Subprime Borrowers
A little earlier today James posted on the problems that subprime lenders are experiencing and there was a comment on that post to the effect that people who bought older homes were more likely to be “subprime borrowers” than those who bought “McMansions” and that got me to thinking. That’s not my intuition.
My intuition is that the phenomenon of the subprime loan is related to the rapid rise in housing prices that haven’t been matched by comparable rises in money wages. The implication is that people are paying a lot more of their incomes in mortgage payments than once they did. That, in turn, would be more prevalent in parts of the country where there’s been more speculative price increases than in areas that have experienced less of a bubble. More where you are than who you are.
So, here are my questions:
- Who are the people taking out subprime loans?
- What kinds of houses are they buying with them?
I don’t have any answers to these questions but I’m starting to research them. Any suggestions would be greatfully received.
UPDATE (James Joyner): Arnold Kling weighs in: “My guess is that the typical defaulter today is not some prudent individual who happened to buy a home that strains his paycheck. Instead, my guess is that the typical defaulter is somebody who is poor at managing spending and credit.”
Subprime borrowers run the gamat of homeowners – from those who can afford a conventional loan but chose to save money up front on the payments, to those who do not qualify for a conventional loan.
The mistake is in thinking that all sub prime loans are made to sub prime borrowers. This is not the case. It makes perfectly good sense for a solid income earner to take a lower payment loan even though a conventional loan is affordable.
This can be a problem if the loan resets and their income drops. But there is little reason to think this will be a widespread problem.
I haven’t noticed that prices for older homes in areas like G’town or Capitol Hill going to subprime borrowers. But as ken’s comment suggests, unless we get to see the loan agreement, there’s no real telling.
Or maybe ‘older homes’ isn’t the right term for houses in historic districts?
My point, BTW, is that credit-worthiness doesn’t necessarily correlate with income or indebtedness but with how much debt you’re qualified to take on. Even if my income is $250,000 a year I’d still be a larger risk if I attempted to buy a $20,000,000 house.
My experience in northern Virginia (1992-2005) was that many of the “house flippers” used the subprimes extensively.
Also, the crazy salaries offered in the tech field in the late 90s had people buying far more house than they could afford.
Sub prime loans are like weapons. They can be useful, but a lot of bad people use them for nefarious purposes.
I am mortgage broker (for 7 years). Sub primes have been sold like credit cards (only a sucker wouldn’t take advantage of money this cheap). They can be useful to a borrower that has decent credit, but might have an old car loan or credit card debt that went bad. Sub prime loans generally give someone a second chance without having to pay off old debts and having to save up a ton of money.
But, in our culture today, you can’t tell anyone they can’t do something or shouldn’t do something (buy a house without having a solid financial foundation), because there are plenty of other brokers who are able and willing to fulfill a home buyer’s desire to own a house, consequences be damned. Realtors work with mortgage brokers that get their transactions closed. Nobody wants to believe or hear that sometimes buying a house or refinancing is a bad idea.
There is plenty of fraud, too. It comes from the originators, buyers, Realtors, lending companies, etc. The sub prime mortgage industry is really a reflection of modern culture, you don’t have to pay any dues and you don’t have to clean up any of your old messes to get what you want.
I sound like a grumpy old man.
Sub-prime mortgages can be used by some-to-many as just one more tool. For instance. I have a colleague who is from Romania. She and her husband separated after she’d been here on tenure-track only one year and were divorced in another. She wanted a place for her and her small daughter.
She got a decent 1200sqft with full basement ranch for just under 1888K (after some hard bargaining) in our area where the median housing price was closer to 235K and McMansions were going up and selling like hotcakes.
By getting an 80-20 wrap-around with the 80 at +.5 points, she had less than $1200 dollars out of pocket. She went from paying $950/mo for a 900sqft rental to a decent house for not much more. After 3 more years and gaining tenure, she has snagged a traditional 30-yr at 5.75, she has finished the basement, and her house is in a decent market and worth at least 30K more than she paid for it.
She just used a (technically) sub-prime loan for leverage and timing.
Two points. First, the D.C. market hasn’t exactly fallen apart. In the real hotspots, it has, as well as in the marginal good communities at the edge of the commuter belt. Prices in Waldorf are dropping like stones, for instance, probably because it handled a lot of overflow of middle class buyers who traded a 70 minute commute for a house they could afford to buy, but they can now afford to buy a little closer in. Prices in other solid communities, like Cheverly or Crofton, haven’t dropped all that much. Yet prices in Laurel, in between the two, have plummeted. Marlboro has dropped hard, yet Bowie has only dropped a little bit. So it’s neighborhood by neighborhood, with slight (less than 10% drops or stalls) in some places, and closer to 25% drops in other areas.
