Why Do Subprimes Fail?

In all the back and forth about subprime mortgages, most news reports miss a central fact:  Many of the families that have subprime mortgage could have paid a mortgage with less onerous terms.  For examples, some families who were sold teaser rate mortgages that escalated from 2.9% to 12.9% may be in trouble even though they could have made payments on 7.9% mortgages.  Other families were told they qualified for $400,000 mortgages, which they could not manage once the introductory rates ended, but they could have managed $200,000 mortgages.  Practices like yield spread premiums encouraged mortgage brokers to steer others to subprime mortgages that they couldn't pay when their credit qualified them for prime that they could have paid.  In other words, the loan product itself caused part of the problem, not just the fact that the loan was made to someone with low income or damaged credit.   

Sharp businesspeople like Herb and Marion Sandler and Martin Eakes built strong companies lending money to people of modest means, many of whom had credit trouble.  But they didn't put their borrowers into loans they couldn't afford.  The whole idea behind their lending model was to put them in loans they could afford--and to keep the default rates low.   

A significant part of the problem in the subprime market is not simply that too many dollars were put into the hands of working families and people with bad credit.  The problem is that too many exploding products--products that were designed from the beginning to become unaffordable--were sold around the country. 

This is important because the suggestion that the subprime meltdown is just about a mistake in trying to expand homeownership is simply wrong.  No one knows the disaggregated statistics--how many people could have made it with a cleaner product and how many would have failed with any product. 

It is tough to solve the problem of helping people without adequate incomes get into homes.  But it isn't tough to ban products that rob people of the only chance they had to get themselves into a home.  It just takes the political will to make it happen.

Comments

[Marie Reilly]

Elizabeth, Do you have a theory about why borrowers of "exploding" mortgage products didn't shop for loans/terms they could afford? I'm wondering whether the entrepreneurs you identify didn't bid away borrowers from the exploding products you rightly see as inferior. Was it collusion? slick and exploitative marketing? Fraud?

There was a story in our local paper (Centre Daily Times) about a couple whose dreams of home ownership blew up when their mortgage exploded. According to the story, they knew at the closing that they were not getting the rates their broker had promised, but they closed anyway because they had already given up their lease and packed, etc. The injury they experienced was fraud and not so much explosion.

My Contracts students are very intersted in the big story about subprime loans because it channels Mrs. Williams and the Walker Thomas Furniture Company.

Thanks for your insight which is always valuable.

[Donald Gaffney]

As an attorney who is increasingly dealing with mortgage issues in and out of the courts, I have to question the empirical basis for a connection between the type of loan product and subprime failures. Our review of the flood back of repurchase demands do not seem to be tied to the type of loan product. Nor does the rising rate of default appear to correlate with the type of mortgage.I have admired the work of you and Prof. Westbrook (Nov. 2005 Harv. L. rev., etc.) but I don't think the facts here support your suggested thesis.

[lmclark]

Regarding Donald Gaffney's post above, I'd be interested in his empirical data on repurchasing demands, and what efforts were made to disaggregate the types of products that were included in the repurchasing demands. I'd also be interested in knowing whether the repurchasing obligation that underlay those demands might have required the originator to repurchase the whole package, as a result of defaults in a narrow band of products within that package. Donald, we are all waiting with bated breath.

I think that Elizabeth's point may be simply that the originators of some loan products made their credit extension decisions based on rationales other than likelihood of nondefault. One such rationale, for example, might have been the interest in earning loan origination fees up front, which can be booked as income immediately. We saw this sort of thing in Texas in the S&L meltdown in the 1980's. Another might have been algorithms that predicted a particular income stream likely to be produced in the aggregate, as opposed to an evaluation of the quality of each particular loan within a package. Certainly, different rationales will trigger different lending behavior, exposing the lender and subsequent purchasers to a different spectrum of risks.

[bac]

"For examples, some families who were sold teaser rate mortgages that escalated from 2.9% to 12.9% may be in trouble even though they could have made payments on 7.9% mortgages."

Given that interest rates haven't moved that much, these people should be able to refinance. And, as for the folks with the teaser-rate loans that bought more home then they could afford, some of these people wouldn't have been in any home but for the loan. Perhaps other teaser-rate customers should have been in a less expensive home, but even among that group, you have a significant number of people who took a calculated risk that didn't pay off. This leaves the group of folks who had decent credit (presumably a trait correlated with semi-decent money management skills) that were "tricked" into getting a teaser-rate mortgage for a home they couldn't afford. I wonder how large a group this really is.

[Donald Gaffney]

Please don't bate on my account. As with most practicing lawyers, my observation is based on anectdotal evidence of litigation cases and mortages being pushed back to issuers; nevertheless, the matters to date suggest a connection between underwriting standards and default increases, but not a connection with loan type. The subject deserves a proper analytical study, though, since a default/product connection would so far seem a thesis at best.

[dkm]

I am a Congressional staffer working on subprime issues. The evidence that I have seen so far, from the Fed and other places, is overwhelmingly against Mr. Gaffney's claim.

Subprime ARMs have a much higher default rate than subprime fixed rate mortgages. Subprime 2/28 or 3/27 ARMs have a much higher default rate than subprime 5 year or 7 year ARMs.

Now there may well be a credit score explanation there as well, and certainly underwriting is part of the problem. So I am not claiming that the product type was the cause of the higher default rates. That being said, there is certainly a very strong correlation. That is one reason the vast bulk of foreclosures is expected to come from ARM resets, particularly from the 2/28 and 3/27 type ARMs.