What Were Subprime Loans Modeled On?

Even after the CJR demolished it, John Cagney lays out his full theory on how the CRA caused so many subprime loans here. I think this is an important point to clarify, as it’s going to float out there in the popular consciousness. It’s a good question why so many people gave out so many questionable loans, and it is natural for people to think someone made them; I think Megan concedes the argument but still wants to see the CRA dismantled. I think the CRA is worth defending, so let’s look at the argument closer.

Cagney acknowledges two key points: (1) CRA loans were very profitable for the banks in question and (2) most subprime loans were from places with no CRA coverage. He thinks that CRA loans looked so profitable that subprime lenders wanted in on that, so they duplicated their efforts but to no avail.

A subprime loan is not a slightly worse CRA loan.

Subprime loans aren’t like CRA loans. Cagney focuses a lot on the LTV numbers, but that is only one characteristic of a subprime loan. My favorite chart of the subprime data (click to enlarge):

80% of the subprime mortgages expired in 30 months; they perpetually had to be refinanced. 75%+ of subprime mortages had a prepayment penalty. This is not at all what CRA loans looked like. CRA rooted for solid, longer-term mortgages. If they ever rooted for a lot of prepayment penalties and fees to get tacked onto their loans, I’ve never seen it.

Another important statistic – in Massachusetts 60% of subprime defaults were originated in prime mortgages. So a large chunk of subprime loans were really prime loans that were collapsing. Either the breadwinners were experiencing “income volatility” or their spending was out of control or whatever. Capturing the disintegrating middle-class on terrible terms is not an objective of the CRA.

I’m going to go into some new research about a favorite topic around here, the roles the consistent refinancing, prepayment penalties and fees did to change the mortgage market, and how a consumer’s bill of rights that took us back to 1982 would be a great move. In case you don’t trust a pseudonymous blogger with a free wordpress account, it’s where the elite research is going to converge when discussing this in my humble opinion. Here’s Did Prepayments Sustain the Subprime Market? by Bhardwaj and Sengupta from the St. Louis Fed:

Using loan-level data on subprime mortgages, we present evidence on the uniqueness of subprime mortgage design. We show that the viability of such products was predicated on the appreciation of house prices. In a regime of rising house prices, a borrowers avoided default by prepaying the loan…Gorton (2008) argues that lenders designed subprime mortgages as bridge-financing to the borrower over short horizons for mutual benefit from house price appreciation…Subprime mortgages were meant to be rolled over and each time the horizon deliberately kept short to limit the lenderís exposure to high-risk borrowers.

The rationality is nothing like that of a CRA loan. It was something new, something about consistent refinancing with a huge amount of fees and penalties, using jumps in the interest rate to force prepayments. They were bad-faith loans, loans that were not meant to be repaid, unlike a CRA loan.

“Wait, Mike. I’m getting a weird sense of déjà vu. I feel like I’ve heard this before.”

Really, where?

“A loan that wasn’t really meant to be paid off. but instead to be paid off enough with high interest rates with higher jumps to force additional payments to occur, and with a lot of the value coming from fees and penalties.”

That does sound familiar.

“Hey wait – that’s how credit cards work!”

Good metaphor. Indeed, the logic of a subprime loan looks disturbingly like the logic of a credit card. If we had to backwards out what motivated someone to go ahead and try to make these subprime loans, you’d have to say they looked at the profitable credit card market and said “ya know what, let’s design a mortgage that looks exactly like that.” The credit card model is about as far away as you can get from the CRA model – and it is very easy to imagine subprime lenders licking their lips at the sweet profits the credit card companies were making moreso than the tiny CRA market.

Comments

[FloridaBoy2:]

It was a Gordon Gecco greed spiral not the CRA. To politicize making a bad business decision is stupid. Everyone was making money and there were no real rules. Just being able to sign the closing papers was the only requirement. Many subprime loans refinanced middle class people that were living beyond their means. They could not qualify for a conventional refi. Loan proceeds were used to pay off credit cards etc. There were a lot of speculators in the game too.

