TCS Daily

Schizophrenia in the Subprime Sector

By John E. Tamny - June 28, 2007 12:00 AM

Testifying before the House Financial Services committee in April, FDIC chairman Sheila Bair addressed problems in the subprime loan sector by calling out the industry itself; telling the committee, "I think we should hold the servicers' and investors' feet to the fire on this. It was clear to investors that these [loans] were high risk. I think everybody needs to share the pain now."

Recently iRep. George Miller (D-California), chairman of the House Education Committee, he will be investigating possible "redlining" practices among student-loan companies that potentially discriminate against students at historically black colleges. This follows past efforts by Congress to increase minority home ownership through pressure on banks to open branches in underserved minority communities.

In 1977, Congress passed the Community Reinvestment Act (CRA), which required banks to apply the same lending criteria in all cities. The Act sought to reduce the aforementioned practice of redlining, whereby banks would allegedly avoid making home loans in poor, mostly minority neighborhoods. The federal government's schizophrenia when it comes to lending speaks to the difficult tightrope banks must walk in seeking to engage in their lending specialty.

The ongoing scandal in subprime home lending lays bare the difficulties lenders face. According to Harvard's Joint Center for Housing Studies, blacks and Hispanics accounted for 49 percent of the increase of homeowners from 1995 to 2005. The latter statistic suggests the CRA was a great success, except Federal Reserve data show that 46 percent of Hispanics and 55 percent of blacks secured high-cost, subprime loans in order to purchase their homes.

With loan foreclosures on the rise, particularly within areas possessing a high number of minority borrowers, Congress is on the warpath against the same lenders that it once denounced for not lending enough to minorities. Congress's message to lenders is pretty clear: "Discriminate against minorities at your peril, but if loans to minorities go sour, expect investigations, fines, and greater regulatory oversight of your activities."

Community groups such as the NAACP and the National Council of La Raza have joined their political enablers in calling for a six-month moratorium on subprime home foreclosures. Charges that subprime lenders acted in "predatory" fashion ring pretty hollow considering the actions of the NAACP and La Raza.

Indeed, banks are in the business of making loans to as many people as possible as profitably as possible. Plain and simple. To assume they were predatory in their actions suggests that they have somehow profited from duping unaware and impoverished customers into taking out loans they couldn't afford to pay back. Given the implosion of New Century Financial and other subprime lenders, the predator characterization is absurd.

If there are people to be demonized in this discussion, it is the politicians, regulators and community activists who seek to have it both ways: plentiful loan availability for their constituents, but debt forbearance if those same loans prove too onerous. Political correctness presumably keeps politicians from fingering the true predators in this situation, but they're surely the people who accessed loans and defaulted on them; in the process imperiling the financial health of the lenders who made the loans to begin with.

The political climate suggests that in seeking to "solve" the problem of loan foreclosures, borrowers will be exonerated at the expense of lenders. If so, there will presumably be short-term political gain for the alleged leaders who stick it to the lending institutions in the name of helpless borrowers.

If so, those same leaders should also be prepared to reap the consequences of the political class's schizophrenia when it comes to subprime lending. It has become clear that politicians don't like discriminatory lending practices, but they also don't like it when failures to discriminate aggressively enough lead to debt defaults.

The result will surely be less in the way of intrepid lenders willing to pass through the Scylla of discriminatory lending, and the Charybdis of default. If that means lenders "redline" a greater number of borrowers to avoid risky lending to the few, the anti-subprime crusaders should be prepared to explain to their constituents why they can't access loans at all.

John Tamny is editor of RealClearMarkets. He can be reached at



Saving lenders from themselves
The problem is not lending to minorities. And it certainly is not lending within neighborhoods someone thinks should be redlined. The problem is with leading gullible home buyers into thinking they can afford loans they obviously will be unable to sustain.

Loan placement officers and real estate sales agents collude in presenting to prospective home buyers only homes that are well above their affordable price range. They then downplay facts that should be part of any enlightened disclosure requirement, omitting, for instance, any mention of the burdens of taxes and homeowners' insurance.

