Unsustainable Lending (part I)

I've been doing way too much reading about the mortgage crisis, and it's kind of depressing how we got ourselves into this mess. The numbers just don't add up...but I guess it never mattered for the people driving us into the ditch, since they get paid based on short-term results, long term be damned.

There are a couple issues that I've been musing about over the break, which I'll break into a couple of posts. The first has to do with prepayment penalties for subprime mortgages, and how they ensure that things were going to blow up even if house prices remained stable. The second (related) issue is why the institutions who own mortgage backed securities (MBS) don't support renegotiating underwater mortgages. Keep in mind that I'm just a humble astrophysicist, and I really don't know what I'm talking about when it comes to these issues.

The stereotypical subprime loan was an "option ARM" where there was a low introductory teaser rate (say, 2%) which lasted a year or so, followed by a reset where the rate would go up significantly (to 6-8%). Notably, the interest rate on the loan would usually reset before the payment rate, so the first year or so would have negative amortization, where the principle on the loan was actually increasing over time. For a modest $100,000 loan, the introductory payment rate would be $370/month, and after the first year or two, this would increase up to $740, or a factor of 2. Although I think I could afford this modest $100,000 loan, in general I don't think I could afford a doubling of my housing costs.

So what's a borrower to do? It seems obvious to me that the only option is to refinance the loan after the teaser rate expires (or sell the house). And this will only work if the price of the house hasn't decreased! But of course the lender doesn't want to see the borrower refinance every year or two to grab the 2% teaser rate over and over again. Other than the fat fees that are grabbed by the brokers, the main impediment to doing this is the prepayment penalty, which is typically 5% of the loan amount, which is $5000 for our $100,000 loan.

Some of this is laid out in this recent (Oct 2008) paper Did Prepayments Sustain the Subprime Market? [pdf] from the St. Louis Fed (mad props to them for using LaTeX!). As they point out for subprime mortgages over the past 5 years, after a reset "prohibitively high rates [leave] the borrower little option but to prepay either by selling or by refinancing," or end up delinquent and finally in foreclosure. As house prices turned around over the past couple years, these subprime borrowers could no long refinance, and were forced into foreclosure, and the authors conclude that "the boom in house prices...was largely responsible for sustaining the subprime mortgage market by allowing distressed borrowers to prepay mortgages."

What the authors don't seem to explicitly state is that because of prepayment penalties even if house prices plateaued, and didn't even decline, these people would be forced into foreclosure. By my back-of-the-envelope calculations, with a 5% prepayment penalty, if the rate resets 2 years after the start of the mortgage, the house price must have increased by at least 2.5% (before any broker fees!) to make a refinancing possible, because you need to pay back $105,000 on your $100,000 loan. It's even worse for the vast majority of subprime loans that start out with negative amortization. In those case, house prices must go up by at least 4-5% to make this all work.

And yes, by some magic, house prices have increased over the long term. But (a) price/rent ratios were so out of whack, it was clear we were in a bubble that couldn't last forever, and (b) even if we weren't in a bubble, there have always been short-term plateaus, declines, etc. But all it takes is one year of trying to pay over 50% of your income toward a mortgage and you'll find yourself broke and out of a house.

Stay tuned for part II...