Wallison and Rational Betting

Peter Wallison responds to the defense of the Consumer Financial Protection Agency by Elizabeth Warren over at the BaselineScenario. Here is Wallison:

The irony here is that Warren is not herself perceptive enough to understand what the consumers who took the subprime mortgages actually understood. She assumes they were cheated or manipulated into taking a subprime mortgage. Let’s look at what really happened…

Now, why would a consumer take a “subprime” mortgage when he or she is eligible for a prime mortgage? For one thing, when the home was bought, probably some time between 2003 and 2007, the consumer knew perfectly well that home prices were rising, and that the home was likely to be worth a good deal more a year later than it was worth at the time of purchase. That would mean that even if there was a low or no downpayment the purchaser would soon have equity in the home simply from price appreciation over time…

In addition, the consumer knows what he is earning currently, and—assuming that the economy continues to grow—what he is likely to be earning in the future as his skills and seniority increase. He can then estimate pretty well what would be a comfortable monthly payment. Oddly enough, if the consumer takes a subprime mortgage—one with a low or no downpayment and perhaps a low adjustable rate—he can afford a larger house in a better neighborhood, perhaps even near better schools, for the same monthly payment that he would be required to make for the prime loan.

So, our hypothetical consumer was not being cheated—as the Left would like to believe—but in many (and probably most) cases made rational choices based on what was known at the time.

A few things. I’ve been meaning to link to The 10 Myths about the Subprime Crisis, because I think it is almost perfect (I’ll discuss it later). One myth is the idea of the “low adjustable rate” – in general the option-ARMs had higher rates than the equivalent prime rate. But Wallison makes a good point – people will adjust their risk profile to account for their information on how they are going to do. I might just juggle hacky-sacks and someon else might juggle chainsaws; you can tell we are both equally matched to our comfort level because we’ll drop something at the same rate. Wallison says it is the same thing with subprime mortgages; it attracted those best suited to handle them.

In that same way, since consumers that have better fundamentals choose to take on more risk, it’s a simple statistical test to confirm this hypothesis by seeing that the default rates for subprime loans are the same as the default rates for prime loans:

fedsubprime

Oh wait, that’s completely wrong.

Wallison is on to something though. Subprime loans allow people to bet on housing prices rising. But whom? Consumers could always bet on housing with prime loans, indeed by definition they are, since they are making an investment in a home. But the interesting part about subprime loans, something we’ve tried to convey here, is that they allow banks to bet as well.

If you take out a loan on a house, and the value of the house doubles, you are really happy. But you don’t pay the bank any more money on your mortgage. The upside is capped for the bank; they have no exposure (or delta, if you will) to the price of the house. They have secondary exposures to the house price; if your house price goes up you are less likely to default, and if you do the recovery is worth more. But these are secondary things conditional on your actions; they aren’t the real money from the rise, or the bubble.

With subprime, by forcing a refinancing with significant prepayment penalties after 2 years, the bank can bet on the house price rising enough to cover those penalties. I walk through this scenario here. If house prices are going to rise 5%, the penalties eat up 3-4%, and the household gets a little left over. The bank is, in effect, hiring someone to sit in a house they couldn’t otherwise afford. Do we want banks to do this, rampant real-estate speculation? No. We want banks to be banks.

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16 Responses to Wallison and Rational Betting

  1. TK says:

    I think this sentence in the last paragraph — “The bank is, in effect, hiring someone to sit in a house they couldn’t afford with subprime loans.” — should read “…without subprime loans.” Right?

  2. Milton Recht says:

    There are geographical and demographic variations in certain financial product usage, sometimes even on a local level (a richer and poorer part of town). To make broad-brush statements about mortgage products defaults, one has to control for the differences of the various groups that use the products that may lead to different default rates.

    A mortgage default is one of three ways to terminate a mortgage. The other two are refinancing the mortgage and selling the home. All three methods reduce mortgage payments. Homeowners who face an inability to continue mortgage payments at their current levels (potential defaults) can use any of the three methods depending on the individual circumstances. Homeowners have private knowledge about their default potential and can sell or refinance, at a lower monthly mortgage payment, to avoid default without the bank knowing of the increase in default risk.

    The private knowledge also allows a homebuyer at the beginning of a home buying process to self-select and self-underwrite the type of mortgage product that is best for their situation and that reduces their default risk and cost to acceptable levels.

