Don't Blame Declining Lending Standards for Subprime Mess

A policy statement by the President's Working Group on Financial Markets signed by Henry Paulson in March placed the root cause of the current crisis on a now-familiar source:

The turmoil in financial markets clearly was triggered by a dramatic weakening of underwriting standards for US. subprime mortgages, beginning in late 2004 and extending into early 2007.

The Working Group -- comprised of Treasury, Fed, SEC, and the CFTC -- felt so strongly about this statement that the italics above were in the original letter.

Now a couple of researchers, Geetesh Bhardwaj of A.I.G. (yes that A.I.G.) and Rajdeep Sengupta of the St. Louis Federal Reserve, have a new working paper where they actually see if this widely-held view is true. They find

that there is no evidence of a dramatic change in underwriting standards in the subprime market, particularly for originations after 2004.

(emphasis mine)

Using individual-level loan data on originations for subprime mortgages from 1998 to 2007, Bhardwaj and Sengupta note that originators compensated for the added risk of lending to borrowers who provided less documentation by requiring that these borrowers have higher FICO scores and that they take out mortgages with lower loan-to-value ratios.

For example, between 1997 and 2006, the percentage of low documentation first lien subprime loans increased from 18.4 percent to 37 percent. But,

the pattern is reversed when one considers the trend in borrower FICO score. The proportion of loans with a FICO score of less than 620 drops from close to 70 percent in the year 2000 to 50 percent in 2005. There is a  orresponding increase in the proportion of loans for FICO-score in the range 620-659 and 660-719.<

One caveat here is that the researchers can't determine from their data whether there was enough adjustment for riskier borrowers through demanding higher FICO scores. It could be the case that even though lenders tried to hedge against default, they didn't hedge enough.

Providing more evidence that lending standards didn't sharply decline post-2004, the researchers also looked at what would have happened if a borrower in 2006 had instead borrowed in 2001. They find that this borrower would have been more likely to default had they bought a home in 2001 than in 2006.

Bhardwaj and Sengupta also point out that another major caveat with their study is that they can't rule out that subprime standards were always low. But if they were subpar from the get-go, then why didn't the subprime meltdown happen sooner? In a companion paper, the researchers argue that prepayments kept the market afloat in the early part of this decade.

Subprime mortgage contracts were designed as "bridge-finance", providing the borrowers the incentive to graduate into a prime mortgage by building equity on their homes and improving their credit records....[In] the early years, a significant proportion of subprime mortgages were prepaid around the reset date. These prepayments were largely sustained by the boom in house prices in the United States from 1995 to 2006.

What does this all mean for the current situation?

Well, the widely held view that underwriting standards declined because of the securitization process is flawed, the results suggest, and this should have implications for how regulatory rules are rewritten under the next president.

Comments

[Tricky:]

Hmm, interesting. Did they take into account whether the later subprime borrowers were more likely to also be given a HELOC, whereas maybe the early borrowers were not?

2008 Oct 17 03:09 PM

[dawdler:]

Socialism cannot compete!,

I don't really buy that this was the Democrats who pulled this off. I think it was pretty much a group effort by everyone: borrowers, lenders, mortage brokers, investment banks, regulators -- everyone fell down.

In my humble opinion, the assertion that anyone was "strong-armed" into subprime lending is absurd and delusional. The subprime lending was driven by greed, not coerced.

The fact is that the whole system went crazy with greed. Everyone involved, including borrowers, was deluded by mass hysteria. Nobody wanted to be the chump not making money.

While I'm opposed to any but the most carefuly crafted and conservative bailouts, I think trying to pin this mess on any one group is useless and counter-productive.

2008 Oct 17 05:40 PM

[Steven Hansen:]

leverage (such as zero down loans) create bubbles followed by crashes. if a borrower comes with 25% of the money, i don't care how he will pay the payments as he has a big stake - he will find the way.

leverage in stocks (such as shorts where you do not own the stock) adds to this problem.

