Subprime Loans = Egalitarian Opportunities

The Following article (published March 20, 2007: http://www.glgroup.com/Council-Member/Joseph-Chatham-138496.html ) by Joseph Chatham brings up the unpopular notion that many borrowers, not all, may bear some responsibility for the loans they took. Although dated, I think it is a good article that brings up the oft overseen benefits of subprime lending; namely, opportunity for tens of thousands of borrowers heretofore unable to access the mortgage monies.

MortgageMaster


"The recent reaction of the media in regards to the subprime “implosion” that we are hearing about is both potentially dangerous to our economy and oftentimes based on half-truths and misinformation. Take the recent headline from USA Today’s Money Section (Friday, March 16, 2007), titled “Some Subprime Woes Linked to Hodgepodge of Regulators“, as an example ( http://www.usatoday.com/money/economy/housing/2007-03-16-subprime-usat_N.htm ). The main gist of the article may be correct: perhaps some uniformity should be required in lending regulations. It is the supporting story that positions the brokers and lenders in a totally negative light that hit home with this writer.

In this article, we visit a disgruntled and “duped” buyer, Andy Sobel, who claims he did not know that he was placed into a interest-only mortgage by his mortgage broker, who, it is inferred, insidiously changed companies sometime after Mr. Sobel‘s loan closed. Furthermore, the lender would not renegotiate the loan (a process called “loss mitigation”) until after Mr. Sobel’s loan turned adjustable and he was three months behind. Mr. Sobel is now in foreclosure because he cannot afford the new payment which followed the two-year fixed-rate “teaser” period.

The journalist who wrote this piece, Noelle Knox, goes on to essentially lambaste the lending industry for shoddy practices and misleading consumers with creatively named “liar loans“, “teasers“, etc. Let’s review some of the half-truths that Ms. Knox and USA Today are putting out there and why, by extension, the media is partially responsible for the “crisis“ we are witnessing:

Mr. Sobel is clearly a bright man, as he is a community organizer for non-profits and he is savvy enough to research and write Rep. Barney Frank, D-Mass., the chairman of the House Financial Services Committee. Aside from the sympathy we feel for Mr. Sobel, and anyone losing their homes to foreclosure, we have to wonder why the author was not up-front about the circumstances that lead to people like Mr. Sobel borrowing subprime mortgages: Poor credit? No/low down payment? Inconsistent work history? “Creative” tax preparation? Etc.? Subprime borrowers created the circumstances that made them subprime borrowers in the first place. The brokers and lenders did not force these borrowers to become subprime.
If we were to listen to the recent media hype and vitriol aimed at the subprime lending world, we would be inclined to completely erase the personal responsibility and accountability of the borrowers and fault the mortgage brokers and subprime lenders for preying on innocents.
At the very least, is the expectation that borrowers read their loan documents asking too much? Are all subprime borrowers unable to “shop” their loans? Can it be that 20% of the borrowing public, or 100% of the sub prime borrowers, is totally duped by the subprime industry? Let us assume that personal responsibility is tossed aside and that the subprime lending world is to remain the focus. Are these lenders the evil, profit-grubbing, and irresponsible predators that the media has painted them to be?

Certainly the principles of lending have been liberalized over the past several years. The four “C’s” of lending; credit, collateral, capacity and character have turned into risk-based models and pricing based on four other letters, FICO. People with high credit scores receive the best rates and programs. People with low credit scores, despite other factors, are relegated to the world of “alt-A” or subprime. Since the infusion of “Wall Street” money incarnated as Mortgage Backed Securities, starting in the latter half of the 1980’s, lenders are not as beholden to FDIC requirements. There are now hundreds of subprime lenders versus a few consumer finance companies in the past. The lending market has been flush with capital. This oversupply of money spurred competition and more liberalization in an effort to get the capital working. Investors willing to take on a little more secured risk with subprime borrowers earned a better yield. Borrowers were willing to pay more to borrow money that was heretofore unavailable to them. It is called the free market and it greatly benefited both parties. Like all markets, however, cycles are inevitable. Dare I say desirable?

The recent softening of the real estate market brought this symbiotic relationship to an end. Prior to the past eighteen months, however, subprime lenders, in fact, have given the opportunity to tens of thousands of subprime borrowers to become homeowners and enjoy all the benefits of home ownership: appreciation, tax deductions, pride of ownership and a roof over their heads. With the exception of the past 18 months, most of these borrowers greatly benefited from more liberal underwriting standards. Many of these borrowers actually listened to their mortgage advisors and “cleaned” up the circumstance(s) that forced them into the subprime category in the first place. These same borrowers, often from the lower and lower-middle classes, refinanced their homes into “A” paper loans and are now sitting on more assets than they ever would have had it not been for the opportunities that subprime mortgages offered! The subprime mortgage provided an entrée into the “American Dream”.
To blame brokers and lenders for providing a loan product in a hot real estate market is like blaming stock brokerages for margin lending during a bull market. The lenders, like the stock brokerages, are providing a product, called leverage, which may greatly benefit the client if applied correctly. If a borrower pays only $5000. 00 in closing costs to purchase a $300,000.00 home and that home appreciates 5%, or $15,000.00, in the course of one year, the client earned 300% on their investment. Yes, they made monthly payments, but they also had a roof over their head and received generous tax deductions as homeowners! Unlike the margin accounts, however, real estate loans have no “margin calls” when the underlying security, the house, goes down in value. The “margin call” on a home loan only becomes due upon sale of the home or default of the payment. In other words, as long as the borrower makes the mortgage payments, they can keep the investment. Alas, here lies the problem.

