The Fed's View of the Sub-Prime Mortgage Market

Robert Reich comments on the problems in the sub-prime mortgage market:

The Fed and the Sub-Prime Lending Debacle, by Robert Reich: What the Fed does or fails to do has more effect on the nation’s poor than any other policy making body. When the Fed decides to fight inflation by raising interest rates and cooling the economy, it’s the poor who are the first to be drafted into the inflation fight because their jobs are the most tenuous, and they’re the first to lose them. When the Fed decides to ease up and reduce rates, it’s the poor who are among the first to get the new jobs because employers who are most likely to hire at the start are small service businesses offering jobs at the bottom rungs of the wage scale. The best example of this occurred in the late 90s, when Alan Greenspan bucked conventional economic wisdom and decided that the economy could safely grow fast enough that unemployment dropped to around 4 percent. The result was to create more jobs for people in the bottom fifth of the income ladder – whose total income therefore began to rise for the first time in decades.

But the Fed affects the poor in another way, too. It determines their access to credit. And here as well, the Fed's decisions can either be a great boon to poorer Americans or a huge curse, depending on how responsibly the Fed manages the credit markets. In this respect, it’s done a lousy job in recent years. In the early 2000s, rates were so low that banks didn’t know what to do with all the extra money they had on hand. But instead of keeping an eye on bank lending standards, the Fed looked the other way. The result: Credit standards were disregarded in a tidal wave of sub-prime lending to the poor home buyers – often without down payments, often with mortgage interest rates that would rise if and when the prime rate went upward. Then what happened? The Fed raised short-term rates seventeen consecutive times, catching poor borrowers in the very trap the Fed allowed banks to set for them. So now millions of poorer Americans face foreclosures on their homes, and sub-prime lenders are in trouble.

Will anyone hold the Fed responsible? Answer: No. Does anyone know how to hold the Fed responsible? Answer: No.

See also "Does Debt Get Enough Credit?" for my views on this, and "Regulation of Mortgage Markets" for a summary and analysis of the regulatory structure. [Update: Tanta at Calculated Risk also comments in Cole Testimony: Cui Bono?, "I want to point out ... the one place in this document where I think the Fed has really drunk a little of the Kool Aid."]

We've all been critical of regulators to one degree or another, so I should let the Fed defend itself. This is testimony from Roger Cole, the Federal Reserve's Director of Banking Supervision and Regulation given today before the Senate Committee on Banking, Housing, and Urban Affairs:

Mortgage markets, by Roger T. Cole, Federal Reserve: Introduction Chairman Dodd, Ranking Member Shelby, members of the Committee, I appreciate the opportunity to discuss mortgage lending, the recent rise in mortgage delinquency and foreclosure rates, particularly in the subprime sector, and the Federal Reserve’s supervisory response.

The Federal Reserve is concerned about recent developments in mortgage markets and has been closely monitoring the effects of these developments on the financial health of mortgage borrowers and lending institutions. Regarding safety and soundness of the banking system, less than half of subprime loans have been originated by federally regulated banking institutions. To date, the deterioration in housing credit has been focused on the relatively narrow market for subprime, adjustable-rate mortgages, which represent fewer than one out of ten outstanding mortgages. Borrower performance deterioration in the subprime market has been concentrated in loans made very recently, especially those originated in late 2005 and 2006, and problems in those loans started to become apparent in the data during the latter half of 2006.

As in past credit cycles, market investors and lenders have begun to implement more appropriate underwriting standards and to change their risk profiles. Some borrowers are clearly experiencing significant financial and personal challenges, and more subprime borrowers may join these ranks in the coming months. We are mindful that any action we take should not have the unintended consequence of limiting the availability of credit to borrowers who have the capacity to repay. I will shortly offer some suggestions to address these challenges, including the potential for lenders to work with troubled borrowers.

We know from past cycles that credit problems in one segment of the economy can disturb the flow of credit to other segments, including to sound borrowers, creating the potential for spillover effects in the broader economy. Nevertheless, at this time, we are not observing spillover effects from the problems in the subprime market to traditional mortgage portfolios or, more generally, to the safety and soundness of the banking system.

Subprime lending has grown rapidly in recent years and has expanded homeownership opportunities for many individuals. It is important to ensure that these gains are not eroded by the recent increase in delinquencies and foreclosures in the subprime market. It is especially important to preserve homeownership for the many low- and moderate-income borrowers who have only recently been able to achieve the goal of owning a home.

