Upheaval in the Sub-Prime Mortgage Market
May 7, 2007
Extensive payment problems among sub-prime mortgage borrowers, along with the failure of a number of sub-prime lenders, were major news topics in early 2007. Among the issues that arose in connection with this episode were the following:
* The causes of borrower defaults.
* The causes of lender failures.
* The impact on the current availability of credit to prospective new sub-prime borrowers.
* What Government should and shouldn’t do about the crisis.
* Whether the sub-prime market could and should be replaced.
The 60-day delinquency rate on sub-prime loans exceeded 14% in January of 2007, and was rising. The delinquency rate at that time on loans made in 2005 and 2006 is not known but it is much higher – perhaps twice as high. A large proportion of these delinquencies will end in foreclosure or in some type of workout arrangement.
Ending of Price Appreciation: The immediate cause of the rise in delinquencies was the end of house price appreciation. Property values in most areas stopped rising in 2006 and in many areas they have since declined. The rise in delinquencies and defaults has been concentrated in what I call "appreciation-dependent mortgages" – those that worked for borrowers only if their properties appreciated. A large proportion -- but not all -- of such mortgages were sub-prime.
Speculative Purchases: Some houses were purchased with 100% loans by borrowers hoping to turn a quick profit from future appreciation. These loans were made for the full amount of the purchase price or appraised value – no down payment was required.
Home buyers taking these loans had negative equity the day they closed, in the sense that if they were forced to resell immediately, the transactions costs – which can be 5% or more – would have to be paid out of their pockets. The buyers looked to appreciation to cover the costs and make a profit.
When the appreciation doesn’t materialize, even if the payments remain affordable, the financial incentive to make them is substantially weakened. Most do continue to pay because they want to remain in the house and they don’t want to ruin their credit, but some fold their cards and walk away. The result is a foreclosure.
Speculative Refinances: A presumption that their houses would appreciate also infected the refinance decisions of many borrowers. A question house purchasers asked me in 2004/5 with distressing frequency is "How long do I have to wait (after purchase) before I can refinance to take cash-out?" Some of these borrowers were influenced by a new breed of financial planners and mortgage brokers who promote the view that unused equity should be used for investment – in common stock, property or annuities.
Some home owners used the growing equity in their homes as a way to live beyond their means. They would build up credit card debt, then consolidate the debt into their mortgage through a cash-out refinance. The consolidation, by extending the term of the credit card debt, reducing the rate and making the interest tax-deductible, would reduce the borrower’s total monthly payment. They could then start building up their credit card debt all over again.
This process could continue only so long as their houses appreciated. As soon as appreciation stopped, they were stuck with total debt service costs that might be unmanageable, or with negative equity in their house, or perhaps both.
Unaffordable Mortgages: The most commonly used mortgage in the sub-prime market is the 2/28 ARM. This is an adjustable rate mortgage on which the rate is fixed for 2 years, and is then reset to equal the value of a rate index at that time, plus a margin.
Because sub-prime margins are high, the rate on most 2/28s will rise sharply at the 2-year mark, even if market rates do not change during the period. This means that while the loan is affordable to the borrower at the initial rate, it may not be affordable after two years when the rate is reset.
If the house has appreciated, this is not usually a problem because the borrower can refinance – if necessary, into another 2/28. While these loans carry refinance costs and typically have prepayment penalties, the costs and penalty can be included in the balance of the new loan if the borrower has sufficient equity.
The borrower who does not have the equity needed to refinance, however, is stuck with the higher payment on the existing 2/28 that may be unaffordable.
The upshot is that many consumers made purchase and refinance decisions based on the premise that their houses would appreciate, as they had for many years. When appreciation abruptly stopped, both their incentive to make their payments and their ability to do so was sharply reduced. While it wasn’t only sub-prime borrowers who fell into this trap, these borrowers had the least capacity to extricate themselves.
This raises an obvious question: why was the mortgage lending industry willing to make loans that were workable for the borrowers only if their properties appreciated?
While it is understandable why borrowers became caught up in the belief that house prices always rise, lenders are supposed to know better. Why was the mortgage lending industry willing to make loans that were workable for the borrowers only if their properties appreciated?
Disaster Myopia: In 1986, with my colleague from Wharton Richard Herring, I published an academic paper called Disaster Myopia in International Banking. The paper set out to explain the international banking crisis of the early 80s, but on rereading it recently, I realized that it also goes a long way toward explaining the current crisis in the sub-prime market.
