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Loose Standards, Sluggish Economy Make for Mortgage Muddle

7/21/2008 --

Foreclosure rates likely to peak in 2010; banks, financial system will remain stressed for some time, say Ross professors.

Ann Arbor—The soaring number of "for sale" signs on the nation's front lawns due to foreclosures can be blamed on two culprits: looser mortgage underwriting standards and a weakening of local economies. The resulting subprime mortgage crisis and high foreclosure rates have roiled credit markets and rocked the nation’s financial system.

Unfortunately, there is no quick resolution to the rippling crisis, according to the paper “Deconstructing the Subprime Debacle Using New Indices of Underwriting Quality and Economic Conditions,” co-authored by Ross professors and real estate experts Dennis R. Capozza and Robert Van Order.

Reflecting back on the deterioration of underwriting standards since 1990, Capozza and Van Order cite two specific periods that led to the current situation. First, the early 1990s through 2002 saw a deliberate lowering of easy-to-see credit standards. That was due to the development of more sophisticated underwriting systems and the use of credit scores.

The problem, they say, is that the negative effects of eroding loan quality were masked by a strong economy.

"The economic environment for mortgage lending from 1990 to 2002 grew more favorable each year and in this environment lenders misjudged the default risks on mortgages, especially subprime mortgages," write Capozza and Van Order in the paper.

After 2002, the share of subprime loans increased sharply but the "observable" measures of loan quality, such as credit scores and down payments, didn't change. There was neither a decrease in credit scores nor a large increase in loan-to-value ratios preceding the sharp increase in defaults after 2005.

Capozza and Van Order suggest that "soft" data did, in fact, erode. For example, investors could see the ratio of loan value to property value, but couldn't see if the property appraisals were accurate. Investors also couldn’t tell if a borrower lied about whether the signee would occupy the property or flip it for a higher price.

At the same time, the number of subprime mortgage-backed securities also increased, despite the fact that they are more difficult to securitize than other types of loans.

Securitization, where loans are bundled and sold, has always been a part of the mortgage market. But Capozza and Van Order argue that the recent situation invited a "moral hazard."

"Lenders who were selling rather than holding the loans had incentives to originate and sell the lowest quality loans that fit within the criteria that investors in the loans can actually see and demand," they write.

Rising interest rates for adjustable rate mortgages don’t appear to have been a major factor, the researchers say. Of the subprime loans originated in 2007, about 2 percent were foreclosed in just over a year.

"It is not easy to foreclose in a year, so these loans must have been bad almost at the first payment," Capozza and Van Order argue in the paper. "It took three years for the 2003 vintage to accumulate to this level. Such sharp increases in early foreclosures suggest changes in loan quality."

In addition to hard-to-see changes in mortgage underwriting, the national and local economies deteriorated, with home values on a sharp decline.

"Our results suggest about a 50-50 split between the looser underwriting and local economic conditions as explanations for the recent surge in foreclosures," Capozza and Van Order write.

The problem will take a while to sort out. The Ross professors project foreclosure rates will peak sometime in 2010 and then decline gradually "to a level that remains worse than the pre-2005 experience. This forecast implies that the problems in the mortgage markets will be with us for some time to come. We can anticipate that the banking and financial system will continue to be under stress for quite some time."

Dennis R. Capozza is a professor of finance and real estate and the Dykema Professor of Business Administration at Ross. He is an expert on real estate and consumer finance. Robert Van Order is an adjunct professor of finance at Ross and an expert on real estate markets and mortgage securitization.

Written by Terry Kosdrosky

Read a Q&A with Capozza and Van Order on the subprime debacle.

Listen to a related podcast with Van Order.

For more information, contact:
Bernie DeGroat, (734) 936-1015 or 647-1847, bernied@umich.edu