I always tell my students to ask what seem like stupid or naive questions, since they’re often important or profound questions instead.
So let me ask a series of dumb questions about subprime mortgages. I understand somewhat the problems that bundling them into securities ended up causing, but I’m still puzzled about the basic idea of a subprime mortgage.
Let’s say you’re a lending institution back in the 1990s or early 2000s. You give customers who have very strong credit records generous interest-rate terms on mortgages or other loans because you recognize that they have very little chance of defaulting on the loan. Presumably you do this because you’re trying to attract those customers away from other institutions who would also like to have them as customers? These loans give you guaranteed long-term income, which makes you willing to shave your profit margin on each individual loan.
At some point, you run out of these customers. So you start thinking about customers whose incomes or credit situation makes them a bigger risk, because you don’t just want to sit upon deposits in your institutions, you want to make money with your money by loaning it out. Here’s where I get really confused, presuming that the previous paragraph isn’t already confused.
As the customer gets riskier and riskier, you make the terms of the loan more and more punitive, though you might sweeten the deal with favorable initial terms to entice the subprime customer into accepting the medium-term pain.
I guess the idea here is that you try to make as much profit as you can off the loan for as long as it lasts? Wasn’t it understood that the more punitive the terms of such a loan, the more likely it would be to cause a risky customer to default over the medium to long term?
If this was well understood by the institutions making subprime loans, weren’t they explicitly pursuing the ramping up of short-term profits off of subprime customers desperately trying to keep up with high interest rates with an equal understanding that many of these loans would default as a result in the medium-term? If so, I can only see one way that would make sense as a business strategy (leaving aside the moral nastiness), and that’s if you assumed that the lending institution would be able to get immediate value from reselling defaulted assets, e.g., that the value of housing and property would continue to go up indefinitely over the medium and long-term. E.g., you were deliberately squeezing customers who had few choices because of their risky profiles and then planning to make money again when they defaulted.
If it was not well understood that more demanding or punitive terms for loans to riskier customers would likely accelerate medium-term defaults, why wasn’t it well understood?
Are there any major American lending institutions out there that took the opposite approach, and looked for riskier customers with some long-term positive potential in order to offer them even more generous terms than they did prime customers in order to add to the base of loans producing secure if small long-term returns?
That’s something of the idea behind microlending, after all, but microfinance emphasizes social welfare returns as well as the financial health of the lending institution. E.g., that by improving social welfare as a whole, lenders create an increasingly positive economic environment for them to be lending profitably to a wider base of customers. Kind of the finance capital version of the Fordian bargain.
Am I missing something fundamental?
The key here is that everyone assumed houses would continue to rise in value indefinitely. Subprime mortgages are attractive because you have an excuse to charge higher interest rates, and with perpetually rising home prices, there would be no downside — the buyer could just sell the house (paying off the mortgage), or in the case of foreclosure, the bank could turn it around at a profit.
The really abusive practices resulted from securitization, which meant that it really wasn’t the originating bank’s problem if the person could pay or not — it was a matter of getting the mortgages signed and out the door, then it was someone else’s problem to deal with. But again, the only reason the securitized subprime mortgages were attractive to investors in the first place was because of the assumption that housing prices would continue to rise indefinitely.
In retrospect, that is a really stupid assumption — it’s easy to tell just from glancing at a graph that housing was already far above historic norms already by like 2004. So it’s hard to believe that that assumption was at work. But it was.
My naive response–and I stress naive–is that the higher interest rates on subprime mortgages were intended not to be punitive but to compensate the lending bank for the higher risk of default and the associated costs of foreclosure and resale.
Perhaps my response is not so naive from the standpoint of mutual savings banks that do not package and resell mortgages. But it’s clearly naive in the world of ARMs and securitization, as akotsko points out.
Am I missing something fundamental?
I think the point you’re going wrong is thinking of the terms as punitive. They’re not, or not intended that way. The idea was that, if you loan to a group of people who are likely to default at some higher level than those with the best credit scores, then you set the terms at such a rate as to make a profit, even assuming a higher default rate.
Punitive is not the right word, got it.
But still, am I right that there’s something fundamentally wrong with a profit model where the nature of the loan actually increases the likelihood of default unless you assume that defaulted assets will always increase in value over the time period of the loan? E.g., that if you’re going to bother to make subprime loans, maybe you should do so on terms that decrease the risk of default rather than significantly accelerate that risk?