    When a homeowner cannot qualify for a refinancing (e.g., unemployment, reduction in wages, increase in non-mortgage debt, decrease in home value requiring more equity, etc.), there is the home sale option. Selling a home is a viable solution, until home prices stop appreciating or decline. An increase in the time on the market for a home to sell also decreases the viability of home sales as a solution. When the economy slows down, unemployment increases, house price appreciation stops, home prices decline and time on the market increases. There will be an expected increase in mortgage defaults.

    Mortgage defaults will increase with higher unemployment rates, declines in home values and longer time on the for sale market. Attributing different default rates to different mortgage products requires controlling for the differences across the varying products in the factors that contribute to defaults to see what, if any, incremental defaults are caused by mortgage products. For example, minorities have a much higher unemployment rate in this recession than non-minorities. Attributing an increase in mortgage defaults of minorities over non-minorities to a particular type of mortgage without controlling for the higher rate of unemployment will result in an unsubstantiated conclusion. Likewise, a greater decline in home prices in particular geographical area will increase defaults, but there may be social factors for a higher use of certain mortgage products in that area. The apparent increase in defaults will not be due to the product but will be due to the greater home price decline.

    Financial product usage varies by region and demographics. Unless one controls for the default factors of the various groups that use the different products, any conclusions about mortgage products causing or increasing mortgage defaults is speculative and unsubstantiated.

  3. Mike says:

    TK – fixed, thanks.

    Milton, thanks for the comment.

    “To make broad-brush statements about mortgage products defaults, one has to control for the differences of the various groups that use the products that may lead to different default rates…The private knowledge also allows a homebuyer at the beginning of a home buying process to self-select and self-underwrite the type of mortgage product that is best for their situation and that reduces their default risk and cost to acceptable levels.”

    Aren’t these statements in conflict? Wallison is saying there is nothing interesting about the groups outside the risk tolerances/levels. People who can handle risk take risker mortgages; as such they should even out.

    I look at the situation and see people being steered into high risk loans by agents rationally looking to collect their YSP. Wallison sees people taking on high risk loans by self-will. Fair, by why would an individual take on a high-risk loan if they couldn’t handle it?

    If your argument is that people with subprime loans are riskier on average than the terms of the loan and we have to control for that I agree completely – however that’s my point, not Wallison’s.

  4. Milton Recht says:

    The issue about steering and risk tolerance levels is complex. In an ideal world, banks could use all default information to determine risk and interest lending rate. In the real world, banks resort to useful broad measures of risk, such as credit scores, for legal reasons. Credit scores, while valid for the general population, appear to have a consistent, systemic bias for subgroups of the general population. For some subgroups, the credit score overstates the risk of loan default and for others it understates the risk of loan default. Adjustments to credit scores or interest rates based on a subgroup’s characteristics probably would not survive a discrimination lawsuit. Certainly, it would be a media and political nightmare for any company or bank that adjusted its mortgage product offering or interest rate because a borrower belonged to a subgroup.

    Overtime, as an economist would expect, the group that is underpaying for its risk will see diminished availability of prime loans and increased availability of higher rate subprime loans. The opposite effect would occur for the group overpaying for its risk of default. When the fed looks into discriminatory lending using actual lending and default rates, it does not find any discrimination. Advocacy groups use credit scores (and not actual loan defaults) to analyze lending patterns and they find unjustified steering into high rate products. Likewise, credit scores do not necessarily capture other group characteristics, such as an increased likelihood of job loss in an economic downturn. One would expect these identified group characteristics that affect future loan default to affect product offerings and rates, but in a way that appears non-discriminatory, such as steering as opposed to denials.

    Yes, there is probably steering, but most lenders do not show abnormal profits on these loans when adjusted for their extra default rates.

    If the potential borrower finds the mortgage overpriced or too risky, why would that consumer go through with the mortgage? I do not know of any studies of the 30- 40 percent or so of non-homeowners, but I wonder how many can afford to buy a home. If some could theoretically afford a home, but find the perceived costs or risk too great, then there is support for Wallison. I think you will find that home ownership rates decline for riskier mortgages than for lower risk mortgages, but the data needs to be compared to the equivalent risk population to determine if it is the lender or borrower that is determining the type of mortgage.

