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Subprime is a Product, not a Consumer

Adam Rust's picture

Posted July 28, 2009

You can't solve a problem until you identify its essence.  That is one of the challenges facing policy makers trying to get our economy back on its footing.

One of the root causes of the recession is the overhang that we are suffering through as so many bad mortgages slowly deplete the balance sheets of our banks. The troubles on Wall Street have spread to Main Street.  Many of our communities have fallen hard and fast.

It was a time of fast lending.  It was a time of loose underwriting.  The share of subprime mortgages

jumped, from just 8 percent in 2003 to 28 percent in 2006.  It was a time of  "innovation." You do not hear much about the innovative wizardry of the collateralized debt obligation any more, eh?

The first step in defining the sub-prime problem is to accept that it describes a set of mortgage products and features.  Sub-prime loans generally had a variety of terms that were distinct from prime mortgages.  They had pre-payment penalties.  They used unusual structures, from 40-year terms to negatively amortizing loan repayment schedule, that assumed that borrowers would repay principal not with monthly payments, but with a refinance loan in the following few years. They were made with stated-income underwriting, with fantastic debt-to-income and loan-to-value ratios, that no bank would feel comfortable holding.  So the banks sold them, pocketing the loan fees, and leaving the risk to the next guy.

That is why legislation must focus on subprime as a set of products.

The CRA bill (join the cause) and its likely parent, the Consumer Financial Protection Act, will help consumers. That is a straightforward statement that wouldn't bear declaring if it were not for the extensive vitriol that has been directed at these endeavors.  However, the blame has been cast (from a lot of places) and the truth needs to be reiterated.

Together, they would create a system of oversight (CRA) and financial products (CFPA) that would help out Main Street borrowers.  The plain vanilla mortgages would eliminate the complexity of the borrowing that comes with the American Dream.

Even better, it would prevent new lending from having the high-risk wealth-depleting characteristics that led so many loans to go bad. Plain vanilla might come in two mortgage products - a fixed and a five-year adjustable - that were shorn of prepayment penalities and yield spread premiums.

If we want to create legislation that stamps out sub-prime lending, then we need to understand what it is that we're trying to root out.  Let's consider a few things about sub-prime lending:

  • Eighty percent of sub-prime loans were refinanced within 30 months.
  • Seventy-five percent of sub-prime loans had a prepayment penalty.
  • Between forty-three and fifty percent of sub-prime mortgages were made with stated-income underwriting.
  • There was a healthy amount of mortgage activity that merited the term "fraud."  They have nothing to do with CRA, and probably not a lot to do with mainstream sub-prime lending, either.

It is the loan product that makes a loan "sub-prime." Prepayment penalties produced attractive cash flows, and they were particularly effective at keeping borrowers with high interest rate mortgages in their loans.

No better evidence of the statement that the sub-prime designation sticks to a product, rather than a person, comes in a Massachusetts study.  It showed that many sub-prime loans went to consumers who had initially qualified for a prime mortgage.   In sixty percent of instances in Massachusetts where borrowers default on a sub-prime loan, those borrowers had initially taken out a prime loan but then refi-ed into a sub-prime product.  The same people took out prime and subprime loan products - the only difference was in the features of the loans.

Those borrowers refinanced from prime mortgages into sub-prime mortgages.  While that seems like poor decision-making, it probably helped a lot of people to lower their monthly payments in the near term.  The day of reckoning, when those teaser rates reset, seemed easily avoidable as long as property values continued to increase at a rate faster than the negative amortization.

An analysis by a team of Federal Reserve economists, using loan-level data from independent providers, concluded that the sub-prime loan product came into existence and subsequently flourished because of one key constant - an economy where continually-appreciating real estate valuations led underwriters to make overly optimistic assumptions about loan repayments.

Rorty has a great link here to an analysis made by one lender about the likelihood of housing price appreciation in a pool of securitized mortgages.  The smart guy who put this together was a bit too optimistic - he or she only gave a 5 percent chance that home values would decline.