Oct012008

Conservative House Financing – Part 1

What they are saying about The Great Housing Bubble

“The Great Housing Bubble is a fantastic resource for anyone looking to understand why home prices fell. The writing has exceptional depth and detail, and it is presented in an engaging and easy-to-understand manner. It is destined to be the standard by which other books on the subject will be measured. It is the first book written after prices peaked, and it is the first in the genre to detail the psychological factors that are arguably more important for understanding the housing bubble. There have been a number of books written while prices were rising that used measures of price relative to historic norms and sounded the alarm of an impending market crash. Economic statistics and technical, measurable factors show what people did, but they do not explain why they did it. The Great Housing Bubble analyzes not only what happened; it explains why it happened.

Morgan BrownThe Great Loan Blog

Conservative House Financing

When people decide they want to buy a house, they figure out how much they can afford, then they search for something they want in their price range. For most people, what they can “afford” depends almost entirely upon how much a lender is willing to loan them. Lenders apply debt-to-income ratios and other affordability criteria to determine how much they are willing to loan. Buyers are generally limited in how much they can borrow because lenders are wise enough not to loan borrowers so much that they default. Borrowers behave much like drug addicts–they will borrow all the money a lender will loan them whether it is good for them or not. Most borrowers are not wise to the differences between the various loan types, and they have limited understanding of the risks they are taking on.

The vast majority of residential home sales have lender financing. The interest rates and various loan terms have evolved over time. After World War II a series of government programs to encourage home ownership spawned a surge in construction and the evolution of private lending terms resulting in the 30-year conventionally amortized mortgage. This mortgage generally required a 20% downpayment, and allowed the borrower to consume no more than 28% of their gross income on housing. These conservative terms became the standard for nearly 50 years. Lending under these terms resulted in low default rates and a high degree of market price stability.

There were experiments with various forms of exotic financing during this period, particularly in markets like California where price volatility required special terms to facilitate buying at inflated pricing. The instability of these loan programs was demonstrated painfully during the deep market correction of the early 90s in California characterized by high default rates and lender losses. Rather than learn a difficult lesson regarding the use of these alternative financing terms from this experience, lenders sought out ways of shifting these risks to others though a complex transaction called a credit default swap. Once lenders and investors in mortgages thought the risk was mitigated, these unstable loan programs were brought back and made widely available to the general public resulting in the Great Housing Bubble.

Mortgage Interest Rates

Mortgage interest rates are the single-most important factor determining the borrowing power of a potential house buyer. When rates are very low, a borrower can service a large amount of debt with a relatively small payment, and when interest rates are very high, a borrower can service a small amount of debt with a relatively large payment. Mortgage interest rates are determined by market forces where investors in mortgages and mortgage-backed securities bid for these assets. The rate of return demanded by these investors determines the interest rate the originating lender will have to charge in order to sell the loan in the secondary market. Some lenders still hold mortgages in their own investment portfolio, but these mortgages and mortgage rates are subject to the same supply and demand pressures generated by the secondary mortgage market.

Figure 2: Components of Mortgage Interest Rates

Components of Mortgage Interest Rates

 

Mortgage interest rates are determined by investor demands for risk adjusted return on their investment. The return investors demand is determined by three primary factors: the riskless rate of return, the inflation premium and the risk premium. The riskless rate of return is the return an investor could obtain in an investment like a short-term Treasury Bill. Treasury Bills range in duration from a few days to as long as 26 weeks. Due to their short duration, Treasury Bills contain little if any allowance for inflation. A close approximation to this rate is the Federal Funds Rate controlled by the Federal Reserve. It is one of the reasons the activities of the Federal Reserve are watched so closely by investors. The closest risk-free approximation to mortgage loans is the 10-year Treasury Note. Treasury Notes earn a fixed rate of interest every six months until maturity issued in terms of 2, 5, and 10 years. The 10-year Treasury Note is a close approximation to mortgage loans because most fixed-rate mortgages are paid off before the 30 year maturity with 7 years being a typical payoff timeframe.

