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Consumer lending cycles and the subprime mortgage crisis
Dr. Peter Cirenza
EH 590 Seminar
13 June, 2012
Introduction – This paper summarises the current status of research that I am
undertaking to examine certain of the causes of the subprime mortgage crisis in the US,
which began in 2007 and led to a significant economic crisis that continues to this day.
My working hypothesis is that the subprime mortgage crisis resulted, in part, from the
institutionalisation of what had previously been a niche, cyclical and relatively risky
lending business. I will also argue that certain consumer lending and tax reforms
implemented in the 1980s, together with innovations in the required documentation of
certain types of mortgage loans, allowed for the initial development of what later came to
be known as subprime lending. I will seek to demonstrate that the subprime lending
markets that began to develop as a result of these regulatory, tax and documentation
changes were initially served by niche and specialty lending companies, and rarely by the
leading banking institutions of the day. These niche lenders experienced periods of strong
loan growth and profitability, frequently followed by rising borrower delinquency and
defaults, leading to significant losses. It was only after the failure of many subprime
lenders in the late 1990s that many of the leading commercial and mortgage banking
companies entered this market. This entry coincided with a push by the Federal
government for greater involvement from Fannie Mae and Freddie Mac, the two principal
government sponsored entities (“GSE”) which operated in the residential mortgage
market.1Alongside the GSEs, investment banking firms also became more active in
providing initial (“warehouse”) and permanent (“securitisation”) financing to the
industry. With the involvement of the leading commercial and mortgage banking firms,
the GSEs, and the investment banks, the subprime lending industry was transformed from
a niche sector into a mainstream business with the backing and participation of many of
the most influential financial organisations in the US financial system.
Literature review – There has been a great deal written about the subprime mortgage
crisis in the short period of time since the onset of the crisis in 2007. The literature has
primarily been focused on the causes of the growth in subprime lending (Maddaloni and
Peydro (2011), Mian and Sufi (2009), Muolo and Padilla (2008), Federal Reserve Bank
of San Francisco (2007), Chomsisengphet and Pennington-Cross (2006) and Temkin et al
(2002)), and the various reasons for the collapse in the market beginning in late 2006
(Purnanandam (2010), Piskorki et al (2010), Longstaff (2010) and Demyanyk and Van
Hemert (2009)). To date, no one has examined the growth and subsequent collapse of the
subprime mortgage market from the standpoint of the institutionalisation of what had
previously been a niche, cyclical and relatively risky lending business. That is the
purpose of my current research.
1
Ginnie Mae also operates in the residential mortgage market, but only with respect government insured
mortgages made to certain lower income borrowers and veterans.
1
Tax and regulatory reforms – There were three principal reforms in the 1980s which
helped to spur the development of the subprime lending market. The Depository
Institutions Deregulation and Monetary Control Act of 1980 pre-empted state level
limitations on interest rates. As a result of this legislation, lenders were able to charge
higher rates than had previously been possible in most US states. The effect of this
change was to allow lenders to offer loan products to higher risk borrowers, who had
often been unable to obtain financing due to the prior caps on interest rates. Lenders who
were willing to provide credit to lower quality borrowers were thus able to “price” their
loans with higher interest rates to compensate them from the higher delinquency and loss
levels that they expected from these borrowers.
The Alternative Mortgage Transaction Parity Act of 1982 allowed lenders to offer
variable rate loan products for the first time on residential mortgages. Prior to the
enactment of this law, only fixed rate loans had been permitted. In addition, this law also
allowed lenders to offer mortgage products that were not fully amortising. This meant
that borrowers could enter into mortgages where at the maturity of the loan, there would
still be a principal balance due on the loan (known as a “balloon payment”). At the
maturity, the borrower would need to have taken out another loan to pay off the existing
one (known as a refinancing or “refi”), sell the home or find some other means of
repaying the existing balloon payment. In stable or strong property market conditions, a
refinancing was the most likely to occur. The effect of having a balloon mortgage was
that it resulted in a lower monthly payment to the borrower (as not all of the principal
balance of the loan would need to be repaid by the loan’s maturity). Together with The
Depository Institutions Deregulation and Monetary Control Act of 1980, these two
changes permitted lenders to provide more and more “affordable” (i.e. lower monthly
payment) loan products to lower quality borrowers.