    I think there are many different forces at work in current mortgage defaults, but economic forces are the dominant factor. Mortgage terminations (defaults and prepayment due to sales and refinancing) are probably relatively stable, but the mix among the three categories varies based on economic conditions. (With a caveat that there are lags: sales lag refinancing and defaults lag sales). In times of high unemployment and declining home prices, defaults increase but refinancing and sales decline. In better times, defaults decline but sales and refinancing increase.

    The current increased rate of subprime defaults is predominantly due to higher unemployment and a decreased home value for these borrowers than to the higher interest rate on the mortgage. Mortgage studies need to eliminate the defaults due to the economy and price declines before attributing any of the defaults to the interest rate or type of mortgage. For the most part, (excluding the regional fed studies, which generally do a good job of controlling for economic and risk variables), many mistakenly put most of the blame for the increase in mortgage defaults on the interest rate and type of mortgage and not the economy or home price declines.

    Mortgage type and interest rate is a coincident factor and not a causal factor of defaults. It will be especially true if the same economic and predictive factors that cause defaults have resulted in banks offering different mortgage interest rates and products to different groups, through steering or otherwise.

  5. dsquared says:

    [we’ll drop something at the same rate]

    I would have thought this would be “we’ll suffer serious injuries at the same rate[1]“; ie, you’d drop the hacky sacks a lot more often than the circus juggler dropped his chainsaws but that’s why you chose to juggle something soft.

    In unrelated news, I think the error in Wallison’s post is that he hasn’t looked at the relevant literature, which does indeed show that lots of consumers have mortgage deals which are strictly dominated by other deals on the market, but have been mis-sold them by mortgage brokers who were paid based on commission. The FTC has been all over this issue for years.

    [1] in small samples …

  6. Not the Mike You're Looking For says:

    I was going to make this comment on an earlier post, when you (Mike) said that interest rates would handle LTV problems, which I found puzzling. Some of the comments here also strike me as suffering from the same assumption: that interest rates provide an efficient means of sorting borrowers by risk.

    Actually, the opposite is true. Loans have a limited downside (you can only lose the amount of the loan) with an unlimited upside. (Theoretically at least, the value of your house could double or triple.) If you raise the interest rate, you’re going to gradually lose the borrowers who intend to repay in favor of the riskier borrowers. Three hundred years ago Adam Smith expressed this principle:

    “If the legal rate of interest in Great Britain, for example, was fixed so high as eight or ten per cent, the greater part of the money which was to be lent would be lent to prodigals and projectors [people who spend or speculate recklessly], who alone would be willing to give this high interest….A great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into those which were most likely to waste and destroy it.”

    Joseph Stiglitz and Andrew Weiss present the same argument more formally in “Credit Rationing in Markets with Imperfect Information,” American Economic Review 71 (Jun. 1981): 393-410.

    The point is that yes, the interest rates are causing self-selection, but this is exactly the problem. The question is, who is doing the selection? Is it the borrowers or the mortgage brokers?

  7. racerx says:

    The big change in subprime lending between 2004 and 2008 is not the % of ARM vs Fixed. Subprime loans are and have been predominately ARMs. What changed is the % of loans that were purchase transactions as opposed to refi. Traditionally subprime loans were low LTV cashout refinance transactions. These loans were truly predatory in the sense that the end result was transfer of equity from the consumer to the lender. I still don’t see how a high ltv subprime purchase loan is predatory. If the borrower has no skin in the game what is the lender taking from the borrower?

    • Not the Mike You're Looking For says:

      It’s not the lender. It’s what the intermediary (mortgage broker, securitizer) is taking. S/he gets bigger fees while exploiting the other parties to the transaction–the borrower and lender.

      • racerx says:

        Good point. No doubt the broker/intermediary is steering but doesn’t the lender set the limits? The lender makes the guidelines and sets the compensation. Other than a race to the bottom, what caused the lenders to get so screwed up?

      • Not the Mike You're Looking For says:

        You would think so, racerx, but no. When I talk about “lenders,” I mean the institutions that bought tranches of securitized mortgages or entered repurchase agreements for asset-backed commercial paper (ABCP) based upon a securitization pool. They made their decisions based upon the rating agencies’ assessment of the underlying loans. As you probably already know, two things were wrong with this picture: (1) the rating agencies were working with faulty models of the real estate market; and (2) they were getting paid by the very people who were putting together the securitization pools.

