THE STASH SEPTEMBER 18, 2009
Soon forthcoming in the top-ranked Quarterly Journal of Economics is a very well- received paper by four economists with convincing evidence of what many believe was the primary cause of the subprime boom and bust: That securitization took away the incentive for lenders to properly vet borrowers.
But there's some new evidence questioning the paper's findings. To understand the how and why, we have to get into the nitty-gritty of the empirics.
If you plot FICO (i.e., credit) scores against the number of mortgages outstanding, you'll notice a peculiar pattern:
Instead of a smooth curve, at certain FICO scores there are big jumps in the number of people with mortgages.
The reason? Rules of thumb observed by those in the mortgage industry for judging the chances a borrower will default. In the 1990's, Fannie and Freddie released research showing that about 50% of defaults are associated with borrowers who have FICO scores below 620. That happens to be where the biggest jump in the graph above takes place, suggesting that the industry looks far more kindly on a borrower with a score of 621 than a borrower with a nearly identical score of 619.
But who used this rule-of-thumb?
The economists -- Benjamin Keys, Tanmoy Mukherjee, Amit Seru, and Vikrant Vig -- assert that securitizers followed the rule in deciding whether to buy a loan from an originator. Problem is, that meant the originator then knew he didn't have to spend much time vetting someone with a FICO score above 620, since there was a good chance the loan would be securitized and off his books. For the opposite reason, the originator would be more likely to put in the proper due diligence when considering lending to a borrower with a score below 620.
What we should then see is borrowers with FICOs just above 620 defaulting more often than nearly identical borrowers with scores just below 620. And lo and behold, when the economists looked at the data, that's exactly what they found.
Case closed, right? Not quite.
In a new paper, two Harvard PhD candidates -- Ryan Bubb and Alex Kaufman -- take an academic swipe at the big boys and point out the following: Although there is a big jump in mortgages at the 620 credit score, there isn't a commensurate jump in mortgages that get securitized at that score. For example, here's a chart showing the securitization rate for low-doc loans around 620:
This suggests that securitizers weren't relying on the rule of thumb en masse; rather, it was the originators who were relying on it. So it's unlikely that we could detect a decline in lending standards caused by securitization with this particular approach to the data.
That isn't to say a decline in lending standards didn't happen. Just that securitization might not be to blame for it. (There is other research making this point.)
Still, securitization isn't entirely off the hook for the subprime debacle. As Yale's Gary Gorton said in Jackson Hole 2008, the problem with subprime securities was how impenetrable they were, making it nearly impossible to find out about the risks they entailed until it was too late.