« Holding Doors for Strangers and Correcting Absentminded Errors | Main | Waitlisted ... »

November 13, 2007

BLA Speaker Tackles Subprime Mortgages

By Sarah Rizzo

Today, it is difficult to open the newspaper without reading about the elusive subprime mortgage crisis. Thankfully, on November 1, the Michigan Business Law Association welcomed Ross School of Business Professor Robert Van Order to provide some much needed information about the crisis, in a talk titled “Sub Prime Markets, Securitization and Housing.” Van Order, who came to Michigan after stints as the former Chief International Economist of Freddie Mac and the Housing Finance Analysis Director of the U.S. Department of Housing and Urban Development (HUD), explained the crisis, why it occurred, and what is going to happen next.

Subprime lending is the practice of making loans to borrowers who do not qualify for market interest rates because of their poor credit history. “Subprime” refers not to the loan’s interest rate but to the borrower’s credit rating, based on his or her credit history. Van Order reports that subprime loans grew from about 10 percent of the market to up to one-third of the market after 2003.

According to Van Order, the markets in which subprime loans are securitized and then traded publicly have more or less collapsed. The securitization of subprime loans is not new; indeed, securitization has been a mainstay of the mortgage business for 30 years.

In the late 1990s, investors began to package subprime loans into big pools of securities, pooling them together with other loans of varying levels of risk and return. With final investors largely distanced from the original loan, an asymmetrical information problem arose, and it became difficult for investors to know the true value and risk of the securities. In some situations, “principals” (those responsible for collecting loans for securitization and then selling the shares in the collected pool to other investors) purposely pooled risky but theoretically high-yield loans with more stable but less lucrative loans. This allowed some less scrupulous lenders to profit on both ends by making predatory loans to less creditworthy borrowers, securitizing them together with “good loans” and then selling the securities, thus passing the risk of default on to unwitting investors.

Van Order partly attributes the problems with securities trading today to pure uncertainty by institutional investors. With the deterioration of historical models, as well as agency problems whereby unscrupulous fund managers purposely mix good loans with bad, investors do not know what they are getting in the loan pools. While it has never been a secret that subprime loans are risky, uncertainty has spooked investors. Whereas risk can be properly assessed in the markets, uncertainty cannot. Consequently, investors do not want to buy at all.

The subprime loan problems are no longer isolated to subprime-mortgage lenders, either. As Van Order pointed out, the crisis is spreading unpredictably across markets and countries. He adds that these strange spillovers are hard to understand because of “the lack of public data available.” Van Order remains skeptical of enacting policy changes today. Critically, he does not rule out the possibility that investors can solve this problem.

Investors are not the only ones being affected by the subprime mortgage crisis. The large number of students who attended Van Order’s talk speaks to the problem’s relevancy in the field of law as well. Van Order discussed law firms’ participation in the pooling of mortgage loans into securities, and several lawsuits have recently arisen over investors’ inability to sell back troubled securities to the originators.