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Of three likely explanations for the unusual economic circumstances leading to the recent mortgage default crisis, innovation in the securitization of subprime mortgages seems the most plausible, said Amir Sufi, assistant professor of finance.
“It’s not necessarily the only cause, but evidence strongly suggests that securitization had at least something to do with it,” Sufi said during the opening talk of the four-part “The Credit Crisis: A Lecture Series,” a Myron Scholes Global Markets Forum presented by the Initiative on Global Markets at Harper Center on October 21.
From 2002-05, a “historically unique” expansion in credit coupled with a decline in interest rates – occurred in the highest quartile of subprime zip codes throughout the U.S., he said. “It was not California, Florida, and Las Vegas,” Sufi said. “It’s a crisis that seems to be there in almost every Metropolitan Statistical Area in our sample.”
The credit expansion was largely divorced from underlying improvements in borrower income and productivity, he said. “The expansion to subprime borrowers may have been driven by house price growth and expectation, but those expectations themselves also seem to be divorced from fundamentals in income, employment, and salary growth,” Sufi said.
Regulators could not have seen the patterns leading to the crisis, he said. “Micro-level data is critical to understanding these patterns,” Sufi said. “With MSA or state level data, you wouldn’t see any of this. If you compare Chicago to Las Vegas, you’ll see some patterns. But then you won’t notice that both the subprime borrowers in Chicago and Las Vegas are experiencing the same phenomenon.”
As early as 2003-04, credit growth became separate from growth in borrower income, Sufi said. “If people had the micro-level data, you would think that would have set off some sort of red flag,” he said. “I’m not saying it’s obvious something is wrong, but you might want to focus and say, ‘Wait a second. Why are mortgage and house price growth going up in areas that actually have negative income growth?’ It’s not consistent with historical standards.”
Economists should carefully consider whether credit growth may have contributed to housing price growth, Sufi said. “I don’t want to push that idea too far,” he said. “We don’t show it definitively, but I think it’s worth thinking about these feedback effects. The rumor I heard was that so many of the credit rating agencies and so many of the people doing mortgage-backed securitization had housing prices on the right hand side of their models.”
Perhaps those agents were thinking housing prices are exogenous, Sufi said. “They seemed to be say, ‘They just keep going up,’ without thinking, ‘Well, maybe the very act of lending might be pushing up house prices in a way that leads to a sort of vicious cycle upwards that is ultimately going to have to have a sharp regression,” he said.
Sufi used real data to successfully pinpoint a likely cause of the crisis that has dramatically affected both the American and world economies, said Teresa Sonka, a PhD student in finance. “He was able to present more clearly theories of why this occurred,” Sonka said. “Another professor I spoke with pointed to the same problem. That’s something to think about in the future: avoiding moral hazard in securitization.”
--Phil Rockrohr