Joint Center for Housing Studies 

Harvard University 

Imperfect Information and the Housing Finance Crisis

Edward Golding, Richard K. Green and Douglas A. McManus

February 2008 

UCC08-6 

Last revised: February 1, 2008 

The authors thank Yan Chang for her assistance.

© by Edward Golding, Richard K. Green and Douglas A. McManus. All rights reserved. Short sections of text, not 

to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is 

given to the source. 

The views expressed in the paper are those of the authors and do not necessarily represent those of Freddie Mac. 

Any opinions expressed are those of the author and not those of the Joint Center for Housing Studies of Harvard 

University or of any of the persons or organizations providing support to the Joint Center for Housing Studies.

1

Introduction

Economists tend to find choice to be unambiguously good. The idea is simple: as the 

choice set gets larger, consumers cannot be worse off, because at worst extra choices become 

irrelevant. Better yet if the choices are produced without benefit of government subsidies. 

Because of this, economists tend to look as such innovations as subprime mortgages as welfare 

improving. Many commentators have expressed this view, including Federal Reserve Chair 

Alan Greenspan, who noted in testimony: 

“where once marginal applicants would have simply been denied credit, 

lenders are now able to quite efficiently judge the risk posed by 

individuals and price that risk appropriately... 

...Improved access to credit for consumers, and especially these morerecent developments, has had significant benefits. Unquestionably, 

innovation and deregulation have vastly expanded credit availability to 

virtually all income classes. Access to credit has enabled families to 

purchase homes, deal with emergencies, and obtain goods and services. 

Home ownership is at a record high, and the number of home mortgage 

loans to low- and moderate-income and minority families has risen rapidly 

over the past five years. Credit cards and installment loans are also 

available to the vast majority of households.”1

The problem is that economists and sometimes policy makers tend to overlook market 

failures until they become too obvious to ignore. And so it was with the subprime market. The 

interesting question, then, is what were the sources of imperfections. This paper discusses 

possible sources of market failure. Market imperfections in the Mortgage Finance System are 

classic: asymmetric information and agency problems. But we argue that the asymmetries and 

agency problems were not one-sided, but rather involved a multiple set of problems that need to 

be addressed. 

 The asymmetric information problems flow between borrowers and brokers, aggregators 

and rating agencies, and investors and issuers. Along with these classic market failure issues, 

increasing competiveness in the mortgage market, may have aggravated these problems. All this 

said, the subprime market is likely to have increased homeownership on net in the United States, at 

least for the consensus default rates expected. But it is not necessarily the case that the expansion 

 1

 See Remarks by Chairman Alan Greenspan at the Federal Reserve System’s Fourth Annual Community Affairs 

Research Conference, Washington, D.C., April 8, 2005. The ellipse is used for brevity: the remarks within the 

ellipse emphasize that consumer worries about the use of technology for underwriting are largely misplaced. 

Available at http://www.federalreserve.gov/boarddocs/speeches/2005/20050408/default.htm. 
2 

of homeowning implies that the subprime market was welfare improving. We believe that home 

ownership could have been increased without some of the excesses that have become evident. 

This paper has two parts. First, we look at the various agents involved in the mortgage 

transaction—including borrowers, brokers, originators, rating agencies and investors—and their 

incentives. These incentives may help reveal how the subprime crisis became so large, and 

inform the second part of the paper, which addresses the appropriate policy responses going 

forward. We will focus in particular on a few, relatively simple reforms that would give agents 

incentives to avoid behavior that has led to the current problems. 

 

Agents and Their Incentives

Borrowers – Heterogeneous 

Within the realm of the traditional conventional-conforming market, borrowers are 

relatively homogenous in terms of downpayments and credit scores as measured by FICO. Any 

variations tend to result in modest differences in default and prepayment probabilities that are 

reasonably well understood by the market. This is why traditional conforming mortgages may 

be placed into pools that sell as commodities in a very liquid securities market. In contrast, 

Jumbo loans are tranched for credit. The Government Sponsored Enterprises’ ability to provide 

a corporate guarantee replaces this credit tranching to provide liquidity for the conforming 

market. The market performs fairly close to a market with complete information. Borrowers 

and investors know roughly what they are getting or at least there are sufficient “informed” 

agents to result in a market equilibrium where even “uninformed” agents are making relatively 

good decisions. 

By contrast, borrowers in the subprime market are highly heterogeneous and the 

differences are not fully transparent. The subprime market was originally served as a market for 

those who had equity in their house, but because of unemployment, hardship, or even over-use of 

credit found themselves shut out of the traditional mortgage market. For example, Weicher 

(1997) concludes, "These data [on the characteristics of subprime borrowers] suggest that 

subprime home equity borrowers are basically the same sort of people as other homeowners and 

are able to make informed judgments about what is in their own best interest." Because of the 

higher default risk, heterogeneity in this group of borrowers is likely higher (see Figure 1). 
3

0%

10%

20%

400 - 419480 - 499560 - 579640 - 659720 - 739800 - 819880 - 900

Figure 1: Distribution of Borrower FICO Scores in Outstanding Loans as of December 2006

Median FICO by Category

Subprime: 618

Government Insured: 647

Prime Conventional: 733

Prime 

Conventional

Government

Insured

Subprime

Servicing

However, over the last 10 years, the market expanded tremendously as evidenced by the 

increase in volume. The subprime market became a source of funds for first time homebuyers 

who otherwise would have had to wait to develop a positive credit history before buying a house. 