My perspective is a little different. I have a friend who lives in Houston. In the spring I go down there and go birding with her and her husband.. Until May of 2007 she wrote mortgages for an independent company. I don’t know how they found their customers, but I know from buying houses myself that the real estate agent often will supply the names of mortgate companies. In any case here is how she described her role in the runup to the current debacle.
Mortgage companies have long been accused of refusing to write loans for people who live in certain areas even though their credit rating might otherwise get them the loan. The accusers said that this technique was used to deny mortgages to minorities. Without going into if this accusation was right or wrong, it was made and our congress passed some regulation that told mortgage companies to stop the practice. After that some people thought that if they were going to be forced to make such loans, then they might as well make money on the deals.
Innovation took over. Bundling of mortgages came along. My friend’s company started writing mortgages, we would call them subprime, like crazy and they were bundled and sold while her company collected lots of fees for the services they rendered, and everybody along the transaction chain got paid as well, including rating companies who gave these bundles AAA ratings — top of the line. Then in May of 2007 my friend told me that she was losing her job, the owners of her company were going out of business, not because they were losing money, but because the party was over. They feared that hell was about to pop and they didn’t want to be around when it happened. So they took their money and ran.
As part of this problem credit default swaps became the biggest scam of all. AIG sold insurance against default of the bundled mortgages. They promised to pay if the borrowers defaulted on their mortgages. But AIG did not have the money to pay all of the liabilities they were assuming. And they themselves were borrowing huge sums to pay the fees and some early defaults, like in a Ponzi scheme. Then the whole thing cratered when housing values finally collapsed and some loans were called in by those who loaned money to AIG and the other Wall Street giants who were involved up to their eyebrows.
One of the amazing parts of this AIG crap is that they could sell the same CDS to more than one person. You didn’t need to have a legitimate interest in the success of the mortgages in order to buy insurance. This kind of gambling was outlawed in the life insurance many, many years ago.
The Republican Secretary of the Treasury saw that his old company was about to collapse and a lot of his friends would be out of work and out of money and he couldn’t let that happen. But he couldn’t single them out because it would look too suspicious. So if he was going to rescue Goldman he would have to rescue some of the other big boys and he did. But in one case there was long-standing bad blood between Paulson and the big guy at Lehman Brothers, so he let that one fail.
Now the stupid fools that run Congress and the Fed were worked like rubes at the carnival dice game and they have put out trillions. Bernanke fell for the idea that he could indulge his economic theories which he had developed over years of studying the Great Depression and other similar disasters. He is like a kid in the candy shop.
I know that this sounds like the usual tin foil hat kind of theory, but I have lived through lots of these things, starting with Medicare, Medicaid, universal life insurance, savings and loan scams, insurance company phony reserves, slow pay of claims, denial of coverage, and more. If there were any honest mistakes being made in the run of the current theft, the regulators, the state insurance companies, the self-described “masters of the universe,” would have put a stop to the whole thing long before it caused much damage. But these guys are smart and they are also smart crooks.
Wall Street and the national government are bereft of honest men and they collectively are not worth the powder it would take to blow them up.
Let me echo akotsko’s point; you really can’t underestimate the pernicious effects of securitization, in which subprime loans where “bundled” with loans of ostensibly higher ratings and then sold en masse to other investors. Because the securities also contained loans that were not subprime and therefore carried higher credit ratings, the securities “automatically” gained higher credit ratings than they would have otherwise merited. In this way, the subprime loans were passed off on investors who just looked at the returns and in many cases didn’t ask too many questions.
Oh, yeah, I forgot to say: The guys who were writing the mortgages knew, I repeat, they knew, that housing prices could not continue rising indefinitely. Only a fool would believe that.
I assume you’ve listened to This American Life’s “Giant Pool of Money” episode on the housing bubble?
As to your question about whether the profit model is necessarily “fundamentally wrong” (I assume you mean economically unsound?), that’s not obvious. If you can increase the profit-per-loan enough, then you’ll still make money even if the default rate increases. The existence of payday loan stores on many city corners makes me think that this model is quite viable.