It is up to the educated buyer to ask the right questions. First time buyers, low income buyers and poorly educated buyers simply don't know those questions. Instead, they just carefully imbibe such information as their agent or broker sees fit to divulge to them.

Imagine their surprise in a year, to find that a loan that's already a back breaking burden floats steeply upward, and their home suddenly becomes unaffordable. Thirty years ago, when I was in the business, the home sales environment included safeguards for the consumer, and disclosure statements that actually disclosed the true financial consequences of the loan under consideration.

Times have apparently changed. At one time no one qualified for a loan if their principle, interest, taxes and insurance totaled more than 25% of their total gross income. Then it was 30%, and we saw some signs that people were having trouble with such a debt burden.

Now they claim the line is at 36%, but that's a joke. Agents will start showing you homes at fifty percent, and insist to you that you can qualify to buy them. In many areas they will not even bother to show you homes you actually can afford.

Then the agent and the loan officer display a little razzle dazzle and show you the tricks they can use to get you to qualify. You feel like you're in good hands, and they can magically open doors for you that would otherwise be closed.

They're actually opening doors that SHOULD stay closed. The lending industry is badly overdue for a fresh set of guidelines, with severe sanctions for infractions.

This will be heartly resisted by the loan industry. But actually it would be the best thing that ever happened for them. Such a move would save them from their own greed.

Ain't goin to happen, of course.

Can't have your cake and eat it too brother

Not from themselves that lenders require saving
I usually enjoy Roy_Bean’s commentaries but I have to conclude from this one that the thirty years since he states he was involved in the Real Estate/Mortgage Origination industry is also the amount of time since he last actually looked at it and he is now relying only on hearsay and what the politicians maunder on about it.

1) Contrary to his statement, the facts about Insurance and taxes are not only disclosed prior to obtaining a mortgage but there are strict requirements imposed on the mortgage industry on both what must be disclosed and on how it must be disclosed – in writing and signed off on by the potential buyer well before and deal is accomplished.

2) If a mortgage is an adjustable rate mortgage it must also be disclosed when it can go up (or down), by how much, and the potential maximum amount it can go up or down over the life of the loan.

3) The limits on TOTAL indebtedness to income can occasionally go as high as 50%, but it is very difficult to get such a loan underwritten and the borrower must have very good credit and/or exceptional liquid reserves to be able to go that high. Suggesting that your average sup-prime borrower can get such consideration is far fetched at best.

4) No one can get considered at a level of 50% on principal-interest-taxes-insurance to income as you seem to be suggesting. No bank or mortgage company would underwrite such a loan and any who tried would be in deep hot water with the regulatory agencies that oversee mortgage brokering and lending.

5) Contrary to your suggestion that the industry was more closely watched over 30 years ago, it is actually much more heavily regulated now than it was then and the regulatory oversight increases on a continual basis. Regulatory requirements, in fact, are responsible for a good number of the costs involved in closing a mortgage that people continually complain about (ex: the requirement in most states that every property must be reappraised each time it is refinanced even if it had been appraised very recently for some other purpose, - at a average cost – to the borrower – of $250 to $425 each time)

6) Finally, the sanctions imposed for ‘infractions’ are so draconian now that they often amount to forced bankruptcy for any broker or lender who is unlucky enough to either err or simply to get in the way of the latest witch hunt. What did you have in mind for more “severe sanctions”? Public executions?

in roy's world, everything is a conspiracy
do you have even the slightest bit of evidence to support your claim that real estate agents are conspiring with loan officers to show people only those houses that they can't afford?

What about the people who don't use real estate agents to find a house? Are they conspiring with themselves?

You Again
First off I am currently in the mortgage lending business. I have been doing this for the last 7 years. I have made loans accross the whole spectrum of residential real estate from AAA borrower all the way down to the lowest subprime categories. I have done mostly refi loans but I do a few purchase loans from time to time.

Let me give you my take on what has happened here particularly in the subprime sector.

