Subprime: boon or bain?

Where to From Here?

The Subprime Mortgage Market

Last year was the year when the term "subprime" became a part of everyday speech and was often followed by any number of other terms--crash, debacle, mess, or meltdown--in the media. We have all become numbed by the hypnotic mantra of subprime statistics; we are all tired of hearing about it. Even if we do not have a subprime mortgage loan or live in a neighborhood adversely impacted by foreclosures or have a retirement account that invested in collateralized debt obligations (CDOs) secured by subprime mortgages, we know the home mortgage industry will be changed for some time to come. The subprime mortgage market grew extremely rapidly--subprime originations grew from about $63 billion in 2000 to over $720 billion in 2006 when one in three mortgage loans originated were subprime. It is fascinating to note that even in the last half of 2007, adjustable rate mortgage loans with abusive features were still being offered--more than $40 billion in the last half of 2007. There is plenty of blame to be shared, or said differently, many parties had a hand in helping the mortgage market unravel. Homebuyers who pushed the envelope, mortgage brokers who pushed product often deceptive products in deceptive ways, federal and state banking regulators who chose not to enforce existing regulations, major investment banks who wanted more and more high-yielding products, or even the venerable bond rating firms that rated essentially junk bonds as AAA were all willing partners in the mortgage craziness.

What Have We Learned and What Questions Remain?

Homeownership May Have Been Oversold

Public policy at a variety of levels has pushed homeownership during the past 15 years or so. Homeownership is so much a part of the American psyche that the American dream cannot be defined without it. For instance, the City of Memphis and many other cities invested millions in down payment grants and loans for lower income first-time homebuyers. The homeownership rate is understood to be a key metric measuring the success of the economy. While thousands achieved homeownership during the last decade because of low interest rates and improved access to mortgage products, large numbers of first-time homeowners were not and will not be able to sustain homeownership. While it is clear that homeownership is the fundamental driver of asset accumulation for most households, is homeownership the right investment for every family? There are indications that the proportion of homeowners with zero or negative equity is growing and that negative equity is increasing because of interest-only type mortgage products. We certainly have learned that we cannot count on perpetual housing price appreciation. Even in the relatively inexpensive Memphis housing market, home price appreciation is now flat or negative. What is the cost to the community of hundreds of families failing to sustain homeownership? Are we better off, or worse off?

We Borrowed to Get Ahead

Home equity loans and lines of credit have been heavily promoted as ways to take the cruise vacation you so richly deserve or to get the shiny new SUV you really need. Lenders somehow discovered the tremendous profit potential of trading parked home equity for new debt. Equity lines have been a very profitable niche for banks even at low rates of interest because of the various fees associated with a refinance. The subprime problem has been confounded by home refinancing. Many homeowners traded in their accumulated home equity for a subprime adjustable rate refinance loan and very frequently took "cash out" of the refinance. This new-found cash got spent either for the consumer goods that keep the economy humming along or to pay off credit card debt. This is sort of like found money since much of the equity realized was due to market price appreciation rather than principal reduction. In 2007, the Mortgage Bankers Association estimated that 50.0 percent of all mortgage originations were for refinance. At the same time, the current national savings rate is negative, meaning we are spending our savings. Because of the tightening of credit availability and because of flattening home price appreciation, home equity borrowing is likely to diminish significantly. Will the consumer economy suffer? Again, are we better off or worse off?

Risk-Based Pricing Spurred the Development of Hundreds of New Mortgage Products Targeted Toward New Customers

The widespread adoption of risk-based pricing over the last 15 years opened the credit window to thousands of consumers who would previously have been denied credit. The whole notion of "subprime" is that consumers deemed to have a higher "risk" profile could be offered credit (mortgages, credit cards, cell phones, etc.) but at higher rates than for "prime" borrowers. Incidentally, subprime refers to borrowers rather than to a particular type of product. The emergence of a massive new market of homeownership-hungry customers fueled lenders into inventing new mortgage products that specifically targeted the subprime market. While there is nothing radically inventive about a fixed-rate 30-year mortgage loan but at a higher interest rate, the vast majority of products aimed at the subprime market have been adjustable-rate mortgages (ARMs). Becoming even more inventive, lenders found ways to tweak the ARM product into very attractive sales packages. More and more loans were offered with very low introductory interest rates for the first two or three years (so-called 2/28s or 3/27s), after which the low teaser rate would reset to a higher interest rate based upon some arcane index value (usually the LIBOR). At the end of 2006, the ARM share of subprime mortgages stood at 65.0 percent, meaning that two out of three subprime mortgages would reset to a higher interest rate. Recall that this was a very low interest rate environment, so with low teaser rates many homebuyers were able to get rates of about 2.0 or 3.0 percent. Risk-based pricing and the subsequent creation of customized mortgage loan products allowed thousands of "high risk" borrowers to become homeowners. Again, are we better off or worse off?

