I recently wrote about sub-prime loans for the first time in a long while because the sector should start taking more headlines in the papers.
I’d hate for you to be unready for it, of course. Sub-prime loans are a big part of mortgage lending.
“Sub-prime” is a broad-sweeping term for the large percentage of loans that won’t get bought by the quasi-government agencies Fannie Mae and Freddie Mac. The opposite of “sub-prime” is “conforming”, as in: these loans conform to the guidelines set forth by Fannie Mae and Freddie Mac to be eligible for purchase.
Typically, the credit profile of a sub-prime borrower includes one or more of the following characteristics:
- Low credit scores
- History of derogatory credit (i.e. bankruptcy, foreclosure)
- Currently delinquent on their home loan
- Lack of credit history or credit depth
- Low asset levels
- Low income levels or non-verifiable income levels
- High loan-to-value combined with low income versus debt
- Contains “random” circumstance that introduces risk
Just because a person exhibits one or more of these traits, however, doesn’t mean that he is automatically a sub-prime borrower. This set of guidelines is very general.
Even though “sub-prime” has negative connotation to it, sub-prime loans serve a very important purpose. Sub-prime loans provide home financing to people who otherwise would not be approved for a loan at all. Remember: they don’t conform to the government guidelines!
Recently, sub-prime lenders have fallen into a world of hurt because the default risk that is inherent in every sub-prime loan is being realized with alarming frequency. Lest you think these defaults are surprising the markets, this is a problem two years in the making and industry insiders know it.
See, the one very important difference between conforming and sub-prime loans is that conforming loans are eventually bundled and sold on Wall Street as long-term bonds called mortgage-backed securities. Sub-prime loans, by contrast, are short-term. Conforming loans are overwhelmingly of the 30-year fixed variety, but sub-prime mortgages are of the 2-year ARM variety.
To understand why this matters, it’s important to review how adjustable rate mortgages work.
With all ARMs, the lender agrees to collect interest at a fixed rate for some period of time. When that period of time is over, the rate will adjust according to a set of rules agreed upon at the time of closing.
The new rate, therefore, is not pulled out of thin air. It can actually be represented by a math formula that is easy to understand.
(New Rate) = (Current Value of Index) + (Margin)
The index is usually something like LIBOR and the margin is a constant that can range from 1.50 to 6.99 or higher. Usually, the riskier the loan, the higher the margin. For comparison purposes, conforming ARMs have margins in the 2.500% range versus a typical 6.999% margin for sub-prime.
At this point in the conversation, I’d like to take a break and remind you of Newton’s First Law of physics:
An object in motion tends to stay in motion unless acted upon by an outside force.
Applied to mortgages, Sir Isaac Netwon tells us that a person who is a sub-prime borrower today will likely be a sub-prime borrower two years from now unless a fundamental change is made to the borrower’s finances. This change usually includes a reduction of overall debt load versus income, but not always.
Author’s Note: Developing and creating accountability for a mortgage plan is the joint responsibility of the homeowner and the loan officer. This is the should be the keystone of a homeowner’s short- and long-term financial plan.
Two years ago, the short-term nature of a sub-prime loan wasn’t so relevant.
At the time, LIBOR was 1.80% and it was reasonable for the “average” sub-prime client to receive a 6.500% interest rate with a 4.999% margin. When that loan would adjust, it would move from 6.500% to 6.7999%. Not a huge impact overall.
Today, however, LIBOR is 5.26% and the average client might receive an 8.500% interest rate with the 6.999% margin.
Can you see where this story is headed…?
When a sub-prime borrowers accepts a 2-year fixed interest rate but the “Plan for Change” is neither implemented nor followed, inertia prevails. Two years later, the borrower typically finds himself in the proverbial position that is between a rock and a hard place. The mortgage’s fixed period is over and he is still a sub-prime borrower.
At this point, the borrower can do one of two things:
- Allow their loan to adjust to the current market conditions according the rules of their loan
- Remortgage their loan to the current market conditions
If the homeowner stays in their loan and lets it adjust(i.e. no remortgage), then the new interest rate on their mortgage will be (5.26) + (6.999) = 12.25%. This is nearly 6.000% higher that their current rate of 6.500%.
Or, the homeowner can remortgage the home loan to to 8.500% — 2.000% higher than their current rate. Naturally, this is the preferred option, but as sub-prime lenders tighten their lending guidelines, there might not be a lender that accepts this sort of risk at all!