First off I do not think RE agents and mortgage lenders collude on housing prices (maybe there is some bad apple exception out there but I have never encountered it). The reason I say this is because the RE agent's first and formost interest is to CLOSE THE SALE. It is hard enough to accomplish the sale just trying to line the deal up let alone try to jack the price up in the process. The RE agent does have a duty to the seller to get highest price they can. Market forces I think take care of this push/pull just fine. A mortgage broker is trying to get the deal closed too. If anyone was trying to overreach it was the seller. I had sevral deals where we had to drop the price of the property to get the loan done. In each case the seller did agree to reduce the selling price. The are many other people involved in the pricing equation to get a deal done. There is the appraiser, the underwriter, the underwriter's appraisal reviewer and sometimes even their bosses get involved. So a pricing conspiracy would be hard to coordinate.

Let me tell you my take on what happened here:

The lending business is extremely competative. I worked for a company that had relationships with like 8-10 different subprime lenders alone. We had about 120 loan officers working in this particular company. The reps for each of these lenders would come in and pitch their offering to us on a regular basis. Where did I place my loan files? There were several considerations. Lowest rate, easiest underwriting, highest rebate. If I put a file into lender X and I experienced a huge underwriting hassel what do think I would do the next time? Probably try another guy. I often times would never go back to the guy that gave me the hassel. So multiply this over the huge volume of laons being done and I think you would find that as the rates dropped the lenders were more willing to ease the underwriting standards to stay competative (to keep their volume up too).

The borrowers loved this. All of a sudden a guy with a subprime credit score could buy a nice house with no money down. That was not possible just 6 or 7 years ago. The underwriting guidelines loosened over the years as it was realized that rising home prices kept foreclosures down. An even if the lender thought that a bubble was forming he was in a no win situation. If he did not loosen guidlines business would dry up but loosening guidlines became riskier and riskier. As you can see most opted for keeping the volume going. To their detriment.

Both borrower and lender have become losers in this market environment.

Many blame the Fed for loosening rates way too much in the wake of the 9/11 disaster. Who knows.

Should we have more government regulation? I am not sure that is the answer. The RE industry is already one of the most highly regulated industries out there. And that did not stop this. You can see the result of this regulation just in the mounds of paperwork when you go to sign a loan or close a RE deal. The docs alone are more than a half inch thick stack of papers containing redundant disclosures,cost estimates and contingencies. The actual loan note is only about 4-6 pages out of all that.

I think just the sheer amount of paper confuses the borrower more than anything. I mean the loan itself is really not that complicated. You have a rate, a loan amount, a payment. Then you have either a fixed rate or a variable rate and a schedule on when that rate will change. The hard part on any variable rate is guessing on where the rate will go in the future. No one knows that. I lay that uncertainty out to all my borrowers and of course thereis considerable disclosure concerning that.

You want more regulation show me what and how would do the trick over what we have now.

I don't get how your truism applies to my comment. I'm speaking from the point of view of having been in the business. And I'm saying that gullible consumers, not knowledgable about the details of the loan packages they sign into, are not good judges of the commitments they bind themselves to.

So, for their own good, we need to return to realistic loan limits and to truth in lending statements that really do disclose important details.

This is not just for the consumer's sake. Lenders could have saved themselves many millions in defaulted loans had they just been a little more prudent.

I look forward to your more complete explanation of your POV.

I will tell one factor that gave rise to what we have today.
As we raised taxes from the time of FDR till now the people demanded and got various tax write-offs. One of the major write-offs was the mortgage interest deduction.

Because of this deduction I think the cost of housing was artifically pushed higher than it would otherwise be today....thus giving rise to the derivitave type loans that are more complicated to understand.

I think the other big factor for many areas is the inability to keep up with the demand for housing due to enviromental concerns. Many areas experience backlash by environmetal groups and existing homeowners (who got there's) to building enough units to meet demand.

