Dr Folarin Akinbami Durham Law School Durham University

INTRODUCTION INNOVATION & FINANCE SUBPRIME MORTGAGES: ORIGINS PROLIFERATION BENEFITS PROBLEMS CONCLUSION

INNOVATION & FINANCE INNOVATION: Implementation and taking to market of new inventions... finding new and more efficient ways of doing things. (Chesbrough, 2003) FINANCIAL INNOVATION: implementation of new products, processes or services in the financial industry Being able to innovate is essential for survival in most industries and this is particularly the case in the financial industry (Bernanke, 2009)

USES OF INNOVATION More efficient allocation of Risk Expanded Financial Intermediation Increased Liquidity New Diversification opportunities

Explaining Subprime Mortgages Subprime Mortgage: A mortgage loan advanced to a borrower who would not qualify for a prime (market rate) loan because they are regarded as posing a greater risk of default Why: Impaired credit or unable to provide documentary evidence of their income The lender charges a higher interest rate than the market rate in order to compensate for the greater risk involved in making the loan

SUBPRIME: ORIGINS Not often discussed Beneficial Loan Society: a US no-bank lender Intimate knowledge of borrowers, which allowed it to lend to even troubled borrowers (Lowenstein, 2009)

SUBPRIME: PROLIFERATION Deregulatory measures Securitization Public Policy (of promoting homeownership) Credit to the poor Market forces Subprime mortgage origination: $65 billion in 1995 to $332 billion in 2003 (around 13% of all home mortgages by end of 2006)

DEREGULATION Depository Institutions Deregulation and Monetary Control Act 1980: prevented the individual states from enforcing interest rate caps Alternative Mortgage Transaction Parity Act 1982: allowed lenders to offer adjustable-rate mortgages and balloon payments Tax Reform Act 1986: made interest payments on mortgages and home equity loans tax deductible

SECURITIZATION The process where illiquid assets (e.g mortgage receivables) are converted into liquid securities whose value is derived from the value of the underlying mortgage receivable or other assets Proportion of subprime that were securitised: 50.% in 2001 to 80.5% in Value of subprime mortgages that were securitised: $56 billion in 2000 to $508 billion in 2005 Effect of securitization: made lenders reduce their underwriting standards

PUBLIC POLICY (homeownership) US housing policy promotes homeownership (Homeownership is a key part of the American Dream) Government-Sponsored Enterprises (GSE): Federal National Mortgage Association (Fannie Mae) Federal Home Loan Mortgage Corporation (Freddie Mac) created to purchase prime mortgages from lenders. This replenishes the lenders’ capital and allows them to make even more loans Pressured into lowering their standards and purchasing subprime mortgages

CREDIT TO THE POOR Helps to address issues of Distributional Justice, Social Justice, Fairness and Equality Equal Credit Opportunity Act 1974 (revised 1976): enacted to discourage race and gender discrimination in mortgage markets Community Reinvestment Act 1977: enacted to encourage lenders to lend to all segments of their communities, including low-income and middle- income borrowers

Home ownership for low income and minority households “I believe that those on welfare, what they really want is a piece of the American dream: homeownership, a good job, opportunities for their children” (President G H W Bush (July 27,1992)) Belief that increased rates of homeownership for those on low incomes would bring with it a wide range of social, behavioural, political, economic and neighbourhood improvements due to the economic investment that homeownership represents

Market Forces Borrowers: borrowers with impaired credit could now enter the housing market Lenders: higher interest rates, fees and charges; potential to lend to a whole new group of borrowers Investment banks: fees for packaging the pools mortgages into residential mortgage-backed securities Global capital market investors: sought AAA rated investments and the CRAs had given AAA ratings to the residential mortgage-backed securities

BENEFITS ASSOCIATED WITH SUBPRIME Homeownership for the poor and the credit impaired Minority households showed the largest rates of increase in homeownership between 1994 and 2003 (Gramlich, 2004) Minority households who own their homes are approximately 36 times wealthier than those that rent (Xiao Di, 2003) More business opportunities for lenders Helps with housing policy Helps with economic policy

PROBLEMS ASSOCIATED WITH SUBPRIME Neo-classical economics criticisms Reduce allocative efficiency Costs Externalities Behavioural economics criticisms Exploit borrowers’ imperfect information and imperfect rationality Cost deferral Complexity

NEO-CLASSICICAL ECONOMICS CRITICISM Reduce Allocative Efficiency complexity prevents effective comparison shopping thus hindering competition Bubbles Costs Imposes costs on borrowers and lenders Externalities Foreclosures impose significant costs on other stakeholders such as neighbours, the community, taxpayers and local authorities

BEHAVIOURAL ECONOMICS CRITICISMS Imperfect information and imperfect rationality: lenders exploit consumers’ cognitive limitations and cognitive biases such as myopia, over-optimism and framing effects Cost deferral: multiple pricing structures that allow borrowers to postpone the bulk of the costs associated with credit till a future time e.g. ARMs Complexity: allows lenders to conceal the true cost of the loan by using a “multi-dimensional pricing maze” (Bar-Gill, 2009)

CONCLUSION Difficult to make an argument for an outright ban of subprime mortgages or any other financial innovation Nevertheless, the problems associated with subprime mortgages suggest that rather than welcome all financial innovation unquestioningly, they need to be viewed with a healthy degree of scepticism Scrutinise them more closely Regulators should take a more robust approach toward carrying out their duties as regulators