{
  "title": "IMF Survey: Lessons from Subprime Turbulence",
  "publication": "IMF News, August 23, 2007",
  "sourceUrl": "https://www.imf.org/en/news/articles/2015/09/28/04/53/sores0823a",
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  "summary": "Recent turbulence in international credit markets has been caused by problems in the U.S. subprime mortgage market. A new IMF working paper traces the origins of the market, looks at current problems, and proposes some possible fixes.",
  "authors": [
    "John Kiff",
    "Paul Mills IMF Monetary",
    "Capital Markets Department August"
  ],
  "publishDate": "2007-08-23",
  "sections": [
    {
      "heading": "Overview",
      "content": "- Recent turbulence in international credit markets was triggered by problems in the U.S. subprime mortgage market.\n- A new IMF working paper traces the origins of the market, current problems, and policy options.\n- Authors and provenance:\n  - By John Kiff and Paul Mills\n  - IMF Monetary and Capital Markets Department\n  - August 23, 2007"
    },
    {
      "heading": "What is subprime lending?",
      "content": "- Definition:\n  - 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.\n  - 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.\n- Historical enablers:\n  - Several legal milestones during the 1980s and the introduction of automated underwriting during the 1990s encouraged market growth.\n  - Securitization dispersed risk, provided investors with highly-rated securities with enhanced yield, and opened origination to specialty finance companies.\n- Outcome:\n  - Relaxation of credit rationing for marginal borrowers led to a substantial expansion of the U.S. homeownership rate since the mid-1990s."
    },
    {
      "heading": "Closing affordability gap",
      "content": "- Drivers of growth:\n  - Growth boosted by more highly leveraged lending against rapidly rising house prices.\n  - Lenders offered \"affordability\" products when higher DTI and LTV ratios were insufficient for many borrowers.\n- Product features:\n  - \"Hybrid\" and \"option\" adjustable-rate mortgages (ARMs) with low initial fixed \"teaser\" rates; these can result in negative amortization during the first few years.\n  - Frequent practice of refinancing into another hybrid or option ARM while house prices were rising.\n- Weakened lending incentives:\n  - Fee-driven remuneration at each stage of securitization and dispersion of credit risk weakened prudent lending incentives.\n  - Common reduction or elimination of income verification requirements (\"low- and no-doc\" loans).\n- Key statistics:\n  - By the end of 2006, subprime mortgages comprised about 15 percent ($1.5 trillion) of outstanding mortgages.\n  - $600 billion were originated in 2006.\n  - About 90 percent of 2006 subprime originations were ARMs, most incorporating affordability features."
    },
    {
      "heading": "Rise and fall of subprime lending",
      "content": "- Timeline and dynamics:\n  - As house price appreciation decelerated in 2006, delinquencies and defaults on subprime mortgages originated in 2006 soared, despite a benign economic backdrop.\n  - While prices rose, distressed borrowers could renegotiate or sell to prepay mortgages; slowing prices and rising rates removed those options.\n- High-risk products and practices:\n  - 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.\n  - Rapid rise in \"early payment defaults\" (EPDs): borrowers miss one or two of the first three monthly payments, followed by rising delinquency rates.\n  - Fraud accelerated deterioration, resulting in failure of originators in 2006-07 as securitizers exercised \"put-back\" options."
    },
    {
      "heading": "Sizing up losses",
      "content": "- Initial impact:\n  - 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.\n  - Commercial and investment banks declared losses from holding subprime mortgages outright or residual interests, but these have been limited thus far.\n- Main locus of losses:\n  - Losses primarily appeared among holders of securitization products (mortgage-backed securities and collateralized debt obligations) with exposure to 2006 subprime and Alt-A mortgages.\n- Estimated loss magnitudes:\n  - Almost all losses will be absorbed by collateralized debt obligations, with mark-to-market loss estimates ranging from $100 to 200 billion.\n  - By comparison, the Savings and Loans crisis of the early 1990s resulted in total losses of approximately $150 billion.\n- Secondary effects:\n  - 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.\n  - Other funds and investors announced losses and restricted redemptions, raising counterparty and liquidity risk concerns, especially in asset-backed commercial paper markets."
    },
    {
      "heading": "Lessons learned",
      "content": "- Rating agencies:\n  - Investors placed excessive trust in rating agencies' approach to structured credit.\n  - 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.\n  - Recommendation: ratings for different types of obligation should be clearly distinguished; investors should not rely solely on ratings to determine investment policy.\n- Near-term outlook:\n  - Combination of interest rate resets will create significant payment shocks for borrowers in 2007-09.\n  - 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."
    },
    {
      "heading": "Policy implications and recommendations",
      "content": "- Improve consumer protection:\n  - Balance improving consumer protection with maintaining the viability of the securitization model that has dispersed credit risk away from systemically important financial institutions.\n  - Challenge: regulatory and legal framework is ill-suited to provide effective consumer protection against predatory lending in an originate-to-securitize model.\n  - 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.\n- Tighten oversight:\n  - Federal banking regulators have recently tightened guidance on nontraditional and hybrid ARM mortgage lending.\n  - 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.\n  - 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.\n- Resist pressure for bailouts:\n  - 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.\n  - Principle: \"Losses should be dispersed to exposed investors rather than taken over by taxpayers if borrowers cannot be assisted through loan modifications\"\n\nSource: IMF Survey: Lessons from Subprime Turbulence; By John Kiff and Paul Mills, IMF Monetary and Capital Markets Department, August 23, 2007.\n\n---\n\n\n References\n\n- https://www.imf.org/en/News/country-focus\n- PRESS CENTER\n- IMF Research\n- Read the Working Paper\n- World growth solid amid market fears\n- IMF Global Financial Stability Reports\n- Money for Nothing and Checks for Free: Recent Developments in U.S. Subprime Mortgage Markets\n- https://www.imf.org/en/home\n\nSource: https://www.imf.org/en/news/articles/2015/09/28/04/53/sores0823a"
    }
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    "Authors: John Kiff, Paul Mills IMF Monetary, Capital Markets Department August",
    "Published: August 23, 2007",
    "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:",
    "Definition:",
    "Historical enablers:",
    "Outcome:",
    "Drivers of growth:",
    "Product features:",
    "Weakened lending incentives:",
    "Key statistics:",
    "Timeline and dynamics:",
    "High-risk products and practices:",
    "Initial impact:",
    "Main locus of losses:",
    "Estimated loss magnitudes:",
    "Secondary effects:",
    "Rating agencies:",
    "Near-term outlook:",
    "Improve consumer protection:",
    "Tighten oversight:",
    "Resist pressure for bailouts:",
    "[https://www.imf.org/en/News/country-focus](https://www.imf.org/en/News/country-focus)",
    "[PRESS CENTER](http://presscenter.imf.org/)",
    "[IMF Research](https://www.imf.org/en/news/search)",
    "[Read the Working Paper](http://www.imf.org/external/pubs/cat/longres.cfm?sk=21200.0)",
    "[World growth solid amid market fears](http://www.imf.org/external/pubs/ft/survey/so/2007/NEW0823A.htm)",
    "[IMF Global Financial Stability Reports](https://www.imf.org/external/pubs/ft/GFSR/index.htm)",
    "[Money for Nothing and Checks for Free: Recent Developments in U.S. Subprime Mortgage Markets](https://www.imf.org/external/pubs/cat/longres.cfm?sk=21200.0)",
    "[https://www.imf.org/en/home](https://www.imf.org/en/home)"
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