So I’m glad Texas is making waves about seceding from the United States right now, since it leads nicely into my first ever weekly project here at Rortybomb. I don’t know the specific talking points of the Texas Teabag Protestors, but if they have a feeling that they did something right while everyone else was doing something wrong during the 2000s, they may have a point.
In 2007, when everyone first started to realize en masse how bad the housing landing was going to be for the country, I remember telling a friend “I bet Texas is going to be a giant crater when this is over.” From my mind, I’ve always associated Texas with the worst boom-and-bust cycles in everything, housing above all. The next day I checked the numbers and realized I was entirely wrong.
Let’s look at some data. Here’s the Case-Shiller numbers for the 20-city US index, Phoenix, Arizona, and Dallas, Texas, seasonally adjusted. (For some reason, Case-Shiller does Dallas instead of Houston. These numbers are generalizable though).
Now Phoenix and Dallas have a lot in common. And so does Texas and Arizona. Yet somehow Texas, which seemed perfectly engineered to replicated the problems of Nevada and Arizona, as well as California and Florida, avoided the fate of the “Sand States.” The value didn’t jump high then crash; they rose a nice 25% over the decade (it looks small on the chart, but only because it is overshadowed by the boom/bust).
From USA Today, we see Texas is right around the median of housing foreclosures, with a normal 1%; Arizona, Florida, California and Nevada all have 4% and above. When you start digging, you see all kinds of signs that the Texas market is fine – it is the first everyone expects to start going again.
So what gives? I’ve thought about this a lot, and have come to a simple three word conclusion: “No prepayment penalties.” Right there in their state law:
§ 343.205. PREPAYMENT PENALTIES PROHIBITED. A lender may not make a high-cost home loan containing a provision for a prepayment penalty.
And, in general, a consumer’s bill of rights:
No Balloons – a high-cost home loan may not provide for a payment that is more than twice as large as the average of earlier scheduled monthly payments within the first sixty months of the loan.
No Negative Amortization – a high-cost home loan may not provide for a payment schedule that may cause the principal balance to increase.
Borrower’s Payment Ability – the lender may not make high-cost home loans based on the collateral value of the property without regard for the borrower’s repayment ability, including current and expected income, current obligations, employment status, and other financial resources.
No Prepayment Penalty – a high-cost home loan may not contain a provision for a prepayment penalty.
No Charge for Service Not Received – a lender on a high-cost home loan may not charge a borrower for a service or product if the borrower does not receive it.
I think all these are good ideas to be brought back to the federal level. It was not always this way, determined at the state, or in a way friendly to whatever banker and consumers could agree on. As part of a wave of deregulation in the late 1970s and early 1980s, Congress passed AMTPA, which allowed the subprime market to be built. That wave of deregulation was a series of experiments; it is in the nature of experiments to sometimes succeed, and sometimes fail. It is our job to determine which is which among the wreckage, and my argument will be that these prepayment penalties created the worst incentives for banks.
I understand that we don’t want to regulate the previous crisis. The Democratic Party is busy with trying to fix the Recession and the banking crisis, while the Republicans are busy heroically fighting the One World Currency and the FEMA internment camps. During 2007, we heard from candidates Hillary Clinton and Chris Dodd that they would want to ban prepayment penalties. We haven’t heard it from President Obama; I would like to see pressure to do so, while Change is in the air.
So I’ll spend a few days talking about this in detail, from empirics, to financial theory arguments, to a model as to why this happened, hopefully accessible to any educated reader. Feel free to skip if you are already bored. I want to consider doing some policy wonk finance stuff here (and perhaps more generally with my life), and I’ll possibly try to expand into a formal paper, one which also keeps its finance and economic chops up – so please criticize away, even if you agree with me.
I also want to get away from the duality of thinking of the subprime crisis as evil banks looting homeowners or evil lenders tricking banks. With the genius of prepayment penalties, banks didn’t have to make money by lending loans to credible homeowners – they could form a de facto company with unqualified borrowers to bet on house prices rising. The prepayment penalty was the bank’s equity in this endeavor. Or another way to say it is that the banks found a way to hire a person to sit in a house they wanted to gamble on; this was a subprime loan with a prepayment penalty. More to follow.