Bacon's Rebellion

Democracy Thrives in Sunlight

Sub-Zero Sympathy for Sub-Prime Speculators

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by

James A. Bacon
in

Gov. Timothy M. Kaine is expected to announce today a plan to regulate high-risk mortgage lenders and staunch the rise in home foreclosures — which the Center for Responsible Lending estimates will number more than 62,000 in Virginia before the mortgage crisis ends. According to the Washington Post:

Lenders who engage in high-risk lending schemes would be required to give borrowers 10 days’ notice of a change in the terms of their loan. The lender also would have to provide contact information for three mortgage counseling agencies. In addition, the lender would be required to grant borrowers who request it a 30-day grace period before starting the foreclosure process.

And what constitutes a “high-risk lending scheme”? According to the Times-Dispatch:

A high-risk mortgage loan covered by the bill would be one whose interest rate exceeds that of U.S. Treasury securities with a similar maturity by 5 percentage points or more or whose upfront points and fees were greater than 7 percent of the total loan amount.

It’s always a sad story when some poor family loses a house and gets dumped on the street. I’m sure that some of those 62,000 foreclosures will be honest, hard-working people who worried that they’d get priced out of the market by ever-escalating home prices if they didn’t jump on board quickly, borrowed more than they really could afford, and ended up losing their shirts. Some few, no doubt, were pressured into taking loans by fast-buck artists who minimized the risks. I feel a measure of compassion for those people. Trouble is, I suspect they account for a relatively small portion of foreclosures here in Virginia.

What do-gooder legislation like Gov. Kaine’s ignores is that many home buyers, whether they planned to live in the house themselves or were simply speculators looking to flip the house for a profit, were motivated by a hope for easy gain from home prices that promised to escalate forever. Many foreclosures result from people walking away from bad bets — from an unwillingness to pay, not an inability to pay.

The legislation also ignores this complexity: Some borrowers wind up losing their houses because they re-financed homes they’d owned for years in order to take out equity, either to spend, pay off other debts, or use otherwise. By taking out equity when houses were appreciating in value, they destroyed the equity cushion that could have tided them over when times turned tough. Just another form of speculation.

A recent study by the Federal Reserve Board of Boston, “Subprime Outcomes: Risky Mortgages, Homeownership Experiences, and Foreclosures,” concludes that, while sub-prime borrowers in Masschusetts are significantly more likely to default on their loans than prime credit borrowers, falling housing prices have played a much a greater role in foreclosures than generally acknowledged.

We present two main findings. First, homeownerships that begin with a subprime purchase mortgage end up in foreclosure almost 20 percent of the time, or more than 6 times as often as experiences that begin with prime purchase mortgages. Second, house price appreciation plays a dominant role in generating foreclosures. In fact, we attribute most of the dramatic rise in Massachusetts foreclosures during 2006 and 2007 to the decline in house prices that began in the summer of 2005.

My mother was smart enough to see the real estate bubble coming in south Florida and sold out her condominium near the top of the market. A young, professional woman purchased the unit from her. Not to live in, but to speculate with. She’d pocketed handsome sums from previous speculations and was expanding her holdings. The market soon turned south, and I wouldn’t be surprised if her properties were foreclosed upon. I don’t bear the woman any personal animus, but I have absolutely zero sympathy for any misfortune she might have suffered — indeed, I might describe my sentiment as sub-zero sympathy, as in, she got was was coming to her if she was forced to foreclose.

Americans are a compassionate people, and we feel the pain of people who have fallen upon hard times. But when government steps in to ease their plight, people learn the wrong lesson: Instead of gaining a healthy respect for taking risk, they expect government to come to their aid. We have become a nation that privatizes profit but socializes loss. That can lead only to riskier and self-destructive behavior. We Virginians should not encourage excessive speculation in any way.

