Subprime Mortgages: The System Is Working
[September/October 2007]
By Peter Linneman, PhD
Subprime mortgages are nothing new. Since the inception of Fannie Mae and Freddie Mac mortgage underwriting standards, there have always been non-conforming mortgages with high interest rates.
Traditionally the subprime mortgage market served two sets of borrowers. The first was those with poor credit histories, high loan-to-value (LTV) ratios, or high ratios of payments to income ("front-end" and "back-end" ratios)—all factors that predict increased likelihood of default. The second was those who were either unable or unwilling to document their credit histories, LTV ratios, or payment-to-income ratios.
Delinquency and default rates have historically been much higher between both groups of subprime borrowers. For example, borrowers with high payment-to-income ratios may have trouble making ends meet while still paying the mortgage; poor credit histories may indicate more willingness to let repayment commitments slip; and loans that lack full underwriting documentation may suffer from lender mistakes, borrower fraud or both.
There has always been a substantial overlap between the two groups of subprime borrowers. For example, borrowers choosing low-doc loans often have high levels of unreported cash income and prefer to pay 50 to 300 basis points more on their mortgage rather than to pay roughly 40 percent of their unreported income to the IRS. In their mind, it is a small (and deductible) price to pay.
Many subprime households are employed in cyclically exposed sectors of the economy, disproportionately decreasing their ability to pay during recessions. Moreover, the disproportionate prevalence of illegal income among low-doc subprime mortgage borrowers means they frequently are unable to pay. (That's especially true when the government has them spend some time in jail!) Thus, subprime borrowers may be able to service their mortgages as long as their employment situation remains solid, but they may be more vulnerable to income disruptions that prevent them from making mortgage payments.
The world of subprime mortgages began to change in 2004, with a new breed of borrowers. From 2004 through 2006, the share of subprime mortgages rose from about 5 percent, to nearly 20 percent of all new mortgages. We believe this increase partially reflects the growth of "investment" home buyers, many of whom not only had poor credit histories, but also could not meet total debt to income criteria beyond their primary residence mortgage.
As condo investments became the investment du jour, these budding Buffetts began to take out multiple subprime mortgages. Is it coincidence that, as spec homes and condos grew to approximately 10 percent to 15 percent of new home sales, the subprime mortgage share of all new mortgages grew to 10 percent to 15 percent? We suspect that the two phenomena are highly interrelated. After all, someone financed these investors.
Mortgage defaults by resident owners generally occur only when people cannot afford to pay the mortgage, primarily due to employment loss or health problems, rather than negative equity. The continued strength of the U.S. economy, with a 4.5 percent unemployment rate and rising personal income, means that massive defaults are unlikely even in the face of falling home prices.
In contrast, when investment owners are faced with the prospect of negative equity, few have qualms about ceasing payment. This is particularly true of the many "investors" with low credit ratings who thought ever rising home prices would allow them to easily flip these homes at a handsome profit well before rate increases kicked in, perhaps even before the unit was completed. In effect, they viewed subprime mortgages as cheap bridge financing for a "can't miss" investment, which was a fallacy.
Not surprisingly, the highest delinquency and default rates are clustered in areas such as Cleveland, Detroit, Louisiana and Mississippi where local recessions make it difficult for some resident owners to make their mortgage payments. These markets are home to old-fashioned, rather than investor, delinquencies. However, delinquencies for subprime mortgages are also rapidly rising in a number of markets where investors were active. More is to come in heavy investor markets.
Gone are the days when defaulting residential loans in a region were held by the local banks that also served as the primary source of growth capital for area businesses. As a result, we expect the U.S. economy will shrug off the subprime mortgages problem, much as it has shrugged off myriad other problems since the 2001 recession.
The true losses from subprime mortgages have already occurred, without permanently damaging the economy. Specifically, capital was needlessly channeled to prematurely build some 300,000 to 500,000 homes, much of which was financed by subprime mortgages. The economic loss is that this misallocated capital could have been productively employed elsewhere in the economy. For capitalism to work, those who misallocate capital must pay the price. The beauty of the subprime mortgages situation is that they are paying it rapidly and visibly.
Peter Linneman is a professor of Real Estate and Finance at the Wharton School of Business at the University of Pennsylvania and principal of Linneman Associates.
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