Issues & Opinions

I can’t be certain, since I didn’t read Wednesday’s LA Times, NY Times, or Financial Times, but based at least on tangentially related articles in WSJ and the UK Telegraph, there’s a rumble in the markets about cheap consumer debt, and the ill effects thereof.

First came the WSJ story, “DAY OF RECKONING - ‘Subprime’ Aftermath: Losing the Family Home“.

Mortgages Bolstered Detroit’s Middle Class — Until Money Ran Out

By MARK WHITEHOUSE
May 30, 2007; Page A1

DETROIT — For decades, the 5100 block of West Outer Drive in Detroit has been a model of middle-class home ownership, part of an urban enclave of well-kept Colonial residences and manicured lawns. But on a recent spring day, locals saw something disturbing: dandelions growing wild on several properties.

Ouch. It’s a long story, well worth a read if you haven’t seen it (and you’ve got a WSJ online subscription).

The Telegraph story, in tomorrow morning’s edition, is entitled “A million debtors face court action“. It’s specific to the British market, and isn’t directly related to subprime mortgages, but does involve easy credit:

Up to a million households struggling with rising living costs and lured by offers of easy credit will face court action over their debts this year.

Easy credit, generally described, can be laid at the doorstep of banks trying too hard to put money to work, saturating the market in good credit risks, and forcing a need to move down-market to the riskier borrowers. It happens in cycles, is specific to the banking and credit card industry, and, aside from central bank interest rate target setting, tends not to be driven by government attempts to help broaden the credit base. The same problem, of course, exists at times (including now) in the US.

Where the US credit problem, typified by Detroit in the WSJ story, differs is that it’s not the banks and credit card companies driving the train. They’re involved, of course, but the prime drivers have been mortgage brokers (the 21st century version of used car salesmen?), Wall Street, and the federal government. No, it’s not been the Federal Reserve’s interest rate setting mechanism in this case, but instead the well-intentioned efforts to ensure that credit is more widely available, particularly for home purchases:

Back in its heyday, the idea that West Outer Drive could suffer from a glut of credit would have seemed far-fetched. Many blacks moving into the neighborhood had to either depend on federal mortgage programs or buy their homes outright. That’s because banks actively avoided lending to them, a practice known as “redlining” — a reference to maps that designated certain neighborhoods as unduly risky. Various attempts to get the money to flow, such as the Community Reinvestment Act of 1977, which pushed banks to do more lending in the communities where they operated, had only a limited effect.

Bank charters, and particularly those of banks seeking to merge or sell themselves to larger banks, have periodically been tied up in state and federal oversight, with one of the exits from that maze being commitments to increase their home community lending. All well and good.

Where does Wall Street come into the picture?

But beginning in the mid-1990s, the evolution of subprime lending from a local niche business to a global market drastically rearranged lenders’ incentives. Instead of putting their own money at risk, mortgage lenders began reselling loans at a profit to Wall Street banks. The bankers, in turn, transformed a large chunk of the subprime loans into highly rated securities, which attracted investors from all over the world by paying a better return than other securities with the same rating. The investors cared much more about the broader qualities of the securities — things like the average credit score and overall geographic distribution — than exactly where and to whom the loans were being made.

There are many good reasons for consolidating loans into securities, not least of which is the ability, just as insurance companies do, to pool risk and manage it via a larger sample by statistical means. The fact that a market has evolved and matured to facilitate that is utterly unsurprising. The fact that sleazy mortgage brokers have seized on that market to essentially steal from unsuspecting or unsophisticated borrowers is equally unsurprising, and deeply unsettling to any right-thinking person.

Given the broad expanse of mortgage brokers who’ve hit the market in the past seven years, many feeding on borrowers’ silly belief that home prices would continue to rise to the skies, the benefits of homeownership have been overtaken, particularly in the imaginations of subprime borrowers, by visions of massive capital gains. And with those potential (now highly unlikely) gains in mind, people have rushed into debts they would never have incurred in leaner banking times.