The final significant change which helped to spur the development of subprime mortgage
market was The Tax Reform Act of 1986. This was a far reaching reform of the US tax
code implemented by the Reagan administration. Among its provisions was the
elimination of the deductibility of interest on all consumer loan products other than
residential mortgage loans. Previously, many forms of consumer debt had been
deductible on the personal tax returns of American consumers. As a result of this change,
homeowners now had a further incentive to take out a mortgage secured by their
residence. In addition, homeowners also had an incentive to borrow against the value of
their home and to pay down other forms of consumer debt which were no longer tax
deductible. Renters had a greater incentive to buy a home. As Table 1 illustrates, the
mortgage lending industry was a clear beneficiary of this change in the tax code.
What is subprime mortgage lending? Subprime lenders offer mortgage products to
borrowers who represent a higher risk of default than borrowers who qualify for the
standard prime underwriting guidelines. There are essentially three types of mortgage
types that are commonly viewed as being subprime: 1) mortgages to borrowers with poor
credit histories, 2) reduced documentation loans (“ALT A” or “no-doc”) to borrowers
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who cannot document all of the underwriting information in their application, and 3) high
loan-to-value (LTV) mortgages (typically over 100% LTV).2
The institutionalisation of the subprime lending – The subprime mortgage market in
the US had its birth in the 1980s, following the enactment of the tax and regulatory
changes described above. New mortgage products emerged which were designed either
for lower quality borrowers or for those homeowners looking to borrow against the value
of their homes in a tax-advantaged manner. These products included the fixed rate second
mortgage loan and the home equity line of credit (HELOC). While the second mortgage
looked very much like a traditional mortgage (and in fact had existed prior to the 1980s
on a small scale), the HELOC was completely new. It combined the revolving features of
a credit card with mortgage security. Metrics such as combined-loan-to-value (the loan to
value assuming full utilisation of the HELOC together with any prior mortgage liens)
were developed by lenders to evaluate credit risk and potential losses, alongside more
traditional measures such as debt-to-income ratios and FICO scores.3 In this period,
HELOCs were typically granted to higher quality borrowers than were second mortgages.
What was important about the growth of second mortgages and HELOCs in this period is
that they represented the first significant use of a mortgage product to systematically
reduce the equity that borrowers had in their houses. Early participants in these products
were primarily consumer finance companies such as Household, Beneficial, Associates
and CIT Group. Commercial banks and other large financial organisations did make these
loans, but were not the leading providers in the market.4
Another important development for the subprime market was the introduction of
mortgage loans with reduced levels of documentation. These loan products, known as
“ALT A”, “low-doc” or “no-doc” loans, also came into existence during the 1980s. The
premise behind these loans was two-fold. Mortgage lenders had come to believe that the
two most important determinants of loan losses were LTV and the FICO score of the
borrower.5 In addition, many self-employed people had difficulty producing the income
verification acceptable to many traditional lenders. As a result of these factors, many
lenders began offering reduced documentation loans, either to attract self-employed
borrowers, or because they believed they could manage the risk associated with these
loans by monitoring the LTV and FICO scores of loan applicants (and thus did not need
the detailed income and asset verification process that was required to originate a full
documentation loan).
Dime Savings Bank of New York was one of these lenders that actively began originating
“low” and “no doc” loans in the late 1980s. Its geographic focus was the Northeast. By
2
Kenneth Temkin, Jennifer E. H. Johnson and Diane Levy, “Subprime Markets, The Role of GSEs, and
Risk-Based Pricing”, The Urban Institute, March 2002, p. 4.
3
FICO stands for Fair Isaacs Company, which developed a credit score methodology for borrowers based
on information from their credit report. It is used to assess the probability of a credit event by the borrower
over a two year timeframe.
4
Paul Muolo and Matthew Padilla, Chain of Blame (Hoboken: John Wiley & Sons, 2008), p. 45.
5
Written Statement of Kerry K. Killinger Submitted to the United States Senate Permanent Subcommittee
on Investigations, April 13, 2010, p. 8.
