It’s not the Borrowers; It’s the Loans.

Option_ARM_Plague_victimsDenial runs deep in the financial markets. The vast majority of participants either want or need prices to steadily increase. Any facts or opinions that run counter to the idea of ever increasing prices must be quelled in order to prevent a catastrophic collapse of prices due to panic selling. One of the more glaring examples of this phenomenon has been the slow leak of information regarding the upcoming debacle in our housing market.

In February and March as the sub-prime lending implosion became front page news, market bulls were presented with a major public relations problem. It was imperative for the bulls to convince buyers the damage from subprime lending was “contained” and would not “spill over” into other borrower categories and ultimately into the overall economy. The supposition is that the widespread use of exotic loans is not the problem, it is the practice of giving these loans to those with low credit scores. In other words, it is not the loans, it is the borrowers. This is wrong. It is not the borrowers; it is the loans.

As a primer, I would like to illustrate the basic distinctions made with the type of borrower and the type of loan (for a better, more detailed analysis see Calculated Risk). There are 3 main categories of borrowers: Prime, Alt-A and Sub-Prime. Prime borrowers are those with high credit scores, and Sub-Prime borrowers are those with low credit scores. The Alt-A borrowers make up the gray matter in between. Alt-A tends to be closer to Prime as these are often borrowers with high credit scores which for one or more reasons do not meet the strict standards of Prime borrowers. In recent years one of the most common non-conformities of Alt-A loans has been the lack of verifiable income. In short, “liar loans” are generally Alt-A. As the number of deviations from Prime increases, the credit scores decline until finally you are left with Sub-Prime.

There are also 3 main categories of loans: Conventional, Interest-Only, and Negative Amortization. The distinction between these loans is how the amount of principal is impacted by monthly payments. A conventional mortgage includes some amount of principal in the payment in order to repay the original loan amount. The greater the amount of principal repaid, the quicker the loan is paid off. An interest-only loan does just what it describes; it only pays the interest. This loan doesn’t pay back any of the principal, but it at least “treads water” and does not fall behind. The Negative Amortization loan is one in which the full amount interest is not paid with each payment, and the unpaid interest gets added to the principal balance. Each month, the borrower is increasing the debt. One of the features of all interest-only or negative amortization loans is an interest rate reset. All these loans have provisions where the loan balance comes due either in the form of a balloon payment or an accelerated amortization schedule. Either way, the borrower must either refinance or face a major increase in their monthly loan payment. This increase in payment is what makes these loans such a problem, and this is why it isn’t the borrower, it is the loan.

loan type

As you can see from the table above, the category of loan and category of borrower are independent of each other. Starting in the lower left hand corner, we have the lowest risk loan for a lender to make, a Prime Conventional mortgage. As we move up or to the right, the risk increases. The riskiest loan a lender can make is the Negative Amortization loan to a Sub-Prime borrower.

The market apologists have admitted there is risk going up the side of the chart because sub-prime borrowers are beginning to default. These same spin-doctors are denying the risk of default will spill over into Alt-A and Prime. They making this argument because these two categories have historically had low default rates. They conveniently forget all the “liar loans” taken out by those with higher credit scores and payment resets for I/O and neg am loans which were also given to the Alt-A and Prime crowd. Historically, this group has not defaulted because they have not been widely exposed to these loan types. Basically, they are ignoring the risk moving along the bottom of the chart: the risk endemic with Interest-Only and Negative Amortization loans. This is a fatal flaw in their analysis.

So why will so many Alt-A and Prime borrowers go into default? To answer that question, we need to make a more detailed analysis of the exhibit: Adjustable Rate Mortgage Reset Schedule

March 2010 ARM Reset Schedule big

First, I would suggest you review Financially Conservative Home Financing. In that post I stated, “At the time of reset, if you are unable to make the new payment (your salary does not increase), or if you are unable refinance the loan (home declines in value), you will lose your home. It’s that simple.” It is my contention based on the information in the above chart, we can deduce the Alt-A and Prime borrowers will face one or both of the conditions which will cause them to lose their homes.

Look at the gray bars which make up the majority of the reset amounts due over the next 24 months (2007 and 2008). These are the Sub-Prime borrowers. They are already defaulting in large numbers, and we have all witnessed the tightening of credit (or elimination of credit) being offered to these borrowers. We also know many of these borrowers were put into the dreaded 2/28 loans and they cannot afford the reset. And, as if that isn’t enough, most of these borrowers were given 100% financing (if they could save up for a downpayment, they probably wouldn’t be Sub-Prime.) Therefore, it is probably safe to assume many if not most of these borrowers will default. Why wouldn’t they? Most haven’t put any money into the transaction, they have no equity as prices are declining, and they already have bad credit. What is the worst that could happen? They will just go back to renting, big deal. Think about what that means… a large number of defaults and foreclosures will occur over the next 3 years (the time span will be spread out due to differences in borrower holding power and the time spent in the foreclosure process).

Visio-foreclosure timeline.vsd

In addition to the tightening credit and worsening buyer psychology, if large numbers of sub-prime borrowers are defaulting over the next 3 years, prices will certainly fall. Therefore, it is also safe to assume that when the Alt-A and Prime borrowers who have taken out adjustable rate mortgages need to refinance starting in earnest 3 years from now (see the red and light gray bars in the Adjustable Rate Mortgage Reset Schedule), they may be underwater and unable to refinance.

Why do I think so many will be underwater? For one, prices will be significantly lower in 2010. In the forums, we have already documented price reductions by the builders of about 15%, and we also know it isn’t helping sales. More builder price reductions are on the way. It isn’t difficult to imagine prices being 30% or more below the peak by 2010. How many Alt-A and Prime borrowers with adjustable rate mortgages do you think have more than 30% equity in their properties?


Nationally, approximately 40% of residential real estate is owned outright; therefore, if the total equity in real estate is 55%, the remaining 60% of homeowners have a total of 15% of home equity. This is admittedly a rough calculation, but it certainly does not appear as if a great many people with mortgages have more than 30% equity in their homes to ensure they are able to refinance. Many bulls have speculated that most Irvine homeowners are sitting on mountains of equity because home prices have increased so dramatically over the last 5 years. Sounds plausible, but it isn’t true. Where did this equity go?


Has anyone else noticed all the conspicuous consumption in Irvine? Every house has two luxury cars in the driveway, the Spectrum is always full of shoppers, and every homeowner is busy competing with their neighbor to see who can look richer (see Southern California’s Cultural Pathology). If you want to know where all the equity went: they spent it.

To bring us back to where we started, a great many Alt-A and Prime borrowers will lose their homes because they will be hopelessly underwater when they need to refinance 3 to 5 years from now. If they had borrowed with conventional mortgages as they did in the past, they would not be facing this mortgage reset timebomb, and they would simply ride out the Sub-Prime debacle just as many homeowners made it through the declines of the early 90’s. However, it is different this time. This time, the loans they have taken out are going to ruin them. It’s not the borrowers, it’s the loans.