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3/27/2007

Re: JLP's Subprime Lender Mess Question

In QotD: Subprime Mortgage Mess - Who's to Blame?, JLP at All Financial Matters poses the question: "Who’s to blame for the subprime mortgage mess? The lenders or the borrowers? Or, should the blame be shared?"

He got a lot of interesting replies, and this was going to be one of them, but I started writing and it got very long, and then I got pulled away and ... blah blah blah. The point is, my answer is here now.

They're both to blame for their own part of the problem.

Anybody who defaults on a loan is obviously to blame for 1) overextending themselves and/or 2) not understanding what they were getting into. That is an individual problem, and each individual is responsible for their own problem.

Lenders are at fault for the bigger, aggregate problem. They made stupid loans, quite simply. They made loans that they couldn't cover. Millions of them. Millions of poor business decisions, pure and simple. They are totally at fault for that and therefore bear the majority of the responsibility for this whole thing. Loaning to subprime borrowers is inherently risky. You go into it knowing that some percentage of them will default. It is the job of the lender to figure out that percentage and set their rates accordingly to keep from going bankrupt.

Your average individual American cannot really tell you how much house they can afford and how much they will be able to afford 2, 5, or 10 years down the road. A bank, with lots of smart people working for it, using tons of actual data to make predictions, can. The credit game is one of "if you build it, they will come." If you decide to loan money to people with poor credit, people with poor credit WILL decide to borrow money. If they default (which some will, no matter what) then you have nobody to blame but yourself for lending them the money. If you create lending programs specifically for people with poor credit, and then advertise them in every newspaper and every other broadcast medium, guess what? People with poor credit will apply for that credit! And if the company is stupid, it will approve more than it should at lower rates than it should.

We are all familiar with the typical bad image of a company with more marketing acumen than actual good products. They come up with something stupid, and then, in order to sell it, they use marketing to "create the market." They generate demand to meet their supply of the product -- demand which, like the product, was nonexistent before. And then millions of people end up with Pet Rocks or Food Dehydrators feeling like idiots, while the marketers of the product are laughing all the way to the bank. This current situation is a case of the lending companies "creating a market" that shouldn't have been created.* And in this case, there are some "just desserts" being dished out in the form of crashed stock, some ethics investigations and maybe even some criminal prosecutions.

(*Note: I'm not saying that lending companies created the demand here. There is always a demand for free money or easy credit. Lenders created the supply, and thus created the market. You could set up a business to lend million-dollar unsecured loans with no credit checks, and I'll bet you'll find pent-up, currently-unsatisfied demand from several billion people -- but obviously it would be a bad business decision to enter that market. All of this comparison to Pet Rocks and the like is just to connect the two different shady kinds of business. In the Senate hearings on this fiasco, I bet we will hear time and time again from lending execs that they were just "trying to meet the market demand for this kind of loan product." And guess what? I just did a Google search for lender trying to meet market demand. The first result was (I admit, this amuses the hell out of me) a recent speech by Sen. Hillary Clinton:

According to most recent statistics, delinquent payments now affect more than 13 percent of subprime loans in our country. That's the highest level in four years. Now, many would attribute this rise to unsophisticated homebuyers, even irresponsible buyers, or the subprime market itself. But the foreclosure rate for all mortgages increased by more than 17 percent in the last quarter of 2006. That's the highest foreclosure rate in four decades.

So when somebody tells you this subprime market thing is no big deal, or maybe, you know what, let the buyer beware, these folks signed on the dotted line, it's their responsibility. Ask them why the rate for all homeowners is so high. Because the economy is not supporting homeownership the way we need it to. And after all, in the absence of an alternative, the subprime market has opened the doors to millions of families and responsible lenders and the market are rightfully casting out some of the worst actors in the subprime industry. But the market will not address the millions of families trapped in unworkable mortgages, hounded by delinquency and facing the grim possibility of foreclosure.

...

We need to expand the role of the FHA to issue more mortgages at better rates to these homeowners. We need to give consumers more counseling and information, prevent families from being trapped in high interest loans with pre-payment penalties and in some cases, allow more breathing room from foreclosure.

...

Now, I will soon be reintroducing my 21st Century Housing Act, which will take steps to modernize the agency by allowing the FHA to reinvest a portion of its revenues in new employees and information technology; to develop new mortgages to meet market demand and to position the FHA to work more efficiently with lenders and to serve more borrowers.

Guess what, JLP? It's neither the lenders' nor the borrowers' fault! It's the economy's fault, stupid! Ok, that was a bit longer diversion than I meant to take, but I was just so amused by that.)

Tech blogger and Yahoo Jeremy Zawodny blogged a couple of weeks ago about New Century Financial Corporation's website and the dangers of having a live stock quote on your company's homepage. I'm sure the slide from $30 to less than $2 in two months is something that NCFC really wants to promote on their front page! (And I'm really surprised that they haven't taken it down yet). That stock is no longer listed on the NYSE.

