One way of looking at the subprime crisis – and by this I mean only the properly real estate–based part of the unfolding drama – is in terms of population dynamics, in terms of three populations of borrowers who first entered the market and then left it in reverse order as the last to come in were also the first to leave.
In order to characterize these populations I’m resorting to a classification that was introduced – although used for a different purpose – by Hyman Minsky, an American Keynesian economist who was born in 1919 and died in 1996. Minsky distinguished [*] three modes in which an economy can operate in terms of behavior related to debt. In the first mode, borrowers are in a position to reimburse principal and pay interest on a regular basis; this is the safe mode which he called “hedged”. In the second mode, called “speculative,” borrowers are able to pay interest but are unable to reimburse principal. Finally, in the third mode, called “Ponzi”, from “Ponzi scheme,” borrowers are unable to meet either interest or principal payments.
How can either speculators or Ponzi players be part of the scene? Speculators are safe as long as there is no request that they pay back principal, as in a non-amortizing or “balloon” loan: they can “roll” their debt until the day of reckoning. How can Ponzi players stay in the game? This is a bit trickier: they need to sell assets or, alternatively, keep borrowing larger and larger sums in order to service their debt.
In normal circumstances, banks would only lend to “hedgers” being able to pay interest and principal, as these borrowers are the only ones likely to make their business profitable. Residential real estate in the US is subsidized by government: interest payments are tax deductible, and so are property taxes and the proceeds from the house sale, up to a ceiling. Federal Housing Association (FHA) contributions to mortgage insurance constitute as well a subsidy. These subsidies mean that owners can put more money into buying a house than they would otherwise. That additional money finds its way to the housing market and leads to inflation in the price of houses. If the circumstances persist, the market for residential properties sets into bubble mode.
Once the market is in bubble mode an interesting change takes place: “speculative” borrowers are allowed to join in. Why? Because although they have enough money to pay interest but not enough to refund the outstanding balance, in the new circumstances that situation is only provisional as equity is slowly but surely building up through the simple expansion of the bubble. At the height of the bubble in the spring of 2005, housing price was rising at 13.7%. At that speed, equity amounting to 25% of the house value was built in after one year and nine months only.
To give “speculative” borrowers a further little push, lenders reinstated the “Interest Only” mortgage. The Home Owners’ Loan Corporation (HOLC) had refinanced delinquent borrowers in 1933, inventing for the occasion the – from then on “classical” – fixed rate amortizing 30 year loan. The “Interest Only” or “balloon” loan had led borrowers to their demise and it should never happen again thought the legislators of the New Deal. “Not so!”, started to say lenders in the new millennium.
What about Ponzi players? Their time was about to come too! They couldn’t pay full interest and needed therefore to sell assets or further borrow to service it. In a bubble they could do both. They could sell their house at its new inflated price and use the proceeds to pay the interest due. But this was not even necessary as they could simply refinance their loan for a larger amount through a “Cash-out” mortgage loan and use that money. Alternatively, and sparing themselves the hassle of refinancing, they could subscribe to a “HELOC,” a Home Equity Line of Credit, exchanging the equity in their home for cash that could be funneled into paying the interest due.
This being a bit too complicated for some Ponzi players, lenders came up with loan types that were pushing the bother of paying the full interest due into a distant future. There were two approaches. One was the subprime “2/28” ARM (for Adjustable Rate Mortgage) with the initial two years benefiting from a “teaser rate” and the remaining 28 years paying interest at a floating interest rate determined at a set margin above the index: most commonly, the 6 Month LIBOR (London Inter-Bank Offered Rate), the rate at which banks could borrow themselves on the Eurodollar market, Eurodollars being dollars traded outside the US domestic market. As is now well-known, at the time of reckoning, when interest was reset at its “true” rate opportunities for refinancing had all but evaporated, “2/28” borrowers then defaulted in droves, contributing thus to the bubble being punctured.
The second approach used to give the Ponzi players a little push was the “Pay Option ARM,” when the option used was that of “minimum payment” – a formula that 85% of the borrowers of these “affordability loans” – as they were called – enthusiastically adopted. Of course, in the same way as with “2/28” subprime loans, a “reset” time would come when truth would prevail and interest would at long last need to be paid. In the “Pay Option ARM” the part of interest accrued but not actually paid would be added on top of the outstanding balance, i.e. the loan’s principal, creating what is called a “negative equity.” Reset would take place when the outstanding balance would have risen in that manner to 115% of the initial principal value, i.e. when the unpaid part of monthly interest would reach 15% of the loan amount.
As we just saw, Ponzi players can only make their payments – however reduced these have become through subtleties in loan underwriting – if housing prices keep rising: they need indeed a constant restocking of equity to make the interest payments they’ve committed themselves to. Ponzi schemes display however the remarkable property of self-extinguishment. They require indeed to sustain themselves a constant flow of new recruits and these are out of necessity in finite number. Shortage in new recruits is what happened: once the Ponzi players had acquired their own home there was nobody to follow. This marked automatically the Ponzi players’ downfall as it meant that the price of housing stagnated and this they couldn’t bear as what they needed to pay interest was a housing bubble.
But stagnating housing prices are but a fleeting moment as the foreclosed homes of the Ponzi players join the by then pretty crowded residential real estate market, leading the price of homes to fall, resulting in no time in the end of… “speculative” borrowers. Why? Because these could just about pay interest and were counting on the rising equity in their house for reimbursing one day the principal they still owed. When the equity stopped rising it became clear that that hope was unlikely to materialize and “speculative” borrowers got nervous. Nothing ominous had yet happened but the future had stopped looking rosy. When housing price began to drop things turned ominous. When paying interest only no equity in the house is being built apart from that which may be resulting from a current real estate bubble. So as soon as that bubble deflates, “speculative” borrowers find themselves in that position variously called “underwater” or “upside down”: when the outstanding balance on the house has become higher than the money that can be made through selling the house. At that point the “speculative” borrower starts dragging a ball and chain and may feel that the best strategy is that of rushing to the exit and propose the bank a “short sale” where the house is returned with the debt being forfeited – whatever the current value of the house compared to the outstanding balance of the loan – no question being asked.
Homes reclaimed by the banks through short sales are put back on the market, pushing home prices further downwards. As I said, “hedgers” are able to pay interest and principal but this may change with plummeting home prices: if these keep coming down, at some point these borrowers also will get “underwater” or “upside down” and will feel that a “short sale” is the best way for preventing being out of their pocket comes the day of reckoning.
This is the time we’re in as we speak. As proof I will quote Marshall Eckblad of Dow Jones Newswires who wrote yesterday: “Delinquencies among home loans to the nation’s more reliable borrowers, known as “prime” mortgages, are rising quickly, and that could dog banks’ ability to shake further losses this year and next.”
In my next installment I will translate this “population dynamics’” approach of the subprime crisis into a financial one, in terms of the financial instruments involved: all those Asset-Backed Securities (ABS), Collateralized Debt Obligations (CDO), Asset-Backed Commercial Papers (ABCP) and Structured Investment Vehicles (SIV) you’ve heard about.
Watch this space!
[*] Hyman Minsky, The Financial Instability Hypothesis, Working Paper No. 74, May 1992