Feb032015

Prime mortgage borrowers inflated the housing bubble

Subprime borrowers endured more painful consequences, but all borrower classes participated in the housing bubble debt orgy.

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Yesterday I noted that most former subprime borrowers are no longer homeowners, but despite enduring most of the negative consequences, it wasn’t subprime borrowers that inflated the housing bubble: prime borrowers did that.

The common narrative is that subprime borrowers inflated house prices, then they quit making payments and caused a crash in house prices that dragged down everyone else. Unfortunately, this narrative lets off the middle and upper classes far too easily.

The reality is all borrower classes participated in the housing bubble equally, but when it came time to clean up the mess, the various borrower classes were not treated equally: low-end, subprime borrowers were foreclosed while mid- to high-end prime borrowers squatted or obtained loan modification deals to wait until prices recovered — to wait in houses they couldn’t afford but enjoyed anyway.

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As Tanta from Calculated Risk pointed out in 2007: We’re all subprime now:

Let us … ask ourselves what constitutes the “upper and middle classes.” If they “moved up beyond their means,” then . . . their means are what, exactly? If 100% or near 100% financing is required to keep these neighborhoods stable (loans over $400,000 for houses in the $400,000-$450,000 price range), then in what sense are they neighborhoods of the “upper and middle classes”? Does our current definition of “middle class” (not to mention “upper class”) include having insufficient cash assets to make even a token down payment on a home? Things seem to have changed since I did Econ 101.

What is the utility of this kind of thinking?

slow_dancingThe utility was political: foreclosing on poor, subprime borrowers doesn’t upset a major voting block; foreclosing on middle and upper class borrowers does. So rather than foreclose on better neighborhoods, under pressure from bureaucrats and legislators, lenders amended loans, extended foreclosure timelines, and pretended these borrowers would ultimately pay them back. The music still plays and the dance continues to this day.

Robert Samuelson: Challenging what we know about the housing bubble

By Robert J. Samuelson February 1 at 7:39 PM

… There’s a standard and widely shared explanation of what caused the bubble. The villains were greed, dishonesty and (at times) criminality, the story goes. Wall Street, through a maze of mortgage brokers and securitizations, channeled too much money into home buying and building. Credit standards fell. Loan applications often overstated incomes or lacked proper documentation of creditworthiness (so-called no-doc loans).

All of the above is true.homeless

The poor were the main victims of this campaign. Scholars who studied the geography of mortgage lending found loans skewed toward low-income neighborhoods. Subprime borrowers were plied with too much debt. All this fattened the revenue of Wall Street firms or Fannie Mae and Freddie Mac, the government-sponsored housing finance enterprises. When home prices reached unsustainable levels, the bubble did what bubbles do. It burst.

This part is not true.

The poor were the main victims of the foreclosures, but everyone equally participated in the foolish borrowing.

Remember the adjustable-rate mortgage reset schedule from 2006? It tells the more nuanced story of what happened.

ARM_Resets

During the housing bubble subprime borrowers were primarily given a specific loan known as the 2/28, which provided an affordable 2-year payment followed by a crushing payment reset that caused most of these borrowers to default. Since their teaser rate period was two years rather than 5, these loans faced reset before the equally unstable loans given to prime and alt-a borrowers.

When the subprime borrowers defaulted, banks followed their standard loss mitigation procedures that included a speedy foreclosure. After foreclosing on millions of these borrowers, banks pounded house prices back to the stone ages in subprime-dominated areas.

Lenders knew their more affluent but equally foolish alt-a and prime borrowers were also going to be crushed by payment resets, and rather than repeat the price-crushing foreclosures of subprime, the lobbied Congress to set aside mark-to-market accounting procedures so they could amend-extend-pretend their way out of a crisis.

Subprime_slaves

Therefore, while all borrower classes were equally foolish in their behavior, only the subprime borrowers endured the brunt of the foreclosure tsunami, and although the middle class took their lumps, they came out much better off than their subprime brethren: most middle-class borrowers are still in their homes.

Now comes a study that rejects or qualifies much of this received wisdom. …

First, mortgage lending wasn’t aimed mainly at the poor. … Borrowers were … much richer than average residents. In 2002, home buyers in these poor neighborhoods had average incomes of $63,000, double the neighborhoods’ average of $31,000.

Second, borrowers were not saddled with progressively larger mortgage debt burdens. … In 2002, the mortgage-debt-to-income ratio of the poorest borrowers was 2; in 2006, it was still 2. …

Third, the bulk of mortgage lending and losses — measured by dollar volume — occurred among middle-class and high-income borrowers. In 2006, the wealthiest 40 percent of borrowers represented 55 percent of new loans and nearly 60 percent of delinquencies (defined as payments at least 90 days overdue) in the next three years.

american gothic parody 200309The biggest travesty of the housing bubble was the unequal treatment of the rich and poor when it came to foreclosure. The wealthier your zip code the less likely you were to face foreclosure, mostly because lenders knew they couldn’t absorb the losses, but partly because wealthier zip codes have more political clout.

If these findings hold up to scrutiny by other scholars, they alter our picture of the housing bubble. Specifically, they question the notion that the main engine of the bubble was the abusive peddling of mortgages to the uninformed poor. …

Let’s not overlook the fact that abusive lending to the uniformed poor was a huge problem. It was. It just wasn’t responsible for inflating house prices. That was a team effort that required the participation of middle- and upper-income borrowers.

It is not that shoddy, misleading and fraudulent merchandising didn’t occur. It did. But it wasn’t confined to the poor and was caused, at least in part, by a larger delusion that was the bubble’s root source.

During the housing boom, there was a widespread belief that home prices could go in only one direction: up. If this were so, the risks of borrowing and lending against housing were negligible. Home buyers could enjoy spacious new digs as their wealth grew. Lenders were protected. The collateral would always be worth more tomorrow than today. Borrowers who couldn’t make their payments could refinance on better terms or sell. …

realtor_guarantee

It’s tempting to blame misfortune on someone else’s greed or dishonesty. If Wall Street’s bad behavior was the only problem, the cure would be stricter regulatory policing that would catch dangerous characters and practices before they do too much damage. This seems to be the view of the public and many “experts.”

Wall Street greed was certainly part of the problem, and we need legislation to prevent the greed of the housing bubble from inflating another one, but it’s accurate to say Wall Street greed wasn’t the only problem. Unfortunately, legislators did little to curb the greed of ordinary borrowers.Absolutely-Fabulous-HELOC_approval

The biggest mistake of Dodd-Frank was failing to limit the loan-to-value on cash-out refinances. Texas has such a limit, and it’s the main reason Texas didn’t participate in the housing bubble. Without access to their home equity with unlimited HELOC extraction like we have in California, Texans has no incentive to drive up prices.

But the matter is harder if the deeper cause was bubble psychology. It arose from years of economic expansion, beginning in the 1980s, that lulled people into faith in a placid future. They imagined what they wanted: perpetual prosperity. After the brutal Great Recession, this won’t soon repeat itself. But are we forever insulated from bubble psychology? Doubtful.

Greed and fear drive financial markets, and unless we radically change human nature, we will always have financial bubbles, and although the greed might have gone underground here in California, the chance of another kool-aid outbreak is always with us.

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