Most subprime programs allow up to 50% debt to income ratios for all debt incurred (including revolving and auto debt etc.) Who do you know that has a substantially lower ratio than that? Again, the government's meddling in the free markets has caused unintended consequences.

Selling the customer up
Thanks for giving your insider's view. I'm not at all current, having gotten out many years ago.

I do have a neighbor currently looking for a house. She's finding it next to impossible to find a realtor willing to show her anything she can afford.

The reason is, of course, that the realtor gets paid according to the cost of the house. Her incentive is to sell someone more than they need.

Now correct me if I'm wrong. You also get paid according to the size of the loan you place. Right? And if the loan goes bad, down the line, you still get to keep your commission. Isn't that how it works?

It's not a matter of "jacking up" any house prices. The list price of a given house is the list price. What happens is that the realtors who work with you every day know full well your guidelines for qualifying a loan recipient. So when they get a fresh customer and qualify them they start right at your upper limit, selling the customer on the size, the features, the neighborhood, with homes they can almost afford.

All this is before any discussion of mortgage amount, or terms. Then when the mark finally asks the important question, she is assured that "plenty of my customers have no problems with loans this size-- you can do it". All of this is very chirpy and upbeat.

By then they are reluctant to consider any house that is of lesser quality than the ones they've been looking at. So lots of people end up over their heads, on the assurances of the trusted professionals they've been working with that they can afford the targeted home.

This process, by the way, is similar to the process by which prices are constantly going up, or "appreciating". You might enlighten us as to exactly how your other friend, the appraiser, manages to convince your money people that a house is worth more than it's worth-- every single time it gets resold!

I think you know what I'm alluding to. Tell us more about the business, and why the great uptick in defaults at the end of an inflationary spiral. Isn't it a bit like musical chairs?

(Disclosure: I got out of sales when prices went, in my opinion, unconscionably high back in 1980. I got into rental management, to fill all those homes that couldn't be resold with warm bodies whose rent helped pay the mortgages.)

On further consideration
I'm re-reading your comment and seeing things as they appear to you, further up the food chain than the placement guy who works with the realtor. If you've never worked as a placement officer maybe you can't quite capture the flavor of these two principles, people who work very closely together.

Don't misunderstand my meaning when I say "collusion". They are not orchestrating some vast plot, nor breaking any laws (normally, at least, although some do). And they're only even bending the rules "just a little". Believe me, as often as not you have someone who wants to be an exception and buy just a little bit over his limit. That's where the "creep" comes in, and guidelines get shaded upward.

It used to be, for instance, that there WAS no subprime market. It was either prime or you got no loan.

I think a major factor that drives prices upward is the pressure of huge amounts of money, trying to get itself lent out. So the bending of guidelines happens as much from pressure at the top as it does from pressure from the home buyer.

And appreciation is always billed as being a good thing (it boosts your equity) instead of a bad thing (it's inflationary and can leave you badly overextended).

Of course what really facilitated the price inflation was low interest rates. People really could afford a far higher list price and still pay a low mortgage. Such a situation was unavoidable, and even the pros, I think, tended to lose their perspective in the scramble for new business.

On all other counts I will go with your superior grasp of the profession. If you say there's enough regulation already, fine. It should be the lenders themselves, badly bitten, who voluntarily change their ways of doing business. After all, it's not just the foreclosed buyers but the actual investors who are out the money. And as I recall, those folks don't like owning lots of bricks.

I do approve of your comment that you lay out to your customers the uncertainty inherent in taking out a loan. Not every officer works that way, as I'm sure you know. Probably the majority of settlements occur with the parties swept along on a tide of good cheer and optimism... like car sales, furniture sales and every other kind of sales.

But thanks for the refresher course. Down here I keep hearing about simple souls who sign paper without actually having the tax and insurance escrow explained to them until the day of settlement. Maybe we should blame the schools for this credulous lot of citizens, who can't be entrusted with their own affairs. :)

You have a point
Your suspicion is correct. I was last in the game in 1978-79, when the rates were at 13-something and prices were going through the roof. But I don't follow what the politicians are saying. What would they know? I'm listening to my neighbors, and their tales of woe at the hands of realtors and lenders.

