Public Interest Comment on Subprime Mortgage Lending:

I have recently become an Affiliated Scholar with the Mercatus Center at George Mason University working on issues within their Regulatory Studies program, especially related to issues of competition and consumer protection. Last week, in response to a request for Comments by the federal financial regulatory agencies I (along with Mercatus staffer Joe Adamson) filed a comment on subprime mortgage lending standards. Our Comment reviews the existing economics and empirial literature on subprime lending.

Our Comment is available here.

Did you find that there is a reasonable correlation between (1) the difference in risk in prime vs. subprime lending, and (2) the difference in interest rates/penalties/etc charged to subprime borrowers versus prime borrowers.

It sounds like the majority of subprime lending is only slightly riskier than prime lending, and thus it seems that the increase in interest rates and the like should be small. Is that the case?
5.10.2007 1:21pm
James Ellis (mail):
Bravo. I thought the public comment was concise and right on the mark. It's about time somebody stood up for a relatively efficient marketplace. I would love to see some real data on subprime defaults and foreclosures that looks at the representations made by the borrowers (and/or their brokers) in the original loan applications. I suspect that many borrowers now in default submitted applications that inflated their incomes or other assets available to pay their loans, understated their other financial expenses or obligations, or misrepresented their intent to actually live in the home.

While it is unfortunate to see borrowers lose their homes, it is important to realize (a) that most purchased those homes with relatively small down payments and extremely high leverage, essentially betting on increasing values, (b) in California and many other jurisdictions, these loans are non-recourse to the borrower, especially where a power of sale is used, and (c) worst case, the protections afforded to the borrower in a default situation are extremely powerful, when looked at in light of other consumer indebtedness.

Try not paying your rent, your phone bill or your car payment for four months and see what happens.

I would also note that interest rates for subprime borrowers today are still far more attractive than they were for the most creditworthy applicants in the 1980s and early 90s. I bought my first home as a "prime" borrower in 1990, when the "teaser" floating rate was 9.9% and the 5-year fixed rate was 11.625%.
5.10.2007 2:17pm
Zuhaib (mail) (www):
As someone who's has a little first hand experience in the mortgage business (my father runs a a Real Estate and Loan company in the SF Bay Area after he retired from Engineering) and i would say the major problem is not subprime lending as a lot of the media is reporting.
Subprime is just a nice way of saying someone who has bad credit, and while yes during the large boom (especial here in the Bay Area) a lot of lender would accept No-Doc/Stated Doc loans with no questions ask, the true problem IS the type of loan.
In the North Cal. area many people with good credit and maybe making a decent income (above 60K a year) still could not afford a decent house with a traditional 30 year loan, so the lenders started making use of more exotic loans like the neg-arm. The Neg-Arm, Negative Amortization, is a loan where you place a bet that your property value will go up. The way it works, you get a loan with a true interest rate of say 6% (adjustable rate but we will treat it fixed) but what you will pay on your monthly payments will only be 1% of interest (with no principle) . So what happens to that 5% your not paying? It is added to your loan amount, and your payment will be adjusted every year for 5 year for the new loan amount, or till you hit 110% (or whatever the lender sets). But the catch is also, if the lender feels you wont be able to pay off the loan in the 30 year time line, they can at any time just force you to pay principle on a new adjusted term which will cause your payments to go up as high as 10x!
So while right now a lot of the news is going around that subprime is where the trouble is, i feel the real trouble is going to be with these new type of loans when people with good credit start not being able to make these payments. This might be an issue more in line with the west cost as our housing prices where way out of line with the average income causing people to only be able to afford these risky type of loans.
Another issue maybe needed to be looking in to is hour brokers work in to all of this. One major factor being blamed for this problem was the fact lender did not check documents or did not require documents aka NO-Doc/Stated. Well a lot of times, the Stated loans are where brokers are involved where they are suppose to take a the customers finical records and then submit the loan to the lender in way vouching for the customer. This is a major hole as many brokers/agent are paid on commission and are pressured to make as many loans as they can, and some might just let clients who should not be getting loans to slide. Lenders are already starting to place more pressure on brokers but i feel the real hole is there.
5.10.2007 2:35pm
J. F. Thomas (mail):
I suspect that many borrowers now in default submitted applications that inflated their incomes or other assets available to pay their loans, understated their other financial expenses or obligations, or misrepresented their intent to actually live in the home.