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  1. Larry Gross Avatar
    Larry Gross

    Here’s a pretty succinct Post Mortem that shows clearly that changing Government Policies played a big role; those relaxed policies are what incentivized lenders to engage in predatory practices:

    “The Community Reinvestment Act of 1977 and later liberalization of regulations gave lenders strong incentive to loan money to low-income borrowers. The Deregulation and Monetary Control Act of 1980 enabled lenders to charge higher interest rates to borrowers with low credit scores. Then, the Alternative Mortgage Transaction Parity Act, passed in 1982, enabled the use of variable-rate loans and balloon payments. Finally, the Tax Reform Act of 1986 eliminated the interest deduction for consumer loans, but kept the mortgage interest deduction. These acts set the onslaught of subprime lending in motion. (To learn more, read The Mortgage Interest Tax Deduction.)

    Over time, businesses adapted to this changing environment, and subprime lending expansion began in earnest. While subprime loans are available for a variety of purchases, mortgages are the big-ticket items for most consumers, so an increase in subprime lending naturally gravitated toward the mortgage market. According to statistics released by the Federal Reserve Board in 2004, from 1994 to 2003, subprime lending increased at a rate of 25% per year, making it the fastest growing segment of the U.S. mortgage industry. Furthermore, the Federal Reserve Board cites the growth as a “nearly ten-fold increase in just nine years.”

    http://www.investopedia.com/articles/basics/07/subprime_basics.asp

  2. Anonymous Avatar
    Anonymous

    I think you have portayed an accurate picture of the situation. Some people have to reach harder to get their homes, and they are more risky to lend to. Lenders compensate for that by charging higher rates (which, unfortunately also increase the risk).

    But, just as one low rice stock sale reprices an entire company, one distressed house sale reprices the entire neighborhood. This means that some home sales that were marginal are no longer viable, through no fault of the people living there or making the payments.

    We are compassionate enough to want to help these people (and it also prevents OUR homes from depreciating further if we can help break the chain reaction.

    But, we are smart enough to see that some of these bailout plans, though marketed as being for the homeower, are really bailouts for the banks that overextended themselves on making risky loans.

    We find ourselves in a dichotomy in which the federal government encourages home ownership, and local government discourages it. Local policies result in higher home prices and ultimately, more risky loans.

    The Feds, through various programs and policies have long invested in increasing howm ownership, and successfully so. The Feds, at least, now have an interest in seeing that their prior investments don’t go south along with the current housing slump. If we think that investors should take
    responsibility when their investments go south, then we should remember to include the Feds in that category.

    Blanket bailouts would be a bad thing for the reasons you mention, but that doesn’t mean there are not some programs that might work well for all concerned, including those with conservative loans on whihc they have promptly made payments for years or decades.

    We now hear calls for some kind of test to restrict the riskiest kinds of loans, but we should also remember that banks have been encouraged to make more risky loans for community redevelopment purposes.

    Also, concerning those with an unwillingness to pay vs an inability to pay, they may find that recent changes in the bankrupcy laws make it harder to walk away than they think.

    Larry’s insistence that the mortgage interest deduction has much to do with this is mostly wrong. For one thing, many working class borrowers don’t make enough money to itemize their deductions.

    To be sure, government policies he mention did increase lending and home ownership. That was their purpose, and in that they succeeded admirably. Even after we subtract out the wave of forclosures, more people will have succeded in owning homes.

    For some people and circumstances variable rates and balloon payments make perfectly good sense with acceptable risk. there is nothing fundamentally wrong with allowing these.

    But, as Larry points out, the lenders overreacted and got greedy. Lets not take it out on the borrowers, or the policies. Eliminateing those policies will substantially reduce existing housing prices, and as JB notes, reducing existing housing prices results in increased forclosures.

    We may need some adjustments, based on recent experience, but that is a long way from rabid, massive overhauls, that wind up throwing out the bath and the baby.

    Finally, it is interesting to note, that many of the Republican backed “bailout” plans would mostly hurt the Blue states, because of differences in locational costs.

    RH

  3. Larry Gross Avatar
    Larry Gross

    “This means that some home sales that were marginal are no longer viable, through no fault of the people living there or making the payments.”

