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Unraveling the mortgage credit crisis

By Sanjay Ramchander

Published December 1, 2007 at 12:05 a.m.

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The crisis in the housing market has resulted in numerous property foreclosures, large losses for financial institutions, tightening of credit markets and the specter of a recession. Central banks around the world, lenders of last resort, have responded to this crisis by providing emergency funds to banks and attempting to shore up investor confidence.

Economic crises, like tornadoes, to a large extent are unavoidable. Yet, while being disruptive, they also carry important lessons that can help us be better prepared when the next one comes around. An understanding of the mix of factors underlying the credit market turmoil is a crucial step in our learning process:

* The Greenspan put: It refers to former Federal Reserve Chairman Alan Greenspan's proclivity to cut interest rates to stabilize financial markets and bail out struggling institutions.

Between early 2001 and June 2003, the Fed reduced short-term interest rates gradually from 6.5 percent to 1 percent. In the same period, yields on 10-year Treasury notes - a prime determinant of long-term mortgage rates - hovered around 4.5 percent. These low interest rates, along with the Greenspan put provided ample incentive for institutions to engage in risky lending practices, resulting in a rapid and unsustainable appreciation of asset prices.

* Foreign savings glut: In the past decade, owing to a diverse set of global factors, there has been a glut of foreign savings. This, combined with the gradual lifting of restrictions on the movement of capital in many countries, made it easier for citizens of foreign countries to invest abroad.

Foreign net buying of long-term assets in the U.S. increased from $58 billion in 1991 to $1,135 billion in 2006. This kept U.S. borrowing costs low and fueled our consumption of everything from cars to houses.

* Regulation: Beginning in the late 1980s, international and domestic regulations enforced stricter capital requirements for banks. The amount of capital that banks had to carry was determined by the quantity and quality of assets in their portfolio. The heightened capital adequacy standards provided impetus for banks to sell loans that they had originated to investors, thus moving these items off their balance sheet. This freed up capital and provided them with resources to pursue additional investment activities. Banks were transformed from being loan originators to diversified distributors of financial services.

* Financial innovation: In recent years, a proliferation of new financial products and processes entered the marketplace.

In general, financial innovations improve the distributional efficiencies of the economy. But they also add an element of uncertainty. The loan securitization business is one such example. Loans are originated and packaged into portfolios that are sold off to investors with differing claims on the underlying cash flows.

According to some estimates, more than 80 percent of the loan production in the past five years was packaged and sold in this manner. Furthermore, in order to increase the product's attractiveness, various add-ons such as credit-default derivatives were created that protected investors against the possibility of default in these securities. These innovations increased the availability of credit and liquidity but also increased the system's vulnerability to shocks.

This confluence of economic forces created an atmosphere that had predictable and unfortunate consequences. Keeping deal flows alive became more important than enforcing sensible credit standards. The share of subprime mortgages in the mortgage market doubled from 10 percent in 2001 to about 20 percent in 2006, and more than two-thirds of these loans were securitized.

So here we are. As the economy slowly unwinds itself from the mortgage market conflagration, it is abundantly clear that there is no easy answer to resolve the situation. It is also clear that there is no turning back of the clock as far as financial innovations are concerned. The important lesson is that individuals must exercise more ownership and responsibility of their financial literacy, and financial institutions should behave more prudently in safeguarding their client's long-term economic well-being.