What, so lenders don't check these things any more?
5.10.2007 8:57pm
pdxnag (mail) (www):

There are two areas of concern. The public interest and the soundness of the system.

The rental justified market cap valuation of property is consistently below that of the amounts loaned.

It is the lenders that want high valuations because they can get more interest payments even with decreasing or stable interest "rates."

Suppose an investor wants their money back from the investment in 10 years -- from either rent or dividends -- they would see a market cap rate of point-one-zero.

Assume that most home buyers are encourage to buy the most home that they can buy and that they do so, on the advice of the "Realtors" and with the complete complicity of mortgage entities and their clients the banks. Their payment will be pegged to the max that they could afford -- regardless of whether they are "purchasing" or renting.

Take that payment for the target property and that particular buyer and recalculate the appraisal of the home from the perspective of the investor that wants a ten percent cap rate from that payment as rent.

And while still trying to isolate out the cost of money from the transaction:

Consider that the lending system for residential homes changed overnight to peg it to ten year mortgages, so as to be in rough harmony with the "investment" valuation principals for an investor, and then reexamine the supposed collateral held by financial institutions as if it has some intrinsic value quite apart from the continued lending and their continued assistance from the federal reserve type market interventionists. (The answer should be obvious.)

When the old Resolution Trust Corporation is revived to accommodate the correction of the huge imbalance between debt and the ability of folks to cover the debt will the lenders again be considered the prime beneficiary, but again in the name of depositors and deposit insurance?

The injection of brokered deposits was the key distinguishing feature between failed thrifts and those that remained sound. Mortgage backed investment opportunities look the same today as a thrift that accepted brokered deposits.

You assert "most borrowers are now better off because of their subprime loans." This is so astoundingly odd, given that the price paid as a result of the lending is so out of whack with the investment value of the collateral, that I could not disagree more. Predatory-lending inquiries must not be confined to the rate of interest but must roll in the price or value of the item purchased. But of course this would result in recognizing, overnight, that much of the financial system is unsound. I would not characterize the unsoundness of the house of cards financial system (state sponsored pyramid scheme for haousing) as positive evidence to glorify debtors as proud homeowners.

There is always a cost and inequity that results from any government disturbance in equilria. The equitable price for a home is the one that the buyer can pay off in ten years. If the seller is disappointed by the lack of unearned gain, so what, I would rather they invest their savings in something productive rather than in the classic dead investment of homes.
5.10.2007 9:14pm
pdxnag (mail) (www):
Oops on the essential link:

SEC: Margin: Borrowing Money To Pay for Stocks
5.10.2007 9:16pm
Rhode Island Lawyer:

What, so lenders don't check these things any more?

Not in many subprime situations. These loans are called "no doc", "low doc" or "stated income" loans, and are more colloquially known as "liar's loans."

The way it often works goes something like this: A prospective homebuyer has identified a property to purchase. The broker says "If you have an income of about $X, I can get you a mortgage to buy that house. Now tell me what your income is and fill out this paperwork." Not surprisingly, the applicant claims to have an income of $X. It's all done with a nod and a wink.
5.11.2007 11:20am
pdxnag (mail) (www):
Rhode Island Lawyer,

In such a situation could the deal be later deemed fraud and treat the seller's receipt of cash on the sale as the fruits of the fraud -- even if the seller has relied on that cash to buy other property or for other transactions with tax related consequences or to settle a divorce issue and on and on? Consider the impact on the system of treating such specific transactions as void. Then consider all the criminal liability that could and should be applicable to all those folks that claim to be professionals. It is like reconstructing a bomb from scattered pieces.

I can't see how the seller should be able to "unilaterally" skate. (See arguments from Armendariz in CA 2000)
5.11.2007 1:54pm
James Ellis (mail):
Meanwhile, check out 18 U.S.C. 1014, which makes it a federal crime to knowingly make a false statement (or wilfully overvalue collateral) on basically any mortgage application (certainly any one using the standard federal form 1003 uniform loan application).

I'm mildly surprised that no up-and-coming US Attorney has emerged to take on the network of mortgage brokers, appraisers and dishonest borrowers that has helped to create this so called "crisis."