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the early 1990s, more than 10% of its balance sheet was non-performing,6 primarily due
to “low doc” loans. The bank, which came close to failing and was subjected to
significant regulatory oversight, engaged in an effort to sell off its non-performing
mortgage loans in order to improve its financial position. Though many other saving and
loan companies also experienced similar problems with low and no doc mortgage loans
(and many failed as a result), this form of mortgage underwriting somehow survived the
savings and loan crisis of the early 1990s and was a very prominent feature of subprime
lending in the 2000s.
Beginning in the mid-1990s, subprime mortgage lending became an industry in its own
right.7 Table 2 lists the leading originators in 1996. What is striking about this list is the
almost complete absence of any leading national lenders. With the exception of consumer
finance firms such as Associates, Household and Beneficial, none of the other leading
subprime lenders were large or well-known firms. And not a single leading commercial
bank was to be found on this list. Subprime lenders were small, niche players who
believed they had the credit skills necessary to successfully originate mortgages to high
risk borrowers. Most of these lenders relied on funding from other financial institutions.
Commercial banks provided lines of credit and investment banks began to offer short
term warehouse lines with securitisation takeouts once a critical mass of loans had been
originated. Some investment banks such as Greenwich Capital (acquired by RBS in
1996) would actually buy the loans directly from certain lenders and include them in their
own securitisations.8 Bear Stearns, Lehman Brothers and Prudential also became active
lenders to the industry.9 And volumes grew. In 1997, investors purchased more than $60
billion of subprime mortgage backed securities, six times more than 1991’s volume of
$10 billion.10
Many of these companies eventually became publicly held, including Aames, Amresco,
Cityscape, ContiMortgage, Delta Funding, IMC Mortgage and The Money Store. The
subprime market had expanded from very low levels to represent approximately 10% of
all mortgage originations by the late 1990s.11 Whereas originations had totalled just $40
billion in 1994, they had risen to approximately $160 billion by 1999.12 This rapid growth
was accompanied by a dramatic increase in delinquencies and losses, as well as from
overly inflated profits due of the aggressive use of gain-on-sale accounting by many
subprime lenders.13 Investment banks began to struggle to find buyers for the lower rated
subordinate classes of subprime securitisations, and liquidity quickly left the market. As
securitisation volumes fell, warehouse financing also declined, leaving smaller lenders
with few options. The industry experienced a dramatic shakeout, with many firms filing
6
Dime Savings Bank filing.
Federal Reserve Bank of San Francisco, “The Subprime Mortgage Market, National and Twelfth District
Developments”, p. 8.
8
Muolo and Padilla, p. 95.
9
Muolo and Padilla, p. 57.
10
Temkin et al. p. 10.
11
Muolo and Padilla, p. 61.
12
Temkin et al. p. vii.
13
Temkin et al. p. 10.
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for bankruptcy or being acquired by larger financial institutions who had more robust
sources of financing (as Table 4 illustrates).
In this period, major financial institutions such as Citibank, HSBC, First Union and
Washington Mutual acquired existing subprime lenders. In the case of First Union, which
acquired The Money Store in 1998; it wrote off its entire investment by 2000 and the
CEO was forced to resign.14 HSBC decided to acquire Household Financial Services, an
investment that would eventually result in subprime losses exceeding $3 billion.15 The
business was clearly a risky one, yet major financial institutions were nonetheless eager
to enter or to increase their presence. As the CEO of Washington Mutual, the country’s
largest savings institution, declared in testimony to Congress, his firm viewed the
subprime market as a “growing and underserved market” where his firm could bring
“better products and pricing” to a market “historically dominated by unregulated
lenders.”16 As Table 3, indicates, by 2000 the composition of the leading originators of
subprime mortgages had changed dramatically. While there were still smaller and more
specialised lenders such as Option One and New Century, most of the leading firms were
now major financial institutions. (Even First Franklin would subsequently be acquired by
Merrill Lynch.)
