The Subprime Problem

Abstract

Today's sub-prime mortgage situation has its roots in the failure of market-based restraints on the riskiness of loans that lenders could make. Before securitization, sub-prime mortgage lenders retained the loans that they originated and, therefore, cared deeply about credit quality. Following the rise of securitization, bond insurers constrained subprime lenders from making unreasonably risky loans through their pricing decisions and through limits on their appetites for risk. Later, sophisticated investors from the mainstream MBS area started taking credit exposure to sub-prime mortgage ABS by purchasing subordinate tranches from uninsured deals. Like the bond insurers, they were experts in mortgage credit risk and that expertise was reflected in their risk appetite and pricing behavior. However, starting in 2004, CDOs and CDO investors became the dominant class of agents pricing credit risk on sub-prime mortgage loans. The departure of the bond insurers and the traditional subordinate investors left a void, because the CDO managers were less discriminating and selective in allowing high-risk loans to be included in securitizations. In the absence of restraints, lenders started originating unreasonably risky loans in late 2005 and continued to do so into 2007. Delinquencies and foreclosures might never have risen to troubling levels had policymakers instituted rational constraints for the sub-prime mortgage sector. All things being equal, the less the government meddles in the lives of individuals the better. However, when market forces fail to produce acceptable results, government intervention may be necessary and appropriate.