With less equity and no established history of making mortgage payments, both the 

heterogeneity of the pool and the lack of market knowledge about how these loans would 

perform over a cycle increased. The subprime market also expanded rapidly into investor loans 

as websites such as “condoflip.com” became prevalent. Investors began using subprime 

mortgages as a de facto call option for investing in a house. And often, we suspect, mortgage 

lenders did not accurately distinguish between investor properties and homeowners. This 

category includes victims of the housing finance system, but also exploiters of the housing 

finance system. We will take each of these categories of borrowers one at a time. 
4 

Borrowers tapping equity 

 Consumers have two ways of getting equity out of their houses: Cash-out refinancing and 

home equity lines of credit. 

A cash-out finance takes place when a borrower pays off one mortgage and replaces it with 

a larger mortgage. Cash-out refinances are a particularly large part of the refinance market when 

market interest rates are rising: under such conditions, consumers simply looking to reduce their 

monthly mortgage payments will not refinance. According to the most recent Freddie Mac 

refinance survey, 87 percent of all refinances in the third quarter of 2007 were cash-out refinances. 

Home equity lines of credit (HELOCS) allow borrowers to tap into home equity without 

going through the relatively lengthy, and often more costly, process of obtaining a first-lien 

mortgage. It also allows owners to borrow amounts they wish when they wish: there is not a 

fixed payment structure. On the other hand, HELOCS are usually tied to a short-term interest 

rates, such as LIBOR, and as such do not give borrowers the benefit of known mortgage 

payments from month-to-month. They also typically carry higher margins than first-lien 

adjustable rate mortgages. 

When homeowners need cash, they have a strong incentive to draw upon home equity: so 

long as the outstanding value of their mortgage balance is less than $1.1 million or the purchase 

price of their home plus the cost of capital improvements, borrowers may deduct mortgage 

interest on home equity loans. We should note, however, that these tax benefits are unequally 

distributed because lower income households that do not itemize and utilize cash-out refinances 

are trading tax-free equity for a mortgage that is effectively paid for on an after-tax basis. 

Borrowers can also benefit from the fact that because a mortgage is a secured loan, as its cost 

will generally be lower than revolving debt, credit card debt or a personal loan. 

But consumers have very different motivations for why they take on home equity debt, 

and these different motivations may tell us something about likely future credit performance. 

Borrowers have four broad motivations for taking equity out of their homes: consumption of 

consumer durables (or non-durables), for home improvements (which may be viewed as both a 

consumer good and an investment), portfolio rebalancings, and bill consolidations. 

Those who do not have liquid wealth often optimize by using home equity to purchase a 

consumer durable, such as a car, because such a financing mechanism lowers the cost of capital 

and allows for consumption smoothing. As subprime mortgages have taken a beating in the media 
5

recently, commentators have forgotten that they allow households to obtain consumer finance far 

more cheaply than other methods of funding: in particular, a subprime fixed-rate mortgage may 

well be less expensive for consumers than those for a subprime automobile loan. Tapping home 

equity to purchase a durable also has only a gradual effect on household balance sheets, as the asset 

one buys through home equity is a depreciating, rather than immediate, expense. 

On the other hand, when consumers use home equity for non-durables, they are causing 

their household balance sheet to deteriorate immediately. Nevertheless, when people lose their 

jobs or become ill, home equity may allow not just consumption smoothing, but solvency. 

Whether a household uses home equity to purchase consumer durables or non-durables 

could well be an important predictor of loan performance: those who use home equity to finance 

consumer durables are likely in a different financial position from those who use it to finance 

immediate consumption. Unfortunately, it is difficult, if not impossible, to know whether this is 

the case because borrowers are not always required to identify the purpose for which they 

accessed their home equity, especially when using HELOCS. 

The use of home equity to fund home improvements is another matter. While home 

improvements do not necessary add to house values on a dollar-for-dollar basis, some home 

improvements actually provide value in excess of costs (new roofs and windows might be 

examples of this). 2 Consequently, home equity used to finance home improvements does not 

necessarily reduce the net equity position in the house, and as such not necessarily increase the 

possibility of default. 

Using home equity to rebalance a portfolio can also reflect optimizing behavior. When 

households have a substantial share of their wealth in home equity, taking money out of the 

house and putting it in the stock and bond markets creates substantial diversification benefits. 

Nevertheless, the increase in leverage makes the position in housing in and of itself more risky, 

and if the household moves from a home equity position of 20 percent to 10 percent, it is 

doubling its leverage ratio, and consequently, is doubling its risk with respect to housing. In 

short, it is not clear whether households that are already highly leveraged reduce their overall 

risk position by borrowing against their house to purchase other assets. To give an example, 

suppose a local housing market has a standard deviation of 5 percent in its returns, while an 

index fund has a 10 percent return. The correlation between the two markets is 0.5. Suppose all 

 2

 On the other hand, swimming pools manifestly do not add as much value as they cost. 
6 

of a household’s wealth is in home equity, and its loan-to-value (LTV) ratio is 20 percent. If it 

takes half the home equity and places it in the index fund, the LTV is now 90 percent. The 

standard deviation of the household portfolio has now increased from 25 percent to 28 percent, 

because the leverage effect offsets the diversification effect. 