Jun 29 10:59 AM

[user396040:]

This is very helpful. It has been difficult for me to understand why anyone in his right mind made these loans but this helps lift the fog a little bit. It would still seem that these loans were clearly very risky because their viability depended on short term refinance but, I guess if you assume that real estate prices keep going up, then the worst case scenario is foreclosure and recovery of the principle in an auction. Of course, in 20/20 hindsight, the whole thing is obviously very risky but, if you make the right set of assumptions, I am beginning to see how it may have appeared to make sense at the outset. Thank you for this post.

Jun 29 11:42 AM

[Larrysyr:]

Basing real estate decisions on the idea that housing prices never go down is as foolish as thinking the stock market always goes up. It is speculation/gambling. The perpetual refinancing based on this assumption set up a musical chairs situation, which is now being played out with huge losses.

Jun 29 11:52 AM

[Houston:]

Agree with Larrysyr. Basing lending on anything other than the borrower's abilty to pay at the time of the loan is crazy. Future income,
future jobs, future assumptions about the real estate market, whatever. Let em re-fi or buy up when and if those assumptions become reality.
Until then it's a bad way to lend money. The guy that ran countrywide knew. Everybody knew. The banks that saw it as bad practice and refrained are in better shape than those that didn't.

Jun 29 01:50 PM

[Radardoc:]

On Jun 29 10:50 AM Larrysyr wrote:

> Poverty is not a sin, and people with less money should not be consigned to the permanent treadmill represented by the credit card model.
> This is NOT a free ride; it's hard work. But people willing to do
> that work should have a way to get ahead.

Larry,

I agree 100% that poverty is not a sin. But I believe equally as strongly that probably precludes you from getting a huge mortgage for a home.

Home ownership is not a right. BMW 735i ownership is not a right. Five star restaraunts for dinner every night is not a right.

They are all "things." Not everyone can afford all the "things" we want in life. Save the 20%, find a property you can afford and buy it if you really want to. If not, I hate to break the news to you but you can't afford it.

What's next? Sub-prime BMW loans?

I'm sorry if Mom and Dad failed to inform you, but life is not equal for every one, nor is it "fair." Get over it and do the best you can.

Jun 29 02:40 PM

[Henry Buttal:]

I think it is an oversimplification to put total fault on the CRA, or on the non-banks, or on sub-prime/adjustable rate loans, or on Fannie and Freddie, or on CMOs, or on the rating companies, or on Congress.

They ALL played their part economic cycle of this most Faustian bargain - from Barney Frank to the Senators who received special loan treatments (sorry, now its below his pay grade) to execs like Franklin Raines, to the NINJA and liar loan applicants.

The chain of events could have easily been broken at one of these points...but no one in the investment banks, or in the public sector, or in Congress chose to do the right thing.

Jun 29 02:49 PM

[White Shield:]

Yes "Rorty" - you make a good point; there IS a difference. However, in this political climate, your story comes across as more of "an apologetic tone" than a banking, finance piece. No matter the focus, the obvious intent of all this crap is BUYING VOTES.

Follow this CRA crap back into Pittsburgh, during the Nixon years...in it's infancy. Why did it ever "go national"? BUYING VOTES. Does EITHER PARTY have a corner on political corruption and misuse of public monies? Absolutely not.

Does one party have a lopsided, clear-cut agenda to (mis)use public funds for social engineering? I think so. Are you trying to errantly justify this in you story? I think so.

Jun 29 04:43 PM

[Mark54:]

Agreed... The American Dream is not home ownership. The Amercian dream is living within your means and still having a very high quality of life. In retrospect it was a sad day when Fannie and Freddie lowered the credit stips to expand home ownership.

On Jun 29 02:40 PM Radardoc wrote:

>

Jun 29 04:56 PM

[Tomcat101:]

There are plenty of "poor" people who pay their bills on time though. I struggle to find pity for people who habitually have bad credit and the knuckleheads who give them loans.


