Mar152008

Mortgage Default Losses

Mortgage Default Losses

delayThere is risk of loss in any investment, and losses in collateralized debt obligations arise from the difference in the book value of the underlying mortgage note and the actual resale value of the collateral on the open market, if this collateral is subject to foreclosure. There is an important distinction that must be made between the default rate on a mortgage loan and the resultant loss incurred when a default occurs. High mortgage default rates do not necessarily translate into high mortgage default losses and vice-versa.

Subprime loans have had high default rates since their introduction. When subprime mortgages began to capture broader market share starting in 1994, the rate of home ownership in the United States began to rise. The increasing use of subprime loans and the subsequent increase in home ownership rates put upward pressures on house prices. As house prices began their upward march, the default losses from subprime defaults began to fall because the collateral was obtaining more resale value. This made subprime lending, and its associated high default rates, look less risky to investors because these default rates were not translating into default losses. As time went on and prices continued to rise, subprime lending established a track record of investor safety which drew more capital into the industry; however, since the relative safety of subprime lending was entirely predicated upon rising prices, it was an industry doomed to fail once prices stopped rising.

Take this phenomenon to its extreme and its instability becomes readily apparent. Imagine a time when prices are rising, perhaps even due to the buying of subprime borrowers, and imagine what would happen if 100% of the subprime borrowers defaulted without making a single payment. It would take approximately one year for the foreclosure and relisting process to move forward, and during that year, the prices of resale houses would have increased. When the lender would go to the open market to sell the property, they would obtain enough money to pay back the loan and the lost interest so there would be no default loss. What just happened? Lenders became de facto real estate speculators profiting from the buying and selling of homes in the secondary market rather than lenders profiting from making loans and collecting interest payments. This profiting from speculation is the core mechanism that disguised the riskiness of subprime lending. When these speculative profits evaporated when prices began declining, the subprime industry imploded and its implosion exacerbated the decline of home prices.