Finally using home equity to consolidate bills indicates perhaps two offsetting 

characteristics of a household: on the one hand, it may be using home equity to reduce its total 

cost of debt, in which case it reduces the overall credit risk of the household. On the other hand, 

it can also indicate that a household got itself into trouble by taking on too much debt. If a 

household is in the subprime market because it has a low FICO score, the need to consolidate 

debt reaffirms the evaluation of a household’s credit worthiness. 

First Time Homebuyers 

 The United States government has long encouraged homeownership. As such, it has had 

a series of tax preferences for owner-occupied housing, as well as specialized housing finance 

institutions, including Savings and Loans, the Federal Housing Administration, the Federal 

Home Loan Bank System, Fannie Mae and Freddie Mac. At the same time, advocates have 

noted the difference in homeownership rates across race and income class. Some commentators, 

such as Melvin Oliver and Michael Sherraden, have shown that housing equity has been the 

principal method by which middle-class and lower-middle class Americans have accumulated 

wealth.3

 The disparate rates of homeownership may, therefore, prevent minorities and lowincome households from accumulating wealth. They are hardly alone in sharing this view—

politicians in particular seem to think that both wealth and good social behavior arise from 

homeowning. Consequently, government policy has encouraged lenders to advance loans to 

lower-income and minority households; the levers they have used for doing this are the 

Community Reinvestment Act and the GSEs’ Affordable Housing Goals. 

 The message to low-income renters was clear: homeownership was good with little 

concern to the location of the house, expected tenure, and long-term mortgage costs. 

Consequently, minorities and low-income households with poor FICO scores and little cash for a 

down-payment were encouraged to use subprime loans to purchase houses even in those markets 

in which opportunities for appreciation were limited. 

 3

 For evidence on this, see Bucks, Kennickell, and Moore (2006), Sherraden (1991) and Oliver and Shapiro (1997). 
7

 We should make clear that when we say opportunities for appreciation were limited, we 

do not necessarily mean inner cities: some of them experienced substantial increases in value 

between the late 1990s and 2005, and even with the declines of the past few years, are 

substantially higher in value than they were ten years ago. For example, even in rust-belt 

metropolitan areas, such as Detroit, Cleveland, Buffalo and Pittsburgh nominal values increased 

by 40 to 60 percent over the last ten years.4 In contrast, in areas where housing supply was very 

elastic, such as on the fringes of an metropolitan area, the growth in housing prices are more 

likely tied to the cost of new construction. 

 Nevertheless, with loan products that allowed borrowers to become owners with little or 

no equity, the prospect of being a homeowner was surely irresistible to many families who never 

thought they would be able to become homeowners. Subprime lending allowed borrows to buy a 

house without any equity—and according to First American LoanPerformance data, the percent 

of purchase money subprime mortgages having LTVs in excess of 100 percent increased from 

1.6% in 2000 to 28.6% in 2006. Having no home equity, these households more resemble 

renters than owners with respect to incentives to maintain, mobility, etc. To the extent buyers 

with little or no money down also had little in the way of financial resources, any major housing 

expense, such as the need to replace a roof or a furnace, could lead to foreclosure. This also 

means that when such households face a trigger event, such as job loss, illness or divorce, they 

have might very well be in a position where the wise financial action is to foreclose. 

It is a worthwhile question to ask whether on net the subprime market has increased or 

decreased the homeownership rate. The Center for Responsible Lending maintains that the 

subprime market has reduced homeownership, because the number of subprime foreclosures 

exceeded the number of subprime mortgages originated for first-time homebuyers for each year 

between 1998-2006.5

 But as Jack Guttentag points out, this comparison stacks up originations 

for first time homeowners against foreclosures for all sub-prime mortgages. 6 It is entirely 

possible that borrowers that refinanced from a prime into a subprime mortgage would have 

defaulted regardless of the refinance, because default usually arises from circumstances, such as 

 4

 This growth is based on the increase in the Freddie Mac's CMHPI MSA-level repeat sales house price index from 

1997Q3 to 2007Q3. 

5

 See Center for Responsible Lending, Subprime Lending, A Net Drain on Homeownership, 

http://www.responsiblelending.org/pdfs/Net-Drain-in-Home-Ownership.pdf. Access October 7, 2007. 6

 See http://www.mtgprofessor.com/A%20-%20Public%20Policy%20Issues/does_the_subprime_market_reduce_home_ownership.htm, Accessed October 7, 2007. 
8 

job loss, divorce and illness, which have nothing to do with the financial characteristics of the 

mortgage (see Galster and Santiago, 2007). 

Investor Properties 

Some of the more exotic subprime mortgage products resembled call options, and as such 

should have been attractive to speculators in a hot housing market. Two products in particular 

stand out: the 2-28 Adjustable Rate Mortgage, which carried lower interest rates for two years, 

and then reset to a rate with a high margin over LIBOR or one-year Treasury securities, and the 

so-called “option-ARM,” where borrowers had a negative amortization option. Investors could 

purchase a house in a market with high levels of appreciation and have low carrying costs for a 

few years. In the event that house prices rose substantially, the investor could sell at a very high 

internal rate of return (because down-payments and monthly payments would be low). In the 

event house prices fell (which, of course, they did), the investor could default at low cost. 

