Subprime lending represented a minimal share of home mortgages in the 1990s. As recently as 2001, it represented only 2 percent of home purchase originations. In 2005, it represented 20 percent. So says Nicolas Retsinas, a lecturer of business administration at Harvard Business School and former assistant secretary for housing in the U.S. Department of Housing and Urban Development.
Last week, Retsinas joined four other Harvard Business School experts in a discussion about the current financial crisis, and today their discussion is published in Harvard Business School’s “Working Knowledge” e-newsletter.
I particularly liked what Retsinas had to say. As time progressed and regular, or prime loans, were replaced more and more by subprime loans, the system increasingly promoted and rewarded the selling of mortgages, he said.
Mortgage brokers originated over two-thirds of the mortgages as opposed to the one-third they did 10 years earlier, Retsinas said. Mortgage brokers were paid on commission and on the basis of originating a loan; they were unconcerned with whether the mortgage was repaid.
Then, in the pursuit of scale, Retsinas said, mortgage banks bundled mortgages and worked with investment banks to put them into complex securities.
“In 2004 and 2005 as these subprime loans started to emerge, it really wasn’t a particular problem because of the lag effect, because people who couldn’t pay off these mortgages with toxic terms and exploding payment schedules” thought, that if they could not pay off their mortgage, they would simply sell the house.
But, Retsinas said, as the housing bubble burst, those exit doors closed.
“All of a sudden, we started to see record numbers of delinquencies, defaults and foreclosures. The question was, who bore that risk? What had happened with these subprime loans is they were brokered apart, taken apart, put in little subsets, and put in a whole variety of different securities. And no one knew what they had. At that point government had stepped aside, had genuflected at the altar of the market as it relates to our housing financing system, and the de facto regulator became the credit rating agencies,” Retsinas said.
The credit rating agencies, he said, were unable to perform their function whether due to the attendant complexity or their own eagerness to participate in this system.
Which leaves us, as Retsinas says and as we all now know, “in a bad place” today. He estimated that there are now a million more homes than are needed. And, just when people need credit, credit is constrained. Subprime lending has vanished.
As for the future, Retsinas said, “We know what happened, we know how we got there. Our short-term strategy is to nationalize the housing market. Is that a good strategy over time? If you nationalize that market, how do you balance between extending credit and making sure you have safety and soundness without burdening the taxpayer? That’s the question.”
Read the entire discussion here.