As for the mortgages – Ric Edelman is on WMAL on Saturday mornings and said about ARMs and novel mortgage schemes, that for some people with a good degree of financial sophistication they make a lot of sense on a short term basis, but generally, most people should look at the 30 year fixed. He also said that if a 30 year fixed isn’t affordable, it’s the market’s way of telling you that you really can’t afford the house you want to buy. That sounds like good advice to me – I can’t imagine going $100k under water on a $500k ARM.
My wife and I bought about 4 months ago in the D.C. area. We feel fortunate about the bubble bursting, it let us actually buy a house and it turns out after taxes, it is about as affordable as the rent we were paying. We don’t care if we don’t build a lot of equity in the next 2-3 years, we aren’t looking to flip, we’re just looking for a place to build equity long term. And yes, we got a 30 year fixed on a first time buyer’s program. Thanks Wachovia! As first time buyers carrying a lot of professional school debt the lenders were tossing tons of subprime offers at us and we weren’t going to do that for all the reasons you could imagine. It’s hard to say how the real estate market is going to do in the short term. Long term it will be fine, it almost always is. It seems to me a lot of the hysteria comes from the amateur capitalists who were trying to make a quick buck. There’s no such thing as easy money, most of the time, and the sound of their expectations shattering seems to be deafening in the market…
I agree with charles to an extent, I am a mortgage broker/banker ( as a banker you can do both ) an for the past several years, dude to the vast amount of new mortgage financing options available, you’d have had to be insane not to take advantage as a consumer.
Virtually anyone with a halfway decent credit score ( sometimes 580 or even lower ) and a job , or not, could get into a wonderful high priced home for ( initially at least ) the same amount of money you’d pay renting decent apartment, often with little or no money down the product variety and more importantly, the reckless underwriting policies of the B/C lenders had led to people obtaining mortgages they really shouldn’t have, not thru fraud as charles suggests ( although there’s plenty of that, as well ) but thru a laxening of guidelines to prevent exactly what it happening.
Sort of like a financial don’t ask don’t tell policy.
The problem is, a lot of these short term adjustable mortgages tend to well, ADJUST, and usually upwards, so a lot these people with year and a half old mortgages find themselves defaulting, and with little or no incentive to stick it out, since they really never put any down payment money at risk in the first place. It makes more sense to walk away.
This in itself, is sad, but from a lender’s perspective, the past 6-7 years have spoiled everyone, because in this scenario historically, you’d just foreclose on the house and sell it for more than you are owed, because values increased incredibly, in other words, bad lending mistakes were offset by rising market values..no one ever had to pay the piper.
now that house values are stagnant or even falling, ( and that’s true in NYC too, there’s been a 5-10 % drop across the board, and it looks to continue, it’s bargain time )
those foreclosure sales are resulting in huge losses. This type of thing could rebound quickly, or worsen dramatically, depending on what new and existing housing sales do, I do see you’ll see a swing back to both conventional and FHA as the B/C lenders pull risky product and start seriously reviewing appraisal values.
Subprime is a useful focus, but you might find it useful to also review the rest of the lending spectrum.
Dangerous, non-traditional mortgage products were extended to large numbers of borrowers not classed as subprime.
That’s why subprime statistics — for instance, the percentage subprime represents of total mortgages, or the portion of subprime instruments at risk of default — are misleading indicators of the overall threat.
Risky borrowing isn’t confined to first-time or move-up buyers. Plenty of people who owned their homes outright or had substantial equity built up are now skating on thin ice due to having tapped that equity.
Further, current trends are an insufficient guide to the future. When resetting interest rates, foreclosures and falling home prices begin to create secondary, self-reinforcing economic impacts (i.e. job losses, reduced consumer spending, consumer debt defaults, etc) the ripple effects will bounce back to accelerate the downward spiral.
Sub-primes are alot like custom derivative products that try to guarantee LIBOR + x. It makes a great deal of sense if you’re a private client with a large, illiquid, volatile stake in a private company that makes most of your money, but isn’t too great of an idea when it has been devolved into a mass-market wrap account that “guarantees” your principal.
Retail financial products are ALWAYS mis-sold. That’s the one assured thing in finance besides taxes.
There are lots of great reasons to get buy and sell a sub-prime, option arm, or whatever… but they should be really, really rare. That they are very, very common… well New Century and HSBC show what comes from that.
I am a real estate appraiser in California.
The problem isn’t only in Sub Prime. Its also in what are called Alt-A loans and in fact the entire mortgage industry.
In my opinion, the loan programs are not the problem, people are.
