sparked by the collapse of a housing boom in the US built largely
on the shaky foundation of subprime mortgage lending. A wealth of
evidence indicates that more robust risk management would have
spared many financial institutions from the pain they are now
enduring.
Addressing the European Parliament on the financial crisis sparked
by the US subprime mortgage fiasco, commissioner for internal
market and services Charlie McCreevy emphasised: “In the light of
events over the past year it has been incredible to see how little
understanding senior managers of financial institutions had of the
risk they were taking on board.”
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Against the background of his speech (see McCreevy pulls no
punches) it is perhaps pertinent to ask: Why did financial
institutions not pay closer attention to the warning signs that
were evident well before the crisis struck?
Unfortunately, it is hard to conclude other than that financial
institutions that have fallen foul of the subprime meltdown did not
assess accurately the high-risk nature of the subprime mortgage
assets they were buying, and in some cases insuring against
default, nor the fundamentals of the US residential property market
itself.
In essence residential mortgage backed securities (RMBS) were
cobbled together from mortgages extended to consumers that would
normally not qualify for a loan.
A dubious risk in the first place and one premised heavily on the
assumption that US residential property values would stay on a
growth trajectory that had, for example, seen the average house
price rise 46 percent between mid-2001 and mid-2006, based on data
from the US Office of Federal Housing Enterprise Oversight.
Adding to risks, as the residential property bull-market progressed
mortgage bond lenders became ever-bolder as they spread their net
wider. Easy credit and willingness of investors to snap-up RMBS’
was their game.
One of the more creative products the mortgage industry came up
with is the negative amortisation mortgage (NMA), which permit
payments less than the interest charged with the shortfall being
added to the outstanding balance of the loan for up to five
years.
NMA’s proved highly popular and according to newspaper The Los
Angeles Times new NMA’s accounted for one in three new mortgages in
California in 2006, up from one in five in 2005 and a miniscule
eight out of every 1,000 in 2003.
NMAs and similar products such as interest-only bonds ensured a
booming subprime mortgage market. In 2001 newly originated subprime
mortgages totalled $150 billion and accounted for 7 percent of all
new residential mortgages.
Three years later, in 2004, new subprime mortgages totalled $520
billion and accounted for 20 percent of all new residential
mortgages, while in the subprime market’s peak-year, 2006, new
subprime mortgages totalled almost $700 billion and accounted for
23 percent of all new residential mortgages.
In parallel the subprime RMBS market boomed with issues
collateralised by subprime mortgages, rocketing from $18.5 billion
in 1995 to $508 billion in 2005.
Beyond the inherent risk in the subprime market what was
particularly notable was that investor enthusiasm for subprime
assets continued well after warning lights had begun flashing.
Among the more notable of these came in mid-2006 from David Lereah,
then the National Association of Realtors’ chief economist.
“The housing boom ended in August 2005,” he declared, a startling
statement from one the housing boom’s biggest protagonists and
author of pro-boom books including Why the Real Estate Boom Will
Not Bust—And How You Can Profit from It.
Lereah’s capitulation came long after warnings from many economists
of the danger to stability of the US economy being created by
excessive credit extension.
Among the most respected of those was the late Kurt Richebächer, an
economist of whom former Federal Reserve Board chairman Paul
Volcker said: “Sometimes I think it’s the job of each Fed chairman
to try to prove Richebächer wrong.”
Richebächer began warning as early as 2001 that the Federal Reserve
Board’s easy money policy – particularly as it pertained to
consumer credit extension and the housing boom – was a recipe for
financial disaster.
Other prominent economists such as Dean Baker, co-director of the
Center for Economic and Policy Research, began warning of the
dangers of boom to bust situation developing in the US housing
market in 2004.
He was in good company. Sharing his view was Yale University
economics professor Robert Shiller – well-known for his book
Irrational Exuberance published in 2000 in which he warned of the
looming stock market slump. In 2005 he turned his attention to the
property market boom.
In a story published in The New York Times in August 2005 titled
‘Beware: Mr. Bubble’s Worried Again’ the newspaper noted: “In
speeches, in television and radio interviews and in a second
edition of his prophetic 2000 book, Irrational Exuberance, [Robert
Shiller] is arguing that the housing craze is another bubble
destined to end badly, just as every other real-estate boom on
record has.”
As events since 2006 have shown, warnings from Richebächer, Baker,
Shiller and others fell largely on deaf ears.
Indeed actual experience in the US subprime market had already
revealed the dangers inherent in the market.
These dangers were highlighted by a study published in 2006 by
non-profit research organisation the Center for Responsible Lending
(CRL). The study was based on an analysis of the performance of
more than 6 million subprime mortgages between 1998 and 2004.
In its summary the CRL noted: “Even during the recent period of
strong housing appreciation… as many as one in eight (13 percent)
subprime home loans ended in foreclosure within five years of
origination.”
If instances of distressed borrowers refinancing their mortgage
bonds were included the effective default rate was almost 25
percent, the CRL added.
All this begs the question: why did credit rating agencies (CRA)
assign investment grade ratings to subprime RMBS’?
An answer was provided by the attorney general of New York, Andrew
Cuomo.
“Investment banks were able to get free previews of RMBS
assessments from multiple credit rating agencies, enabling the
investment banks to hire the agency that provided the best rating,”
said Cuomo in a statement.
It seems for good reason that McCreevy warns that a “new regulatory
approach” lies ahead.
