Risk/reward
We've heard a lot about the downsides of mortage securitization recently: how spreading the risk has also made it difficult for strapped borrowers to obtain workouts, while obscuring the extent of the financial system's exposure. But here's a benefit you aren't hearing much about: no one in America is currently worried about bank runs. In England, on the other hand, where one of the biggest subprime lenders was also a major bank, the government has stepped in to guarantee all of Northern Rock's deposits in order to prevent a solvency crisis for the institution:
News that U.K. Chancellor of the Exchequer Alistair Darling, who oversees the Treasury, together with the Bank of England, had taken the highly unusual step of guaranteeing all deposits at Northern Rock, combined with an unscheduled £4.4 billion ($8.78 billion) injection from the central bank, brought a measure of calm to depositors and investors yesterday. A Treasury spokesman said the guarantee extends to any solvent bank in similar circumstances.
Northern Rock said that lines at its branches and traffic at its call centers had decreased sharply. In London yesterday, Northern Rock's shares rose 8.2% to 306 pence ($6.11), after losing about 30% on each of the two previous trading days. Shares of other U.K. mortgage lenders bounced back sharply as worries eased.
Did the bankrupcty reform touch off the mortgage bubble?
Yves Smith thinks it might have
Half the subprimes were cash out refis. This isn't implausible. Freddie Mac reported that cash-out (meaning the new mortgage was at least 5% larger than the one it replaced) refis for its borrowers were 35% in the second quarter of 2007, and noted that refinancings as a proportion of total mortgages were declining, which is typical in a rising interest rate environment.
Now why is this so significant? It gives a completely different picture of the nature of the problem. It suggests that many of the people who took out subprimes weren't people who bought more housing than they could afford. It says they were already overstressed and overstretched financially. Using their home as a source of cash was a gamble to keep themselves out of bankruptcy, but in many cases, that bet didn't work out.
The high proportion of cash-out refis suggests that it would behoove someone to do some investigation to get a better grip on why people took these loans and what became of them. Were most, as Lee suggested, in bad shape and taking the one way they saw out, or were they merely foolhardy overspenders? If they needed the new mortgage to pay off other debts, how did they get in trouble in the first place?
The last large scale study of why people filed for bankruptcy (published in 2005 but looking at 2001 bankruptcies) found medical expenses were the top reason and job loss/interruption was number two. If these are the real reasons that a large proportion of subprime borrowers went that route, it suggests a completely different set of remedies than if it is say, primarily a housing bubble (too many people felt they could gamble on appreciation) or predatory lender problem.
Dean Baker pointed out that some borrowers defaulted before reset, which suggests that pre-existing financial stress may have played a role:
[M]any of the subprimes were seriously delinquent or in foreclosure long before the mortgages reset to higher rates. In an analysis done early this year, the FDIC found that 10 percent of the subprime adjustable rate mortgages issued in 2006 were seriously delinquent (missed three or more payments) or in foreclosure within 10 months of issuance.
A parenthetical note: that bankruptcy study is horrendous and should never be cited by anyone. It counted any bankruptcy in which the parties had more than $1,000 in uninsured medical bills as having been caused by the bankruptcy, even when the respondents themselves cited other reasons. $1,000 is a nasty sum, but no matter how poor you are, it is not bankruptcy-level. Anyone who declares bankruptcy over a couple of thousand dollars worth of debt should sue their lawyer for incompetence. More rigorous studies find the commonest causes of bankruptcy are divorce and job loss; where medical problems are a cause, the main factor is usually income loss from lost work, not bills. Medical providers will almost always take a workout rather than bankruptcy.
But the broader point is interesting--though Yves, like most observers, is more interested than I am in assigning blame. I'm less interested in who was wrong, than in what broad forces pushed us in this direction. And he hints at an interesting one:
One other factor that may have contributed to the subprime frenzy: Lew Ranieri, the so-called father of mortgage backed securities, has stated that the overheated phase of subprime lending started at the end of the third quarter of 2005 and extended through most of 2006. When did the new bankruptcy law take effect? October 24, 2005. There is no ready way to prove a connection between the new law and the explosion phase of subprime growth, but consumers became much more cautious in taking on credit card debt after the law became effective. And the ones that had above median incomes which would force them into a Chapter 13 (meaning they'd have to repay their debts) might be even more eager to tap home equity if they saw themselves at risk.
One way to cast this: mean lenders got Congress to change the bankruptcy laws, which meant people desperte to get out of their credit card debt put their houses on the line. Another way: irresponsible borrowers confronted with the cost of their past profligacy, gambled their houses, too. The interesting explanation, though, I think is more value-neutral.
