Friday, March 21, 2008

Subprime Mess - Who Are The Real Victims?

There is tons of news on the Subprime mess, and most of it is about how people are losing their homes as a result of "Sub-Prime" loans. This story is a huge lie. People are not losing their homes as a result of Sub-Prime loans. What happened is that banks made loans to people with no money down, poor credit, and no ability to pay back the loan. When the value of houses started to fall, the banks who made these huge mistakes were left to pay the price. And they are who should pay the price. It was their mistake in the first place.

So let me describe a sub-prime loan. They come in many flavors, but they are all pretty much adjustable mortgages in some form or another. Nearly all of them involve a teaser rate that fully adjusts to the normal rate in about two years. There are interest only, and payment option loans as well, but at their heart they are all about getting people into houses that they can't actually afford. With house prices getting pumped up by the continued easing of credit standards and more subprime loans, quite a bubble in home prices was created. As long as the bubble keeps expanding people can refinance out before the normal rate hits. But bubbles don't last forever.

So lets look at it from the perspective of a home buyer with poor credit and no money to put down. They see house prices flying up, and they want to take part. They find a house that is not affordable, but they find a loan where the interest rate and payment will be affordable for the first two years. They no damn well that they will have big issues making the payment in two years, but they are counting on the house going up in value so they can refi, take cash out, and I guess make payments with the cash they took out. This is not home ownership by any stretch of the imagination. This is making an investment, and when you invest your money, you can lose.

Now if interest rates were rising it would be a different story. If the fully indexed rate is 6% and you can afford to make those payments when you take out the loan, but interest rates rise to 8% by the time the payment adjusts up you can have unplanned issues. The problem is that interest rates are not rising. Is somebody took out a subprime loan exactly 2 years ago the federal funds rate was 4.75%. Today the rate is 2.25%. Two year old sub-prime loans adjusting today are adjusting to a rate that is 2.5% below what was planned. The fully indexed non-teaser payment is much less today than what would have been planned for when the loan was taken out. How this can lead to massive foreclosures is beyond me. Adjustable Rate mortgages get more affordable every time the fed lowers rates, and rates are dropping fast.

So what is the real story? The people losing their houses to foreclosure could not afford the fully indexed rate. They can't even afford a fully indexed rate that is 2.5% lower than expected. They were doomed to lose their house the second the agreed to buy it. Falling home prices have nothing to do with the problem. If you can afford your loan and plan on living in your home for a while, the underlying value of the home makes no difference. Your house losing value, can't cause you to lose it. Only not being able to afford the payments can cause you to lose your home.

Every horror story from a consumer perspective is based on the premise that they did not understand the loan, or did not know it would adjust up. It like they though you could buy a million dollar home on a $1000 a month payment. You simply can't. If you are not capable of understanding a loan for the biggest purchase of your life, you should not be buying a house. The idea of refinancing out of a high interest rate to a lower one is a pipe dream. Fixed rate loans are always higher than an adjustable one. You can't refi out of an adjustable loan into a lower payment fixed loan. You also can't refi into a lower adjustable rate loan from an existing adjustable, as both are based on the same short term interest rates.

So basically, I have no problems with consumers who can't pay for their homes losing them to foreclosure. Lets say you bought a 50" Plasma TV on a no interest/no payment loan for 12 months. The 12 months expire, and since you didn't pay it off, the interest rate jumps to 20% and you are forced to make payments. If you can't afford those payments, you can't really go back to the store, and demand they lower your payments, or greatly reduce the amount of money you owe on the TV because now you can't afford it. What happens in the real world is you have to give the TV back. You have no equity in it, and can't afford it.

So what about a company like Bear Stearns collapsing as a result of all this? This is simply capitalism at its finest. If you bet your company on something and lose, your company fails. The ones who are smarter than you were live on, and gain market share. The fittest and strongest survive. I will comment on why Bear Sterns failed though, as it is a symptom of a huge problem in corporate America. Too much of a companies profits are syphoned off to upper management and/or traders in the case of Bear Stearns. If you take huge risks to make money, you need to hold on to that money for when times are bad. If you pay out 1/2 of that money in bonuses the money is simply not there to cover a bad year. When these same guys screw up, they don't pay a negative bonus at the end of the year. So they are incentivized to take huge risks with the corp's cash, and are rewarded heavily when successful, and not punished at all when they fail. Its like gambling with the house's money! Until the pay and bonuses for top officers, can be reduced to something reasonable, I think this is just the beginning of more big name collapses. We are also losing our ability to compete globally due to upper management raiding the corporate balance sheets for bonus cash year after year.



At 3:43 PM, Blogger Lifesagrind said...

