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What went wrong with subprime loans in 2006?
Yuliya Demyanyk and Otto Van Hemert report:
We analyze the subprime mortgage crisis: an unusually large fraction of subprime mortgages originated in 2006 being delinquent or in foreclosure only months later. We utilize a loan-level database, covering about half of all US subprime mortgages, and identify two major causes. First, over the past five years, high loan-to-value borrowers increasingly became high-risk borrowers, in terms of elevated delinquency and foreclosure rates. Lenders were aware of this and adjusted mortgage rates accordingly over time. Second, the below-average house price appreciation in 2006-2007 further contributed to the crisis.
Neither point is shocking news, but the mystery deepens upon inspection. After 2006, 2001 was the next worst performing year for mortgage repayment, a puzzling fact. I had expected a rising crescendo of failures; why did things suddenly get so much worse when they did? Furthermore variable rate loans and low documentation loans do not seem to worsen disproportionately in 2006, contrary to common suppositions. The ratio of loan value to house value is a critical variable, but again there is the puzzle of why 2006 was so much worse for these loans than preceding years. Unless you think everyone is "flipping," (not the case), falling home prices don't stop you from repaying your loan. Note also that lenders could see the risk of these loans worsening, and it was reflected in the rates they charged, although apparently not enough.
Addendum: Here is James Hamilton on same.
Posted by Tyler Cowen on October 23, 2007 at 06:44 AM in Economics | Permalink
Comments
This paper will be quite influential if only beacuse of their very large dataset.
I view the entire subprime crisis as originating from one single factor- people thought significant HPA could go on forever. From the blog Calculated Risk, it's obvious how many prime borrowers used subprime loans(typically the ARM resets) as a bridge loan for real estate speculation. Securitization imposed a moral hazard problem in the chain. Note that the authors say that rates were increased ex-ante to reflect the risk but now ex-post it's obvious it wasn't enough.
Posted by: sa at Oct 23, 2007 8:04:05 AM
I would think that things suddenly got worse in 2006 because lots of "teaser rate" ARMs of the ~2004 vintage started to reset. When you say "variable rate loans ... do not seem to worsen disproportionately in 2006" you're talking about originations, not resets, right?
Declining home prices don't just matter for sellers; they also matter to people in teaser ARMs who thought they could refinance when the reset came.
Posted by: mph at Oct 23, 2007 8:45:25 AM
MPH:
The article appears to be talking about loans that originated in 2006.
I think it's clear that many of those loans were fraudulent, that by 2006 crooks and con-artists had discovered how disturbingly easy it was to get money they never intended to repay. Mortgage brokers still get their commissions, even if the "borrower" is fictitious.
Posted by: bartman at Oct 23, 2007 8:59:26 AM
Looks interesting, but it appears to me that an important element of the issue was missing, probably because they couldn't measure it from the data they had: the kickbacks that brokers got for originating certain types of loans. Mortgage brokers receive hefty fees from certain lenders for more expensive loans, some up to $30k.
Posted by: Peter at Oct 23, 2007 9:06:14 AM
mph-
That's the trick of the data, it was originations that occured in 2006 that have been the problem, not originations from 2004 that reset in 2006. ARMS originated in 2004 remain at very low delenquencies through 2006. 2006 originated loans are worse than all other years (beginning in month 1-2 in most cases), but no category of them (ARM, lo doc, etc) is singularly responsible for the increase.
It looks to me like, 2006 loans were made with apprased value much higher than actual value. Which is generally true as every boom turns to a bust.
Posted by: nelsonal at Oct 23, 2007 9:07:58 AM
Peter is on to something here. Not only did the teaser rates have higher commissions, the lenders could afford those commissions because there are pre-payment penalties built into the loans. I saw something familiar happen in the financial services industry in the late 90s, where high-commission/high back-end-fee annuities were selling heavily whilst competing low fee/higher performance annuities were not being sold.