Consequently, some of the subprime products attracted speculators. As we shall discuss later, it 

is a bit of a surprise that investors in mortgage-backed securities didn’t understand the kind of 

adverse selection that were an inevitable consequence of these products. 

Beyond the fact that they had an incentive to get exotic subprime products, investors may 

not qualify for prime loans and use no/low documentation loans to get around credit policies. 

According to Loan Performance data, shares of no/low documentation loans for subprime homepurchase originations are higher with investor properties and second homes (see Table 1).7

Table 1: Percentage of No/Low Documentation Loans by Occupancy Status

Percent No/Low Documentation Loans 

Origination Year Owner Occupied Second Home Investor Property 

2003 44.0% 60.1% 51.0% 

2004 48.6% 57.1% 53.5% 

2005 42.2% 65.5% 60.3% 

2006 32.4% 58.2% 46.3% 

Source: First American LoanPerformance data 

 7

 In addition, there can be misrepresentation of investor properties as owner-occupied. For example, FitchRatings 

(2007) "The Impact of Poor Underwriting Practices and Fraud in Subprime RMBS Performance," conducted a file 

review of early defaults and finds that 66% of these loans were misrepresented as owner-occupied. 
9

 In short, while different types of borrowers had very different motivations for borrowing, 

many of them—those doing bill consolidation, first-time homebuyers, and investors, were per se

default risks. 

To this point, however, we have described borrowers as if they were fully informed about 

their mortgage decisions. Because of the nature of mortgage disclosures, this is almost certainly 

not the case. Green and Wachter (2007) set forth the nature of the problem: 

Asymmetric information also arises because it is likely that mortgage 

originators understand mortgage pricing and risk better than borrowers. 

To make this concrete, consider the nature of mortgage disclosures. The 

Truth in Lending Act requires that borrowers be informed of the Annual 

Percentage Rate (APR) on their mortgage. The APR rate is the internal 

rate of return on a mortgage based on its coupon rate, discount points, 

amortization and term. The APR calculation assumes that borrowers 

never refinance, and makes no provision for fees other than discount 

points. As such, it does not give an accurate picture of mortgage cost. 

Both borrowers and investors in mortgages are interested in yield, which is 

the internal rate of return on a mortgage. But of course, the yield is not the 

same thing as the mortgage coupon rate (the basis on which the mortgage 

amortizes) or the Annual Percentage Rate (APR) (a rate that amortizes the 

cost of discount points over the amortization period of the mortgage). The 

yield is rather the true return/cost of a mortgage. Even in the context of a 

fixed rate mortgage, disclosing effective cost is not straightforward. 

Inadequate disclosures create market failure. As Federal Reserve Board Governor Randall 

Kroszner notes, “Information is critical to the effective functioning of markets...[a] core 

principle of economics is that markets are more competitive, and therefore more efficient, when 

accurate information is available to both consumers and suppliers...pages and pages of fine print 

may provide comprehensive descriptions that lawyers might love, but consumers find it 

confusing, or, worse, useless. We need to translate legalese into something consumers can use.”8

 

Intermediaries 

Channels between consumers and the mortgage market 

A number of channels connect consumers to the mortgage market. We focus on one: the 

wholesale channel. Apgar, et al. provide a good characterization of this channel: 

 8

 See remarks by Governor Randall Kroszner, "Creating More Effective Disclosures" at the George Washington 

University Financial Services Research Program conference on subprime lending, May 23, 2007. Available at 

http://www.federalreserve.gov/newsevents/speech/kroszner20070523a.htm. 
10

Most wholesale lending operations include two distinct components: 

mortgage brokerage, and correspondent lending. Typically, correspondent 

lenders are smaller mortgage banks, thrifts, or community banks that 

operate much like retail lenders in that they take applications, underwrite 

and fund mortgages, and then sell these “whole loans” to a wholesale 

lender under prearranged pricing and delivery terms. In contrast, brokers 

are independent agents who identify customers and match them to 

mortgage products. The broker’s role is to help the borrower submit the 

mortgage application to the wholesale lender, who then makes the 

decision to accept or reject the application and fund the mortgage. 

In one sense, the mortgage brokerage market is highly competitive. As licensing requirements 

are in many places non-existent, there is free entry into the mortgage brokerage market. Brokers, 

moreover, do not have the capital requirements that portfolio lenders have. Consequently, we 

would expect economic profits for brokerage to be, at the margin, on average, zero, and for 

brokers to engage in what Krueger (1974) refers to as 'rent seeking'. The methods of rent 

seeking take two forms: identifying borrowers who are particularly incapable of understanding 

mortgage pricing, and exploiting the implicit moral hazard arising from being able to initiate 

mortgages without capital, by shopping loan applications to various lenders. 

While we do not have adequate controls, aggregate data suggest that the nature of the loans 

initiated by brokers are different from those originated through other channels. For example, the 

propensity of brokers to originate loans with low or no documentation is substantially higher than 

for retail channels. In fact, in 2005 and 2006, brokers were more than twice as likely to originate 

low/no doc loans than retail channels, and were more likely to originate hybrid ARMs (Table 2). 