The difference in yield between a 10-year Treasury Note and a 30-day Treasury Bill is a measure of investor expectation of inflation, and the difference between the yield on a 10-year Treasury Note and the prevailing market mortgage interest rate is a measure of the risk premium. Inflation reduces the buying power of money over time, and if investors must wait a long period of time to be repaid, as is the case in a home mortgage, they will be receiving dollars that have less value than the ones they provided when the loan was originated. Investors demand compensation to offset the corrosive effect of inflation. This is the inflation premium. The risk premium is the added interest investors demand to compensate them for the possibility the investment may not perform as planned. Investors know exactly how much they will get if they invest in Treasury Notes, but they do not know exactly what they will get back if they invest in residential home mortgages or the investment vehicles created from them. This uncertainty of return causes them to ask for a rate higher than that of Treasury Notes. This additional compensation is the risk premium.  Mortgage interest rates are a combination of the riskless rate of return, the risk premium and the inflation premium.

The fluctuation in mortgage interest rates has implications for when it is the best time to buy and the best time to refinance a home mortgage. It is a popular misconception that low interest rates make for a good buying opportunity. When interest rates are declining, borrowers can finance larger sums, and this does prompt many people to buy and home prices to rise, but when interest rates are low is also when prices are highest. A buyer in a low-interest-rate environment may obtain an expensive property, but the resale value of that property will decline when interest rates rise because future buyers will not be able to finance such large sums. A low-interest-rate environment is an excellent time to refinance because a conservative borrower can either obtain a lower payment or shorten the amortization schedule and pay the loan off faster. The best time to purchase a house is when interest rates are very high. Again, this is counterintuitive because the interest is so much greater, but this will also mean the amount financed will be much lower and house prices will be relatively low. It is better to buy when interest rates are high and later refinance when interest rates decline. A borrower can refinance into a lower payment, but without additional cash, a borrower cannot refinance into a lower debt.

Types of Borrowers

Borrowers are broadly categorized by the characteristics of their payment history as reflected in their FICO score. FICO risk scores are developed and maintained by the Fair Isaac Corporation utilizing a proprietary predictive model based on an analysis of consumer profiles and credit histories. These models are updated frequently to reflect changes in consumer credit behavior and lending practices. The FICO score is reported by the three major credit reporting agencies, Experian, Equifax and TransUnion. Borrowers with high credit scores have generally demonstrated a high degree of responsibility in paying their debt obligations as promised. Those with low credit scores either have little or no credit history, or they have a demonstrated track record of failing to pay their financial obligations. There are 3 main categories of borrowers: Prime, Alt-A, and Subprime. [1] Prime borrowers are those with high credit scores, and Subprime borrowers are those with low credit scores. The Alt-A borrowers make up the gray area in between. Alt-A tends to be closer to Prime as these are often borrowers with high credit scores which for one or more reasons do not meet the strict standards of Prime borrowers. In recent years one of the most common non-conformities of Alt-A loans has been the lack of verifiable income. In short, “liar loans” are generally Alt-A. As the number of deviations from Prime increases, the credit scores decline and the remainder are considered Subprime.

Types of Loans

There are also 3 main categories of loans: Conventional, Interest-Only, and Negative Amortization. The distinction between these loans is how the amount of principal is impacted by monthly payments. A Conventional mortgage includes some amount of principal in the payment in order to repay the original loan amount. The greater the amount of principal repaid, the quicker the loan is paid off. An Interest-Only loan does just what it describes; it only pays the interest. This loan does not pay back any of the principal, but it at least “treads water” and does not fall behind. The Negative Amortization loan is one in which the full amount of interest is not paid with each payment, and the unpaid interest gets added to the principal balance. Each month, the borrower is increasing the debt. Two of the features of all Interest-Only or Negative Amortization loans are an interest rate reset and a payment recast. All these loans have provisions where the interest rate changes or loan balance comes due either in the form of a balloon payment or an accelerated amortization schedule. In any case, borrowers often must refinance or face a major increase in their monthly loan payment. This increase in payment is what makes these loans such a problem.

