Editors note: Part four of a four-part series on the crisis in subprime mortgage lending looks at why lenders underestimate the cost of making risky loans during housing booms, and how the credit crunch may play out in the marketplace. Read Part 1, Part 2 and Part 3.)
The impacts of the current rise in mortgage delinquencies and foreclosures will be plain to see. Hundreds of thousands of families — even millions — are expected to lose their homes as they are unable to make payments on loans that, in many cases, will exceed the value of the homes that secure them.
The rise in foreclosures could depress housing prices in some regions by flooding the market with inventory. While those foreclosures will be painful for many, it’s possible that the greatest impact on the housing market will come from more complex repercussions already underway.
As the percentage of bad loans increases and home prices stagnate or decline, investors who have poured trillions into the U.S. housing market may look for other places to put their money. That could raise the cost of loans, especially subprime loans made to borrowers with marginal credit histories.
Local, state and federal lawmakers, motivated by a public outcry over foreclosures, are also moving to put in place stricter rules for lenders, which could severely curtail the use of some loans perceived as the riskiest. Many lenders have already tightened up their underwriting standards and are charging more for risky loans. Those moves have been prompted in part by regulators, and also by market forces.
If foreclosures are like an undersea earthquake, the ensuing credit crunch may be like the tsunami that sometimes follows — a disaster of even greater magnitude.
In September, federal bank regulators issued new guidance requiring banks to tighten up their underwriting and disclosure standards for "exotic" interest-only and payment-option adjustable-rate mortgage (ARM) loans.
By instructing banks to qualify loan applicants at the fully-indexed rate — assessing their ability to make the highest possible monthly payments, rather than the lowest — regulators were trying to ensure that those who are granted this type of loan can handle the payment shock when interest rates reset. But the inevitable consequence is that fewer people will qualify for these loans.
Other borrowers may be scared away by the more comprehensive disclosure requirements that fully explain the risk of payment shock these loans can carry.
Although the guidance applies only to federally chartered banks, 26 states and the District of Columbia have followed suit, applying the federal guidance to all lenders doing business in those states.
Consumer advocacy groups like the Center for Responsible Lending — which predicts 2 million subprime mortgages are or will end up in foreclosure — are pushing lawmakers to go further in restricting the use of loans they say are used in a predatory fashion. Lawmakers are lending a sympathetic ear.
Sen. Christopher Dodd, the new chairman of the Senate Committee on Banking, wants the federal guidance on exotic loans to apply to hybrid ARMs such as the 2-28 and 3-27, which carry two- or three-year introductory teaser rates that are then bumped up and fluctuate with market interest rates. The Connecticut Democrat and five other members of the committee wrote federal banking regulators in December, saying hybrid ARMs have some of the same risky attributes as exotic mortgages and should be covered by the new guidance.
Federal banking regulators responded on March 2, proposing tighter underwriting and disclosure guidelines for hybrid ARMs marketed to subprime lenders.
The regulatory agencies proposing the new guidance for ARM loans include the Federal Reserve and the Office of the Comptroller of the Currency, which will accept comments for 60 days. The agencies say they are interested in hearing arguments about whether the guidelines would "unduly restrict" existing subprime borrowers’ ability to refinance their loans, and whether they should be applied to others besides subprime ARM borrowers.
The lending industry is resisting a push for tighter regulations, saying that the new loans helped increase the rate of home ownership and that it should be up to consumers to choose the loan type that fits their financial circumstances. Although some originators made bad loans, industry leaders concede, market forces should be allowed to rein in excessive practices.
"Simply put, a mortgage broker should not, and cannot, owe a fiduciary duty to a borrower," Harry Dinham, president of the National Association of Mortgage Brokers told Sen. Dodd and other members of the Senate Banking Committee at a Feb. 7 hearing. "The consumer is the decision maker, not the mortgage broker."
No law or regulation, Dinham said, "should ever require any mortgage originator to supplant the consumer’s ability to decide for him or herself what is or is not an appropriate loan product."
Although not a spokesman for the industry, Chicago-based mortgage planner Dan Green has firsthand experience with what was a well-intentioned effort to combat predatory lending, the Illinois Predatory Lending Database Pilot Program.
The program, launched in September 2006, required residents in 10 predominantly minority Chicago ZIP codes who fell short of certain credit and income thresholds to seek financial counseling. After the program went into effect, the Illinois Association of Mortgage Brokers circulated a list of about two dozen lenders the group claimed had stopped serving the neighborhoods affected by the program.
Green analyzed MLS data to see if the program was hurting sales in the neighborhoods affected by the program. He found sales were down in comparison to similar surrounding neighborhoods.
