of return curve rises as loan risk
is increased to point A, reflecting the increased earnings available on loans of greater
risk if the lender has the capability to control those risks. The curve falls after point A,
reflecting that if loans of too great a risk are taken on, the realized defaults will
eventually rise and the net earnings on the loans will diminish. In other words, a lender
whose risk control capabilities are matched against point A will maximize the return
on his portfolio if he makes loans whose average risk is measured by point A. At that
point his return will exceed the return given by the capital market line because
intermediated loans require more expensive governance than do capital market
securities, and consequently portfolio earnings must be higher to defray the greater
governance costs[13].
Now consider a loan portfolio whose average risk is B, greater than A. If the original
lender with capacity A were to assume this portfolio, he would suffer greater default
risk than anticipated and his expected earnings would fall below the capital market
line as shown by point A0 on the left-hand curve. On the other hand, a lender with
Figure 2.
Costs of governance
MRN greater risk control capability B, who moves along the right-hand curve, would profit
from this loan portfolio in the same way that the lender with capability A profited from
31,1 the first portfolio. B’s greater risk control capability can be attained by increasing the
stringency of application procedures, by more aggressive pursuit of loans whose
repayment was falling behind schedule, and by more aggressive pursuit of defaulting
borrowers. Both the interest rates charged by lender B and the costs he incurs would be
higher than they were for A.
20 So far we have only analyzed a situation in which the lender did not securitize or sell
the original loan portfolio. However, a similar analysis could be done for the group of
agents involved in originating, securitizing, and investing in the securitized portfolio.
The main difference is that the default risks are now spread among agents, and those
agents may also pursue defaulters less aggressively. Consequently the agents’
combined incentives to improve risk control procedures are attenuated, as indeed are
their capabilities to do so.
The above example demonstrates the relationships among mortgage risk, risk
control (governance) capability, governance cost, and return. It is a special case of
transaction cost economics theory, which argues that throughout a financial system,
agents who take a comprehensive view of the costs and benefits to lending strive to
align governance capability and deal attributes to obtain the most efficient governance
framework. For perspective’s sake, the more general theory is outlined in the
Appendix.
3. Analysis
We now apply the theory of section 2 to the subprime market. Our analysis focuses on
how the risk of subprime lending increased even as the lenders decreased their risk
control capabilities. It also examines how incentives affected the different agents’
actions and thus contributed to increasing the misalignment of loan attributes against
financier governance.
4. Conclusions
The direct damage to Wall Street has yet to be determined. Although there has been
concern that the failure of some hedge funds could lead to more systemic problems, the
underlying loss potential may not be as great as the market gloom of mid-August 2007
suggests[19]. A repossessed property will eventually be sold, albeit at a discount. Mr
Cagan’s estimate of $326 billion of repossessed mortgages translates into roughly $112
billion of losses, spread over several years. In comparison, about $600 billion was
wiped out on the US stock markets as share prices fell on 27th February 2007.
Although the subprime market poses a small direct threat to Wall Street it could still
affect bankers and the broader economy in other ways. Investors are now shunning
subprime and all other mortgages that seem risky. Spreads have dramatically widened
on the pooled and debt-laden CDOs based on them, and currently the issuance of
subprime-related CDOs has plunged. Indeed, the spreads on other CDOs are also Subprime
widening, not least because it is far from easy to determine who shoulders the burden mortgage
in the case of pool defaults.
Lenders’ current reluctance to commit additional funds, along with tightening loan market
standards, may combine to form a classic credit crunch. Several lenders have stopped
making no-money-down mortgage loans. HSBC has cut back on second-mortgage
loans. Freddie Mac recently announced it would no longer buy some subprime loans.
No one is sure how dramatic, or lasting, the pull-back will be, but Credit Suisse thinks
23
the number of originations in subprime markets could fall by some 50 per cent in the
next couple of years and Alt-A loans may fall by a quarter.
What about the way forward? For new subprime loans, regulators must tighten
credit standards if lenders are unable or unwilling to do so. Regulators should inspect
software to ensure that appropriate standards are in place, and ensure that loans
originated by mortgage brokers are subsequently authorized by credit officers who are
not paid volume commissions. For existing loans, where possible lenders should extend
terms rather than increase payments in an attempt to minimize the number of defaults.
Studies carried out to clarify the incidence of realized default risks would help agents
to make better decisions in the future.
Financial history contains many examples of the cycle characteristic of the
subprime market: discovery of profitability, expansion of credit activity, weakening of
credit standards as competitive pressures to maintain volumes increase, followed by
subsequent collapse. The subprime cycle is unique mainly in the lack of clarity
regarding the distribution of mortgage default risks, especially in the failure to
recognize that even the mortgage trusts might suffer enough writeoffs that their own
securities could be wholly or partially defaulted. The principal lesson from each of
these cycles is that risk control needs to be tougher during the upswing of the cycle,
just when everyone believes it to be unnecessary. If the industry cannot control risks on
its own – regardless of how confusing the allocation of the risks might be – then
regulators must ensure they do so. Sadly, in the many cycles where the foregoing
effects have been observed, regulatory corrective action is almost always too little and
too late to offset some painful losses.
