PrefBlog

The Great Credit Crunch of 2007-?? will be rich source of theses and fistfights for many years to come. The New York Fed has published a staff paper by Andrew Haughwout, Richard Peach and Joseph Tracy titled Juvenile Delinquent Mortgages: Bad Credit or Bad Economy?

Even borrowers with negative equity, however, default less frequently than simple models would predict (see Vandell 1995 for a summary of the empirical evidence and Elul 2006 for an update). For an owner occupant considering default, transactions costs include moving costs, the cost of purchasing or renting a new residence, and damage to one’s credit score resulting in higher future borrowing costs. All told, some authors have argued that these costs can typically range from 15 to 30% of the value of the house, helping to explain why default appears to be underexercised relative to the simple option-theoretic prediction (Cunningham and Hendershott, 1984). Investors face fewer of these transaction costs and therefore may be more likely to default for a given LTV level.
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The rapid house price increases in the boom/bust states prior to the downturn would act to keep the put option for default out-of-the-money. Even where the lender finances most or all of the borrower’s down payment with a 2nd lien loan, twelve months of double-digit house price appreciation will generate more than sufficient equity to cover the transactions costs of selling the house. Similarly, in cases where a borrower in a boom/bust state suffers a job loss, divorce or significant health problem during the boom period, we would not expect to see this result in a default. The borrower would have a financial incentive to sell the house and prepay the mortgage rather than default. Finally, as discussed earlier, owners may be less likely to exercise the default put option than investors other things equal.
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Despite the focus in the press made on no-doc mortgages, in each year the incidence of no-doc mortgages was in single digits, and was declining over the sample period. What is more notable is the shift in composition from fully documented to limited documented underwriting. From 2001 to 2006, the share of fully documented subprime mortgages fell from 77.8 percent to 61.7 percent, while the share of fully documented alt-a mortgages fell from 36.8 percent to 18.9 percent.
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For borrowers with negative equity, the data indicate that investors appear to be much more likely than owners to default. The point estimate for the incremental effect on the default rate is over 24.6 percentage points for subprime investors and 20.3 percentage points for alt-a investors
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The major difference between 2003 and 2005-2007 was a dramatic change in house price appreciation. After rising nearly 14% in 2003, the OFHEO index accelerated to 16% in 2004 before slowing and eventually reversing. For 2005-2007, OFHEO grew 10%, 1% and –4% respectively.31 The decomposition indicates that changes in economic variables, particularly this reversal in house price appreciation, from 2003-2007 account for the bulk of our explanation for observed increases in early defaults. In 2006, we estimate that changes in the economy added 2.4 percentage points to the average early default rate for subprime loans, while in 2007 that figure rises to 4.1 percentage points.
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“Bad Credit,” on the other hand, contributes less to our explained rise in average early defaults. Had the economy continued to produce unemployment and house price appreciation rates in 2005 through 2007 like those in 2003, our model predicts that changes in the credit profiles of new nonprime mortgages in each year would result in an increases in average early default rates for subprime loans of less than a percentage point in each year.
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We use loan-level data on securitized nonprime mortgages to examine what we refer to as “juvenile delinquency”: default or serious delinquency in the first year following a mortgage’s origination. Early default became much more common for loans originated in 2005-2007. Two complementary explanations have been offered for this phenomenon. The industry-standard explanation of default behavior focuses attention on a relaxation of lending standards after 2003.

We see evidence of this in our data, as some underwriting criteria, particularly loan-to-value ratios at origination, deteriorated. At the same time, however, the housing market experienced a sharp and pervasive downturn, a factor which has received attention in recent research. Our results suggest that while both of these factors – bad credit and bad economy – played a role in increasing early defaults starting in 2005, changes to the economy appear to have played the larger role.

Perhaps as important a finding is that, in spite of the set of covariates we control for, our model predicts at most 43 percent of the annual increase in subprime early defaults during the 2005-2007 period. Observable changes in standard underwriting standards and key economic measures appear to be unable to explain the majority of the run-up in early defaults. The fact, noted in our introduction, that many participants in the industry appeared to have been surprised by the degree of the increase in early defaults is in some sense verified here: observable characteristics of the loans, borrowers and economy seem to leave much unexplained, even with the benefit of hindsight. The difference between what we predict, conditional on observables, and what we actually observe is the difference between a bad few years for lenders/investors and a full-blown credit crunch.

The data does indicate a significant difference in behavior between owners and investors, especially in terms of how they respond to downward movements in house prices and negative equity situations. This has implications for underwriting. First, there may be payoffs to increased efforts at determining the true occupancy status of the borrower as part of the underwriting process. Second, originators may want to require additional equity up front from investors to reduce the likelihood that future house price declines could push the investor into negative equity.

In other words, a good part of the sub-prime debacle can be blamed not just on poor under-writing and the fashionably loathed originate-and-distribute model, but on a failure of investors to understand that they were short a put on housing prices … or, if they understood that, to price the put option properly.

OK, this is way off topic. I admit that freely. But I really enjoyed the paper by Kenneth D. Garbade recently published by the New York Fed: Why the US Treasury Began Auctioning Treasury Bills in 1929:

The U.S. Treasury began auctioning Treasury bills in 1929 to correct several flaws in the post-war structure of Treasury financing operations. The flaws included underpricing securities sold in fixed-price subscription offerings, infrequent financings that necessitated borrowing in advance of need, and payment with deposit credits that gave banks an added incentive to oversubscribe to new issues and contributed to the appearance of weak post-offering secondary markets for new issues.

All three flaws could have been addressed without introducing a new class of securities. For example, the Treasury could have begun auctioning certificates of indebtedness (instead of bills), it could have begun offering certificates between quarterly tax dates, and it could have begun selling certificates for immediately available funds. However, by introducing a new class of securities, the Treasury was able to address the defects in the existing primary market structure even as it continued to maintain that structure. If auction sales, tactical issuance, and settlement in immediately available funds proved successful, the new procedure could be expanded to notes and bonds. If subsequent experience revealed an unanticipated flaw in the new procedure, however, the Treasury was free to return to exclusive reliance on regularly scheduled fixed-price subscription offerings and payment by credit to War Loan accounts. The introduction of Treasury bills in 1929 gave the Treasury an exit strategy—as well as a way forward—in the development of the primary market for Treasury securities.

I also found the following to be amusing:

Bidding on a price basis insulated the Treasury from specifying how bids in terms of interest rates would be converted to prices. Market participants used a variety of conventions. For example, the price of a bill with n days to maturity quoted at a discount rate of D is P = 100 – (n/360)×D. The price of the same bill quoted at a money market yield of R is P = 100/[1+.01×(n/360)×R]. In the case of a ninety-day bill quoted at 4.50 percent, P = 98.875 if the quoted rate is a discount rate, that is, if D = 4.50 percent, and P = 98.888 if the quoted rate is a money market yield, that is, if R = 4.50 percent.

Some things never change!