From what I hear, the evidence on bankruptcy reform is that all the actors involved behaved in a perfectly economically predictible way. Lenders, with more assurance that they would be repaid, became more willing to lend. But borrowers became less willing to borrow, so the amount of credit supplied to the market contracted. (Incidentally, people who think that we should protect the poor from credit cards and payday lenders should be glad about this.)
But there was a huge credit glut in this country, thanks in part to a torrential inflow of foreign capital. That credit had to go somewhere; if credit card borrowers wouldn't take it, they'd just offer cheaper rates to someone else . . . like mortgage borrowers. Mortgages aren't much affected by bankruptcy, because it's secured debt. Under the new law, as the old, borrowers either hold onto the house by committing to meet the payments, or surrender it to the lender. So falling interest rates in that market, especially combined with rising prices, were likely to produce the bubble conditions we saw.
Tighter . . . and tighter . . .
Mortgage holders aren't the only borrowers getting themselves into trouble:
US consumers are defaulting on credit-card payments at a significantly higher rate than last year, raising the prospect of problems in the stricken US subprime mortgage market spreading to other types of consumer debt.
Credit-card companies were forced to write off 4.58 per cent of payments as uncollectable in the first half of 2007, almost 30 per cent higher year-on-year. Late payments also rose, and the quarterly payment rate – a measure of cardholders’ willingness and ability to repay their debt – fell for the first time in more than four years.
Analysts at Moody’s, the rating agency, said the trend could be related to the slowdown in the US property market and a fall in the number of borrowers rolling their mortgage debt into new and cheaper home loans.
There are multiple avenues for the spread. The credit contraction, to begin with; just as it's making it hard for strapped borrowers to refinance, it's also cutting down on those zero balance transfer deals that some people use to get themselves out of trouble, or at least stave off the bailiffs.
But of course, there's also the fact that for the last ten years, many homeowners have resolved crushing credit card debt by borrowing money on the value of their homes. That's suddenly gotten much harder to do, which may be forcing people into default.
And, obviously, people who are having trouble meeting their mortgage payments may decide that Visa and Mastercard need to get in line behind the bank with the power to kick them out of their house.
No one knows which of those things is dominant, however; or even how deeply the two phenomena are related. As the article says:
But it is not clear that the borrowers defaulting on their credit cards are the same people defaulting on their subprime mortgages, it added. This is in part because underwriting standards in the credit-card sector have been more robust than in the mortgage industry. Also, many highly leveraged subprime borrowers, with little or no equity in their homes, may choose to default on a mortgage before risking being unable to charge everyday necessities to their credit card.
This doesn't seem like a good strategy; the conventional wisdom is hold onto the house! On the other hand, the conventional wisdom that said "Buy a house ASAP!" doesn't seem to be working out so well for subprime borrowers, so perhaps it's time to give the CW a rethink.
Carping on credit
The Wall Street Journal reports that Illinois is experimenting with mandatory credit counseling for people considering non-traditional loans:
Yet Illinois's experience to date shows how difficult it is to create even modest safeguards in the home-buying process. A previous pilot program similar to the new law was viciously attacked and rescinded in January, after only a few months. Instead of winning plaudits, the pilot program quickly became mired in charges that it would make it harder for minorities to buy homes. Mortgage brokers, fearing a loss of business, claimed that access to credit would tighten in the neighborhoods targeted by the law. Rumors flew that dozens of lenders had pulled out of the area.
The general response of economists is to dismiss this claim with a derisive laugh. If mortgage brokers find it harder to sell their wares when borrowers better understand the terms, then those are mortgages that shouldn't be sold.
But it isn't quite that simple. Much depends on the quality of the information given, which is why pro-choice activists often object to counseling requirements, and of course "crisis pregnancy centers" that counsel against abortion.
Even worse, there is some evidence from heterodox economics that more information doesn't necessarily make for better decisions. General economic theory dictates that the more information is available to participants in a market, the better ("more efficient") the outcomes in that market should be. But that dictum is not always borne out in economic experiments; sometimes more information makes things worse. And we're not talking about more information like "this is what your BABY looks like!" (or "it's just a clump of cells"). I mean more information about things with ostensibly neutral emotional valence, like the underlying value of traded assets.
Is an hour or two enough to give financially naive people good information about mortgages, or just to confuse them? Is the state biased towards being too conservative? Even if the information being given is good, is the information the borrowers are taking equally good? As any blogger knows, no matter how clearly and effectively you think you are explaining things, misunderstandings are rife.
I'm tempted to say that scaring low-income buyers off non-traditional mortgages is an obvious, unalloyed good, given what's happening in the property markets. But there's an uncomfortable whiff of the paternal about that instinct. 85% of subprime mortgages are still in good standing; presumably, many of those homeowners would not thank me for preventing them from buying their first house.
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