When the borrower can’t find new financing because nobody will lend to him, the 12.25% looks suddenly sweet and painful, all at once.
Three and four years ago, short-term interest rates were very, very low and that made sub-prime mortgage money appear cheap next to its conforming counterpart. Sub-prime lenders took advantage and “relaxed” their guidelines on to whom they would lend. They looked like geniuses, too, because so few loans were defaulting.
In fact, when the 2-year period ended, it was no big deal really because a sub-borrower whose ARM reset faced a 0.000-1.000 percentage point increase. That is a manageable figure for a lot of households.
But, then came last fall.
As the Fed raised the Fed Funds Rate, short-term borrowing rates increased and that impacted sub-prime mortgages. Instead of a 1 percentage point increase on a reset, the figure ballooned into the 5.000-6.000 point range.
I blogged a lot on this at the time because some high-profile lenders were closing their doors in response to the market conditions and still other lenders tightened up their guidelines (i.e. stopped lending to the riskiest borrowers in the loan applicant pool). Those that did neither have seen their sub-prime mortgages default at a much higher clip than normal.
Example: In Q3 2006, the number of late payments on sub-prime mortgages reached 12.56% of all mortgages outstanding, it’s highest mark in three years. The sub-prime lenders that stayed in the game are getting clobbered in part for the loans they granted in 2003 and 2004 — those loans are now resetting and households on tight budgets are being pushed over the edge.
Since late-2005, the sub-prime shake-out has been slow and steady but now the walls are quickly crumbling down. As long as the Fed Funds Rate sits near its current levels, the lender carnage should continue because — just like their borrowers — Sir Isaac Newton and the principles of inertia have taken over.
Source
More Borrowers With Risky Loans Are Falling Behind
Wall Street Journal Online, Ruth Simon and James R. Hegerty
Decemeber 5, 2006
http://online.wsj.com/article/SB116528735773440781-search.html?KEYWORDS=default+mortgage&COLLECTION=wsjie/6month
Tim says:
Dan, I’m a fan. I’m stunned (not really) that no one is commenting on your article in your neck of the woods and on Bloodhound. I’d like to make a comment though.
Regarding the sub-prime market getting hammered:
Is anyone really surprised? Not me. But, what does an escrow guy know. Our office has had very recent cases where mortgage brokers have submitted loans to Ownit Mortgage (sub-prime lenders) among others and have failed to fund on the loan commitments. If there are Realtors reading this information, I think it would be wise to know as early as feasible in the transaction, particularly in purchase transactions where much is at stake, where their clients are getting their loans funded.
Why is this a big deal? A couple reasons immediately come to mind. In Washington State, transactions can be released to record at the county prior to actually receiving funding from the lender. There are some obvious benefits to this arrangement, but there are also some pitfalls.
The obvious pitfall is transfering ownership without actually receiving money. This presents a host of issues. If you don’t get funded and the transaction gets recorded BEFORE you find out or find out in the news, how do you reconvey title back to a seller when a lender like OwnIt basically ceased operations. When escrow is released to record, generally it means money is on it’s way—until recently. Furthur, excise tax at nearly 2% of the sale transaction is paid and on the way to the county along with the title closing order. I can’t wait to try to get that back from the appropriate governments (county and state).
So what to do? Since we close so many sub-prime loans for LO’s and borrowers in purchase & refi transactions,our office is implementing a “no money, no recording and closing policy.”
The sub-prime woes are just beginning and it’s only January 4th. Guess the sub-prime folks didn’t think terribly much about the buy-back pressure from Wall Street.
January 4, 2007 — 6:09 pm
NYCJoe says:
Dan,
Good post. And Tim, I’m about to comment – it took me a while to read through it and formulate some comments/questions. 🙂
I’m all for people being able to purchase a house, but I’m not sure I agree that making this kind of financial transaction available to people who can’t afford or understand it is a good idea.
The British playwright George Bernard Shaw once wrote “the surest way to ruin a man who does not know how to handle money is to give him some.” Seems like that’s almost what the sub-prime lenders were doing. In a country where almost 50 percent of people who earn between 15K and 25K per year think that the lottery will fund their retirement, giving these people access to products like interest-only mortgages and Option ARMs is just a recipe for disaster.
But I’m interested in what you think about this report from UBS that says that second mortgages are more responsible for delinquency than anything else: Lenders begin to tighten loan standards.