Later in my testimony, I will discuss the recent activity in mortgage markets and the possible causes for the increases in delinquencies and foreclosures in the subprime market. I will discuss the Federal Reserve’s ongoing efforts as a banking supervisor to ensure that the institutions we supervise are managing their mortgage lending activities in a safe and sound manner, including assessing the repayment capacity of borrowers.  ...

I will also discuss our efforts in the area of consumer protection, including guidance to ensure that lenders provide consumers with clear and balanced information about the risks and features of loan products at a time when the information is most useful, before a consumer has applied for a loan. The Federal Reserve Board has significant responsibilities as a rule writer for several consumer protection laws, and I will discuss our efforts to date to improve the effectiveness of our regulations in this area as well as our plans to continue this work in the near and longer term.

Mortgages and the Role of the Capital Markets The banking system has changed dramatically since I first joined the Federal Reserve Bank of Boston in the mid-1970s. Back then, banks and savings and loans used their deposit bases and other funding sources to finance, originate, and hold loans to maturity. These financial institutions were highly exposed to any problems that might emerge in residential markets, and their analysis of credit risk was generally limited to making sure that each loan was underwritten properly. Home mortgages had fixed rates and few bells and whistles.

Today, the mortgage lending business has changed dramatically. With the remarkable ... in securitization, that simple book-and-hold model has evolved to incorporate an alternative and more complex originate-to-distribute model. While commercial banks still play a significant role in the mortgage origination and distribution process, they are no longer the only originators or holders of residential mortgages. Securitization has had profound effects in financial centers, where investment bankers use a broad array of approaches to package and resell home mortgages to willing investors, and in local communities, where mortgage brokers and mortgage finance companies compete aggressively with banks to offer new products to would-be homeowners.

These innovations in housing finance have brought many benefits to lenders, investors, and borrowers. Much more so than in the past, insured depository institutions are now able to manage liquidity and control risks by adjusting credit concentrations and maturities through the use of financial instruments such as mortgage-backed securities. For capital market investors, securitization has reduced transaction costs, increased transparency, and increased liquidity. The market has become very proficient at segmenting cash flows of mortgage portfolios into risk tranches targeted at investors with differing risk appetites.

Homebuyers have also benefited in this environment of financial innovation and market liquidity. More lenders are actively competing in the mortgage market, product offerings have expanded greatly, the underwriting process has become more streamlined, borrowing spreads have decreased, and obtaining a mortgage loan has become easier. In short, securitization has helped to expand homeownership, which recently reached a record 69 percent.[1] Not surprisingly, there have also been significant gains in homeownership for low- and moderate-income individuals. The development of the subprime mortgage market has been an integral factor in creating these homeownership opportunities for previously underserved borrowers.

Recent Trends in the Subprime Market ...While still only a relatively small part of outstanding mortgages, the subprime sector grew rapidly over the past three years and accounted for an outsized share of originations in 2006. The roots of this increase can be traced back to the low levels of market interest rates that existed in the early part of this decade which, in turn, spurred significant volumes of mortgage refinancing, as well as new originations. To meet this demand, financial institutions significantly increased their mortgage origination and securitization infrastructures. New entrants in the mortgage industry ... also ramped up their origination capacity. With the rise in short-term market interest rates beginning in 2004, the cost burden of such infrastructures came under increasing pressure as both mortgage refinance and new origination volumes declined.

In this environment of high liquidity, rising home prices, and competition, some lenders that had an originate-to-distribute model responded to the capital market’s demand for new products by easing their credit standards and increasing risks through “risk-layering” practices such as simultaneous second liens, no- or low-income documentation, and high loan-to-value ratios. Some borrowers were actually investors utilizing the ease in terms to purchase investment and rental properties. In the latter part of 2005 and in 2006, risk-layered loans were originated in greater numbers and, increasingly, to borrowers with lower credit scores. An additional layer of risk was embedded in the subprime market since subprime borrowers are more likely to use adjustable-rate mortgages, or ARMs, because these loans generally carry lower interest rates at origination, particularly if a promotional or “teaser” rate is offered for the loan’s introductory period. While these loans contribute to more manageable payments early in the life of the mortgage loan, borrowers can be exposed to payment shock when rates adjust. ARMs account for only about one in eight prime mortgages, but they account for between one-half and two-thirds of subprime mortgages.