In some states, such as Massachusetts, pre-payment penalties are illegal. In spite of housing price/income disparities as bad as you see in California, you do not see as many problems loans out there. There are serious subprime issues here in MA, but 0% teaser rate mortgages are not nearly as prevalent. Plenty of bad B paper, less bad A paper.
Posted by: Xenos at Oct 23, 2007 9:22:23 AM
2006-7 was the breaking point from a virtous cycle to a vicious one.
Very low interest rates in 2002-3 and their slow rise inflated house prices - since the primary component of house payments is interest, house prices act like bonds and rise when rates fall, all else equal. Rising prices allowed zero downpayment purchases and rapid refinancing with equity extraction, improving borrowers' cash flow and credit profile. Mortgage products (i.e. teaser rate arms) that kicked the cost of credit forward past a likely refinancing expanded, and subprime expanded tenfold, representing 40% of mortgage originations.
Stable home prices and rates (notably a flat curve) in 2006 stopped that cycle. Now, flat-to-down home prices stop refinancingn and equity extraction and teaser rates expire, both hammering borrower cashflow. Overbuilding and stuck markets leave a higher percentage of homes empty than ever recorded. Mortgage credit distribution was built on rating agency assumptions that were just insufficient, leading to massive withdrawal of funds from the market. The weakening dollar keeps rates high. All this increases homeownership costs, further depressing prices and continuing the vicious cycle.
Posted by: mkl at Oct 23, 2007 9:48:09 AM
Random comments:
-I don't like when people say that defaults spike "because of a payment/interest rate reset". That's like
saying someone got run over "because he crossed the street". Yes, that was a necessary, but far from
sufficient condition, and doesn't explain the special circumstances that led to a significant event.
Similarly, defaults don't go up because of a reset. It's more appropriate to say the other cause that
led the reset into a default. For example, "defaults spiked because many borrowers didn't understand
that there would be a reset" or "because borrowers expected an easy refi."
-I also don't like when people equate "current payment rate" with "interest rate". For example, if I
am obligated to pay you 4% of the balance the first year, during which time the balance increases 6%, the interest rate
is 10%, not 4%! (Yes, I'm simplifying away the monthy compounding.) Yet, the practice of equating
this two is rampant -- see virtually any internet mortgage ad for starters.
-Loans in '04 most certainly did have higher-than-usual default rates, just not has high as '06.
-I wish we could go beyond the days of a paper being good "because of its dataset". Why not release the
dataset for everyone, so everyone has the same chance to write a paper on it. If you're going to be
scientific and all. (Perhaps it was available and the paper isn't valuable for this reason.)
Posted by: Person at Oct 23, 2007 9:48:39 AM
I'd like to see analysis of broader data sets about how consumers allocate their money to housing relative to other expenses. There's a lot of focus on all aspects of mortgage lending, but I'd like to see more on overall household decision-making.
The recent news story about consumers paying credit card bills before mortgages showed a shift in behavior that might be explained by the bundling of transaction services (the card as a cash substitute, now adopted by many as every day behavior) with credit in the credit card product. With increasing consumer debt, do people see mortgage debt differently in the past 5 to 10 years?
I also strongly believe that for the current system to function well there must be intensive prosecution of fraud and misrepresentation among lenders, as well as stringent ethics policies on lenders. As a mortgage professional as well as a borrower myself, I've been personally horrified by some of the practices I've seen and experienced. The system is only as good as its ethical foundation.
Posted by: Laocoon at Oct 23, 2007 10:03:48 AM
I posted this link over on Arnold Kling's and Bryan Caplan's blog and I'll paste it here
http://www.greaterdemocracy.org/wp-content/uploads/2007/08/haymanjuly07.pdf
It's a colorful report on this subject from a hedge fund that was short subprime credit at the right time.
Posted by: Mt57 at Oct 23, 2007 10:17:45 AM
falling home prices don't stop you from repaying your loan
People may see it as throwing good money after bad. Whereas when you are in the black, you want to protect the expected profit.
