|Source: Financial Crisis Inquiry Commission|
By this time, subprime originations were near their peak, as a proportion of the total mortgage market.
And, yet, with all of that turmoil, the mortgages made up to that point had healthy, low default rates. Here are graphs of Alt-A default rates and subprime default rates, by vintage.
Even the 2005 vintage of mortgages performed fairly normally until late 2007, when home prices really began to drop. So, even the year with the highest level of subprime originations and housing starts, with homes bought at the top price of the market, were preforming within the range of the previous five years. Think about how much this contrasts with rhetoric about this period of time. These were households who, as of 2008 or 2009, were experiencing the worst home price performance of the post-WW II era, by a wide margin. They are the unluckiest set of homeowners in modern US experience, and they had used non-conventional financing at a scale far outside any previous ranges. And loan performance was normal. Even at the depth of the price collapse, the 2004 cohort was similar to earlier recession era cohorts that had experienced no price declines.
Oh, and by the way, the Fed Funds Rate was above 4% by the end of 2005 and above 5% by the summer of 2006, with an inverted yield curve. None of the mortgage cohorts with high default rates were made when the Fed Funds Rate was low, and none of the mortgage cohorts originated when the Fed Funds Rate was below 2% had high default rates. So, if there was some sort of Austrian Business Cycle capital misallocation going on in 2003 and 2004, someone needs to tell the borrowers and lenders who purchased homes at the time. They may not have noticed.
If your response to this is that I am naïve - that you knew an unemployed guy who was flipping houses in 2003, that you knew a guy who worked for a predatory subprime lender in 2001 or 1996, and that they were doing terrible, irresponsible things - then you need to think about evidence, what it is, what makes it relevant, and what could possibly falsify your explanation of events at the macro level.
Here is a copy of the S&P downgrade announcement of Residential Mortgage Backed Securities on July 11, 2007. From the report:
Although property values have decreased slightly, additional declines are expected. David Wyss, Standard & Poor's chief economist, projects that property values will decline 8% on average between 2006 and 2008, and will bottom out in the first quarter of 2008.And:
While our LEVELS model assumes property value declines of 22% for the 'BBB' and lower rating category stress environments (with higher property value declines for higher rating category stress environments), the continued decline in prices will apply additional stress to these transactions by increasing losses on the sale of foreclosed properties, as well as removing or reducing the borrowers' ability to refinance or sell their homes to meet debt obligations.
As lenders have tightened underwriting guidelines, fewer refinance options may be available to these borrowers, especially if their loan-to-value (LTV) and combined LTV (CLTV) ratios have risen in the wake of declining home prices.
The loan performance associated with the data to date has been anomalous in a way that calls into question the accuracy of some of the initial data provided to us regarding the loan and borrower characteristics. A discriminate analysis was performed to identify the characteristics associated with the group of transactions performing within initial expectations and those performing below initial expectations. The following characteristics associated with each group were analyzed: LTV, CLTV, FICO, debt-to-income (DTI), weighted-average coupon (WAC), margin, payment cap, rate adjustment frequency, periodic rate cap on first adjustment, periodic rate cap subsequent to first adjustment, lifetime max rate, term, and issuer. Our results show no statistically significant differentiation between the two groups of transactions on any of the above characteristics. Reports of alleged underwriting fraud tend to grow over time, as suspected fraud incidents are detected upon investigation following a loan default.They seem to take the lack of explanatory power from all the typical sources of default as a sign of fraud. But, wouldn't this also be a sign that the source of the defaults is not buyer quality? If the source of stress in these mortgage pools was from some outside influence, wouldn't we still expect fraud to increase as the market distress increased and wouldn't we expect those instances where fraud was involved to be more frequently noticed (much like with S&Ls in the 1980s)? "Our results show no statistically significant differentiation between the two groups of transactions on any of the above characteristics." That is a very strong effect from underwriting fraud from a market that just 2 years prior appears to have created a cohort of mortgages that performed very well. In two years, with similar rates of originations, subprime loans went from being benign in the face of extreme volatility to being so devoid of honest underwriting that FICO, LTV, DTI, and many other reported variables had no explanatory value at all? And the fraud was so universal that even the issuer wasn't explanatory? Fraud somehow meant even the terms of the mortgages weren't explanatory?
Also, note that at the time this report was published, home prices had basically been flat for about 18 months. There were some local markets that were dropping by then, but nationally, prices were still at the plateau they had been on since early 2006. But, S&P projects a decline in home prices of 8% nationally, and up to 22% in some areas. At a point where home price trends are still stable, they predict future price trends far outside any previous experience. This must have had a large effect on the implied value of the securities in question.
And, what did the Federal Reserve have to say about the effect of these extreme expectations of nominal collapse, when they met just a couple of weeks later on August 7?:
The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.In their defense, although the minutes of the meeting mention a softening even in the jumbo loan market, at that time, mortgage levels outside the subprime market were still growing modestly. But, I wonder how much of a difference it would have made if the Fed had simply made a rhetorical statement that they didn't expect home prices to fall, or that they would expect to add liquidity if home prices appeared to begin to slide. They didn't make that statement because they had no intention of supporting nominal stability as home prices fell by nearly 1% per month for the next year. This nominal collapse, after all, was not a problem, it was the "correction" of a problem.
Economic growth was moderate during the first half of the year. Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.
Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.
Although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the outlook for both inflation and economic growth, as implied by incoming information.