Subprimes Blowing Up Early

Subprimes are terrible because when their adjustable rates adjust, the bootstrap borrowers who could barely afford the starting teaser rates really can’t afford the post- adjustment rates. At least that has been the logic thus far. Now it seems that due to our old economic nemeses Moral Hazard and The Agency Problem, these loans were so shaky to begin with that they are blowing up even before the rates reset. The requirements for borrowing were so lax that many of these borrowers are not even able to afford the teaser rates. That’s nice. I’m going to write my Congresswoman and demand that she bail out these lenders and preserve the giant bonuses for the executives that caused this disaster! Won’t somebody throw a benefit concert or start a charity? Bank-Aide would be a nice name.

CNN/Money.com reports in “Subprime loans defaulting even before resets,” (Les Christie, February 20 2008):

For instance, in both 2006 and 2007, well over 40 percent of subprime borrowers were awarded mortgages with either little or no documentation of their ability to pay. With these so-called "liar loans," borrowers did not have to show proof of either earnings or assets.

And even when borrowers did go on the record about their earning power, it didn't bode well. Both 2006 and 2007 saw a large proportion of loans with high debt-to-income ratios (DTI), which indicates the percentage of gross income required to pay debt. In 2007 subprime originations, the DTI hit 42.1 percent, up from 41.1 percent in 2006. Borrowers were simply taking on more debt that they could afford.

But surely these lenders, as sophisticated as the biggest financial institutions in the United States of America are, should have had some warning that there was trouble on the horizon?!

Read on:

By late 2006, lenders knew that the housing market was heading south. Foreclosure filings took off during the third quarter that year, up 43 percent from 12 months earlier, according to RealtyTrac, the online marketer of foreclosure properties. And home prices began to drop.

But instead of cutting back on risky loans, lenders kept lending. Why?

"Because investors continued to buy the loans," said Doug Duncan, chief economist of the Mortgage Bankers Association.

Despite their quality, subprime mortgages were as profitable as any other for lenders like Countrywide and Wells Fargo, who were able to quickly securitize the loans and sell them in the secondary market. The loans sold easily because they carried the promise of high yields.

"As long as you could sell the loan, you made the deal," Duncan said.

Lenders needed the fees that these loans generated because their finances were weakening. Their cost of borrowing money was rising, while competitive pressures were keeping mortgage interest rates low.

"By 2006 many lenders were running into red ink," said Youngblood.

So, they revved up lending to increase short-term profits. And, to outside analysts, there appeared to be nothing wrong with loan quality.

"There were very few overt changes in industry underwriting guidelines," said Youngblood. What did change, he said, was that lenders made more exceptions to their standard practices, approving people with poor work histories or insufficient proof of income.

"These exceptions generally amounted to no more than 5 percent [of subprime loans] before 2006," said Youngblood, "but they represented the majority of these loans issued in 2006 and 2007."

The reason for that shift: Lenders depended on independent mortgage brokers for much of their business, and brokers pushed them to approve subprime loans because they delivered big profits for the brokers.

"Lenders felt they had to take the loans to preserve their access [to the rest of the loan pool]," he said. They accepted some risky subprime loans so that the brokers would also send them safer prime and Alt-A loans.

Of course that's a bet that went bad. And it's likely to get worse as resets for ARMs issued in 2006 and 2007 kick in this year.

And now the LetItSink Soap Box:

Business in America is very big on fighting regulation and wanting the market to police itself when things are going well. Then they cry like little babies when things go badly. Now things are bad and this country needs to deliver a big generous dose of tough love to BofA, Countrywide, Citibank, and all the rest of them. If they vanish, good riddance. If we can brush aside the constitution when it is convenient for the president, then I think we could have some nice kangaroo court antics for the officers of these companies. Let's plan a Perp-Walk Parade to the gallows. FDIC will take care of depositors, and let the vultures take care of the rest.