Mortgage Defaults and Skin-in-the-Game: Why This Correlation Is Wrong

This is the first of a series that I will be posting to respond to inaccuracies, falsehoods and fabrications which permeate much of the discussion as it relates to housing and mortgage lending.

There is a significant amount of chatter, even on a strong site such as Seeking Alpha, regarding the issue of down payments… the skin-in-the-game concept…and the housing/foreclosure problem. There are repeated attempts to correlate the crisis and leveraging on the part of borrowers and buyers…and, the evidence does not pass scrutiny. It is simply kool-aid served to willing readers. There is a lot of extrapolation…a nice word for an educated guess…and a lot of “bobble-head” nodding…but no real evidence.

To understand the present, sometimes it helps go back and review the past.

By way of background, ver the years, beginning the mid 1980s, I have attended mortgage underwriting training sessions. I have, in the past, held signature authority as a mortgage lender. At these sessions, discussions of the leading causes of default and foreclosure usually centered on what I will refer to as the “5 D’s”: Death; Disability; Discharge; Downturn; and Divorce.

The amazing fact is that these “5 D’s” are not observable prior to the fact. There is no way to document them…they are beyond what can be reasonably quantified and guarded against in the underwriting process. In other words, stuff happens, and some of it cannot be anticipated or prevented.

The missing “D” in the list is “down payment,” mistakenly cited today as a prime cause for the mess in which we now find ourselves.

The “D’s” that truly affect the mortgage payment process are all related to monthly household income. Quite simply, homeowners use monthly income to pay monthly obligations, and if the income declines or goes away entirely, problems begin and things can get bad, fast.

Death and disability are leading causes of bankruptcy, especially if the cause if a severe, long term medical problem, such as a form of cancer. Both lead to loss of income, and they become a factor in default and foreclosure.

Discharge (layoff, fired, etc) and downturn relate to patterns and trends in the general economy. Both lead to loss or reduction in income.

Divorce leads to a splitting of the household…and related incomes…and often emotional strife as well.

When I work with a client on a mortgage modification, I gather a lot of personal information, so I have real data in real time. Part of the modification presentation is to illustrate the change in household income. To date, 100% of the clients I work with, who are seeking help on their mortgage payments through modification, have experienced a severe downturn in their monthly incomes…35%-50%...some actually 100%.

Similarly, when I work with a client on a refinance, and they are not in payment trouble…their paperwork shows that 100% of these customers have maintained, or increased, their income during current recession.

Notice, down payment is not part of the discussion. It’s about the monthly income.

Years ago, in the 1980s, as an underwriter at a Savings and Loan, working primarily with wealthy, complex borrowers, we used to look at “cash as king” and we would strongly consider down payment and liquid reserves as a sound reason for us to expand our underwriting vision for a particular borrower, along with our review of the projected stability of the sources of income. In spite of the cash available for the deal, and to support the deal long term, everything always came back to income and how we felt about its stability and anticipated continuance.

The real problem in the housing market, that has lead us to the current crisis, was the distortion of underwriting…not necessarily the “no doc…state income” stuff, although they contributed…but the broader agency lending practices fueled by the automated underwriting systems at Fannie and Freddie.

In the 1984/1985 time frame, I saw the first of the “no doc / stated income” type loans. Keep in mind that fixed rates were still double digit at this time, and lenders were in the process of introducing adjustable loans and adding staff. My gut feeling was that many lenders decided to avoid complicated paperwork, and chose to simplify the processing, and shift a great deal of the perceived risk to the borrower. In essence…there wasn’t enough time or talent to deal effectively with the surge in mortgage demand, and, since the perceived risk was shifted to the homebuyer /borrower (through a large down payment), many lenders simply ignored the income/ qualifying issue.

Back then, a 25% down payment got the customer into this special underwriting classification….and with a credit report (the mistake of relying on credit scores had not yet been made)and a big down payment (or lots of equity), everyone was an approved borrower.

Somehow, in spite the requirement for really big down payments, the supply-demand balance was screwed up…more borrower/buyers were enabled than actually existed, and they were chasing too few properties. Asset values (property values) went through the roof.

By 1989, or so, lenders were giving me feedback that upwards of 90% of the stated income loans were failing in audit review…results were pointing to the fact that the borrowers simply misstated income.

Imagine that…with no real controls in place, the borrowers fudged...who would have thought.

In response to the audits, about this time, lenders began to shut off the ‘no doc/stated income” processing, the borrower pool was dramatically reduced, and in the late 1980s housing crashed and we endured the S&L crisis.

Interesting to note that the “equity” that was lost during this time period was mostly real cash…lots of it.

Regardless, does any of this sound familiar?