> Poverty is not a sin, and people with less money should not be consigned
> to the permanent treadmill represented by the credit card model.
> This is NOT a free ride; it's hard work. But people willing to do
> that work should have a way to get ahead.

Jun 29 07:24 PM

[kingaj12:]

The Fed has a great analysis on securitization of subprime.

www.newyorkfed.org/res...

The basic point is that the subprime ARMs were so punitive that that owner was forced to refinance in 24 or 36 months at the option of the issuer. The issuer (of course) counted on the refi to turn a risky mortgage into hard cash.

You don't need to invoke CRA abuse to follow their argument. So long as investors believed that home prices would not fall, then subprime was an amazingly good deal for the issuers.

Jun 29 10:10 PM

[THofler:]

Why quibble? ALL of the gov. intervention into real estate financing, including income tax deductions for mortgage interest, is a terrible idea. Why is real estate investment to be preferred above all others? I believe that Shiller's historical data shows that on average, real estate valuations match the rate of inflation. No better, no worse.

Jun 30 01:33 AM

[Mark54:]

Excellent read...

"Slippery slope" arguements don't hold much validity with me and in retospect how did anyone even get comfortable with the term "subprime". It has eerie ring.


On Jun 29 10:10 PM kingaj12 wrote:

> The Fed has a great analysis on securitization of subprime.
>
> www.newyorkfed.org/res...
>
> The basic point is that the subprime ARMs were so punitive that that
> owner was forced to refinance in 24 or 36 months at the option of
> the issuer. The issuer (of course) counted on the refi to turn a
> risky mortgage into hard cash.
>
> You don't need to invoke CRA abuse to follow their argument. So long
> as investors believed that home prices would not fall, then subprime
> was an amazingly good deal for the issuers.

Jun 30 07:02 AM

[brb1978:]

Model doesn't matter ... Barney Frank & Slick Willy were strong arming lenders, forcing them to lend to borrowers who simply didn't deserve to own homes. Unfortunately, this is proof that liberal social policy isn't always the most fiscally prudent.


On Jun 29 09:46 AM Michael Young wrote:

> So in summary, in words that even I can understand, the bank's business
> model is designed to give them fat profits in the good times but
> fundamentally damages the financial stability of the country in recessions?
>
>
> Is the US run by Gordon Gekko? It feels like it.

Jun 30 08:48 AM

[robert.b.fe...:]

Agreed. People in lower income brackets should get a shot at home ownership if they can qualify. Your credit union is an example of how neighborhood financial institutions can provide that oportunity. That being said social engineering through government intervention is not sound financial policy and the CRA should be repealed. The author completely misses the point. The CRA is a indefensable government intrusion tnto the real eastate market which has had severe unintended consequences. There is a reason home ownership is called the American dream; you must work to make dreams come true. At the risk of sounding repetitious home ownership is not a right.


On Jun 29 10:50 AM Larrysyr wrote:

> I work on the board of a credit union that makes lots of sub-prime
> loans. That's the demographic served. The delinquency rate runs high
> but is managed carefully through quick collection efforts and much
> hands-on negotiating. Members don't get loans unless they prove a
> willingness and an ability to repay. People with bad credit get financial
> counselling and maybe small loans, not big teaser-rate ARMs.
>
> This credit union also makes prime loans, but these are usually securitized
> and sold on the open market to generate cash flow.
>
> Banks like to work with the credit union because it helps meet CRA
> requirements, and the credit union is closer to the ground and better
> able to find people who are willing to work and meet their agreements.
>
>
> Poverty is not a sin, and people with less money should not be consigned
> to the permanent treadmill represented by the credit card model.
> This is NOT a free ride; it's hard work. But people willing to do
> that work should have a way to get ahead.

Jun 30 09:10 AM

[Philip Gvinter:]

The biggest difference between CRA and Subprime which has not been mentioned are the underwriting standards. CRA was a subsidy placed on top of FNM/FRE loans which made them cheaper in designated areas. Subprime are loans made to non credit worthy borrowers with lax underwriting standards. The fact that both types of loans were made to similar demographics obfuscates the true intent and nature of the programs.

