Saturday, October 25, 2008

Synonyms and Subprime

As I read the newspapers and the blogs about the mortgage meltdown, a certain pattern is emerging. Toxic mortgage = subprime mortgage = low income borrower = minority borrower.

That's a lot of assumptions packed into a very small box.

At every equal sign, logic gets twisted a little (or a lot) to try to end up with the outcome preferred by the writer, or else the writer is trying to combat the outcome of the argument (poor minorities have brought down the financial markets through subprime loans) without deconstructing the false logic of the chain. The connections in that chain need to disrupted, so that the items being chained are not treated as synonyms, but as distinct and independent elements in the financial crisis.

The two biggest leaps of logic are in the first two equivalencies. Without those reductions, the argument as a whole cannot work.

First, not all toxic mortgages are subprime, nor are subprime mortgages invariably toxic. Option Adjustable (OA) and Alternative A-paper (Alt-A) are also part of the mix and will be as great or greater a problem than the subprime mortgages are currently. Their reset/default window is in the future. Here is a slightly old chart from Credit Suisse that illustrates the distribution of existing mortgages due for a reset. (Image from Jim the Realtor)

These are loans with adjustable interest rates that will reset. Subprime resets, by this chart, are almost complete, the tailend of resets falling in 2009. Once reset, the borrowers will continue payments, refinance, sell or default as a result.

The wave that is picking up is the combination of OA and Alt-A which will go on until 2012. (Note that the severe fall off in 2012 is a lack of data, not an end to adjustable rate loans. The Alt-A and OA loans made after the chart was generated are not included.) OA and Alt-A loans are just as much a part of toxic loans as the subprimes, perhaps more as they have tended to be for larger amounts with riskier terms, relying almost exclusively on FICO scores and claims of income. The OAs explicitly increase indebtedness. These are loans made later in the bubble as a replacement for subprime.

I also point out the Agency loans (grey), which are those guaranteed by the GSEs, Fannie Mae and Freddie Mac, which also get reset. A much smaller proportion of the pie and with terms that are, on balance, less onerous than the previous three types, thus having a greater probability of remaining affordable and not going into default. Again, this chart is out of date and does not fully reflect the push in late 2006 and 2007 for the GSEs to reduce their standards and buy up non-conforming loans.

But what distinguishes the subprimes from the OA and the Alt-A? Not a whole bunch, as Tanta of Calculated Risk has written. Her long but incredibly lucid and informative post What is "Subprime"? should be required reading for everyone. Here are a few key paragraphs. Let's start with just what gets (or should get) evaluated when determing whether to make a loan (my emphasis throughout):

That said, what it’s about is just working through the complexity of the variations on three things that have been the core of mortgage underwriting since roughly the dawn of time: the three Cs, or Credit, Capacity, and Collateral. Does the borrower’s history establish creditworthiness, or the willingness to repay debt? Does the borrower’s current income and expense situation (and likely future prospects) establish the capacity or ability to repay the debt? Does the house itself, the collateral for the loan, have sufficient value and marketability to protect the lender in the event that the debt is not repaid?

There is no New Paradigm, there was no New Paradigm, there is not going to be a New Paradigm. The Cs are the Cs. What we “innovated” was our willingness to believe that we had established the Cs with indirect or superficial measures (that are, not coincidentally, cheap and fast compared to direct measures). We looked at FICOs—scores produced by computers—instead of full credit reports and other documents to supplement them. We looked at the borrower’s statement of income or assets, not the documents; when we got docs, we looked at the last paystub or the current balance of an account, not the documentation of a long enough period to establish stability of income or source of account balances. We looked at AVMs instead of full field appraisals. We read the Cliff’s Notes.

These practices have not worked out so well, of course, but my point is that they were simply “innovative” ways of answering the three C questions, not new questions. They’re not a repeal of the laws of physics or the laws of the Cs. They’re just wrong ways to answer the right questions.

Someone with low income but a small purchase can get a prime loan if the borrower meets the the three C conditions. Someone with a solidly middle class income may not be able to satisfy the same conditions if the loan amount does not conform to the standards. Tanta then goes into a detailed examination of the traditional role of subprime lending in the mortgage industry, which I strongly recommend everyone read. Her explanation of the "take-out" function of these loans is an education in and of itself, and vital to understanding the tectonic shift in lendign practices. She sums it up, saying:

You therefore have this giant conceptual gulf between industry analysts and the media, the latter being, on the whole, those who never really spotted the problem with the idea that homeownership is always and everywhere a good thing for everybody because it’s always an “investment.” If you believe that, you don’t tend to see anything odd about lending practices that offer purchase-money (not refi money) to people who appear to have no particular qualifications for homeownership. In essence, the old “hard money” or “collateral dependent” loan went mainstream, except that it went from the margins of the housing stock—manufactured homes, dilapidated row houses, the old farmstead—to the front and center—new homes, flashy condos, high-quality existing homes whose previous owners were heading for the McMansion. Given assumptions about the collateral—like, its value always goes up and its value always goes up—you could more or less forget about problems with the other two Cs. When the RE markets were hot enough, in fact, there weren’t “problems” with the other two Cs. Sure, borrowers with loads of consumer debts and insufficient incomes failed to make mortgage payments just like they always did, but it was always possible to sell out from under foreclosure or get another cash-out. A humming RE market keeps those cash-out appraisals plausible.

