Subprime Mortgage Crisis, Housing Bubbles, and Market of Lemons
On September 29, 2008, the worst day on Wall Street since the crash of 1987, people watched in awe as the value of the market disappears by the seconds. In the same month, two giants in the finance industry, Lehman Brothers and American International Group (AIG) disclosed that they have gone bankrupt. This unleashed a wave of panic and officially cast the Great Recession. Leading up to this crisis was the subprime mortgage crisis of 2007 – 2010, a turmoil triggered by the overselling of mortgages to high-risk borrowers (low credit ratings, no income, no employment) feeding the demand for the voluminous mortgaged-backed securities. When the housing price dropped, the system no longer held, and a full-fledged crisis began. There is still little consensus over the cause of the subprime mortgage crisis. Deregulation of the banking system, abrasive lending practices, illegal fiddling, unregulated financial instruments, and unforeseen interest changes could all be factors contributing to it (Docking, 353). This blog, backed up by the article written by Levitin and Wachter in 2012, will focus on the information asymmetry between the financial institutions that act as a middleman for mortgage finance and the investors. Using examples, it simulates how the situation created a similar market of lemons.
Levitin and Wachter suggested the leading cause for the housing bubble, which led to the sub-prime mortgage crisis, was the deregulation of the house finance market. They believe that “it was caused by an excessive supply of housing finance” which was in turn caused by the fundamental shift from a regulated mortgage finance market to an unregulated one (Levitin and Wachter, 1181). Financial institutions took advantage of this shift at the expense of the investors. Especially for private-label mortgage-backed securities (PLS), which is the mortgage-backed securities that are not insured by government entities, did not provide enough information for investors to make a good judgment.
Information Asymmetry is created when one party has more information than the other party. In this case, there are multiple parties involved that contributed to it.
1) Between Celler and Buyers.
Sellers, or the financial intermediaries, knew more about the complicated product that they are selling, but they refrained from providing more information. “PLS and the non-traditional mortgages they finance are heterogeneous, complex products”, whose structure made it harder to measure its price and risk (Levitin and Wachter, 1184). Moreover, these financial instruments created an opportunity for profit in every transaction, which gave the bankers more incentive as their pay is tied to it. Buyers, on the other hand, do not have the literacy to understand those financial instruments and are carried away by the boom of the housing market. While there were relevant documents-which was usually hundreds of pages long – that contained the information, it was too complicated for an average person to understand. Therefore, the buyers turn to a third party: credit agencies.
2) Between Buyers and Credit Agencies
Credit agencies were expected to provide a sound explanation for the asset-backed securities. Little did the buyers knew, these credit agencies were paid by the company that provided those products. Moreover, the regulation at the time allowed the financial institutions to shop around for ratings. If one credit agency did not give an AAA rating (the highest rating) for the financial asset, the company simply turned around and went to a new agency.
These two information asymmetries gave the seller a huge advantage in the transaction. As the demand for mortgage-backed securities and relevant derivatives surges, the financial industry increased the volume of the securities by using sub-prime mortgages, or loans are given to people with a high risk of defaulting. This was only possible when the housing market was booming. Of course, there are more parties involved that created a chain of participants that ultimately created the flawed market. Since those asset-backed securities and their derivative is based on real assets: the houses sold through mortgages, the housing market, and the underwriting standards for mortgages, the loan originators needed to relax the standards for loans to make it happen.
The above situation creates a perfect market for lemons: the seller knows about the quality, but the buyer does not. Lemon, in its original context, was defined as a car that was found defective after purchase. However, in this case, it was the sub-prime mortgages that turned out to be worthless as the housing bubble busted. The incentive explained above – the fee-based business model and the arbitrage of information asymmetries – tempts the financial asset issuer to “push ever more questionable product on investors” (Levitin and Wachter, 1230). Buyers, unable to gauge the risk, believe that the high-credit rating products which are backed by junk loans are underpriced, so they overpurchase. The more they purchase, the more these financial intermediaries make. Let’s create a hypothetical payoff diagram for the sub-prime mortgage-backed securities market.
Before the interest rate went up and housing prices went down, Buyers were not aware of the problem. (Numbers are hypothetical)
| Buyers | Sellers | |
| Good (backed by normal mortgages, had AAA rating) | 180 | 90 |
| Bad (backed by sub-prime mortgages, had lower than AAA rating) | 75 | 20 |
As mentioned, this market has signals for lemons, which is the credit ratings (AAA, AA, A, A- and so on). Up to 90% of the PLS had AAA ratings, “meaning the risk of default or loss was negligible.” Therefore, Buyers are optimistic, believing 90% of the MBS out on the market are good, and 10% are bad. Doing a calculation:
Expected Price = 180*0.9 + 75 * 0.1 = $97.5
Therefore, theoretically speaking, both good and bad products could exist in the market as $97.5 is higher than the cost for sellers. However, the incentive to make a profit each transaction would push the financial intermediaries to supply more lemons in the market, as it gives a higher profit of $77.5 instead of a $7.5. However, this only works when the house price keeps going up, which many had the illusion of a housing bubble could persist forever.
However, once that illusion disappears, whether it was caused by the rise of interest rate or the drop in housing prices, the sub-prime mortgages suddenly became less valuable. Assuming the buyers now know the credit-rating agencies were not reliable – at that time between 2006 and 2007, the agencies did start to admit the AAA ratings were not accurate – buyers become more pessimistic. Their view on the value of both good and bad products go down because the mortgage market is not performing well. Their value for the bad product went down even further. As for their view on the market, now they believe that more bad products are out there instead of the good products.
| Buyers | Sellers | |
| Good (backed by normal mortgages, had AAA rating) | 100 | 90 |
| Bad (backed by sub-prime mortgages, had lower than AAA rating) | 15 | 20 |
To illustrate the point, we assume an extreme case where the buyers believe almost all products are bad (near 100%), the calculation would then be:
Expected Price = 15
This is lower than the cost of sellers buying sub-prime mortgages from the originators to use them as collaterals. Thus, the market collapses, which led to hundreds of institutions failing, including Lehman Brothers and AIG, and later the “too Big to Fail” policy where the government used the Troubled Asset Relief Program to ease the shockwave.
The 2008 subprime mortgage crisis created a lasting impact on the world economy. Many lost their homes, jobs, and more, and it all started with human greed. While information asymmetry is a market’s tool to create lucrative market opportunities. Initiators must think about the consequences of their actions. In the 1970s, Milton Friedman famously said business of business is business (maximizing its profit). Now is the time to change it if you haven’t.
Sources:
Levitin, Adam J, and Susan M. Wachter. “Explaining the Housing Bubble.” Georgetown Law Journal, vol. 100, No. 4, pp. 1177-1258.
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1669401
Akerlof, George A. “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism” The Quarterly Journal of Economics, vol. 84, no.3 (Aug., 1970), pp. 488-500.
http://wwwdata.unibg.it/dati/corsi/8906/37702-Akerlof – Market for lemmons.pdf
Docking, Diane S. (2012). “The 2008 Financial Crises and Implications of the Dodd-Frank Act.” Journal of Corporate Treasury Management, 4 (4), pp. 353-363.