During the years of exceptionally strong growth in housing prices and low, stable interest rates, most borrowers did not face large payment shocks and many of those that did could later take advantage of home price appreciation to refinance. These conditions changed in 2006, when mortgage interest rates hit four-year highs, the volume of home sales declined, and the rate of house price appreciation decelerated, leaving the most recent subprime borrowers vulnerable to payment difficulties. Subprime borrowers with hybrid ARMs have experienced the largest recent increase in delinquency and foreclosure rates.[3] Meanwhile, an unusual number of subprime loans have defaulted shortly after origination; these “early payment defaults” are further evidence of laxer underwriting standards by subprime lenders, especially during 2006. Based on anecdotal evidence, it seems possible that fraud has also been a factor in the recent increase in early payment defaults.

Undiversified subprime finance companies have been hit especially hard... This consolidation in the subprime sector of the mortgage finance industry began several months ago and has likely not yet run its course. These changes in market conditions may assist the industry as investors become more focused on risk-reward tradeoffs and as lenders become more prudent. However, over the next one to two years existing subprime borrowers, especially those with more recently originated hybrid ARMs, may continue to face challenges.

Supervisory Guidance Over the past several years, the Federal Reserve has been monitoring these developments and has adjusted our supervisory activities accordingly. ... Since the early 1990s, the Federal Reserve and the other banking agencies have issued a number of guidance statements on residential real estate lending that focus on sound underwriting and risk-management practices, including the evaluation of a borrower’s repayment capacity and collateral valuation. 

[...Summary of regulations issued since 1990...]

Supervisory Activities Regulators became concerned in the late 1990s about certain subprime lending activities that had become the primary or sole business activity of some institutions. As regulators increased their scrutiny, it became clear that risk-management practices were deficient at some institutions. ... Supervisors took actions to address identified deficiencies, including formal enforcement actions...

[...Summary of actions taken by regulators...]

Regulatory Action to Protect Consumers The Federal Reserve also has significant rule-writing responsibilities for consumer protection laws such as the Truth in Lending Act (TILA) and for laws designed to assist in consumer protection efforts such as the Home Mortgage Disclosure Act (HMDA) of 1975.

[...Summary of actions taken by regulators...]

Responding to the Challenge The Federal Reserve believes that the availability of credit to subprime borrowers is beneficial and that subprime loans can be originated in a safe and sound manner. We continue to focus on institutions’ sound underwriting and risk-management practices and to promote clear, balanced, and timely consumer disclosures.

The proposed Interagency Statement on Subprime Mortgage Lending specifies that an institution’s analysis of a borrower’s repayment capacity should include an evaluation of the borrower’s ability to repay the debt by its final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule. In proposing the guidance, the agencies specifically asked whether the subprime guidance would unduly restrict the ability of subprime borrowers to refinance their loans in order to avoid payment shock. We are mindful of unintended consequences that may affect credit availability to otherwise sound borrowers and are prepared to make changes in response to constructive comments.

Lenders and investors should take an active role in working through the current problems in the subprime market. They should not manage subprime and nontraditional mortgage portfolios in the same way as they manage more traditional portfolios that do not contain the same level of risks. Lenders, portfolio managers, and mortgage servicers should be examining how interest rate increases, real estate price fluctuations, and future payment resets can affect delinquencies, default rates, foreclosures, and losses. Strategies should be developed to minimize the effect of deteriorating conditions on segments of the portfolio identified as at-risk. Lenders should be assessing how severely a stressed environment may affect the credit quality of their portfolios, especially with respect to the large volume of subprime adjustable-rate mortgages underwritten in the last year or so. ...

Although a rising number of borrowers are having difficulty meeting their obligations, regulated institutions do not face additional supervisory scrutiny if they pursue reasonable workout arrangements with these borrowers. Existing regulatory guidance does not require institutions to immediately foreclose on the underlying collateral when a borrower exhibits repayment difficulties. Working constructively with borrowers is typically in the long-term best interests of both financial institutions and the borrowers.  Capital markets investors in securitizations have the same motivation as direct lenders in maximizing recoveries on defaulted loans. Thus, mortgage servicers will have an important role to play in working with delinquent borrowers. ... [O]ptions could include modification of interest rates, payment restructuring, and extension of maturities. ...