Brokers always apply pressure to appraisers to make deals. If you can’t make the value, they find someone that can.
When values were rising, doing your job in the mortgage industry is easy. But most mortgage brokers, underwriters and appraisers have never worked in a “down market”.
I do mostly review work, reviewing other people’s appraisals for lenders, typically banks. More often than not, the home is over valued. Sometimes, grossly over valued. What is most scary to me is that after I determine the appraisal has over valued the home, I receive an amazing amount of abuse. What is shocking is that much of the abuse comes from my client, the lender. To them, no deal is a bad deal and they will twist my arm to make it work. The broker twists the appraisers arm on the front end, the lender on the back end.
I am in essence the firewall, yet my own client often over rules me and makes these loans and 6-9 months later, the file comes back to me…in foreclosure.
I’m not an economist, but it seems to be that there is a direct correlation between the explosion in subprime loans and the ability for the people who SELL the loans to offload their risk onto someone else.
Here’s how the market in loans seems to the layperson to operate:
1) I sell a “crap loan” (defined as a loan to someone who can’t possibly pay it back if the interest rate goes up more than .25% a year.)
2) I earn a nice fat commission
3) Those loans are then packaged up together and sold to someone else, who assumes the repayment risk.
Where exactly is my incentive to ensure that the loan I sold can be repaid? I’m not in the “banking” business, I’m in the “sales” business.
This has negative effects. In order to keep those loans from going bad en masse, the government must supply to the market a constant source of low-wage earners.
Huh?
Well, yes. You see, the only way to control the interest rate on sub-prime adjustable rate mortgages is to keep wages stagnate, thus keeping prices stagnate and inflation in check. The only way to keep wages stagnate is to keep pumping into the market new, lower-paid labor.
Since Americans are no longer having children thanks to the demographic effect of the baby-boom aging, there’s only one place to get new fresh low-cost labor … Mexico.
Seems like a never ending cycle, doesn’t it? In fact, it’s probably worse – it’s probably a feedback loop guaranteed to cause the market to pop one day if say … gas prices rise so fast that inflation rises despite the labor market mix.
So, how to change the incentives?
1) Require mortgage brokers to KEEP some percentage of the loans they originate for the life of the loan (thus, ensuring they assume some risk.) Naturally, the brokers would try to keep the “best” loans for themselves, but this would bottom out the market for the “worst” loans and change behavior as the brokers quickly find there would be no market for their “worst” loans.
Anonymouscoward,
Mortgage Brokers are on the hook (somewhat) for a couple of years. They can be made to buy back loans that go bad. That is actually what is happening to the sub prime lenders. They are having to buy back loans from investors on Wall Street and don’t have the capital to do it.
Start with transcripts of every congressional hearing reqarding a merger in the financial services industry where you will find endless complaints regarding funding of “underserved areas” and complaints by community activists regarding “redlining” and “discrimination”. If the borrower were capable of paying the loan when he bought, he still is since jobs and incomes are up, one caveat his helpers in government have raised his property tax 60% this decade. Loan balance hasn’t changed. Kinky loans were the only way the victims of governmental blackmail could reach their outreach “goals”. Guess what happened? What the panderers in government called “redlining” was credit analysis. Practical suggestion, do a geographical analysis by neighborhood, then look at 2000 census.
As somebody that needed to get a sub-prime mortgage, my evidence is anecdotal, but I suspect others fit into this category.
I had credit issues about 4-5 years ago. Some of which still haunts me on my credit report and as such, my scores. Though the last 3-4 years have been fine, and things got better, it still put me in the sub-prime market. Thankfully, working with our mortgage broker, my wife and I were able to purchase a house for about $186K (3BR, 2BA, 2 car garage and around 1700sq feet of space – I live in Palm Coast, Florida). The higher mortgage payment as opposed to rent is being offset by tax breaks, and in another year and half, we’ll refinance and lower our payment with a 30 year fixed which will bring us to around where that rent payment was.
Thankfully, a good friend of mine who is a real estate agent stopped me from doing what others were suggesting I do which was to file bankruptcy to clear up those old debts instead of trying to pay them slowly. He put me together with his mortgage broker and I couldn’t believe my ears when he told me that I would be able to buy a home. The thing was, he told us up front that it would be sub-prime and that for the first couple of years, it would be some work making those payments, but he said to continue to work on my credit until that time and we’d be ready to re-finance.
Luckily for me, while I live in an area that has enjoyed tremendous growth and and the real estate market boomed, it’s still lower than the US average or even the rest of the state. The same house I purchased would cost close to $300K in say, Boca Raton.
