A lowering of underwriting standards was at the root of the sub-prime problem.
In the last three Viewpoint articles I discussed the two general causes behind the current financial turmoil in the developed markets - a benign macroeconomic environment breeding high risk appetites; a search for yield and increasing use of leverage; and financial innovation creating risks beyond the capability of those concerned to manage them. I would like to continue this series of articles by discussing some of the specific causes, starting this week with the now familiar sub-prime mortgage problem.
Sub-prime mortgages have been around for a long time in the US, but it is only in the past five or six years that this market has grown rapidly. Part of the reason for this is the sustained economic expansion and low interest rates in recent years, which encouraged home ownership and led to rising house prices. Rising house prices in turn may have lured some borrowers into indebting themselves to a greater extent than would have been considered prudent based on their debt-service capacity. But it is not clear why the banks were so willing to provide mortgage finance to people whose repayment ability was in doubt in the first place, and why the banking supervisors seemed not to be too concerned about the risks that the banks were taking. In many jurisdictions, the banking supervisors insist on prudent underwriting standards for mortgages, typically through the use of supervisory guidance such as imposing a maximum loan-to-valuation ratio.
Credit-risk transfer through securitisation or the acquisition of protection against default through credit enhancement or credit-guarantee arrangements may have been considered adequate measures to mitigate risks. But obviously, no matter how well these measures are structured, there must still be doubt about whether the credit-risk-transfer arrangements are complete, as shown by the recent re-intermediation of sub-prime-mortgage-related financial assets back onto the balance sheets of some banks. Protection against credit default can also only be as credible as the sellers of the protection. But it seems that concern over these issues, if any, was not serious enough to limit the growth of the sub-prime-mortgage sector or justify preventive supervisory actions that now, with the benefit of hindsight, appear to have been necessary.
It is perhaps not difficult to understand why banks were so keen to get involved in this business when they could distribute the sub-prime mortgages, and transfer the risk, through securitisation. This is particularly true when banks are operating in a highly competitive environment and when there is considerable pressure, arising from capital constraints, to pursue business models that optimise the use of capital. The originate-to-distribute business model enables the banks to transfer the risk, earn a fee and create opportunities for doing other banking business with an expanded pool of mortgagors. As long as the originate-to-distribute production lines are kept running and running fast, the banks are happy, and the credit worthiness of the sub-prime mortgagors is less of a concern.
In any case, there was a quite widespread expectation that house prices would continue to go up and the delinquency rate of sub-prime mortgages would remain low. This provided further encouragement to the banks to develop this line of business. After all, even if the household incomes of the mortgagors declined, affecting their ability to service the mortgages, there was always the option of taking out second mortgages based on the appreciated value of the properties. Many commentators pointed out that, historically, adjustments in house prices in the US only took the form of slower increases rather than actual decreases. This may well have been the case in the past, or when talking about the national average, rather than prices in particular cities or areas. But that assumption looks a bit shaky, particularly to us in Hong Kong who experienced a cumulative fall in property prices of 65% over six years. The dynamics of the residential housing market in the US may be very different from those of Hong Kong – in terms of factors such as land supply, competition on the supply side, and the time lag between changes in demand taking place and supply reacting to catch up. But there is a first time for everything, as we have seen in the past year or so, and the current trends seem to indicate an acceleration of the downward adjustment in residential housing prices in the US in absolute terms.
One certainly hopes that sub-prime mortgages are the only assets in which underwriting standards have been found to be inadequate, whether or not they have been securitised. But capital constraints and competitive pressures apply to the whole spectrum of banking businesses, many of which may be sensitive to adverse developments, either in the economy as a whole or in particular sectors. For example, credit-card loans and car loans in the household sector and loans to facilitate leveraged buy-outs in the corporate sector have been popular candidates for securitisation and credit enhancement. Hopefully these assets will not share the same fate as the sub-prime mortgages.
Joseph Yam
13 March 2008
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