Table 2: Loan Type and Borrower Type Matrix

Conventional Interest Only Neg Am
Subprime Subprime Conventional Subprime Interest Only Subprime Neg Am
Alt-A Alt-A Conventional Alt-A Interest Only Alt-A Neg Am
Prime Prime Conventional Prime Interest Only Prime Neg Am
RISK

 

The category of loan and category of borrower are independent of each other. Starting in the lower left hand corner, there is lowest risk loan for a lender to make, a Prime Conventional mortgage. Up or to the right, the risk increases. The riskiest loan a lender can make is the Negative Amortization loan to a Subprime borrower.

Conventional 30-Year Amortizing Mortgage

A fixed-rate conventionally-amortized mortgage is the least risky kind of mortgage obligation. If borrowers can make their payment–a payment that will not change over time–they can keep their home. A 30-year term is most common, but if bi-weekly payments are made (two extra per year), the loan can be paid off in about 22 years. If borrowers can afford a larger payment in the future, they can increase the payment and amortize over 15 years and pay off the mortgage quickly. The best way to deal with unemployment or other loss of income is to have a house that is paid off. Stabilizing or eliminating a mortgage payment reduces the risk of losing a house or facing bankruptcy. Unfortunately, payments on fixed-rate mortgages are higher than other forms of financing, so borrowers often opt for the riskier alternatives.

The Interest-Only, Adjustable-Rate Mortgage

The interest-only, adjustable-rate mortgage (IO ARM) became popular early in this bubble when fixed-rate mortgage payments were too large for buyers to afford. In the coastal bubble of the late 80s, these mortgages did not become as common, and the bubble did not inflate far beyond people’s ability to make fixed-rate conventional mortgage payments. [ii] This is also why prices were slow to correct in the deflation of the early 90s. Most sellers did not need to sell, so they just waited out the market. The correction was a market characterized by large inventories, but this inventory was not composed of calamitous numbers of must-sell homes. The few must-sell homes that came on the market in the early 90s drove prices lower, but not catastrophically because the rally in prices did not get too far out of control. The Great Housing Bubble was different.

IO ARMs are risky because they increase the likelihood of borrowers losing their homes. IO ARMs generally have a fixed payment for a short period followed by a rate and payment adjustment. This adjustment is almost always higher; sometimes, it is much higher. At the time of reset, if the borrower is unable to make the new payment (salary does not increase), or if the borrower is unable refinance the loan (home declines in value below the loan amount), the borrower will lose the home. [iii] It is that simple.

These risks are real, as many homeowners have already discovered. People try to minimize this risk by extending the time to reset to 7 or even 10 years, but the risk is still present. If a house were purchased in California in 1989 with 100% financing with a 10-year, interest-only loan, at the time of refinance the house would have been worth less than the borrower paid, and they would not have been given a new loan. (Fortunately 100% financing was unheard of in the late 80s). Even a 10 year term is not long enough if purchased at the wrong time. As the term of fixed payments gets shorter, the risk of losing the home becomes even greater.

The most egregious examples of predatory lending occurred when these interest-only loan products were offered to subprime borrowers whose income only qualified them to make the initial minimum payment (assuming the borrower actually had this income). This loan program was commonly known as the two-twenty-eight (2/28). It has a low fixed payment for the first two years, then the interest rate and payment would reset to a much higher value on a fully amortized schedule for the remaining 28 years. Seventy-eight percent of subprime loans in 2006 were two year adjustable rate mortgages. [iv] Anecdotal evidence is that most of these borrowers were only qualified based on their ability to make the initial minimum payment (Credit Suisse, 2007). This practice did not fit the traditional definition of predatory lending because the lender was not planning to profit by taking the property in foreclosure. However, the practice was predatory because the lender was still going to profit from making the loan through origination fees at the expense of the borrower who was sure to end up in foreclosure. There were feeble attempts at justifying the practice through increasing home ownership, but when the borrower had no ability to make the fully amortized payment, there was no chance of sustaining those increases.