This would seem to be low-hanging fruit. The public is looking for scapegoats here, and many of these potential defendants would likely come off as unsympathetic characters...
5.11.2007 1:57pm
Re: In such a situation could the deal be later deemed fraud and treat the seller's receipt of cash on the sale as the fruits of the fraud

In the situation described the seller is not the one who has perpetrated a fruad. The borrower and the broker have colluded to do so. The seller is innocent; the penalties should fall on the borrower and the agent who encouraged him.
5.11.2007 4:32pm
pdxnag (mail) (www):
Note in the UCC the distinction between Void and Voidable where both buyer and seller are innocent (for personal property, of course). The inquiry would -- I think it should -- turn toward who has greater control over the professional intermediaries. Here that would be the creditor over the professional parties to whom they entrusted with the "money" and upon whom they relied/partnered. If the transaction (the delivery of money) is void, and of necessity the transfer of title, then both buyer and seller are nominally returned to where they were had there been no deal.

In a criminal case of receipt of stolen personal property an element would be knowledge that an item had been stolen, but that is not the inquiry here, assume innocence.

Imagine that a real estate agent, as a precautionary move against personal liability, insisted that any residential property transaction they participated in had to be accompanied by a separate appraisal based on rental-justified market capitalization in addition to the one supplied that conformed to the federally related rules/disclosures designed to assist/encourage the secondary mortgage market. I am not going to assume that a banker or bank regulator is unfamiliar with the discretion given to an appraiser to choose their method of appraisal (or even to choose more than one), as with Wilsonville Heights Assoc. v. Department of Revenue (S50763, 2005) Would a banker be compelled to reject a loan for X dollars if an alternative appraisal pegged the value under a different appraisal method of much-less-than-X was also submitted? The formulas are nothing new or odd and are known to all appraisers and surely to bank examiners. It seems almost superfluous to submit such additional appraisal because any banker should be held to have constructive knowledge of the alternative appraisal methods. And I would insist that at least in Oregon that bankers are aware that the decision above turns on the federal restriction on "rent" as a condition the the federally-related loan -- for which a requirement of "owner-occupancy" is no less "restrictive" on the collection of rent. It seems that it is already OK to have two parallel appraisals on the books, one for the loan and one for setting the property tax.

I would have no qualms telling a banker to recover any money, upon a declaration that a loan agreement is void, delivered in excess of the genuine lower appraisal price from the seller rather than from the buyer. Particularly when the almost certain payment increases kick in on an ARM, where the lender tailored their offer to induce someone to incur debt that they might not have otherwise qualified for in any other way.

If I were a buyer broker and present the seller with a rental justified market cap appraisal the seller and their broker, and the lender too, would surely just laugh . . . each for their own reasons.

Here in Portland, in perfect lockstep with the ownership society (through debt) crowd, the higher the price the higher the perceived "wealth." But they have a tax collection focus and bonding and bond rating (to maximize lending/borrowing) tunnel vision. In the public bond context, often sold as a means to achieve "affordable housing" through devices such as Tax Increment Financing, I would insist that the bondholders have constructive knowledge that the valuation of the "property" IS the lower market cap valuation notwithstanding the higher amount lent (consistent with a court case where the developer themselves asserted the same so as to achieve lower property taxes) -- and simply present them with the phone number and address of the ultimate private developer recipient of the cash. This is not to say that any of the professionals should not be held personally responsible but that innocent parties that are demanded to pay off a debt have a claim against the real-party-in-interest recipient of that cash. To isolate on collection against the title holder of property (or municipal taxpayer for private project X Y or Z) is unjust.

The lesson from the Savings and Loan bailout and the overnight transfers of "unsound" financial institutions by the Resolution Trust Corporation is that the public interest is perverted into the private interest in monopolization of the entire banking system -- which is/will just be exacerbated with the active complicity of the Federal Reserve. The question set for the report was sufficiently narrowly drawn to exclude the "PUBLIC INTEREST" from examination. The borrower is the "mark" in this real life version of "The Sting," where their ignorance of the dynamics of money (and the money supply, including money-equivalents) let's them believe they are something other than the mark. (See JKG generally.) Incomplete knowledge can lead even the most confident analyst to make conclusions that are against the public interest. Here, just zero in on a ten year payoff period and it will guide you back to sanity.
5.12.2007 1:55pm
ProspectZone Mortgage:
I'm impressed that you were willing to stand up and make a firm comment on this topic. Everyone seems to want to complain and point fingers, but nobody wants to logically analyze it and figure it out. The mortgage industry is a hugely important piece of many peoples' financial lives, and so the ability to understand and work within (and around) the system is vital.
5.15.2007 6:37pm