The disaster myopia thesis is that if potential shocks that can cause major losses to lenders occur very infrequently, they will not be fully reflected in loan prices and conditions. If the market is competitive and some lenders are willing to discount the likelihood of a shock altogether, other lenders who might be inclined to be more cautious, are forced to go along or lose market share.
In the mortgage market, disaster myopia meant basing mortgage prices and underwriting rules on the assumption that because house prices had risen for a very long period, they would continue to rise. The cessation of price increases was thus a shock for which lenders were no better prepared than borrowers.
Disaster myopia was especially prevalent among aggressive sub-prime lenders, who could make a lot of money in a very short time so long as house prices kept rising. Other sub-prime lenders who might not be disaster myopic were forced operate as if they were in order to remain competitive.
Underwriting requirements in the sub-prime market are set by the investment banks who buy the loans and securitize them. While the investment banks may or may not have been disaster myopic, those who were willing to accommodate the more aggressive lenders did more business (so long as house prices were rising) than those who insisted on being more cautious.
Mortgage Market Shocks Spread Rapidly: Virtually all sub-prime mortgages are converted into mortgage-backed securities that are sold to investors. These securities are actively traded and are therefore under constant surveillance by investors, traders and rating agencies. Bad news about defaults surfaces quickly and is quickly reflected in lower market prices of securities. The value of loans in the pipeline – on the way to securitization but not there yet – also drop.
The rapidity with which the current crisis in the sub-prime market spread marks a very important difference with the international banking crisis of the 80s. The international banks kept virtually all the "bad" international loans in their own portfolios, and used various stratagems for keeping the original values on their books unchanged.
This avoided widespread failures, but it also shut down the market for new loans. In the sub-prime crisis, in contrast, much lender blood was spilled but the market for new loans remained open.
Failures of Sub-Prime Lenders: As of May 1, 2007, National Mortgage News, a trade publication, counted 32 sub-prime lenders that had become "defunct" since early 2006. The immediate cause of most of these failures was the reduction in the market value of the loans in their pipelines – loans they had already purchased but not yet sold.
Lenders originate mortgages in preparation for sale mainly with borrowed funds – their capital is usually quite small. Most borrowed funds come from what are called "warehouse lenders", mainly large commercial and investment banks, who protect themselves by requiring that the unsold mortgages be posted as collateral. When the value of the collateral drops, the account becomes "under-margined", and the warehouse lender asks for more collateral. If the decline in the value of the mortgages exceeds the capital of the sub-prime lender, the latter will be unable to comply and probably will be forced to shut its operations.
A marked deterioration in the payment experience of sub-prime borrowers poses a second threat to the solvency of sub-prime lenders. Under their arrangements with investment banks, lenders are required to repurchase loans that become delinquent within a few months after sale. The more aggressive the lender in pushing through marginal cases, the more buybacks they are likely to face. Collateral calls and buybacks are the major causes of lender failures.
The Current Pain: The 32-odd sub-prime lenders who failed have garnered the least sympathy. Put simply, they gambled and lost. But some borrowers fall in that category as well because they were looking to profit from house price appreciation. Instead, they are facing foreclosure.
Investors in securities issued against pools of sub-prime mortgages have also felt pain, as the market value of these securities has declined. Lehman Brothers estimates the decline at $19 billion. Most of it is concentrated among the riskiest of the securities, which promised the highest yields. (No collection plates are being passed for them, either.) Securities rated AAA, which are first in line to be repaid and last in line to take losses, have been impacted very little.
Mortgage brokers have not been significantly affected. A few have lost access to sub-prime lenders, but most of them have been able to replace defunct lenders with other lenders.
The big losers are those borrowers who, as unwitting victims of hype and deception, took out mortgages that were unworkable if house prices stopped rising. Now that prices have stopped rising, many of these borrowers are waiting for the next shoe to drop. They have ARMs on which the rate will reset to a much higher level within future months.
The Sub-Prime Market Remains Open: This is the good news, and it should not be taken for granted. When the international banking crisis erupted in the early 1980s, the market adjustment stretched over a decade during which there was virtually no new lending.
The sub-prime lenders who remain are the more cautious ones. They are also more likely to be affiliated with other firms with deep pockets, which will help them ride out any future market disturbances.
Of course, the profit potential in sub-prime lending is not what it was. Investors require a higher yield than before, especially on the riskiest securities. This has caused a tightening of underwriting requirements that has effectively lopped off the riskiest segment of the market.
Underwriting Requirements Are More Restrictive: Underwriting requirements are the conditions that borrowers must meet to be eligible for a loan. They are significantly more restrictive now than they were a year ago. One of the most important shifts is the virtual disappearance of the 100% (no down-payment) loan.