Twice now, in my 30 year career, the industry, which leads from the top…corporate leadership … government/agency leadership…and the money-men on wall street… has gone over the top and managed to take simple supply & demand mechanics and trash the dynamics by inflating the buyer/borrower pool through manipulation of the income/underwriting process…thereby eventually over-inflating asset values. Then, at the point of the full realization of the error in their methodology, and the mess they had created, they reverse the process, and they impose drastic restrictions on the underwriting process, leading to a crash in the buyer/borrower/demand pool, and, eventually the reversal causes a severe downturn in asset values…they crush home prices. Somewhere in here, the manipulation of how income is treated, lies the true heart of the problem.

This known history makes the current crisis all the unbelievable and unfathomable. It’s not like we haven’t experienced this before. We should have learned. Unfortunately, not many industry participants have actual experience over this entire time frame of 1980 – 2009.

I have read much of what is available on recent studies relating to the housing and mortgage crisis, and have traded thoughts with many of the authors. When you strip away the fluff, you find that all of the studies are following false intuition to arrive at a predetermined end.

There are simply more critical factors which need to be reviewed and understood, and the correlation between down payment and default, simply does not exist.

Disclosure: No positions

Comments

[prairiedog555:]

I also was in the mortgage business for years. I think you can add a couple of more reasons.
There now seems to be less of a onus of shame on defaulting on a mortgage. Where before if one did others would not trust you.
Also, I believe that the class of 2005-2007 top of the market buyers have just lost too much equity to fast.
Just think if you bought a 500K home in Las Vegas and put 100K down in 2005, your home is now worth about 300K. Now that is a hit.

Jul 09 07:45 AM

[MichaelJ007:]

John- I don't have nearly your experience in underwriting mortgages. While I agree with you that loss of income has the strongest correlation to default, Equity HAS to have some correlation to default as well. If there were NO correlation whatsoever, then Lenders and underwriters wouldn't have ever required it or factored it into their decision making process- how many 100% loans have you made? When chosing between two identical loans a lender will ALWAYS opt for the one with more borrower equity as that is the one with less risk. Bottom line is a Borrower with no equity or skin in the game is always more likely to walk away from the table when times get tough. Therefore income is the most relevant factor, but equity/down payment is still relevant.

Jul 09 08:34 AM

[Free Market...:]

I think you missed something. The people that can't come up with a down payment are the same ones that have no cushion against the 5-Ds you speak of. When you put 20% down, and get divorced or laid off, at least if you have to sell your house, you are likely to have no negative equity. In other words, the sale amount will cover the note. It was the people that financed 100%, or worse yet, 125% that made this situation so much worse. If there was positve equity in the home from a larger dwon payment, when bad things happen (excpet in the worst markets (EG CA, FLand NV) then there was at least some chance for an equity loan to tide you over. The lack of down payment may not be the chief culprit, but I don't think you can dismiss it as a cause.

Jul 09 08:43 AM

[Greg10:]

Thankyou John. This is the best historical perspective I have seen. It still worries me that Fannie and Freddie feel 125% LTV solves the problem. I hope it all get restructured as recourse.

Jul 09 08:46 AM

[rm:]

[When I work with a client on a mortgage modification, I gather a lot of personal information, so I have real data in real time. ]

All of the shouting about negative equity has been coming from people who are not in the trenches, like you and me.

Here is the reason why there is such a strong correlation between negative equity and foreclosure:

Historically, the vast majority of defaults occur within the first 24-36 months of the loan.

Because that still holds true, it's only natural that the majority of these borrowers are underwater- they bought at the top, were not required to pay (much of) a down payment, and housing prices have collapsed.

If you're doing a fair amount of volume of loan mods, the majority of the loans you're seeing are vintage 2005 and later... so OF COURSE most of those loans are underwater.

How much time and money was spent finding this out?

And what difference does it make?

If there's something USEFUL to be learned, it's what separates re-defaulters from those who stay current on their mods.

It will take the industry 3-5 years to figure out what we, on the front lines, already know.

Jul 09 10:08 AM

[Augustus:]

The S&L crisis was in the late 1970's. It was caused by changes in interest rates on deposits vs. long mortgages. It had nothing to do with defaults on the 90% loans with PMI.
Requiring a large downpayment does reduce the buyer pool. That would have restrained the extreme price runups. It also requires a borrower to demonstrate that they can live on their income and also accumulate a bit of savings by some form or another. Both factors make for a more stable housing market.

