Thursday, September 13, 2007

Prepayment Penalties and Bologna Sandwiches

by Tanta on 9/13/2007 08:20:00 AM

The NYT has an article on prepayment penalties this morning, that almost but not quite arrives at the core issue:

The lenders say the trade-off is the only way to offer low monthly payments initially because otherwise borrowers would flee when rates adjust upward and make the loan a losing deal. The fees usually equal several months’ interest, and they decline over a few years before disappearing altogether.
The "traditional" prepayment penalty is, indeed, a way of putting an "exercise price" on the "imbedded call" in a mortgage loan. A mortgage borrower always has the right to prepay the loan (in options lingo, that's a "call"). Without a prepayment penalty, the price of that call is always par: you may refinance at any time by paying the lender just the principal due (and any accrued interest to the payoff date).

A prepayment penalty, in essence, forces you to "buy" your loan from the original lender at an above-par price. Looking at it in terms of yield, which is more a more everyday way of going at it, the prepayment penalty collects the interest that the lender gave up by making the loan at an originally discounted interest rate. If you "survive" the prepayment penalty period, the discount is in your pocket; if you don't, the lender is "reimbursed" for the discount out of the penalty interest. You give up mobility in return for lower interest costs. Is the theory.

In an environment of "traditional" underwriting in which people actually qualify for the loans they get, prepayment penalties can certainly be construed as "fair" (assuming they're fully disclosed and the penalty is no more than the value of the initial discount). The problem we have here is that the "discount" is a teaser: it crosses the line from "initial rate break" to "hook," as qualifying on the teaser rate is the only way the borrower can get the loan. Then it becomes just "back-loaded" interest payments, because these loans are structured to either force the borrower to refinance (and pay the penalty) to avoid the way above market reset, or to pay the way above market reset, which quickly "erases" the initial discount. That's some "call option."

The Nontraditional Mortgage Guidance, insofar as it put paid to qualifying borrowers at anything other than the fully-indexed, fully-amortizing loan payment, has already indirectly cut out most toxic prepayment penalties, since it takes away the incentive to artificially discount the start rate of the loan. Indeed, the 2/28 expired as a product not all that long after widespread adoption of the Guidance. From a certain perspective, this does, exactly, mean what all the industry lobbyists so plaintively warned us it would mean: the cost of mortgage credit went up in response to regulatory action.

But it is always worthwhile to look at it from another perspective, which is that the cost of mortgage credit just got smoothed out, not increased: borrowers are now paying their interest load from the beginning, at a tolerable level, rather than paying it "at the back of the loan" in a way that breaks the borrower's back. Insofar as it is still "unaffordable" to get a mortgage loan, we can return to the subject of insane home prices and lagging incomes.

We close, as does the Times article, with words of wisdom from a mortgage broker:
That is what happened to Dorinda Weisman, a social worker in Elk Grove, Calif. In 2005 she borrowed $353,000 from Pacific American Mortgage to buy a home in Sacramento with a small down payment. The prepayment penalty, of $9,000, expired in just a year.

“One of the things I always wanted was to own a house,” Ms. Weisman said in a telephone interview. “I was a single parent, and my son is a hemophiliac. I had been living in a middle-class African-American neighborhood that went downhill after the drugs came in.”

By the time the penalty expired, her house had declined in value. Refinancing was no longer possible.

Her interest rate had shot up to 9.8 percent from 4.75 percent. She says about 85 percent of what she brings home — her salary is $60,000 as a social service consultant with the state government — now goes to the mortgage.

She is trying to negotiate a new loan with the help of the Neighborhood Assistance Corporation of America, a nonprofit home ownership organization based in Jamaica Plain, Mass.

“Like a lot of people, the adjustable ate up her equity,“ said her mortgage broker, Antonio Cook of Toneco Financial. “She’s got to ride it out and sacrifice. I tell people, ‘I don’t care if you eat bologna sandwiches, just pay your bills on time.’ If she can ride it out, things start coming up good.”