As I mentioned previously, the principles of sound lending have been with us for generations.  From a supervisory perspective, the Federal Reserve believes those principles need to be part of any risk-management approach to new and emerging products such as subprime lending and risk-layered loans, as well as the securitization of such loans.  We also believe that consumer education efforts to explain both the benefits and risks of new financial products are important, including disclosures that borrowers who are not fully conversant with financial products can easily understand.  ...

Comments

[paine]

that fed statement is obscene

[William Smith]

I can appreciate the balancing act the Fed has to play with here, but if their advice is ultimately a guidance document, I would hope for stronger language, including updating risk assessment to include ability to repay ARMs after a credit shock of a minimum level.

[john c. halasz]

Just to snark a bit, is it an accident that Susan Bies, one of the governors with regulatory oversight responsibility, resigned from the Fed abruptly last month?

But to get back to the Reich piece, the liberal concern for poorer homebuyers and the restriction of the issue just to sub-prime mortgages is utterly myopic. It's been obvious since 2002-03, at least to use leftie cynic types, that a housing bubble was or would be developing, since the Fed cut its FF rate below rate of inflation. Combined with the Bushevik tax reductions for the investor class, which were clearly designed to re-flate assets after the tech-bubble bust, which amounted to an effort to restore the "wealth effect" on consumption, i.e. the domestic dissavings effect, and which predictably amounted to incentivizing corporate investment abroad, in a disinflationary environment with little domestic stimulus, there has resulted the huge macro-economic mess that we're now in, which guarantees that not just the poor, but the working class and much of the middle class are about to be royally screwed. And pace Bruce, who might be right that the Seattle market is fine, the bubble took off precisely in some of the wealthiest and most densely populated parts of the country, where the value of residential RE as a % of the national total was already high, so the national impact on credit availability will be felt regardless of local conditions. Traditionally, consumer spending has been ~67% of U.S. GDP, rising to 68% during the tech boom, when employment was unusually high anyway. But since the 2001 recession, it took 29 months for emplyment levels to return to the trough level of the recession and employment growth has remained poor to fair since, with the employment to population ratio down, wages have been stagnant in the face of marked recorded productivity growth, and corporate profits have been high, while corporate real investment low. Yet consumption rose to 70% of GDP. Go figure. But it was obvious that, even if interest rates didn't rise, the inflation of housing prices would eventually tap out buyers, ( and note the the FF rate has been above the 10 year bond, which tends to determines mortgage rates for some time now), as the run-up in housing prices encouraged debt-financed consumption in the absence of wage growth through MEW, invited speculation, and required ever laxer or more extended lending in order to keep the market going. And residential construction has been running at 6% of GDP, compared to 4.5% as the historical average, ensuring an overhang of unsold housing once the bubble popped, and hence a marked downward pressure on house prices which would lead to further financial distress and credit disruption, not to mention the subtraction of construction spending and employment from GDP. All this was easily forseeable: it's only a question of when. Well., Roubini, Baker, and a few business economists have made their recession predictions and now mumbles Greenspan even says a 1 in 3 chance. This ain't nearly over and it's not a narrow issue of subprime mortages. It's about the over-extension of credit in a bubble economy and the macro-economic imbalances that result.

[dd]

Cole's speech is breathtaking. Beneath all the financial gimmickry it's a classic recipe for fraud. The wonders of securitization decouple the risks from the rewards and incentivize fraud as the default risks are with investors and homeowners while the origination, underwriting and packaging fee rewards are pocketed by the banking industry.

[calmo]

Vintage john. c. halasz who sees this like I do, but damn if I don't need a special breathing apparatus to make it from one end of a sentence to the other, and I know this just says something about my reading skills and needing a certain over-sized font that just naturally makes for an increase in the probability of miscues at the end of a line, but just see how you like it and wish that I could find the 'Period' button before you die of exhaustion or start tormenting the cat for no apparent reason, or maybe you do like it and see no big deal between a period and a comma, or between a haiku and a 100+ word sentence.
Just sayin john is always worth the punishing read.

[Lafayette]

The Fed: “To date, the deterioration in housing credit has been focused on the relatively narrow market for subprime, adjustable-rate mortgages, which represent fewer than one out of ten outstanding mortgages.”

So, once again the media has blown this problem way out of sensible proportions?

No kidding …. ?

“As in past credit cycles, market investors and lenders have begun to implement more appropriate underwriting standards and to change their risk profiles.”