At the same time, Fannie Mae and Freddie Mac were under increasing pressure to
provide their services to the subprime sector of the mortgage market. The Department of
Housing and Urban Development (HUD) established a rule in 2000 under which these
GSEs were expected to increase their subprime business as part of their response to
meeting higher affordable housing goals.17 Given their lower funding costs, implicit
government guarantee and market power, it was anticipated that their entrance into the
market would have a material impact on lowering mortgage rates, increasing liquidity
and improving standardisation in the market.18 By 2007, each of Fannie Mae and Freddie
Mac had outstanding loan purchases or guarantees of securities backed by subprime loans
in excess of $100 billion.19 According to the CEO of Washington Mutual, the two GSEs
had become the leading purchaser of its option arm subprime product by 2006,
purchasing a majority of their annual production.20 The GSEs had entered the market and
were having a sizeable impact by the mid-2000s.
Finally, Wall Street firms also became much more active in providing financing
(warehouse, buying loans outright and securitisation) to the subprime industry. In part
this was because more of their traditional mortgage clients (Countywide, GMAC,
Washington Mutual, Bank of America, Fannie Mae, Freddie Mac, etc.) were now active
in the sector. In addition, they clearly saw an opportunity to expand their mortgage
14
15
16
17
18
19
20
Temkin et al. p. 11.
“HSBC Ousts Its North American Chief”, New York Times, February, 22, 2007.
Killinger, pp. 3, 8.
The GSEs had been subject to such housing goals since 1993. Fannie Mae Annual Report 2009, p. 38.
Temkin et al. p. vii.
Data from 2007 and 2008 Annual Reports for Fannie Mae and Freddie Mac.
Killinger, p. 10.
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finance and trading businesses as the subprime market expanded and became more
“mainstream.” In contrast to the 1990s when just a small number of investment banking
firms were active in this sector, now virtually all the firms were.
With the financial backing of so many of the leading financial organisations in the US
now active in the sector, government policy encouraging home ownership and affordable
housing, a non-restrictive regulatory environment for mortgage lenders, low interest rates
and abundant liquidity, house prices in the US rose and the subprime mortgage sector
grew rapidly in the 2000s. In addition, the share of the subprime market which was
financed through securitisation also increased, from 54% in 2001 to 75% in 2006.21
Demyanyk and Van Hemert (2011) also found that the quality of subprime originations
declined every year from 2001 to 2007. They argue that the subprime mortgage market in
this period “experienced a classic lending boom-bust scenario with rapid market growth,
loosening underwriting standards, deteriorating loan performance, and decreasing risk
premiums.”22
Conclusion - As we know too well, the subprime market crashed spectacularly beginning
in late 2006, with the bankruptcy of Ownit Mortgage, a subprime lender, and the
announcement of significant losses at HSBC weeks later. Substantial losses began to
appear throughout 2007 in the financial statements of firms such as Citigroup, Merrill
Lynch, UBS, Bear Stearns and Countrywide. Few market participants were prepared for
the extent of the losses that were to be realised over the next 18-24 months in this sector
(and it broader impact on asset prices and financial stability). Unlike the prime mortgage
market, where lenders and mortgage securities traders and investors had experienced
decades of strong credit performance (with interest rate and prepayment risk being their
prime concern), the subprime market had proven itself to be much more risky and
cyclical in terms of credit performance. As Table 5 illustrates, the delinquencies and
losses on subprime mortgages (in this case at Freddie Mac) were breath-taking. As my
research here has shown, subprime and “low”/”no” doc borrowers had a history of such
performance. Despite that history, most of the largest financial institutions in the US (and
many foreign firms such as RBS, UBS, Dresdner Bank and IKB, among others) became
actively involved in the sector. With the combined financial muscle of these firms and an
increasing reliance on securitisation, the subprime business expanded dramatically in
size. However, the poor underlying fundamentals of this sector ultimately resulted in
spectacular losses to lenders, investors, banks and the broader economy.
Further work – I recognise that this paper requires more evidence, in particular to
support the argument that there had been prior cycles of high delinquencies and losses on
subprime and no doc mortgages in the late 1980s and 1990s. I plan to target research and
data from the Federal Reserve, rating agencies, trade publications such as American
Banker, Inside Mortgage Finance and National Mortgage News. I may also access
databases from LoanPerformance ABS and the Mortgage Banking Association.
