Saturday, May 9, 2009

investors were aware that borrowers with little equity in their homes often default when house prices fall

From Free Exchange:

"Why do people turn subprime?
Posted by: | NEW YORK
Housing markets

WHO is a subprime borrower? You hear a lot of speculation about this small, but significant population. Were they greedy, irresponsible people who wanted a bigger house than they could afford? Or were they naive, seduced by unscrupulous lenders and the American dream of home ownership?

This Boston Fed paper (via Rortybomb) offers a precise definition of subprime borrower, which traditionally referred to a person with a low credit score. But the increase in subprime lending in the mid-1990s expanded the definition to someone who elects not to give detailed financial information, offers a low down payment, or wants a bigger house than a prime lender would grant them. In exchange for being subprime they paid higher interest rates.

One surprising thing about subprime borrowers is that up until the mid 2000s most loans were used to refinance rather than purchase a new home. So many subprime borrowers initially qualified for a prime loan, but then refinanced using subprime. This signals deeper financial issues with many subprime borrowers. It would take a significant shock to lower your credit score and make you refinance your mortgage at a higher rate. It suggests many subprime borrowers were struggling to stay in a home they already bought through a prime lender.

Subprime borrowers are more likely to default, primarily because they tend to have much less equity in their homes—negative equity brought on by a large and persistent fall in home prices, rather than a spell of unemployment, is the biggest determinate of default. Even if you have negative equity in your home, if you expect prices to increase in the near future and turn your equity positive you will be less likely to default.

In a later paper the authors wonder if investors in mortgage-backed securities did not appreciate the consequences of lending to vulnerable borrowers with little equity in their homes. It now seems astounding that the primary concern for banks when pricing mortgage securities was pre-payment rather than default risk. Prepayment from refinancing using a prime mortgage is sensitive to interest rates, but people who refinance using a subprime mortgage do so because they've faced an income or wealth shock (why else would they refinance at a higher rate). The authors scoured analyst reports from the mid-2000s to retrace the thinking behind the mortgage market implosion:

Mortgage pricing revolved around the sensitivity of refinancing to interest rates; subprime loans appeared to be a useful class of assets whose cash flow was not particularly correlated with interest rate shocks. Thus, Bank A analysts wrote, in 2005:

[Subprime] prepayments are more stable than prepayments on prime mortgages adding appeal to [subprime] securities.

In some respects subprime was more desirable than prime mortgages.

The Fed study concludes that investors were aware that borrowers with little equity in their homes often default when house prices fall. The problem is they applied a trivial probability to house prices falling."


Don the libertarian Democrat wrote:

May 9, 2009 15:57

"The long delay in issuing the guidance allowed companies to keep making billions of dollars in loans without verifying that borrowers could afford them. One of the largest banks, Countrywide Financial, said in an investor presentation after the guidance was released that most of the borrowers who received loans in the previous two years would not have qualified under the new standards. Countrywide said it would have refused 89 percent of its 2006 borrowers and 83 percent of its 2005 borrowers. That represents $138 billion in mortgage loans the company would not have made if regulators had acted sooner."

"It was clear to some Washington Mutual employees that the company was making loans that borrowers could not afford and that the bank could suffer as a result. In 2005, a small group of senior risk managers drew up a plan that would have required loan officers to document that borrowers could afford the full monthly payment on option ARM loans.

The plan was shared with OTS examiners, according to a former bank official who spoke on condition of anonymity because the bank's practices are the focus of a federal investigation as well as several lawsuits.

"We laid it out to the regulators. They bought into it. They supported it," the former official said. But when a new executive team at the bank nixed the plan, the former official said, "the OTS never said anything."

In addition to taking more risks, Washington Mutual was setting aside a smaller share of revenue to cover future losses."

I find that following Countrywide is a useful guide to what went wrong.

"March 19 (Bloomberg) -- An American International Group Inc. unit sued Countrywide Financial Corp., accusing the mortgage lender of misrepresenting the underwriting standards of loans the company insured.

“As a result of the unprecedented number of defaults in the mortgage loans, United Guaranty has already paid out insurance claims totaling over $30 million and is exposed to additional claims of several hundred million dollars more,” AIG said today in a complaint filed in federal court in Los Angeles.

Countrywide, which was bought by Bank of America Corp., sought insurance for the mortgage loans to increase the credit ratings of mortgage-backed securities in which the loans were bundled, according to the complaint.

Shirley Norton, a Bank of America spokeswoman, declined to comment on the complaint.

The case is United Guaranty Mortgage Indemnity Co. v. Countrywide Financial Corp., U.S. District Court, Central District of California (Los Angeles.)"

I think that the mountain of litigation over Countrywide will reveal what the practices really were, and not what people said they were.

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