Jun292016

Taxpayers insure the riskiest subprime mortgages underwritten today

 The US taxpayer is directly responsible for any losses on loans to low-quality borrowers since 2008.

subprime_steakLenders prefer to loan money to people with ample reserves, strong income, and a proven track record of repaying debts. Borrowers that lack any of those components default at higher rates, so lenders charge them higher interest rates to compensate for the increased costs and potential losses.

Competition between lenders prompts them to reach out to fringe borrowers that may be lacking in certain desirable characteristics, but lenders rarely reach too far for too long because shaky borrowers are the first to default in an economic downturn. However in the mid 1990s lenders embarked on a long-term foray into loaning money to high-risk borrowers: subprime was born.

Subprime lending as an industry barely existed prior to 1994. Few lenders extended mortgage loans to people with poor credit, and since no secondary market existed to purchase these loans if they were originated, lenders kept them on their own books. The growth of subprime was brought about by the creation of the secondary mortgage market that allowed lenders to sell off their risky loans to investors willing to accept that risk for a slightly better yield.

The growth of the secondary mortgage market changed the business model of lending from originate-to-hold to originate-to-sell. Once lenders no longer had responsibility for holding the loans they originated, their incentive was to increase volume; quality meant nothing and quantity meant riches. The easiest way to increase volume was to lower standards, and since lenders didn’t have consequences for loans going bad, the race to the bottom was on. The only thing holding back this race to the bottom today is the “put back” requirements forcing lenders to buy back their bad loans, which is why lenders complain about it.

Subprime Originations, 1994-2006

Subprime Originations 1994-2006

With the collapse of subprime, the US government now insures the riskiest subprime loans originated today.

Risky Business: Government Mortgage Insurance Programs

W. Scott Frame, Kristoper Gerardi, and Joseph Tracy, June 20, 2016educated_borrowers

Homeownership has long been a U.S. public policy goal. One of the many ways that the federal government subsidizes homeownership is through mortgage insurance programs operated by the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), and the USDA’s Rural Housing Service (RHS). These programs facilitate home financing opportunities for first-time and low- and moderate-income homebuyers. Virtually all of these government-insured mortgages are securitized by Ginnie Mae, a government agency that guarantees the timely payment of principal and interest of these loans to investors that purchase the securities. That is, the U.S. taxpayers assume the credit risk on these mortgages. In this post, we assess the riskiness of these loans.

Although the exact terms and conditions for each government mortgage insurance program are different, a common thread is that their borrower profiles are generally quite risky. These loans are typically characterized by significant leverage and borrowers often have checkered credit histories as evidenced by very low credit scores. For example, the FHA program allows for mortgages with an original loan-to-value (LTV) ratio of up to 96.5 percent; and such loans are also subject to an upfront mortgage insurance premium that is typically rolled into the loan balance, which further raises the initial LTV.

In other words, the US taxpayer now backs the subprime mortgage market.

The lack of upfront equity implies that FHA mortgage borrowers are at greater risk of default than conventional mortgage borrowers. Highly leveraged borrowers might also be expected to behave like “renters with debt,” as opposed to “owners with equity,” and hence not generate the perceived social benefits of homeownership early in the life of the mortgage. These highly leveraged government-insured loans are also typically issued to borrowers with weak to poor credit histories, further increasing the risk of default and foreclosure. Borrowers with poor credit histories are more likely to face adverse income shocks and the combination of negative equity and a high risk of adverse income shocks implies that these mortgages are at high risk of default.

The high risk of default coupled with taxpayer backing puts the entire housing market at risk. Subprime loans have had comparatively high default rates since their introduction; however, these high default rates did not translate into large default losses.

As house prices began their upward march, the default losses from subprime defaults began to fall because the collateral was obtaining more resale value, or was being sold by the subprime borrower before foreclosure. This made subprime lending, and its associated high default rates, look less risky to investors because these default rates were not translating into default losses.ponzi_chain

Since subprime didn’t look risky, and since interest rates and fees were higher, subprime mortgages became a very popular investment: a track record of investor safety drew more capital into the industry. However, since the relative safety of subprime lending was entirely predicated upon rising prices, it was an industry doomed to fail once prices stopped rising — which they did.

