The Subprime Crisis is Just Starting
by Daniel R. Amerman, CFA | March 20, 2008
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Overview

As the author of three books on mortgage finance and related derivative securities, and speaking as someone who first turned mortgages into rated securities in 1983, I’m going to let you in on an unfortunate little secret – the real subprime mortgage securitization crisis may not have even started yet. But, there is a good chance the real crisis will arrive soon.

This assertion that the crisis could just be getting started may seem absurd and extraordinarily out of touch. What about the approximately 45,000 homeowners losing their homes to foreclosure in the United States every month? What about the 8.9% plunge in nominal housing prices in 2007, the largest decline in over 20 years? What about Bear Stearns losing 94% of the value of its stock in 2 days, with even the remaining 6% in value being based on an unprecedented loan from the Fed before JP Morgan would agree to the acquisition? How much worse could it get?

To understand the full extent of the danger requires moving beyond current headlines to take a brief and simple look at how mortgage securitizations actually work. These securitizations are based on what are known as “stress tests”, or the ability of a security to withstand an adverse economic change and still pay principal and interest on schedule. The heart of the subprime problem is that no major stress tests happened in 2007 – and the market still blew up. Which brings up the question of what will happen to subprime and other mortgage derivative securities in 2008 if actual stress tests do occur in such possible forms as recession, increases in interest rates, or a further plunge in housing values? Given that the safety margins have already been stripped bare? As we will explore, should one of those stress tests occur – or worse, if two or three occur together – then we may look back at 2007 as being a mere stroll in the park in comparison.

The Lack Of A Problem

To explain what I mean about nothing going wrong, let’s review a bit of ancient history, and talk about how ratings and securitized mortgages used to work. You started with a creditworthy borrower, and a significant piece of equity invested in the property. The assessment of “creditworthy” was not a guess or an experiment, but rather the result of decades of underwriting experience on a national basis, through good times and bad. With single family mortgages, you had a large pool of such creditworthy borrowers, each having equity in their properties.

Then, you applied what are known as “stress tests”. A stress test is the assumption that something goes wrong. For instance, you might assume that there was a recession that would lead to homeowners losing their jobs, and then their homes. If rising interest rates hurt the security, you would check out some rising interest rate scenarios, and if falling interest rates hurt the security, you would check out some falling interest rate scenarios. Essentially you would push on the security until it fell over (using financial modeling).

The rating was simply a description of how hard you had to “push” before the security fell over and was unable to make contractual principal and interest payments to investors. If the ability to make payments was a bit shaky under the current economic environment, then the rating was junk. If the ability to repay investors was pretty good with a decent economy, but possibly grew problematic with a mild recession – then maybe you got the lowest investment grade rating, that of “BBB”. The highest rating, “AAA”, was reserved for those securities that had such powerful coverage and reserves built into them that they could withstand another Great Depression, and still make investor payments in full and on schedule. (Or so the theory went until Wall Street got collectively “brilliant” a few years ago.)

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