Wednesday, April 25, 2012 Wisconsin Real Estate Viewpoint Blog
U.S. Housing Policy: Who Bore the Risks in the Mortgage Market? by Abdullah Yavas

The U.S. economy recently experienced one of the worst financial and economic crises since the Great Depression. The crisis was triggered by a collapse of the bubble in residential real estate markets. Many commentators cite the recent dramatic growth in mortgage “securitization” (when banks sell housing loans to investors in the secondary mortgage market) as a key contributor to the real estate bubble and ensuing crisis. Why? Partly because securitization created additional layers in the lending process, leading to lax underwriting and higher mortgage default rates.

But which loans did banks decide to sell to investors and which ones did they keep on their balance sheets? Did banks simply pass on the risk of lower-quality loans by selling them to the secondary mortgage market? Or did they seek to protect their reputations by retaining lower quality loans while selling the better quality to investors?  My research (Journal of Financial Economics, forthcoming) studies the economic forces that may drive the decisions of lenders to keep some types of loans in their portfolios while selling others.

My co-authors and I analyzed lenders’ securitization decisions using information from several large datasets of mortgage loans originated between 2004 and 2007. Unlike other studies of mortgage securitization that focused only on mortgage default risk, we considered lenders’ choices around two types of mortgage risk: borrower default risk (i.e., the likelihood that the borrower may stop making payments) and prepayment risk (the risk that the mortgage will be repaid before it comes due).

Our analysis found significant differences in lenders’ securitization choices, depending on the mortgage market. In the prime market, banks generally sold low-default-risk loans to Fannie Mae and Freddie Mac while retaining higher-default-risk loans in their portfolios. In contrast, banks were more likely to sell loans with higher prepayment risk to investors and retain loans with lower prepayment risk on their own balance sheets. One possible explanation for this is that Fannie Mae and Freddie Mac offer investors guarantees against default risk and, as a result, impose more stringent underwriting standards to control default risk of the loans they buy. Another possible explanation is that such a strategy was profitable for banks during the boom years when prepayment risk, driven by high refinancing activity, was a bigger concern for lenders than default risk in the prime market. In support of this explanation, we found a dramatic shift in banks’ mortgage securitization strategy in the 2007: as the housing crisis set in and borrower defaults rose rapidly, lenders stopped retaining higher-default-risk loans in exchange for lower prepayment risk. In the subprime mortgage market, on the other hand, we found no clear pattern in lenders’ securitization choices.