A year ago, few had heard the phrase "subprime mortgage mess." Today, a Google search for this phrase returns more than 150,000 hits. Defaults and foreclosures on subprime loans have soared, and some analysts have suggested the wealth effects might reduce economic growth. How did this happen? What were mortgage originators thinking when they originated so many loans to homebuyers now unable to repay?
The seeds of the subprime mortgage problem, in part, are international. During 2003 and 2004, large surpluses of savings were evident in the Far East (including China), in oil-exporting areas and in many developing countries. International investors hungry for yield and safety sought U.S. Treasury securities and agency-issued (Fannie Mae and Freddie Mac) mortgage-backed securities (MBS). This phenomenon was cited by many, including then-Fed Chairman Alan Greenspan and then-Governor Ben Bernanke, as a factor behind lower-than-anticipated long-term U.S. interest rates. One factor driving this higher savings rate was developing countries' desire to build foreign exchange reserves in the aftermath of currency crises in Thailand, Brazil, Argentina, Mexico and elsewhere. To do so, developing countries purchased financial assets denominated in the currencies of countries unlikely to be engulfed by a currency crisis, including the United States, France, Italy, Spain, Australia and the United Kingdom. These purchases supported the developed countries' exchange rates and, in turn, encouraged a deterioration in their current account balances. These countries all experienced substantial increases in house prices, housing investment and household wealth.
Into this market stepped U.S. investment banks. The investment banks' innovation was to expand the sale of private-label MBS and derivatives backed by pools of mortgages. The role of the mortgage broker/lender was to originate new loans and sell them to the securitizing firms. Customers for new mortgage loans were not difficult to find. Mortgage brokers advertised heavily, attracting families who doubted they ever would be able to buy a house. Mortgage lenders knew they would not hold the paper they originated. They knew that the buyers of the mortgages were casual with regard to quality and that serious recourse against the lender for future delinquencies was unlikely.
Fault lines in the subprime lending market became visible during late 2006. During late 2005 and 2006, as the pool of higher-quality borrowers had thinned, originators had maintained origination volume by reducing lending standards. Between 2003 and 2006, for example, the share of subprime loans made with little or no documentation of income approximately doubled and the share of piggyback loans (two mortgages, combined to cover 100 percent of the purchase price) quadrupled. During the same period, early delinquency rates-payments more than 60 days in arrears during a loan's first five months-increased. In some cases, such delinquencies triggered contract provisions requiring that originators repurchase the loan from the upstream investor. Some originators exited the business, often via bankruptcy. As subsequent losses mounted for investors, including hedge funds and some banks, the subprime business collapsed.
Proposals to address subprime mortgage problems must recognize that, to date, the cause is excess borrower leverage, not rate increases on adjustable rate mortgages; loans originated during 2005 and 2006 have not yet reset. Encouraging are anecdotal reports of increased flexibility among some mortgage servicers, including delaying payments, extending the terms of loans and refinancing adjustable-rate borrowers into fixed-rate loans while reducing or waiving prepayment penalties.
Recently, the International Monetary Fund has estimated that there is approximately $2.3 trillion of subprime-related mortgage derivatives held around the world. The sorting out of the subprime mortgage mess will be a topic of discussion for many more years.