Notes
1. This has not been wholly true with all insurers. For example, the monolines MBIA and
Ambac have very little subprime exposure, and are said to be highly conservative in
issuing liabilities. In particular, they had little exposure to the largest failure to date,
New Century (The Economist, 28 July 2007).
2. Patricia McCoy, law professor at the University of Connecticut, quoted in the New York
Times, 23 March 2007.
3. Scott Berry, executive vice president at Countrywide Financial, quoted in Bank Systems
& Technology, Summer 2004.
4. Automating the underwriting software moved what was in 1999 a niche product into the
mainstream. The software speeded up processing, reduced processing costs, and made it
easier to design an array of new mortgage types such as no down payment and interest-
only mortgages.
5. The Economist, 24 March 2007.
6. Quoted in The New York Times, 23 March 2007.
7. The New York Times, 23 March 2007.
MRN 8. The unusually optimistic ratings were not just restricted to mortgage pool securities.
They also affected asset based commercial paper.
31,1
9. Joint press release issued by the four agencies, dated 31 January 2001.
10. The theory of this section is a special case of the governance theory outlined in the
Appendix.
11. Relations between apparently different types of financing are also stressed by Cochrane
24 (2005) who compares the risk and return in venture financing with the risk and return
for small NASDAQ stocks.
12. Securitization will involve issuing marketable instruments against the non-marketable
portfolio.
13. See, for example, Freixas and Rochet (1997). The authors and the references they cite
model intermediated transactions as being more costly than capital market
transactions.
14. In 2006, a 24-year-old web designer from Sacramento, Casey Serin, bought seven
houses in five months. He lied about his income on ‘‘no document’’ loans and was never
asked for a deposit in any of his seven loan applications. Today Mr Serin has debts of
$2.2m. Three of his houses have been repossessed so far. On the whole, one subprime
borrower in eight is currently behind with payments. Source: The Economist, 24 March
2007.
15. See Shiller and Weiss (2000) for discussion of moral hazard in home equity conversion.
16. Securities issued against mortgage pools often carry default insurance, thus protecting
the institutional investors who buy into the pool. The original mortgages may or may
not be protected by default insurance. If they are, lenders face fewer incentives to
monitor the risks of those original mortgages.
17. See Franzini (2007) for a discussion of the importance of proper risk management
principles to subprime lenders.
18. Christopher Cagan, using a sample of 32 m houses. Reported in The Economist, 24
March 2007.
19. Of course, much of that market gloom seems to stem from repricing risks of many
securities types. To that extent, the role of subprime pool securities is rather more
symptomatic than directly causative.
References
Allen, F. and Gale, D. (2000), Comparing Financial Systems, The MIT Press, Cambridge, MA.
Carlin, W. and Mayer, C. (2003), ‘‘Finance, investment and growth’’, Journal of Financial
Economics, Vol. 69, pp. 191-226.
Franzini, L.M. (2007), ‘‘The management of risk in subprime lending’’, The RMA Journal, Vol. 89
No. 8, pp. 46-9.
Freixas, X. and Rochet, J.C. (1998), Microeconomics of Banking, MIT Press, Cambridge, MA.
Johnson, L.D. and Neave, E.H. (1992), ‘‘Strategic real estate management: the case of Olympia &
York’’, Canadian Investment Review, Vol. V No. 2, pp. 51-61.
Johnson, L.D. and Neave, E.H. (1994), ‘‘Governance and competitive advantage’’, Managerial
Finance, Vol. 20 No. 8, pp. 54-68.
Neave, E.H. (2005), Financial System Economics: Theory and Application, Thomson Nelson,
Toronto.
Passmore, W. and Sparks, R.W. (2000), ‘‘Automated underwriting and the profitability of
mortgage securitization’’, Real Estate Economics, Vol. 28 No. 2, pp. 285-305.
Shiller, R.J. and Weiss, A.N. (2000), ‘‘Moral hazard in home equity conversion’’, Real Estate Subprime
Economics, Vol. 28 No. 1, pp. 1-31.
Williamson, O. (1996), The Mechanisms of Governance, Oxford University Press, Oxford.
mortgage
market
Appendix. Governance complementarities: further analysis
Our theory of aligning loan default risk and lender risk control is a special case of the
transactions economics theory of financial governance. In this theory, financiers and their clients
seek cost-effective forms of transacting (Williamson, 1996; Neave, 2005; Johnson and Neave, 25
1992, 1994; Allen and Gale, 2000; Carlin and Mayer, 2003) that involve aligning loan attributes
with financier capability. The theory identifies three main classes of governance structure:
markets, intermediaries (hybrids), and hierarchies, each with different capabilities for governing
deal attributes. Each main class has subclasses of governance structures. The theory in the main
part of our paper refers to two classes of mortgage lending intermediaries, one with higher
capabilities for risk control than the other.
26
Figure A1.
Deals’ attributes,
governance capabilities,
and alignment
governance. Market deals tend to be more standardized, and to have smaller informational
differences among the parties. The governance costs of market deals are relatively low, mainly
because market governance uses relatively few monitoring and control capabilities. The costs of
hierarchical governance tend to be higher, because of its greater monitoring, control, and
adjustment capabilities. Thus, financings under uncertainty are likely to have higher governance
costs, which must be compensated for by higher returns on the investment.
Corresponding author
Lewis D. Johnson can be contacted at: ljohnson@business.queensu.ca