I think your oversimplifying an issue without first hand knowledge. I don't believe this is a result of mortgages that are just now adjusting. This is being caused by homeowners who bought into mortgages 4-5 years ago. I will concede the fact that most of these people should not have been homeowners to begin with. If you can't afford the down payment, don't buy.
That stated I personally have knowledge of the following case which I believe is more representative of the types of cases involved.
A family purchases a home with an 80/20 loan and the broker assures them that if they make payments on time that they can refinance when the rate gets ready to adjust. The loan is setup to make substantial jumps but based on previous and expected income they can weather a few adjustments.
Two years go by and even though payments have been made they are unable to refinance. The company the man works for has had a wage freeze in effect since shortly after the home purchase and his income has not changed. The loan has been sold several times to other lenders and then the rate adjusts. It becomes a little harder but payments are still made. Every six months the mortgage payment increases by a few hundred dollars but his income has stayed static for years. The adjustments finally exceed the ability to pay and foreclosure becomes eminent.
Was the guy an idiot for buying a home he couldn't afford. I'd argue no. With the information given by the mortgage company and the assurances that after two years of payment history he'd be able to refinance the purchase was reasonable.
All the posturing by congress to freeze foreclosures won't help a family in this situation. It was already to late. Despite what you may think their were mortgage companies acting in a predatory manner issuing loans they shouldn't have and making statements they shouldn't have. Was that the case in this example. Perhaps but other economic factors played a role in this story as well. I'm quite sure that a lot of factors played a role in most of the cases on the news too.

At 4:23 PM, Blogger OhCaptain said...

Sure, there are predatory lenders, but Blinder argument is true. ARMs are not something that any financial advisor would recommend to the average home buyer. These people took financial advice from the same person making money on the advice.

Caveat emptor

Our society is determined to making sure that people who make bad decisions and chose not to educate themselves are protected from the fact that they didn't exercise due diligence.

I learned a LONG TIME ago, not to take advice from the person making money on my decision. You don't take the used car you are looking at buying to the mechanic that works for the seller.

The real estate business in general is some of the most corrupt enterprises in the nation. The National Association of Realtors has been in the business of protecting one of the last remaining monopolies in our country. See the Justice Dept. last look into their practices for more information. It is no surprise that the tertiary business are also corrupt.

In Utah, it was discovered that there was collusion between the appraisers, mortgage broker and the realtors. Artificially inflating the prices of homes to create bigger commissions for all involved.

All of this occurs because the public fails to educate themselves in the process of the biggest transaction of their lives. All they see is the dream. People getting screwed doesn't bother me as much as it does other people because people spend more time researching the American Idol finalist then they do understanding their home purchase.

That's a lot of 2 cents. Nice post Blinders!!!!

At 4:35 PM, Blogger Blinders said...

First off, a 80/20 loan is basically a loan with no down payment. Without any equity it is very hard to argue that you "own" anything. It is pretty hard to argue that you can lose something you never put any money into. I feel for the person in this situiation, but "assurances" that you can refi in the future are worthless. Were these "assurances" given in writing? No, that is not possible, you can't assure anyone of anything two years in the future. The only way you can refi into a lower rate in the future is if rates go down. There is no automatic way to do this without the rates actually going down. Assuming that you will never have to pay the fully indexed rate is rediculous. The bank is ultimately who pays here. They are the ones stuck with the house worth less than the loan after the foreclosure. The person in the situation, got to pay an artificially low payments on a house for a few years, and can stop paying now and live for free for 6 months. He is not out a down payment becuase he did not make one. He is basically out rent, but did he not get a place to live? Where is the huge loss here? Sounds to me like the bank takes the big loss here, not the home buyer who made no down payment.

At 10:05 AM, Blogger Astin said...

When Blinders steps out of the poker world, he steps out big.

I got into a HUGE argument with some people a year or so ago about this issue. Not sub-prime per se (because we don't really have them in Canada) but mortgages in general and personal responsibility when taking the largest loan you'll ever take in your life. They blamed the banks for fooling people and making money. I laughed at their complete ignorance. Other friends at the table sat silent until they were dragged in and they aggreed with me, that if you're going to borrow $200k, you'd damn well better do your homework.

Banks have a fiduciary responsibility to help you understand what you're signing, and if they mislead you, it's fraud.

Mortgage lenders don't. A large part of the subprime market was that fly-by-night sub-prime operators would sweet talk people into taking mortgages for houses they couldn't afford. Finessing work descriptions, annual income, and other info on their applications so they could be approved. Then assuring them they'd have no problem once rates jumped.

My favourite was the "pay less than interest" plan. Guaranteed to keep you in debt for life!

But the buck ultimately stops with the person making the decision to buy something that is far, FAR beyond their means.

Yes LaG, there are extenuating circumstances in some cases. A lost job, a severe injury, a death... these can all happen and cause problems for otherwise solvent people.

As for the banks losses - a foreclosure and auction doesn't mean the buyer is out of the woods. If the bank doesn't recoup its costs from the sale of the house, you still owe them and they can come after you for it.