Keep in mind I am not trying to explain the whole effect, just a possible small addition.
Posted by: anomdebus at Oct 23, 2007 11:18:28 AM
Simple answer to:
"After 2006, 2001 was the next worst performing year for mortgage repayment, a puzzling fact. I had expected a rising crescendo of failures; why did things suddenly get so much worse when they did?"
Easy. The number one indicator of whether a loan will go into default is the borrowers equity in the home. A borrower will rarely default on loan with at least 20 percent equity. When prices boomed 2002-2005, it did not matter if a borrower could afford the loan, since he could easily sell 6 months later if he fell behind.
When the market flattened and dropped, not only can people not appreciate their way out of a bad loan, but many who can afford their loan are more likely to defult,especially if, through bankruptcy or state law, they are not liable for the deficiency.
Posted by: Dude at Oct 23, 2007 12:43:09 PM
2006 vintage loans have an unusually high default rate for primarily one reason: fraud. When the pace of home sales started to slow down in late 2005 the lenders responded by dropping their lending standards so low that commissioned brokers essentially invited fraudulent loan applications. There was never any intention by the "borrowers" to pay those mortgages. Look at the story of Crisp & Cole in Bakersfield CA if you want a case study.
Posted by: Brian Mihalic at Oct 23, 2007 3:18:13 PM
Many of the 2002-2004 loans were quickly refinanced due to price appreciation, either to a fixed loan or to a new 2005-2006 adjustable pulling what equity there was out. A 2006 loan would typically not even be facing reset yet, but refinancing would typically be impossible without appreciation.
There was a recession in 2001.
Posted by: Lord at Oct 23, 2007 4:58:55 PM
I think Dude may be on to something beyond the speculation of fraud. From my experience in the industry, by 2006 a lot of people were simply expecting to get the highest LTV that they could and thus a lot of loans were made with little equity.
Add to that the timing. Late in the market is when a lot of people who shouldn't buy do because 'everyone' is. Not all of them achieve this through fraud, but brokers are a lot more willing to shepherd someone through a credit fixing process when they are running out of other prospects. However, this only fixes the credit scores, not necessarily the bad habits that created the original bad credit.
Finally, compound that with desperate mortgages brokers and lender account managers (also commission based) and the line between fraud and negligence gets very thin.
I spoke with one broker in the Ann Arbor, MI market and he told me that 20% of his recent closings featured sellers who had to bring money to the closing to pay off their loan.
I can imagine that by 2006 there were a lot of buyers who never really had great credit to begin with, had always been renters, and who when faced with having gotten themselves in over their heads just said "screw it" and walked.
Posted by: ElamBend at Oct 23, 2007 5:07:53 PM
2001 being the second-worst year isn't really that surprising. That was the last time the economy took a large hit stemming from the terrorist attacks. Since people use various sources of income to pay off their debt, the hit to the stock market may explain that particular year. Also, the rates do get progressively worse from 2003-2006.
They seem to be leaving out a lot of factors that contribute to delinquency and foreclosure, such as geographic region. Since their dataset only includes 60% of the subprime market, they are omitting a lot of loans and leaving a lot of room for the rates to change. Where are they getting this dataset from?
Lastly, they appear to be looking at the different vintages and saying which ones went delinquent within the first 24 months. They don't go beyond that age. So falling home prices would impact recent numbers since before people who couldn't afford their home to begin with could just sell it instead of defaulting, whereas now people who have gotten into trouble in the past 18 mos. can't. This is because of declining appreciation rates, being upside down on your mortgage, and tightening credit....all which didn't really come into play outside the last year.
Posted by: mck at Oct 23, 2007 5:07:53 PM
Can anyone point me to a place that lists which state's are mandatory non-recourse and which aren't? I'm most interested in Michigan, but I'm curious about other states as well.
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