The subprime, OA and Alt-A loans became the way for the mortgage industry to avoid making hard choices about loans that were unsupportable no matter the income of the borrower. Here is a fascinating interactive map created by the New York Federal Reserve on mortgages around the country. You can switch between loan types in the upper right hand corner. Look at the different measurements in California and toggle between Subprime and Alt-A loans. Alt-A is in somewhat better shape, but not what you could call strong.

Barry L. Ritholtz of The Big Picture add another vital piece of information to this situation in his post How Lending Standard Changes Led to the Housing Boom/Bust, namely that the term being underwritten was really just the initial period of the loan:

In this ultra-low rate environment, where prices were appreciating, and most mortgages were being securitized, all that mattered to the mortgage originator was that a BORROWER NOT DEFAULT FOR 90 DAYS (some contracts were 6 Months). The contracts between the firms that originated mortgages and the Wall Street firms that securitized them had explicit warranties. The mortgage seller guaranteed to the mortgage bundle buyer (underwriter) that payments were current, the mortgage holders were valid, and that the loan would not default for 90 or 180 days.

So long as the mortgage did not default in that period of time, it could not be "put back" to the originator. A salesman or mortgage business would only lose their fee if the borrower defaulted within that 3 or 6 month contractually specified period. Indeed, a default gave the buyer the right to return the mortgage and charge back the lender the full purchase price.

What do rational, profit-maximizers do? They put people in houses that would not default in 90 days -- and the easiest way to do that were the 2/28 ARM mortgages. Cheap teaser rates for 24 months, then the big reset. Once the reset occurred 24 months later, it was long off the books of the mortgage originators -- by then, it was Wall Street's problem.

This was a monumental change in lending standards. It created millions of new potential home buyers. Why? Instead of making sure that borrowers could pay back a loan, and not default over the course of a 30 YEAR FIXED MORTGAGE, originators only had to find people who could afford the teaser rate for a few months.

I would add a final piece to the puzzle, which is that house prices in bubble areas rose far, far faster than incomes in response to the lax lending standards. All income levels, not just "low income" were confronted with house prices (and loan amounts) completely out of wack with their incomes - and an ever so helpful collection of mortgage brokers eager to help them get creative financing to "afford" those inflated costs, if only for 2 years. The unsupportable loans were not just subprime and not just to low income borrowers.

Tanta was one of the first and most critical voices against the conservative narrative about those lazy, opportunistic stupid minorities messing up our loan system, which is the main reason why I had my antennae up for it just before it became the topic de jour on the left-leaning econoblogs. She made no bones about the subtext of the arguments:

The association of subprime lending with the brown people is just the most overtly disgusting bit of bigotry to arise from the great mess. The belief that subprime borrowers are “poor people” has taken root so deeply that you need a jackhammer to rip it out. The capacity C of traditional underwriting was, of course, always relative to the proposed transaction. A lower-income person buying a lower-priced property was, you see, not a case of subprime lending; assuming a reasonable credit history, it was a prime loan. People with quite good incomes and stellar credit histories who tried to buy way too much house got turned down by the prime lenders. That was back in the days when you could live within your means, and you were expected to do so.

The trouble with the low-income prime loan was that it was a small prime loan. And that there were, in many market areas, more lower-income people than lower-priced properties. Both industry greed—wanting to make the biggest loans possible to make the biggest profits possible—and industry overcapacity, combined with ever less-affordable housing in the employment-rich population centers, brought us to a situation in which we might not have started with poor people, but they were certainly poor by the time we got done putting them into too much loan to buy too much house. There are subprime borrowers you find. There are those you create.

Poor people couldn't borrow enough to make money in conventional loans for the WaMus and Countrywides of the financial industry. Thus, exotic mortgage vehicles for everyone! This is a fast way to creating subprime (uncreditworthy) borrowers in every income bracket. Tanta then goes right for the jugular of the conservative argument:

The argument goes that it was the relatively low defaults of those 90s-era affordable mortgage programs that spawned the current mess by giving everybody the impression that you could do no-down loans all over the place and not worry about it. This assumes that the lending industry is so stupid that it cannot understand the mechanisms that kept those defaults low: first, selectivity in the programs; second, the availability of home equity lenders (the old subprimers) to take out the problems; third, cheaper real house prices. Perhaps it is the case that the industry is too stupid, on the whole, to figure this out. But how that becomes the “fault of” the original affordable housing initiatives just isn’t clear to me.

What is clear to me is how convenient this argument is for certain folks whose only other option is to admit to having been stupid and greedy. Exhibit A, our favorite Tan Man [Countrywide's Angelo Mozillo], whose transformation from “I got into this business to help poor brown people” in the 90s to “those brown people made me do it” is nothing short of nauseating. Exhibit B is everybody who decided that the best way to avoid being given fraudulent income and asset documentation and appraisals was to not ask for documentation or appraisals. Exhibit C is everybody who made “investment” loans for properties that did not and could not cash-flow, and hence had to flip to survive. Exhibit D is the “bridge loan,” or the product designed to blow up in 24 months and force either sale or refinance. There are many more Exhibits in this sorry book. The point is that the whole flimsy edifice had to fall down. That it started with the weakest parts—subprime—is no surprise. That this means that it’s all about subprime is mystification.

