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Monday, August 11, 2008

Reflections on Alt-A

by Tanta on 8/11/2008 03:30:00 PM

Since for media and headline purposes "Alt-A" is the new subprime--the most recent formerly-obscure mortgage lending inside-baseball term to become a part of every casual news consumer's working vocabulary--it seems like a good time to pause for some reflection on what the term might mean. Much of this exercise will be merely for archival purposes, as "Alt-A" is now pretty much officially dead as a product offering and is highly unlikely to return as "Alt-A." Eventually, after the bust works itself out and the economy leaves recession and the bankers crawl out from under their desks and stretch out those limbs that have been cramped into the fetal position, a kind of "not quite quite" lending will certainly return. I am in no way suggesting that the mortgage business has entered the Straight and Narrow Path and is going to stay on it forever because we have Learned Our Lessons. Credit cycles--not to mention institutional memories and economies like ours--don't work that way. It's just that whatever loosened lending re-emerges apr├Ęs le deluge will not be called "Alt-A."


Subprime will eventually come back, too. The difference is that it will come back--in some modified form--called "subprime." That term is too old, too familiar, too, well, plain to ever go away, I suspect. "Subprime" is a term invented by wonky credit analysts, not marketing departments. It is not catchy. It is not flattering nor is it euphemistic. You may console yourself if your children "have special needs" rather than "are academically below average." If you get a subprime loan, you may console yourself that you got some money from some lender, but you can't avoid the discomfort of having been labelled below-grade.

Actually, the term "B&C Lending" used to be quite popular for what we now universally refer to as "subprime." (It was also called "subprime" in those days, too. We didn't have to pick one term because nobody in the media was paying any attention to us back then and there were no blogs and even if there had been blogs if you had suggested that a blog would generate advertising revenue by talking about the nitty-gritty of the mortgage business you would have been involuntarily institutionalized.) In mortgages as in meat, "prime" meant a letter grade of A. These were the pre-FICO days, when "credit quality" was determined by fitting loans into a matrix involving a host of factors--whether you paid your bills on time, how much you owed, whether you had ever experienced a bankruptcy or a foreclosure or a collection or charge-off, etc. "B&C lending" encompassed the then-allowable range of sub-prime loans that could be made in the respectable or marginally respectable mortgage business. It was always possible to find a "D" borrower, but that was strictly in the "hard money" business: private rather than institutional lenders, interest rates that would make Vinny the Loan Shark green with envy. "F" was simply a borrower no one--not even the hard-money lenders--would lend to.

As in the academic world, of course, there was always the problem of grade inflation and too many fine distinctions. You had your "A Minus," which is actually the term Freddie Mac settled on back in the late 90s for its first foray into the higher reaches of subprime. Discussing the difference between "A Minus" and "B Plus" was just one of those otiose pastimes weary mortgage bankers got into over drinks at the hotel bar when the conversational possibilities of angels dancing on the head of a pin or whether "down payment" was one word or two had been exhausted. More or less everyone agreed that there wasn't but a tiny smidgen of difference between the two, except that "A Minus" sounded better. Same with the term "near prime," which wasn't uncommon but never became as popular as "A Minus." "Near prime" is also "near subprime." "A Minus" completed the illusion that it was nearer the A than the B, even if the distances involved were sometimes hard to see with the naked eye.

But all of that grading and labelling was still basically limited to considerations of the credit quality of the borrower, understood to mean the borrower's past history of handing debt. Residential mortgage lending never, of course, limited itself to considering creditworthiness; we always had "Three C's": creditworthiness, capacity, and collateral. "Capacity" meant establishing that the borrower had sufficient current income or other assets to carry the debt payments. "Collateral" meant establishing that the house was worth at least the loan amount--that it fully secured the debt. It was universally considered that these three things, the C's, were analytically and practically separable.

That, I think, is very hard for people today to understand. The major accomplishment of last five to eight years, mortgage-lendingwise, has been to entirely erase the C distinctions and in fact to mostly conflate them. For the last couple of years, for instance, you would routinely read in the papers that "subprime" meant loans made to low-income people. Or it meant loans made to people who couldn't make a down payment or who borrowed more than the value of their property--that is, whose loans were very likely to be under-collateralized. This kind of characterization of subprime always struck us old-timer insiders as bizarre, but it seems to have made sense to the rest of the world and it stuck. After all, the media didn't really care about or even notice this thing called "subprime" until it began to be obvious that it was going to end really really badly. It therefore seemed perfectly obvious to a lot of folks that it must primarily involve poor people who borrow too much.

Those of us who were there at the time tend to remember this differently. In the old model of the Three C's, a loan had to meet minimum requirements for each C in order to get made. We didn't do two out of three. The only lenders who ever did one out of three were precisely those "hard money" lenders, who cared only about the value of the collateral. This was because they mostly planned on repossessing it. Institutional lenders' business plan still involved making your money by getting paid back in dollars for the loans you made, not by taking title to real estate and selling it.

