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.

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    6 Responses to Ban Prepayment Penalties 2: Banks Gambling on Real Estate

    1. Terry Ivanauskas says:

      So, let me see if I got it right. Your point is that Prepayment Penalties cause an adverse selection of borrowers, and banks are willing to take that as long as the home prices are going up and flipping the coin in their favor, right?

    2. Mike says:

      I’m trying to argue that the prepayment penalties give banks a direct exposure on housing, as if they are directly investing in house prices.

      They do this de facto in secondary effects – if house prices rise/fall, it impacts their defaults and their LGD. But it doesn’t have a direct effect on their portfolio. This, as we are seeing in the Too Big To Fail cases, has a disastrous effect when they take big housing bets.

      I’m using this blog to try and find a language to talk about embedded options with; it comes and goes in success 🙂

      Thanks for reading!

    3. Pingback: Will Dearman Lifestream » Daily Digest for May 13th, 2009

    4. Pingback: Mortgage Prepayment Penalties: Not The Beast You Perceive | But Then What

    5. q says:

      i’m confused about your argument. mind if i repeat it in different words and you tell me whether i have got it?

      your reasoning says that banks DO take direct house price risk with all mortgages, but it is in the form of selling a put, and that put depends on the borrower’s percentage equity.

      say i take out a prime mortgage and put 20% down. if i stop paying and the bank forecloses, the bank makes money except in the case where prices are 20% lower. if you go back to 2006, hardly anyone (certainly no one in the mortgage business) thought this would happen, so they probably figured the put was worth zero. this put option is contingent on foreclosure, and foreclosure is in turn somewhat dependent on the borrower’s equity.

      your logic seems to be that prepayment penalties lower the amount of equity the borrower has contingent on foreclosure, so it would make the put more valuable thereby increasing the exposure of the bank to house prices. however, does it also increase the probability of foreclosure?

      two other comments that may or may not be valuable:

      — credit liquidity is poorly understood and modeled even by experts and refinancing is strongly dependent on credit liquidity. any debt that needs to be rolled carries a strong risk that credit will not be available or will be very expensive at that time. this is where most of the systemic risk style tail risk lies (see your prime brokerage post). most pricing models completely ignore it. and on other end of this, if credit is loose and you can roll everything it becomes very hard to lose money by making loans — just loan someone the money they need to pay you the interest they owe you.

      — i’d think from a consumer point of view that you would want to reduce refinancings — period. if there is a prepayment option due to lower interest rates in the future, consumers aren’t going to be able to properly value it anyway and will be poor judges of optimality. in any case it complicates the contract for both the borrower and the risk holder. it also creates a lot of unnecessary paperwork and a lot of nonproductive labor due to refinancing. prepayment penalties are one way of reducing the value of this option — effectively paying the borrower the expected value of the option up front. (i might choose this if, for instance, i know i am lazy and expect to do a poor job timing a refinance or think it shouldn’t be my job to do so.) another way of doing this would be to do what i hear they do in canada — make the borrower take the prepayment interest rate risk. ie make the borrower pay the difference in PV between the future payments as measured from now and the future payments measured from the origination of the contract. that means that refinancing is neutral with respect to interest rates, so it is infrequent.

    6. Per Kurowski says:

      “Ms. Todd couldn’t get a mortgage in spite of her good credit and low debt. …. The 32-year-old changed careers, taking a permanent job as a teacher, to boost her chances.”

      And you think this is a good example?

      No prepayment penalty fees? If you think that to set up the client so as to be able to collect a prepayment penalty fees was what the banks did, a-priori, you sure got a conspiratorial mind that has gone berserk.

      In Europe for instance, if you finance yourself at a fixed rate, you have to pay a penalty rates for prepayment if rates go down for the simple reason that on the other side of this debtor is an investor who accepted to commit his money at a fix rate and who runs the risk of losing big if rates go up.

      I am all for good regulations but not just for the sake of putting in place regulations. The burden of proof should always be on the regulation not on the market.

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