Subprime Mortgage Worries

August 15, 2007

Subprime mortgage worries continue to spread fear in markets around the world. What is the problem and who is to blame? Basically, over the past six or seven years enormous amounts of money have been lent out to individuals and firms with poor credit at low interest rates. In theory, the interest rate of a loan should be higher for riskier loans in order to compensate the lender for taking on higher levels of risk. This is simply the law of supply and demand at work. Fewer people are willing to supply loans to high risk borrowers and so the price of such loans (the interest rate) is higher. Low supply high price. Conversely, many lenders compete in order to loan to borrowers with well-established credit and thus drive the interest rate down. High supply low price.

Because banks want to offset their risks, they package these loans into securities and sell them to investors. These securities are claims on the future repayments of the loans, basically a monthly flow of payments. They have a value much like a stock does, and so they can be bought, sold and traded. In a simple sense, the value of the loan is the discounted value of the future payments. There are of course many variables that affect the nature of these payments and how much one should discount them. On one hand, there is a chance that the loan could be paid off in full in the near term or that the borrower might default. These effects lower the value of the security. The interest rate operates in the opposite direction, raising the total amount to be repaid and thus increasing the value of the security. All this is much more complicated in the financial world where all kinds of mortgages and other assets are packaged together to form complex financial instruments. Properly valuing these creatures is itself part of the problem.

Recently, as lenders and markets finally begin to realize the risks involved with subprime mortgages, everyone is beginning to place more weight on the risk of default, in effect lowering the value of the securities that many investors and hedge funds around the world are stuck holding. If those risks are realized and many consumers begin to default, those holding the bag will be in even more trouble. Right now, everyone is looking around at everyone else wondering just who is holding the bag. Banks don’t want to lend to other banks or firms who might be at risk.

So, who is to blame? First there are the banks and mortgage brokers who offered seemingly (perhaps even deceivingly) cheap loans to risky borrowers in the first place. Then there are the homeowners and consumers who did not properly evaluate their means to repay the loans they were taking out. To be fair, there were some very complex loans being offered at low initial interest rates. However, it was also their responsibility to read and understand the contract they were signing.

Finally, there are the rating firms who blessed such loan-backed securities as safe for investors. Again, it is ultimately up to investors to do their homework. However many are now pointing to a conflict of interest between the banks and rating firms (Lucchetti and Ng, 2007). Essentially banks seeking a particular rating for a security were able to shop around at the various rating firms to get the rating they wanted. Of course, it isn’t in the best interest of a rating firm to just hand out good ratings to anyone. That’s a quick way to destroy a reputation. But the flexibility to shop for ratings seems to have contributed to the mess.

Overall, The Economist thinks that while things could still go badly wrong, as it stands this looks like a healthy market adjustment and reevaluation of risk. The world economy is strong and U.S. banks have plenty of cash on hand to cushion them if problems arise.

To many investors, the recent volatility has provided a good shopping opportunity. Stocks of very good companies are being beaten down with the rest of the market providing good buys. Most likely though, the road ahead is still going to be a little rough.