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Foreclosure Failures

posted by Katie Porter

From an editorial that urged Congress to focus on the 90% of subprime loans that aren't currently in serious default to a how-to foreclosure sale primer aimed at potential buyers, The Wall Street Journal could have masqueraded as the Mortgage Bankers Association newsletter last week. The most interesting piece was the front-page announcement that HSBC underestimated by $1.76 billion the amount that it needs to set aside to cover bad debts, including subprime mortgages gone awry. The article was titled Faulty Assumptions, and contained an acknowledgement by HSBC that "FICO scores are less effective or ineffective" in assessing the risk in subprime loans in a low-interest rate environment. If HSBC (and its predecessor on these loans, Household Financial) can't figure out whether buyers can repay non-traditional or subprime loans with a team of 150 PhDs on the task and incredibly sophisticated models at their disposal, how is the subprime borrower supposed to decide if buying the home is a good risk for their individual family? The 2003 Fannie Mae National Housing Study reported that 59% of the population believes that housing lenders are required to give borrowers the best possible rates on loans; I'm betting that an equally large percentage of consumers relies on their broker's or banker's assessment of how much they can 'afford' to borrow or their suggestions of a particular financing arrangement. The misestimation about the risks of subprime loans is bad news for HSBC shareholders who may lose their shirts on the stock. The real pain of such mistakes will fall on HSBC subprime customers who will lose their homes. Unlike HSBC shareholders, such individuals can't easily hedge the risk of homeownership.


The good news is that the loan losses are starting to hit the paper in a meaningful way. The fastest way to clean up the sub-prime lending market is for investors to suffer because of poor lending practices. These loans generate fees in the short term, but in the long run they do not perform. We are now seeing the Wall Street acknowledge the poor business model that sub-prime lenders embraced during the last 5 years. This will do more for reform that Washington ever could.

Can you provide a link to the Fannie report that says 59 percent believe lenders must provide the best rate?

The statistic on how many people believe that "Housing lenders are required by law to give you the best possible rates on loans" comes from the 2003 Fannie Mae National Housing Survey, p. 7. The report is available here: http://www.fanniemae.com/global/pdf/media/survey/survey2003.pdf;jsessionid=CK4MH3BDYEZRLJ2FECISFGQ

I've also inserted a hyperlink in my original post.

The Fannie Mae data raises the interesting point that borrowers look at loans as somehow different from other commercial transactions. I doubt these same people would expect that auto dealers are required by law to give them the best possible price on a car. Why is home lending different? Or more precisely, why is it perceived differently? It does raise the question of whether we would not be better off repealing the existing disclosure regulation and replacing it with a simple statement that "Your lender makes money from its loans; they do no have to consider your best interests in this transaction."

That's any interesting question Stephen, why do most people think their m-broker has their best interests in mind? I think many people have the same perception that realtors have their best interests in mind. If you read I believe it's chapter 2. of "Freakeconomics" you'll discover that realtors, like mbrokers, rarely have the homeowners best interests in mind. One may argue that if the typical person believed the mbrokers, realtors, etc. were out to make $$$ they would purchase differently. Some certainly would. But many times people purchase cars they struggle to afford, and everyone knows a car dealer is out to make profit.

The Wall Street Journal printed a letter to the editor on yesterday (Feb. 13, 2007) from a mortgage banker. The banker admitted that the industry as a whole may not always operate in homeowners' best interests but offered the observation that borrowers need to be more attuned to the adjustment on their budgets that a mortgage obligation will create and reduce their spending accordingly. He says that in his experience many people "go the opposite way, spending more money than ever before." This is an intriguing observation. Does the homeownership education process need to point out the perils of homeownership, instead of singing its praises? The government has long pushed citizens to become homeowners but perhaps there are hidden risks to homeownership, such as a false sense of financial security or accomplishment. As Elizabeth Warren and Amelia Tyagi pointed out in The Two-Income Trap, homes are "cement life rafts" for many families in financial trouble.

I read a 2-13-07 WSJ article on derivative trading related to the sub-prime mortgage market. Also, on a nightly investment talking heead show, I heard reference to "the sub-prime mortage" issue. Sub-prime defaults are making big news in the investment and banking markets. The lending market itself will be the quickest fix for the problem.

Stephen's question is interesting, but for a very sad reason. Most americans, and I am not limiting this to people who borrow in the sub-prime market, are generally illiterate. I mean this in a broader sense. They don't think. They know words, but can't understand a sentence, let alone a 16-page mortgage. They have become complacent about analyzing their own situation. They ahve become lazy to the point of abdicating the responsibility for protecting themselves to someone else - their broker, the government, their spouse. I truly believe that the proliferation of regulation has led many, if not most, people to believe that the government has made the lending waters safe. This false belief gives borrowers a false sense of security, and encourages them to trust.

I don't suggest deregulation. But we do need to re-arm borrowers with knowledge and understanding of the process, as well as base education which permits comprehension.

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