Subprime: Tentacles of a Crisis

• Author: Randall Dodd
• Position: Senior Financial Expert in the IMF's Monetary and Capital Markets Department
• Pages: 15-19

Page 15

The mortgage market turbulence is as much about the breakdown of the structure of U.S. financial markets as it is about bad debt

How could a modest increase in seriously delinquent subprime mortgages, which amounted to an additional $34 billion in troubled loans, so disrupt the $57 trillion U.S. financial system last summer that worldwide financial turmoil ensued? Lax, if not fraudulent, underwriting practices in subprime mortgage lending largely explain the rise in the rate of seriously delinquent loans from 6 percent to 9 percent between the second quarter of 2006 and the second quarter of 2007. But the impact on financial markets and economies far exceeds any expected losses from mortgage foreclosures.

The answer lies in the evolution of the structure of the home mortgage market. over the past 70 years, it has changed radically from one in which local depository institutions make loans to one that is centered in the major wall Street banks and securities firms, which employ the latest in financial engineering to repackage mortgages into securities through credit derivatives and collateralized debt obligations. Today's mortgage market depends critically on the ability to carve the debt into various risk segments through complex financial instruments and then sell those segments separately-the riskiest segments to high-yield-seeking, and sometimes highly leveraged, buyers such as hedge funds.

To understand how the mortgage market has changed-and to identify where the market broke down, show its structural weaknesses, and explain why the rupture reached across borders to other developed and emerging economies-requires an architectural tour of the U.S. mortgage market.

How the market evolved

Before 1938, the U.S. mortgage market consisted primarily of regulated depository institutions, such as banks and savings and loanPage 16 associations, that used their deposits to fund home loans. These lenders "originated" the loans and, because they kept them in their portfolios, held the credit risk, the market risk of interest rate fluctuations, and the liquidity risk from funding long-term assets with short-term liabilities (deposits).

To provide greater liquidity and fresh capital to these markets, the government, as part of President Roosevelt's New Deal policies, created the Federal National Mortgage Association (known as Fannie Mae) in 1938. It was a government-owned corporation with the mission of creating a secondary market for mortgages. Fannie Mae bought mortgages from the originators, returning the cash proceeds to the institutions. By buying the mortgages outright and holding them as a portfolio, Fannie Mae acquired the credit risk, market risk, and liquidity risk. But Fannie Mae was in a better position than depository institutions to deal with market and liquidity risks because it could borrow longer term. Fannie Mae was also better able to manage credit (or repayment) risk because it held a mortgage portfolio that was diversified nationwide, which even the largest banks then found difficult to do because of regulatory limits on interstate banking. Fannie Mae would purchase only mortgages that "conformed" to certain underwriting standards. Those lending standards are used today to define "conforming" loans and are synonymous with "prime" mortgages.

"Over time, the business models of Fannie Mae and Freddie Mac converged, and together they provided an enormous amount of funding for U.S. mortgages."

Fannie Mae proved to be very successful, and, by the 1960s, the borrowing it did to fund its mortgage purchases constituted a significant share of the debt owed by the U.S. government. To move Fannie Mae's activities off the federal operating budget, the government-sponsored mortgage market was reorganized during the Johnson administration in 1968. The reorganization created the Government National Mortgage Association (Ginnie Mae) to handle government-guaranteed mortgages through veterans and other federal housing programs. It also privatized the remaining activities into a federally chartered, privately held corporation- offically named Fannie Mae-that retains some public interest obligations for low-income housing. In 1970, Ginnie Mae developed the mortgage-backed security, which shifted the market risk to investors and eliminated from the federal budget much of the debt that had been incurred to fund the government housing programs. The plain mortgage-backed security works by pooling similar mortgages and selling securities that have claims on the mortgage payments from the pool. The payments are passed through directly to the security holders.

The Federal National Mortgage Corporation (known as Freddie Mac) was created in 1970, both to securitize...