What was a subprime loan modeled on?

Even after the CJR demolished it, John Carney lays out his full theory on how the CRA caused so many subprime loans here. I think this is an important point to clarify, as it’s going to float out there in the popular consciousness. It’s a good question why so many people gave out so many questionable loans, and it is natural for people to think someone made them; I think Megan concedes the argument but still wants to see the CRA dismantled. I think the CRA is worth defending, so let’s look at the argument closer.

Carney acknowledges two key points: (1) CRA loans were very profitable for the banks in question and (2) most subprime loans were from places with no CRA coverage. He thinks that CRA loans looked so profitable that subprime lenders wanted in on that, so they duplicated their efforts but to no avail.

A subprime loan is not a slightly worse CRA loan.

Subprime loans aren’t like CRA loans. Carney focuses a lot on the LTV numbers, but that is only one characteristic of a subprime loan. My favorite chart of the subprime data:

80% of the subprime mortgages expired in 30 months; they perpetually had to be refinanced. 75%+ of subprime mortages had a prepayment penalty. This is not at all what CRA loans looked like. CRA rooted for solid, longer-term mortgages. If they ever rooted for a lot of prepayment penalties and fees to get tacked onto their loans, I’ve never seen it.

Another important statistic – in Massachusetts 60% of subprime defaults were originated in prime mortgages. So a large chunk of subprime loans were really prime loans that were collapsing. Either the breadwinners were experiencing “income volatility” or their spending was out of control or whatever. Capturing the disintegrating middle-class on terrible terms is not an objective of the CRA.

I’m going to go into some new research about a favorite topic around here, the roles the consistent refinancing, prepayment penalties and fees did to change the mortgage market, and how a consumer’s bill of rights that took us back to 1982 would be a great move. In case you don’t trust a pseudonymous blogger with a free wordpress account, it’s where the elite research is going to converge when discussing this in my humble opinion. Here’s Did Prepayments Sustain the Subprime Market? by Bhardwaj and Sengupta from the St. Louis Fed:

Using loan-level data on subprime mortgages, we present evidence on the uniqueness of subprime mortgage design. We show that the viability of such products was predicated on the appreciation of house prices. In a regime of rising house prices, a borrowers avoided default by prepaying the loan…Gorton (2008) argues that lenders designed subprime mortgages as bridge-financing to the borrower over short horizons for mutual benefit from house price appreciation…Subprime mortgages were meant to be rolled over and each time the horizon deliberately kept short to limit the lenderís exposure to high-risk borrowers.

The rationality is nothing like that of a CRA loan. It was something new, something about consistent refinancing with a huge amount of fees and penalties, using jumps in the interest rate to force prepayments. They were bad-faith loans, loans that were not meant to be repaid back, unlike a CRA loan.

“Wait, Mike. I’m getting a weird sense of déjà vu. I feel like I’ve heard this before.”

Really, where?

“A loan that wasn’t really meant to be paid off. but instead to be paid off enough with high interest rates with higher jumps to force additional payments to occur, and with a lot of the value coming from fees and penalties.”

That does sound familiar.

“Hey wait – that’s how credit cards work!”

Good metaphor. Indeed, the logic of a subprime loan looks disturbingly like the logic of a credit card. If we had to backwards out what motivated someone to go ahead and try to make these subprime loans, you’d have to say they looked at the profitable credit card market and said “ya know what, let’s design a mortgage that looks exactly like that.” The credit card model is about as far away as you can get from the CRA model – and it is very easy to imagine subprime lenders licking their lips at the sweet profits the credit card companies were making moreso than the tiny CRA market.

Update: Barry just placed a $100,000 bet saying someone could not convince a jury over him about this issue. God bless the internet.

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11 Responses to What was a subprime loan modeled on?

  1. racerx says:

    …60% of subprime defaults were originated in prime mortgages. So a large chunk of subprime loans were really prime loans that were collapsing

    Would CRA loans have counted as prime loans in this statistic? Did CRA lending increase the size of the subrpime market?

  2. uff the fluff says:

    The preponderance of the evidence certainly seems to absolve the Community Reinvestment Act.

    Also, your spellcheck turned Carney into Cagney, and now Joe Weisenthal can go by Lacey, which is nice.

  3. Mike says:

    Sigh. Misspelled name fixed, no offense meant to anyone. I shouldn’t write these late at night.

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  7. Another Mike says:

    Another way that subprime mortgages were like credit cards: the minimum payment option of negative-amortization loans.

    My brother recently moved into a townhouse that he bought from a bank. The foreclosure papers were still in the house, so I had a look. The former mortgagor “owned” the house for exactly one year and owed $8,000 more when he left than when he started (paid $251,000, owed $259,000). I wish I had held onto the documents, as I can’t confirm this number, but I believe the initial interest rate was something like 11 percent.

  8. MutantCapitalism says:

    Prime or subprime? That’s not the point. 20/20 hindsight analysts err when they focus on loan product and origination shortcomings. Yes, there were certainly plenty of issues in there but the rubber really meets the road in servicing – mortgage servicing.
    To be more specific Mortgage Servicing Fraud. Google it for a real eye opener on extent of this epidemic.
    These 2 FTC Settlements on servicer fraud involved over 367,000 mortgage servicing fraud victims:
    http://www.ftc.gov/os/caselist/0323014.shtm FTC v. Fairbanks/SelectPortfolioServicing
    and
    http://www.ftc.gov/os/caselist/0623031/index.shtm FTC v. EMC/Bear Stearns
    Many would like you to believe that credit default swap excesses on ABX Index were all to do with risk management. They weren’t. Investment Banks placed rigged bets on specifically targeted REITs because they knew full well that their subsidiary or contract servicers were busily manufacturing bogus defaults. This will go down as the biggest insider trader scheme of all time. Bank on it!

  9. Anal_yst says:

    I like Carney for what he’s good at; he’s entertaining, and even gets stuff out there very early in the game. However, as you (barry, everyone else) has pointed out, sometimes he has a tendency to delude himself into believing he’s right, even in the midst of an ever-mounting pile of evidence to the contrary.

    This isn’t the 1st, nor will it be the last (for him, or any number of other prognosticators, not necessarily excluding myself)

  10. Ron Stone says:

    It’s all about greed. Subprime loans were fast and easy to issue so the borrower got a quick, usually painless loan to buy a home and the lenders flipped them for quick profits. Everyone was happy until reality set in. I believe the concept of a subprime loan was good. And while there were a good many people that got loans that shouldn’t, the big problem came from pre-payment penalties and ARMs. Without these two elements, the defaults would have been dramatically reduced.

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