Ban Prepayment Penalties 2: Banks Gambling on Real Estate

The Economist does a great follow up on the posts for Friday, about thinking of subprime loans as also reflecting a collapse of prime mortgages.

One surprising thing about subprime borrowers is that up until the mid 2000s most loans were used to refinance rather than purchase a new home. So many subprime borrowers initially qualified for a prime loan, but then refinanced using subprime. This signals deeper financial issues with many subprime borrowers. It would take a significant shock to lower your credit score and make you refinance your mortgage at a higher rate. It suggests many subprime borrowers were struggling to stay in a home they already bought through a prime lender.

So we are getting a better picture on the consumer demand side. But one question floating out there is “why would banks want to issue these high-risk, perpetually refinancing subprime loans?” In trying to start to tie together some threads I’ve been thinking and writing about over the past month, I want to explain how to think of this in terms of prepayment penalties, something that had been outlawed until the early 1980s but was allowed as part of the first wave of neoliberal financial deregulation.

Looking at another Boston Fed paper, Making Sense of the Subprime Crisis, we see this:

Investors allocated appreciable fractions of their portfolios to the subprime market because, in one key sense, it was considered less risky than the prime market. The issue was prepayments, and the evidence showed that subprime borrowers prepaid much less efficiently than prime borrowers, meaning that they did not immediately exploit advantageous changes in interest rates to refinance into lower rate loans. Thus, the sensitivity of the income stream from a pool of subprime loans to interest rate changes was lower than the sensitivity of a pool of prime mortgages. According to classical finance theory, one could even argue that subprime loans were less risky in an absolute sense. While subprime borrowers had a lot of idiosyncratic risk, as evidenced by their problematic credit histories, such borrower-specific shocks can be diversified away in a large enough pool. In addition, the absolute level of prepayment (rather than its sensitivity to interest rate changes) of subprime loans is quite high, reflecting the fact that borrowers with such loans either resolve their personal financial difficulties and graduate into a prime loan or encounter further problems and refinance again into a new subprime loan, terminating the previous loan. However, this prepayment was also thought to be effectively uncorrelated across borrowers and not tightly related to changes in the interest rate environment. Mortgage pricing revolved around the sensitivity of refinancing to interest rates; subprime loans appeared to be a useful class of assets whose cash flow was not particularly correlated with interest rate shocks. Thus, Bank A analysts wrote, in 2005:

[Subprime] prepayments are more stable than prepayments on prime mort-
gages adding appeal to [subprime] securities.

Let’s look again at this chart from Friday. Sitting as that analyst in 2005, you’d see that the loans from 2003 were 80% prepaid in 2005. And most of those loans have prepayment penalties.

Let’s look at some rough numbers.

Prime mortgages are roughly 98% prepayment penalty free. Prime mortgage holders choose against prepayment penalties in mass numbers. This makes me not worried about efficiency loses from banning them. Given that prepayment penalties have the same expected value for both parties as paying a small interest rate hike across all time periods – and if markets are efficient they should, no free lunches and all that – consumers choose to self-insure, to smooth risk and payments across time rather than concentrate them. That is good for consumers, and it makes sense they choose it. (I can expand on this, and probably will, at some point in the future, though it is tangential for this point now.)

Banks holding home loans, and investment banks holding bonds of home loans, do not have exposure to rising house prices. They have secondary exposures – there are less defaults if people have more equity in their homes, which they do if prices rises. If people do default, they get better recovery on their collateral, the house itself. But if house prices are rising, banks, commercial or investment, aren’t getting a cut.

70%+ of subprime mortgages had prepayment penalties. They were one of the specific features of them (they are, in a sense, how we define subprime mortgages).

Let’s assume a mortgage, 30 years, at 8% interest for the first 2 years, something much higher beyond, with a prepayment penalty for 3 years. We’ll talk in percentages so the housing amount doesn’t matter, though there’s no downpayment (100% LTV). At 8% interest, a borrower has paid off a little less than 2% of their mortgage balance after two years of payments.

There are a lot of prepayment penalties, but a good rule of thumb is six months interest. With that in mind, a prepayment penalty is going to be roughly 4%. So after two years, when, as we see from the chart above, 80% of mortgage holders will repay, the consumer is +2% – 4 % = negative 2% on his equity in his home. This is incredibly risky for the banks. This is the exact profile of someone who walks away from their house. Why did the banks make the loans?

Let’s assume that the bank thinks house prices will rise. If house prices rises 10% during that 2-year time period, the homeowner now has ~12% equity in the home, ~3.5% (4%, adjust for the new house cost) of which is transfered to the bank in form of the prepayment penalty. In addition to a high interest rate, they get a jackpot 4% every time this crap loan is recycled.

So this loan has value for the bank if housing rises, and lower value if housing decreases. Because of the quick recycling of these loans, where they refinance every two years, it is direct exposure. Instead of providing consumers with loans so they can buy homes, they are instead taking bets on house prices, using consumers as people who sit in and look after the homes they are betting on. The purpose is less to get consumers to build good equity but rather find ways to transfer equity from the home to the bank itself.

So that’s why I find arguments that some form of political correctness, or government mandates, or the CRA were required for these subprime loans to go out lacking. I’ve heard things like “analysts couldn’t communicate the true risks of these borrowers because they’d get sued for discrimination” – but looking for risky homeowners is the whole point! Only risky homeowners would be willing to take this gamble, as prime homeowners avoid prepayment penalties like the plague, and if consumers had good enough credit to refinance into a prime loan, the merry-go-round of refinancing wouldn’t pay out the same way.

And seek them out they did. This model of subprime lender less as consumers gambling on house prices but banks betting on them directly makes sense only if they thought house prices would rise for the foreseeable future. Is that what the analyst thought? Going back to that first paper, quoting a 2005 paper (HPA stands for Housing Price Appreciation):

We see that they thought the “meltdown” scenario, a mere 5% likelihood of happening, so way out there in the tail, would be -5% for three years. They assumed it was 80% likely house prices would still be appreciating. The actual decline is more like a third, with some hot spots as high as 50% losses. So they thought what is reality only had less than a percent chance of happening. No wonder the stress tests have to be massaged so much.

There is a lot of economic debate over how much looser lending standard inflated the housing bubble, causing a bigger crash and have externalities for all kinds of people. I don’t know how conclusive the evidence is one way or the other, but these banks may have been like a dog chasing its own tail with these returns.

As we think about banking regulation going forward, we want banks to do less in terms of risky investments. Getting a direct, beta-like, exposure on housing is bad for banks and consumers. Prepayment penalties allow them to do that, and prepayment penalties should be the first to go.