Global Housing Price Boom and its Aftermath, The

Housing Finance International, Dec 2007 by Renaud, Bertrand, Kim, Kyung-Hwan

Many of the subprime mortgage loans that went bad in 2007 did so before their interest rate reset. Some of these loans had gone to speculators who planned to flip their houses but no longer could, others went to borrowers that should never have been qualified for a loan, and still others had elements of fraud. The bulk of interest rate resets has yet to come. Each quarter until the end of 2008 more than 400,000 subprime loans will be reset compared with 200,000 resets per quarter during the first half of 2007. A major and pressing systemic challenge facing the US market is how to manage loss mitigations and avoid foreclosures as much as possible, preferably on a mass basis rather than through the current slow and costly case by case process The social benefits for the households and the financial savings for lenders will be very large: current industry estimates are that 40% to 50% of the unpaid mortgage balance is lost in a foreclosure. The spillover effects for some housing markets could be large and in turn affect the US economy.

Financial innovation, global securitization and the US subprime market

While the US Savings and Loans crisis of the 1980s was about interest rate risk faced by various types of banks, the 2007 financial crisis is about credit risk diffused throughout the global securities markets. It is not limited to a sub-sector of the banking industry. Bad subprime loans have been the catalyst revealing much broader systemic problems with risk evaluation, risk pricing and ratings of structured finance products (Mason and Rosner, 2007b). Central banks and regulators are not well equipped to address present liquidity and solvency problems because these problems arise mostly outside regulated banks in unregulated and poorly documented private capital market institutions. The magnitude of problems has been even harder to estimate than in earlier financial crises. In his Congressional testimony of 8 November 2007, FRB Chairman Bernanke ventured that "a ballpark estimate" of the losses was $150 billion. If the history of past financial crises is any guide, this early figure is an underestimate.

Securitization had made the funding of US subprime loans possible because in the low interest environment prior to 2007, capital market investors were willing to assume much greater risk in their search for yield. To maximize their return on capital in a low-margin loan environment, banks moved forcefully to fee-based activities and derivatives trading. An explosive growth of derivatives markets and the creation of increasingly complex credit risk transfer (CRT) instruments took place during the last five years.

What has surprised some observers is "how toxic the securitization of [US] subprime mortgages has turned out to be for the [global] financial markets".14 Indeed, how could credit problems in such a small segment of the global securities markets have such a disruptive and widespread impact on the global financial system? In its Financial Stability Report of October 2007, the Bank of England has put the subprime securities markets in perspective (Bank of England, 2007, Figure A). The BoE estimates that subprime securities outstanding amounted to $ 0.7 trillion in total global securities markets of $149.1 trillion at the end of 2006, which is less than 0.5% of the global securities markets.15