Mr. Sobel, the borrower from the USA Today article, may be one of thousands who tried to “play the market”: leveraged purchase, low teaser payment, and the hopes of double-digit appreciation. If this gamble worked, as it had for tens of thousands before, this speculative buyer would have made a pretty penny for a nominal investment. Where are the success stories? The gamble did not work, however, for most of the highly leveraged buyers of the past eighteen months, prime or subprime. The difference is that the prime borrowers probably took out longer term loans (>2 years). Subprime loans are designed to provide a reasonable payment for two years while the borrower works on becoming a prime borrower. The USA Today article called these “teaser” rates rather than allow that the low payments bought time for the subprime borrowers until they could clean up their proverbial acts. Prime loans, if not 30 year, fixed-rate loans, are usually five, seven or ten year loans, with a thirty year payments. The prime loans will most likely miss any market corrections as they are longer term and require no immediate action. Prime borrowers can afford to wait the market out. The two year loans, with low initial rates and payments, and often with interest-only payments are the ones causing all the headaches Journalist Knox refers to.

Sub-prime loans often adjust after two years: they are no longer interest-only payments based on a low interest rate. The subprime loan becomes a fully amortized adjustable rate mortgage with rates and payments considerably higher than the one the subprime borrower has become accustomed to. If they did not put down a large down payment and property values remained the same or went down, the subprime borrower’s only choices to make the new payment, renegotiate, or walk from the house.

If they can afford the new payment, great! How about renegotiation?

The horrible lenders that would not negotiate with our Mr. Sobel are simply following normal protocol. How are you supposed to negotiate a loan that is not behind? Simply change the terms? It would simply be too easy for borrowers to call and say “I cannot afford this loan! Please renegotiate!” This option would put all the burden and negative consequences on the lender, not the person who chose to take the loan in the first place. Renegotiation, or loss mitigation's, requires that the borrower still be able to make the payment on the negotiated loan, still at higher rate than the prime loans available, but perhaps a workable solution. Loss mitigation efforts may be the saving grace of this “crisis”: keeping people in homes, less short sales, less depreciation, etc. What about the foreclosure option?

Short sales and foreclosures can certainly affect real estate values. I contend that foreclosures are not the bigger threat, but that the overreaction of regulators and legislators is far more of a threat to both the real estate markets and the American Dream.

Ms. Knox contends that a bevy of federal and state regulators supervise lenders. She is correct in this, but is only half correct with some facts; for example, in California, brokers can lend under a Department of Real Estate or a Department of Corporations license(s). However, regional and national differences may necessitate having different regulatory agencies supervising different types of lending or different types of corporate structures. This article is not to rebut Ms. Knox’ contention regarding regulatory agencies.

Assuming the figures shared in USA Today are correct (and, I believe they are), 20% of borrowers in 2006 were subprime borrowers. What we do not know is what percentage of that 20% are two year adjustable, what percentage of that 20% are above 80% loan-to-value, and what percentage of that 20% will have to walk away from their homes. The borrowers that are in real trouble are those who borrowed 100% of the purchase price, greatly exaggerated their incomes, borrowed two-year money, borrowed in the last 18 months and have not improved their credit scores. What percentage of the 20% of subprime borrowers is that? Countrywide(NYS:CFC) recently reported a 19% default on its subprime servicing portfolio. If Countrywide(NYS:CFC)’s numbers are any indicator of the overall default rates, than we can construe that subprime loan defaults represent about 3.8% of all loans. Overall. 3.8% is hardly the crisis that our friends in the media would have us believe. It is, however, the front page, top-of-the-hour news reporting that drives our friends in Washington DC to create over-reactive policy. Exposure-hungry and love-to-create-a-national-crisis-out-of-an-industry-problem congress may choose to severely limit the ability to lend to borrowers with “challenges. Thus, eliminating 20% of our home buyers. THIS IS A REAL THREAT.

Foreclosures, while much higher than in recent years past, are still moderate. Compared to the past few years, the foreclosure rates seem off the charts. Who, however, would allow a foreclosure in the red-hot real estate market of the past seven years? Foreclosures were nearly non-existent. A mild increase would, in percentage-terms, look like a huge increase.

Lastly, Wall Street has rightfully hung many of the subprime lenders out to dry. The only issue is that many of those same funding sources are the ones that were feeding the habit. Lending standards have already tightened substantially in the past several weeks, probably blocking out those who should not have borrowed in the first place. Lenders such as New Century, Fremont and many others will pave the way for more sound lending practices with their headstones. Chances are a few may rise again given their cheap cost and vulnerability to takeovers. Perhaps loans will become less expensive with the Wall Street lending the money directly? Either way, the lenders who chose to lend without regard to sound lending principles are gone or are taking their lumps. The market has corrected its imbalances and we will see it flush-out the problems.
New products and loss mitigation vehicles will replace a good number of the “bad” loans in the market and by August, 2009, most of this mess will be solidly behind us. Thank goodness!"