Risky Mortgages and Subprime Mortgage Fraud

Lewis Ranieri, the godfather of the mortgage-back securities and the late American economist and Hyman Philip Minsky, the late professor of economics at Washington University in St. Louis, offered concern and a perspective on the proliferation of risky mortgages and subprime mortgage fraud.

February 24, 2007 the Wall Street Journal interviewed Lewis Ranieri when he was at Salomon Brothers. He worried about the proliferation of risky mortgages and convoluted ways of financing them, saying “too many investors don’t understand the dangers.” He also worried that with so many risky mortgages being packaged and sold in slices to investors all over the world, U.S. mortgages were being spread to a much less sophisticated community. Some risky mortgages probably will perform ‘horribly’ in terms of defaults due to subprime mortgage fraud, leading to major losses for some investors.”

During the mortgage lending fraud crisis, Hyman Philip Minsky's theories about debt accumulation received revived attention in the media during the subprime risky mortgages crisis of the late 2000s. Earlier, he argued that a key mechanism that pushes an economy toward a crisis is the accumulation of debt. He identified three types of borrowers that contribute to the accumulation of insolvent debt: hedge borrowers, speculative borrowers, and ponzi borrowers.

Applying Hypothesis to Recent Subprime Mortgage Fraud

Economist Paul McCulley described how Minsky's hypothesis translates to subprime mortgage fraud and the financial crisis that occurred. McCulley illustrated the three types of borrowing categories using an analogy from the mortgage market: a hedge borrower would have a traditional mortgage loan and is paying back both the principal and interest; the speculative borrower would have an interest-only loan (meaning they are paying back only the interest and must refinance later to pay back the principal), and the ponzi borrower would have a negative amortization loan (meaning the payments do not cover the interest amount and the principal is actually increasing). Lenders only provided funds to ponzi borrowers due to a belief that housing prices would continue to increase.

Demand for housing was both a cause and effect of the rapidly—expanding shadow banking system that helped fund the shift to more lending of the speculative and ponzi types of mortgages and subprime mortgage fraud. This helped drive the housing bubble collaspe, as the availability of credit encouraged higher housing prices. Since the housing bubble bust, we are seeing the progression in reverse, as businesses deleverage, lending standards are raised and the share of borrowers in the three stages shifts back toward the hedge borrower.

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