If you haven’t yet, listen to the This American Life episode on the mortgage crisis – it’s fabulous. From that episode (and my addiction to Planet Money), I think that the first comment hits on the answer: there was an appetite for mortgages, not for banks but from security firms. A bank was trying to initiate as many loans as possible in order to sell them to bigger banks and then security firms. As long as a loan met the terms for securitization (which became riskier & riskier through tranching), banks were happy to sign them & sell them, passing the risk onto larger & larger institutions. Who then “insured” them with AIG…
The disaster of bundling/securitization I understand, precisely because it involved the loss of information about the mortgages.
I’m just curious about the granting of the mortgages in the first place, about what would lead a bank loan officer to look at a risky customer and agree to make a loan whose conditions vastly aggravated the risk. The only thing I can come up with is that the programmatic intent is to make as much short-term profit from the loan recipient’s payment of high interest rates or fees prior to their eventual default. Which again makes no sense if the principal of the loan isn’t coming back through quick resale of the assets at or above their initial value: if you end up sitting on worthless or seriously devalued assets, there’s no possible way that the short-term profit outweighs the longer-term loss. I’m just trying to understand if there’s some other calculation of expected profit involved in granting a high-interest or high-fee loan to a high-risk customer.
That’s a good point, Chris, about payday loans. Or pawn shops, which I know one of my colleagues in the economics department has studied.
I heard part of this episode of “This American Life”, about halfway through. I’ll have to go back and hear the whole thing.
Herr Burke, I think the motive for making risky loans is that the risk could be transferred to someone else, while the originator was making a tidy sum for snookering the buyer of the bundled risky loans. Think greed, well, one really should think GREED!.
Perhaps your view of the subprime market is overly influenced by the recent bubble, when mortgage brokers gave away money to anyone who asked for it? This did vastly aggravate the risk, but it’s not clear (to me anyway) that the original subprime market worked that way. Traditional subprime loans certainly held higher risk than other loans, but if everything is done right, I don’t think they are necessarily (even given the less favorable terms) vastly more risky. Riskier yes, but I think they were still profitable.
So, for example, a traditional subprime mortgage (pre-1995 or so) still made profit because the rate of default was balanced out pretty well by the higher payments on non-defaulting subprime mortagages, plus the value of assets was usually recoverable. Rather like the way that payday lenders make money from low-income communities. It may not be a great way to increase social welfare, but it makes money.
But what happened in the last decade was that too many subprime mortages were given out too freely under increasingly risky conditions so that banks would have more loans out that could be bundled and sold. Rather as if payday lenders started loaning you not next month’s salary but your expected salary over the next five years, and they started making those loans to pretty much anyone who asked and then they bundled those loans and resold them with information about the riskiness of the loans obscured?
And one more thing, the “retention bonuses,” being paid by AIG are more accurately described as “hush money.”
AIG chairman Liddy is testifying right now and the “retention bonus” contract, which is at least 10 pages long and which was written in the first half of 2007, promised that the bonus pool would not be affected by any downturns due to mark-to-market resets of the credit default swaps. The only reason that paragraph was necessary was that those guys knew that the had built, and were continuing to build, a huge house of cards. They knew that it was wrong, but like the owners of the mortgage that my friend worked for, they knew, or believed, or hoped, that they could take the money and run. BTW my friend lost her job in May of 2007, about the time the AIG contract was being negotiated. What a load of evil.
I think that’s spot-on, Hestal: the nature of the contract strongly suggests that these guys in 2007 were already looking for protection against the coming collapse.
I think there’s a more complicated explanation here that doesn’t make the bankers seem quite so stupid. I’m not sure this is entirely correct so please point out places where it doesn’t make sense.
If you lend money, and accurately know the average default rate amongst your clients then you simply adjust the terms of the loan such that you still make profit.
Let’s consider the simple case where I lend ???100 to 10 people (???1000 total). If I know that 50% of the people will never repay I can simply set my interest rate such that each person ends up paying me back the ???100 they borrowed, an extra ???100 to make up for the 50% that defaults (i’ve now got my original ???1000 back by charging 5 people ???200) and i can add an extra ???10 on to each loan make my profit. So after the loan period i get ???1050 returned to me. Obviously this can be adjusted to take into account any default rate.
The only way that you can lose on this proposition is if you underestimate the risk. In the competition to sign people on for loans i could see some banks shaving a bit too much profit off but i don’t think this would explain a world encompassing recession.
