Subprime: A Predictable Surprise

Michael Watkins on how the subprime crisis provides another textbook example of the theory of predictable surprises and how to prevent the disasters they bring

by Michael Watkins

In 2004, my colleague Max Bazerman and I published Predictable Surprises: The Disasters You Should Have Seen Coming and How to Prevent Them. We defined "predictable surprises" as problems that (1) at least some people are aware of, (2) are getting worse over time, and (3) are likely to explode into a crisis eventually but are not prioritized by key decision-makers or have not elicited a response fast enough to prevent severe damage. We supported our thesis with detailed analyses of the September 11 attacks, the collapse of Enron, and the war in Iraq.

While embraced by many, our work on predictable surprises came under predictable attack. "Hindsight is 20:20" the critics said. In response, Max and I were able to point to specific instances where we had accurately predicted major problems: Max gave congressional testimony on conflicts of interest in the auditing of public companies, and I had written about the dire consequences of an invasion of Iraq. But some critics remained unmoved.

Hindsight: The Road to Ruin

Imagine my delight then, when the financial markets offered up a near-perfect natural experiment that supported our theory: the collapse of the market for subprime mortgage-backed securities.

The contributing causes of the subprime collapse certainly are clear in hindsight:

• To avoid damage to the economy following the collapse of the Internet bubble in 1999, the U.S. Federal Reserve lowered interest rates which, in turn, lowered mortgage rates. The rate for 30-year, fixed-rate mortgages in the U.S. declined from 8.25% in January, 2000, to a low of 5.25% in January, 2003, and remained at low levels not seen since the 1960s for several years.

• A resulting surge in investment in housing, speculative and otherwise, helped drive median housing prices in the U.S. from $170,000 in 2000 to $240,000 in 2005. The resulting "equity cushion" permitted homeowners to increase their borrowing and encouraged still more speculation, creating a feedback loop.

• Securitization of mortgages into collateralized debt obligations (CDOs) decoupled mortgage originators (brokers and others) from the credit risks of the loans they were writing. At the same time, U.S. investment law shielded sellers of these securities from the legal consequences of fraud by originators. This introduced corrosive conflicts of interest into the system.

• The lure of easy money, creativity in the design of subprime mortgages (e.g., various forms of adjustable-rate mortgages with low initial payments), the inability of borrowers to fully understand the consequences of what they signed up for, and laxness in regulatory oversight fed a dramatic surge in subprime lending. A Wall Street Journal analysis has shown that the number of subprime mortgages written in California alone increased from 273,000 in 2004 (11.8% of total mortgages) to 573,000 in 2006 (29.4% of total).

• Mortgage brokers wrote loans of increasingly poor quality, including many that were apparently fraudulently obtained. In another conflict of interest, appraisers, whose livelihoods depended on getting work from front-line lenders and brokers, colluded in fraud by making higher-than-justified assessments of home prices.

• The risk of the CDOs based on these mortgages rose dramatically. Rating agencies, for reasons not yet fully understood, systematically underestimated the risks associated with these instruments.

• The inevitable first wave of defaults and foreclosures eventually took hold, triggering the collapse. (Another, potentially larger wave of defaults triggered by upward resetting of rates on ARMs may be averted by government-led efforts to prevent interest rate rises.)