The Mortgage Muddle

I've been struggling to figure out what to say about the mortgage situation. There is so much happening that is difficult to know where to start. These are a few random notes about subprime and other loans headed for trouble, and the belated efforts by government officials to respond in some useful way.

Subprime

The issues connected with subprime loans are only a part of the broader problems in the mortgage market, and mortgage finance problems are only part of the distress in the housing market. But mortgage lending was a big factor in speculative activity, housing oversupply, and inflated prices. And subprime loans accounted for a disproportionate share of recent wayward lending and current loan defaults.

The basic dynamic that led to the subprime debacle has been exposed pretty broadly already, but for a (literally) graphic exposition, you might refer to this description. Thanks to Bernie Markstein of NAHB for forwarding the link.

During the past year, particular concern has focused on the risks from imminent resets of hybrid subprime ARMs originated in 2006. A large share of subprime loans originated in 2005 and 2006 were 2/28 and 3/27 hybrids, meaning that they carried fixed rates for the first 2 or 3 years, after which the interest rate is reset every 6 months, based on a specified index and margin. The most common index is the 6-month LIBOR (London Interbank Offered Rate) – no doubt chosen because it was the rate least likely to be comprehensible to a subprime borrower. The margin is typically a whopping 600 basis points.

Although the initial fixed rates on these subprime ARMs were below the specified fully-indexed rates, they were not cheap. In some cases, the rate for the first couple of months was set very low, but during the rest of the fixed-rate period, the rates were well above prime fixed-rate loans. FDIC Chair Sheila Bair (one of the few officials to recognize the dangers before it all blew up) reported that the average for hybrid subprime ARMs in 2006 was 8.23 percent.

In early December, a program orchestrated by the Treasury Department was announced with great fanfare to defer resets for subprime borrowers who (a) were current and able to continue to make payments at the existing fixed rate and (b) would not be able to make payments after resets. It is still not clear whether the promised modifications were forthcoming, but since the announcement the 6-month LIBOR has fallen from about 5 percent to about 3 percent, implying that resets would only produce changes from 8.2 percent to about 9 percent, rather than to about 11 percent (subject to caps on per-period adjustment). Therefore, relatively few subprime borrowers can be characterized as able to pay before reset but unable to do so afterward. The reductions of the Fed funds rate and other Federal Reserve (and foreign central bank) actions have thus done much more to forestall reset payment shock than any modifications or forbearance actions.

While those factors have reduced the threat from reset payment shocks, that's not the central problem anyway. Very high shares of these loans were already in trouble before facing resets, as the sketchy underwriting that characterized subprime lending earlier in the decade became much more reckless in 2006.

Alt-A

Although many subprime loans had small downpayments and some had interest-only payments during the initial years, it is among the "near-prime" or "Alt-A" category that really exotic loans were most common. That's where there was the greatest concentration of loans to investors, downpayments using piggy-back loans, low-doc loans, low teaser rates, and non-fully-amortizing (interest only, option ARM, and balloon) loans. Average FICO (credit) scores of Alt-A borrowers were much closer to those of prime borrowers than to subprime borrowers, but the creative features represent risks that are hard to evaluate but (especially in combination) quite frightening.

Prime

While prime conforming loans, largely sold to Fannie and Freddie, and prime jumbo loans did not exhibit craziness comparable to the alt-A and subprime loans, even there the characteristics of loans became riskier, at the same time that inflation in house prices was adding to the potential risk in standard loans. For example, the interest-only share of loans in GSE pools jumped from about 8 percent in 2005 to about 16 percent in 2006.

The response

Two recent surveys of servicers, by the Mortgage Bankers Association and the Hope Now Alliance (with considerable overlap) attempted to measure the handling of delinquent subprime (and other) mortgages. They indicate that a substantial and growing share of lender responses involved loan modifications (new loan terms) or repayment plans (allowing more time to pay without changing terms). That was before any of the government-organized initiatives. Thus, it is unclear how much the involvement of the Treasury Department and other government entities changed things. Treasury argues anyway that it only encouraged a wholly-private effort, but encouragement from government officials with regulatory authority over your business can seem like more than casual advice.

Capozza and Thomson have described how subprime lenders expect high delinquencies and have a greater incentive for forbearance than prime lenders. Compared to prime loans, the interest rates on any further payments are higher and the recovery from foreclosure and sale is likely to be lower. Ultimately, despite repayment plans and modifications, troubled subprime loans are likely to lead to forced sales or forfeitures, but only after lengthy delays. Therefore, much of the impact on the already-glutted housing market still lies ahead.

One of the least documented aspects of default and foreclosure is the fate of the residents. Do they find housing elsewhere as renters or owners, double-up with others, or become homeless? In addition to the human cost, the answer to that question has significant implications for the market.

Among the limited audience who may read this are people who know much about this subject than I. Please contribute your thoughts and correct my errors.

February 20, 2008 -

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