Illinois Gov. Rod Blagojevich suspended the program in January after a report by the University of Illinois Urbana-Champaign confirmed Green’s work. The report found housing sales in the 10 affected ZIP codes dropped by nearly half during the fall of 2006. The slowdown in the housing market had also hurt sales in comparable ZIP codes, but the drop was less severe — 20 percent.
"The part that I feel like is getting missed is everybody talks about the lenders, that they shouldn’t have made the guidelines so easy," Green said of the current tightening of credit nationwide. "That’s just business. That’s capitalism, it happens."
Now, Green said, "There is no loan product available as credit tightens up. These people are in the same position, with slightly lower credit scores, nonprovable incomes, and are now being frozen out. There are going to be some terrible, terrible stories coming out of this."
Higher highs and lower lows
A look at past real estate boom and bust cycles around the world suggests that risky loans can not only send home prices soaring to artificial highs, but that taking them away can worsen the inevitable bust.
In a series of academic papers published in recent months, Andrey Pavlov and Susan Wachter have looked at what happens when lenders underpriced risk during real estate booms around the world.
"If there is one thing that the most severe real estate bubbles have had in common, it is easy access to low-cost credit," Pavlov and Wachter write in "Underpriced Lending and Real Estate Markets."
When lenders underestimate the risks of mortgage lending and underprice their products, real estate investors and homeowners take advantage and bid up land prices above what the fundamentals — supply, demand and wage increases — can support.
"While this may or may not start a market price bubble, it certainly enables the bubble formation and makes it worse," Pavlov and Wachter said. "Easy access to low-cost financing stimulates demand and drives up prices. If the lending standards in this type of environment are lax, or weakened further, in order to increase profits for lenders, the risk of a bubble is heightened. The bubble then bursts when market prices exceed the fundamental values of the underlying properties by so much that even virtually costless financing cannot generate more demand."
Pavlov, an associate professor of finance at Simon Fraser University, Vancouver, Canada, is currently the visiting associate professor of real estate at the University of Pennsylvania’s Wharton School of Business, where Wachter is on the faculty.
Pavlov told Inman News that he and Wachter can say with confidence that lending contributed to mid-1990s real-estate bubbles in Thailand, Malaysia and Indonesia. They can also say that more restrictive lending practices in Singapore and Hong Kong kept lending from contributing to price inflation there.
But the data they need to study the impacts of lending on prices, which includes property sales records and loan yield spreads, keeps Pavlov and Wachter looking at the recent past, not the present. Pavlov warns that it’s too soon to gauge whether underpriced lending played a role in the most recent U.S. housing boom.
"I don’t have any empirical evidence that current loans are underpriced in any way," Pavlov said. "We need the market decline to be able to say that."
But Pavlov said there is anecdotal evidence that lenders did, in fact, underprice risk. Some big lenders have pulled out of some volatile markets in California, he said, and the underwriting standards for aggressive loans have been changing "because lenders are worried about the market crashing. If those loans were fairly priced to begin with, you wouldn’t make any changes midstream."
Lenders big and small are already repricing "aggressive instruments" such as negative-amortization and interest-only loans, Pavlov said. It’s more common to qualify borrowers for these loans at the fully indexed rate, rather than lower "teaser" introductory rates.
"They are still available, but they are more expensive," Pavlov said. "To me, that is like, ‘What took you so long?’ The fact that there is a change now is an indicator that those loans were probably underpriced. Even if they were not underpriced, they probably helped the market move even higher than it would have" in the absence of easy credit.
Pavlov and Wachter aren’t the first to theorize about the role lending plays in real estate booms. But they may be the first to show how the same loans that can drive up prices can make them fall harder when they are taken away.
In their December 2006 paper, "Aggressive Lending and Real Estate Markets," the two examined the use of ARM loans in 22 Los Angeles neighborhoods that saw prices plummet by more than 21 percent between 1990 and 1995.
Using historical sales prices from DataQuick and loan origination data from Wells Fargo Mortgage, Pavlov and Wachter found that for every percentage point of additional market share held by ARM loans in a particular neighborhood at the top of the market, prices declined by an additional 1.3 percent on the way down.
Perhaps most importantly, Pavlov and Wachter concluded that it was the presence or absence of the loans themselves — not the higher rates of defaults associated with such products — that influenced prices. Not only did neighborhoods that had the highest concentration of aggressive loans at the top of the market cycle suffer the largest price declines, but those neighborhoods also had the smallest concentration of aggressive loans at the bottom of the market.