It’s at this point it becomes important to see what the bankers did when they repackaged the loans. Basically they took loads of loans and threw them together into a bucket. Now all these loans had a high default rate but individually that should mostly have been taken care of by the terms that the loans were offered with (sure the terms might have been too lenient but is that enough for a global crisis?). However in the repackaging the bankers played another clever trick.
From our bucket of loans we take all the repayments and pay them into one account. By promising that people who buy the most expensive contracts (i.e. CDS’s with a AAA rating) get paid first from the money that comes into that account (if you have a cheap contract then you get paid last or not at all if the money runs out) we’ve reduced the risk that the customer with the AAA contract doesn’t get paid. Here’s the crux. How much have we reduced that risk?
This seems to be the point at which the whole issues turns. The banks assumed that the risks of people defaulting on their loans was uncorrelated (technically that means you can assume a gaussian distribution for your risk). So they priced these contracts accordingly. When you assume a gaussian distribution you’re basically assuming that there’s a big chance something small could go wrong but a small chance that something big could go wrong.
But this isn’t true. There’s a good chance that the reason that you can’t repay your loan (i.e. you lose your job at the factory) is the same as mine (i also lost my job because i worked at the same factory). This means the risk of defaulting is correlated and our assumptions for the pricing are incorrect (in fact there is literally no known mathematical way for dealing with correlated risks – one of the reasons why very smart bankers bought into this; there is literally no other nicely quantifiable way). Or something really hug may go wrong – like a housing bubble bursting.
So we now see why the assets are mis-priced (banks underestimated the risk), but why the massive crisis? Well, i think it’s because at the point where these loans were repackaged people realised that they could do away with tying them directly to loans. Simply by betting on the outcome of a few loans, effectively as a side bet (or if you play blackjack, it could more accurately be described as betting behind. If you play you realise immediately here that the behind bet is can be many times larger than the original bet – in the same way a few billion of bad loans led to a few trillion of global losses), you can increase the amount of money invested in these assets. And because the mis-assessment of risk tended to underestimate the chance of an unlikely but catastrophic event, this wasn’t noticed until it was too late. There are other factors (the bonus culture and the interdependency of modern banks) that made it worse/global.
Simply put:
Banks underestimate risk of people repaying
Banks think because they’re making huge profits that they must be doing something right (not realising that it’s specifically the rare events that they’ve underestimated) so invest many many times the value of the loans
Housing bubble collapses
The loans aren’t paid back and because the banks are hugely leveraged they are exposed many times over so they make massive losses
Banks unwilling to lend any more (credit crunch)
That’s very cogent. Helps me to understand, at any rate. Seems a strong consensus here that subprime mortgages per se are not really the issue at all: it’s the assessment of the housing market + the securitization of mortgages.
Right.
And the problem with blaming the securitization of mortgages is that this is merely a logical extension of productive and prudent capitalist business as usual. First, in the sense that making money involves risk and prudent risk involves securitization. Second, in the sense that abstracting liquidity from concrete assets is the signal development of the modern economy. Think replacement of land with stock as the engine of capitalism, replacement of the gold standard with fictional gdp backing, etc. Without this move nothing like the relative economic, demographic and political prosperity of the last couple hundred years would have been possible.
Just like a loan doubles + liquidity by taking a single sum and turning it into the sum plus its own future repayment, securitization takes the repayment and multiplies it again by guaranteeing the repayment as its own notional value (I’m out of my depth on terminology here, hope I’m making sense). This can be done over and over, each time multiplying the liquidity derived from the original asset, in effect printing money without inflationary consequence. It’s really nifty.
I’d have to look up the reference and time is short before my carpool, but apparently there’s an economist at Yale who’s arguing that the problem was not too much securitization but too little – that if sub-prime borrowers had had their own access to insurance against default, rather than restricting that asset to a few big players like AIG, the inevitable downturn of housing prices and rise in defaults would have been much better granulated and not run into the ‘too big to fail’ problems we’re in now.
I’d have to disagree with you’re last summary, Tim. You’re right about the subprime mortgages being part of the problem; it’s not just the securitization and assumption of rising values. The risk of default for the subprime mortgages was clearly not calculated correctly: even with rising asset prices, unless there was massive inflation in incomes, many of these “low introductory rate” mortages were clearly unsustainable, and a significant number of them were made under conditions which can only be described as fraudulent (mostly on the sales side).
