Editor Pick – Money for Nothing and Checks for Free: Recent Developments in U.S. Subprime Mortgage Markets

Author: Christian Menegatti  ·  August 8th, 2007  ·  209623http%3A%2F%2Fwww.economonitor.com%2Fanalysts%2F2007%2F08%2F08%2Feditor-pick-money-for-nothing-and-checks-for-free-recent-developments-in-us-subprime-mortgage-markets%2FEditor+Pick+-+Money+for+Nothing+and+Checks+for+Free%3A+Recent+Developments+in+U.S.+Subprime+Mortgage+Markets2007-08-08+15%3A30%3A50Christian+Menegattihttp%3A%2F%2Fwww.economonitor.com%2Fanalysts%2F2007%2F08%2F08%2Feditor-pick-money-for-nothing-and-checks-for-free-recent-developments-in-us-subprime-mortgage-markets%2F › Share This Print

In a new IMF working paper, John Kiff and Paul Mills discuss the recent developments in the U.S. subprime mortgage markets.

“The recent experience in the subprime market is a case study in the costs and benefits of financial innovation in an environment of shifting asset price dynamics.  On the one side, the cost of risky mortgages has fallen, allowing for the expansion of homeownership—especially among minority groups—and default risks have been dispersed away from core depository institutions to the capital markets.  On the other, the viability of the riskiest mortgages and mortgage-related securities became reliant on continuing house price appreciation, and lending standards were relaxed to generate high-yielding loans to meet securitization demand.  Moreover, lending standards may also have suffered because fee-remunerated intermediaries within the securitization process had insufficient incentive to monitor and maintain long-term loan quality.  Less sophisticated investors were content to outsource the risk management of their positions to the credit rating agencies, who initially appeared slow to respond to deteriorating mortgage performance.  It is questionable whether the extreme version of this business model, which satisfied demand for high risk loans from nonviable borrowers at the top of the housing market, should have a future.

With lending standards already tightened, the policy response should balance greater consumer protection with maintaining the viability of the securitization model. Most of the actual and anticipated losses from subprime delinquencies have been suffered by bankrupt originators, on-balance sheet lenders, or investors in the riskier ABS and CDO tranches.  Appropriately, lending standards been have tightened and ratings models are being strengthened but subprime credit is still readily available—at a price—while no depository institution has failed as a result.  When considering future policy changes, regulators and lawmakers need to balance carefully the need to limit future predatory lending excesses, while preserving a model that has successfully dispersed losses from higher-risk mortgages away from the banking system and maintaining the ability of stretched but viable subprime borrowers to refinance when confronted with reset payment shock. This is a challenging task within a regulatory and legal framework ill-suited to provide consumer protection in an originate-to-securitize financial system.