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.
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.