I’m also intrigued by your comment:
While reducing debt load would no doubt improve a borrower’s finances, I’m not sure that the typical sub-prime borrower would see much more than a momentary boost. The problem is that lower-income people have few other choices but debt in order to fund basic living. Consider the rise in “payday loan” shops and the rise in the number of consumers using credit cards to pay living expenses, such as food and rent.
It seems like a better way to make a larger improvement in the finances of a sub-prime borrower would be to find a way to increase income. Unfortunately, there’s no easy answer to that one.
How do you see this playing out? Does the turmoil in the sub-prime market have any implications for the conforming market?
January 4, 2007 — 6:35 pm
Greg Swann says:
Hi, Tim,
> I’m stunned (not really) that no one is commenting on your article in your neck of the woods and on Bloodhound.
For my own part, I have nothing to say. I found the information fascinating, but I’ve never had a sub-prime buyer. I’ve never worked with an interest-only buyer. I’d done one neg-am, but the buyers were hugely solvent. I’ve done a bunch of 80/20, 80/15/5, 80/10/10 transactions, but the buyers all had great income. Most of those homes are refinanced to 80% (or less) 30-year-fixed loans. (I would have argued for 5/1, 7/1, 10/1 fixed-adjustables, but people like pie — and by now the rates aren’t that different.) There may be homeowners in big trouble, but I have no first-hand experience of this.
January 4, 2007 — 7:23 pm
Kris Berg says:
Doug:
That is a really BIG picture of Sir Isaac Newton!!!
(Sorry. I know that is unrelated to the post topic, but get used to it. It happens to me all of the time.)
January 4, 2007 — 9:58 pm
Dan Green says:
It’s drawn to scale.
January 4, 2007 — 9:59 pm
Kris Berg says:
🙂
January 4, 2007 — 10:17 pm
NVmike says:
Mr. Green, what are your feelings anent the Center For Responsible Lending
report, which estimates that approx. 20% of existing sub-prime mortgages will fail?
You seem to have your finger on the pulse of the sub-prime issue; I’d like your feedback on that report.
January 5, 2007 — 3:00 am
Brian Brady says:
Dan:
The history of non-prime lending is quite an evolution. What started as a 2 year “band-aid” loan solution for the temporary credit-challenged to has evolved into a product line that aids the truly “non-conforming” borrower in his/her quest for real estate ownership.
Should these loans be outlawed as the heroin for the fiscally irresponsible debt-addicts or is America still the place where a fella’s life can still get better?
Call me a cock-eyed optimist but I’m still betting on the American homeowner.
January 5, 2007 — 9:07 pm
NYCJoe says:
Brian, I’m not sure that giving people who can’t handle money is necessarily a good thing. There’s a reason why these people don’t conform to normal loans.
For some reason, and I’m not sure when this happened, but at some point in this country it was suddenly decided that everyone should have an equal chance to have what they want right now. Somehow, time-tested notions of hard work and patience went out the window. A country where a 600 FICO can get a no-money-down loan for a 300, 400, 500K house is simply in trouble.
Having said that, I do think that there needs to be a way for those people to better themselves and work up to where they can have a home of their own. But providing 2-year ARMs to them is just not it. They’ve already shown that they don’t understand fiscal prudence, and now we’re going to saddle them with a loan whose payments are gonna jump by as much as 50% in 2 years?
An industry that has grown from $13 billion to over $500 Billion in less than 10 years shows that something is wrong, don’t you think?
January 6, 2007 — 10:01 pm
NYCJoe says:
By the way, looks like Secured Funding bit the dust as well…
January 6, 2007 — 10:09 pm
Brian Brady says:
Joe:
I agree in the pessimistic part of my brain with you. The practical part says this:
You really have no right to sit in judgement. Banks make loans that perform 98-100% of the time. If they can make a profit doing that, so be it. Borrowers will know much better than you or I what they can or can’t handle in terms of debt. If the bank’s happy and the borrower’s pleased to have a second (or in many cases first) chance, then I’m all for it.
I’ll reiterate my earlier assertion:
“Call me a cock-eyed optimist but I’m still betting on the American homeowner.”
I’ll err on the side of optimism versus elitism any day of the week.
January 6, 2007 — 11:07 pm
Brian Brady says:
“You really have no right to sit in judgement. Banks make loans that perform 98-100% of the time”
ERROR: I meant to say 95-98% of the time
January 6, 2007 — 11:08 pm
NYCJoe says:
Brian, the funny thing is that I’m not a pessimist. I’m very optimistic that once we get through this rough patch, we’ll be fine.
