It is by now well known that the present global crisis was trigged off by the subprime mortgage housing crisis in the US. However, it is not well understood how the crisis in this market started off. In a recent paper titled “The subprime panic”. (National Bureau of Economic Research (NBER) Working Paper 14398). Gary Gorton of the Yale School of Management examines the details of the event, the exact precipitating factors for the decline in house prices and the actual channel of how that affected credit spreads on short-term borrowing.
A subprime mortgage is a mutually beneficial transaction aimed to profitably finance housing for risky borrowers. The borrowers are usually credit-constrained individuals who would not have had access to loans otherwise and the lenders are financial institutions who make healthy profits off these loans. From this perspective, subprime mortages seem to be confined to real-estate markets. How has this started off what is now the deepest financial crisis since the Great Depression?
In order to make subprime mortgages profitable, lenders created a unique “securitisation” model, where they created subsidiaries whose job was to exclusively manage subprime assets. These subsidiaries were legally off the lender’s balance sheet and their focus was only on issuing short-term bonds off the long-term subprime assets. They issued this short-term debt in various”tranches”, stacking high risk and high returns on some, and lower risk and lower return on the others. This debt was purchased by various banks and investment companies, and was used as the basis of many derivative instruments, which were then traded widely across the world financial system. What started off as a long-term asset financing operation became inextricably linked with money markets and short-term borrowing as a whole.
The problem, according to Gorton, arose when US housing prices began to fall in 2006. The classic 30 year subprime mortgage had a unique structure, where the interest rate for the first two years was much lower than that of the remaining 28 years, creating an incentive to refinance after 2 years. Effectively, this meant that subprime borrowers were incentivised to roll over their short-term debt every two years. This became difficult when house prices were falling, and so the defaults began. Since the subprime assets were at the heart of the securitisation process and the tranches of short-term debt, defaults on these led to a crisis in short-term borrowing, which led to a liquidity crunch and sparked off a negative shock to financial markets as a whole.
Gorton identifies the ABX.HE index as a key “multiplier” of the impact of subprime defaults on liquidity. This index, which is a synthetic over-the-counter instrument, was launched in January 2006 by Markit Group, a financial information services company. It is a credit-derivative index that contains 20 equally weighted subprime backed short-term bonds, each of different risk-return ratings. Once this index was launched, it was possible to trade and price subprime risk, and even more importantantly, to short the subprime market.
A careful look at prices of the ABX index over 2007 show a sharp decline, and Gorton argues that the impact of this trend on investor sentiment is huge. Gorton’s analysis shows that it was the opacity in the design and securitisation of subprime transactions which was the culprit. Subprime mortgages have significant social and economic potential—after all, they are a mechanism to provide credit for borrowers excluded from the formal banking system. However, inadequate regulatory oversight resulted in intrinsic features often not explained well to borrowers—such as the 2/28 rule or severe prepayment penalties. Moreover, unregulated off-budget build-ups and incorrect estimates of risk compounded the issue further.
The author is consultant, National Institute of Public Finance & Policy. These are her personal views