"This magnifying effect on the downside is present even in the absence of sizeable default rates," they wrote. "In other words, it is the fluctuation of the use of aggressive market instruments that exacerbates market downturns, not the fact that such instruments generate relatively higher default rates."
When Pavlov and Wachter looked at price trends nationwide, they found that ARM loans tended to magnify price swings in both directions — adding to price appreciation in a boom market when they were available, and bringing prices down harder during a bust when they were not.
If the latest housing boom was in fact driven by aggressive lending, Pavlov and Wachter say the markets that are likely to see the largest price declines are those that saw the highest use of aggressive loans: Florida, Arizona, Washington, D.C., Nevada and California for prime loans, and Illinois, Utah, California, Arizona and Nevada for subprime loans.
Rather than placing restrictions on such loans, Pavlov and Wachter’s research suggests that regulators and lawmakers should ask why lenders underprice risk, and figure how to prevent them from doing so.
They suggest several possibilities in yet another paper, "Real Estate Crashes and Bank Lending."
Many established banks don’t like taking risks that might undermine their long-term financial soundness because their reputations are valuable to them, Pavlov said.
But short-term lenders may be willing to extend risky loans without an adequate rate spread because many mortgage loans are guaranteed by the government or carry other insurance, and because banks have deposit insurance covering potential losses. As long as the boom market doesn’t go bust and the collateral underlying the loans is sound, loan officers and mortgage brokers can get away with underpricing — for a while.
Once these short-term lenders start underpricing loans, it becomes "impossible for correctly pricing banks to compete, as other lenders are forced into underpricing, regardless of whether they are focused on short-term profits or long-term performance," Pavlov and Wachter wrote.
"Lenders that underprice steal market share from correctly pricing banks," they conclude.
While a sharp runup in prices may strike some as an artificial and unsustainable boom, there’s little that can be done to stop it. Unlike stocks and commodities, it’s hard to sell real estate short, so "optimists exert significant and asymmetric influence on the setting of real estate property prices," Pavlov and Wachter write.
When the whole thing comes crashing down, lenders are often let off the hook, Pavlov and Wachter conclude, because "If all lenders face sudden large losses, both regulators and the public will likely blame the general economic conditions rather than underpricing behavior of the lenders."
So how to keep lenders from underpricing?
Pavlov said that if lenders can get away with underpricing without fears of paying the price, it’s logical to assume that they are not paying enough for mortgage and deposit insurance.
In Canada, Pavlov said, the price of mortgage insurance stays relatively stable during ups and downs because two insurers — one public, the other private — have a lock on the market.
"It’s not totally government regulated, because you still have competition between those two players," Pavlov said.
Consumers can look up the price of mortgage insurance online. Although it’s probably too expensive at some times and too cheap at others, in the long run, "Negative demand shocks tend to be not as bad in Canada as in the U.S. because of the constant availability of credit."
Placing the regulatory emphasis on mortgage insurance, rather than the mortgages themselves, means Canadians still have access to a variety of loan products, including ARMs, negative-amortization and interest-only loans. "Just about anything you want," when it comes to mortgage loans, "you can have in Canada," Pavlov said.
Another way lenders may be getting away with underpricing is by securitizing and selling loans in the secondary market.
When banks once relied primarily on their customers’ deposits as a source of capital to make loans, bad loans could wreak havoc on their bottom line. But securitization allows lenders to move loans off their balance sheets and make more loans.
The government-sponsored entities, or GSEs, Fannie Mae and Freddie Mac, were created for this purpose — to provide "liquidity" to the mortgage lending market, making home loans more affordable.
Source: Thomson Financial.
Data compiled for agency, commercial and residential securities at least 50 percent backed by mortgages with a principal balance of $300,000 or less; does not include home equity loans.
Securitizing large pools of mortgage loans allows private investors to play the same role. And because mortgage-backed securities, or MBS, are backed by property, they have been seen as safe investments.
Pavlov said that, in theory, securitization should solve the problem of underpricing risk.
"Securitization is a great thing — it solves problems we discuss" about underpricing risk, he said. "Efficient markets incorporate publicly available information. If they do that, these instruments will be correctly priced, and ultimately that translates into correctly priced loans."
The problem is that securitized loans are often originated and insured by the same institutions that have financial incentives to underprice them. Investors may not have access to the information that would let them assess the fair market value of MBS.
Those concerns are laid out in detail in a recent paper, "How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions?" by Joseph Mason and Joshua Rosner.
Mason, an associate professor of finance at Drexel University’s LeBow College of Business, and Rosner, managing director of Graham Fisher & Co., shed light on a recent twist in the way mortgage loans are packaged and sold to investors — through collateralized debt obligations, or CDOs.