Ah. But that wasn’t so much a problem with the intrinsic concept of the subprime mortgage where the terms of the loan force the recipient to pay higher interest rates or fees, as it was the rush to make too many subprime loans under terms so unfavorable that they guaranteed early defaults, which was in turn a result of the rush to package and sell as many of these mortgages as possible in a bundle.
Another reason that subprime loans nominally made sense to both the lender and the borrowers goes back to akotsko’s original point about how everything hinged on the continued rise in housing prices. The thing was, neither party expected that the loans would be held to maturity, but rather the borrower would refinance into a prime loan soon after the teaser-rates ended. Prime loans traditionally required a substantial downpayment, which a subprime borrower is unlike to have, but when house prices are rising quickly, ones equity after a couple of years can be used as that downpayment.
Silly as this seems, this strategy did work in areas like Southern California where prices were rising at 20%/year for almost a decade. I think one big cause of real-estate bubbles like this is that people have a very short view of history, using maybe the past 2-3 years to define “normal”; thus at some point housing prices had been rising at 20%/year for effectively forever and people act accordingly…
Hi Tim,
I’m a former student (Spring ’02) and first-time visitor to your blog.
I think that there’s a related issue to your original question that’s not fully addressed in the comments. I agree with your summary that subprime loans per se weren’t really a major issue in terms of the overall economic crisis, but I think that your question is useful in examining how subprime mortgages relate to “predatory loans.”
It’s my understanding that people usually distinguish between regular subprime mortgages and predatory loans, in that the latter is usually associated with deceptive marketing or racial discrimination. But the discussion here seems to indicate that subprime mortgages are by definition predatory in that they impose higher fees on people with the lowest ability to pay them. As with payday loan centers, pawn shops, and places like Rent-a-Center, subprime mortgages match high-risk customers with high fees in order to give lenders an incentive to deal with an otherwise unattractive population. On a population-wide level, you can see how this group of customers benefits from the availability of high-priced commerce as opposed to no commerce opportunities at all. But on the individual level, if you’re a low-risk person being classified as part of a high-risk population, you get screwed.
Or, as you put it, “it may not be a great way to increase social welfare, but it makes money.” I think that’s a pretty important point, regardless of whether or not subprime mortgages were a major issue in the economic crisis.
Hey, Nadav. I think this is a smart observation–that there is a tipping point between a subprime loan where the lender is hedging against his greater risk and a predatory loan where the objective is frankly about really short-term smash-and-grab profits at the expense of social welfare. This is where John Caskey’s work on “fringe banking” is very useful.
Hi Tim,
Thanks for the tip about Caskey’s work. I’ll definitely have to check it out. What really interests me is in the justification — both economic and ethical — of the different ways that lenders and insurers determine whether a particular transaction is risky or not. From a purely economic risk-management perspective, the following practices are probably all justifiable, though they are very different from an ethical (and legal) perspective:
1) Higher loan interest rate because a borrower has a history of making loan payments late.
2) Higher health insurance rate because of a pre-existing medical condition.
3) Higher loan interest rate because people of the borrow’s race have a higher default rate than the national average.
My intuition is that the ethics involved depend in large part on how the transaction works at the individual level, as opposed to the broader perspective of economics. If an individual pays a higher price for a given product (in this case, a loan), because of the individual’s past behavior (bad credit history), that seems more justifiable than paying a higher price based on something beyond the individual’s control (health status, race).
I think, on a long term perspective, they are making a huge amount of money off of the people who are more of a risk but still manage to pay off their loan. They are stuck with a higher interest rate, and therefore pay some ridiculous extra amount of money over what they borrowed.
I know some lenders use ethically unsound logic such as giving a person a loan after bankruptcy with a crazy interest rate. Why? Because they know the person cannot file bankruptcy again for a certain length of time, therefore they will have nothing to stop them from taking every asset away from that person if they stop making payments.
And if they do make payments, the lender makes a huge profit off of the interest. Like credit card companies that give you a $200 limit, and you make the month payment which barely covers the interest, so you end up paying $700 for the $200 you actually spent.
I feel as if most banks have a special department whose goal is to figure out how to rip the most amount of money off the most people. If they were not doing this, then there is no way people would be getting loans for homes, cars, and other large assets that are too close to barely tipping over the means they can really afford.