Subprime primer

Guambat stumbled across this research paper published by the Federal Reserve Bank of St. Louis in 2006. Makes for interesting reading.

The Evolution of the Subprime Mortgage Market
by Souphala Chomsisengphet and Anthony Pennington-Cross

Many factors have contributed to the growth of subprime lending. Most fundamentally, it became legal.

The ability to charge high rates and fees to borrowers was not possible until the
Depository Institutions Deregulation and Monetary Control Act (DIDMCA) was adopted in 1980. It preempted state interest rate caps. The Alternative Mortgage Transaction Parity Act (AMTPA) in 1982 permitted the use of variable interest rates and
balloon payments.

These laws opened the door for the development of a subprime market, but subprime lending would not become a viable large-scale lending alternative until the Tax Reform Act of 1986 (TRA). The TRA increased the demand for mortgage debt
because it prohibited the deduction of interest on consumer loans, yet allowed interest deductions on mortgages for a primary residence as well as one additional home. This made even high-cost mortgage debt cheaper than consumer debt for
many homeowners.

In environments of low and declining interest rates, such as the late 1990s and early 2000s, cash-out refinancing6 becomes a popular mechanism for homeowners to access the value of their homes. In fact, slightly over onehalf of subprime loan originations have been for cash-out refinancing.

In addition to changes in the law, market changes also contributed to the growth and maturation of subprime loans. The growth through the mid-1990s was funded by issuing mortgage-backed securities (MBS, which are sometimes also referred to as
private label or as asset-backed securities [ABS]). In addition, subprime loans were originated mostly by nondepository and monoline finance companies.

During this time period, subprime mortgages were relatively new and apparently profitable, but the performance of the loans in the long run was not known. By 1997, delinquent payments and defaulted loans were above projected levels and an accounting construct called “gains-on sales accounting” magnified the cost of the unanticipated losses.

In hindsight, many lenders had underpriced subprime mortgages in the competitive
and high-growth market of the early to mid-1990s (Temkin, Johnson, and Levy, 2002).
By 1998, the effects of these events also spilled over into the secondary market. MBS prices dropped, and lenders had difficulty finding investors to purchase the high-risk tranches.

the structure of the market also changed dramatically through the 1990s and early 2000s. The rapid consolidation of the market is shown in Table 3. For example, the market share of the top 25 firms making subprime loans grew from 39.3 percent in 1995 to over 90 percent in 2003. Many firms that started the subprime industry
either have failed or were purchased by larger institutions.

Although the subprime mortgage market emerged in the early 1980s with the adoption of
DIDMCA, AMTPA, and TRA, subprime lending rapidly grew only after 1995, when MBS with
subprime-loan collateral become more attractive to investors.

The paper does not touch on the credit meltdown or tie subprime mortgages to it. That is not within the scope of the study. But it is useful to understand what it is that is being blamed for the crisis.

Guambat's take is that it has little to do with the subprime borrower and everything to do with the securitization and financial gimmickry of the mortgage debt after the lackless buyer signs up.

Note that the article says the thing that triggered subprime debt was Ronald Reagan's iconic Tax Reform Act of 1986: "The TRA increased the demand for mortgage debt". This got a toxic kick-along when the finance houses began to demand every kind of debt to securitize and re-securitize for sale to yield-hungry pension, insurance and other funds in the long lasting low interest rate Greenspan years.

Guambat reckons this will not become a perfect world until they repeal the law of unintended consequences.