Subprime Mortgage Crisis Predicted By Three Academica In 2004

On December 18, 2007, Jonathan Chevreau writes for the National Post:

A group of three finance academics foresaw the looming U.S. subprime mortgage crisis at least three years before the problems started to become public early in 2007.
   Go here and you can find an as yet unpublished working paper entitled Default risk in the U.S. morgage market.
   I talked to one of the report’s three coauthors when he was in Toronto in the fall for the Northern Finance Association conference.  
    Toby Daglish is a native of New Zealand and a professor at the Victoria University of Wellington. Earlier in his academic career he had stints in North American universities. His two coauthors – Jon Garfinkel and Jarjisu Sa-Aadu – are both at the University of Iowa.
    When Daglish was in Iowa, he bought a house in Iowa City late in 2004 and arranged a morgage through a small regional bank.  "I was thinking I was going to have to pay morgage insurance there  but the lady from the bank said oh we’re having a promotion this month and you don’t have to buy morgage insurance. I remember thinking that’s not a very sound way to run your business."   
     That was the genesis of the paper which continues to be revised even as events overtake it. The paper used options analysis to analyze the default risk of various house financing strategies. One of the key findings is that the popular "zero down" floating-rate interest-only morgages can lead to situations where default is optimal even after quite small declines in house prices.
   The August 14, 2007 version of the paper [still the most recent as of December] notes the explosion in housing starts and home prices the last three years coincided with a dramatic loosening f credit in the morgage market. As lenders faced declining per-unit revenues as morgage rates dropped, many simply opted to make more mortgage loans. As we now know all too well, the marginal borrowers approached by the banks "is likely declining in quality." The paper also notes the "secular rise in the percentage of morgages written with zero down payments."  
  Daglish et al wrote that as interest rates rose on variable rate morgages more borrowers would find them unaffordable, tempting many to walk away from the morgage. As they do so, the excess supply will further depress housing prices.
   We noted in this earlier blog entry the hilarious British skit that explained the subprime morgage crisis as having its origins with a morgage salesman approaching an unemployed Alabama man in a "string vest" whose house was about to fall down.

About Luke Ford

I've written five books (see Amazon.com). My work has been followed by the New York Times, the Los Angeles Times, and 60 Minutes. I teach Alexander Technique in Beverly Hills (Alexander90210.com).
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