Subprime Root Cause Analysis

by: Myron Shlapak

The question to be asked is not what caused the subprime implosion but rather what exacerbated it.

1. Subprime loans are not bad. They give people with moderate to low incomes an opportunity to participate in the American Dream of home ownership.

What went wrong is that the lenders lent with no regard to the borrower's ability to repay since the loan was removed from the books of the lender via the securitization process. Had the loan originator retained possession of the liability they would have been more demanding of evidence of the borrowers intention to repay the debt.

2. The securitization of loans is not bad. It allows lending institutions to recycle their assets among a larger universe of customers and gives investors an ability to earn a higher income.

What went wrong is that inflation stayed low and debtors' income and asset values could not keep up with the cost of servicing their debts. Rather than reducing their expenses by lowering their lifestyles many chose instead to refinance as Bankruptcy was no longer a solution to excessive credit card debt.

3. Excessive demand of all collateralized debt obligations.

Various hedge funds invested in securitized debt instruments, which in it self is not bad. It allowed the loan originators to lend more by removing long term assets from their books and replacing them with cash.

While the buyer was paid a higher then available yield then could be expected at the higher rated debt levels. The problem expanded with the leverage, that the hedge funds took on, to purchase additional securitized debt obligations. This caused a demand for more of these instruments, which caused the providers to increase their lending to less qualified people as there was an ever-expanding market for these obligations. As this became apparent to the less than honest portions of our society those that saw a way to get rich quick rapidly, with little or no risk to themselves, stepped in. As well as a once in a lifetime opportunity for those that hoped beyond hope for a chance at the American Dream, and got in well over their heads.

4. The rating agencies saw fit to accept the issuers assurance that the questionable loans as packaged could be broken up into different risk levels.

As the demand for collateralized debt obligations grew and the number of these securities increased to satisfy these demands, the rating agencies appeared to bless all the securities with their magic wand of risk assessment. There was logic to the process, we can be certain. And there was certainly some form of method to the now obvious madness but both might be questionable when viewed in hindsight.

5. Mispricing or lack of pricing for the lightly traded securities.

The various collateralized debt obligations were traded on a closed, members only market due to their high prices. These securities could only be invested in by small investors through mutual funds, or hedge funds. The general market never saw what these collateralized debt obligations were initially sold for only what they were finally dumped at, $0.27 on the dollar as recently reported.

We now see that if there had been a more open market for these debt instruments, various purchasers might have been more cautious in their leveraging of risk.

With the reduced leveraging by various hedge funds, the loan originators would not have had the incentive to create the stock that filled these debt instruments.

With more accurate pricing of these instruments, the short-term cash markets would have known what they were getting as collateral.

Had the bankruptcy laws not been changed for the benefit of the credit card companies, homeowners would not have accessed their home equity to pay off these debts and increase their expenditures.

Had there been a higher rate of inflation that increased the salaries of the various debtors they might have been able to keep up with their payments and eventually refinance at a lower rate.

Had the ratings agencies been more skeptical of a relatively new product, filled with questionable parts, the distribution of the contagion would have been limited.

In conclusion, the pricing of risk, or the lack there of, seems to be the most obvious root cause, as greed is always with us.

We see that a new private, big-boys-and-big-girls-members-only network is being created for Institutional investors. If the subprime root cause is due to this lack of pricing then these Networks will fall victim to repetition.