An Appetite for Yield: The Anatomy of the Subprime Mortgage Crisis

Abstract

In early 2007 a dramatic set of developments signaled a crisis in US mortgage markets as lenders specializing in subprime mortgagesöloans made to borrowers with poor credit histories, often made with unconventional terms or structures öfound themselves with exploding levels of loss due to increased defaults and foreclosures. The overall level of these losses triggered a sudden collapse in one of the most dynamic segments of the US financial system. Instead of the high yields that had recently drawn investors into mortgage markets in droves, those involved in the subprime market faced evaporating demand for their products, plummeting stock prices, devalued bond ratings, and margin calls among investors, leading to a number of prominent bankruptcies and fire sales. By late summer of 2007 this contraction was beginning to have broader ramifications for the global financial system as increased market volatility and a sharp contraction in credit rippled through Wall Street and into Europe and Asia (Fender and Ho« rdahl, 2007).These outcomes came as a surprise to many observers, including policy makers from the Federal Reserve Bank and prominent industry groups such as the Mortgage Bankers Association. These observers had celebrated the rise of subprime lending through the 1990s as the`completion' of the mortgage market; through a process of institutional and technical innovation, it was argued, mortgage loans to marginal borrowers or with unconventional terms could be more accurately priced for the risks they posed, and allocated to investors with appropriate tolerances for risk. This was supposed to increase access to capital for borrowers across the spectrum and make the overall housing finance system more efficient.What happened? Numerous popular accounts of the subprime mortgage meltdown have pointed to missteps by the Federal Reserve or bond rating agencies, a lack of due diligence on the part of lenders and investors, and unscrupulous borrowers who benefited from lax loan underwriting. This paper challenges these interpretations by arguing that the sources of the subprime crisis need to be located instead in the deep structure of mortgage markets as they have become more integrated into global financial markets. It does this in two ways. First, it contrasts mainstream interpretations of mortgage market

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