(This is Part 1 of a five-part series. See Part 2, Part 3 Part 4 and Part 5.)
Extensive payment problems among subprime mortgage borrowers, along with the failure of a number of subprime lenders, have been major news topics in recent months. Speculation about the causes of the defaults has been widespread. That is the topic of this article.
Future articles will consider why so many lenders have failed, the impact of the crisis on the current availability of credit to prospective new subprime borrowers, and what — if anything — government should do. The final article will discuss whether the subprime market could and should be replaced, and, if so, by what.
Ending of Price Appreciation: The immediate cause of turmoil in the subprime market was the end of house-price appreciation. Property values in most areas stopped rising in 2006, and in many areas they have since declined. This has led to a rise in delinquencies and defaults on what I call “appreciation-dependent mortgages” — those that worked for borrowers only if their properties appreciated. A large proportion — but not all — of such mortgages were subprime.
Speculative Purchases: Some houses were purchased with 100 percent loans by borrowers hoping to turn a quick profit from future appreciation. These loans were made for the full amount of the purchase price or appraised value — no down payment was required.
Home buyers taking these loans had negative equity the day they closed, in the sense that if they were forced to resell immediately, the transactions costs — which can be 5 percent or more — would have to be paid out of their pockets. The buyers looked to appreciation to cover the costs and make a profit.
When the appreciation doesn’t materialize, even if the payments remain affordable, the financial incentive to make them is substantially weakened. Most do continue to pay because they want to remain in the house and they don’t want to ruin their credit, but some fold their cards and walk away. The result is a foreclosure.
Speculative Refinances: A presumption that their houses would appreciate also infected the refinance decisions of many borrowers. A question house purchasers asked me in 2004-05 with distressing frequency was “How long do I have to wait (after purchase) before I can refinance to take cash out?” Some of these borrowers were influenced by a new breed of financial planners and mortgage brokers who promote the view that unused equity should be used for investment — in common stock, property or annuities.
Some homeowners used the growing equity in their homes as a way to live beyond their means. They would build up credit card debt, then consolidate the debt into their mortgage through a cash-out refinance. The consolidation — by extending the term of the credit card debt, reducing the rate and making the interest tax-deductible — would reduce the borrower’s total monthly payment. They could then start building up their credit card debt all over again.
This process could continue only so long as their houses appreciated. As soon as appreciation stopped, they were stuck with total debt service costs that might be unmanageable or with negative equity in their house, or perhaps both.
Unaffordable Mortgages: The most commonly used mortgage in the subprime market is the 2/28 ARM. This is an adjustable-rate mortgage on which the rate is fixed for two years, and is then reset to equal the value of a rate index at that time, plus a margin.
Because subprime margins are high, the rate on most 2/28s will rise sharply at the two-year mark, even if market rates do not change during the period. This means that while the loan is affordable to the borrower at the initial rate, it may not be affordable after two years when the rate is reset.
If the house has appreciated, this is not usually a problem because the borrower can refinance — if necessary, into another 2/28. While these loans carry refinance costs and typically have prepayment penalties, the costs and penalty can be included in the balance of the new loan if the borrower has sufficient equity.
The borrower who does not have the equity needed to refinance, however, is stuck with the higher payment on the existing 2/28 that may be unaffordable.
The upshot is that many consumers made purchase and refinance decisions based on the premise that their houses would appreciate, as they had for many years. When appreciation abruptly stopped, both their incentive to make their payments and their ability to do so was sharply reduced. While it wasn’t only subprime borrowers who fell into this trap, these borrowers had the least capacity to extricate themselves.
This raises an obvious question: Why was the mortgage lending industry willing to make loans that were workable for the borrowers only if their properties appreciated? This will be discussed next week.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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