Should Subprime Lending Die For Good?

This post is resurrected from a draft post written April 28, 2012 when the aftermath of the Financial Crisis was still fresh in our minds.

The subprime mortgage industry is dead. Should it die for good?

There are basically two reasons to object to subprime lending. First, the industry as it was conducted before the financial crisis is unsustainable. Second, the industry as it was conducted before the financial crisis relied on unconscionably luring borrowers into making objectively bad decisions from an economic perspective for most of its business.

Subprime mortgage lending should be revived only on a sustainable basis, and only in the narrow subset of transactions where the decisions borrowers are making to borrow money on this basis are not objectively bad ones from an economic perspective.

But, it is possible to reform the subprime mortgage lending industry to be sustainable with important, but relatively subtle modifications to its business model. Its underwriting standards need to be reformed, mostly by rethinking how the risk that the collateral will be insufficient to satisfy the loan in the event of a default is evaluated. The way that the subprime mortgage industry funds itself also needs to be changed to create simpler, more transparent mortgage backed securities whose risks are more clear and that have inherently less risk than those that the markets declared to be toxic.

Situations where subprime lending makes sense

It is also possible to identify categorically situations where subprime lending transactions do make economic sense for both the lender and the borrower, and to limit subprime lending to categories of loans, in some cases with terms necessary to make them appropriate to that category of loan, where the transaction is not objectively bad for the borrower.

These situations include:

(1) reverse mortgages to provide cash flow for the elderly while allowing them to remain in their homes,

(2) hard money lending on business and investment properties where the owner's income from sources other than the property is not the main source from which the loan is expected to be repaid,

(3) loans where (i) conventional loan refinancing is not available because the homeowner is in default or at a high risk of defaulting or has a hard to determine risk of defaulting, (ii) that replace existing secured or unsecured loans, and (iii) reduce the homeowner's effective interest rate, monthly payment, or both, (iv) that the homeowner believes he or she has a realistic change of paying, (v) that do not unduly increase the homeowner's obligations beyond those that would survive a bankruptcy.

(4) loans to people whose past bad credit was due to causes that are no longer present, have a present ability to pay the loan, and would not be better off renting a home,

(5) hard money loans for personal residences to people who can make a substantial down payment and would not be better off renting a home, and

(6) loans to people who have significant home equity, have no investments or lower cost source of credit from which they can obtain funds, urgently need funds for purposes that are practical necessities (such as medical care, bail, defense against serious criminal charges, a pending judgment or tax lien, etc.), and for whom selling their home is not an option that is available soon enough to meet the need or is for some other reason an unreasonable option.

The big constraint is that for first time subprime buyers, the cost of owning is often much greater than renting, mostly because rental rates reflect the prime credit interest rates of the landlords much more than they do the often subprime interest rates of the tenants.  Otherwise, subprime lending pretty much only makes sense for existing homeowners who have an interest in stability and face a "choice of evils" situation.

A subprime mortgage lending industry organized within these constraints would be much smaller than the industry as it existed before the financial crisis and would have a much different character. But, there is a good case that subprime mortgage lending should not die for good, but instead should be dramatically reformed. Indeed, the creation of a subprime mortgage lending industry that is available to meet subprime borrower's legitimate needs would be a positive development because it would discourage the development of more toxic subprime mortgage lending.

Is Subprime Lending Inherently Unstable?

As it was, was the financial crisis proof that subprime lending was an inherently unsustainable industry?

If the subprime mortgage industry is inherently unsustainable, it should die, for the same reasons that, for example, the Ponzi scheme industry should die, or Tulip mania had to collapse in Holland in 1637. Even if some people can profit from it, in the end it might be an inherently unstainable business model. The financial markets killed the subprime market because, as it was originized at the time, it was an unsustainable industry that was rotten to the core.

But, was subprime lending inherently unstable? Not necessarily. So long as its business model doesn't rely on rising asset prices and insists on enough equity or credit strength to buffer the harm to the lender if there is a default, it can be a sustainable industry, and with suitability rules incorporated into underwriting standards, it can even be non-exploitive.

But even though it is possible to organize a subprime lending industry on a sustainable basis (with government or private sector customary practices that prevent it from repeating the mistakes of its past business model, which itself would limit its scope somewhat), a recreated subprime lending industry should also be subject to regulation that would often make subprime lending unavailable in circumstances where it was most commonly used in the past.

