The Panic of 2007

This is a fascinating paper by Gary Gorton titled "Panic of 2007" (https://www.kansascityfed.org/publicat/sympos/2008/Gorton.08.04.08.pdf). He is a prof at Yale and was the brains behind the risk models of AIG.

What Gorton says is that there were some unique design features in subprime mortgages, which are not there in other mortgages. We might criticize subprime mortgages for their high LTV's and their option ARM features today. But lets step back to figure out why they came in the first place.

In late 1990's, US legislators wanted banks to make housing loans widely available - even to the poorest people. Now these people can neither put down a downpayment, nor can they pay a high interest rate - commensurate with their risk profile. So the only possible way to design these subprime mortgages was to have high LTVs (close to 100%), and low risk-adjusted interest rates. To make money on these mortgages, banks thus put an optionality in these mortgages (the option ARMs) - whereby the bank stood to benefit if house prices appreciated. Effectively, the subprime borrowers sold call options on their homes to the banks to get attractive mortgages. This feature is not present in prime mortgages.

The implication of this is huge - for Indian real estate market. We might not see massive mortgage defaults because of negative home equity here - there are no option features in mortgages. Defaults would be driven by traditional factors - overleveraging, job loss, health problems, divorce etc.

Not to say that we should buy Indian real estate stocks. My bull case scenario is that 95% of them will fall another 95% from here. Bear case is that real estate promoters hire the underworld to get some of the lenders - especially private equity investors - threatened.