Brokers also were more likely to originate controversial products such as 2-28 ARMS with 

prepayment penalties. Borrowers with FICO scores in excess of 660 were also more likely to 

obtain a 2-28 subprime loan from a broker than from a retail lender. 

Table 2: Loan Characteristics by Channel 

Share of No/Low Doc 

Loans 

Share of Hybrids Origination 

Year Retail Broker Retail Broker 

2003 28.1% 34.8% 54.6% 62.7% 

2004 26.1% 40.8% 69.0% 70.6% 

2005 22.6% 41.4% 62.8% 68.1% 

2006 17.0% 36.2% 47.2% 53.1% 

Source: First American LoanPerformance data
11

At the same time, lenders competed for the opportunity to fund borrowers through brokers. 

As one trade journal explains, “Brokers would fax application information to multiple lenders: 

73% of brokers shopped identical Alt-A and subprime loan packages for prequalification to two or 

more lenders.”9

 An originator maintaining high credit standards in an environment where brokers 

vigorously shop loan applications among a number of lenders, risks losing market presence. 

We may then ask what the equilibrium is between the broker and retail lending channels. 

To simplify, let’s assume that the fundamental difference is capital: brokers needn’t hold it, 

while retail lenders do. Let us also say that the prime market is chiefly rationed through 

underwriting standards, while the subprime market is priced. In this stylized economy, the 

appropriate capital for a prime mortgage is lower than the appropriate capital for a subprime 

loan, because default losses on prime loans are lower than on subprime loans. Let us also say 

that it takes more effort to originate a subprime loan than a prime loan. Expected profits before 

effort on subprime loans are identical to prime loans, but the variance of profits is greater in the 

subprime market. This should lead to a separating equilibrium whereby brokers take the 

subprime market and retailers take on the prime loans. 

 Retailers will want to avoid subprime loans, because capital is expensive, and because 

they will want to avoid costs associated with subprime loans. Brokers, on the other hand, will 

want to take on subprime loans, because if the loan fails, the broker suffers no costs. 

Consequently, from the standpoint of the broker, the distribution of profits is truncated at zero, 

and so the expected profit from subprime loans is greater than prime loans. Because the broker 

must engage in effort to originate the loan, it prefers loans whose realizations will be more 

profitable to it, and consequently will originate only subprime mortgages. 

The actual marketplace is more complex than this example suggests. While many 

brokers specialize in either prime or subprime lending, many do both types of loans. Moreover, 

some correspondent lenders have become 'super mortgage brokers' with the ability either to 

originate loans or to serve as a wholesale broker. This arrangement allows a firm to channel 

subprime loans through the broker channel, and thus limiting both capital needs and legal 

liability.10 The important point is that, disproportionately, subprime loans are originated in an 

 9

 Inside Alternative Mortgages 1/13/2006; Inside B&C Lending 1/6/2006. 

10 Inside Mortgage Finance, 7/28/2006 
12

environment in which there will be strong incentives for the production of loan volume with 

limited offsetting exposure to the underlying financial and legal risk.11

 The mystery in all of this is why investors did not understand this dynamic. That is an 

issue to which we will return later. 

Rating Agencies 

 Ratings agencies have long borne criticisms for a compensation structure that encourages 

overstated ratings (see for example, Smith and Walter, 2000). Securities issuers themselves pay 

for ratings, and they do not pay the agency until the security is rated. The explosion of subprime 

MBS and collateralized debt obligation (CDO) issuance has, until recently, resulted in a large 

and growing share of the agency income generated through rating these structured products. 

Changes in ownership structure may have increased the pressure for short-term earnings growth, 

as well as acting to increase competition among agencies. Moreover, those who work for rating 

agencies can often move to higher paying positions working for the firms being rated. That 

rating agencies benefit from rating as many securities as possible comes from the stock price of 

Moody’s, which rose dramatically relative to the S&P 500 over the period in which subprime 

lending grew rapidly (Figure 2). 

 11 For an practitioner's perspective on this issue see Andrew Davidson's essay "Six Degrees of Separation," in The 

Pipeline – Special Edition, Andrew Davidson & Co.
13

0

100

200

300

400

500

600

700

800

Jan-00May-00Sep-00Jan-01May-01Sep-01Jan-02May-02Sep-02Jan-03May-03Sep-03Jan-04May-04Sep-04Jan-05May-05Sep-05Jan-06May-06Sep-06Jan-07May-07Sep-07

Figure 2: Moody's Stock Price Performance Relative to the Market

Price (1/3/00 = 100)

Source: Bloomberg©

Moody's

S&P 500

 It is clear ex post that ratings agencies substantially underestimated the risk in structured 

securities (especially CDOs). This is why they have needed to downgrade so many securities, 

especially those securities based on subprime collateral. On the other hand, this does not by 

itself indicate that the compensation structure of agencies led to high ratings; rather, it could have 

been driven by spurious assumptions about continued house price growth, or flaws in the 

modeling. Indeed, the ratings downgrades have been especially concentrated in the subprime 

market (see Table 3).12

 Table 3: Ratings Change by Collateral Type 

 Prime/Jumbo Alt-A Subprime 

Number of Upgrades 

1,379 374 1,180 

Number of Downgrades 416 73 5,111 

% Downgrades relative to all 

ratings changes 

23.18% 16.33% 81.24% 

Source: Bear Stearns ‘Across the Curve’ includes Moody's, S&P, and Fitch rating changes from 1/3/06 to 9/7/07 