The advantage of IO ARMs is their lower payments. Or put another way, the same payment can finance a larger loan. This is how IO ARMs were used to drive up prices once the limit of conventional loans was reached (somewhere in 2003 in California). A bubble similar to the last bubble would have reached its zenith in 2003/2004 if IO ARMs had not entered the market and inflated prices further. In any bubble, the system is pushed to its breaking point, and it either implodes, or some new stimulus pushes it higher: the negative amortization mortgage (Option ARM).

Negative Amortization Mortgages

The Negative Amortization mortgage (aka, Option ARM or Neg Am) is the riskiest loan imaginable. It has all the risks of an IO ARM, but with the added risk of an increasing loan balance. Using this loan, there is the risk of not being able to make the payment at reset, and the borrower is much more at risk of being denied for refinancing because the loan balance can easily exceed the house value. In either case, the home will fall into foreclosure. The Option ARM is one of the most complicated loan programs ever developed. It was heralded as an innovation because it allowed people greater control over their monthly payments, and it provided greater affordability in the early years of the mortgage. [v] Twenty-nine percent of purchase originations nationwide in 2005 were interest-only or option ARM (Credit Suisse, 2007). The percentage in California was much higher. The proliferation of this product is largely responsible for the extreme prices at the bubble’s peak.

An Option ARM loan provides the borrower with 3 different payment options each month: minimum payment, interest-only payment, and a fully amortizing payment. In theory, this loan would be ideal for those with variable income such as sales people or seasonal workers. This assumes the borrower has months where the income is more than the minimum, the borrower sees a need in good times to make more than the minimum payment and the borrower understands the loan. None of these assumptions proved to be true.

Figure 3: Interest-Only and Negative Amortization Purchases, 2000-2006

IO and Neg Am loan Originations 2000-2006

 

When confronted with several different prices for the same asset, people naturally will choose the lowest one. This common-sense idea apparently escaped the innovators who developed the Option ARM. Studies from 2006 showed that 85% of households with an Option ARM only made the minimum payment every month (Credit Suisse, 2007). Many could not afford to pay more, and many more could not see a reason to pay more. Most simply thought they would refinance when the payments got too high.

These loans are also very confusing. The interest rate being charged to the borrower adjusts frequently, and the payment rate (which is not correlated to the actual interest rate being charged) also changes periodically. The separation of the interest rate charged and the interest rate paid is what allows for negative amortization, and it also creates a great deal of confusion. The following is an attempt to explain the mechanics of this loan.

Payment Rate

A negative amortization loan is any loan where the monthly payment does not cover the monthly interest expense. Interest-only or conventionally amortizing loans do not have this feature, and the monthly payments are based on the interest rate charged and/or the duration of the amortization schedule. Since the negative amortization loan breaks down this traditional relationship, there is a completely separate rate calculated for the minimum payment amount. In general, this rate starts out low and increases gradually each year for the first several years. This is to allow the borrower time to adjust to a higher loan payment amount. These yearly increases are usually capped to prevent dramatic phenomenon known as “payment shock.” The payment rate is based on an interest rate, but this rate has no relationship to the interest rate the borrower is being charged on the loan balance. The presence of two interest rates is responsible for much of the confusion regarding these loans. The low starting payment rate is often called a “teaser rate” because it is a temporary inducement to take on the mortgage. There was a widespread belief among borrowers that one could simply refinance from one teaser rate to another forever in a process known as serial refinancing. The biggest confusion regarding this loan is when people mistake this payment rate for the actual interest rate they are being charged on the loan. This is a natural mistake to make because historic loan programs did not make this distinction.