        Plus, firms like AIG were selling “guarantees” (credit default swaps) on the tranches, so there seemed to be an extra layer of safety.

        So the “lenders” in this case did not determine any of the limits of lending, nor did they delve too deeply into the characteristics of the underlying mortgages. They simply saw that this was an investment that paid a high yield but had a AAA bond rating.

  8. Mike says:

    Huh. This has gotten very interesting. dsquared is right Milton – the YSP and other fees based on interest hikes explains the rerouting before you need to get to risk models. Indeed even if people were good credit risks, it is rational to try and get them to pony up on interest since you get a cut of it.

    As for the employment factors, Wallison specifically states that people know this and other things related to their future earnings and choose a mortgage accordingly.

    Mike/racerx – I’ll read more up on this later. Fascinating stuff, and thanks for writing it. I feel like I should just sit down and read everything Stiglitz has ever written.

  9. Milton Recht says:

    Mike,
    Mortgage markets are competitive with varied pricing of products. Unless you can show me that within the product groups i.e., subprime, arm, conventional, high ltv, etc., in local markets that prices, including points and fees, are collusive, how can their be routing, steering and YSP and fee explanations. The customer can always go to a competitor with a lower price for the same product.

    In every local market, there is more than one mortgage product vendor and there is a range of prices for each product. Bankers understand this very well. They control their product mix and individual product volumes by pricing above the competition to turn off a product’s volume.

  10. Mike says:

    Re price sensitivity:

    Forbes, Nov 16, 1998 p050(1)
    Willing lender of last resort Banking.

    (Apollo Management LP )(Brief Article)(Company Profile)
    Seth Lubove

    ===
    ..Within a year after buying the old Weyerhaeuser operation, Black and the company’s management steered it from mostly conforming mortgages to subprime lending…says Scott McAfee, who runs the since-renamed WMC Mortgage Corp. for Black…

    Just as the deal was closing, the quasifederal agencies that buy packages of conforming mortgages hiked the required credit ratings of so-called A borrowers. Thus did Fannie Mae and Freddie Mac demote millions into the subprime category and into the arms of Black and the other 10% lenders. “This business isn’t price sensitive,” says McAfee. “Borrowers are far more concerned about just getting the loan.”
    ===

    Certainly the kings of 1990s subprime believed that the business wasn’t price sensitive. They are actually declaring this to the business community, daring them to enter the business. Why shouldn’t I believe the words of the Kings of Subprime Lending?

  11. sippycupnation says:

    I don’t do well with math models. I’m a narrative girl, a writer. These are the words Paulson used last fall in a press release he issued on 9/19/08 to define the crisis:

    “As we all know, lax lending practices earlier this decade led to irresponsible lending and irresponsible borrowing. This simply put too many families into mortgages they could not afford. We are seeing the impact on homeowners and neighborhoods, with 5 million homeowners now delinquent or in foreclosure. What began as a sub-prime lending problem has spread to other, less-risky mortgages, and contributed to excess home inventories that have pushed down home prices for responsible homeowners.”

    Lax lending practices – putting people into homes they could not afford – with a particular focus on the subprime market because, as Mike K says “….subprime loans allow people to bet on housing prices rising.”

    To me – freed from the mathematical equations that made Harvard MBAs feel this was all okay – I simply cannot understand a business environment that offered far too many people loans they would never be able to afford based on the rather ephemeral assumption housing prices would continue to rise stratospherically.

    (If you bought or sold real estate during the bubble, you were an idiot if you truly believed that kind of increase in value was at all sustainable.)

    It is sickening that people continue to absolve the financial community for their absolutely appalling business judgment and flawed math models and instead place the blame on the backs of the consumers – and only the consumers.

    Wallison obviously hasn’t listened to This American Life’s “Giant Pool of Money” episode, where an Iraq vet is rooked – rooked! by a mortgage broker who made $18K commission on the sub-prime loan he sold to the vet.

    I agree with Mike. We don’t want banks to be shysters. We want banks to be banks.

  12. Chris says:

    Wallison’s argument makes perfect sense if you replace the human homebuyer with a freshwater-economic-theory superrational, omniscient market participant.

    It breaks down horribly when applied to human beings.

    This tells me that Wallison is not practicing economics, he is practicing pseudoeconomics. It bears the same relationship to the study of actual economies composed of human beings that alchemy does to chemistry.

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