Thursday, July 17, 2008

The Rise and Fall of the Subprime Mortgage Market

The chart above shows the subprime share of mortgage originations from 2001 to 2007, using data from Harvard's "2008 State of the Nation's Housing" study, available here.

1. From 2004-2006 the subprime share of mortgage originations was around 20%, almost triple the 7-8% share from 2001-2003. What a rise!

2. By the end of fourth quarter 2007, the subprime share dropped to only 3.1%, lower even than the 7-8% average during the 2001-2003 period. What a fall!

3. That 20% subprime mortgage share from 2004-2006 was obviously the cause of the subprime crisis. Although that huge amount of subprime mortgage activity from 2004-2006 might create problems for a few more years, it's also the case that a significant correction in subprime lending has taken place - that market has almost completely dried up. Looking forward, this correction suggests a future mortgage and housing market that will be much better than today's.

14 Comments:

At 7/17/2008 9:55 AM, Blogger Sophist said...

I'm skeptical as always -- no surprise here...

They mean that 20% of the loans causes the major crisis we have been facing with worldwide side effects?

What about if 40% of the loans were subprime? What would have happened then?

I cannot see the causality established. I am inclined to think some other factor coupled with the subprime loans caused the financial woes.

I suspect that factor has the cute name "leverage". I won't matetr if subprime is 5%, 10% or 50%. What matter is the leverage financial institutions use to trade the resulting synthetic instruments, like CMO, CDO, etc.

Thus, MP, the problem may come up again, IMO of course, even if subprime stay below 10%, unless there are rules about using leverage to try to profit from the resulting instruments.

I'm not calling for more regulation. I am talking about the effectiveness of risk control these institutions use, purposely or not, in the name of profit.

 
At 7/17/2008 9:57 AM, Blogger Marko said...

This comment has been removed by the author.

 
At 7/17/2008 10:05 AM, Blogger Marko said...

Ok, so the banks took big risks in lending money to more people with bad credit. That was the BANK's risk. They were betting housing prices would continue to go up so they could easily recoup losses. They were wrong, and now they are suffering. It seems to me that is what is causing the current crisis in the financial institutions.

The only regulation I think we need is to let the banks fail when they screw up royally like this. That causes SELF regulation, the best kind. That will cause them to be more cautious in the future, like they are now. That is keeping housing costs low, which would be great if there hadn't been a bubble for a few years. I like low housing costs, it lets me buy more houses (in theory).

The other type of regulation needed is also self regulation - the Fed should be cautious about keeping rates too low too long. The housing bubble was caused by too low interest rates, which made loans too cheap, which drove up demand, which artificially increased housing costs, right? Even better, we should figure out a way for the market to determine the Fed's interest rate. Maybe peg it to the two year or something.

 
At 7/17/2008 10:15 AM, Blogger Sophist said...

I agree with both:

a) letting banks fail
b) not keeping rates low too long

Unfortunately, the socialist FED did both.

Now, they keep rates low even if inflation for last 12 months hit above 5%.

They should have raised rates yesterday by at least 75 bp.

Let the market consolidate after that, being already at low levels.

Now markets will rally, FED will repeat Vocker's mistake in 1987 and markets may crash after a panic rate increase in autumn.

They learned nothing from the past.

 
At 7/17/2008 10:22 AM, Blogger Walt G. said...

marko and sophist,

I think you are forgetting that the banks/mortgage lenders were legally forced to provide loans to people that would not normally qualify for those loans. In essence, the banks had a gun held to their heads to give up their cash.

Whether taxpayers like it or not, the government was part of the problem, so they should probably help clean up their own mess.

 
At 7/17/2008 12:01 PM, Anonymous Anonymous said...

Looking forward, this correction suggests a future mortgage and housing market that will be much better than today's.

It doesn't say that one iota. All it says is that subprime mortgage originations are trending towards their normalized percentage of about 5%-8% of total originations (at least since the mid 1990's.) You could have at least extended the chart back further in time to show the trend but that wouldn't suit your conflationary opinion.

If anything, the explosion in adjustable rate mortgage originations (including subprime) in the 2004-2006 time period was a sop to the ratings agencies, broker/dealer channels and structured finance black boxers on Wall Street, etc. It won't happen again for many years, if at all.

Now how much of that toxic origination waste is on the books of Fannie and Freddie? They are "the mortgage market" now.

 
At 7/17/2008 1:33 PM, Blogger bobble said...

