Mike Konkzal has a new post on the homeowner crisis. In it, he describes the current phenomenon of homeowners being offered mortgages, which they can’t afford once rates are reset after a teaser period, then being left with an uncertain future as banks defer on foreclosure after they‘ve gone delinquent. He gives this a term, “Fake homeownership”, which is probably a very apt term for what the arrangement essentially amounts to. He has given vivid illustrations of what is actually going on in the ground, and like many, is reasonably perplexed at how banks could have let people come this far into trouble. Not being in the US, many of the things he says are new to me, but having once been in a bank, I will put my comments and clarifications on key passages of his post, to try to put more light on some of the reasons why they are what they are, so that Mike (who’s doing an admirable work of trying to get to a deeper understanding) can give us more nuanced recommendations.
Here’s what fake homeownership looks like on the way up: a subprime loan’s “teaser rate”, the initial rate, was much higher than the prime rate. It was often in the 8-9% range. So the teaser is set at the maximum level a borrower could pay, and there’s an interest rate jump at the 2 or 3 year mark. It is highly unlikely the borrower can make the jump payment, so they must refinance it. In fact, you see something like 80% of subprime mortgages refinanced by the 3 year mark. I see the logic of subprime having a higher rate than prime, simply because it is subprime. But I do not see the logic of why a mortgage whose teaser rate was already at the maximum that a borrower can pay, was still offered. Of course, this can only result in a default once the teaser rates expire. This is absolute insanity, and admittedly, US banks were greedy and probably either relied too much on constantly rising home prices, or more likely, on the risk diversification provided by securitization.
What is often not discussed is that over 70% of subprime loans have a prepayment penalty. The prepayment penalty is quoted in terms of months of interest (BS like that is reason alone to have vanilla contracts), and a rule of thumb is something like 6 months interest which at the 2nd or 3rd year is somewhere about 4% of the principal. Now the subprime borrower probably doesn’t have 4% of the principal laying around, so it is rolled into the new principal of the refinanced loan. From my experience, prepayment penalties are there to compensate the bank from any loss it will incur from losing a loan account that may have already been matched with a funding of similar maturity, ex. A mortgage that earned 8% that resets after 3 years was probably matched with funding (most likely by attracting long-term deposit or issuing CDs) that matched that duration, and provided the bank with an economic spread. Losing that income stream before the bank was able to pay out its funding in full results in a loss for the bank, and the bank usually capitalized this loss in the prepayment penalty. Of course, assuming that a subprime borrower would have 4% lying around upon rate reset is obtuse, and likely, the intention was really to include the penalty into the principal all along.
This is influenced by the binomial approach Yale economist Gary Gorton takes in his The Panic of 2007 paper (see around page 15 if you are a finance geek). Note that this contract is rational only if housing prices are expected to appreciate faster than the fees, and on average analysts thought housing prices would go up about 5% a year. So the endless recycling of these loans generates fees that eat up a large chunk of the house price appreciation. No wonder all these homes are underwater! Analysts who projected 5% house price increases were probably making assumptions that you and I do not use or are aware of. Whatever, it is obvious now in hindsight, that this was stupidity of the superlative order. More likely, they were just looking at the fees, and justifying them by assuming the 5% increase.
What Gorton puts weight on in his model is that banks can choose not to refinance, and the homeowner will likely have to sell the house – so there’s an option embedded for a foreclosure after two years by the bank (he argues that refinancing with other institutions is difficult because of the adverse selection issue). So from a financial engineering point of view, the bank has hired someone to sit in a house for them, and they are each getting paid by splitting the home equity. The borrowers need to be of poor quality else they’d just gamble on HPA with a prime mortgage. This makes sense, and illustrates how the entire housing crisis was (deliberately or unwittingly) engineered by the banks looking to cash in on the perpetual fees coming from “perpetually” refinancing mortgages, and obviously, only people who never accumulate sufficient equity in a house will fit this criterion. Perhaps it’s true that banks also saw the positive option value of a foreclosure, once they have accumulated enough fees from said ‘house sitter’.
This is a widespread phenomenon – the rate of prime loans failing is doubling at all times. One solution would be large principal reductions. Another would be to allow for mortgage cramdowns, to make negoiations more credible. Another would be to subsidize short sales. Another would be to have the government purchase a huge chunk of these mortgages at a cheap price and sit through whatever profit can be made – Roosevelt’s efforts to do this in the Great Depression made a profit. Now I see why principal reductions are very necessary. The reduction should be of an amount at least equal to the fees already ‘robbed’ by the guilty banks over the years, that should have otherwise accumulated as equity for the ‘house sitter’ by this time.
But it is fascinating to think of what is happening with the people who can’t make their mortgage payments but haven’t been foreclosed on. The bank in this case is exercising an option to defer foreclosure – an option I never thought would be used on such a wide-scale. How does that option work? And what kind of ‘ownership’ do people in these situation experience? Is it a kind of mini-vacation, where you get to live in a nicer house than you could ever afford? Is it a perpetual sense of anxiety, where someone could come to remove you within a week? Is it just a sense of resignation at being a widget that the largest banks are using to pretend second-liens assets are worth something other than a penny on the dollar – their home as juking some financial statistics? I’d love to read more about that. In all likelihood, the banks are not foreclosing because the positive option value of foreclosure is no longer there, i.e., if they foreclose, to whom can they sell at the previously assumed value? And for as long as the market for housing has not stablized, foreclosures will likely be deferred. This is absolutely the kind of ‘fake home ownership’ that Mike has termed. And second liens will definitely be worth pennies if not zero, hence, you won’t see them initiating any of the foreclosure proceedings. I don’t know if this deferment has been to juke any statistics (they're nonperforming assets either way), it is probably more the reality that the costs of foreclosure far outweigh any tangible benefit it accrues for the banks. Benefits of foreclosing will only become more tangible once prices have stabilized, and ironically, that will likely only come once more mortgage cramdowns are effected.