Too late. Regulate the SOBs, or they'll do it again.

We live in a rules-based society, not some Amazonian jungle.

“Subprime lending has grown rapidly in recent years and has expanded homeownership opportunities for many individuals.”

Yes, and had it been done at the Fed window, proper credit-rules may have been in place.

The Fed, through the FHA, should be the lender of last resort. Decent housing is basic right for all individuals/families.

Where market economics cannot properly assure this right, then the state must.

“I will discuss the Federal Reserve's ongoing efforts as a banking supervisor to ensure that the institutions we supervise are managing their mortgage lending activities in a safe and sound manner, including assessing the repayment capacity of borrowers. “

Blahblahblah.

They're shutting the barn door long after the horse is out.

Someone was asleep at the wheel.

[dd]

No, not asleep at the wheel. Cole's testimony was chilling in that the nation has been down this path twice in the last twenty years (S&L/Fannie&Freddie). The fraud players and patterns are well known; but this time the gates were opened wide but the income generating rewards were concentrated in banking while the all the risks were shifted to investors and homeowners. The homeowner end of the equation is known; but why are there no howls from investors? Cole's speech indicates "sophisticated" investors meaning institutional and government pension plans. Next up a "pension" crisis and higher state and municipal taxes. Just a taxpayer bailout of a different stripe.

[Bruce Webb]

I'll repeat this over and over. Sub-prime is not about lenders recklessly extending credit to the poor. Sure there is some of that but it would be nice to seem some of the anecdotes replaced by data.

Speculators went sub-prime to get the loan. Lenders went sub-prime to get the loan written. Why? Because both sides were making money in a bubble market.

I just left a job where my assignment was to identify properties with unlocked value, that is properties whose actual market value would not be supported by the appraisal. Oddly enough there are hundreds of properties out there that fit this description. The problem we identified, and the one that ended up costing me my job, is that we couldn't find a way to finance the acquisitions, banks won't lend on future value. Now we had a plan, one that might actually work once my ex-boss spends a couple of years preparing the ground work, but the particular acquisition that was going to fund my salary in the interim collapsed. Oops.

But the point is that if you can get the bank to lend you money, and the higher the Loan to Value (LTV) the better, you can make money and big money in real estate. The only thing preventing that is a little couple somethings called underwriting standards and penalties for mortgage fraud. If you can steel yourself to face the latter there are ways around the former. Which frankly is what fueled a lot of sub-prime lending.

Risk/reward. Its a hard master. The harder you push risk the bigger your potential reward. Of course you also increase your risk of jail time or bankruptcy or both. But in the golden years the risk of either was essentially zero, housing was in fact raising all boats, it made sense to lend to people with poor credit, it make sense to extend credit to speculators who had exhausted their conventional credit (I suspect the large majority of stated/stated fall in this category). After all the loan was securitized by an asset increasing 10, 20, 30% per year.

Until that all stalled and risk/reward moved to a whole new place on the axis. In the process of resetting the sweet spot there is going to be some friction, the risk side of the equation is going to bite some people. And it might even bite some who were not in on the reward portion. Containing spillover will be important.

But for God's sake don't rescue people who knowingly pushed the risk/reward equation. They certainly were not prepared to share the gains, we shouldn't have to share the losses.

But prepare for the tearjerking stories. They want to make this about the victims. Me I want the data to figure out who is who. Subprime loans were always risky to the poor, nothing has changed in that over the last couple of years. What changed is that the market softened a little (not much most places), certain people as a consequence started looking at the underwriting standards (which in sub-prime amounted to "sign here") and the people who were making huge money playing at the margins of acceptable practice started going to the wall.

There was nothing inherently evil about any of this. Given the level of asset appreciation at the time conventional underwriting standards were too strict to properly assess risk/reward. So people pushed those standards - hard. Now that strategy is not, or perceived to be not, the correct set point on the risk/reward axis. Investors woke up and realized where they were actually sitting by holding securitized sub-primes, which is to say on a whole bunch of money lent with not a lot of equity backing it, the gravy started tasting a little thinner on the gravy train.

But please don't buy the hype. Or at least wait until you see the data on how this breaks down between owner/occupied and investor. And then take a hard look at the data. Because not every property financed 'owner/occ' is actually occupied by the owner. It gets you a better rate so where possible investors will get the lender to write the loan owner/occ. And exactly no one is in the business of tracking down "owner-occupied" houses that oddly enough have "For Rent" signs. Because all the risk is shifted to the investor on the back end and the securities are packaged in a way that it would be pretty difficult to check even if you wanted to.