I have mentioned to bladerunner that many of these folks are a little naive and credulous. It is news to me that they are still being informed of the total PITI at the time they sign the disclosure papers. That's the way it was when I was in sales. So when they tell me they're getting whopped with a big surprise, maybe that has more to do with their native intelligence than with being pushjed around by sharpies.

I have to go with your view that the industry is more heavily regulated now than it was thirty years ago. You sound like you would know.

Then there would have to be another explanation crying out to be made as to why the lenders, who are thought to be the pros in the game, lost so much of their own money by having unrealistic expectations as to their customers' ability to pay.

Let's close the discussion with the thought that the best course would be for these people to learn from experience, and next time be perhaps a little stodgier in their willingness to give ordinary dorks vast sums of their cash. Agreed?

Neither a borrower nor a lender be
You have an interesting take on the mortgage interest deduction. Of course, like Social Security, that's the third rail of American politics. You can't mess with the average Joe's only deduction. They all feel that's what has made the whole miracle of home ownership possible.

"Most subprime programs allow up to 50% debt to income ratios for all debt incurred (including revolving and auto debt etc.) Who do you know that has a substantially lower ratio than that?"

Me. I haven't paid anyone one cent in interest since we paid off our home loan early, some years back. We're old school. If there's something we want to buy, we save up our money in the piggy bank until we can go downtown and buy it. Right now we're putting aside for a new roof and our next car.

50% is, IMO, insane. This explains why the national savings rate has just dipped below zero. We now owe to someone more money, collectively, than our entire net worth.

I'm just as happy owning all my stuff, and not just having it on loan from someone. For one thing, my payments are nil. And we've still managed to get everything we need in life.

Mortgage Interest Deduction
Unless the allowability of interest as a business deduction is simultaneously eliminated along with the residential mortgage interest deduction, only eliminating the latter will create a tax-induced price advantage to lessors and skew the market to rental housing.

I know of no one who would want to create a tax disincentive to home ownership, regardless of political sentiment.

Of course, if business interest expense were treated in the same way dividends were (non-deductible), that would solve that problem and not encourage debt financing at the corporate level to boot.

Don't bet on it. Too many constituencies love the status quo and will generate specious, disingenuous and/or emotional reasons to keep their little piece of the tax mess, all while claiming their drop has nothing to do with the flood of Internal Revenue Code inanity.

This is how
You can't have the cake of the prudent lenders' own un-coerced determination of WHO should have the doors CLOSEd and also eat the cake of GOVAGs force OPENed doors.

That is how.

rentals already have an advantage.
They can deduct any expense involved in owning a rental unit.
Things like insurance and basic repairs are deductable to the landlord, but aren't deductable for an owner.

real estate
So it sounds like you're saying the lenders are dumbies for lending to people who can't pay back, and the buyers are dumbies too because they're too stupid to understand how much they can afford. Maybe the government should take over those properties and give them out as they wish; I believe you advocated that for Venezuela.

So Roy is listening to people who are too stupid to know: how much house they can afford, that adjustible rates can go up, that payments that take 50% of their income is too much debt, etc. Good sources, Roy!


Working the lower depths
"So Roy is listening to people who are too stupid to know: how much house they can afford, that adjustible rates can go up, that payments that take 50% of their income is too much debt, etc. Good sources, Roy!"

What you have just done is to define the subprime market. Whether or not they are "too stupid" they are certainly naive, not knowledgable and prone to taking some seller's words at face value instead of performing their own researches.

Typically these people will rely on what trusted sources tell them-- because they know their own minds are sufficiently disorganized they know better than to trust their own judgment. (Sound like anyone we know?)

So such a gullible person can be easily convinced to sign paper that (a) gets them the house of their dreams and (b) obligates them to paying back sums they can't realistically expect to fit into their budgets.

Question: who is the biggest sucker? The person who borrows such money? Or the one who lends it?

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