Jul 09 10:33 AM

[mr subprime:]

I concurr. I was a no-down-payment buyer (because the lender required me to use cash-on-hand to clean up the credit report). Since the asset statement was now barren, the lenders' agent saw fit to give me some (fraudulent asset statement) to please the "underwriter". We made payments in spite of the predatory servicing (losing payments to create default) and illegal/immoral behavior of the lender. It was only when the income stream dropped (due to the banking crisis affecting sales) that the payments stopped being made. Upon further review, fraudulent closing docs (generated by the LENDER) were found and a fraud case ensued. This case is in litigation. The banksters thought they could insure away the risk, regardless of the borrowers credit history (the worse the credit, the higher the rate charged) making it a win-win for themselves (take the property via foreclosure, take the 35% mortgage insurance proceeds, and keep the investors' money). How foolish they look now. The "Blame the Borrower" mantra seems to have run its course, and the predatory actions of the lenders are coming to light. This was no accident! How can a loan trust have a 40%+ default rate? Did all the borrowers decide in concert to stop making payments? Hardly. I hope to report sometime soon that the mortgage has been extinguished because of the fraudulent origination performed by the LENDER. THEY ARE THE CRIMINALS HERE, NOT THE BORROWERS.

Jul 09 10:44 AM

[Radardoc:]

John,

I've got another D for you - Dishonesty.

Whether on the part of the lender that convinced a single mother she could afford a no-interest payment schedule or the buyer who, though still able to pay, walks away because they don't like the game any more.

I'm sad to say we have reached a point where no one seems to hold themselves accoutable for their lives any more. "If everyone else is doing it, why not me?" seems to be the question.

What ever happened to the answer "Because it's wrong!"

(stepping down from my over-idyllic soap box...)

Jul 09 11:19 AM

[Falconflight:]

The "D" that isn't always present and in fairly constant numbers is Discharge. However, the writer loses credibility due to the simple fact that the discharges occurred in significant numbers long after the 'bubble' pop in those 5 infamous states that account for such a high percentage of the national total of foreclosures.

Jul 09 12:41 PM

[FinancialEn...:]

Hi John,

I think it's important to differentiate "voluntary" vs. "involuntary" foreclosures.

The 5 D's you spoke of contribute to, what I categorize as, "involuntary" foreclosures. However, the "no skin in the game" primarily contribute to "voluntary" foreclosures.

Jul 09 01:41 PM

[Gregman2:]

"Part of the modification presentation is to illustrate the change in household income. To date, 100% of the clients I work with, who are seeking help on their mortgage payments through modification, have experienced a severe downturn in their monthly incomes…35%-50%...some actually 100%." And why is this? Why have their earnings dropped? Have you spotted any trends?

Jul 09 02:40 PM

[Gtarras:]

First off, John
thank you for great piece! Its the best I have seen in months, looking forward to more from you.

rm
your point that a lot of defaults happen to the 05-07 vintage and thus most likely to be underwater is exactly that I have been pointing out myself at my company. Thank you, I am in total agreement with you here.

As a statistician, I have seen it time and again how people often confuse cause and consequence. For example, there is high correlation between global warming and levels of CO, but I am still not convinced what causes what. But, oh, the temptation for some to use the "lies, damn lies, and statistics" is so great sometimes!!!

On Jul 09 10:08 AM rm wrote:

> [When I work with a client on a mortgage modification, I gather a
> lot of personal information, so I have real data in real time. ]
>
>
> All of the shouting about negative equity has been coming from people
> who are not in the trenches, like you and me.
>
> Here is the reason why there is such a strong correlation between
> negative equity and foreclosure:
>
> Historically, the vast majority of defaults occur within the first
> 24-36 months of the loan.
>
> Because that still holds true, it's only natural that the majority
> of these borrowers are underwater- they bought at the top, were not
> required to pay (much of) a down payment, and housing prices have
> collapsed.
>
> If you're doing a fair amount of volume of loan mods, the majority
> of the loans you're seeing are vintage 2005 and later... so OF COURSE
> most of those loans are underwater.
>
> How much time and money was spent finding this out?
>
> And what difference does it make?
>
> If there's something USEFUL to be learned, it's what separates re-defaulters
> from those who stay current on their mods.
>
> It will take the industry 3-5 years to figure out what we, on the
> front lines, already know.

Jul 09 03:19 PM

[mdharbison:]

I disagree wholeheartedly.
I work as a Surety Bond Underwriter, and the precepts are the same. I would rather the client have their cash available in a liquid low risk investment instrument than tied up as a down payment and unavailable for emergencies. The additional monthly payment is incremental without the down payment, and if held for a rainy day (such as the loss of a job), it could enable the mortgage holder to hold on to the house instead of going through foreclosure.