Interest Rate Reset

The Option ARM is a hybrid adjustable rate mortgage with payment options. The interest rate being charged to the borrower is subject to periodic fluctuations with changes in market interest rates similar to other adjustable rate mortgages. The timing of adjustment and limits therein are contained in the mortgage contract. The interest rate charged is fixed for certain periods at the end of which there is a change in the interest rate. When the interest rate changes on most adjustable rate mortgages, the payment required of the borrower changes as well. Since the charged interest rate and the payment rate are not the same for Option ARMs, the payment may not be affected and negative amortization can occur. The interest rates on most adjustable-rate mortgages are lower than those for fixed-rate mortgages because the lender is not subject to interest rate risk. If interest rates rise, lenders who have issued fixed-rate mortgages have capital tied up in below-market mortgages. With adjustable rate mortgages, higher interest rates are passed on to the consumer.

Since the low payment option on Negative Amortization loans is so appealing to consumers, the actual interest rate charged on Option ARMs is often higher than interest-only or fixed rate mortgages, which make these loans very attractive to investors. Since the interest rate is higher than the payment rate, negative amortization occurs, and the loan balance grows each month as the deferred interest is added to the loan balance. This capitalized interest is recognized as income on the books of mortgage holders. Generally Accepted Accounting Principles (GAAP) allow this, but the amount of income is supposed to be reduced to reflect the likelihood of actually receiving this money. Since the loan program was new, and default rates were low due to the bubble rally, the reported income was very high making these loans even more appealing to investors. From the investors’ perspective, they were buying high-interest loans with great income potential and low default rates. From the borrowers’ perspective, they were obtaining a loan at a very low interest rate–a perception rooted in a basic misunderstanding of the loan terms–and a very low payment which allowed them to finance large sums to purchase homes at inflated prices. This dissonance between the investors who purchased these loans and the borrowers who signed up for them did not become apparent until these loans began to reset to higher rates and recast to higher payments. In short, these loans are time bombs with fuses of varying lengths set to blow up the dreams of investors and borrowers alike.

Payment Recast

Interest-only and negative amortization payments cannot go on forever. At some point, the loan balance must be paid in full. For all adjustable rate mortgages, there is a mandatory recast after a fixed period of time where the loan reverts to a conventionally amortizing loan to be paid over the remaining portion of a 30 year term. This recast eliminates the options for negative amortization and interest-only payments and requires the fully amortized payments on an accelerated schedule for what is often an increased loan balance. For instance, if an interest-only loan is fixed for 5 years, at the end of 5 years, the loan changes to a fully-amortized loan with payments based on the remaining 25 year period. The longer interest-only or negative amortization is allowed to go on, the more severe the payment shock is when the loan is recast to fully amortizing status. Also, in the case of negative amortization loans, the total loan balance is capped at a certain percentage of the original loan amount, typically 110% but sometimes higher. If this threshold is reached before the mandatory time limit, the loan is also recast as a conventionally amortizing loan. Since many borrowers were qualified based on their ability to make the minimum payment at the teaser rate, when the loan recasts and the payment significantly increases (double or triples or more,) the borrower is left unable to make the payment, and the loan quickly goes into default.

The natural question to ask is, “Why would lenders do this?” There is no easy answer. Most simply did not care. The lender made large fees through the origination of the loan and subsequent servicing, and the loan itself was sold to an investor. The investor bought insurance against default, and many of these loans were packaged into asset backed securities which were highly rated by ratings agencies due to their low historic default rates. Nobody cared to examine the systemic risk likely to result in extremely high future default rates because the business was so profitable at the time of origination. Most assumed this would go on forever as house prices continued to appreciate. It was envisioned that most borrowers would either increase their incomes enough to afford these payments or simply refinance into another highly profitable Option ARM loan. In hindsight, the folly is easy to identify, but for those involved in the game, there was little incentive to question the workings of the system, particularly since it was so profitable to everyone involved.


