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The Relation of Structured Finance to Subprime
To ensure a continuous supply of credit to home buyers, government-sponsored agencies such as Fannie Mae, Freddie Mac and Ginnie Mae were chartered topurchase mortgages originated by local banks, provided they satisfy certain size and credit quality requirements. Mortgages conforming to these requirements are repackaged by these agencies intomortgage- backed securities, and resold in capital markets with the implicit guarantee of the U.S. government. In contrast, mortgages that do not conform to size restrictions or borrower credit qualitystandards, are not eligible for purchase by the government-sponsored enterprises and are either held by their issuers or sold directly in secondary markets.7 In recent years, issuance of so-called“non-conforming” mortgages has increased significantly. For example, origination of subprime mortgages – mortgages given to those below the credit standards for the government- sponsored enterprises – grewfrom $96.8 billion in 1996 to approximately $600 billion in 2006, accounting for 22 percent of all mortgages issued that year (U.S. Securities and Exchange Commission, 2008). During the same period, theaverage credit quality of subprime borrowers decreased along a number of measures, as evidenced by rising ratios of mortgage values relative to house prices, an increased incidence of second lienloans, and issuance of mortgages with low or no documentation (Ashcraft and Schuermann, 2008). When house prices declined, the stage was set for a significant increase in default rates as many of theseborrowers found themselves holding mortgages in excess of the market value of their homes.
7 Jumbo mortgages have notional values exceeding the conventional loan limit, which was $417,000 for asingle- family home in 2008. Sub-prime borrowers are defined as those with a FICO credit score below 620, limited credit history, or some other form of credit impairment. Alt-A borrowers have credit...