BANKS at the centre of the financial crash of 2007/8 should have understood better the underlying behaviour of sub-prime mortgage securities, according to research by Professor Gauthier Lanot of Keele University and Professor David Leece of Manchester Metropolitan University Business School.
Their research, to be presented at the Royal Economic Society’s 2011 annual conference, examines the behaviour of typical households with the types of mortgages that contributed to the financial crisis.
Using a statistical model based on UK sub-prime mortgage securities issued over the four-year period before the crisis began (2003-06), they conclude that the probabilities of default and refinancing varied significantly with the variety of mortgage types included in the securities.
A single issue of mortgages for securitisation could contain over 600 different types of mortgage contract – for example, self-certified, self-certified, fixed and discounted mortgages – and each of these contracts have different properties. Not only were the securitised mortgage instruments technically complex but the fundamentals of household behaviour in this market were not well understood, the authors note.
Professor Leece said: “It is a commonly accepted explanation in the UK and the United States that the banks were imprudent in their lending to sub-prime borrowers’, Professor Leece comments. The question is why? Our study suggests it could be because the banks did not understand the behaviour of the households that made up these securities.”
The researchers sourced data from a reputable financial services provider,covering 100,000 mortgage contracts. Their study concludes that a careful analysis of the constituent parts of any mortgage-backed securities should lead to a reliable valuation of the securities.
They recommend that any securitised mortgage market – prime or sub-prime – should be based on simpler or better understood combinations of contracts. This would help securities traders and operators on these markets to get a better idea of the risk-return trade-off that such assets offer.
A Model of Competing Risk and Unobserved Heterogeneity Applied to the Loan Performance of United Kingdom Securitised Subprime Mortgage Debt; by David Leece and Gauthier Lanot