Tsz-Nga (Russel) Wong

Economic analysis is all about supply and demand. Subprime mortgages exist because someone prefers to pay for them and someone finds it profitable to sell them. After all, mortgage underwriters were willing to offer low interest rates, which dropped even further when housing prices rose and the opportunity seemed too good to pass up.

Why were underwriters so willing to lend to the borrowers who are not able to afford the mortgage? They did so because they could transfer the default risk through securitization.

Securitization is an arrangement through which security holders can lend their funds to a pool of borrowers. Potential home buyers who have limited funds can borrow from mortgage underwriters as subprime borrowers. Subprime borrowers have less down-payment requirements and lower interest rates in the beginning, which can be extended or even cut if housing prices keep rising. Mortgage underwriters cash in immediately by reselling mortgages they hold to investment banks. Investment banks then pool many mortgage contracts together into securities and sell them to other institutional investors or the general public.

Thanks to securitization the holders of mortgage securities have little reason to worry about borrowers’ defaulting on their mortgage. In fact, they do not even know who the borrowers are.

By pooling a sufficiently large number of mortgage contracts together, the holders of securities believed they had a sound idea of what sort of defaults were possible. They could do this because of the law of large numbers, which works for any kind of insurance. From this perspective, the overall net return on the securities is almost assured, and even if a particular mortgage goes into default, it would be possible to sell the collateralized house. With house prices going up, the security holder could even gain if borrowers default, and that is precisely why lenders are willing to refinance the borrower at a lower interest rate when house prices are on the upswing.

So what is wrong with this logic? It worked well as long as housing prices were rising, but even the most astute use of the law of large numbers fails to eliminate the risk that housing prices could go down. In particular, the law of the large number only works well for individual risk but not risk to the market as a whole. Think about auto insurance. A company like GEICO can accept the risk of individual drivers because individual car accidents are almost completely independent events. But this is less obviously the case when insuring against a bad harvest since droughts or tornados often affect all the fields in a region.

This latter case is the more appropriate analog to securitization as insurance against mortgage default. In other words, the risk of default is not totally covered.

The most common reason for borrowers to default on a mortgage is that they no longer can obtain affordable mortgage terms from the lender by refinancing when housing prices collapse. The price of my house is not independent of that of my neighbor’s, and the result is that defaults can sweep through an area like tornado. If a house price goes down so much that the value of the collateralized house is less than the principal borrowed, which is known as being “underwater” or having a negative asset, the borrower may be forced to sell and even be forced to declare bankruptcy. The lender suffers loss as well since collateralized houses sell for less. To cover their loss, lenders are no longer willing to offer favorable terms to other solvent borrowers, or they may simply refuse to lend in general. And this causes housing prices to slump further, since there are more borrowers forced to sell their houses while fewer people can obtain mortgages to buy into the market. This vicious cycle results in a crisis. In short, the subprime mortgage market works only if housing prices increase forever.

This presents just the tip of the iceberg. There are many factors that have contributed to the economic crisis that emerged in 2008, including the failure of the rating agencies, predatory lending practices, and the failure of mortgage underwriters to recognize moral hazard.

All this is not to say that the scope of the crisis indicates the inevitable failure of capitalism. On the contrary, by studying the crisis we can recognize the potential flaws of capitalism and help design more sophisticated regulatory policies. The capitalist system will survive and become stronger if—but only if—it can learn from its errors and evolve into something stronger.