A Plague of Subprimes
Part II: Provenance
Five Factors:
2) Subprime Mortgages
The historically easy availability of lending capital created the potential for a heyday in the home mortgage business. And as the easy money extended through time, so did the opportunity for lenders to profit. For this a large and continuing supply of new customers was required. That was a need simple enough to fulfill, for a vast supply of prospective borrowers was immediately at hand who had been excluded from the mortgage market by bad credit, low income or lack of a down payment. They were a large and hungry group, and all lenders need do to tap this market was to start saying “yes.”
Such leniency is in normal times too expensive for lenders, but the time was a propitious. It had become profitable to say “yes” to those previously shunned due to the coincidental appearance of ready loan capital and rapidly appreciating housing prices. High-risk borrowers and marginal properties suddenly became reasonable ventures—at the right price. And the price could be made right because credit-starved buyers often ignored booby traps in the closing documents lucrative for the lender, including not only high origination fees, but also more subtle snares, such as low initial rates on mortgages with a balloon structure, or an adjustment feature indexed to a highly sensitive benchmark plus a large increment (e.g., the 6-month LIBOR + 5%). One arrangement popular with lenders, now-notorious, was the “2/28” loan, which shifted to an onerous 28-year amortization schedule after a two-year introductory period. Greenlaw et al (2008) calculate that 80% of subprime mortgages—about $1 trillion in face value—issued from 2005 through Q3 of 2007 were adjustable rate. A companion factoid from the Wall Street Journal (February 27 and August 7): By 2006, 44 to 46% of subprime mortgage originations were done without full documentation of income and assets, and a substantial but unspecified portion were done absent a down payment.
Subprime lenders anesthetized their clients to these tricks by folding closing costs into loans, and by showing low initial payments on the disclosure documents (in the usually well-founded hope that the client was not reading the fine print). The lack of a down payment was finessed with separate financing, called a “piggyback” loan. As subprime mortgage originations jumped from less than 8% of all home loans in 2003 to more than 18% in 2004, and 20% in the two following years, borrowers, regardless of qualification, could close a residential purchase and walk away on a cash-flow-positive basis (Wall Street Journal, February 27, 2008).
That such lending practices worked, even for a time, is an artifact of the boom in the housing market. Rising home prices provided some motivation for marginal borrowers to be more tenacious in meeting their installments, but more important was the escape created when payments could not be met—namely, the option of refinancing to extract appreciated equity. In the worst case—foreclosure—the bull market meant lenders could recover much or even all risked capital at auction, making even a bad loan profitable, or near enough (net of fees and tax effects) for the risk to be worthwhile. Meanwhile, performing loans—still the predominant majority—were earning prodigiously.
Mortgage lenders thus had a means of tapping into a vast reservoir of what one pair of economists call “latent demand” (Atif Mian and Amir Sufi, 2008). The demand was met aggressively. Beginning in 2001, acceptance rates on home loan applications began to rise sharply, as did the debt-to-income ratios for borrowers and loan-to-value ratios for approved properties. The portion of household debt represented by mortgages—historically about half the total—began rising about 30% faster than non-mortgage debt, and by 2007 was larger by half. Lenders took no note, and loan volume continued to grow even as the income qualifications deteriorated for new subprime borrowers, and default rates increased (Mian and Sufi, 2008).
Subprime mortgages volume reached $600 billion in 2006. Somewhere in the process, writers of subprime mortgages lost sight—if they ever had sight—of the fact that all of this was founded upon a continuously rising housing market and a continuously paying army of borrowers. A contraction in prices would trap borrowers and lenders alike under a pyramid of insupportable loans.
Bibliography:
Leveraged Losses: Lessons from the Mortgage Market Meltdown, David Greenlaw (Morgan Stanley), Jan Hatzius (Goldman Sachs), Anil Kashyap (University of Chicago Graduate School of Business; National Bureau of Economic Research; Federal Reserve Bank, Chicago) and Hyun Song Shin (Princeton), U.S. Monetary Policy Forum Conference Draft, 2008.
The Consequences of Mortgage Credit Expansion: Evidence form the 2007 Mortgage Default Crisis, Atif Mian, University of Chicago Graduate School of Business and NBER; Amir Sufi, University of Chicago Graduate School of Business, 2008.