Should subprime loans be a government subsidized entitlement?
These are important questions. How we answer them will guide how we remake our housing finance system which was destroyed with the collapse of the housing bubble. The current system of government props with the taxpayer insuring more than 90% of the mortgages in the US is not tenable or desirable.
Is there a balance between public and private sector appropriate to the housing market?
Edward J. Pinto — June 20, 2013
Those who want government guarantees for mortgages see them as a path to encourage homeownership and market stability, but instead guarantees pose needless risks to homeowners and taxpayers. Government guarantees suffer from three flaws: the inability and unwillingness to price for risk, asset allocation distortions, and the politicization of lending.
the inability and unwillingness to price for risk
Subprime borrowers default in larger numbers than prime borrowers do. That’s why they’re subprime. At a FICO score of 640, there is a 15% chance of default. The percentage of defaults rise as the FICO score drops. Banks must make enough on the 85% of borrowers who don’t default to cover the losses on the 15% that do, and make a profit. This forces banks to charge higher interest rates to subprime borrowers than prime borrowers who default less frequently.
With government mandates put on the GSEs, the risk of subprime borrowers was spread over all borrower classes. This under-priced the risk and caused them to underwrite more subprime loans than they would in the ordinary course of business. This is what politicians wanted, but it does create the inability and unwillingness to properly price for risk. Ultimately, that exposes the underwriting entity to large losses when economic conditions deteriorate.
asset allocation distortions
Any time risk is underpriced or subsidized by the government, capital flows into that asset class. Again, this is what politicians wanted, but it’s also economically inefficient as resources are diverted from other, more productive uses.
politicization of lending
Anyone who watched the advocates for the GSEs on Capital Hill would agree that lending becomes politicized when government subsidies are involved.
At a recent conference on housing finance reform, community and industry advocates called for a replay of the failed government “affordable housing” experiment begun in the early 1990s. That experiment cost America’s homeowners trillions as loose lending drove the homeownership rate and home prices to unsustainable levels.
Proponents of Subprime 2.0 say a government centric housing system is necessary to assure flexibility, accessibility, affordability and stability. We know from the last experiment that “flexibility” means subprime lending, “accessibility” means entitlements, “affordability” means subsidies, and “stability” means increasing leverage during boom times.
Further, affordability is an illusion. Each subprime borrower who is subsidized by the government crowds out another borrower who does not qualify for the subsidy. There is a finite number of houses, and although builders may respond by building more, the crowding out effect always occurs on the margins. The equilibrium state of a subsidized market is a higher price level. Affordability cannot be permanently increased by subsidy.
For example, achieving flexibility would require the widespread use of subprime loans with low down payments, low credit-score requirements and high debt-to-income ratios.
We know how that turned out.
Such a system is doomed to failure. The alternative is a home finance market based on tried and true principles:
First, the long-term credit performance of the housing mortgage market requires sound underwriting practices that result when a preponderance of loans are of prime quality.
Second, traditional prime mortgages performed well in the past because lenders required sizable down payments, solid borrower credit histories and a well-demonstrated capacity to cover household obligations.
Third, subprime mortgages lack one or more of these pillars, resulting in default rates that are many multiples of those for prime loans.
And in the absence of rising prices, these higher default rates make for much higher default losses, particularly when combined with low down payment mortgages.
Fourth, all programs intended to help low-income families become homeowners should be on budget and should limit risks to both homeowners and taxpayers.
One of the main reasons politicians loved the GSEs was that they didn’t have to pay for the subsidies. By pushing mandates onto profitable private companies, they could obtain all the benefits without incurring any of the costs. Obviously, that didn’t work out well over the long term.
When policy makers recognize these four principles, the nation will have a robust housing finance sector, in which the private market and the government play appropriate and complementary roles.
I am in favor of a national housing market insurance fund like the FHA. If it properly prices risk, it can sustain itself indefinitely without government support. Its market share would shrink in good times as private lending takes a larger role, and if we ever have another disaster, it will serve as a backstop. It would lend when private money would not. The FHA would be a good model if it didn’t have the 3.5% down payment. This puts too much risk on the taxpayer. An insurance fund like the FHA that mandates 20% down payments could serve as a positive part of a new mortgage landscape.
Their Option ARM blew up
The former owners of today’s featured property paid $1,653,000 putting nearly $500,000 down. They decided to “liberate” their equity in 2005 and took out a $1,435,000 Option ARM with a 1.37$ interest rate. Since this was obviously in jumbo loan territory, nobody was willing to refinance them into a stable mortgage, so when their mortgage recast to the higher payment, they couldn’t afford it.
[idx-listing mlsnumber=”PW13115418″ showpricehistory=”true”]
$1,270,000 …….. Asking Price
$1,653,000 ………. Purchase Price
8/3/2004 ………. Purchase Date
($383,000) ………. Gross Gain (Loss)
($101,600) ………… Commissions and Costs at 8%
($484,600) ………. Net Gain (Loss)
-23.2% ………. Gross Percent Change
-29.3% ………. Net Percent Change
-2.9% ………… Annual Appreciation
Cost of Home Ownership
$1,270,000 …….. Asking Price
$254,000 ………… 20% Down Conventional
4.74% …………. Mortgage Interest Rate
30 ……………… Number of Years
$1,016,000 …….. Mortgage
$271,319 ………. Income Requirement
$5,294 ………… Monthly Mortgage Payment
$1,101 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$265 ………… Homeowners Insurance at 0.25%
$0 ………… Private Mortgage Insurance
$350 ………… Homeowners Association Fees
$7,009 ………. Monthly Cash Outlays
($1,741) ………. Tax Savings
($1,281) ………. Principal Amortization
$457 ………….. Opportunity Cost of Down Payment
$179 ………….. Maintenance and Replacement Reserves
$4,623 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$14,200 ………… Furnishing and Move-In Costs at 1% + $1,500
$14,200 ………… Closing Costs at 1% + $1,500
$10,160 ………… Interest Points at 1%
$254,000 ………… Down Payment
$292,560 ………. Total Cash Costs
$70,800 ………. Emergency Cash Reserves
$363,360 ………. Total Savings Needed