As for trader and management bonuses - if I make my company $100 Million in profits, am I not entitled to my cut? Only independent traders see 50% bonuses, and they're rapidly being phased out of the big banks. Plus, most large bonuses are deferred over years, and CAN be held back. Bonuses in the form of options or stock have a vesting period to ensure the employee stays with the firm. Plus, the beauty of a stock bonus is that if the company suffers, the employee's bonus is effectively reduced accordingly.

At 11:08 AM, Blogger Hammer Player a.k.a Hoyazo said...

I like your argument about the silly mortgages that uninformed / unintelligent borrowers have agreed to over the past several years. Yes there are extenuating and unforeseeable changes in circumstances, but in general Americans took out a million dumb loans with no reasonable plan to pay them off, and it all came in to roost. And I agree that the banks should share the responsibility for this given a bunch of the predatory bullshit they pawned off on unknowing consumer victims.

The Bear Stearns comments though, they are just plain silly and not at all related to reality. To suggest that Bear's collapse was related to excessive CEO and other officer compensation is redonkulous and not based on any facts at all. It is so much larger and different than that. You may have an issue with how much these i-bank CEOs are taking home every year (and I'm not necessarily disagreeing with you there), but Bear was neither the most nor the most excessive in this area by a long shot (ahem ahem, Goldman Sachs) and yet they were the ones with the problems. Problems, I might add, which honestly havent got one whit to do with CEO or other officer compensation.

Nice post once again.

At 2:00 PM, Blogger Blinders said...

I don't have a problem with cash bonuses in general, but it is hard to imagine how Bear Stears could have lost all of its value had they maintianed enough cash on hand to meet obligations. The fact is massive bonuses were paid out in 2007 to the people who made horrible bets on mortgages, and that money could have been used to keep the company afloat. At heart this is all about variance. Bear decided to waste their bankroll on other things (bonuses), while still playing at higher and riskier stakes. They simply went busto, just like a poker player would if they pulled too much money out for personal expenses. What happened to all of the money Bear earned in the good years????

At 5:57 PM, Blogger Astin said...

I can't claim to be an expert on every detail of the Bear collapse, but as I understand it:

They lost money on the mortgage-backed securities, and in fact posted their first loss in 83 years.

This caused the stock to drop late last year.

They then had concerns about liquidity, although they were not by any means insolvent. These concerns became public, which caused fear among other institutions and clients, causing a withdrawal of funds and lack of ability to enter collateral agreements with other firms.

Unlike a bank, firms like Stearns don't have pools of client money sitting in accounts to provide liquidity. Clients contribute money to be directly invested for their purposes.

Profits are redistributed to shareholders and invested in secure collateral. No financial house in the world would just have a pile of money sitting around.

So, they actual liquid assets dropped rapidly, and they were unable to secure financing or loans to shore themselves up. Hence the government loan through JP Morgan.

However, the market panicked and the stock price crashed. The $2 offer to buy from Morgan was pushed by the fed in order to maintain market stability. Of course, it went up to $10 today.

To put that original offer in perspective, the building Bear Stearns was housed in, and they owned, alone was worth more than the offer for the entire company. In other words, their physical, illiquid assets were worth far more than a panicked market made the company worth.

So it's far more complicate than a simple "they had no money left because it all went to the executives and traders." And, as I stated earlier, cash bonuses in excess of a certain number are usually deferred for years, so much of that money would in fact be in hand.

At 12:14 PM, Blogger Drizztdj said...

We did the 80/20 ARM (since we could only put down 15% not the full 20%) cwmoving from our duplex to a single family home about 3 years ago. But, we were smart about it knowing that the object was to save up some cash and make larger payments on a 30-yr fixed when the interest rates were more favorable.

We knew the payments would go up unlike people you cite in your post.

At 3:09 PM, Blogger bayne_s said...

Let's move past the "victims" and figure out how we can make money exploiting this situation.

If goverment guarantees the junk mortgage backed securities then suddenly the holders of securites avoid writeoffs and can expect to shoot up in value.

Housing prices are falling, but have not figured out how to make money off that.

At 3:33 PM, Blogger OhCaptain said...

Can we short sell homes?

At 9:58 AM, Blogger Lifesagrind said...

***Off Topic***

Just noticed my url is wrong in your blogroll. The new link is

***resume topic***

At 11:04 PM, Blogger sara l said...

I agree that many folks who are facing foreclosure right now should not have been homeowners to begin with.

Some folks were greedy and knowingly took on more than they could handle. Others (and I think this is the larger group) were mislead along the way. The problem with saying everyone should have known better is that it assumes everyone has a base of financial knowledge. Since this isn't taught in most high schools and at many universities most of your financial knowledge comes from your family/upbringing.

In paragraph five you ask how today's lower rates can lead to massive foreclosure. Today's lower rates are trying to stave off the foreclosure. But if you've been behind for months foreclosure is a real possibility. Depending on your arm your reset schedule will vary, but if you reset every 6 months and have been at a rate you can't afford for 4 months the 2.5% rate reduction might not save you from loosing your home. This is how despite the rate cut many are still facing foreclosure.


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