CRA = welfare. It was meant to subsidize those considered disadvantaged in the process of becoming home owners.

Subprime lending = high risk lending.

Subprime lending when done as a niche of the overall mortgage market was still punitive in structure for the borrowers. In the 1990s subprime loans were typically used as "credit repair" loans. They were granted to borrowers who met lower than agency but still somewhat reasonable underwriting guidelines which required the documentation of income. The loans were structured to reset in rate after 2 or 3 years at which time the timely payments made on the loan should have allowed borrowers to refinance into an agency or other prime loan. These loans were indeed very profitable because they carried high interest rates and low life expectancies with a significant amount of fee income. They were done by portfolio lenders who had a major stake in their performance.

This changed dramatically with the passage of the Financial Services Modernization Act of 1999 also know as Gram Leach Blyley which allowed the cross selling of financial products. GLB which replaced the depression era Glass-Steagle Act allowed commercial banks, insurance companies, mortgage banks and investment banks to sell the full range of financial services products. This allowed the investment bankers on Wall St. to look for opportunities in markets previously closed to them. Among those markets was the subprime mortgage market. As interest rates fell and house prices rose the default rates on subprime loans declined. This allowed for these risky loans to be packaged up and sliced up into traunches the majority of which could be rated investment grade. This created tremendous demand for the underlying loans as the packaging and re-selling of these loans was highly profitable. In order to meet this demand the traditional underwriting standards in the subprime business began to be relaxed. Higher loan to value ratios, higher debt to income ratios and worst of all the use of stated rather than documented income were the tools used to entice borrowers who would not have qualified.

This created a new set of buyers who placed tremendous demand on the housing market at a pace which could not be matched by the supply of homes further boosting house prices. Everyone seemed to be a winner as more people owned homes, the value of homes went up and everyone was making tremendous amounts of money. The elephant siting in the corner that no one wanted to acknowledge was the fact that the affordability of homes as well as the underwriting standards were reaching historic lows. No one in either political party or in the influential home building and financial services industries wanted the party to stop. It is always extremely difficult to be the wet blanket who turns off the music and ruins everyone's fun.

The need for action was fairly clear in 2003 and 2004 when house prices had reached an unsustainably low level of affordability as measured by median home price to median income ratios and underwriting standards had clearly been compromised and included products like 100% financing with seller paid closing costs and no verification of income assets or employment (no doc loans.) But everyone had too much invested in the housing market bonanza to do anything about it. By 2005-2006 there were not enough borrowers willing to take on huge mortgage payments to keep prices moving up. By 2007 the poor underwriting standards lead to massive foreclosures and the price action reversed. By 2008 the leverage which the financial system had been allowed to use in funding these loans nearly brought it to its knees as default rates quickly surpassed what had been predicted using rose colored models.

Today we are still in the middle of the process as there are still several waves of mortgage defaults coming from traditional factors like job loss to the payment resets on interest only and neg am loans scheduled to take place between 2010 and 2012.

Jun 30 11:07 AM

[racingman28:]

There is another problem with Subprime loans that unless you worked in the industry you would know about. Service Release Primium (SRP). Once the regulators began to work on limiting how much the brokers go paid by the lenders they needed to continue feeding the monster they built and had to make up for loss of revenue in volume. You cannot creat volume with same rules so in order to open up to build more volume they needed to soften the rules and find ways to build profits that were being limited by regulation. Most of the companies selling subprime mortgages were public companies so shareholder profits were of concern and so it goes.

Also the Section 32 filings for high cost loans pushed alot of the equity market second mortgage players into the subprime world to create revenues for their smaller firms.

Again the regulations have a great cause in mind but no one runs through the process to get to the affect it will have on the consumer. And here is another situation where we created a right for some one (homewonership) with the responsibility to pay for it on the back of someone else (taxpayer). Will the Government learn?

Jun 30 02:25 PM

[Badgolfer:]

Wrong ! Wrong ! Wrong !