Mortgage Brokers Added Froth to the Brewing Subprime Mess

New mortgage products, the internet, and limited barriers to entry stimulated an increase in the number of mortgage salespeople (brokers) which, in turn, stimulated increased pressure to sell product. Traditionally, people have gone to their local bank or credit union and talked with a loan officer to apply for a home mortgage. The vast majority of home mortgages are no longer made by locally-regulated financial institutions. Risk-based pricing and automated underwriting allow mortgage brokers to sell loans from anywhere at anytime using the net or phones. While most mortgage brokers are reputable, many are also super salespeople. Brokers work for transaction fees--the more transactions, the more they earn. Often brokers earn a premium from lenders by selling higher-cost loans to borrowers. This yield spread premium is not typically disclosed to borrowers, as brokers have no fiduciary responsibility to borrowers. Regulatory oversight is lax in most states, including Tennessee, and there is no national licensing or registration system. The growth in the number of mortgage brokers in the last decade or so has offered consumers more convenience and more choices in where to find a home loan. Are we better off or worse off?

Home Mortgages Became Commodities Like Pork Bellies

While mortgage securitization has been a vital component of the home mortgage industry over the last 30 years, the tremendous growth of the subprime market and accelerating housing price appreciation have driven demand for mortgage capital to unprecedented levels. Because subprime mortgages earned a higher return, investment banks found that by adding various proportions of subprime paper into large pools of mortgages (e.g., CDOs, often representing 3,000-5,000 underlying mortgages), the returns on these securities could be juiced. Rating agencies were paid by the investment banks that issued the debt instruments which these banks wanted to sell to investors. Even though a security might contain a substantial share of subprime mortgages in its pool, rating agencies typically rated these bonds as investment grade (which is another story). Securities backed by home mortgages packaged like spicy sausages sold quickly near and very far. In fact, demand could not keep up with supply in 2006, which increased the pressure down the food chain to create more product. Many actors dined very well on this feeding frenzy, gaining through transaction fees. Good times for investment bankers, lenders, and loan brokers ended when it became apparent that the spice in the sausage covered some degree of taint. The market grew sicker and roiled with the realization that no one knew how much taint was in their sausage. Lots of money was made, but lots will be lost. Are we better off or worse off?

Piling on Risky Products to Risky Borrowers Deepened the Problem

While default rates are higher for fixed-rate subprime mortgages than for prime mortgages, it is the subprime option ARMs that have dramatically higher default rates. The Mortgage Bankers Association reports that at the end of third quarter 2007, foreclosure start rates for prime fixed-rate loans stood at 0.22 percent, whereas the start rate for subprime ARMs was 4.72 percent. The rate for subprime fixed-rate loans was only 1.38 percent. Even though subprime option ARMs are a small fraction of total outstanding mortgages, they constitute a very substantial share of defaults and foreclosure starts. So, it was not subprime loans per se that caused the mortgage mess. There are thousands of subprime borrowers who are current on their mortgages. Both the type of mortgage products offered and the deceptive or abusive manner in which they were sold to borrowers led to the ultimate devastation of the mortgage market. Borrowers were sold option ARMs based upon low teaser interest rates, with the option of paying only interest and for 100% of the value of the home. Frequently, these loans were made without verification of income and underwritten without consideration of ability to pay at the normal interest rate after the reset in two or three years and without any escrow for taxes and insurance. Bad mortgage products were made worse because full disclosure of the terms and conditions of the loan frequently did not happen. It is also notable that less than 2.0 percent of prime mortgages carry a prepayment penalty, but over 70.0 percent of subprime mortgages do. Many borrowers were totally unaware of the nature of their loans. Borrowers with blemished credit got loans and, therefore, homes, but at very high risk. Are we better off or worse off?

Print Get the Mag Weekly Updates