 12 It is also interesting to note that over the 1/3/06 to 9/7/07 period there were material differences in the downgrade 

rates across the agencies. The rates of downgrades to total ratings changes were 69% for Moody's, 79% for Fitch, 

and 90% for S&P. 
14

Instead, the agencies may well have predicted performance poorly because their 

empirically based models of subprime loans did not predict substantial losses. This was 

understandable considering that nominal house prices throughout the United States rose from the 

middle-1990s through the year 2004. Under these house prices conditions, borrowers that got 

into financial trouble had strong incentives to sell their house (and therefore keep some equity) 

rather than default. This may have led analysts to believe that a large portion of the credit risk 

in subprime securities was idiosyncratic, and hence diversifiable. Given the favorable loss 

experience over this period, some critics argued that the agencies were overestimating the credit 

risk in subprime MBS (see, for example, Engle and McCoy, 2007, p. 2055). The decline in 

underwriting quality over this period can also impact the risk associated with a given factor, 

rendering models based on historical relationships outdated. For example, the incremental risk 

associated with low documentation loans has greatly increased in recent years (see Table 4). 

Table 4: Delinquency Rates by Documentation Level 

Ever 90-Days Delinquent by Origination Year 

Documentation 

Level 

2001 2002 2003 2004 2005 2006 

Low 23% 19% 15% 16% 20% 20% 

Full 22% 17% 13% 13% 14% 11% 

Risk Ratio 1.04 1.06 1.13 1.24 1.47 1.85

Source: First American LoanPerformance data on ARMs with 590 to 660 FICO scores and 80 to 90 LTV. 

Housing market conditions began changing in 2005. Deteriorating economic conditions 

in the rust-belt led house prices to plateau and then fall in some cities—notably Cleveland and 

Detroit. One hundred percent LTV loans no longer developed a cushion; more important, flat 

average house prices in a metropolitan area meant that some neighborhoods had deteriorating 

values. As a result of slowing house price growth, defaults on subprime loans started rising 

sharply. As defaults increased, in submarkets with high subprime concentrations, a glut of REO 

houses caused market values to fall, which in turn led to increasing losses conditional on default. 

To the extent that the agencies adopted overly optimistic views of future house price 

performance and were slow to adapt to changing market conditions, this alone could lead to a 

substantial difference between the ratings and the actual risk in structured products based on 

subprime loans. 
15

The failure by the agencies to properly assess the risk of pooled subprime tranches in 

collateralized debt obligations (CDOs) had particularly important implications for the subprime 

market. Typically, the largest challenge in securitizing a pool of subprime loans is marketing the 

lower rated tranches of the structure. CDOs had been providing such a market but only because 

ratings agencies (and investors) had overstated the diversification gains available through 

pooling, effectively viewing the lower-rated subprime tranche risk as largely idiosyncratic. This 

resulted in a substantial under pricing of the credit risk in these tranches, and consequently, an 

excessive demand for subprime issuance. It is now clear that to a large degree this risk was 

systematic. Consequently, the market demand for lower rated subprime tranches is unlikely to 

return to the levels seen over the last few years. 

Perhaps as important as the spuriousness of the models that underlay credit ratings was 

the fact that the meaning of credit ratings changed across time and varied across industry type. 

Nomura Fixed Income Research (2006) argued that both Moody’s and Standard and Poor's lost 

their moorings over the course of the last ten years.13 Nomura argues: 

...a rating system is most useful when each rating symbol has a constant 

meaning over time, geography, currency, and type of instrument. A rating 

system works best when a given symbol (e.g., BBB) denotes the same 

measure of credit risk for a German corporate bond in 1985, a U.S. 

municipal bond in 1995, and a Korean mortgage-backed security in 2005. 

Yet Nomura produces evidence that the performance of securities with the same rating varied 

across time, industry sector, and security type. Consequently, a BBB+ rating on a CDO meant 

something different from a BBB+ rating on a MBS, which in turn meant something different 

from a BBB+ rating on a corporate bond. Bond ratings are an important ingredient for regulating 

financial institutions and, more generally, for articulating investment guidelines for asset 

managers. If they are not consistent across security types, institutions and asset managers can 

have an incentive to shop for securities that have the highest rating per unit of risk. 

 Beyond the general issue of the inconsistency with which rating agencies evaluated 

securities, and the fact that the agencies underestimated subprime risk, the agencies also 

appeared to be behind the market in their procedures for evaluating CDOs, especially those 

backed by subprime mortgages. One factor contributing to this gap was that other market 

 13 Mark Adelson, "Bond Ratings Confusion" June 14, 2006, revised June 29, 2006, Nomura Fixed Income Research. 
16

players, such as hedge funds, would often recruit the agencies’ strongest analytical talent.14 It 

should also be noted, however, that CDO risk analysis is an emerging area of finance and there 

were market-wide weaknesses in the methodologies used to value CDOs and their risks over this 

period. One interesting aspect of reports of CDO-related losses at financial institutions active in 

creating these instruments was that they retained significant positions in these structures--

suggesting (by revealed preference) that they also overestimated the diversification gains. 