On Jul 09 08:34 AM MichaelJ007 wrote:

> John- I don't have nearly your experience in underwriting mortgages.
> While I agree with you that loss of income has the strongest correlation
> to default, Equity HAS to have some correlation to default as well.
> If there were NO correlation whatsoever, then Lenders and underwriters
> wouldn't have ever required it or factored it into their decision
> making process- how many 100% loans have you made? When chosing between
> two identical loans a lender will ALWAYS opt for the one with more
> borrower equity as that is the one with less risk. Bottom line is
> a Borrower with no equity or skin in the game is always more likely
> to walk away from the table when times get tough. Therefore income
> is the most relevant factor, but equity/down payment is still relevant.

Jul 09 03:47 PM

[evergreen:]

Everything is about the lender. If you can't afford something, don't buy .it. Rent, don't buy ,if you can't afford the house.


On Jul 09 10:44 AM mr subprime wrote:

> I concurr. I was a no-down-payment buyer (because the lender required
> me to use cash-on-hand to clean up the credit report). Since the
> asset statement was now barren, the lenders' agent saw fit to give
> me some (fraudulent asset statement) to please the "underwriter".
> We made payments in spite of the predatory servicing (losing payments
> to create default) and illegal/immoral behavior of the lender. It
> was only when the income stream dropped (due to the banking crisis
> affecting sales) that the payments stopped being made. Upon further
> review, fraudulent closing docs (generated by the LENDER) were found
> and a fraud case ensued. This case is in litigation. The banksters
> thought they could insure away the risk, regardless of the borrowers
> credit history (the worse the credit, the higher the rate charged)
> making it a win-win for themselves (take the property via foreclosure,
> take the 35% mortgage insurance proceeds, and keep the investors'
> money). How foolish they look now. The "Blame the Borrower" mantra
> seems to have run its course, and the predatory actions of the lenders
> are coming to light. This was no accident! How can a loan trust have
> a 40%+ default rate? Did all the borrowers decide in concert to stop
> making payments? Hardly. I hope to report sometime soon that the
> mortgage has been extinguished because of the fraudulent origination
> performed by the LENDER. THEY ARE THE CRIMINALS HERE, NOT THE BORROWERS.

Jul 09 04:39 PM

[c smith:]

5D model worked great until home prices collapsed...now being 30% underwater on your home has supplanted all the other variables...this is the same sort of thinking that got us into this mess.

Jul 09 06:55 PM

[Allan Frain:]

The suggestion in the article is counterintuitive and ludicrous. The author would make a good mouthpiece for the Fed.

Jul 09 07:09 PM

[michaelsass:]

Mr. President why are the banking,and loan company not making loans as you promised they would do for the american people we are all hurting and not getting any help. Time for them to answer to you for not helping us the little people that keep them in business, maybe we should boycott their business. Check obamamortgage2009.blog...

Jul 10 01:12 AM

[johngonole:]

The author is basically purposefully untruthful. He skips over the D for downturn. He fails to mentions that home prices had never risen 10-20 percent per year for five years before. He fails to mention that home price inflation had exceeded overall inflation way more than it had ever before. And while it may be true that the 5 D's are the primary cause for default he fails to mention that the downpayment provided protection for the banks from losses. The downpayment established the homeowner with equity that the bank could harvest during foreclosure. Now when a homebuyer stops making payment the banks lose 12-24 months of payment income and it immediately becomes a loss. Furthermore with home prices falling this loss has intensified on loans made during the peak of the home bubble. He also fails to mention that people who can't afford the downpayment are the most likely to suffer from the five D's because the obviously have less money in reserve. Without any reserve unemployment causes default much faster. It also makes refinancing much harder. As a tax payer I'm pretty pissed that I'm having to pay for the banks failure to secure adequate downpayments to account for default risks.

It figures that the author worked for a savings and loan during the 80's. Wasn't it the savings and loans that caused the last financial crisis in America.

As far as I'm concerned bankers of failed banks should be thrown in jail. Its really simple mathematics folks. This wasn't an accident. They all fully knew this was going to happen. Anyone with a lick of common sense saw this coming and definately well educated bankers knew it was coming...the author included.

If we were in the old days before the printing press we'd be having riots right now. Fortuneately the bankers have figured out how to STEAL our money bit by bit year after year.

Jul 11 01:48 AM

[johngonole:]

I'll also mention that the downpayment ensure homeowner equity. This is the reason mortgages have a lower interest rate than say car loans. If the mortgage isn't backed (which is the case with negative equity) than the banker stands to lose a lot more money. No deposit loans should require much higher interest rates.

If downpayments are made then the foreclosure process is painless for the banks and the taxpayers. They get their money back. The homeowner loses only what he failed to pay the banker during the default period. Everyone is whole. So while the 5D's might cause default its not really a big deal. The person just goes out and rents. We don't end up with a national crisis.

The money changers were pretty pissed off at Jesus. Jesus was right to call them out for what they were. Its time for the American public to do the same.

Jul 11 02:01 AM