Periodically I receive an advertisement from a sub-prime wholesale lender rep advertising what is available from his firm. (He thinks I am a mortgage broker.) One came to me on April 19, 2007 showing that a borrower with a credit score of 620 (which is low) could qualify for a loan of $650,000 with a down payment of 10%. Checking back in my "Deleted Items" archive, I found a message from the same rep dated June 20, 2006. At that time, he was offering the borrower with a 620 score a loan of $1 million with nothing down.
The 2006 offer was insane, a product of the euphoria created by steadily rising real estate prices. The current rules are no longer based on the inevitability of rising prices.
Prospects: If house prices begin to rise in 2007, the problems of the sub-prime market will go away. In 1998/99, we had a similar episode in which as many as 20 sub-prime lenders failed. But in 2000, house prices took off, the problems disappeared, and few people today even remember the episode.
This time, however, the prospects for a quick revival of house price appreciation are very poor; a further weakening is much more likely. Under these conditions, there is an ominous cloud on the horizon: sub-prime borrowers who took 2/28 ARMs in 2005 and 2006 will have their interest rates and payments reset to much higher levels during the remainder of this year and next. A significant number will not be able to make the new payments, and won’t be able to refinance because the equity in their houses is not sufficient to meet the new underwriting requirements. They face foreclosure.
The Federal Government is presently under enormous pressure to "do something" about the sub-prime crisis. The various proposals that have emerged appear to reflect concern for abused borrowers in or heading toward foreclosure, a desire to punish those responsible for their plight, and the usual urge to score political points.
This is not a brew likely to generate thoughtful reforms that look to long-term consequences. Doing nothing is also an option, and in my opinion, a better one than most of the proposals that have emerged.
Here are some principles that reform advocates ought to observe.
The Sub-Prime Market is Open, So Let’s Not Do Anything to Shut it Down. As I noted last week, the sub-prime market has undergone a significant blood-letting, yet for all that it has stayed open for business. Borrowers with poor credit who can’t document their income can’t get 100% loans anymore, but that’s a good thing. And other borrowers with better credentials, though not good enough for the mainstream market, are still being served.
We should always keep in mind that for every foreclosure of a sub-prime borrower, there are at least 10 others who have become successful homeowners who might not have made it otherwise. We don’t yet have a substitute for the sub-prime market, that possibility is discussed below. Meanwhile, draconian penalties that could cripple the sub-prime market should be avoided.
Borrowers Who Speculated on House Price Appreciation and Lost Should Not Be Bailed Out. It would be a travesty if house buyers can enjoy an increase in their wealth when house prices increase, while shifting losses to someone else when prices decrease. There is no more reason to do that in the house market than in the stock market.
The Lien Enforcement System Should Not Be Weakened. Law-makers should be ever-mindful that a core requirement of an effective housing finance system is the pledge of property as collateral for loans, and the ability of lenders to enforce their liens on the collateral. An enforceable lien is what makes possible the $500,000 loan at 6% for 30 years to a borrower who, without the house to pledge as collateral, might be able to borrow $25,000 at 10%. While the laws of the various states require lenders to observe due-process, these are not serious impediments to lien enforcement. Let’s keep it that way.
Ill-Advised Proposals: These include a moratorium on foreclosures, which would benefit all borrowers in trouble, whether they deserved it or not, seriously weaken the lien enforcement system, and possibly shut down the sub-prime market, depending on how long the moratorium lasted and how it was implemented. Another bad idea is making loan purchasers and investors legally liable for the misdeeds of loan originators. This would shut the sub-prime market without any question.
A More Targeted and Modest Proposal: My proposal focuses on the major black cloud on the horizon: the large number of sub-prime ARMs with interest rates that will reset to much higher levels over the next 2 years. Many of the borrowers will be unable to make the higher payments and won’t have enough equity in their homes to refinance.
I would mandate a 3 year extension of the initial rate period of all ARMs that met the following conditions:
1. The first rate reset is scheduled to occur (or did occur) during the period January 1, 2007 – January 1, 2009.
2. The loan is secured by the borrower’s primary residence – no vacation homes or investment properties.
3. The loan had an original balance no more than twice as large as the current FHA maximum in the county in which the property is located. The maximums would thus vary by county from $400,320 to $725,580.
4. The loan had a margin of 4% or higher, and a prepayment penalty that extends past the initial rate reset date.
Conditions 2 and 3 are crude ways to limit the benefit to the most deserving. Condition 4 is designed to narrow eligibility to the borrowers most likely to need the extension, who are also the borrowers most likely to have been over-charged. Note: The margin is the number that is added to the interest rate index to determine the new rate at reset. The higher the margin, the higher the new rate.
