Why The 3-Year Freeze To Curb ARM Problems Won’t Work

Register now

Congress’ Joint Economic Committee (JEC) issued a report last October titled, “The Subprime Lending Crisis: The Economic Impact on Wealth, Property Values and Tax Revenues, and How We Got Here.” The study conservatively estimates that through 2009, “Approximately $71 billion in housing wealth will be directly destroyed” through foreclosure; “More than $32 billion in housing wealth will be indirectly destroyed by the spillover effect of foreclosures” on neighboring properties; and “State and local governments will lose more than $917 million in property tax revenue” due to the erosion of housing wealth.

The report asserts that subprime ARMs “were largely sold to financially vulnerable borrowers without consideration for their ability to afford them.” While this is true in some cases, the notion that it was “largely” the case is dubious. The report indicates the average value of subprime ARMs outstanding in 2005 was about $200,000. The median home price in 2005 was $223,121, thus the average ARM balance represents 90% loan-to-value.

Since the average ARM borrower was that close to the median, they clearly represented the middle of the bell-shaped curve. If the middle of the curve is populated by “financially vulnerable borrowers” who don’t understand their mortgage terms and were duped by predatory lenders, we’d all be in trouble.

The report cites estimates from the Center for Responsible Lending (CRL) that minority homeownership, which posted gains during the housing bubble, will suffer a net reduction of 85,000 homeowners. Conveniently ignored is the fact that overall homeownership gained during the bubble, and has now declined to pre-2002 levels–in other words, subprime borrowers across the socioeconomic spectrum have suffered.

The Trouble With The ‘Lightly Regulated’

The study notes that about 80% of subprime originations were by wholesale lenders that are more lightly regulated than depository institutions, arguing that “some states have tried to apply federal predatory lending advisories to all lenders ... but the resources that states have for oversight are far fewer than those of the federal government.” Not mentioned is the fact that in 2003, the OCC exempted national banks from state regulations against predatory lending.

The study calls for increased credit counseling resources–a great idea, but one that will require tax dollars. The second suggestion is to direct servicers and lenders to modify or refinance existing loans. But nearly 80% of subprime originations were securitized, reinforcing the difficulty of tracking down the ultimate owners of the cash flows and gaining their acceptance of reduced returns, plus the risk of stifling future securitizations, impairing liquidity and making future mortgages more expensive.

Other recommendations include increasing FHA’s ability to refinance subprime loans (again requiring tax dollars), expanding Fannie Mae’s and Freddie Mac’s ability to refinance the loans (which, given the capital issues the GSEs face, would also likely require a taxpayer bailout), or amending the bankruptcy code to exempt home loans, which would be catastrophic for lenders and would result in a surge in real estate speculation, which was a significant cause of the housing bubble.

The two recommendations that make sense are banning predatory lending, and ensuring that all borrowers understand their mortgage terms. But the former should have been addressed early in the subprime build-up, not after the bubble burst. Acting now is noble, but will only help prevent future bubbles.

The latter is conceptually sound, but practically difficult to achieve. The specific recommendation would require lenders to provide a one-page sheet that clearly states the terms of the mortgage and their impact on future rates and payments. But that doesn’t guarantee the borrowers will get it. Another study found that while nearly half of subprime borrowers didn’t know how their ARM reset, and nearly two-thirds didn’t know how much the payment could increase, almost 80% said the lender’s information was “accurate and truthful.”

The study cites the CRL in estimating that “20% of existing borrowers that were able to repay their loans before their rates reset … could afford their loans over the life of the mortgage if their current ‘teaser’ interest rate was fixed at that rate” (a point that elicits a response of “duh”).

That point is also argued in a paper by the Greenlining Institute, which says a freeze for the life of the mortgage is the best solution. Their basis is a Boston Fed study that “states that up to 55% of subprime loans were made to borrowers who could be eligible for prime rates.” The key phrase here is “could be eligible,” and “up to 55%” could mean considerably less than that–and 55% is just over half.

The Boston Fed study actually says: “During its beginning stages, this subprime lending channel focused almost exclusively on…borrowers with impaired credit.

Subprime Lending Could Expand

However, with the rapid increase in mortgage securitization, as well as the persistent growth in house prices nationwide, the subprime lending channel soon expanded its credit to borrowers on other margins. These borrowers included households that did not want to produce a down payment … that did not wish to fully disclose their income and financial wealth …, that wished to purchase a larger home than they otherwise could have purchased with financing from a prime lender, or households who wanted to do some combination of these actions (or even all of them). Thus, a subprime mortgage evolved from a loan originated by a subprime lender to a borrower with a poor credit history, to a loan ... to a borrower that was marginal and thus riskier relative to the average borrower on any one of a number of different dimensions. The point is that the subprime lending channel no longer focused on only credit-impaired borrowers, but also on borrowers who might be considered prime based on their FICO score, but who were perceived to be elevated credit risks because of other characteristics.”

The study also noted the number of subprime borrowers who purchased their homes using prime financing, but refinanced into a subprime loan due to credit deterioration, a desire to pull equity, or some combination of such factors.

Clearly, the point made by the Boston Fed was that the swath of homeowners touched by the subprime crisis is not as narrow as the politicians would have us believe. But the Greenlining Institute co-opted the study to fit its own bias. It–and the JEC report–conveniently ignore the overwhelming moral hazard that would result from a permanent lock on the teaser rate, as well as the penalty on responsible, creditworthy borrowers who paid a fixed prime rate higher than the subprime teaser. The proposed lifetime lock is tantamount to a housing subsidy.

The Boston Fed study draws another important conclusion in discussing the originally-prime borrowers who refinanced into subprime loans: “It is likely that in the absence of a subprime market, many of those borrowers that ended up defaulting would have defaulted on their previous prime mortgages.” This explains why the Paulson plan’s three-year freeze will fail. When those loans reset, unless real estate values are once again escalating at a bubble-like pace, they’ll default anyway.

Brian Hague, CFA, is President/CEO, CNBS, LLC. (c) 2008 The Credit Union Journal and SourceMedia, Inc. All Rights Reserved. http://www.cujournal.com http://www.sourcemedia.com

For reprint and licensing requests for this article, click here.