When you see commentaters equating "2.1 million foreclosures" to "2.1 million homeowners losing their houses" hold onto your hat. Because a certain percentage of that is speculators walking away from investments in which they had no equity anyway. That is what 100% LTV means. And if you spent a couple hundred bucks setting up a LLC (Limited Liability Company) and acquiring the properties through the LLC you can walk away clean.

They want you to believe that this is all about Ma and Pa Kettle. Well lets check out the data corrected for the distortions before we start crying about poor people moving into their cars. This isn't that simple.

[calmo]

Thanks dd, I'm not sure about this career bureaucrat, Cole and am fighting the inclination to see him as colluding with the investors. How does one balance that substantial experience with "if we knew then what we know know" reply to this low maintenance-carefree (hat tip to Isabel) attitude when it comes to oversight? [The individual investors have not lost much of their hordes, but as you point out, the pensioners and their lawyers will be up next. James at Econobrowser for a case study.]

Bruce, this opener is not telling us we're slow :I'll repeat this over and over.is it?
[Just that we've got all morning to read it...not like that busy body melvin.]
Just in case it is, I feel the urge to defend. Like so:The problem we identified, and the one that ended up costing me my job, is that we couldn't find a way to finance the acquisitions, banks won't lend on future value. And of course banks have, do and will always lend on "future value". What could 'value' possibly mean if it did not depend entirely on that future estimate? [See, I'm so with it. You are probably still reading only because you think I might say something really valuable ...ok, in the next parentheses probably.] Their perceptions of that "future value" were different than your company's.
I'm glad you include the time sensitive nature of this position:But in the golden years the risk of either was essentially zero, housing was in fact raising all boats, it made sense to lend to people with poor credit because those experienced folks (folks who are able to detect the end of the golden years long before ordinary Moe) extending the credit, know that those less experienced folks (in smaller boats not renown for their seaworthiness) receiving it are also on the receiving side of this predatory practice. (Well this ain't the Sally Anne, people. This economy goes nowhere if self-interested players are excluded.) [I'm tellin you this only because you are such a weak self-interested player that other predators might pass you over as not even qualifying as a morsel.]

I have more, but not time.

[dd]

"But in the golden years the risk of either was essentially zero, housing was in fact raising all boats, it made sense to lend to people with poor credit, it make sense to extend credit to speculators who had exhausted their conventional credit (I suspect the large majority of stated/stated fall in this category). After all the loan was securitized by an asset increasing 10, 20, 30% per year."

This is where the responsible regulators are supposed to regulate and no it doesn't make sense to lend to those who must rely on ever-increasing valuations to continually refinance housing they couldn't afford in the first place. Risk/reward modelling is wonderful; but an actual financial stake tempers speculation hence margin requirements. A minority view to be sure as the Fed agrees with your perspective.

[Bruce Webb]

Well Calmo it depends on how you define future value.

Let's say you have a 3BR 1 bath house on an acre. The zoning allows for subdivision at the rate of 4 houses per acre but also requires that sewer to beprovided to the property before you can. (Real code provisions in the Snohomish County zoning code.)

Let's say further that I know that a developer is going to be doing a subdivision that will in fact bring sewer by the property in the next year.

Okay what is that property worth? Well in one calculation you take your acquistion costs plus your development and holding costs and subtract them from the value of four ready to build lots. Which in my market right now means $700,000 in value. What can I finance the property for? Well in my market you would have a hard time getting that 3BR 1 bath to appraise for more than $300,000. And the bank is not going to lend more than that. It doesn't matter that in certain circumstances the $400,000 is essentially guaranteed. They won't lend.

That is what I mean by "future" value. Of course the bank understands that that $300,000 house is going to appreciate, they may even be willing to write you a negative appreciation loan based on that. They can push the risk pretty far, but they won't be able to write you a loan not backed by comps. And comps are based on current use.

