On the Canard that Subprimes Are Good for Borrowers

I assume that a high proportion of readers of this blog also follow Calculated Risk. I nevertheless wanted to comment on a particularly good post by Tanta on a favorite topic of mine, the efforts of the financial services industry to maintain that Suprimes Are Good For The Poor.

Extensive news coverage of on-the-ropes borrowers has sidelined that argument, but Tanta sighted a rare revival in Barron’s this weekend, apparently triggered by the prospect of Congressman Barney Frank sponsoring legislation that endeavors to bring responsible lending back into fashion by making it harder for lax originators to evade liability.

Her entire post is very much worth reading. She was so fully occupied trouncing the obvious stupidities in the Barron’s piece that she didn’t have the chance to get around to one of my favorite arguments against the idea that expensive loans are somehow good for people with lousy credit records.

The core argument is that subprimes enabled people to buy housing that they could not otherwise afford. However, over half the subprimes were cash-out refinancings made to existing homeowners to pay off existing loans. This had zero, zip, nada to do with home acquisition. Instead, these borrowers were putting their houses at risk to reduce the burden of other debt. That’s hardly the American dream in action.

Tanta dismantles another misconception I have heard from proponents of subprimes: that if the borrower makes payments for 24 months, he can refinance with a prime loan:

For what it’s worth, a recent research report from Lehman* just caught my eye. The analysts looked at a pool of subprime ARM loans from older vintages that are current, and have always been current, but have never refinanced out of those old pools. This is a curious phenomenon, since these borrowers are paying very high interest rates (they’re in ARMs that have already adjusted), they didn’t necessarily start with a high CLTV, and in many cases their properties have probably not depreciated that much, or even appreciated at least some, since origination. Why wouldn’t they refi into a cheaper prime loan with a 24-48 month perfect mortgage payment history and a sliver of equity?

The analysis compared the borrowers’ FICO at origination of the loan with the borrower’s current FICO (presumably ordered for account monitoring purposes). Some 40% of subprime loans with a perfect 24-48 month mortgage history have FICOs that are unchanged or have dropped by as much as 75 points since the loan closed. The implication is that a significant number of current borrowers subsidized their mortgage payment shocks with credit cards: the high balance-to-limit or mounting delinquencies on consumer debt is offsetting the positive FICO effect of on-time mortgage payments. This is a recipe for a permanent subprime borrower: someone who “performs” on the mortgage by supplementing income shortfalls with credit card debt, keeping the FICO at a level that precludes ever becoming a prime mortgage borrower.

That should knock the last leg out from under the argument of subprime lenders that they are giving borrowers a chance to “cure” their credit problems. You have to wonder whether these folks would have been given a mortgage in the first place if they had been qualified on the fully-indexed, fully-amortizing payment and documented income; my guess is they probably wouldn’t. In that sense, they’d “lose out” under tighter mortgage regulation.

But they’re trapped: they’ve got some equity they don’t want to walk away from, yet they can maintain the mortgage payment only by racking up unsustainable consumer debt. Eventually they’ll have to sell the property: there’s only so long you can keep making your mortgage payment with a credit card. But in what sense will they then have been “successful” homeowners? They may never have had a mortgage delinquency, and they may have avoided foreclosure, but they still spent years paying too much for too little purpose.

Until we get straight on the idea that there’s something wrong with holding a high-risk lottery to see who among first-time homebuyers gets to become middle-class, and that there’s something wrong with a situation in which “success” is defined as quitting before you get fired, we’re never going to get straight on what has to be done to reform the mortgage industry.

*Akhil Mago, Lehman, “Overview of the Subprime Sector,” October 2007 (not available online)

So these two examples show the arguments of subprime advocates to be largely baseless. Subprimes aren’t a route for the poor or lower-middle class to bootstrap their way into middle class respectability. Instead, it uses the lure of aspiration to a middle class lifestyle to burden chumps with debt that in all too many cases, will push them into eventual loss of their home and/or bankruptcy (their loans often get refinanced many times before the borrower fails).

I am not saying that this merits wholesale relief to borrowers, mind you. But as we have noted elsewhere, renegotiating mortgages is often a lesser evil than foreclosure from the investor’s as well as the borrower’s perspective.

What I am saying is that policymakers need to understand what the dynamics of this industry in order to devise suitable remedies. And it is important to recognize that financial literacy in this country is low, and these products are often complex. That, combined with a cultural high tolerance for debt and clever salesmanship, is a toxic mix.

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