But that’s just it – many of them don’t! If they went in with 20/20 vision, then I’d agree with you. But Brian, there has to be a reason why these folks find themselves in this position, and I don’t think reckless lending will improve their lot in life.
Yeah, I was wondering how long it would take for that epithet to raise it’s head. Right, of course – I think that someone who has a history of mishandling money should not be given more rope to hang themselves, but that makes me “elitist”.
Come on, Brian. Seriously.
January 7, 2007 — 12:18 am
NYCJoe says:
By the way,
Yeah, I’m quite sure that Ownit, MLN, Secured Funding, et al were “happy” up until they closed. Oops!
In case it’s not clear, I think sub-prime borrowers definitely deserve a chance to move up in life. I honestly do.
Predatory lending is not that chance.
January 7, 2007 — 12:31 am
Dan Green says:
Hi, NYCJoe. I think I see why this conversation is heading in the direction it is.
It’s because you equate sub-prime lending with predatory lending. Those are two very different things. Just because a loan has higher interest rates than a conforming loan does not make it “predatory”.
Predatory lending is the practice of taking advantage of the information disadvantage that exists between a mortgage industry insider (i.e. a banker, a broker, a lender) and a borrower.
Just because a loan has a high interest rate, it is not considered predatory. This is because lending — like all other financial fields — is based in the idea of Risk v Reward. If a borrower represents more risk to the lender, the expected return (i.e. rate) for the client should be higher, too.
When a lender knowingly underwrites and approves a loan for which he knows a borrower does not have the capacity to repay is when we head into predatory lending territory.
Many sub-prime borrowers can pay their mortgages, and do so. The number is usually in the range that Brian stated, but right now, it’s a little bit less.
And that was the point of my post.
Because the number is less, lenders are tightening up their guidelines. They don’t WANT as much risk as before. As a result, people who got loans two years can’t necessarily get them today. The key is to have a plan to become “un-sub-prime” and reverse the effects of inertia.
Predatory lending is not at all limited to the sub-prime arena and — I agree with you — its practice continues to hold down folks that want to move up in life.
January 7, 2007 — 6:57 am
NYCJoe says:
Hi Dan,
I actually didn’t intend to make that exact connection, because it’s totally wrong, and reading my comment I can see where it sounded like that, so let me clarify.
I don’t think that sub-prime lending is automatically predatory. However, I do think that the majority of predatory lending occurs in the sub-prime market. But that’s a different story.
Sub-prime lending certainly has its place in the industry, I’m not suggesting otherwise. But something is seriously wrong with the machine when defaults/lates are usually around 10% and now they’re 12.5% and heading up (I saw one measurement at more than 13% the other day – I’ll see if I can look it up). The percentage of borrowers being late with payment #1 has also risen dramatically. That’s a really bad sign.
But back to my original question for you, Dan – how do you see this playing out? Will the conforming market be affected at all? And what did you think of the study that suggested that second mortgages were the main culprit behind bankruptcies?
January 7, 2007 — 9:46 am
Russ says:
Dan:
Great post as usual. I have always viewed sub-prime loans as a band-aid and for many borrowers, they do allow them to get a piece of the American dream. The borrowers that are able to get out of these loans in 2 -3 years are grateful. However, sub-prime lending has gotten out of hand and I think the contraction of u/w guidelines for these borrowers is a good thing. To be blunt, many people are not financially responsible enough to be home owners.
There is no good reason to have loan programs for people who are six months out of bankruptcy and didn’t even pay last month’s cell phone bill on time. Owning a home is a priviledge, not a right. It is not a matter of if these borrowers will default, it is a matter of when.
I think we have a perfect storm brewing with sub-prime borrowers who are unable to improve their credit situation for whatever reason. As you mentioned, it was no big deal to refi out of 2/28’s and 3/27’s as long as rates were stable and values were increasing even if the borrower didn’t fix their credit issues.
This is a big deal because now refinancing their way out of the problem can’t be done like in the past.
1) Little or no equity due to lack of appreciation or worse, declining values.
2) Tigher guidelines means the loan program they originally qualified under may not even exist anymore.
3) Rates are higher so even if another sub-prime lender takes on the loan, they are still screwed and probably won’t be able to afford the payment.
4) Increase in inventory in many areas means many of the borrowers won’t even be able to sell their homes at even minimal profit (see point #1). A large amount of these loans have high LTVs as it is.
I hope it doesn’t get that bad, but this could have been seen from a mile away.
January 8, 2007 — 10:47 am