We got this all the time. Our business model fundamentally rested on finding 3BR 2 bath houses that we could rent for an appropriate cap rate. Our acquistion agents didn't even look at 3 BR 1 bath. Those are significantly harder to rent at the rate we needed. Well what if we found that 3 BR 1 bath with the future value? Do we stretch and pick it up? Man you would love to, a couple hundred in rent lost is nothing compared to capturing $250,000 to $350,000 in value over a one to two year period, particularly if you can find a lender who will lend you 100% LTV. But you have to come up with the cash to bridge the difference between the appraised value and the acquisition price. Because sellers, or their agents anyway know what they have in most cases, they will demand their slice of that future value.

You need to bridge the gap. It is what keeps people in single-occupancy motels at a higher overall rate than an apartment would cost. Or keeps people in apartments when for the same money they could be in a bigger house. Or keeps me from buying that 3 BR 1 bath house and making $250,000 in an 18th month period. For a lot of people sub-prime provided that bridge.

Of course someone is always available to write a loan, sub prime is not the only non-traditional route, but lets just say that risk/reward can start being defined in whole new ways.

There was an old cartoon, maybe Frank and Ernie, but you get the idea:
One guy says to the other "I know the secret to becoming rich. It takes money to make money." To which the other guy replies "So why aren't you rich?" The answer of course is "I can't afford it".

A lot more truth packed into that then is comfortable. Trump and Gates made their own fortunes. Starting from pretty comfortable starting points.

[Bruce Webb]

"and no it doesn't make sense to lend to those who must rely on ever-increasing valuations to continually refinance housing they couldn't afford in the first place."

Well you are building some assumptions in that are not true for all markets.

Let's say your area has been experiencing very strong appreciation and based on restrictions on land supply and a strong labor market you have reasonably concluded you will get a certain rate of return on your investment. It doesn't have to be real estate, it could be anything. If you can acquire it at a reasonable price, can get it financed and can afford the carrying costs then why wouldn't you leverage yourself as needed?

That you couldn't afford to buy that much house using a conventional loan, through inability to put down a 10 or 20% down, or because of sub 720 FICO scores doesn't make that investment irrational or particularly in need of regulation.

If you can afford the mortgage payment you can afford the house, pretty much by definition. If you are confident you can refinance before the reset, don't have a prohibitive pre-payment, and are reasonably confident that two or three years of steady mortgage payments will improve your credit so that the combination of your equity and credit will allow you to go conventional then why NOT make the loan?

The whole argument about the housing bubble and sub-prime is an argument from irrationality. Odd indeed in a discipline that usually assumes that all economic actors are fully informed market participants.

Sub-prime worked, sub-prime in large part continues to function very well. Certainly certain homeowners got trapped into houses they really, truly couldn't afford, and certainly a lot of investors mistimed markets and didn't accumulate enough equity to readily finance their carrying costs.

But the fact is that people lose money in investments. And not all of them are victims. Some were acting in bad faith, some were stupid, some were victims of unforeseen circumstances.

I lost a well paying job where I had just moved into a new office with a killer lake view. Panoramic. We had three existing docks and a staff of young women who would have really been enjoying some summer sun bathing, and some middle age guys that would have enjoyed the views. What happened? A creek took an unexpected turn on a property we were looking to acquires. When we cleared the blackberries enough to view it about $800,000 in future value (as defined above) vanished over a half hour period.

Well that is real estate investment. It's not day trading, you have some significantly different time lines and different measures of liquidity.

But a lot of what we have here is people arguing for crisis and regulation when it is not clear anything fundamental happened beyond people walking away from a failed investment.

Foreclosure is a scary word, but a lot depends on how much skin you have in the game. In prime markets the risk is shifted forward to the borrower, in sub prime the risk is shifted back to the lender and ultimately the investor. It looks like a lot of supposedly sophisticated investors got taken to the cleaners by the mortgage industry. It is far from clear how much suffering is being experienced on the front end.

As an example the NYT used a Chicago man to illustrate the problems of ARMS. The guy's loan had just reset and his payment went from $1000 to $1300. Well that would be painful. But then the article went on to say that part of the problem is that he had just lost his job and was going through a divorce. Somehow I am not thinking that the core of this guy's financial challenge was the reset of the ARM. You can have a 15 year 5.0% fixed and have a problem if you unexpectedly lost a job. The problem isn't the mortgage product, its that you no longer have a paycheck.

The Seattle paper had a different story. Here the story was more complicated and the woman clearly was the victim of some predatory lenders. On the other hand she had three sons, all veterans, two of whom were living with her and who the paper reported she "supported". Well there is a back story there that could use some explication. The job market here is not such that you can't get some job, what do those guys do all day?