Not many industry insiders acknowledge this inherent risk, and even fewer investors do. But even among those who do recognize subprime lending is an unsustainable Ponzi-like scheme, many will chose to enter the industry anyway. During the housing bubble everyone learned they could earn huge profits while the scheme went on, and when it blows up, they can leave the empty shell of liabilities for others to deal with, probably taxpayers with another bailout.

The lesson of Subprime is that it’s growth snowballed into more growth and ultimately becomes unstable. If relegated to a small fringe industry providing high-interest rate loans to poorly qualified borrowers, subprime poises no real risk to the housing market or the banking system; however, if we return to unlimited securitization of subprime mortgages fueled by desperate investors chasing yield, then we risk the same implosion we witnessed in 2007-2008.

The table below summarizes annual data for Ginnie Mae securitized loans included in the Lender Processing Services (LPS) data that were originated between 2000 and 2011. Before the start of the housing bust in 2007, the median LTV for these loans was generally around 98 percent and the borrower’s median credit score was below 650. More striking is that in several years more than 10 percent of government-insured loans had LTVs over 101 percent and one-quarter were made to borrowers with FICO scores in the low 600s and below.

Risk Measures for Government-Insured Residential Mortgages: 2000-2011 Originations
In the post-crisis period after 2008, borrower credit scores for Ginnie Mae-securitized mortgages were markedly higher across the board. …

At the bottom of the credit cycle, lenders tighten standards until default rates decline to safe levels.

The use of government mortgage insurance programs has varied significantly in recent years. During the housing boom from 2000 to 2005, such loans comprised less than 3 percent of mortgage originations, as the privately insured subprime market accounted for about 20 percent of new loans. However, after the collapse of new subprime lending in 2007, government insurance programs rapidly expanded and more than filled the void. The chart below illustrates these patterns. The market share of government-insured mortgages reached a peak of almost 35 percent in 2009, and has held relatively steady at around 20 percent over the past four years. …

Mortgage Originations by Product

The above chart is clear and convincing proof that the US government became the replacement for subprime.

Government mortgage insurance programs are largely used for very high LTV loans, although borrower credit scores demonstrate significant dispersion. The table below, which presents five-year CDRs for various credit score ranges, shows the important relationship between credit scores and government mortgage performance. While the proportions of defaults vary significantly within categories over time, the levels also shift across categories in expected ways (for example, lower FICO loans persistently default at a higher rate than higher FICO loans). We see that loans obtained by borrowers with FICO scores lower than 600 are by far the most risky segment of the credit score distribution, as their five-year CDRs peaked at more than 40 percent in 2007.

Cumulative Default Rates of Government-Insured Residential Mortgages

Very high default rates are costly to the government programs and the affected households. … A policy intended to increase the homeownership rate will only be effective if it both makes homeownership more affordable and more sustainable.

Realistically, replacing subprime lending with government-backed loans wasn’t a policy of choice — it was a necessity. For as deep and as painful as the housing bust was, it would have been far worse if Uncle Sam weren’t the lender of last resort. The problem now is how do we wean the market of these supports? Nobody has a clear answer, so taxpayers directly insure 25% of the market through Ginnie Mae, and taxpayers indirectly insure another 50% or more through the conservatorship of the GSEs, and Congress has made little progress on reforming the system.

In the meantime, both lenders and borrowers take advantage of the government guarantees.

FHA loans as a stoploss

Back in 2006 when I started publicly warning people not to buy homes due to the impending crash, I pointed out to people that there is no stoploss protection in event of a major decline in prices. Leverage works both ways, and the people who were making huge money on small investments were enjoying stellar returns. However, if prices go the other way, the losses are even more brutal.

Another commonly leveraged investment is stocks. People in a margin account can buy twice as much stock as they can afford by borrowing money from their broker. In the event stock prices collapse, the broker will close out an investor’s position before the account goes negative to preserve their original loan capital. There is no such stoploss protection in residential real estate. If house prices go down, people lose money until prices stop going down. They can easily lose many times their original down payment investment.

Well, at least that used to be true…

Now in an era of short sales as an entitlement, borrowers and speculators have no downside risk beyond their initial down payment. If values go down, people simply petition for a short sale, and the lender absorbs the loss. And when that loan is an FHA loan, the lender simply passes the loss on to the US taxpayer.

The incentive here is clear. Everyone should put the minimum possible down payment on a property to minimize their own exposure. If prices go down, they can petition for a loan modification, a short sale, or simply strategically default with no financial repercussions.

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