12 September 2008

Subprime Loans No Longer Exist

In 2006, roughly one in three new mortgages was a subprime or Alt-A loan, with about three subprime mortgages for every two Alt-A loans. Two years later, those loans make up about one in fifty new mortgages, and the more creditworthy Alt-A loans outnumber the less creditworthy subprime loans by a 3-1 ratio.

In the 2nd quarter of 2008, there were just $4 billion of subprime loan originations. This is down more than 97% from the subprime lending rate in 2006, and is down about 92% from the subprime lending rate in 2007. Subprime lending increased more or less steadily since 1994, yet current subprime lending rates are less than half of what they were in fourteen years ago.

Other Non-Conventional Lending Has Also Collapsed

Like subprime mortgage lending, Alt-A lending is unraveling, after a boom that paralleled the growth in the subprime market.

In 2001 Alt-A loans represented 2.7 percent of a $2.2 trillion market. In other words, Alt-A loans issued that year were worth $59.4 billion. Skip ahead to 2006 and Alt-A loans were 13.4 percent of a $3 trillion market, meaning that Alt-A originations in 2006 totaled $402 billion — almost seven times the dollar volume originated in 2001.


In the second quarter of 2008 "the subprime share fell to 0.5 percent and the Alt A share slipped to 1.6 percent." Thus, the Alt-A share in the second quarter was about $13 billion (down about 87% from the peak in 2006, and down about 12% from 2001 levels).

This continues a trend that I noted in March of this year (and here). The share of jumbo loans issued as also declined.

Various loan products designed to reduce monthly payment size relative to the amount of the loan have also dramatically declined.

What are Alt-A and Subprime Loans?

An Alt-A loan is one with a borrow who does not meet conventional loan standards, but is more creditworthy than a subprime loan borrower, which includes everyone who does not qualify for an Alt-A loan (link below):

"Alt-A" loans, also called "nontraditional" mortgages, are typically offered to borrowers with credit scores between 620 and 700 and include interest-only loans, option ARMs, "no-doc" loans, those requiring little if any income documentation, and others.


An average Alt-A loan is for about $172,000. The average subprime loan that was a first mortgage was originally about $202,000 in 2006, with the average subprime second mortgage originally involving about $35,000.

Why Has Mortgage Lending To Those With Poor Credit Collapsed?

The trend is driven by a lack of third party investors to buy the loans in the secondary market, and a soaring default rate on existing subprime and Alt-A loans (which have in turn reduced the interest of investors in the loans). Default rates, in turn have been driven in part by a collapse in a housing price bubble combined with declining underwriting standards when investors were eager to put money in mortgage backed securities.

For Alt-A loans: "Fourteen months after origination, 4.21 percent of 2006's Alt-A loans face 90-plus-day delinquencies. The rate is 1.59 percent for 2005 Alt-A loans and 0.91 for 2004 originations, in both cases also after 14 months of existence." The fourteen month measure, moreover, does not reflect most defaults that arise from variable rate mortgage resets, which often take place after two years.

Troubled Banks

The disappearing mortgage market has devistated the financial industry, which had been the leading source of growth in the assets of the uber-rich in the United States until the last couple of years.

About 283 major mortgage lenders in the U.S. have left this line of business since 2006. At least fourteen more are in trouble. The vast majority of subprime lenders have left that market. In 2005, there were 210 mortgage lenders that specialized in subprime lending nationally, while a small number of additional lenders dabbled in that business. Fannie Mae, Freddie Mac, two of the biggest investment banks (Bear Sterns and Lehman Brothers), and a major commercial bank (Washington Mutual) have all either been taken over or face make or break financing challenges within a week.

Commercial banks, thifts and credit unions with diversified lending portfolios are essentially the only major mortgage lending institutions that are not in crisis right now. Foreclosure rates for conventional, fix rate mortgages to prime credit borrowers remain extremely low. These institutions have now largely limited their lending to these conventional loans and to government guaranteed mortgages, in addition to a small percentage of jumbo loans (currently about six percent) to people with good credit and significant down payments.