So lets get some data infused into this debate. A lot of what real information I have seen in the last few weeks can be summed up as "rich people losing money". Which outside the editorial page of the WSJ shouldn't be equated to 'crisis'.

[anne]

So far, my sister agrees with you.

[dd]

"Odd indeed in a discipline that usually assumes that all economic actors are fully informed market participants."

Umm, no. That is what regulatory structures are about at least in the old FDR meaning. It is the entire basis for the SEC, CFTC, FDA, FTC et.al.: a recognition that everyday economic actors have imperfect information and to level that playing field there are government intermediaries that dare one use the word "protect" investors, consumers and everyday citizens from speculation or deadly drugs. There may be no subprime crisis but there is a regulatory illusion crisis. The Fed had a regulatory function in subprime and didn't regulate; just as the SEC had a regulatory function in the tech bubble and didn't regulate; just as the FDA had a regulatory function in Vioxx and didn't regulate. The Fed's failure to regulate speculative credit is a landmark; but then again that's from an old regulator and times have changed...now where's my walker.

[calmo]

I can see you really enjoyed that job, Bruce...and if the Seattle real estate market is as buoyant as you say it is, I'm sure there will be other companies interested in your talents and passion for it.
Very quickly, those numbers we all need to see up close and personal are the affordability ones. Maybe in Seattle, wages are climbing in step with house prices and there is hardly any need to resort to Subprime or Alt A loans. But in most of the country this was not the case. Nobody paid enough attention to stagnant wages that coerced people into using sub prime loans.
You B right about "rich people losing money" because they are the only ones who had any...unless you think about the pension funds that might have been attracted by double digit earnings that were available through HFs using CDOs. That may be coming as dd notes above.

[Lester]

For a sickly sentimental view of the recent subprime crisis, check out the video:

http://economicdespair.blogspot.com

Lots of poor folks crying how they can't afford their payments.

[Bruce Webb]

"Maybe in Seattle, wages are climbing in step with house prices and there is hardly any need to resort to Subprime or Alt A loans. But in most of the country this was not the case."

Ha, ha! Yes wages are climbing in step (kind of) but we are using Subprime and Alt A loans anyway!! Because they allow leverage in ways conventional loans don't.

Prove your case that most of these loans were coercive. Certainly that is conventional wisdom, but then I am not a conventional guy. I kind of like my data points data driven. I'm funny that way.

There are two simultaneous narratives out there. One has lenders coercing borrowers into subprimes with disasterous resets. Another has borrowers fleecing lenders into lending them dollars on phony stated assets/stated income.

Who is the shark in these scenarios? It is odd to imagine that both are in play at the same time. Are their really "Chump Lenders" and "Shark Lenders" out there? And how would you tell the difference?

I'm reading the stories carefully, I freely admit that things are happening, but we are a few too many years into "bubble blowout" reporting for me to take this all without a bucket of salt.

New Century getting their funding pulled does not equate to people having to move into their cars. Certainly their are effects up and down the line but the nature of ARMs didn't magically change. Poor people in overleveraged loans on bad terms have always been at risk. Are rates spiking in a way that makes ARM resets that more burdensome than they were in the past? Was there really a bunch of boo-hooing about poor people losing houses before Countrywide and New Century started taking a bath?

Convince me that all of this is not just a lot of angst about rich people realizing their mortgage security portfolio was not as secure as their risk premium justifies. And then we'll talk. Until then I am waiting and watching.

[Bruce Webb]

DD: "Umm, no. That is what regulatory structures are about at least in the old FDR meaning. It is the entire basis for the SEC, CFTC, FDA, FTC et.al.: a recognition that everyday economic actors have imperfect information and to level that playing field there are government intermediaries"

You are preaching to the choir here, cut me and I bleed New Deal. But I doubt a lot of Friedmanites and Miesians would agree that those regulatory structures were necessary or useful. I hear you. I am not sure they would be hearing you in Chicago or Austria. Those folk have a very different opinion on regulation of markets.

[dd]

Ahh, yes as I am UC trained at the tit of Epstein dare I say but indeed from the trenches of reality where the last can of tuna fish was all betwixt hunger and the tuition payment. Hence the ire for which I apologize.

[gopal]

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[M Petrone]

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[John Noble]

Is it a good time to be doing this with the state of the economy?