Condition 4 also means that the extensions of the initial rate periods, and the costs associated with the extensions, will be concentrated in the sub-prime market. Almost all sub-prime mortgages have margins exceeding 4%.
Most of the mortgages affected by extension of the initial rate period will be in trouble without the extension. Hence, any additional loss to investors and any effect on new lending should be very small.
Can The Sub-prime Mortgage Market Be Replaced?
FHA is the only possible substitute that would both meet the loan needs of disadvantaged borrowers and protect borrowers against abuses that arise in the sub-prime market. But converting FHA into a viable substitute for the sub-prime market requires a number of far-reaching changes.
Risk-Based Pricing: A core feature of the sub-prime market is risk-based pricing over a very wide range. On the price sheet of a typical sub-prime lender, the interest rate on the worst risk is 7-8% higher than the rate on the best risk. For FHA to operate effectively in this market, it must do the same.
However, FHA is an insurer, not a lender. The adjustments to risk would be in the FHA insurance premiums, not in the interest rate. This has advantages to borrowers, as noted below.
For risk-based pricing to work, FHA has to be free to set premiums over a wide range. Congress can’t impose limits on the premiums, or require FHA to favor one category of borrowers over another. These would be difficult limitations for Congress to accept.
With risk-based pricing, there would be no need for Congress to specify down payment requirements. FHA would be free to insure no-down payment loans at an appropriate premium, or it might decide (as sub-prime lenders have) that no risk premium would be adequate for zero-down loans when the borrower also has poor credit.
Enlisting Mortgage Brokers: More sub-prime loans are refinance than purchase transactions. In many cases, borrowers who have no plans to refinance are actively solicited by mortgage brokers. For FHA to make significant inroads on the sub-prime market, it must enlist the brokers, while protecting borrowers against broker abuse.
To enlist mortgage brokers, FHA must relax its capital and audit requirements. It should be as easy for brokers to originate an FHA as a conventional loan. FHA holds lenders responsible for following FHA rules, and brokers should be the sole responsibility of the lenders, as they are in the conventional market.
Protecting Against Broker Abuse: Broker abuse consists of overcharging borrowers by collecting payments from lenders for delivering higher-rate loans. These payments are called "yield spread premiums (YSPs)". FHA could prevent this abuse by adopting a rule that YSPs must be credited to borrowers, who would have to authorize their payment to brokers.
Protecting Against Lender Abuse: Pricing risk in the insurance premium, rather than in the interest rate as it is done in the sub-prime market, narrows the range of FHA interest rates. This is a major advantage for borrowers, since the lender can’t tell the borrower the rate is high because of poor credit, small down payment, or anything else that affects risk. The borrower pays for these in the insurance premium, and the premium is set by FHA, not by the lender.
Nonetheless, too many price variables remain: interest rate, points, fixed-dollar lender charges, and third party charges. The last two in particular are a potential source of abuse because they are not part of the price quotes that borrowers shop, and can be manipulated at the 11th hour.
FHA currently provides protection against egregious abuse by limiting lenders to a 1% origination fee plus other "customary and reasonable costs". Third party charges are limited to actual charges, with no lender markups permitted. These rules made sense 4 decades ago when FHA set the interest and points, but with the rate and points set by the market, they are obsolete.
The "customary and reasonable" rule eliminates any competitive pressure to reduce lender costs. The "no-markup" rule does not prevent lenders from having an ownership interest in, and thereby profiting from, their referrals to high-priced third party service providers.
FHA should require lenders to absorb all costs and third party fees, and pass them to borrowers in the rate and points. Then borrowers would have only two price variables to shop, and competition by lenders would force down their own costs and the prices of third party services.
Disclosure Requirements Need Updating: It isn’t enough that FHAs become a better deal for disadvantaged borrowers than sub-prime. Borrowers must also perceive that they are a better deal. Comparisons can be misleading because of what is not disclosed.
For example, when the sub-prime loan is 6% compared to 7.5% for the FHA, the borrower may not be aware that the balance of the sub-prime loan will be loaded with fees, or that the sub-prime rate will jump to 9% in 2 years even if the market is stable. For a revamped FHA to compete on a level playing field with the sub-prime market, the disclosure system must be fixed so that this and other critical information hits the borrower between the eyes, and the garbage disclosures that are now a distraction are removed.
