IMF Survey: Lessons from Subprime Turbulence
IMF News, August 23, 2007
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Bibliographic details
- Authors: John Kiff, Paul Mills IMF Monetary, Capital Markets Department August
- Published: August 23, 2007
Overview
- Recent turbulence in international credit markets was triggered by problems in the U.S. subprime mortgage market.
- A new IMF working paper traces the origins of the market, current problems, and policy options.
- Authors and provenance:
- By John Kiff and Paul Mills
- IMF Monetary and Capital Markets Department
- August 23, 2007
What is subprime lending?
- Definition:
- Subprime mortgages are residential loans that do not conform to the criteria for "prime" mortgages and so have a lower expected probability of full repayment.
- Assessment metrics include the borrower's credit record and score, debt service-to-income (DTI) ratio, and, in some cases, mortgage loan-to-value (LTV) ratio.
- Historical enablers:
- Several legal milestones during the 1980s and the introduction of automated underwriting during the 1990s encouraged market growth.
- Securitization dispersed risk, provided investors with highly-rated securities with enhanced yield, and opened origination to specialty finance companies.
- Outcome:
- Relaxation of credit rationing for marginal borrowers led to a substantial expansion of the U.S. homeownership rate since the mid-1990s.
Closing affordability gap
- Drivers of growth:
- Growth boosted by more highly leveraged lending against rapidly rising house prices.
- Lenders offered "affordability" products when higher DTI and LTV ratios were insufficient for many borrowers.
- Product features:
- "Hybrid" and "option" adjustable-rate mortgages (ARMs) with low initial fixed "teaser" rates; these can result in negative amortization during the first few years.
- Frequent practice of refinancing into another hybrid or option ARM while house prices were rising.
- Weakened lending incentives:
- Fee-driven remuneration at each stage of securitization and dispersion of credit risk weakened prudent lending incentives.
- Common reduction or elimination of income verification requirements ("low- and no-doc" loans).
- Key statistics:
- By the end of 2006, subprime mortgages comprised about 15 percent ($1.5 trillion) of outstanding mortgages.
- $600 billion were originated in 2006.
- About 90 percent of 2006 subprime originations were ARMs, most incorporating affordability features.
Rise and fall of subprime lending
- Timeline and dynamics:
- As house price appreciation decelerated in 2006, delinquencies and defaults on subprime mortgages originated in 2006 soared, despite a benign economic backdrop.
- While prices rose, distressed borrowers could renegotiate or sell to prepay mortgages; slowing prices and rising rates removed those options.
- High-risk products and practices:
- Highest delinquency rates associated with hybrid and option ARMs, particularly those with risk "layering"—high LTV loans to high DTI borrowers with little income verification.
- Rapid rise in "early payment defaults" (EPDs): borrowers miss one or two of the first three monthly payments, followed by rising delinquency rates.
- Fraud accelerated deterioration, resulting in failure of originators in 2006-07 as securitizers exercised "put-back" options.
Sizing up losses
- Initial impact:
- Rapid rise in EPDs and delinquencies initially affected thinly-capitalized specialist mortgage lenders (representing about 40 percent of 2006 subprime originations), many of which closed, declared bankruptcy, or were bought out.
- Commercial and investment banks declared losses from holding subprime mortgages outright or residual interests, but these have been limited thus far.
- Main locus of losses:
- Losses primarily appeared among holders of securitization products (mortgage-backed securities and collateralized debt obligations) with exposure to 2006 subprime and Alt-A mortgages.
- Estimated loss magnitudes:
- Almost all losses will be absorbed by collateralized debt obligations, with mark-to-market loss estimates ranging from $100 to 200 billion.
- By comparison, the Savings and Loans crisis of the early 1990s resulted in total losses of approximately $150 billion.
- Secondary effects:
- Losses crystallized in hedge funds specializing in lower-rated subprime mortgage-backed securities; investor withdrawals and margin calls forced sales in falling and illiquid markets.
- Other funds and investors announced losses and restricted redemptions, raising counterparty and liquidity risk concerns, especially in asset-backed commercial paper markets.
Lessons learned
- Rating agencies:
- Investors placed excessive trust in rating agencies' approach to structured credit.
- The ratings methodology for corporate credit risk is fundamentally different from that used for structured credit, yet ratings are placed on the same scale, implying similar potential losses.
- Recommendation: ratings for different types of obligation should be clearly distinguished; investors should not rely solely on ratings to determine investment policy.
- Near-term outlook:
- Combination of interest rate resets will create significant payment shocks for borrowers in 2007-09.
- With lending standards tightening and house equity falling, refinancing to avoid resets will be significantly harder; defaults on riskier U.S. mortgages are likely to continue rising in the short- to medium term.
Policy implications and recommendations
- Improve consumer protection:
- Balance improving consumer protection with maintaining the viability of the securitization model that has dispersed credit risk away from systemically important financial institutions.
- Challenge: regulatory and legal framework is ill-suited to provide effective consumer protection against predatory lending in an originate-to-securitize model.
- Option: securitizers have access to relevant loan-quality information and could be assigned (capped) liability if checks against fraud and predatory lending in securitized pools are inadequate.
- Tighten oversight:
- Federal banking regulators have recently tightened guidance on nontraditional and hybrid ARM mortgage lending.
- Fragmented U.S. financial regulation means observance and enforcement of such standards is not uniform—non-bank lenders and loan brokers are regulated at the state level, relying on consistent state-level enactment and enforcement.
- The U.S. Federal Reserve is reviewing its powers to regulate mortgage transactions; tighter restrictions concerning clarity of disclosures to borrowers and availability of the riskiest loans appear warranted.
- Resist pressure for bailouts:
- Policymakers will face continuing pressure to bail-out or subsidize stretched subprime borrowers, but such pressures generally should be resisted to avoid reinforcing speculative or fraudulent behavior.
- Principle: "Losses should be dispersed to exposed investors rather than taken over by taxpayers if borrowers cannot be assisted through loan modifications"
Source: IMF Survey: Lessons from Subprime Turbulence; By John Kiff and Paul Mills, IMF Monetary and Capital Markets Department, August 23, 2007.