An article, “Better Deeds,” by Doug Smith at Slate tells us that, contrary to popular opinion, one group of subprime mortgage lenders has done well with the product and is experiencing default rates comparable to that of prime mortgages. And no, they aren’t seeing rising arrearages either (generally speaking, mortgage defaults and foreclosures track the unemployment rate, rising when it rises).
So who has managed to find solid subprime borrowers? Not-for-profit housing enterprises.
Before I hear the Friedmaniies howl that this group’s success was due to its lack of a profit requirement (and hence enjoyed lower expenses), consider that these enterprises kept their loans on their books to a much greater degree than commercial subprime originators. Anyone who knows anything about banking will tell you that securitization has vastly superior economics to buy and hold (that’s why it has become so prevalent). So whatever benefit they might have derived by not having to show a profit was more than offset by their higher cost of capital.
Why have the not-for-profit lenders been more successful? Smith, who is a colleague, tells us that it’s due to their adherence to old-fashioned credit practices. They verify income, make sure the borrower understands his obligations, consider stability of employment. All of this sounds basic, yet it has largely gone out the window.
Here’s a snapshot of the quality of loans made by two kinds of lenders to aspiring homebuyers who are financially strapped: The record for the first kind of lender is that one out of every five or six borrowers are late on payments, and foreclosure rates are rising. For the second kind of lender, at the most one in 20 borrowers pay late, and foreclosure rates are holding steady.
Which group do you want lending your money or financing your home purchase? Obviously, the second kind. And yet if you picked them, you’d be running against the tide of American capitalism. The lenders with the strong record are America’s nonprofit housing enterprises. The lame numbers come from subprime lenders, who apparently never meet a homebuyer too risky to bet on. Over the last several years, investors have poured more than $1 trillion into subprime lending. By contrast, the housing nonprofits got, at best, a few billion. And that helps explain why the American dream of homeownership is a nightmare for millions of people now caught in an epidemic of bad deeds.
Subprime refers to loans with high interest rates for risky borrowers. It makes sense for riskier borrowers to pay higher rates than well-heeled ones. What makes less sense is that about a decade ago, lenders began to care much more about signing up new borrowers than about averting big risks. To understand why, you have to follow the money to see who ends up holding the bag when the loans go bad. The real-estate agents, mortgage brokers, attorneys, and initial lenders in the subprime game get paid high fees when they sign up borrowers. Then, the instant a loan is made, the initial lenders sell that loan to other investors, in what are called mortgage-backed securities.
Surely the investors who buy the mortgage-backed securities evaluate the risks involved in doing so? They did 20 and 10 years ago, but not any more. In the past, investors who bought housing loans required initial lenders to provide and verify facts about borrowers’ income, expenses, debts, and assets. This was the 1980s and ’90s, when these initial lenders were bankers who were well-schooled in old-fashioned lending. They asked the borrowers about their jobs and how long they’d held them. They took borrowers through their monthly expenses and showed them how those expenses would change in light of mortgage payments and other homeownership obligations, such as property taxes. And, in close cases, bankers looked borrowers in the eye and made a judgment about character. This was subjective, but it also protected their money.
These practices produced high-quality mortgage-backed securities that earned the bankers fees and replenished their capital to make more loans. Investors in these securities got attractive commensurate returns. It was a good deal all around: profits for bankers and investors, and mortgages that homeowners could afford. Delinquency rates ran about one in every 20 to 25 borrowers, for mortgages overall in the United States.
By 2000, however, things had changed. Investment banks and hedge funds eager to maximize profits and bonuses realized they could make money faster if, like the initial lenders, they could re-sell the loans to other investors—that is, if they could find somebody else to hold the risk. Deploying the tricks of financial engineering, complex accounting, and sophisticated lawyers, investment banks and hedge funds created new securities with exotic names like “collaterized debt obligations” and “real-estate mortgage-investment conduits.” They sold these instruments to down-the-line investors who, frankly, were confused and overly optimistic about what they were doing. All of this worked brilliantly for the investment banks and hedge funds. Like the initial lenders, they got their capital back to do more deals—and they raked in huge fees and annual bonuses.
This generated a heckuva lot more capital to lend and a lot more enticing of borrowers to go beyond their means. The high-fee-earning, no-risk-taking subprime players pushed hard to expand the home-buying market well beyond qualified buyers. This was easy in an economy spawning tens of millions of prospects. Hundreds of billions of dollars flooded into more than 250 variations of bait-and-switch mortgages with low introductory teaser rates, no money down, interest-only payments, generous appraisals.
Then, down the line, these mortgages triggered “resets”—higher, unaffordable interest rates promised to the down-the-line investors seeking high returns. Also piled on were high-cost insurance and other fees. According to one report, up to half of subprime borrowers actually qualified for better terms but were steered to the more costly deals. In a lot of these families, parents were working two jobs to make ends meet or addicted to credit cards. When the “resets” they’d agreed to triggered higher interest rates—when their mortgages exploded—the borrowers defaulted at previously unheard of rates.
What about the information about borrowers that down-the-line investors need to assess the risks? “Common sense suggests that a mortgage lender would almost always wants to verify the income of a riskier subprime borrower,” says John Dugan, the U.S. controller of the currency responsible for keeping our banking system sound. “But the norm appears to be just the opposite: Nearly 50 percent of all subprime loans last year accepted stated income.” This means that in contrast to the not-so-old days, lenders don’t verify the income that buyers say they have on their loan applications. Actually, it’s worse than that. Subprime players often encourage borrowers to lie by overstating income, assets, and other qualifications. Or, more politely, they look the other way and hurry the borrowers along. As one subprime appraiser for industry leader New Century Financial said about these so-called “liar’s loans” to the Washington Post, “You didn’t want to turn away any loan because all hell would break loose.”
No wonder subprime delinquencies are skyrocketing. None of this, however, means investors need to turn their backs on low- and moderate-income Americans who want to buy houses. Instead, they should invest in the nonprofits with the low default rates, by rewarding their superior track records with the capital to expand. Nonprofits like these haven’t forgotten the wisdom of old-fashioned banking. They educate homebuyers about the full responsibilities of ownership. They encourage homebuyers to look only at homes, and financing, that they can understand and afford. They often hold on to some part of the loan, so they have a stake in its success. And, if trouble brews, the nonprofit—just like the banks of yesteryear—is there to counsel and help homeowners through the crisis.
Instead of a hard sell, the nonprofits offer education. Instead of exploding mortgages, affordable financing. Instead of high-priced homes that maximize commissions, more modest ones. Instead of winking while borrowers sign liar’s loans, looking them in the eye to stress the seriousness of owning a home. Instead of bad deeds, good deeds. This is the way to go for poorer families who want to own a home and for investors who want a dependable return.