Extensive payment problems among sub-prime mortgage borrowers, along with the failure of a number of sub-prime lenders, were major news topics in early 2007. Among the issues that arose in connection with this episode were the following:
* The causes of borrower defaults.
* The causes of lender failures.
* The impact on the current availability of credit to prospective new sub-prime borrowers.
* What Government should and shouldn’t do about the crisis.
* Whether the sub-prime market could and should be replaced.
The Causes of Sub-Prime Defaults
The 60-day delinquency rate on sub-prime loans exceeded 14% in January of 2007, and was rising. The delinquency rate at that time on loans made in 2005 and 2006 is not known but it is much higher – perhaps twice as high. A large proportion of these delinquencies will end in foreclosure or in some type of workout arrangement.
Ending of Price Appreciation: The immediate cause of the rise in delinquencies was the end of house price appreciation. Property values in most areas stopped rising in 2006 and in many areas they have since declined. The rise in delinquencies and defaults has been concentrated in what I call "appreciation-dependent mortgages" – those that worked for borrowers only if their properties appreciated. A large proportion -- but not all -- of such mortgages were sub-prime.
Speculative Purchases: Some houses were purchased with 100% loans by borrowers hoping to turn a quick profit from future appreciation. These loans were made for the full amount of the purchase price or appraised value – no down payment was required.
Home buyers taking these loans had negative equity the day they closed, in the sense that if they were forced to resell immediately, the transactions costs – which can be 5% or more – would have to be paid out of their pockets. The buyers looked to appreciation to cover the costs and make a profit.
When the appreciation doesn’t materialize, even if the payments remain affordable, the financial incentive to make them is substantially weakened. Most do continue to pay because they want to remain in the house and they don’t want to ruin their credit, but some fold their cards and walk away. The result is a foreclosure.
Speculative Refinances: A presumption that their houses would appreciate also infected the refinance decisions of many borrowers. A question house purchasers asked me in 2004/5 with distressing frequency is "How long do I have to wait (after purchase) before I can refinance to take cash-out?" Some of these borrowers were influenced by a new breed of financial planners and mortgage brokers who promote the view that unused equity should be used for investment – in common stock, property or annuities.
Some home owners used the growing equity in their homes as a way to live beyond their means. They would build up credit card debt, then consolidate the debt into their mortgage through a cash-out refinance. The consolidation, by extending the term of the credit card debt, reducing the rate and making the interest tax-deductible, would reduce the borrower’s total monthly payment. They could then start building up their credit card debt all over again.
This process could continue only so long as their houses appreciated. As soon as appreciation stopped, they were stuck with total debt service costs that might be unmanageable, or with negative equity in their house, or perhaps both.
Unaffordable Mortgages: The most commonly used mortgage in the sub-prime market is the 2/28 ARM. This is an adjustable rate mortgage on which the rate is fixed for 2 years, and is then reset to equal the value of a rate index at that time, plus a margin.
Because sub-prime margins are high, the rate on most 2/28s will rise sharply at the 2-year mark, even if market rates do not change during the period. This means that while the loan is affordable to the borrower at the initial rate, it may not be affordable after two years when the rate is reset.
If the house has appreciated, this is not usually a problem because the borrower can refinance – if necessary, into another 2/28. While these loans carry refinance costs and typically have prepayment penalties, the costs and penalty can be included in the balance of the new loan if the borrower has sufficient equity.
The borrower who does not have the equity needed to refinance, however, is stuck with the higher payment on the existing 2/28 that may be unaffordable.
The upshot is that many consumers made purchase and refinance decisions based on the premise that their houses would appreciate, as they had for many years. When appreciation abruptly stopped, both their incentive to make their payments and their ability to do so was sharply reduced. While it wasn’t only sub-prime borrowers who fell into this trap, these borrowers had the least capacity to extricate themselves.
This raises an obvious question: why was the mortgage lending industry willing to make loans that were workable for the borrowers only if their properties appreciated?
Disaster Myopia and its Consequences
While it is understandable why borrowers became caught up in the belief that house prices always rise, lenders are supposed to know better. Why was the mortgage lending industry willing to make loans that were workable for the borrowers only if their properties appreciated?
Disaster Myopia: In 1986, with my colleague from Wharton Richard Herring, I published an academic paper called Disaster Myopia in International Banking. The paper set out to explain the international banking crisis of the early 80s, but on rereading it recently, I realized that it also goes a long way toward explaining the current crisis in the sub-prime market.