When home prices are unsupportable by normal incomes and when the mortgage industry is pushing exotic loan vehicles to line its own pockets as quickly as possible, we are, in Tanta's phrase, all subprime now. It is not the exclusive condition of people with dark skins and low income. It is many, many fair complexioned people with upper five-figure household incomes. It's most borrowers in San Diego County from the last 6 years. You can talk about the influence of the GREs on the rate or volume of other than prime loans, but you cannot make the case that all of these loans, or even the majority of them, went to low income minorities without demonstrable income. They went to people like my coworkers, white males with high-five figure incomes who wanted to buy luxury homes in "white" (East Asians and pale Hispanics OK) suburbs to get away from the older suburbs filled with lower income, darker skinned, immigrant populations, and who now are talking at work about "walking away" or "jingle mail" because their $500K, $600K, $700K, or even more expensive houses in North County and Eastlake are worth 25%-45% less and they can't afford the coming reset on their Alt-A ARMs. That's what the mortgage meltdown looks like in San Diego. Tanta has some words for them, too, in her post We Are NOT All Subprime Now, Thank You:

What a foreclosure and a "killing" of your credit rating does to you is make you "subprime." "Prime" is not a birthright; it is not an immutable characteristic like having blue eyes. The confident assertion that credit will be easily and quickly available to these borrowers formerly known as prime rests on a hidden assumption that they are unlike any other "subprime" borrower, and therefore will get preferential treatment in a year or two.

Mystification aside, this is a prediction that the subprime mortgage lending industry--and the investors therein--will have recovered sufficiently in just a year that this new large crop of subprime borrowers with a year-old FC on their records will be deluged with mortgage offers. Perhaps that will happen, but what makes anyone think it will happen just because these were once "prime" borrowers? Most subprime borrowers were once prime. With the exception of borrowers who have never had any credit, which is a fairly small group, subprime borrowers once had prime credit, and did not manage it well, and therefore now have cruddy credit records and FICOs. How, exactly, will these "walkaways" be any different from any other subprime borrower?

The whole thing is so nonsensical that I am forced to the conclusion that for this (and many other writers), "subprime" is code for "poor people" and "prime" is code for "middle and upper class people," hence the need for distinguishing terms for loan failure: "foreclosure" for the poor, "walkaway" for the non-poor. Foreclosure is something that happens to you against your will; "walkaway" is something you do to the bank as an exercise of control over your finances. If we can maintain these illusory distinctions, we can maintain "our" distance from "them."

If we can just pretend that we aren't subprime, that we're special and that we would have been OK except for the undeserving poor and illegal aliens who bought up all those mansions, driving up the home prices on us deserving middle and upper-middle class folks, then we don't have to address the restructuring of risk and the rewarding of greed that the Movement Conservatives fought for in the financial markets, and that The Village so desperately wants rescued.

I fight against this attempt to reinterpret the housing bubble and its collapse because the people with the least power in structuring this outcome are being made scapegoats for the robbery. It will interfere with real reforms to the GSEs to make them ethically and transparently fulfill their charters to expand mortgage credit to underserved populations. It will damage attempts to create a HOLC/HOME agency to address the need to revalue homes with minimum of moral hazard and prevent bailout of the prepetrators. It directly hurts women who make up the biggest slice of the working poor and who need access to affordable housing.

We are all subprime now, not just the people the power elite has thrown under the bus.



Koshem Bos said...

The bailout will end up costing, probably, two trillion dollars. About half of it will go to the banks. Currently, the banks that already received bailout money continue to foreclose on mortgage the money for which they got from the government.

It's more efficient, equitable and socially responsible to give the money to the mortgage holders, who will reduce their mortgages drastically by paying off the bank most of the mortgage balance. You can reduce millions of mortgages for a trillion dollars.

This will restart the markets, and, hopefully, bring back the pre-Bush days.

Elise said...

An excellent post and - as always - you have clarified my understanding of a key part of this mess - why teaser rates were so popular and so deadly.

I will forever cling (perhaps bitterly) to my belief that Fan-Fred contributed to this mess but I have never been convinced that belief translates to the idea that poor or dark-skinned borrowers somehow managed to crash an entire national - indeed international - financial system. I imagine the disadvantaged of this country can only wish they were that powerful.

I recently talked with a friend in her 50s who bought (with some financial struggle) a perfectly nice, 3-bedroom, 2-bath ranch style house several years ago. She is quite outraged by a younger co-worker who insists her house is practically a hovel and believes he "deserves" to own a far more expensive house which she knows he cannot possibly realistically afford. (She is particularly horrified by the fact that he insists his house have pillars which cracked me up - both his insistence and her horror.) I can assure you that she, at least, would be disinclined to consider middle-class people who buy more house than they can reasonably afford as different from poor people who do the same.