Subprime vs subprime

The financial industry’s way with words — that is, the industry’s way of making sure that words never mean what you think they mean — has tripped up the academics once again.  The recent debate between Raghuram Rajan and Paul Krugman over the role played by Fannie Mae and Freddie Mac seems to hinge on the fact that they are talking at cross purposes.

The commonly understood meaning of “subprime” when referring to securitized mortgages is to be found in wikipedia:

Varieties of underlying mortgages in the pool:

  • Prime: conforming mortgages: prime borrowers, full documentation (such as verification of income and assets), strong credit scores, etc.
  • Alt-A: an ill-defined category, generally prime borrowers but non-conforming in some way, often lower documentation (or in some other way: vacation home, etc.) (Article on Alt-A)
  • Subprime: weaker credit scores, no verification of income or assets, etc.

There are also jumbo mortgages, when the size is bigger than the “conforming loan amount” as set by Fannie Mae.

Since a “conforming mortgage” is one that meets the criteria set by Fannie Mae and Freddie Mac, the traditional meaning of subprime is a loan that does not meet Fannie Mae and Freddie Mac’s criteria for a reason other than loan amount.  (Alt-A came much later than sub-prime.)  For this reason it is common to see the words “prime” and “conforming” used interchangeably in mortgage articles.

Thus using the traditional approach, any MBS issued by Fannie or Freddie is, by definition, not a sub-prime MBS.  When Fannie and Freddie invested in sub-prime they did so by buying up privately issued sub-prime MBS.  It seems obvious that in this market Fannie and Freddie were two of many, many guilty parties.

What makes the whole discussion complicated is that (I think) the GSE’s loan criteria became less discriminating over time.  Thus, if one wants to fix the definition of sub-prime based on the GSE’s standards in, for example, 1998, one can claim that the GSEs themselves were issuing “non-conforming” MBS.  On the other hand, it is unarguable that even when the GSEs were issuing “non-conforming” MBS, the loan criteria were always noticeably stricter than those in the privately issued subprime MBS market.  The bottom line is that the lending behavior of the GSEs is not well suited to a casual assertion that they started issuing subprime MBS, but instead deserves a carefully researched dissertation that breaks loans into far more granular categories than prime, subprime and Alt-A.

Tanta is of course the go-to source for anyone who wants to understand the nitty-gritty details of the mortgage market.  For an extremely thorough discussion of what precisely it means for a loan to be sub-prime or Alt-A see here, and here for a thorough discussion of what precisely the GSEs were doing when they securitized loans — see in particular the paragraph that starts:  “Propaganda from certain other market participants aside, you cannot just put any old loan in a GSE MBS.”

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