The difference between a prime and a subprime lender was simply how low you set the bar for one of the C's, creditworthiness. Unless you were a hard-money lender, you expected to be paid back, so you never lowered the bar on capacity: everybody had to have some source of cash flow to make loan payments with. Traditional institutional subprime mortgage lenders were even more anal-compulsive about collateral than prime lenders were, a fact that probably surprises most people. Until very recently, historically speaking, institutional subprime lending involved very low LTVs and probably the lowest rate of appraisal fraud or foolishness in the business.

That isn't so surprising if you think about the concept of "risk layering," which is also an industry term. In days gone by, with the three C's, you didn't "layer" risk. If the creditworthiness grade was less than "A," then the capacity grade and the collateral grade had to be "summa cum laude" in order to balance the loan risk. It wasn't until well into the bubble years that anybody seriously put forth the idea that you could make a loan that got a "B" on credit and a "B" on capacity and a "B" on collateral and expect not to lose money.

Of course there has always been a connection between creditworthiness and capacity. Most Americans will pay back their debts as agreed unless they experience a loss of income. People rack up "B&C" credit histories most commonly after they have been laid off, fired, disabled, divorced, or just generally lost income. But this was true at any original income level: upper-middle-class people can lose income and become "B&C" credits. Lower-income folks may well be most vulnerable to income loss--first fired, first "globalized"--but then lower-income folks until recently had smaller debts to pay back out of reduced income, too. What is so dishonest about the association of "subprime" and "poor people" is that it simply erases the fact that a lot of rich people have terrible credit histories and a lot of poor people have never even used credit. The "classic" subprime borrower is Donald Trump as much as it is "Joe Sixpack."

Traditional subprime lending was what you might think of as "recovery" lending. That is, while the borrower's past credit problems were due to some interruption in income or catastrophic loss of cash assets with which to service existing debts, the subprime lenders didn't enter your picture until you had re-established some income. If you want to know what a "D" or "F" borrower was, it was basically someone still in the financial crisis--still unemployed, still underemployed, still unable to work. "B" and "C" borrowers had resumed income, but they still had a fresh pile of bad things on their credit reports--charge-offs, collections, bankruptcies. Prime lenders wouldn't make loans to these borrowers because even though they had resumed capacity, their recent credit history was too poor. Prime lenders want to you "re-establish" your credit history as well as your income, which pretty much means that those nasty credit events have to be several years old, on average, without recurrence in the most recent years, before you can be an "A" again. Absent subprime lenders, that means going without credit for those years.

This is where the idea came from--much promoted by subprime lenders during the boom--that subprime loans were intended to be fairly short-term kinds of financing that helped a borrower "re-establish" his or her creditworthiness. The whole rationale for the famous 2/28 ARM was that after two years of good payment history on that loan, the borrower could refinance into a prime loan and thus never have to pay the "exploding" interest rate at reset. (If you didn't keep up with the payments in the first two years, you were thus "still subprime" and deserved to pay that higher rate.) That was a perfectly fine rationale as long as subprime lenders used rational capacity and collateral requirements--reasonable DTIs during the early years of the loan, low LTVs--to make those loans. When all the "risk layering" started, it was less and less plausible that these borrowers would ever "become prime" in two years by making on-time mortgage payments, and what we got was a class of permanent subprime borrowers who survived by serial refinancing, each time into a lower "grade" loan product, until the final step of foreclosure.

You're probably still wondering what all this has to do with Alt-A. Alt-A is sort of a weird mirror-image of subprime lending. If subprime was traditionally about borrowers with good capacity and collateral but bad credit history, Alt-A was about borrowers with a good credit history but pretty iffy capacity and collateral. That is to say, while subprime makes some amount of sense, Alt-A never made any sense. It is a child of the bubble.

"Classic" subprime lending worked because, while it always charged borrowers a higher interest rate, it found a way to restructure payments such that the borrower's overall prospects for making regular payments improved. A classic "C" loan, for instance, was also called a "pre-foreclosure takeout." The borrower had had a period of reduced or no income, got seriously behind on her mortgage payment, and was facing loss of the house. Even though income had resumed, it wasn't enough to make up the arrearage while also making currently-due payments. So the subprime lender would refinance the loan, rolling the arrearage into the new loan amount, and offset the higher rate and larger balance with a longer term or some kind of "ramping up" structure. The "ramp-up," by the way, was not, historically, mostly by using ARMs. There were all kinds of old-fashioned exotic mortgages that you don't hear about any more, like the Graduated Payment Mortgage and the Step Loan and the Wraparound Mortgage and so on, all of which involved some way of starting off loans with a lower payment that slowly racheted up over three to five years or so into a fully-amortizing payment. It certainly wasn't always successful, but its intent was exactly to enable people to catch up on an arrearage and then actually begin to retire debt.

Alt-A, we are regularly told, is a kind of loan for people with good credit but weak capacity or collateral. It overwhelmingly involved the kind of "affordability product" like ARMs and interest only and negative amortization and 40-year or 50-year terms that "ramps" payment streams. But it doesn't do this in order to help anyone "catch up" on arrearages; people with good credit don't have any arrearages. Alt-A was and has always been about maximizing consumption, whether of housing or of all the other consumer goods you can spend "MEW" on. If subprime was supposed to be about taking a bad-credit borrower and working him back into a good-credit borrower, Alt-A was about taking a good-credit borrower and loading him up with enough debt to make him eventually subprime.

