Alex J. Pollock
The subprime market is contracting sharply and rapidly, if belatedly. The subprime boom is over; the bust is here. Former enthusiasm has been replaced by large financial losses, the bankruptcy of subprime lenders, layoffs, accelerating defaults and foreclosures, fear, a liquidity squeeze--and of course political recriminations, some deserved, as well as proposals for increased regulation. Committees in both the US Senate and House of Representatives are holding hearings on the issue.
A single page of the April 23, 2007 issue of the trade publication, National Mortgage News, contained the following items:
• "Four of the top 25 subprime lenders have gone bust in the past four months"
• "Several others are trying to sell themselves to avoid liquidity crunches"
• Subprime lending volume in 2007 is anticipated to fall to half of its 2005 peak
• A top subprime lender, WMC Mortgage, "last week laid off 50% of its workforce"
• Washington Mutual, by far the largest savings and loan, announced a $113 million loss in its home loan business for the first quarter of 2007 due to subprime problems
• Fremont General, another large subprime lender, announced a $100 million loss on the sale of subprime loans
• Fraud in the mortgage industry is "skyrocketing"
• The Senate Banking Committee leadership "ruled out any government bailout for delinquent subprime borrowers"
Subprime adjustable rate mortgages (ARMs) have serious delinquencies of 9% and rising. This is six times the comparable 1.45% for prime ARMs. The current subprime foreclosure rate is 4% and rising rapidly. This is below its recent peak of 9% in 2000, but the subprime market is much larger than it was then, having grown from about $150 billion in outstanding loans to $1.3 trillion or over 8 times during the boom years. So its political impact is now much greater.
Sources of Risk
As usual, this credit cycle displayed the human sources of financial risk. These include short institutional memories and the inclination to convince ourselves that we are experiencing "innovation" and "creativity" when all that is happening is a lowering of credit standards by new names.
For example, in the latest cycle, "stated income" loans became common--in other words, loans without confirmation of the borrower's income. The disastrous previous experiences with this bad idea, then called "no doc" or "low doc" loans, seem to have been forgotten. Such loans are an obvious temptation, or even invitation, to exaggeration of household income in order to get a bigger loan than one can legitimately qualify for. They are now being called "liars' loans"--a surprise only to those with no memory.
Human elements of risk also included, as always, optimism, gullibility, short-term focus, belief in momentum or the extrapolation of so-far successful speculation, group psychology or the lemming effect, and inevitably in some cases, fraud.
In addition, this cycle became enamored with statistical treatments of risk. Household International was a large subprime lender bought by HSBC, which is now greatly embarrassed by its subprime losses. Household's former CEO is said to have bragged that his operation had 150 PhDs to model credit risk. What happened?
The huge subprime securitization market is based on the mathematical models of the bond rating agencies. Moody's has recently announced that losses on securitized pools of subprime mortgages may be as much as one-third higher than they expected. This should put us in mind of Moore's Law of Finance: "The model works until it doesn't."
Pressure on Regulators
Given the bust, it is not surprising that there is political pressure on regulatory agencies to do something. But what should be done at this point? Late in the credit cycle, when losses are rising, liquidity is shrinking and asset prices are already falling, regulators face a dilemma. The former mistakes and scandals are now clear in retrospect, and they feel like they must respond somehow, but how to take action that is not pro-cyclical and will make the current problems worse?
For example, the combined US financial institution regulators have issued a joint "Proposed Statement on Subprime Mortgage Lending." Many subprime borrowers now cannot afford the reset to a higher interest rate their mortgages call for. So a key requirement of this combined regulatory "guidance" is that ARM borrowers must be qualified using mortgage expense ratios with the fully-indexed interest rate, not only the low introductory or "teaser" rate.
This is a sound and fundamental credit principle. It would have been excellent if implemented at the beginning of the subprime boom. But to put it in place now will mean that subprime borrowers facing large increases in their interest rate and mortgage payments will be cut off from refinancing possibilities, locking many of them into default. So it is probably not a good idea now, at least as it applies to existing subprime borrowers facing "payment shock" from increasing ARM rates.
Another idea discussed in Congress and elsewhere is the possibility of some kind of government fund to refinance defaulted subprime mortgages. The Federal Housing Agency (FHA) is often suggested in this context, although it is a credit insurer, not a mortgage investor. Moreover, the FHA's own delinquency rate is at the same level as the subprime sector, which suggests that loosening its credit standards further is probably not a good idea. Naturally, no one wants to bail out subprime lenders and investors, who should be on their own for whatever losses are in store.
There is one interesting historical precedent for government refinancing of defaulted mortgages: the Home Owners' Loan Corporation (HOLC), created by the Home Owners' Loan Act of 1933. Of course, the subprime problems of today do not begin to approach the financial collapse of 1933, but HOLC makes a useful study for anyone intrigued by such a possibility.
As noted above, recent statements by the leadership of the Senate Banking Committee suggest that the "bailout fund" idea is not being pursued, at least for now.
The One-Page Disclosure
The legislative and regulatory action I propose is to require a one page form ( PDF) for every mortgage loan, with short, simple and clear disclosures of the essential loan terms and their relation to the borrower's household income. The borrowers should be able in effect to "underwrite themselves" and understand their basic risks.
A good mortgage lender wants a borrower who understands how the loan will work and what the financial commitments of the loan agreement are. Current American mortgage loan documents certainly do not achieve this. Most borrowers are overwhelmed and befuddled by the huge stack of documents full of confusing language in small print presented to them for signature.
To achieve an informed and understanding borrower, the key information must be simply stated and clear: 90% of the relevant information which is understandable is far better than 100% which is complex and confusing - the latter results in effectively zero information transfer to the borrower.
The following one-page "Basic Facts About Your Mortgage Loan" form demonstrates the idea. There is some Congressional interest--I hope it will grow.
Alex J. Pollock is a resident scholar at AEI.