The disaster myopia thesis is that if potential shocks that can cause major losses to lenders occur very infrequently, they will not be fully reflected in loan prices and conditions. If the market is competitive and some lenders are willing to discount the likelihood of a shock altogether, other lenders who might be inclined to be more cautious, are forced to go along or lose market share.
In the mortgage market, disaster myopia meant basing mortgage prices and underwriting rules on the assumption that because house prices had risen for a very long period, they would continue to rise. The cessation of price increases was thus a shock for which lenders were no better prepared than borrowers.
Disaster myopia was especially prevalent among aggressive sub-prime lenders, who could make a lot of money in a very short time so long as house prices kept rising. Other sub-prime lenders who might not be disaster myopic were forced operate as if they were in order to remain competitive.
Underwriting requirements in the sub-prime market are set by the investment banks who buy the loans and securitize them. While the investment banks may or may not have been disaster myopic, those who were willing to accommodate the more aggressive lenders did more business (so long as house prices were rising) than those who insisted on being more cautious.
Mortgage Market Shocks Spread Rapidly: Virtually all sub-prime mortgages are converted into mortgage-backed securities that are sold to investors. These securities are actively traded and are therefore under constant surveillance by investors, traders and rating agencies. Bad news about defaults surfaces quickly and is quickly reflected in lower market prices of securities. The value of loans in the pipeline – on the way to securitization but not there yet – also drop.
The rapidity with which the current crisis in the sub-prime market spread marks a very important difference with the international banking crisis of the 80s. The international banks kept virtually all the "bad" international loans in their own portfolios, and used various stratagems for keeping the original values on their books unchanged.
This avoided widespread failures, but it also shut down the market for new loans. In the sub-prime crisis, in contrast, much lender blood was spilled but the market for new loans remained open.
Failures of Sub-Prime Lenders: As of May 1, 2007, National Mortgage News, a trade publication, counted 32 sub-prime lenders that had become "defunct" since early 2006. The immediate cause of most of these failures was the reduction in the market value of the loans in their pipelines – loans they had already purchased but not yet sold.
Lenders originate mortgages in preparation for sale mainly with borrowed funds – their capital is usually quite small. Most borrowed funds come from what are called "warehouse lenders", mainly large commercial and investment banks, who protect themselves by requiring that the unsold mortgages be posted as collateral. When the value of the collateral drops, the account becomes "under-margined", and the warehouse lender asks for more collateral. If the decline in the value of the mortgages exceeds the capital of the sub-prime lender, the latter will be unable to comply and probably will be forced to shut its operations.
A marked deterioration in the payment experience of sub-prime borrowers poses a second threat to the solvency of sub-prime lenders. Under their arrangements with investment banks, lenders are required to repurchase loans that become delinquent within a few months after sale. The more aggressive the lender in pushing through marginal cases, the more buybacks they are likely to face. Collateral calls and buybacks are the major causes of lender failures.
Market Adjustments and Future Prospects
The Current Pain: The 32-odd sub-prime lenders who failed have garnered the least sympathy. Put simply, they gambled and lost. But some borrowers fall in that category as well because they were looking to profit from house price appreciation. Instead, they are facing foreclosure.
Investors in securities issued against pools of sub-prime mortgages have also felt pain, as the market value of these securities has declined. Lehman Brothers estimates the decline at $19 billion. Most of it is concentrated among the riskiest of the securities, which promised the highest yields. (No collection plates are being passed for them, either.) Securities rated AAA, which are first in line to be repaid and last in line to take losses, have been impacted very little.
Mortgage brokers have not been significantly affected. A few have lost access to sub-prime lenders, but most of them have been able to replace defunct lenders with other lenders.
The big losers are those borrowers who, as unwitting victims of hype and deception, took out mortgages that were unworkable if house prices stopped rising. Now that prices have stopped rising, many of these borrowers are waiting for the next shoe to drop. They have ARMs on which the rate will reset to a much higher level within future months.
The Sub-Prime Market Remains Open: This is the good news, and it should not be taken for granted. When the international banking crisis erupted in the early 1980s, the market adjustment stretched over a decade during which there was virtually no new lending.
The sub-prime lenders who remain are the more cautious ones. They are also more likely to be affiliated with other firms with deep pockets, which will help them ride out any future market disturbances.
Of course, the profit potential in sub-prime lending is not what it was. Investors require a higher yield than before, especially on the riskiest securities. This has caused a tightening of underwriting requirements that has effectively lopped off the riskiest segment of the market.
Underwriting Requirements Are More Restrictive: Underwriting requirements are the conditions that borrowers must meet to be eligible for a loan. They are significantly more restrictive now than they were a year ago. One of the most important shifts is the virtual disappearance of the 100% (no down-payment) loan.