Tens of thousands, if not hundreds of thousands of people in the financial industry, many of them well paid investment bankers, have been laid off.

Terminology

A commercial bank takes deposits from the general public (and can borrow funds from other banks such as the federal reserve), their deposits are generally either federally insured or ultra-safe, and they make loans from their own funds to individuals and businesses, usually for specific transactions or purposes. Only a small number of commercial banks that invested their deposits heavily in the subprime and Alt-A markets, with a small market share and weak retail banking operations serving the general public, have been shut down to date.

Thrifts, formerly known as savings and loans, and credit unions, are very similar to commercial banks. The former makes loans primarily to consumers as opposed to businesses and consumers. Thrifts and commercial banks are generally owned by ordinary shareholders, while credit unions are generally mutual companies owned by their depositors. Commercial banks, thrifts and credit unions are subject to parallel but seperate regulatory regimes. There are also multiple regulation regimes (state and federal) for commercial banks.

In contrast, an investment bank facilitates public offerings of stocks and bonds by corporations and devises other ownership level transactions, such as mergers and acquisitions, split ups, and spin offs, for these companies. Investment banks are not government insured, and secure most of the funds for their deals from third parties in exchange for third party investments in particular deals, although they also sometimes finance transactions with their own funds. Investment banks are closer to what an ordinary person thinks of as a stock brokerage, than to what an ordinary person thinks of as a bank. Investment banks have taken a harder hit in the current financial crunch than commercial banks. Private equity funds, venture capital funds, and hedge funds, are similar to investment banks, but less diversified than a stereotypical investment bank.

Mortgage brokers and finance companies underwrite loans, i.e. determine who should get loans, and originate loans, i.e. locate borrowers and conduct closings for them, but do this with other people's money, either as an independent contractor for the true lender, or by immediately reselling the loans made to a larger financial institution or fund in what is known as the "secondary market" for mortgages. Typically, mortgage brokers and finance companies have only modest capital of their own, so their duty to compensate the third parties who finance their loans if there are excessive defaults is to a significant extent illusory. Effectively, they are even more highly leveraged than investment banks in most cases. Most of the distressed lenders are mortgage brokers or finance companies.

The Impact of Leverage

For a bank, loans are assets, and deposits or loans from third parties like the Federal Reserve or other banks are debt. A bank deposit is simply a loan from a customer to the bank that is payable on demand, no more and no less. Contrary to many ordinary people's belief, a bank deposit is not comparable to putting currency in a safe deposit box. Safe deposit boxes are a not very profitable side business that many banks offer.

All banks are highly leveraged (i.e. have a high debt to asset ratio) compared to most businesses in the "real economy" where 1:1 debt to equity ratios are the average level of leverage in publicly held companies. This leverage is possible because bank deposits, interest due on deposits, amounts owed on loans to banks, interest due on those loans can be known with great certainty, and because banks usually make only loans with a very high likelihood of repayment in full after whatever allowance for defaults in made in the interest rate for that class of loans (like conventional mortgages and car loans where there is collateral to make good on a bad loan). The certainty that makes leverage possible also arises because banks make so many small loans relative to a bank's total loan portfolio that default rates are statistically very predictable even if determining which particular loan will go bad is impossible to determine.

Commercial banks have historically avoided lending to high risk borrowers because these loans make it hard to determine the exact real value of the bank's loan portfolio which in turn makes it risky to be highly leveraged. As a result, most commercial banks do relatively little subprime and Alt-A lending with their own money, and usually do so, when they do, through subsidiaries organized as mortgage brokers and finance companies.

Also, there are strict limits on the amount of leverage that a commercial bank can undertake (the required reserve ratio in the United States for commercial banks was 10% on transaction deposits like checking and savings accounts and zero on time deposits like certificates of deposit, and all other deposits) which were adopted after the wave of bank failures during the Great Depression and have been adjusted from time to time since then, while investment bank leverage is largely unregulated and is generally greater than in commercial banks. Thus, a commercial bank typically has a little more than nine times as much debt as equity, while an investment bank typically has a higher debt to equity ratio. This leverage increases a bank's return on equity, i.e. on shareholder investments, when it is profitable, but means that small defaults percentage-wise in the bank's loan portfolio can wipe out large percentages of its equity.

