A group of three finance academics foresaw the looming U.S. subprime
morgage crisis at least three years before the problems started to
become public early in 2007.
and you can find an as yet unpublished working paper entitled Default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
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 of credit
in the morgage market. As lenders faced declining per-unit revenues
as morgage rates dropped, many simply opted to make more morgage 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
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.