Mr. Schuler: The short answer to your question is that no one where these loans are, but the question is somewhat beside the point. The economy can handle the meltdown of subprime (because of the way the risk is spread). The current risk is, and what is not known, is the extent to which the housing market will be further affected by subprime fallout, and whether this was set into motion a cycle of defaults, foreclosures and lower home prices that can’t be stopped.
I was a kid when it happened in Texas in the 80’s, but the reason for the meltdown in RE then was due to several factors. The types of loans had graduated payments (smaller payment for first few years on the theory as you advanced in your career your pay would increase), second interest rates were ridiculously high (by today’s standards), Oil went bust so there was a big change in employment rates here, and finally as people lost jobs (and quit making mortgage payments) home values went down and graduated mortgage payments kept going up, it truly did not make financial sense to keep paying for a home. It was like buying a really expensive car. The conditions are not like that exactly (at least here) now, because we have not had the insane appreciation that the coasts have.
I am sure that every house that was foreclosed in the 80’s has been re-sold at least once or twice since then. Some of these lenders will take it in the shorts and there should be a new wave of affordable housing on the market in the next few years. Hopefully we can get back to realistic expectations when it comes to buying a house. (Generally they don’t appreciate 20% a year, every year and if you shouldn’t buy a house somebody will tell you and help you get in a better position to do so, when it makes sense).
To clarify, the reason that the lack of insane appreciation is good, is so that there’s not much to give back when appreciation rates level out or even dip.
Most the flippers have successfully resold their units and paid off their loans or have rented them at a rate that covers most of their carrying costs. Some amateur flippers overpaid and then held on too long listing the property at too high a price and are now having trouble making their payments. Most of them could refinance or pay down their loans but they won’t because it’s just an investment to them, not a home. These are the units headed for foreclosure.
The people living in their units are doing fine, with interest rates still quite low their total payment after tax deductions similar to the cost of renting. If there’s appreciation at the rate of inflation over the time they own their home and they own it for three or four years they will come out far better off than they would have been renting.
100% financing and graduated payments are a boon for young people and for those who need to start over for some reason or another. They are technically only available for primary residences. The lenders routinely allowed people to lie and say they were buying a home when they were buying an investment. It would be a shame to lose a useful financial instrument because it has been abused.
I think if people who lied on their loan applications were held personally liable for the deficit on resale following the foreclosure, foreclosures (already well below 1/2 of 1% of mortgages) would sink to nearly nothing. Only the nasty divorces and those truly unable to pay would be left.
I’m not really trying to hijack this thread to talk about a different topic, but subprime lending it seems to me is directly related to illegal immigration.
Apropos … today’s story in the Boston Globe. Here’s what Alan Greenspan says the United States needs to do:
“Allowing more skilled workers into the country would bring down the salaries of top earners in the United States, easing tensions over the mounting wage gap, Greenspan said.
“Our skilled wages are higher than anywhere in the world,” he said. “If we open up a significant [immigration] window for skilled workers, that would suppress the skilled-wage level and end the concentration of income.”
Let me put that in terms you non-economists can understand.
Greenspan wants to “bring down salaries” by flooding the job market with cheap low-wage workers, so that your employer can give your job to someone who will do it for less.
Greenspan thinks you earn too much money. His solution to that problem is to increase immigration.
(The politician’s solution: just don’t enforce immigration laws – that way, when the political pressure to get rid of the immigrants grows to the point where politicians are threatened, they can just begin enforcement again.)
Greenspan wants to allow more workers who will do your job for less than you will into the country. This is the Republican strategy on immigration.
It leads DIRECTLY to subprime lending abuses, as these less-savvy new potential homeowners flood into the country to take away jobs from higher wage earners.
This just leads the higher-wage earners into housing unaffordability and bankruptcy as their incomes can no longer keep up with rising interest rates.
Who raises interest rates?
Why, Alan Greenspan (and his successors over at the Federal Reserve.
What a coincidence, huh?
OK all you theorists – anonymousecoward wins the prize.
There is a direct correlation between subprime foreclosures and illegal aliens All the rest of you experts need to stop watching TV or reading the Post.
Dig a little deeper and you will see that not many subprimes are going to flippers and boomers cashing out to get a new Volvo – they are going to minorities, and in the last few years mostly to Hispanics. Illegals are now allowed loans with only a taxpayer ID number (ITIN) and enough names added to the mortgage to qualify for the loan. Now that the balloons are coming due they can’t afford the higher rates, the prepayment penalties to re-fi, or the negative equity that drive home value below mortgage balance.
So they walk away – as illegals they don’t worry about credit ratings.
This is being repressed for now until amnesty is passed. It will come out when Congress investigates this next savings & loan scandal in about a year.