The utter fraudulence of the whole idea of Alt-A involves the suggestion that people who have managed debt in the past that was offered to them in the past on conservative "prime" terms must therefore be capable of managing debt in the future that is offered to them on lax terms. FICOs or traditional credit analyses are good predictors of future credit performance, but only if the usual terms of credit-granting are similar in the past and in the future. Think of it this way: subprime borrowers had proven that they couldn't carry 50 pounds, so the subprime lenders found a way to restructure their debts so that they were only carrying 40. Alt-A lenders took a lot of people who had proven they could carry 50 pounds and used that fact to justify adding another 50 pounds to the burden.

This has not worked out well.

The "Alt" in Alt-A is short for "alternative." Alt-A is one of the purest examples of a "new paradigm" thingy you can find. The conceit of Alt-A is that there is another way to approach "prime" lending that is equivalent in risk (assuming risk-based pricing) but--amazing!--way more painless. Toss out verifications of income and assets, and you are no longer evaluating capacity. Toss out down payments and careful formal appraisals and analysis of sales contracts and you are no longer evaluating collateral. But lookit that FICO!

A lot of folks see the failure of Alt-A as a failure of FICO scores. I don't see it that way. FICO scoring is just an automated and much more consistent way of measuring past credit history than sitting around with a ten-page credit report counting up late payments and calculating balance-to-limit ratios and subtracting for collection accounts and all that tedious stuff underwriters used to do with a pencil and legal pad. I have seen no compelling evidence that FICO scoring is any less reliable than the old-fashioned way of "scoring" credit history.

To me, the failure of Alt-A is the failure to represent reality of the view that people who have a track record of successfully managing modest amounts of debt will therefore do fine with very high amounts of debt. Obviously the whole thing was ultimately built on the assumption that house prices would rise forever and there would always be another refi. There was also the assumption that people are emotionally attached to their FICO scores--in more old-fashioned terms, that borrowers care about their "reputation" and don't want to ruin it by defaulting on a loan. The trouble with that assumption was that we were busy building a credit industry in which there was plentiful credit--on easy terms--for people with any FICO, any "reputation." A bad credit history is only a strong deterrent to default when credit is rationed, granted only to those with acceptable reputations, or--as in the case of "classic" subprime--granted only to those with poor reputations but strong capacity and collateral, and at a penalty rate. Unfortunately, the consumer focus (encouraged, of course, by the industry) on monthly payment rather than actual cost of credit meant that for a lot of people the fact of the "penalty rate" just didn't register. In such an environment, the fear of losing your good credit record isn't much of a deterrent to default.

I should point out that besides the "stated income" and no-down junk, the other big segment of the Alt-A pool was "nonstandard" collateral types. One of the biggies in that category were what insiders call "non-warrantable condos." (The warranties in question are the ones the GSEs force you to make when you sell a condo loan; in essence a non-warrantable condo means one the GSEs won't accept.) What was wrong with these condos? Not enough pre-sales. Not enough sales to owner-occupants rather than investors. Inadequately funded HOAs with absurd budgets. Big blocks of units owned by a single entity or individual. In other words, speculator bait. This kind of thing isn't an "alternative" to "A." It is commercial or margin lending masquerading as long-term residential mortgage lending. It may well be "prime" commercial lending. It just isn't residential mortgage lending.

Part of the terrible results of Alt-A lending is that this book took on risks that historically were taken only on the commercial side, where the rates were higher, the cash-flow analysis was better, and the LTVs a lot lower. (Not that commercial real estate lending didn't also have its dumb credit bubble, too.) The thing is, as long as the flipping of speculative purchases worked--and it did for several years--it worked. Meaning, those Alt-A loans prepaid quite quickly with no losses. That masked the reality of Alt-A--that it was largely a way for people to take on more debt than they ever had before--for quite some time.

Of course we all know now--I happen to think a lot of us knew then--that Alt-A is chock-full o' fraud. My point is that even without excessive "stated income" or appraisal fraud, the Alt-A model was essentially doomed. "Alt-A" is the kind of lending you would only do after a real estate bust, not during a real estate boom--that is, when housing costs and thus debt levels are dropping, not rising. Unfortunately, we're going to have a hard time using something like Alt-A to stimulate our way into recovery once the housing market has actually bottomed out, because Alt-A is too implicated in the bust. I don't think anyone is going to be allowed to get away with moving all that REO off their books by making loans on easy terms to someone who managed to maintain a good FICO during the bust, even though that might actually make some sense.

One of the main reasons we are in a mortgage credit crunch is that two possible models of "recovery" lending--subprime and Alt-A--got used up blowing the bubble. I think it will be a long time before lending standards ease significantly, and I think subprime will come back first. But I do suspect we've seen the last of Alt-A for a much longer time.

I want the rest of a VERY long post! And I want it now!