Are the individuals responsible for their own individual problems? Of course. But they're basically too stupid to keep themselves from getting into these problems. That's an assumption you can always bank on (pun intended). "Nobody ever went bankrupt underestimating the intelligence of the American public." This is pure statistics, and (as I have written before) it is the thing that has driven the success of Dave Ramsey's philosophy more than anything else: you simply can't trust the majority of people to make good decisions about money. People are short-sighted. The story of Faust is resonant for a reason.

I read stories like this one and I find it hard to place the blame in any particular place. First off, the people sound like idiots because they knew they were signing for a more expensive mortgage than they wanted. Secondly, the real estate agent sounds like a scumbag. Thirdly, the loan originators sound just as stupid as the borrowers for lending to people skating so close to the edge, without requiring enough equity to be able to withstand a hit if the local housing market dropped. The kind of loan that these people got (100% financing) sounds like the kind of loan I'd only give to somebody with A to A+ credit. And then there's Wall Street, which seems to gobble up mortgages like there's no tomorrow. I've actually read (and thought it was reasonable) several authors writing about investing in REITs (Real Estate Investment Trusts) because they produce a good rate of return and their loans are backed by actual assets. Well, New Century Financial Corp. was an REIT. There are undoubtedly some good (non-subprime) REITs out there, but this whole thing leaves a bad taste in my mouth. Also, the "backed by assets" promise doesn't seem so great any more.

There's also the matter of subprime loan recipients. Think about it: if you're applying for this kind of loan, you're already desperate. Your credit sucks. Do you really care that much about a foreclosure if you're already so badly off to begin with? At that point, taking on a mortgage is just a gamble, and you probably realize it. You think "Well, I know I probably won't be able to make my payments for the next 5 years, but I'll just enjoy the house while I have the chance." So you're sitting there, you found a house and this guy is telling you that you can qualify for a loan. The terms are ridiculous, but who cares? You'll be no worse off than you currently are if you default on the loan. And if you happen to keep a good job and pay off the loan eventually, hey, great. It's other people's money anyway, right? And there's never been a better opportunity for these people (in terms of interest rates and the housing market) than there was two years ago. Is it any wonder? Can you really blame these people for taking out these mortgages? They took a risk, sure, but it really wasn't terribly risky for them. They weren't even going to lose their down payment, because they didn't make one.

Anyway, I'm just rambling now. My main point: Everybody has their share of the blame. Individual borrowers: to blame for their individual loans, taking out too much in loans, not reading or understanding the loan documents properly. But we're talking about millions of individuals here. On the corporate side, we're talking what, maybe a hundred (order of magnitude) companies all originating these loans? Shouldn't these companies with billions of dollars at their disposal have been more prudent than the unwashed, credit-less masses? (I do realize that I'm probably giving too much credit to these corporations.) Moving on upward through the chain, I have a pretty hard time blaming the government at this point, although the government will be to blame if it bails out any of these bankrupt companies or encourages any more of this kind of loan. On principle, I'll rarely argue for more regulation, and if the further regulation goes the way that Senator Clinton is proposing, it will just make things worse.

3 comments:

Golbguru said...

Wow..quite a rant there. :)

My instincts are more towards pointing the fingers at people like ourselves. It seems like we are loosing the concept of "personal accountability". So what if your loan deal is good?, so what if your house is fabulous?...you don't go on possessing everything that seems good and fabulous.

Or may be like you said, most of us are loosing foresight in addition to the lack of accountability.

Siggy said...

The main problem is the lenders selling 100% mortgages at 1% that are actually charging 7% which is rolled into the principal under the principal gets to 125% of the valuation.

It is all very well saying that the buyer beware, but;

a) the buyer is an idiot anyway and probably doesn't even know how to spell APR.

b) the buyer has got nothing to lose.

c) the lender knows what the buyer is earning and what they are likely to be earning next year and knows what the mortgage payment will be when the teaser rate ends. How do they expect the buyer to pay it ? Or to refinance it since the loan will now be at 125% of the appraisal.

You want to fix the problem ?

1. Allow advertisements etc to only quote the APR for the first three years. (If it is adjustable, only show the maximum it can be)

2. Require that the buyer be able to afford the payments for 7 years assuming that that they get a 10% pay raise each year no matter how the interest rate changes.

Sure, you will get some people with problems anyway, but they will be few and far between. The 7 year perspective will allow an economic cycle to pass, which will usually provide an equity gain and alleviate the bank's foreclosure cost.

Fewer people will qualify for loans, but the ones that do will be better able to pay them and the housing market will be less prone to boom and bust cycles.

lenders will come up with shared equity plans that will help lower earners afford to buy a property... You buy a house, but the lender owns half of it so you only have half the mortgage payment. The lender only charges a token rent on the other half since they expect that half to pay for itself when the property is sold. As part of the deal, you buy full service homeowners insurance which covers everything including an annual property inspection.

Thersites said...

Just chiming in to say that my instinct is to blame the corporations that made the predatory loans. I also agree that both parties are at fault.

I believe that this is an area where more government regulation is needed to prevent similar crises.

Lastly, I had a hilarious captcha while writing this comment: sukpp!