Sep242014

Will subprime mortgage lending 2.0 be a disaster?

Some form of subprime mortgage lending will return. Will subprime 2.0 be a disaster to rival the Great Recession and Housing Bubble?

subprime_steakSubprime lending as an industry barely existed prior to 1994. There were few lenders willing to loan to people with poor credit, and there was no secondary market to purchase these loans if they were originated. The growth of subprime was the direct result of the lowering of lending standards created by the change of incentives brought about by the creation of the secondary mortgage market.

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

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.

So do we have reason to be cautious and worried about Subprime 2.0?

Yes, we do.

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.

Are Subprime Mortgages Coming Back?

By BINYAMIN APPELBAUM, SEPT. 9, 2014works_for_me

Ali and Mariluci Sleiman wanted to buy a house. The couple, who run a day care service inside their first-floor rental apartment, had outgrown their space in Taunton, a small city in southern Massachusetts. They also wanted to avoid answering to a landlord who might complain about 10 little kids running around all day. They were “desperate to buy a home,” Ali told me. And with good credit and $46,000 in joint income, they hoped they wouldn’t have a hard time getting a loan. So they were disappointed when the bank rejected their application, and then when a local credit union did too.

Are low income borrowers running a daycare out of a rental property stable candidates for a 30-year loan? Perhaps they were turned down because they pose a very high risk of default. And maybe, just maybe, they should be turned down. Don’t you think?

Six years ago, a deluge of mortgage lending sparked a credit crisis that led to the worst financial meltdown since the Depression. Now, after years of chastened retreat, we are in the midst of a lending drought. Banks have ratcheted mortgage-qualification standards to the tightest levels since at least the 1990s.

I still don’t understand this idea that lending standards should constantly be looser. Isn’t a retreat to the safe standards of the 1990s a desirable thing? We saw what happened in the 00s, do we really want to go back there again?

The federal government — seeking to formalize this new caution — has imposed a host of rules, starting with requiring banks to document that borrowers can repay the loans. “We’ve locked down mortgage lending to the point where it’s like we’re trying to avoid all defaults,” said William D. Dallas, the chairman of Skyline Home Loans, who has three decades of experience in the industry. “We’re back to using rules that were written for Ozzie and Harriet. And we’ve got to find a way to help normal people start buying homes again.” …

I’m I supposed to feel sorry for this guy that prudent lending standards are cutting into his business? In case people didn’t notice, the rules in the 1950s when Ozzie and Harriet were popular made for a very stable housing market.

Ultimately, it hinders the economy through fewer new-home sales and less spending on furnishings, landscaping, renovations and other consumer spending.”

Well, if you don’t let millions of Ponzis start borrowing and spending free money, the economy naturally suffers. Is this surprising to anyone?

It seems, in other words, as if it might be time for the revival of the subprime-lending industry. Long before these risky loans were blamed, in part, for helping usher in the financial crisis, subprime lending was embraced as a promising antidote to the excessive caution of mainstream lenders.

There were many fallacies believed by left-wing housing advocates who wanted to expand home ownership and right-wing free-market capitalists that wanted to loan more money and charge high fees. Obviously, everyone was wrong about subprime, and it blew up in their faces.

Subprime_slaves

After all, key mortgage rules were first written in the middle of the last century, and they still reflect old-fashioned economic assumptions.

What old-fashioned assumptions? That borrowers should have the ability to repay the loan?

It’s still easiest to qualify for a mortgage if a household has one primary breadwinner who is paid a regular salary, has a history of repaying other loans and has enough money saved or inherited to make a significant down payment. …

american_bankers_dreamNo kidding? You mean lenders want to know potential borrowers have capacity to repay and good repayment habits? I’m shocked, aren’t you?

The subprime solution has always been relatively simple. Instead of offering fixed terms to anyone who meets “prime” standards, terms are tailored to borrowers. People who are judged less likely to repay loans are charged a proportionately higher interest rate. Before things got out of hand during the last decade, subprime lending offered opportunity for many people, including minorities and immigrants, whose economic lives, like the Sleimans’, did not conform to the mortgage industry’s traditional expectations. …

And as long as subprime continues to charge higher interest rates and evaluate the credit quality of borrowers carefully, these make for nice portfolio loans. The higher rates compensate lenders for the higher risk, and it pushes these loans to the fringes where they do little damage.

Some experts also agree that access to lending should be broadened. But in order to protect borrowers, stronger institutional measures must be taken. One approach would change the rules of bankruptcy, which currently allow judges to reduce the burden of most kinds of debt but, notably, not primary home mortgages. Jennifer Taub, a professor at Vermont Law School, argues that changing this law would keep lenders on good behavior because they wouldn’t want to end up at the mercy of a bankruptcy judge. “If everyone knows that these are the rules of the game,” Taub told me, “there will be a lot more attention to make sure that the underwriting is proper.”

In theory this might work, but in practice, the investor who bought the loan is likely the real loser. When people go through bankruptcy, they can quit paying their car loans, but then they must give back the cars. If they quit paying their home loans, they should have to give back their houses, not have their principal reduced to keep a house they can’t afford.

Amir Sufi, an economist at the University of Chicago, and Atif Mian, an economist at Princeton, have proposed a slightly more ambitious plan. During broad economic downturns, they suggest, mortgage payments should automatically drop as area home prices fall. In exchange, lenders would get a share of eventual profits if the price of a home eventually rose again.

These are the guys who came up with the crazy and impractical equity-share loan. (See: Would homebuyers be willing to share appreciation with their lenders?)

In truth, the benefits of homeownership are often overstated. Home values have climbed only a little faster than inflation over the last 125 years, according to data compiled by the Yale University economist Robert Shiller. The kind of house that sold in 1890 for the inflation-adjusted equivalent of $100,000 would sell today for about $134,000.

2011-Case-SHiller-updated

Still, Americans just want to buy them. A recent poll found that 76 percent of Americans considered homeownership “necessary” to be a member of the middle class. When I asked the Sleimans why they wanted to move, their answer was as emotional as it was practical. “This is a good property, but it’s not ours — it’s a rented home,” Ali Sleiman told me. “It does not fit our needs. Or our dreams.” And as long as that is the case, it makes sense for public policy to focus on safety rather than abstinence.

Why do we need to fulfill their dreams? Is the American Dream an entitlement now? Don’t people have to work, save, and sacrifice any longer to obtain the American Dream? Perhaps it’s time to rethink this idea and rename it the American Entitlement.

American_Dream_Just_add_money

The return of subprime lending is not a bad thing. Some form of subprime was bound to come back, but we need to make sure it’s an expensive fringe product with properly priced risk. If it takes off again and becomes another huge Ponzi scheme, the peddlers of these loans will make fortunes while the people who take out these loans get screwed once again.

check-out-of-american-dream

Lenders would be happy to inflate another Ponzi scheme, and both lenders and investors have the moral hazard of successful market manipulations to back their ambitious plans. If they inflate another housing bubble, most market participants believe they can simply modify loans, keep distressed properties off the market, and wait it out. Given the success they enjoyed over the last two years, they are probably right to believe this; however, armed with a false sense of security, they will likely inflate a new bubble so large even the manipulations of the last go-round won’t be enough to bail them out. That’s the potential disaster of subprime 2.0 we must avoid.

[listing mls=”OC14203225″]