(i) According to Credit Suisse, the average credit score for Alt-A borrowers was 717 and for subprime borrowers it was 646.

[ii] There was a steep rise in prices in California and selected large metropolitan areas of the East Coast during 1987, 1988 and 1989. This was followed by a 7 year period of slowly declining prices as fundamentals caught up. This is considered by some to be a bubble because prices showed a detachment from fundamentals and a later return to the former relationship. This “bubble” did not see capitulatory selling, so it did not show the behavior of classic asset bubbles.

[iii] A study by Consumer Federation of America’s Allen J. Fishbein Piggyback Loans at the Trough: California Subprime Home Purchase and Refinance Lending in 2006 (Fishbein, Piggyback Loans at the Trough: California Subprime Home Purchase and Refinance Lending in 2006, 2008), reveals the following “1.26 million home purchase and refinance loans in California metropolitan areas in 2006 and found about one sixth of California home purchase borrowers taking out single, first lien mortgages and one quarter of refinance borrowers received subprime loans in 2006. The subprime mortgage market provides loans to borrowers who do not meet the credit standard for prime loans. To compensate for the increased risk of offering loans to borrowers with weaker credit, lenders charge subprime borrowers higher interest rates – and thus higher monthly payments – than prime borrowers. California has historically had lower rates of subprime lending than the national average, but the rates of subprime lending crept up in 2006. Additionally, more than a third of California home purchase borrowers also utilized a second “piggyback” loan on top of a primary, first lien mortgage. Piggyback loans combine a primary mortgage with a second lien home equity loan, allowing borrowers to finance more than 80 percent of the home’s value without private mortgage insurance. These borrowers took out loans on as much as 100 percent of the value of the home in 2006. More than half these piggyback borrowers received subprime loans on their primary mortgages. Many subprime loans are adjustable rate mortgages (ARMs) that reset to higher interest rates after the first two years, meaning that homeowners that received subprime purchase or refinance mortgages in 2006 are likely to see their interest rates and monthly payments increase – in many cases significantly – in 2008. Moreover, as real estate markets cool and decline, borrowers that utilized piggyback financing could find themselves owing more on their mortgage than their homes are worth.” An earlier related study, Exotic or Toxic? An Examination of the Non-Traditional Mortgage Market for Consumers and Lenders (Fishbein & Woodall, Exotic or Toxic? An Examination of the Non-Traditional Mortgage Market for Consumers and Lenders, 2006 ) by Allen J. Fishbein and Patrick Woodall also sounded the alarm concerning exotic financing.

[iv] This data comes from the Credit Suisse Report (Credit Suisse, 2007). The source of their data was Loan Performance.

[v] The impact of exotic mortgage terms was explored by Matthew S. Chambers, Carlos Garriga and Don Schlagenhauf in the paper Mortgage Contracts and Housing Tenure Decisions (Chambers, Garriga, & Schlagenhauf, 2007). Their abstract reads as follows, “We find that different types of mortgage contracts influence these decisions through three dimensions: the downpayment constraint, the payment schedule, and the amortization schedule. Contracts with lower downpayment requirements allow younger and lower income households to enter the housing market earlier. Mortgage contracts with increasing payment schedules increase the participation of first-time buyers, but can generate lower homeownership later in the life cycle. We find that adjusting the amortization schedule of a contract can be important. Mortgage contracts which allow the quick accumulation of home equity increase homeownership across the entire life cycle.” The cold reality of negative amortization loans is summed up in the observation that increasing payment schedules decrease home ownership over time. People default when their payments go up. It is the fatal flaw of all these loan programs. One of the more amusing papers from the bubble was written by James Peterson (Peterson, 2005) “Designer Mortgages: The Boom in Nontraditional Mortgage Loans May Be a Double-Edged Sword. So Far, Most Banks Have Moved Cautiously.” The lenders during the Great Housing Bubble were anything but cautious.