Securitization Prime Suspect In Subprime Meltdown
Two new papers reviewed by The Economist support the argument that by breaking the link between those who vet borrowers and those who bear the cost when they default, securitization is to blame for the lax lending that both fuelled and felled the US housing market.
A new paper* by Atif Mian and Amir Sufi of the University of Chicago’s business school provides hard evidence that securitisation fostered “moral hazard” amongst mortgage originators, which led them to issue loans to uncreditworthy borrowers:
Our findings demonstrate that the expansion in the supply of credit driven by disintermediation is responsible for the rapid increase in new loan originations, house price appreciation, and subsequent large increase in default rates.
By allowing mortgage originators to shed credit risk by selling loans, disintermediation significantly increased the amount of lending to riskier borrowers. The paper’s authors directly link the disintermediation process to credit expansion, house price appreciation, and ultimate defaults by showing that these changes take place in precisely those zip codes that experienced the greatest increase in disintermediation. For example, credit growth from 2001 to 2005 and growth in default rates from 2005 to 2007 is significantly higher for zip codes with larger increases in disintermediation.
Furthermore, the positive relation between disintermediation and subsequent defaults is concentrated in zip codes in which a larger fraction of loans were sold by originators to unaffiliated, non-commercial bank institutions.
In other words, disintermediation only leads to higher default rates when originator incentives are less aligned with buyers and when the buying institution has no specialized screening skills.
“Taken together, these findings suggest that moral hazard on behalf of originators is a primary culprit for the default crisis.”
Another recent paper** concurs, finding that the types of loans that are more likely to be securitized are also more likely to default:
An 80% increase in securitization volume is on average associated with about a 20% increase in defaults. These defaults are being driven by characteristics of the loan or the borrower that are unobservable to both the researchers and the securities market.
The authors of this paper caution against policy that emphasizes excessive reliance on default models. “The use of default models to predict and manage risk has become widespread in recent years and is also one of the key features of the Basel II Accord that is slated for implementation soon.
The recent subprime crisis has demonstrated that these default models have mispriced risk and therefore implementation of Basel II may need to re-examined.
“Our research suggests that these pricing models put excessive weight on an individual credit score, and ignore essential elements of strategic behavior on the part of lenders that are likely to be important.”
*The Consequences of Mortgage Credit Expansion: Evidence from the 2007 Mortgage Default Crisis: Atif R. Mian and Amir Sufi (University of Chicago Graduate School of Business).
**Securitization and Screening: Evidence From Subprime Mortgage Backed Securities: Benjamin J. Keys (University of Michigan), Tanmoy Mukherjee (Sorin Capital Management), Amit Seru (University of Chicago Graduate School of Business) and Vikrant Vig, (London Business School).
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February 15th, 2008 at 11:59 am
[...] Also popular during the latest week were a pair of academic analyses featured by The Economist pointing to securitization as the prime suspect in the subprime meltdown. [...]