"I think you are forgetting that the banks/mortgage lenders were legally forced to provide loans to people that would not normally qualify for those loans."

walt, i can't find it, but i'd love to see the stat on the percentage of "forced loans" to total loans gone bad. i suspect you may be overstating the case.

can you expand on how banks were forced by the goverment to make bad loans?

 
At 7/17/2008 2:54 PM, Blogger bobble said...

" . . subprime lending . . has almost completely dried up. Looking forward, this correction suggests a future mortgage and housing market that will be much better than today's."

hmmm, maybe not. JP Morgan’s Dimon: Prime Mortgages Look Terrible


"[JPM CEO] Dimon suggested that losses in JP Morgan’s prime mortgage book could triple in the foreseeable future as the credit mess moves out of subprime and into Alt-A and jumbo loans."

 
At 7/17/2008 5:12 PM, Blogger Walt G. said...

bobble,

I don’t have statistics for you. But, banks/mortgage companies are heavily regulated against even disparate redlining, which is unintended, often accidental, and proven through difficult statistical analysis. (Check out the Community Reinvestment Act (CRA)). As such, they are not allowed to just make any loan they want or feel that will be profitable like a free business can—that’s capitalism and a free market. So, banks can’t choose their own risk level and loan money only to wealthy whites in suburbia with a spot-free credit record and leave the other business to those willing to assume the increased risk. No, banks are not in charge of their own destiny: The government is.

How would you feel if you were forced to loan money to your lazy brother-in-law who you know will not pay you back? I don’t have figures to back up a claim that you seek; however, I can spot a flawed regulatory process ripe for abuse from a mile away.

 
At 7/18/2008 7:30 AM, Anonymous QT said...

Walt g.,

Must agree with you that public policy has been pushing home ownership as a social good for decades. Both parties have actively pushed for home loans for lower income Americans.

The problem of subprime was also exacerbated by the changes in capital requirements under Basel II, the international banking rules. The new rules increased capital required to be held as collaterol for conventional loans and mortgages but did not apply to loans/mortgages held in the form of securities creating an incentive for securitization.

Once the issue of subprime arose, it called into question all securitized instruments. Overnight, the market evaporated.

There are really 2 problems going on: a housing downturn with a small percentage of bad loans and a credit crunch as banks must take loans back on the balance sheets and set aside capital to guarantee those loans or write them off creating huge losses. Many of these assets are sound loans.

It would appear that we are past the worst. While the FED does risk moral hazard, they seem to have done a very credible job in addressing the crisis and learning from the disasterous approach taken by the FED which led to the collapse of thousands of banks triggering the Great Depression.

Once runs on banks begin, they are very difficult to stop.

 
At 7/22/2008 1:44 PM, Blogger Walker said...

Walt and QT,

The New York Times was all teary and impressed by subprime loans last year...

http://www.nytimes.com/2007/03/29/business/29scene.html?ex=1332820800&en=e09a15f9b118d649&ei=5088&partner=rssnyt&emc=rss

 
At 7/22/2008 1:45 PM, Blogger Walker said...

This comment has been removed by the author.

 
At 7/22/2008 1:46 PM, Blogger Walker said...

Shorter link to NYTimes praising lenders for creative financing

 
At 10/13/2008 4:43 PM, Anonymous Anonymous said...

2007-2008 is an example in economics of the “perfect storm”. The subprime market was only one element.
First, the enormous amount of money that flowed into the house market in the form of subprime, Alta-A and stated-income loans forced home price up and up. As values rose, large numbers of homeowners borrowed their paper equity using home equity loans and home-equity-lines of credit. Rising appreciation (a form of inflation) finally priced most American families out of the house market. In 2007, hundreds of thousands ARM loans reset at higher interest rates. A large percentage of those loans were subprime and the homeowners could not afford the increased payments and could not afford to refinance. Those who tried to sell, flooded market and forced prices down. Soon large numbers of homeowners were “upside down” in their loans—that is, they owed more than the homes were worth. Foreclosures continue flood the market and values continue to fall.
Second, years of political gridlock and environmental propaganda have prevented a coherent national energy policy.
Third, the lack of effective regulation of mortgage brokers and lenders, Fannie Mae and Freddie Mac, PMI insurers, Wall Street investment banks, Hedge funds and other financial institutions allowed incredible levels of greed and incompetence to undermine the U.S. economy.
Fourth, the global economy and “free trade” have become a sort of religion. Do we really think we can ship jobs, factories, technology, knowledge and money overseas and remain economically strong? We are now the greatest debtor nation in the world. We now import more “cheap” products than we export and buy those “cheap” products on credit.
Parachute

 

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