Money for Nothing and Checks for Free: Recent Developments in U.S. Subprime Mortgage Markets

Abstract

This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. After a number of warning signs, the U.S. "subprime mortgage crisis" became a headline issue in February 2007. Notwithstanding the bankruptcy of numerous mortgage companies, historically high delinquencies and foreclosures, and a significant tightening in subprime lending standards, the impact thus far on core U.S. financial institutions has been limited. This paper reviews the history and structure of the subprime market. The results suggest that new origination and funding technology appear to have made the financial system more stable at the expense of undermining the effectiveness of consumer protection regulation. Potential solutions to the management of this trade-off are then explored.

Government intervention in response to the subprime financial crisis: The good into the pot, the bad into the crop

“…8 Still in mid-2007, market participants believed that advances in credit risk modeling would prevent severe losses on highly rated tranches and credit derivatives, see e.g. Mills and Kiff (2007). 9 See e.g.…”

“…The deterioration of the average loan quality is further amplified by the incentive schemes within the lending business, where employee compensation largely depends on lending volume rather than on riskadjusted return (see e.g. Mills & Kiff, 2007).…”

Behavioural Real Estate

“…The risks and uncertainty associated with these new mortgage products are often underestimated. Mills and Kiff (2007) confirm by stating that the success of the new risky products became reliant on the continuation of housing price appreciation. Another dubious development is the upswing of refinancing deals that allows borrowers to use their property as cash machines by converting equity for cash.…”

“…By lending to individuals with poor credit scores, the so called sub-prime market, financial institutions and investors in mortgage-backed securities were effectively speculating on ever increasing house prices (Gorton, 2009). In addition, the presence of fee remunerated intermediaries led to deteriorating lending standards because they did not have incentives to maintain long-term loan quality (Mills and Kiff, 2007).…”

Risk Management and Regulation

“…This special treatment has been questioned, particularly given financial institution resolution regimes introduced after the 2008 financial crisis(Paech 2016). 5 Affordability products included "hybrid" and "option" adjustable-rate mortgages requiring interest-only payment at fixed "teaser" rates that can result in negative amortization during the first few years(Kiff and Mills 2007).…”