Tuesday, September 25, 2007

A Clockwork Mortgage

by Tanta on 9/25/2007 10:51:00 AM

I made an idle threat a while ago to write something about the negative convexity of mortgages--and options theory generally--but I haven't gotten around to punishing you all like that. I looks like I should. Exhibit ZZ in my never-ending war on "economist-underwritten loans" showed up this morning, courtesy of our WaitingInOC, and it's a doozy: "Surprise: Toxic Mortgages Are the Best."

This is a summary of an academic paper by professors Tomasz Piskorski and Alexei Tchistyi, the full text of which I don't have. If any of you do and feel the need to forward it on to me, why, go ahead. It has to be more fun than a sharp stick in the eye. What I can glean from the Reuters paraphrase suggests that it's about a massive campaign of borrower re-education designed to convince you that giving up your option to prepay and your fixed rate protection in exchange for a couple of nickels of interest is in your best interest, since investors who suddenly experience positive convexity with MBS--it's like perpetual Christmas morning--will give up all the resulting price gains in rate concessions to you, and interest rate cycles will be repealed. Or something. Remember that I am working with a summary here.

Right now is not the moment for the major UberNerd treatise on convexity, so suffice it to say that the main issue is the imbedded options in mortgage loans. In options theory terms, a mortgage gives the borrower a put (the right to default or "send jingle mail") and call (the right to prepay the mortgage with proceeds of a refinance or any other funds). Although both options have costs--especially if you have a prepayment penalty on your loan--those costs can end up being much lower than the cost of keeping your current mortgage. Because the "strike price" of these options is so heavily dependent on local and national economic conditions, interest rate levels, and home price changes, it is notoriously difficult to predict for any given borrower over any given stated loan maturity.

The lender, on the other hand, is "long a bond, short an option." Mortgages cannot be called or accelerated by the lender, except in case of default. No lender can make you refinance (although loan terms can certainly be created that will make you see that as your best option). If you are given a 30-year fixed rate, the lender must allow you to keep that rate for 30 years, even if it subsequently becomes uneconomic for the lender, as market rates rise and new investments would return more. On the other hand, if market rates drop, you may exercise your right to prepay, which means that the lender loses your old higher-rate mortgage and must reinvest its funds at new, lower market rates.

All this produces some difficulty in valuation of mortgage securities, since mortgages have a tendency to prepay at the worst time for the investor and to extend durations--stay on the books--when prepayments would be best for the investor. The mortgage origination industry--as distinct, here, from the investment community--has a lot at stake in making refinances fast, cheap, and easy, as each new loan is a new fee opportunity. But the lower the option cost of the borrower's "call," the less valuable the loan is to the investor (and servicer). Prepayment penalties have become, basically, an attempt to put the genie back into the bottle.

We think of the ARM mania so much in terms of payment "affordability" that we forget why lenders like them: the idea of an ARM is that, subject to some lags due to adjustment frequency, caps, index volatility, and so on, the ARM is designed to keep "repricing" itself to current market rates. Theoretically--and we are definitely in the realm of theory here--ARMs obviate the borrower's refinance option because a refinance would offer no better rate, as long as the ARM is "at market" at any point in its life and the refi rate is "at market." In the real world, of course, we've created enough "inefficiency" here with teasers, discounts, "lagging" indices, long adjustment intervals, and cap structures to make sure there's still--or there was until recently--plenty of incentive for borrowers with an ARM to refinance. Not coincidentally, we have used the best technology we can buy to make refis fast and cheap in terms of transaction costs, which we're perfectly happy to finance if even low upfront costs bother you.

"Until recently" is a way to speak volumes about the flaw in this plan: the refinance option depends as much on the value of the collateral as on the availability of cheap, easily-obtained mortgage money, and we have a little bit of a problem right now with that. As the LTV rises on a loan, that other option, the borrower's "put," gets a whole lot cheaper for the borrower and more expensive for the lender. Theoretically, the "perfect" loan, for the investor, would be one with no or minimal options for the borrower to call or put, and with a rate adjustment mechanism with very short reset invervals, large caps, and a highly sensitive (not "lagging") index. This ideal loan would prohibit prepayment or make it terribly expensive, and also allow the payment to fluctuate such that borrowers in a bit of an income or expense jam are less tempted to put the thing back in periods of home price declines.

Well then why, you ask, have we not invented this perfect loan? Apparently we're nearly there:

If you had to name the most toxic, dangerous, foolhardy kind of mortgage loan that exists, you'd very likely pick a pay-option ARM, which lets borrowers get deeper into debt by paying less than the minimum interest they owe each month and adding the unpaid interest to the loan principal. Worse yet, you might say, would be a pay-option ARM with a very high penalty for prepayment so borrowers can't get out of it easily once they're in it. There's a move afoot to ban these worst-of-the-worst loans.

Guess what? The worst is actually the best.
It's the best, not the perfect, because even though we've managed to stick the most onerous prepayment penalties on these loans that the law allows, we have yet to find a legal way to extend them to the life of the loan at a high enough penalty rate to make Option ARMs permanent loans. If we did that, you see, these things would be a fabulous deal; we would need only to "educate" borrowers about how giving up options is handsomely repaid in lower interest rates forever, and we're nearly there.
If the optimal loan really is better for homeowners who behave rationally, maybe it makes sense to get people to behave rationally through extensive, even expensive, consumer education. In an interview, Piskorski told me that by his rough calculation, the benefits of the optimal mortgage vs. a conventional mortgage amount to a least half a percentage point of interest -- namely, $50 billion or more a year for the U.S. as a whole. In other words, you could devote many billions of dollars a year to consumer education about these misused-but-potentially-valuable loans and still come out ahead.
Anyone who can determine who "you" is in that last sentence wins a free subscription to Calculated Risk. When dollars are being proposed to be spent, it is always wise to ask whose those dollars are.