2008 Oct 17 08:50 PM

[Jimmy Lathrop:]

The answer is that low FICO scores has no correlation to delinquency models . FICO scores create artificial parameters asuuming those factors may indicate a higher or lower probability of delinquency or outright default. They do not indicate fraudulent intent such as equity stripping, inflated appraisal values and careless underwriting practices. Fraudulent activity distorts any pure mathematical correlation between subprime and underwriting. Underwriting fraud took place through phantom income, no income verification loans, failure to disclose ownership interests in other properties or outright fabrication of information on a 1002 Uniform Mortgage Application.

If someone wants to point the finger, it should be pointed at the CEO of Goldman Sachs who testified in front of Congress in 2000 and asked for less regulation and more leverage. We need it, he pleaded, to keep up with the rest of the world and maintain our competitive edge. And yea, verily it came to pass that the Congress was convinced, and the capital limits for the investment banks were lowered, and the leverage poured forth in great volumes, a flood, intoxicating the nation and providing a feverish rush in the homes along the countryside.

2008 Oct 17 08:53 PM

[kingaj12:]

The real issue lies with the Ratings Agencies. Why else do banks no longer accept AAA rated paper as collateral?

2008 Oct 17 09:49 PM

[huskerbob:]

Good point kingaj.
Earlier this year, the two morons we have appointed to solve the crisis, Bernanke and Paulson, assured us that the subprime crisis was contained. Whoops! It could have been, but the wizards of Wall St. mixed subprime in with higher rated debt and sold it as AAA debt, spreading the contagion to everyone and making the problem impossible to contain.
Of course Paulson, lacking any connection to Wall St., could not have known this and therefore put all the blame on underwriting standards. Wall St. absolved!

2008 Oct 18 08:12 AM

[dinochick:]

We also need to take into consideration that the housing prices were going up, and income was going down. Big corporations and some small businesses are also at fault here, by not paying salaries to meet standard of living costs. By allowing stated income for salaried borrowers, we created this mess. If the buyers couldn't afford the home, the sales prices would have dropped... Period.. .Natural supply and demand. It was a feeding frenzy, powered by greed, fraud etc. And many borrowers are fault here, and now crying for help for their misdeeds.

I also feel that the pricing of houses need to be "controled" by certain factors. As there is a median price placed by FHA/VA , there should only be allowed an annual percentage increased based on the GNP and salaries. Each state, city, etc should be analyzed for the price of the area prior to the bubble, and adjust for salaries, areas and amenities. Any percentage that goes up over the percentage must have an approval of an "agency" created to monitor this. This could be funded by an addition to the property sales tax collected by the counties.

And.. we need to do away with Wholesale. It obviously is a problem.

2008 Oct 18 09:35 AM

[Jakester:]

Dinochick: Not sure what you mean by "big corporations and small business are also at fault here by not paying salaries to meet standard of living costs". What standard of living are you benchmarking and why? Do you get to decide what salaries should be and what a proper standard of living is?

2008 Oct 20 09:24 AM

[Socialism c...:]

dawdler: Sorry, but there *was* strong-arming of banks going on! It is well-known that Fannie & Freddie were given "goals" that they had to have 50% of their mortgages be subprime. A

2008 Oct 20 12:29 PM

[Socialism c...:]

@dinochick: you are wrong on at least 3 points!

1) stated income is not the problem -- the problem is that the government takes 30-40% off the top of most working Americans' checks, for fed taxes alone! time to get that back where it oughta be so that people have their own money to do with as *they* need.

2) control house prices -- you mean like communists would do? we don't operate like that here for a reason -- it doesn't work! there are already *natural* barriers in place, such as cost to build.

3) the last thing we need is another agency and more property taxes! cut the d@mn bloody taxes and then we can afford our mortgages! you actually want to cap what people can sell for, and require approval by an agency to exceed that? where's freedom anymore?

2008 Oct 20 05:24 PM