Arnold Kling  

Subprime Mortgage Loans

Bayesian Analysis of Hypocrisy... Regulation-exempt...

Megan McArdle passes along a question from Dave Schuler.

My intuition is that the phenomenon of the subprime loan is related to the rapid rise in housing prices that haven't been matched by comparable rises in money wages. The implication is that people are paying a lot more of their incomes in mortgage payments than once they did. That, in turn, would be more prevalent in parts of the country where there's been more speculative price increases than in areas that have experienced less of a bubble. More where you are than who you are.

He asks whether this intuition is correct. Having spent the late 80's and early 90's at Freddie Mac, my guess would be that it is not. My guess is that subprime borrowers are subprime borrowers, meaning people with flaws in their past record of managing credit.

One thing that happens in mortgage lending is that rising home prices cover up a multiple of sins. You can get away with really lax lending standards in a rising market, even to the point of tolerating a bit of fraud. What happens is that when people get into trouble with making payments but their houses have appreciated in value, they almost never go to foreclosure. Instead, they can sell their house, repay the loan, and walk away with some cash.

Looking at data from, say, 1998 through 2005, a lender would say that subprime lending was a high-margin, low-risk business. So standards got pretty loose. Now that house prices are not going up so much, some of the lenders are getting burned. When the borrower's bad spending habits get the better of him, he can no longer bail out by taking the profits on his house. He just stays and waits for the lender to come after him.

My guess is that the typical defaulter today is not some prudent individual who happened to buy a home that strains his paycheck. Instead, my guess is that the typical defaulter is somebody who is poor at managing spending and credit. Of course, either defaulter is going to appear to be "over his head."

UPDATE: Following up on my blog post (just kidding), the WSJ reports,

Fraud appears to be one reason for a recent rash of defaults occurring within the first few months of subprime loans. One hint that fraud might be a problem at New Century came in the company's disclosure last week that in December, borrowers failed to make even the first payment on 2.5% of New Century's loans. Normally people who borrow in good faith manage to make at least the first few payments.

Lenders loosened standards considerably in the first half of this decade. Home prices were climbing so fast that borrowers who couldn't keep up on payments could almost always sell their homes for a profit or refinance into a loan with easier terms. That emboldened lenders to offer loans with little or no down payment. Sometimes they let borrowers skip burdensome paperwork such as digging out tax forms to prove how much money they made.

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TRACKBACKS (3 to date)
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The author at Outside The Beltway | OTB in a related article titled Subprime Borrowers writes:
    A little earlier today James posted on the problems that subprime lenders are experiencing and there was a comment on that post to the effect that people who bought older homes were more likely to be “subprime borrowers” than those who boug... [Tracked on March 12, 2007 5:38 AM]
The author at More Than Loans in a related article titled The media and the mortgage crisis writes:
    With stagnant property values, their LTV hasn't improved much if at all in the intervening years, and often if they were in a sub prime loan in the first place it's unlikely that their credit improved in the meantime. Someone who had sub prime credit... [Tracked on March 12, 2007 2:02 PM]
The author at Econbrowser in a related article titled Subprime fallout writes:

    New Century Financial Corporation, formerly one of the nation's biggest subprime mortgage lenders, has had a spectacular trip up and even more spectacular trip down.

    [Tracked on March 13, 2007 10:32 AM]
COMMENTS (3 to date)
Dave Chapman writes:

I don't know about the rest of the country, but in Silicon Valley, the typical sub-prime loan situation is a person who bought an expensive house a few years ago, when they had a six-figure income. They lost that job, and have been scraping along on temp work, etc. while running down their savings and taking out home equity loans. All the while, they have been trying to get back into the high tech job market, such that they would have a job which pays the bills again.

Until about a year ago, when these sort of people got to the end of their rope, they could sell the house and walk away with a hundred thousand or so. Today, they often can't sell the house for what they owe on it.

In the world of junk bonds, a "fallen angel" is a bond which was originally investment grade but which subsequently turned into junk. I don't think that most of the sub-prime first mortgages around here were sub-prime when they were written: I think that most of the sub-prime mortgages in Santa Clara county are fallen angels.

another bob writes:

I worked for two subprime leanders in the 80s and 90s. Arnold's view is correct as far as it goes. One extra wrinkle is that some loan officers are good at teasing out the details of a borrower's credit history and finding those that have bad pasts but good futures.

Examples were; recently divorced people whose ex's were profligate spenders, solid citizens who had a medical or legal crisis that sent them into banruptcy which they've gotten past, newly married males with a good job and poor credit histories.

Bill Conerly writes:

When I went to work for a bank and attended my first credit policy committee meeting, I was appalled that they looked at only five years of loss experience in setting interest rates on different types of loans. I pointed out that the last five years (at that time) did not include a recession; they really should take an average over a business cycle. I saw the look of understanding on all the bankers' faces: this is why they had not previously invited the economist to credit policy meetings.

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