Predatory Borrowing?

The ongoing cacophony about subprime mortgages does indicate that a discussion regarding certain mortgage types and their risk is appropriate.

I will try here to categorize several types of mortgages and discuss the problems which could exist with the various types.

First let's take a step back and ask "when did the problem begin?" Until about 25 years ago the only thing that existed were fixed rate mortgages. Adjustable rate mortgage got their start when fixed rates got so high that few could afford them. Adjustables made home ownership possible for many.

Since then the mortgage business has grown gigantically. It has at all time tried to be accommodating. I am not stating or implying that the reason for being accommodating was altruistic. Whether a lenders motive is solely greed or altruism is irrelevant.

In a sense the mortgage business has become too accommodating. It has (or had) created mortgage products for folks with bad credit and no down payment and no documentation of income. That, in my view is darn accommodating.

I can identify 4 types of mortgage which have risks above the fully documented, good credit, fixed rate loan.

First of all every adjustable rate mortgage has some risk (to the borrower) associated with it. The risk is that the rate in the future will be so high that the payment will be unaffordable. Generally individuals are less able to take rate risk than financial institutions are. Adjustables are attractive only is as far as the rates are lower than fixed.

Option ARM and any negative amortization loans have risk. The risk is that the balance will increase, the rate increase and the payment become unaffordable. For my clients I recommend Option ARMs for certain sets of people:

- folks with highly variable income
- folks who are young professionals whose income will almost certainly be increasing and are buying a house today that they will be able to afford the fully amortized payment on in 2-3 years
- folks who are buying a fixer upper and may want to put money into the house rather than the mortgage for the first couple of years
- folks who are buying a new home and have not yet sold their present home and don't want 2 fully amortized payment for a half year or so.

Almost all of the people I have gotten Option ARMs for are in the first 2 categories.

Option ARMs should not be used to make loans to people who will never be able to afford a fully amortized payment. I see two areas for abuse here. Some folks are talked into refinancing into an option ARM by a loan person who is motivated solely to make a commission. The pitch is: hey you can cut your $2,500 payment in half. The issue as to what the implication for the future might be are avoided. Who's to blame? Take your pick: the borrower, the loan officer and the lender are all to blame. From my personal perspective every borrower is responsible for making sure that he does not get screwed.

(Over)Stated Income

This is, from my perspective, the Twilight Zone of mortgage lending. I think that it started by recognizing that mortgage underwriting was unfair to self-employed people who were aggressive deductors They had their business paying for expenses who for the wage earner came out of his take home check. When I first got started in the mortgage business stated income was solely for folks who could document self employment. In recent years it has been open to most anyone.

I am willing to believe that the vast majority of stated income loan applications overstate the borrowers income. What has happened is that the mortgage industry and the Wall Street enablers behind this product have sought short-term benefits over long tern health. "Health" here means both the health of the borrower, the lender and the investor.

The extreme case of this is the subprime, B-paper (bad credit) 100% CLTV scenario. For the most part these loans are insane. LTV’s of 98% or more combined with FICO scores of 680 or less accounted for 12% of home purchases in 2006 and 77% of delinquencies.

I read an on-line piece on Thursday indicating that a consumer advocacy group was portraying this as something akin to "predatory lending." This is more like "predatory borrowing." It is the investors who are getting screwed. It is difficult for me to see someone with bad credit, no down payment and an overstatement of his income as simply a victim. The Wall Street firms which enabled these products did so with little regard for either the borrowers or the investors.

The B-paper Story Continues

There is an important aspect to this story about B-paper. This is an example of the changes in folks' view of what the economy is and what is of economic value. It use to be the case that companies which made things were of value. With the change in the economy from goods producing to service producing a change in perception has occurred which has strangely had the effect of making the economy something which runs on the expansion of credit and money supply rather that profit. This B-paper mess would never have existed if property values had not been increasing sharply.