They say CDOs — also known as collateralized mortgage obligations, or CMOs, when they are used to fund real estate debt — have been a major source of funding for subprime lenders. But because of their complicated structures and because managers make changes on the fly to the composition of loans that underly them, CMOs are even more difficult to value than MBS.
Investors may be surprised when these don’t perform as expected because of changes in origination and servicing practices, Mason and Rosner say. And if there’s one thing investors don’t like, it’s surprises.
If there’s a mass exodus by investors from CDOs and CMOs, the impacts could be on the order of the savings-and-loan crises of the 1980s, Mason and Rosner predict.
"High yields in MBS in the past several years led to a massive infusion of CDO ‘hot money’ into the MBS sector in an environment similar to that of the thrift crisis of the late 1980s," the authors say. "Like the thrift crisis and its aftermath, therefore, recent events not only threaten these institutions, but also threaten the U.S. consumer and taxpayer as well."
Mason and Rosner say that done right, mortgage securitization and the transfer of risk to investors through CDOs, benefit consumers and the economy. But more regulations are needed governing the structure, issuance, ratings, sales and valuation of CDOs so investors know exactly what they are buying.
Wrong time to regulate?
"Nobody ever talks about regulation when times are good, only in times of crisis, and that’s the most dangerous time to be doing things," said Green, the Chicago-based mortgage planner.
"Subprime is not a dirty word," Green said. "These loans serve a real purpose for a lot of people, but they can’t be orphaned, because they are short-term loans and they require constant attention. The loan officers who have put their clients in these loans can do them a service by calling them and telling them what’s happening in the market."
If restricting consumers’ access to some loans can be just as harmful to housing markets as the foreclosures associated with their improper use, then perhaps a loan perceived as one of the villains of the housing boom — the stated-income loan — will be resurrected as a hero of the bust.
That’s the bold proposition put forward by CoreLogic, which is touting a new software application, IncomePro, as a way for lenders to continue to use low-doc or no-doc loans with confidence.
It’s a bold proposition, because during the boom, inflating borrowers’ income to qualify them for loans they might not be able to repay was a commonly employed technique.
When the Massachusetts Division of Banks began conducting surprise examinations of mortgage brokerages in low-income areas in the Boston area last fall, for example, they found numerous egregious examples of income inflation. One brokerage had used a Web site to inflate the income of a borrower who made $15 an hour as a machine operator to $90,000 a year.
The branch manager told investigators that he’d been authorized to use the Web site www.salary.com, which provides wage statistics by occupation and geographic area, to "gross up 25 percent from the highest income."
A copy of Fintera Capital Corp.’s underwriting standards obtained by investigators recommended that the company’s brokers use Web sites "similar to www.salary.com" to "validate whether income stated is reasonable." Investigators said the Web site was instead used to inflate incomes reported to lenders.
Regulators have uncovered hundreds of similar instances of income inflation around the country, which are believed to represent a small fraction of the problem.
To prevent misrepresentation and fraud, CoreLogic Executive Vice President Anthony Romano said IncomePro searches three national databases and returns income estimates by job type and region in seconds.
"We look at income composition by neighborhood, look for inconsistencies in prior addresses, do some reverse phone lookup and employer validation — we’re really able to determine if a person has demonstrated the ability to make this level of income," Romano said.
Romano said IncomePro has turned out to be a good predictor of loan performance, and is a useful tool not only for loan originators, but for Wall Street firms and investors who need to gauge the quality of loan pools they’re considering sinking money into.
"When a lender wants to challenge income, often the deal goes away — which may not be a bad thing. There may be fraud there," Romano said. "But with more than $1 trillion in option ARMs ready to reset in 2007, many folks south of 5 percent will move north of 7 percent, and have $400, $500 or $600 a month payment shock. So they are going to refinance. Without income growth the industry was expecting, you will have people going to low-doc programs."
Other estimates put the dollar value of first-lien ARMs set to reset in 2007 at closer to $500 billion, but Romano’s point is one others have made: a credit crunch could exacerbate the problems that lie ahead.
"The onus is on the industry, the GSEs and the secondary market players, to figure out what kind of products these people can move into," Romano said. "Maybe 40-year products. If I give you 10 more years on the term, that’s good. With a different loan product, you don’t need fraud and misrepresentation" to get a green light on a loan.
"Some people, with their incomes and circumstances, ought not to have a mortgage," Romano said. "But I don’t believe in a doomsday scenario. There will be defaults, and more losses, but if the industry responds with some of these creative products done the right way, it will be fine."
Send tips or a Letter to the Editor to email@example.com or call (510) 658-9252, ext. 150.