And why are Option ARMs, in a perfect world, "optimal" for borrowers?
-- The option to pay less than the minimum monthly interest owed on the loan is valuable for people with good self-control whose income fluctuates a lot. They can pay just a little in lean months and catch up in fat months. It's good for lenders, too, because they don't have to foreclose on people who fall behind, which is an expensive process. People with steady incomes don't need this feature, but having it doesn't hurt them.
We must, of course, leave aside "good self-control," because that will undoubtedly be covered in "our" training program. We will have to content ourselves with asking how, in a perfect world, incomes "fluctuate." In some tight band around a mean to which they revert? In that case, why would you not qualify the borrower at an interest only payment at the "bottom" of the band, allowing for sporadic principal payments when times are "fat," but preventing negative amortization? Perhaps we are really talking about incomes that never quite "fluctuate" up to where they need to in order to retire the debt? And how does this option not hurt people who don't need it, when it comes at the cost of losing the right to prepay and the inflation-protection of a fixed rate?
-- The fact that the loan is an ARM -- namely, its rate fluctuates with market interest rates -- is especially valuable to lenders. This is a subtler notion, but the idea is that if there are going to be a certain number of defaults in a pool of mortgages because of random bits of bad luck like a job loss or a divorce, the lender would prefer that they be concentrated during periods of high interest rates. Why? Because when market interest rates are high, the lender that forecloses and gets back (most of) its money can redeploy the cash in high-yielding alternatives. The lender would prefer not to foreclose and get its money back when rates are low and other options are unattractive. An ARM loan achieves what the lender wants. Borrowers, meanwhile, are neutral about whether they default in periods of high or low market interest rates.
So "lenders" don't want to foreclose because it's expensive, except for the fact that apparently investors would like to see foreclosures happen when rates are high. Whether the additional cost of foreclosure in a high-rate environment doesn't offset reinvestment gains is a good question. All that high past-due interest has to be recouped out of the liquidation of the REO, and there is a theory about connections among RE values, marketing time, and high interest rates, you know.

Similarly I'd like to know why borrowers are "neutral" about default in various rate scenarios. But I am most interested in the idea that lenders wouldn't want to foreclose on an ARM when rates are low. It's, um, an ARM. Why would the rate on a new loan be lower than the rate on an existing ARM, in our perfect frictionless world? If there is in fact some friction here--the ARM rate is still higher than market in this falling rate environment--then where is this "discount" that these consumers got in exchange for giving up the refi option?
-- Finally, the economists say the optimal loan contract would outright ban getting a new loan from a different lender. There are no such bans. But they say that the prepayment penalties that are common in subprime loans are a good second best. How could that be? Because lenders will offer more favorable terms if they know that they'll be able to hang onto the loan long enough for it to be profitable. If they fear that the borrower will refinance at the drop of a hat, they'll give less favorable terms.
OK, guys. What are "more favorable terms" on an ARM? I mean, you do not have to have the cynical response that lenders who know you can never get out of the contract will be motivated to extract as much out of you as possible short of forcing you into foreclosure to wonder where the deal comes in without the offer of a fixed rate.

The problem with those subprime ARMs, of course, is that while the borrowers did get a "discount" on the initial rate in exchange for that prepayment penalty, it is not at all clear to informed observers that it was much of a discount: you have to rule out the possibility of predatory lending, and assume perfect pricing of credit risk, in order to say that no borrower got a "discounted" subprime ARM that involved a higher rate than that borrower would have paid on an undiscounted FHA fixed rate. You also have pretend we haven't been having a major affordability problem with home prices in order to understand rate discounts as something other than "qualification" games, or simply a matter of rate concessions the lender makes solely because the alternative is no loan at all if you have to qualify at a "market" interest rate. A "teaser" is not a simple discount in exchange for a prepayment penalty; it's a means of getting you into a loan you cannot afford, because lenders who do not own the loan forever just want to make lots of loans.

You can, of course, assume anything you want in a "perfect world," but I notice these helpful economists are not proposing a massive educational campaign designed to teach lenders and servicers and investors not to be greedy, sociopathic cretins. We are proposing that "we" spend "our" money to teach "you" to understand that what is in our best interest--all the options on our side, none on yours, except your "option" to get deeper in debt each month--is really in your best interest.
Says Piskorski: "Obviously people are to some extent irrational. But if you want to ban this type of contract, you should really weigh the benefits and the costs. How much could you educate people? Make people understand them. Provide them with software. Make a federal law that requires the lender to reveal what this contract is about."
In other words, we need to keep our toxic products but fire these irrational borrowers, replacing them with some trainees who can be brought to have more rational points of view. I suggest issuing this software with applications for Social Security Numbers; as soon as you begin to work for money, you should begin the process of understanding how to become contributing members of the "free market" by handing over your "pricing power" and behaving the way the rentier class wants you to.

I am not, of course, suggesting that there's no room for improvement in borrower education. I certainly don't think your "refi options" are always more about saving your money than about handing over fees to an industry that loves to "help you out." Nor do I claim that these academics are mere useful tools of the mortgage industry. However, I am reaffirming an old conviction of mine: there is no fruitcake like academic fruitcake.

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