    If you bought a house before the run-up in prices and you pay your mortgage on time – there is no adverse impact because the run-up in price occurred AFTER you bought your house – and just like stocks and land speculation – what goes up “on paper” comes down also and no one should expect the “paper value” of something to be anything more than “paper”.

    short version of the above: don’t count your chickens before they hatch.

    These folks – about 90% of those that hold mortgages did not get hurt.

    Of the ten percent. If you paid more for a house but you did not buy more house than you can afford then you just keep the house and wait out the market.

    Now, if you bought a house that you could not afford or you bought it on credit terms such as as ARM and/or a balloon note that basically relied on a safety-net bailout of selling the house and getting your money back –

    … well you screwed up

    you gambled.. took risks… did not plan ahead.. all these behaviors describe WHY your loan is sub-prime to start with…

    because you are the kind of person who gambles, takes risks and does not plan ahead….

    Now the question is – should the 90% who paid their bills, did not engage in risky gambling.. and did plan ahead… are we going to take money away from them and give it to the guys who did the opposite?

    is this.. as RH says: how we “not take it out on the borrowers”?

    [ i.e. by sticking it to the folks who were financially responsible ]

  4. Anonymous Avatar
    Anonymous

    “Now, if you bought a house that you could not afford or you bought it on credit terms such as as ARM and/or a balloon note that basically relied on a safety-net bailout of selling the house and getting your money back –

    … well you screwed up”

    Now, see, you have almost got it. but then you go and screw it up as follows.

    you gambled.. took risks… did not plan ahead.. all these behaviors describe WHY your loan is sub-prime to start with…

    because you are the kind of person who gambles, takes risks and does not plan ahead….

    You insist on blaming this on certain kinds of persons. In fact, there are ALSO persons who took (what now appear to be unacceptable) risks for perfectly reasonable and well planned reasons, who simply got caught up in a chain reaction started by others.

    I’m in my last year of Grad School, I have a guaranteed job with a good salary and expected bump after six months and a year. I get a good buy on a home from an older partner leaving the area. It’s a little over my head right now, but an ARM will let me keep it on layaway (and give me a place to live for a year, I can let a room to other grad sudents). Past six year history suggest that if I wait till next year, i won’t be able to get something as nice.

    Why is that person a deadbeat bum?

    SOME of what you say is true, but then you blow it by trying to make it a truism.

    On the other side of the fence, I’m older, paid my note on time, took MY interest dedcuction over the years, and suddenly now I’m looking at a (paper) loss of 100k in assessment. I didn’t complain when my home assessment went up, nope, I was bragging that I got in on the ground floor (Never mentioning that daddy-in-law helped. Off the books, of course, so as not to fritz the loan.) I didn’t complain about my interest deduction.

    How is it I’m getting “stuck” by new borrowers? My cash flow is the same, Taxes on my lower assessed value will be down, if I’m lucky.

    If I’m P.O.’d why would it be against the borrowers (other than a few egregious risk takers?) more than the lenders (who were the ones really bending the rules.)

    There is a difference between being marginal and deliberately taking huge risks. There is a difference between being unwilling to pay when a (calculated) risk goes south and being unable to pay, after a predatory lender sets someone up.

    Sure, we can take the self righteous position that it their risk, let them take it, and the consequences. We can cut our nose off to spite our face, too.

    That position might cause an additional 70,000 foreclosures, and another round of lower prices across the board.

    Is that how we want to “protect” those that are financially responsible?

    I don’t see the point. And I don’t see your point, either.

    RH

  5. Darrell -- Chesapeake Avatar
    Darrell — Chesapeake

    Ever look at an amortization schedule? Most of the first several years of payments are nothing but interest. Now you know why some people took on a lower rate interest only loan. Perhaps they only planned to be in the house for a set period of time.

    Oh, remember those suburban slums down in Charlotte? Did you know that around 60 percent of those houses were financed with ‘qualified’ government insured loans?

    Subprime loans are only the tip of the iceberg. When are people going to quit jabbering about bums and realize the entire homeownership system is in trouble? That’s your house as well.

