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Understanding the subprime crunch

  • Story Highlights
  • Business schools are swiftly analyzing the subprime lending crisis
  • Subprime market was "too good to be true," says one professor
  • Studies aim to point out lessons for the future
  • Next Article in World Business »
By Peter Walker for CNN
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LONDON, England (CNN) -- As well as educating the chief executives of the future, business schools have a broader role -- understanding the essential workings of not only companies, but also the wider economic system.

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Market crunch - business schools are studying the subprime crisis.

When things go wrong for a business or an economy, it is thus often business schools rather than governments or even traditional university economics departments which provide the most timely and incisive analysis of how a crisis developed and how it can be prevented in the future.

It's thus no surprise to see a spate of recent scrutiny by business schools about one of the most dramatic difficulties to hit the global economy in years -- the credit crunch prompted by US subprime lending.

Subprime lending proved a boom market in recent years in the U.S., allowing people with less of the capital or other financial guarantees enjoyed by more affluent citizens, or so-called "prime" borrowers, to nonetheless take out mortgages and buy their own homes.

Many of these debts were "parceled" together and sold off to other financial institutions, which took on not only the potentially high returns but also the risk of default.

For some years, the market -- one, like in many other countries, fueled by a boom in non-traditional private mortgage lenders -- boomed and everyone was happy.

However, as Nicolas P. Retsinas, a lecturer of business administration at Harvard Business School and director of Harvard University's Joint Center for Housing Studies, points out in a new analysis of the crisis, subprime lending was often "a deal that was too good to be true".

"As long as house prices were escalating, all parties thrived," he notes.

"Homeowners got their dream, brokers got their commissions, lenders got their return, investors got rich. If a homeowner could not make the monthly payments, particularly after the grace period of the low opening rate, he could sell the house, maybe make a profit.

"The dizzying escalation in home prices, however, masked the shaky underpinnings of this empire. When prices leveled, or even fell in many regions, the empire started to crumble."

This, of course, is what happened, as home builders over-built and houses remained stubbornly unsold.

The ensuing credit crunch, felt around the world, sparked fears it could usher in a more general economic downturn.

Fact Box

FT MBA Rankings
1. Wharton, U.S.
2. Columbia, U.S.
3. Harvard, U.S.
4. Stanford GSB, U.S.
5. London Business School, UK
6. Chicago GSB, U.S.
7. Insead, France/Singapore
8. Stern, NYU, U.S.
9. Tuck, Dartmouth, U.S.
10. Yale, U.S.
Source: Financial Times 2007

"It's the realization of my worst nightmares -- the extent of the negative impacts on the rest of the economy," says Susan M. Wachter, professor of real estate and finance at Wharton Business School, also in the US, and joint author of another new study of the crisis.

In retrospect, the roots of the crisis are easy to spot, Wachter writes in her analysis, co-written with is Richard K. Green, professor of finance and economics at George Washington University.

"For a time, capital markets seemed to have an appetite for almost any kind of risk, so long as it received sufficiently large yield in exchange," they write. "[But] many subprime loans had essentially no underwriting, and insufficient data were available to calibrate default risk for subprime mortgages."

In the future, it must be hoped, business schools will be able to help any repetition of the crisis.

For now, they must also look into the fallout of the subprime affair, not only for the multi-million dollar hedge funds who bought up loan parcels, but also those at the beginning of the whole process - those seeking to buy a home on a low income.

"Tighter credit will eliminate the shakiest loans, but will shut off many credit-impaired borrowers who truly could make the payments," notes Retsinas.

"In fact, today's credit crunch has exacerbated the crisis, by making it hard for the homeowner with a toxic subprime mortgage to refinance to a fixed-rate product or to sell his home." E-mail to a friend E-mail to a friend

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