Periodically I receive an advertisement from a sub-prime wholesale lender rep advertising what is available from his firm. (He thinks I am a mortgage broker.) One came to me on April 19, 2007 showing that a borrower with a credit score of 620 (which is low) could qualify for a loan of $650,000 with a down payment of 10%. Checking back in my "Deleted Items" archive, I found a message from the same rep dated June 20, 2006. At that time, he was offering the borrower with a 620 score a loan of $1 million with nothing down.
The 2006 offer was insane, a product of the euphoria created by steadily rising real estate prices. The current rules are no longer based on the inevitability of rising prices.
Prospects: If house prices begin to rise in 2007, the problems of the sub-prime market will go away. In 1998/99, we had a similar episode in which as many as 20 sub-prime lenders failed. But in 2000, house prices took off, the problems disappeared, and few people today even remember the episode.
This time, however, the prospects for a quick revival of house price appreciation are very poor; a further weakening is much more likely. Under these conditions, there is an ominous cloud on the horizon: sub-prime borrowers who took 2/28 ARMs in 2005 and 2006 will have their interest rates and payments reset to much higher levels during the remainder of this year and next. A significant number will not be able to make the new payments, and won’t be able to refinance because the equity in their houses is not sufficient to meet the new underwriting requirements. They face foreclosure.
What Should Government Do (And Not Do)?
The Federal Government is presently under enormous pressure to "do something" about the sub-prime crisis. The various proposals that have emerged appear to reflect concern for abused borrowers in or heading toward foreclosure, a desire to punish those responsible for their plight, and the usual urge to score political points.
This is not a brew likely to generate thoughtful reforms that look to long-term consequences. Doing nothing is also an option, and in my opinion, a better one than most of the proposals that have emerged.
Here are some principles that reform advocates ought to observe.
The Sub-Prime Market is Open, So Let’s Not Do Anything to Shut it Down. As I noted last week, the sub-prime market has undergone a significant blood-letting, yet for all that it has stayed open for business. Borrowers with poor credit who can’t document their income can’t get 100% loans anymore, but that’s a good thing. And other borrowers with better credentials, though not good enough for the mainstream market, are still being served.
We should always keep in mind that for every foreclosure of a sub-prime borrower, there are at least 10 others who have become successful homeowners who might not have made it otherwise. We don’t yet have a substitute for the sub-prime market, that possibility is discussed below. Meanwhile, draconian penalties that could cripple the sub-prime market should be avoided.
Borrowers Who Speculated on House Price Appreciation and Lost Should Not Be Bailed Out. It would be a travesty if house buyers can enjoy an increase in their wealth when house prices increase, while shifting losses to someone else when prices decrease. There is no more reason to do that in the house market than in the stock market.
The Lien Enforcement System Should Not Be Weakened. Law-makers should be ever-mindful that a core requirement of an effective housing finance system is the pledge of property as collateral for loans, and the ability of lenders to enforce their liens on the collateral. An enforceable lien is what makes possible the $500,000 loan at 6% for 30 years to a borrower who, without the house to pledge as collateral, might be able to borrow $25,000 at 10%. While the laws of the various states require lenders to observe due-process, these are not serious impediments to lien enforcement. Let’s keep it that way.
Ill-Advised Proposals: These include a moratorium on foreclosures, which would benefit all borrowers in trouble, whether they deserved it or not, seriously weaken the lien enforcement system, and possibly shut down the sub-prime market, depending on how long the moratorium lasted and how it was implemented. Another bad idea is making loan purchasers and investors legally liable for the misdeeds of loan originators. This would shut the sub-prime market without any question.
A More Targeted and Modest Proposal: My proposal focuses on the major black cloud on the horizon: the large number of sub-prime ARMs with interest rates that will reset to much higher levels over the next 2 years. Many of the borrowers will be unable to make the higher payments and won’t have enough equity in their homes to refinance.
I would mandate a 3 year extension of the initial rate period of all ARMs that met the following conditions:
1. The first rate reset is scheduled to occur (or did occur) during the period January 1, 2007 – January 1, 2009.
2. The loan is secured by the borrower’s primary residence – no vacation homes or investment properties.
3. The loan had an original balance no more than twice as large as the current FHA maximum in the county in which the property is located. The maximums would thus vary by county from $400,320 to $725,580.