Investors 

 One of the great mysteries of the subprime crisis is why investors failed to understand the 

risk they were taking on when they bought securities backed by subprime mortgages. We 

speculate that investors were lulled into a false sense of security by the boom period for the 

housing market that lasted from around 1993 (when markets on the East Coast and California 

pretty much hit bottom) through 2005. A similar malfunction in financial markets took place in 

1993, when after a remarkably extended worldwide bond market rally, rising interest rates 

caused leveraged investors with positions in long-duration fixed income securities to experience 

large losses.15

 Another contributing factor is the structure of fund manager compensation. Hedge fund 

managers tend to be compensated by the “2-20” rule: they get two percent of the value of the 

fund they are managing, and 20 percent of any yield the fund earns above a designated index. 

This compensation scheme is like an option: the payoffs are asymmetric. If the fund does better 

than the index, the manager gains a lot; if it does worse, the manager in the short run is no worse 

off than if the index matches the market (although in the longer run, underperforming funds will 

lose assets). This will create incentives for fund managers to take on greater risk. 

A third possibility is that subprime based CDOs were sufficiently complex to analyze that 

investors relied heavily on ratings agency risk assessments, and consequently higher rated 

tranches commanded a liquidity premium: many investors face ratings-driven restrictions on 

 14 "If the ratings agency ends up coming up with a really, really good pricing model, the individual responsible for 

developing those models will very quickly be hired by the hedge funds," MIT Finance Professor Andrew Lo quoted 

in the Reuters article "Can Wall Street be Trusted to Value Risky CDOs?" July 13, 2007 15 Orange County, California, was probably the best-known example of an institution that took a highly leveraged 

position in long-duration fixed income securities. The outcome was that the bonds of one of the richest counties in 

the United States went into default. Also, at the same time a number of money market funds managed by large 

financial institutions suffered major losses. 
17

investments that result in highly rated tranches benefiting from greater liquidity.16 At the same 

time, CDOs were not very transparent, and many investors, it seems, relied solely on rating 

agencies to properly evaluate risk. 

 All this said, we must finally acknowledge the possibility that some investors may have 

made decisions with their eyes wide open, fully understanding the nature of the product they 

were buying. Just because investors take risks that ex post don’t pay off doesn’t mean that they 

were ill-informed when they made their decision. 

 Finally, many commentators have noted that world financial markets have recently been 

swimming in liquidity. For example, Figure 3 indicates that foreign central banks demand for 

high quality assets outstripped the supply of U.S. Treasury and Agency assets by about $300 

billion in 2007. Outside of the United States, the world saved so much that yield spreads 

narrowed on almost all types of investments. 

Figure 3: Changes in Reserves and High Quality Assets

-100

0

100

200

300

400

500

600

700

2000 2001 2002 2003 2004 2005 2006 2007

$ Billions

FCB $ Assets

Tsy/Agency Supply

What next?

 Policymakers are suggesting a variety of actions to avoid repeating the events 

characterizing the mortgage markets over the past year. Many of these actions are regulatory, 

and include such things as the development of “suitability rules” and assignee liability. We 

 16 See Fender and Mitchell (2005) for a discussion of the heightened role of ratings agencies in guiding investors in 

structured financial instruments. 
18

would like to suggest practical alternatives for reducing externalities arising from the crisis. We 

also would hope that new regulation would focus on aligning incentives to mitigate against the 

adverse selection and moral hazard issues that led to the current crisis. To be more specific, 

changes in policy should accomplish three things: 

1. It should make sure that more parties in the lending chain have “skin in the game.” While 

reputational risk mitigates against bad behavior, there is not a substitute for financial 

incentives. 

2. It should make sure that parties in the lending chain are subject to federal supervision. This 

will both reduce regulatory arbitrage and investor monitoring costs, facilitating the flow of 

capital into this sector. 

3. It should do what it can to improve disclosures throughout the lending chain. Borrowers 

must be better informed as to the consequences of their lending choices (although this will be 

difficult); ratings must be more consistent, and securities must be more transparent. 

These types of reforms will only help the market going forward. The coming wave of defaults 

could be dramatic: some analysts have suggested that the default rate among all subprime 

mortgages could reach as high as 20-25 percent. To put this in context, the mortgage default rate 

during the Great Depression was around 10 percent (Green and Wachter, 2005). While the 

subprime market never made up more than 20 percent of origination volume in a particular year, 

there are neighborhoods that relied heavily on subprime financing, and so this magnitude of 

defaults could have depression like effects on these neighborhoods. 

 As such, it may be appropriate to think of a housing triage program, particularly for those 

households who kept current on their payments before a rate reset. Two proposals are intriguing. 

One comes from Andrew Samwick, and Dean Baker: 

There is a simple way to allow troubled homeowners to stay in their 

homes without also bailing out the mortgage issuers and speculators. 

Congress can pass legislation granting current homeowners the right to stay 

in their homes as long as they like, simply by paying the fair-market rent. In 

other words, no one gets tossed out on the street, as long as they can pay the 

rental value of their house. The fair rent would be determined by an 

independent appraiser — exactly the same way that a lender is supposed to 

determine the size of a mortgage that can be issued on a home. 

