Wednesday, October 24, 2007

Subprime: Winners are Losers, Too

by Tanta on 10/24/2007 06:37:00 PM

We haven't seen that many defenses of subprime lending recently. Long-time readers of the blog will remember a certain vogue earlier this year for the "but subprime helps the poor" schtick, which predictably got less fashionable as the losses racked up.

So it was interesting to see this Barron's column heaving out the old argument in order to scare us all about Barney Frank's proposed subprime mortgage regulation:

Some two million borrowers have taken subprime mortgages in the past few years, of which one-quarter astonishingly may go into foreclosure. That means 1.5 million Americans own homes that they wouldn't likely get to buy under Barney Frank's rules. They are lucky, indeed.
What a ringing defense of the subprime industry: we have to make 500,000 disasters in order to get 1,500,000 successes, and apparently which group you're in is a matter of luck, since tighter standards would have eliminated all 2 million, not just the 500,000. I am curious: do other industries get away with results like that?

Then there's the "strivers" canard:
Immigrant and other minority borrowers would be most likely to be shut out. These strivers often have cash businesses and avail themselves of "no-doc" loans, even though they may have good incomes and assets. Frank's measure would end that.
If there's an interpretation of that claim that isn't "Look, we know that brown people frequently cheat on their taxes, and tax cheats have great cash flow to make loan payments with!", would someone share it with me in the comments?

But this part is my favorite, and I think the key to Forsyth's real discomfort with Frank's proposed legislation:
Legislation introduced by Barney Frank, the Massachusetts Democrat who heads the House Financial Services Committee, would, among other things, permit subprime borrower to sue Wall Street firms that underwrote securities backed by those loans. No matter that Lehman, Merrill Lynch or any their cohorts weren't in the neighborhood when some slick mortgage broker [was?] selling an unsophisticated borrower on a lousy loan, the big Street firms can be deemed an accessory after the fact.
Here's my modest proposal: you should not be allowed to opine on the subject of assignee liability if you do not understand that the definition of a broker (as opposed to a lender) is that a broker has no money to lend. Someone else must supply the money. Assignee liability is a matter of getting clear on who the "lender" really is in the first place. And you should also not use Lehman or Merrill as your example of innocent Wall Street bystanders when two minutes on Google would tell you they both own mortgage originators.

So there's your argument: people with capital to lend cannot be responsible for what kinds of loans get made, because they delegate the process of taking applications to brokers, and nothing that happens after the application is taken matters. This is true because apparently loan success or failure is unpredictable, a sheer matter of luck. That implies that you just have to produce 100 loans, and let God pick out the 75 that are blessed with homeownership. Drag and all about the 25, but as long as you change the disclosures to let everyone know that this is just a casino, the ones who lose can't complain. New motto: Subprime: The odds are better than blackjack!

For what it’s worth, a recent research report from Lehman* just caught my eye. The analysts looked at a pool of subprime ARM loans from older vintages that are current, and have always been current, but have never refinanced out of those old pools. This is a curious phenomenon, since these borrowers are paying very high interest rates (they’re in ARMs that have already adjusted), they didn’t necessarily start with a high CLTV, and in many cases their properties have probably not depreciated that much, or even appreciated at least some, since origination. Why wouldn’t they refi into a cheaper prime loan with a 24-48 month perfect mortgage payment history and a sliver of equity?

The analysis compared the borrowers’ FICO at origination of the loan with the borrower’s current FICO (presumably ordered for account monitoring purposes). Some 40% of subprime loans with a perfect 24-48 month mortgage history have FICOs that are unchanged or have dropped by as much as 75 points since the loan closed. The implication is that a significant number of current borrowers subsidized their mortgage payment shocks with credit cards: the high balance-to-limit or mounting delinquencies on consumer debt is offsetting the positive FICO effect of on-time mortgage payments. This is a recipe for a permanent subprime borrower: someone who “performs” on the mortgage by supplementing income shortfalls with credit card debt, keeping the FICO at a level that precludes ever becoming a prime mortgage borrower.

That should knock the last leg out from under the argument of subprime lenders that they are giving borrowers a chance to “cure” their credit problems. You have to wonder whether these folks would have been given a mortgage in the first place if they had been qualified on the fully-indexed, fully-amortizing payment and documented income; my guess is they probably wouldn’t. In that sense, they'd "lose out" under tighter mortgage regulation.

But they’re trapped: they’ve got some equity they don’t want to walk away from, yet they can maintain the mortgage payment only by racking up unsustainable consumer debt. Eventually they’ll have to sell the property: there’s only so long you can keep making your mortgage payment with a credit card. But in what sense will they then have been "successful" homeowners? They may never have had a mortgage delinquency, and they may have avoided foreclosure, but they still spent years paying too much for too little purpose.

Until we get straight on the idea that there's something wrong with holding a high-risk lottery to see who among first-time homebuyers gets to become middle-class, and that there's something wrong with a situation in which "success" is defined as quitting before you get fired, we're never going to get straight on what has to be done to reform the mortgage industry.

*Akhil Mago, Lehman, "Overview of the Subprime Sector," October 2007 (not available online)