  6. Darrell -- Chesapeake Avatar
    Darrell — Chesapeake

    “So let us consider the implications for the household sector of price declines of the order of 20 to 30%. The math is simple as I will flesh out in this note: 10 to 15 million households will end up in negative equity territory and will be likely to default on their homes and walk away from them. Then, the losses for the financial system from these massive defaults will be of the order of $1 trillion to $2 trillion, a multiple of the $200 to $400 billion of losses currently estimated for mortgage related securities.”

    “Currently politically unthinkable appropriate solutions – such as an outright across the board reduction of the face value of the mortgages of the order of 10% to 20% to reduce the jingle mail are unconceivable now but may become necessary in the near future to stem a tsunami of defaults and foreclosures.”

    http://www.house.gov/apps/list/hearing/financialsvcs_dem/roubini022608.pdf

  7. Anonymous Avatar
    Anonymous

    As usual, Darrrell is on the mark. Letting mortgages go down the tube wholesale has unthinkable results.

    The other possibility is to just let inflation take over, so that home prices rise to the face value of their loans. This will be just as painful, over the long run, but it won’t hurt as much all at once.

    In there are some great bargains out there now. Get a home at a bargain basement price while you can, with the biggest loan possible. You will be paying back the loan with dollars that are worth 75 cents.

    RH

  8. Anonymous Avatar
    Anonymous

    Good point.

    The only reason shared vehicles work is because they get to have private guideways.

    That’s some trafeoff.

    RH

  9. Larry Gross Avatar
    Larry Gross

    A person who signs up for a risky high interest loan – an ARM or BALLOON Note that will result in a future payment that is higher than their current (or foreseeable future) income may not be a “deadbeat” but they are surely not very responsible either.

    They’ve willingly assumed substantial “exposure”.

    And many of them had a choice – between a 400K home with an ARM/Balloon mortgage and a 200K home with a fixed interest mortgage.

    or.. to continue to rent until they accumulated enough for a substantial down payment that qualified them for a fixed interest mortgage.

    No one forced them to take a riskier path.. they chose that willingly on their own.

    Someone handed them a bunch of money in exchange for their signature on the dotted line and no one made them sign it.

    Remember, 90% of folks who have mortgages chose to NOT to do that.

    The folks who chose the more conservative financial path – should not be given the bill for the folks who chose not to.

    someone who took a bad loan is not a deadbeat.

    Someone who did that and now expects others to bail them out – or they’ll walk away … if not a deadbeat is headed that way IMHO.

  10. Anonymous Avatar
    Anonymous

    Well, even the Fauquier Democrat suggests that there should be a middle ground between bailing out every deadbeat and scrungy loan company and throwing people out of their homes unnecessarily.

    We can either bail out the most worthy and cover part of the bill, or force them to walk away and eat all of it.

    Like it or not, believe it or not, regular folks do wind up footing the bill for various kinds of losses, invoked, caused by, or deliberately created by others. It goes for everything from lost library books to insurance.

    RH

  11. Anonymous Avatar
    Anonymous

    The Mortgage Forgiveness Debt Relief Act of 2007 removed the last incentive for borrowers to remain in “their” homes. This law must be rewritten and retitled the Patriotic Mortgage Repayment Act of 2008.

    The Patriotic Mortgage Repayment Act of 2008 – If a borrower defaults on a mortgage and the market value of the collateral is insufficient to repay the money borrowed, the Treasury will recover 105% of the residual borrowed but unpaid amount using IRS collection methods and interest schedules. Such a law would prevent the general population from bailing out the speculators that purchased more house than they could reasonably afford. These wannabee flippers took grandma’s money out of the bank, now the bank has collapsed the the FDIC is having to pay off grandmas. The least these deadbeats should do is repay 100% of grandmas’ money to the treasury plus 5% as a handling fee.

    It should be trivial for the borrower to meet his obligation. After the foreclosure sale recovers 60% of the original loan, the payments on the remaining 40% loss should be well within the budget of even the biggest speculative wannabe flipper real estate genius that bought at the top of the market using grandma’s money.

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