Building a Bubble: Business Strategies during the Rapid Expansion of Mortgage Credit from 2002 to 2007 Worked to Boost the Emerging Housing Credit Bubble Fostered by Low Interest Rates and Investor Demand. This Is the Second of a Two-Part Series

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The boom years' rapid and unchecked expansion of housing credit in an environment of very low mortgage rates was, as we now know beyond a reasonable doubt, a high-risk enterprise. Profits were initially high and rising as the expansion got under way, but with the benefit of hindsight, the level of risk incurred appears to have been poorly understood by many. * Never had so much credit been available to allow mortgage lenders to pursue an ever-widening array of business strategies. Rarely had leverage been more alluring, as higher leverage produced higher profits. * The seemingly boundless supply of credit from the secondary markets allowed mortgage players leeway to experiment on a large scale. Mortgage companies rushed to copy what seemed like successful efforts by other players in the market. A number of companies found themselves in uncharted waters. * Some mortgage lenders raced to gain market share in order to improve their competitive positions, with the hope and expectation that ever-greater economies of scale would boost profitability. * Subprime and alternative-A lending became the new frontier where new entrants did well and old-time players began to slug it out for a piece of this ever-growing pie. The initially low levels of delinquencies and defaults with risk-based pricing strategies encouraged more growth in these riskier markets.

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The ready availability of credit from the secondary market was a green light to business-expansion strategies. It created a climate that would allow competition overall to eventually drive lending standards downward. Thus, while the business strategy of each player seemed to make sense in isolation, in the aggregate it paved the road to mortgage perdition.

The refi boom of 2002 and 2003

The business conditions created in the aftermath of the huge mortgage refinancing boom of 2002 and 2003 are identified as a primary factor behind the credit bubble by Michael Young-blood, the former managing director of asset-backed securities (ABS) research at FBR Investment Management Inc., Arlington, Virginia. Youngblood left FBR in June to form, with Steve Gaenzler, a new hedge fund firm, Five Bridges Capital, Washington, D.C., which will manage the Mortgage Opportunity Fund, which will focus on investing in undervalued mortgage assets. "When mortgage rates began to rise in early 2004, it brought an abrupt end to a two-year-long refi boom that was historically unprecedented," says Youngblood.

During the refi boom, premium non-agency pass-through securities were prepaying in excess of 90 percent of the conditional prepayment rate (CPR), Youngblood says, while agency pools were prepaying in excess of 80 percent of CPR. The weighted average life of mortgages in these pools was less than a year. Youngblood notes that the Mortgage Bankers Association (MBA) mortgage application survey refinance index peaked at 8,599 in June 2003. By May 2004, it had fallen to 1,583. "This massive up-swelling in refinancing obviously was highly profitable to the industry," Youngblood says. "And in order to serve the demand for refi credit, the industry expanded its infrastructure and staffing levels," he adds.

By the second quarter of 2004, neither refi loans nor purchase-money loans produced sufficient volume to justify the expanded capacity of the industry. "Rather than downsizing, which had been the industry's traditional response to refi busts, the industry began to reallocate resources to emerging sources of demand for non-traditional credit, particularly alt-A and subprime, and particularly to adjustable-rate rather than fixed-rate [product]," Youngblood says.

The industry also began to consolidate both by acquisition and by efforts to gain market share, according to Youngblood. Consolidation at times led to a bloating of staffing levels.

"No manager likes to downsize, and no industry likes to downsize. The desire to preserve the growth of 2002 and 2003 was perfectly understandable," Youngblood says. …