Let me expand that last point. If one were to look at appraisals over the last 10 year one would see that it is not in fact the value of homes that has been increasing sharply but the value of the land under then that has increased. That increase has been fueled by credit markets - the availability of a near infinite money supply for mortgage backed securities. It would be more accurate to talk about a "land bubble" rather than a "housing bubble." Going to the supply side one might simply offer that the lead time to get developments approved and do the actual construction was simply to long. Supply inelsaticity could be deemed the culprit for the large increase in values. The ready supply of money made demand more elastic than supply.

This expansion in credit has affected the economy in other adverse but less obvious manners. Everyone is modestly affected by gasoline prices but the fact is that oil futures are not affected solely by supply and demand but by derivative trading as well. Speculation in oil futures for the sole motive of greed is enabled by credit markets and affects everyone. Derivatives in general and hedge funds in particular are unregulated. I do not subscribe to the thesis that hedge funds are necessarily going to at some time create substantial shock on the economy but they certainly do have that capability.

The B-paper market was enabled by Wall-Street not from the motivation of providing home ownership to folks with bad credit but for profit. Now that it has headed south borrowers and loan officers will be castigated. The effect is similar to that of recent corporate scandals. Short-term profit has been sought even though it threatens the long-term viability of a company or something such as the housing market.

B-paper Angst Redux

Subprime mortgages have received a lot of press lately. What is involved is the perception of the value of B-paper mortgages. The expression "B-paper" merely means mortgages for folks with poor credit. This is also referred to as "subprime" and will probably gain a new handle once the dust settles.

B-paper is not new. What is recent and what is almost entirely responsible for the current problem is the proliferation of absurd lending. I mean specifically B-paper, stated income and especially B-paper stated income 100% combined loan-to-value loans. Many of these are loans which should never have been made. If someone has bad credit and I were lending them money I would like a complete look at their income so that I could answer the question, "can these folks really make this mortgage payment?"

What happened is that Wall Streeters were able to sell investors on high returns in exchange for this truly unknown risk. This was expedited by the fact that these pools of B-paper mortgages were insured. Third (or maybe it is fourth) parties were taking the derivative risk.

What happened was inevitable. This encouraged the funding of loans which had early defaults, default rates on these loans increased, the cost of credit insurance became prohibitive and the originators of these loans wound up with no one to sell them to. This creates serious illiquidity and has resulted in the shutdown of some of the largest players in this field. These changes can be abrupt. Investors simply announce at the start of a business day that they are no longer buying this paper. Individuals may have recently found that they signed loan documents and before the loans could fund investors stopped buying the loans that were about to be funded. This has occurred mainly with high CLTV B-paper seconds.

The B-paper industry will make a come back but hopefully it will do so with sensible underwriting. In short: no stated income 100% LTV B-paper. Maybe no stated income B-paper at all.

I do not think that this will have a wide macroeconomic effect. The effect so far has been on the folks who have these mortgages and are going to lose their homes and on the folks in the mortgage business who made a very nice living by originating these loans. To be sure this will have the effect of creating a few more sellers and a few less buyers but hardly will have a dramatic effect of values in general To be sure there is probably a geographic clustering of B-paper and those places will see a consequent downturn in values but the overall nationwide effect will be a slight downward pressure on values.

It is not yet apparent that there is any significant damage to banks in general or the banking system. The only parties at risk here may be the commercial banks which extended credit lines to these now halted B-paper originators. I don't mean that these commercial banks will go out of business I only mean they will suffer some losses or diminished profits and stock value.

One other point. The is another mortgage space between subprime and "A" paper which is usually called "Alt-A." That may mean slightly different things to different lenders. Alt-A can mean: below 680 but not really terrible credit or it can mean good credit but high-ratios (housing expense divided by income and total debt obligation divided by income). The best description is that it is A-minus and not B paper.

Once the angst plays out Alt-A will probably be affected also but probably not as much a B-paper.

As for housing values I believe that we are looking at several years slightly lower to flat values (on a nationwide average) and in the long run that is healthy. The increase in values in the past few years produced more supply and the market is better balanced. Getting speculation out of the market is also healthy and relates to what I said about derivatives affecting commodity prices. With housing it is not hedge funds but individuals who helped push value too high with speculation.

The good news is that first time homebuyers will get lower prices.

Dick Lepre