Subprime credit: the evolution of a market: the subprime lending crisis is simply the latest variation of a traditional cycle

Business Economics, July, 2008 by John Silvia

About once every decade or so economists get to witness the evolution of a credit market. In the 1970s there were mutual funds, in the 1990s there were high yield bonds, and today we have subprime lending. How do we establish a framework for a market that allows itself to undergo a quiet evolution but ends in speculation and credit revulsion? America's latest credit cycle, subprime lending, is not a unique experience but rather the latest variation of a traditional cycle of innovation, excess, and correction that is compounded by public policy laxity and followed by overreaction. Indeed, there is little that is new or creative in the whole subprime saga. This is disappointing because the subprime credit patterns we observe are so typical that they suggest much of the recent experience could have been avoided. This provides a simple analytical framework for the sub-prime credit market. It suggests that public policy actions, taken as if the subprime lending is simply a matter of speculative excess, fail to properly address the dynamic of credit markets that we have witnessed in the financial market over the last thirty years.

**********

America's latest credit cycle, subprime mortgage lending, is not, contrary to popular commentary, a unique experience. Rather, it is the latest variation of a traditional cycle of innovation, excess, and correction that has been compounded by public policy laxity. Earlier cycles included the go-go mutual funds of the 1970s, energy lending in the 1980s, and high-yield bonds of the 1990s. In hindsight, the subprime credit pattern of innovation/excess/correction was quite typical. A challenge for analysts and policymakers is developing a reliable means by which to recognize these patterns before the correction.

This paper aims to provide such a statistical framework--one that economists can use to disentangle even as complex a pattern of behavior as a credit bubble. For economists, the value added is that time series that suggest a change in credit markets and assets prices--such as those for homes--can be monitored to give a possible heads-up on significant change. This provides the caution flags that management can understand to better manage risks and avoid significant financial losses, even in the case of "hot" markets such as housing and subprime lending.

1. Sub-prime Lending: Different Asset Class--Similar Credit Cycle

In many ways the market for subprime loans is typical of any credit market from a cyclical perspective. There is both a demand and supply for that credit, reward and risk are judged, and a price is assigned to that credit. This simple framework highlights that in any decision-making network, it is important to recognize that credit reflects the dynamics of both supply and demand. Moreover, the dynamics of the credit market reflect the interaction of finance and the real economy over time.

So how does the dynamic credit process apply to the sub-prime experience? The demand for mortgage credit is a derived demand for housing. It reflects the influence of factors such as personal income, household wealth, interest rates, and current and expected home prices. On the credit supply side, we have a lender who qualifies and issues a mortgage that enables the borrower to purchase a home. The supply of credit reflects the influence of factors such as bank reserves, global liquidity, the value of the housing asset, the expected value of the asset in the future, and the credit experience of the lender.

Expectations drive both supply and demand. During the past four years, what have expectations been and how did they evolve? The buyers expected home price appreciation--in some markets very big appreciation--and often expected their personal income to also rise over time to cover their future payments. In Figure 1, we can see that assumptions about higher home prices were validated up to mid-2006. The builder saw a healthy housing market and was willing to build many homes that were expected to sell at a profit in a very short time. The lender also anticipated a healthy mortgage market and expected there to be an active market for the ultimate holders of the mortgages. Moreover, up until the end of 2005, the delinquency experience on subprime mortgages was very favorable.

2. What Made the Subprime Market Different and Yet a Logical Outcome of Traditional Lending?

Residential mortgages are typically broken down into three categories. Prime mortgages are the traditional type with borrowers with good credit, traditional down payments, and documented income (DiMartino and Duca, 2007). Borrowers are generally classified by credit score (Fair Isaac & Co. or FICO) as follows:

Subprime: 620 FICO and below

Near prime: 621 - 679

Prime: 680 or greater FICO

Historically, a lower credit score is associated with higher frequency of default. For example, a FICO score below 479 has been associated with a 17 percent frequency of default, while a FICO score between 560 and 579 has been associated with a five percent frequency of default. FICO scores above 660 have been associated with a frequency of default of two percent or less. (1)