If a bank is highly leveraged and investments are made from company assets rather than merely being brokered by a bank directly between two third parties, a moral hazard is present. If a deal goes well, bank management is in a position to take big bonuses, but if a deal goes badly, bank management loses little if anything except future employment for a while. So, there is an incentive to take risks that aren't in the economic interests of shareholders or depositors. In commercial banks, FDIC regulation prevents bank management from taking these kinds of risks. In credit unions, the allegiance of management to depositors discourages this kind of risk taking. But, in investment banks, mortgage brokerages and finance companies, this moral hazard is very real.

Leverage and diversification of investments are the two biggest factors that have determined which financial institutions have failed and which have weathered the credit crunch. Highly leveraged institutions that are heavily invested in mortgages have taken the brunt of the subprime mortgage crisis of the last two years.

Consequences

The decline of these markets has greatly increased the importance of FannieMae and FreddieMac, which were the subject of a federal takeover last week: "Fannie Mae and Freddie Mac financed or guaranteed 82% of home loans initiated in January, 2008, up 46% in the second quarter of 2007." This April, 2008 report stated that "Fannie Mae’s portfolio includes 2.8 trillion in mortgage debt, about 23% of all residential home loans in the US. This includes 314 billion in Alt-A loans."

The subprime meltdown has also made it virtually impossible for families with poor credit, and borrowers who want unconventional loan terms, to get mortgages.

Many of the people who currently have subprime and Alt-A loans don't qualify to get any kind of new mortgage now, although there are programs in place to refinance existing "slavagable" loans in some cases. If you have a subprime or Alt-A loan that isn't in default, and want to continue to be a homeowner, you can't sell your home and buy a new one to replace it.

The decline of the subprime and Alt-A credit market also means that families with poor credit but significant real estate equity who have a financial crisis must sell their homes, often at a loss given the current state of the real estate market, and start renting, to access that equity. Previously, home equity loans would have been a common solution for these families.

Going forward, the demise of the subprime market is not necessarily a bad thing, and may not even hurt home ownership rates very much. Many subprime loans involve debt consolidation by people who are already homeowners, rather than new home purchases.

Also, many subprime loan borrowers would be better off economically selling their homes to an investor, putting the proceeds, if any, in an FDIC insured certificate of deposit, and renting the property back at the going market rate rental (at least in the absence of a pre-payment penalty). One of the biggest virtues of renting is that the mortgage interest rates available to landlords generally are more important in determining rental rates than the mortgage interest rates available to tenants, which typically have lower credit ratings than landlords.

This is less obviously true in the case of Alt-A loans (which, until recently weren't very common), but according to at least one source I skimmed recently (I don't have the citation and wouldn't have considered it authoritative in any case), many Alt-A loans are for second homes and investment properties.

Still, for a family who already has one of these loans, particularly if the loan has a pre-payment penalty (and new laws banning pre-payment penalties typically aren't and constitutionally can't be retroactive), the demise of the subprime and Alt-A market will force some difficult choices as homeownership must be weighed against a potential new job far from an existing home, for example.

1 comment:

Max Ray said...

The decline of the subprime and Alt-A credit market also means that families with poor credit but significant real estate equity who have a financial crisis must sell their homes, often at a loss given the current state of the real estate market, and start renting, to access that equity. Previously, home equity loans would have been a common solution for these families. Going forward, the demise of the subprime market is not necessarily a bad thing, and may not even hurt home ownership rates very much. Many subprime loans involve debt consolidation by people who are already homeowners, rather than new home purchases. Also, many subprime loan borrowers would be better off economically selling their homes to an investor, putting the proceeds, if any, in an FDIC insured certificate of deposit, and renting the property back at the going market rate rental (at least in the absence of a pre-payment penalty).