Bankruptcy

How did Lenders Get it So Wrong?

By Mechele Dickerson

An economist, Professor Amir Sufi (University of Chicago), shifted our focus in the afternoon session from debtor, to lender, behavior. In discussing his paper, Lender Incentives, Credit Risk, and Securitization: Evidence from the Subprime Mortgage Crisis, Professor Sufi asks why lenders made such bad decisions when making subprime mortgages. He concludes that securitization reduced lender incentives to scrutinize borrowers, because lenders knew they would sell virtually all the subprime loans they originated and, thus, knew they would shed the credit risk associated with those loans. Professor Sufi argues that this is to be expected, since financial intermediaries overcome information frictions only if they have an incentive to properly screen and monitor borrowers.

Professor Sufi?s paper traces the increase in consumer mortgage debt relative to non-mortgage debt (it skyrocketed after 2002) and the increase in the number of securitized mortgage loans (skyrocketed after 2003). He examined differential securitized mortgage growth rates by zip codes and found that high securitization zip codes had riskier loans. Borrowers in these zip codes had lower incomes, were given more subprime loans, and the loans in these areas had a higher fraction of denied loan applications (all suggesting that the loans were riskier). While brokers should have been exercising greater caution in examining borrower information (income and employment) before approving these risky loans, the data show that lending in these areas increased but that lenders did not appear to consider whether these loans should have been made. This finding confirmed what many have suspected, .i.e., that the subprime lending boom was lender-based and was not created because of borrower demand.

Professor Sufi does not believe that securitization is always bad. He believes, however, that removing lender incentives to scrutinize borrower information coupled with the unrealistically optimistic ratings agencies gave mortgage-backed securities caused investors not to investigate the true risks associated with these mortgage investments. He also suggested that, because the collateral that backed the mortgages (houses, that is) was appreciating, investors also had no reason to consider the actual risks associated with the loans. He, like others, believe that the subprime lending itself caused much of the house price appreciation for the last several years. To fix the problem in the future, Professor Sufi suggests that securitization pools should require the loan originator/arranger to hold more of the credit risk.

Dr. Yuliya Demyanyk, an economist with the Federal Reserve Bank in St. Louis, disagreed that securitization distorted lender incentives. Instead, she argued that lenders had no incentive to screen borrowers because lenders were making the subprime loans specifically for securitization. Her research indicates that lenders understood that they were serving as an intermediary between Wall St. and the ultimate investors (she cites China as an example of an investor that was willing to purchase these high risk, but potentially high return loans). Dr. Demyanyk contends that Wall Street securitizers asked lenders to originate a certain number of loans over a certain period of time, that lenders made the loans and then sold them back to Wall Street. Thus, Dr. Demyanyk rejected the claim that lenders were surprised by the risks, arguing instead that they knew that the loans were risky.

Full post as published by Credit Slips on May 04, 2008 (boomark / email).