21
Yuliya Demyanyk and Otto Van Hemert, “Understanding the Subprime Mortgage
Crisis”, The Review of Financial Studies, Vol. 24 no 6 2011, p. 1875.
22
Demyanyk and Van Hemert (2011), p. 1875.
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Table 1
Source: FDIC
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Table 2
Top Ten B&C Mortgage Originators – 1996
Associates
The Money Store
ContiMortgage
Beneficial Corporation
Household Financial
United Companies
Long Beach Mortgage
Equicredit
Aames Capital
AMRESCO
Table 3
Top Ten B&C Mortgage Originators – 2000
CitiFinancial
Household Financial
Washington Mutual
Bank of America
GMAC
Option One
Countrywide
Conseco
First Franklin
New Century
Source: Inside B&C Lending
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Table 4
Selected Events in the Subprime Mortgage Market in Late 1990s
Company
Date
2/98
9/98
9/98
10/98
10/98
Event
Sold credit card portfolio to Fleet Bank; focus primarily on
subprime home equity
Acquired by Conseco; significant writedown and subsequent
equity infusion
Bought by First Union Corp.
Substantial 3Q 1998 loss due primarily to hedge loss; filed for
bankruptcy in 5/00.
Significant credit losses; arranged financing with CIR group
Significant losses due to higher than anticipated prepayments
Filed for bankruptcy
Filed for bankruptcy
11/98
11/98
11/98
Discontinued subprime home equity originations
95% control sold to Greenwich Street Capital Advisors
Nearly 19% of company purchased by US Bancorp
12/98
Coast to Coast partnership failed to materialize; Firstplus
Financial filed for bankruptcy in 2/99.
Selling noncore business to raise cash: filed for bankruptcy in
3/99
Filed for bankruptcy
Filed for bankruptcy
Selling servicing portfolio to CitiFinancial Mortgage, ending
relationship with Greenwich
FDIC closes lender
Filed for bankruptcy
Ceased operations
Conseco restructures subprime unit, formerly Green Tree
Financial
Purchased by Citigroup
Advanta Corp.
6/98
Green Tree Financial
The Money Store
ContiFinancial Corp.
Homegold Financial Inc.
MegoMortgage
Cityscape Financial Inc.
Southern Pacific Funding
Corp.
Amresco Corp
IMC Mortgage Co.
New Century Financial
Corp.
FIRSTPLUS Financial
Group Inc.
United Companies Financial
Corp.
MCA Financial
United Companies
7/98
9/98
4Q/98
3/99
3/99
IMC Mortgage Co.
Pacific Thrift & Loan
First Alliance
The Money Store
7/99
11/99
3/00
6/00
Conseco (Green Tree)
7/00
Associates First Capital
9/00
Sources: Fitch IBCA. 1999. “Subprime Home Equity: What Next?” Financial Services Special Report. April 27. Inside B&C
Lending (www.imfpubs.com). March, 1999; March 2000; May 2000; July 2000; and September 2000.
Source: Temkin et al. p. 11.
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Table 5
Freddie Mac— Credit Statistics, Non-Agency Mortgage-Related Securities Backed by
Subprime, Option ARM and Alt-A
Loans
12/31/2009 09/30/2009 06/30/2009 03/31/2009 12/31/2008
As of
(Dollars in millions)
Delinquency rates:(1)
Non-agency mortgage-related securities backed by:
Subprime first lien . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49% 46% 44% 42% 38%
Option ARM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45 42 40 36 30
Alt-A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ….. . . . . . . . . . . . . . . . . . . 26 24 22 20 17
Cumulative collateral loss:
Non-agency mortgage-related securities backed by:
Subprime first lien . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13% 12% 10% 7% 6%
Option ARM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
6
4
2 1
Alt-A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ….. 4
3 3
2 1
Gross unrealized losses, pre-tax… . . . . . . . . . . . . . . . . . . . $33,124 $38,039 $41,157 $27,475 $30,671
(1) Based on the number of loans that are 60 days or more past due as reported by servicers.
Source: Freddie Mac 2009 Annual Report
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