4. The loan had a margin of 4% or higher, and a prepayment penalty that extends past the initial rate reset date.
Conditions 2 and 3 are crude ways to limit the benefit to the most deserving. Condition 4 is designed to narrow eligibility to the borrowers most likely to need the extension, who are also the borrowers most likely to have been over-charged. Note: The margin is the number that is added to the interest rate index to determine the new rate at reset. The higher the margin, the higher the new rate.
Condition 4 also means that the extensions of the initial rate periods, and the costs associated with the extensions, will be concentrated in the sub-prime market. Almost all sub-prime mortgages have margins exceeding 4%.
Most of the mortgages affected by extension of the initial rate period will be in trouble without the extension. Hence, any additional loss to investors and any effect on new lending should be very small.
Can The Sub-prime Mortgage Market Be Replaced?
FHA is the only possible substitute that would both meet the loan needs of disadvantaged borrowers and protect borrowers against abuses that arise in the sub-prime market. But converting FHA into a viable substitute for the sub-prime market requires a number of far-reaching changes.
Risk-Based Pricing: A core feature of the sub-prime market is risk-based pricing over a very wide range. On the price sheet of a typical sub-prime lender, the interest rate on the worst risk is 7-8% higher than the rate on the best risk. For FHA to operate effectively in this market, it must do the same.
However, FHA is an insurer, not a lender. The adjustments to risk would be in the FHA insurance premiums, not in the interest rate. This has advantages to borrowers, as noted below.
For risk-based pricing to work, FHA has to be free to set premiums over a wide range. Congress can’t impose limits on the premiums, or require FHA to favor one category of borrowers over another. These would be difficult limitations for Congress to accept.
With risk-based pricing, there would be no need for Congress to specify down payment requirements. FHA would be free to insure no-down payment loans at an appropriate premium, or it might decide (as sub-prime lenders have) that no risk premium would be adequate for zero-down loans when the borrower also has poor credit.
Enlisting Mortgage Brokers: More sub-prime loans are refinance than purchase transactions. In many cases, borrowers who have no plans to refinance are actively solicited by mortgage brokers. For FHA to make significant inroads on the sub-prime market, it must enlist the brokers, while protecting borrowers against broker abuse.
To enlist mortgage brokers, FHA must relax its capital and audit requirements. It should be as easy for brokers to originate an FHA as a conventional loan. FHA holds lenders responsible for following FHA rules, and brokers should be the sole responsibility of the lenders, as they are in the conventional market.
Protecting Against Broker Abuse: Broker abuse consists of overcharging borrowers by collecting payments from lenders for delivering higher-rate loans. These payments are called "yield spread premiums (YSPs)". FHA could prevent this abuse by adopting a rule that YSPs must be credited to borrowers, who would have to authorize their payment to brokers.
Protecting Against Lender Abuse: Pricing risk in the insurance premium, rather than in the interest rate as it is done in the sub-prime market, narrows the range of FHA interest rates. This is a major advantage for borrowers, since the lender can’t tell the borrower the rate is high because of poor credit, small down payment, or anything else that affects risk. The borrower pays for these in the insurance premium, and the premium is set by FHA, not by the lender.
Nonetheless, too many price variables remain: interest rate, points, fixed-dollar lender charges, and third party charges. The last two in particular are a potential source of abuse because they are not part of the price quotes that borrowers shop, and can be manipulated at the 11th hour.
FHA currently provides protection against egregious abuse by limiting lenders to a 1% origination fee plus other "customary and reasonable costs". Third party charges are limited to actual charges, with no lender markups permitted. These rules made sense 4 decades ago when FHA set the interest and points, but with the rate and points set by the market, they are obsolete.
The "customary and reasonable" rule eliminates any competitive pressure to reduce lender costs. The "no-markup" rule does not prevent lenders from having an ownership interest in, and thereby profiting from, their referrals to high-priced third party service providers.
FHA should require lenders to absorb all costs and third party fees, and pass them to borrowers in the rate and points. Then borrowers would have only two price variables to shop, and competition by lenders would force down their own costs and the prices of third party services.
Disclosure Requirements Need Updating: It isn’t enough that FHAs become a better deal for disadvantaged borrowers than sub-prime. Borrowers must also perceive that they are a better deal. Comparisons can be misleading because of what is not disclosed.
For example, when the sub-prime loan is 6% compared to 7.5% for the FHA, the borrower may not be aware that the balance of the sub-prime loan will be loaded with fees, or that the sub-prime rate will jump to 9% in 2 years even if the market is stable. For a revamped FHA to compete on a level playing field with the sub-prime market, the disclosure system must be fixed so that this and other critical information hits the borrower between the eyes, and the garbage disclosures that are now a distraction are removed.