Does Subprime lending prey on irrational decision making?

The main objection to subprime lending that liberal policy analysts like myself, who accept the conclusions of mainstream economics and have a healthy respect for the autonomy interests that market economics advance, have is not that subprime lending is inherently unsustainable. 

Liberal policy analysts, instead, are concerned that subprime mortgage lending, and many of its cousins like payday loans and rent-to-own transactions, lend mostly in circumstances where borrowers are making decisions that are objectively bad when viewed by a well informed third party observer, and are made only as a result of deceptive marketing and insufficient information that could be provided cheaply enough if someone had the right incentives to provide it.

When private business transactions are objective bad ones, a strong presumption arises that they are unconscionable, and there is a long common law and regulatory tradition that holds that unconscionable private contracts should not be upheld, or at least, should be enforceable in the courts to the extent that they are unconscionable despite the general rule that agreements reached between private parties create legally enforceable obligations.

Why did the subprime mortgage industry die?

The subprime mortgage industry died because: (1) the underlying mortgages were underwritten on the assumption that the property values that provided security for the mortgages would fall only slightly or increase in value, without sufficient regard for the risk created by a developing housing price bubble, (2) mortgage backed securities were created in ways that enhanced the risk inherent in the underlying mortgages that backed up these securities, and (3) credit rating agencies understated the risk involved in these securities causing them to be underpriced and causing them to be purchased by inappropriate investors.

Credit rating agencies understated the risk involved in these securities. They understated the risk because: (1) they too underestimated the risk that the mortgages would decline in value as a result of falling housing values when the housing bubble collapsed, and (2) they underestimated the counterparty risk involved in credit enhancing guarantees in the form of credit default swaps from third parties. They underestimate the counterparty risk because the credit default swap market and credit default issuers were insufficiently transparent for credit rating agencies to evaluate the risk. Credit rating agencies were also insufficiently aggressive in insisting on more accurate estimates of the risks that they underestimated because credit rating agencies had conflicts of interest arising from the fact that they were chosen and paid by the issuers of the securities to which they assigned credit ratings.

In theory, regulating disclosure in mortgage backed securities would solve the problems that caused its collapse, because the money to fund them would dry up when underwriting became reckless, but in practice, it is very hard to regulate anything that effectively.

The financial crisis was triggered when subprime loans soured in large numbers, and years later, the losses that the financial industry is suffering in the mortgage market overwhelmingly involves subprime loans, which are defaulting at astronomical rates.

The subprime industry was killed by the marketplace, not by government regulation, and the market was far more swift and decisive than government regulators. Investors divested themselves from the market so completely that the entire subprime and Alt-A mortgage lending industry almost entirely ceased to exist in a matter of months. Government regulation has since made it virtually impossible to resurrect the subprime mortgage industry on the business model that was in place before it crashed, but that regulation came after the industry was dead anyway, it was not the cause of the collapse which died without government regulatory intervention.

The investors weren't wrong.

"Planet Money," an NPR syndicated program about business issues, illustrated this point graphically by having their staff by a $1,000 "toxic asset." It was a complex mortgage backed security tied to the performance of a portfolio of mortgages with unexpectedly high default rates, but was still producing a small stream of interest payments. They named it "Toxi" like a mascot. They traced its life, interviewed people whose loans were included in the pool and tracked its returns. Last week, Toxi died, reaching a point where it would no longer ever make any more payments. Despite the fact that they bought Toxi at a 99% discount from the price it was originally sold to investors for of $100,000, they lost a little more than half their investment. The return on the original $100,000 of principal investment was less than $500.

Some of those mortgage backed securities really were horrible investments that lost a very large percentage of their value.

Most often this is because the securities were highly leveraged investments.

In some cases, mortgage backed securities had leverage that flowed from the collateral they held itself, because the collateral they held was made up of non-recourse or poor credit borrower second mortgages on part of the last 10% to 20% of assumed value of the loan, rather than first mortgage loans of the first 80% to 90% of the loan (often available from conventional commercial banks or government banked lending programs). This second mortgage collateral could be significantly impaired by even a modest decline in the value of the home that was collateral for the mortgage.

In other cases, the underlying assets weren't particularly highly leveraged, but a pool of loans was broken up into subpools of risk in which higher tier securities received paybacks only when lower tier pools were repaid in full. Thus, leverage was created from fundamentally sound underlying mortgage investments in the pool in the higher tier subpools.