SubPrimes were modeled on how many fairies there were in the bottom of the borrower's garden

Jun 30 02:36 PM

[BrentB:]

The argument is that the CRA model led to changes in behaviour that eventually led to the subprime fiasco. For this to be true, you have to identify the groups who chose to adopt the CRA model as appropriate to them. The options include: lenders, borrowers, politicians.

Lets look first at borrowers. We know that total mortgages ballooned from $7 trillion to $14 trillion during the Bush II years, while home ownership as a percentage went from 66 to 70 percent. Lets assume all of the 4% new home owners were CRA. CRA borrowers bought below average value homes. So, 4% of homes at below average price accounts for at most 4% of mortgages.

We know that most of the CRA loans are ok. So, CRA homes are not the problem. The only option then is that people who ALREADY owned homes increased their mortgages. The argument that they did this because CRA mortgages existed would then go as follows. Mr Average Home Owner who decides to remortgage his home to buy a new BMW does it because ACORN is helping poor people in Detroit or Chicago. Nah! The guy just wanted the car and his banker was OK with that. CRA did not change the buying habits of most non-CRA home owners.

So, what about the bankers. Did they look around and say: we have these poor folks being encouraged to buy homes and helped along a bit. Why, I think that I should encourage people who already have homes to remortgage and buy a new car or take a vacation in Vegas. Nah! The banker makes money by lending money. The banker makes more money by lending more money. The people at Washington Mutual who made all these bad loans were not told about CRA loans. They were told to move the product to middle income people who wanted to buy bling.

So, what about the politicians? Do you think Phil Gramm justified his law by saying that middle america needed a level playing field with the poor folks? Nah! This item on the UBS web site explains Phil's motivations pretty well: "Senator Phil Gramm to join UBS Warburg".

For the growth in mortgage debt to be attributed to existence of the CRA concept, you have to require irrational behaviour by all the people who actually grew the mortgage debt.

That is not how it happened. What did happen was Middle America was conned by mortgage lenders. And the con continues with many of the people responding to this article. They still don't admit that it was middle class acquisativeness, facilitated by politicians like Gramm and lobbied for by bankers and non-bank lenders (primarily the latter) that led to this collapse.

Blaming it on a few poor folks, whose total mortgages may amount to 2 or 3 percent of total mortgage debt is a denial of the facts. People who still believe this need a twelve step program of some sort.

If you take John Carney's argument and work through how people must have responded for the argument to work, you find the argument makes no sense at all. It only works for people who don't think it through. Sounds like a lot of people who are underwater on their mortgages today.

Jul 01 12:18 AM

[John Wake:]

"CRA rooted for..." and similar to avoid facts. Your argument seems to be that CRA's intentions were good.

Jul 01 03:26 AM

[Bill Cassill:]

Okay, I'm a little late to the conversation, but I'm going to throw my two cents into the mix here. It seems that some of the debate about CRA loans depends on personal views concerning social engineering. On one extreme are those who believe that government subsidies equals a handout to the unmotivated poor and is basically a tax on hard working Americans who pay their own way. On the other extreme, you have the lefties who have no problem in giving away other people's hard earned money.

Well, I hate to break this to everyone, but this country is full of social engineering and government giveaways. What about massive subisidies to agri-business, low interest student loans for college (or the G.I. Bill after WWII), the rebates to install energy efficient water heaters and solar panels to reduce electricity consumption, the fees that are added onto your garbage bill to get you to recycle, or the punitive consequences against those who don't wear seat belts. I could go on and on.

The judicious use of economic incentives can be used in a socially responsible way to improve the quality of life and incent people to make decisions that are good for the community as well as for themselves (e.g. like wearing seatbelts). Several years ago, Bank of America helped to revitalize downtown Charlotte, NC through low interest rate loans to get people to buy and fix up run down properties in the downtown area. Now instead of boarded up buildings and prostitutes, you have a place you would happy to take the family to.

Just my thoughts.

Jul 06 01:54 PM