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Sunday, February 08, 2009

Affordability "Products" Lead to Higher Defaults in the O.C.

by Calculated Risk on 2/08/2009 08:10:00 PM

From Mathew Padilla at the O.C. Register: Good O.C. borrowers brought down by bank's bad loans

Even as the housing market began to crack, investment bank Bear Stearns increased its bets on mortgages to Orange County homeowners.

The loans were often to people with good jobs and solid credit. But many borrowers stretched their incomes to buy some of the county’s pricier homes. Now an alarming number of those borrowers are facing foreclosure.
In Orange County, Bear’s borrowers generally had credit scores, known as FICO, above 700 – considered strong during the housing boom.

But by the middle of last year, 12.9 percent of Bear’s loans were in foreclosure. By comparison, subprime loans, which have lower credit scores, had an industry-wide foreclosure rate of 11.8 percent at the time. ... Many of the loans allowed borrowers to provide little or no proof of income, while at the same time delaying payment of interest and sometimes principal too.
These were "good borrowers" in the sense that they had high FICO scores. But they used affordibility products - Option ARMs and stated income loans - to buy overpriced homes in Orange County, California. The lenders forgot the three C's!

This is a good time to reread Tanta's post: Reflections on Alt-A. Here is a brief excerpt:
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.
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.