Under this plan, homeowners would turn over their property to the 

mortgage holder. This would generally not be a loss since borrowers 
19

currently face crises precisely because they owe more than the value of 

their house. If the value of the home exceeded their debt, then they 

wouldn’t have to sign up for the program. 

As a renter with secure tenure, the former homeowner would have 

incentive to do necessary maintenance and keep the home from falling 

into disrepair. This would prevent the blight that is already hitting 

neighborhoods where foreclosures have become commonplace. 

There are some issues here; among others are the fact that it might not be straightforward to 

determine market rent, and will require capital to be raised to fund acquisition of the homes. 

This capital will either need a subsidy or will entail higher expected returns. It will be difficult 

to sell a detached single family home if the renters in it have absolute tenure security, and hence 

this constraint will have to be reflected in a higher return on equity. 

 As for going forward, we begin with capital. A mortgage finance system in which more 

participants have some 'skin in the game' may help better align individual interest with social 

interest. The current 'originate to securitize' model of housing finance with participants having 

little stake in the performance on the loans they arrange has led to perverse incentives. 

Compensation could be tied to loan performance and deferred for a year or two. 

 The current compensation system for brokers also produces perverse incentives. Brokers 

benefit from two things: yield spread premiums (YSP), which are largely invisible to borrowers, 

and volume. Their compensation is not tied to loan performance. As such, brokers have an 

incentive to steer borrowers to high YSP loans that have low initial payments (the low initial 

payments allowed borrowers to qualify for larger loans). The probability that loans would repay 

had almost no impact on brokers’ incentives. So long as house prices were rising, the poor 

quality of the loans was masked; as soon as house prices began to flatten, the poor quality 

revealed itself. 

 The best way to have brokers avoid this behavior in the future is for their compensation 

to be somehow tied to loan performance. It is possible that in the end this could only come about 

with a restructuring of the broker market that required some combination of bonding and capital. 

 Second, it is important to make mortgages and their costs more transparent to consumers. 

Consumers should be aware of the total compensation that brokers earn (including the yieldspread premium). This would be analogous to the current practice wherein consumers see the 

wholesale cost to the dealer of an automobile, so they know the mark-up they are paying when 
20

they buy the car. Guttentag (2007) has an interesting proposal wherein consumers would get 

only two mortgage prices: a rate and points. All fees would have to be wrapped into either the 

YSP or the rate. To continue to analogue with automobiles, Guttentag argues that just as it is the 

case that car buyers do not get to choose whether the car has tires, borrowers do not get to 

determine whether the loan gets an appraisal. 

 Guttentag’s proposal, however, does not deal with adjustable rate mortgages, where rates 

can change over time. It would almost certainly be a good thing to have clear disclosures about 

potential payment shocks, but it is not entirely clear that such disclosures would help the most 

vulnerable borrowers. Perry (2007) and others argue that borrowers are myopic, and have a hard 

time seeing beyond their first mortgage payment. 

 With respect to intermediaries, there are two points worth making. First, as Gramlich 

(2007) noted, we currently have two banking systems: one that is under federal supervision, and 

another “shadow” banking system. This not only means that there are institutions with inadequate 

capital making loans, but also that there is opportunity for regulatory arbitrage, which may well be 

more distortionary than a second-best uniform regulatory regime. Placing all lenders under the 

Home Ownership and Equity Protection Act (HOEPA) would be a good first step. 

 Second, it is important to closely monitor the effectiveness of the recent changes to the 

regulatory regime under which rating agencies do business. 

Finally, we must think carefully about how to define and punish predatory lending. Part 

of the definition of a predatory loan must involve its opaqueness: when lenders hide fees, when 

prepayment penalties are not clearly spelled out, when good faith estimates of closing costs are 

substantially different from those on the HUD-1 form at closing are all indicators of predatory 

lending. Note, the issue is more about disclosure than price per se. 

Conclusions

The subprime mortgage market in the first years of the 21st century was a natural 

experiment of a purely market-based financial system. The market was supplied by atomistic 

competitors, and was largely unregulated, with an unregulated sector performing both 

originations and securitizations. Investors were supposed to be informed by private ratings 

agencies and protected by the structuring of the securitization. 
21

In the end, things fell apart because of market imperfections highlighting the lessons from 

the theory of the second best (in the sense of Lipsey and Lancaster, 1956). Some brokers 

exploited asymmetries in compensation and information to extract rents; some borrowers 

adversely selected into loan products with advance knowledge that they would ruthlessly default. 

None of this would be of concern to policymakers if the losses involved were confined to 

investors in houses, mortgages and securities. But the losses are not so confined. Homeowners 

who did not understand the complicated documents they were signing wound up converting their 

home equity into fees for brokers. Neighborhoods with high concentrations of defaults saw 

wealth disappear even for households with no mortgage at all. 

The question is how to move forward without unduly restricting the flow of mortgage 

capital. Targeted intervention into neighborhoods suffering from waves of defaults; developing 

incentives grounded in capital adequacy or bonding to discourage the making of unsuitable 

loans; and greater transparency throughout the mortgage process would help. 
22

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