Sub-Prime Mortgage Lending And Hard Money Lending

These mortgage backed securities were themselves examples of hard money lending. The ability of the loans to be repaid from the underlying mortgages that were collateral for the loans, while unrealistically high, was always in doubt. But, the mortgage backed securities received inflated credit ratings because in addition to the underlying mortgages they were also backed by guarantees from the originating mortgage finance companies, which were themselves big businesses sometimes with long track records, that default rates would not exceed a certain level, and from third party guarantors via derivatives called credit default swaps, who were themselves often reinsured by big established financial institutions like AIG., which the U.S. government eventually bailed out in exchange for 80% of its stock which the U.S. is now about to start reselling to the public in an effort to recover some of the money spent on the AIG bailout.

Investors in mortgage backed securities were making hard money loans backed by the ability of the underlying mortgage borrowers to repay, by the value of the houses that were collateral for those mortgages, by the ability to repay of the mortgage finance companies, by the ability to repay of the credit default swap issuers, and by the credit of the credit default swap issuers reinsurers. The soundness of these collateral and guarantee arrangements was then blessed by credit reporting agencies.

Not necessarily.

Banks take losses on loans only when both of the following two circumstances are present.

First, the borrower defaults, something that generally happens in the case of a recourse loan when the borrower is unable to repay the loan, or when there is a dispute over whether the loan is owed.

Second, the collateral securing the loan is worth less, on a distressed sale basis, after the costs of collection and the costs of disposition of the collateral, than the amount owed.

In California, which was the epicenter of mortgage losses when the housing market collapsed, and to a lesser extent in Florida, both of these conditions were absent in a huge number of loans.

The first condition didn't apply, because the loans were non-recourse, so borrowers had the ability to not pay mortgages, even if they had the ability to repay them and did not dispute that the debts were valid.

The second condition didn't apply because the loans were made against collateral valued at prices that had risen dramatically during a housing price bubble which then collapsed to amounts far below the purchase price, in the case of purchase money loans, or the appraised value, in the case of home equity loans.

Regulators and the market have responded to the massive failure to their collateral to prevent them from suffering losses by becoming much more strict about the first condition. Now, underwriters are usually approving loans only to people who can prove that they have an ability to repay their loans as they come due from their incomes.

In this business model, the collateral is as much an incentive for borrowers to prioritize payment of the debt as it is something that lenders are relying upon to make them whole if the borrower defaults.

The borrower's more than economic attachment to a personal residence, and the hard that a foreclosure does to a borrower's credit rating, along with the hope that losses from declining home values can be recovered if the home owner keeps the property until real estate values appreciate again, encourage borrowers who have an ability to repay not to default on upside down loans (i.e. where the house has a fair market value of less than the loan), even in states like California where the loan itself is non-recourse and they have the ability to simply send in the keys and walk away from the home.

But, the whole point of the subprime and Alt-A mortgage market was that lending to people who can't prove that they have an ability to repay their loans from their income can be good business too, since the second condition is true, even if the first is not.

At its greatest extreme, this kind of lending is called "hard money" lending. I've represented private lenders doing hard money lending. 

 For example, it makes sense to make this kind of loan to people who need a small amounts of money relative to the property value for legal and business expenses necessary to cure problems that make it unmarketable for legal reasons. I've also represented borrowers seeking hard money loans because their income is hard to document, for example, because they are relying on income from a loved one to whom they are not married.

There is a small network of affluent private individuals out there in Denver who make hard money loans for real estate developers who build spec houses, fix and flip, scape and increase density, or pop top and flip houses, all of which are basically different species of infill development in Denver. In these deals, what matters is that the proposed sales price after the development is realistic, that the costs and time frame for the improvements is realistic, that the purchase price of the property is sufficient low, and that the developers have enough business acumen and enough of a financial incentive to finish the deal. Sometimes the principals of the borrowers actually would have an ability to repay, but organize a limited liability companies to make the loans effectively non-recourse, and the private lenders agree because the economics of the hard money loan still make sense and they can charge a higher interest rate.

When the lender is primarily relying on the value of the collateral, and not the ability of the borrower to repay a loan, "no doc" or "low doc" lending (in theory, including so called "liar loans") can make sense, because the loan can be good business for the lender even if the loan defaults.