Several vignettes from the WSJ story that don’t flatter the mortgage brokers:

Minority-dominated communities attracted more than their fair share of subprime loans, which carry higher interest rates than traditional mortgages. A 2006 study by the Center for Responsible Lending found that African-Americans were between 6% and 29% more likely to get higher-rate loans than white borrowers with the same credit quality.

Is that redlining? An argument can be made that it’s not. Not a good argument, but an argument.

“A lot of people were steered into subprime loans because of the area they were in, even though they could have qualified for something better,” says John Bettis, president of broker Urban Mortgage in Detroit. He says a broker’s commission on a $100,000 subprime loan could easily reach $5,000, while the commission on a similar prime loan typically wouldn’t exceed $3,000.

That extra 66% commission? From selling initially attractive mortgage rates that soon became quite ugly. Like this one:

April Williams was feeling the pain of the downturn back in 2002, when she saw an ad from subprime lender World Wide Financial Services Inc. offering cash to solve her financial problems. …after a loan officer from World Wide paid a visit, they became convinced they could afford stainless-steel appliances, custom tile, a new bay window, and central air-conditioning — and a $195,500 loan to retire their old mortgage and pay for the improvements. The loan carried an interest rate of 9.75% for the first two years, then a “margin” of 9.125 percentage points over the benchmark short-term rate at which banks lend money to each other — known as the London interbank offered rate, or Libor. The average subprime loan charges a margin of about 6.5% over six-month Libor, which as of Tuesday stood at 5.38%.

“I knew better than to be stupid like that,” she says. “But they caught me at a time when I was down.”

(ellipsis and emphasis mine)

Of course she knew better, but she was borrowing in an environment that seemed to encourage hucksters and dirtballs to actively seek out people in her position. And she was hardly the only one:

Raymond Dixon, a 36-year-old with his own business installing security systems, borrowed $180,000 from Fremont Investment & Loan in 2004 to buy a first home for himself, his wife and six children, across the street from Ms. Hollifield at 5151 West Outer Drive. After all the papers had been signed, he says, he realized that he had paid more than $20,000 to the broker and other go-betweens. “They took us for a ride,” he says.

Good grief. Sure, he got taken for a ride, and he should have known better, but what ever happened to the protections that are supposed to be built into the system to keep people from rushing into bad deals? That $20,000 for the broker and the go-betweens? It was based on the juice available when the interest rate reset and Dixon’s monthly mortgage payment went up by 33%.

But the other structural problem in the market is summarized here:

“You have no time to look really deeply at every single borrower,” says Michael Thiemann, chief investment officer at Collineo Asset Management GmbH, a Dortmund, Germany-based firm that invests on behalf of European banks and insurance companies. “You’re looking at statistical distributions.”

It’s possible to offer too much separation between lenders and risk, to the point where the lenders can rely on statistics, rather than reality, to comfort themselves that they’ve done well. And where the statistics tell untruths is in cases like West Outer Drive, where:

Subprime mortgages accounted for more than half of all loans made from 2002 though 2006 in the 48235 ZIP Code, which includes the 5100 block of West Outer Drive, according to estimates from First American LoanPerformance. Over that period, the total volume of subprime lending in the ZIP Code amounted to more than half a billion dollars — mostly in the form of adjustable-rate mortgages, the payments on which are fixed for an initial period then rise and fall with short-term interest rates.

That’s the other side of the coin, and the counterargument to whether redlining is occurring when “African-Americans are 6% and 29% more likely to get higher-rate loans”. When a neighborhood like West Outer Drive is inundated with homeowners who’ve been flatly taken advantage of by mortgage brokers who are unchecked by the financing system, the good risks get mixed in with the results of the bad, and the good risks become bad risks themselves, just due to neighborhood deterioration. Improperly managed, synonymous in my mind with “managed with far too many levels of indirection between borrower, property, and lender”, pockets of default risk can be found in any securitized mortgage pool. Mix the good with the bad and the mortgage pool can come out unscathed. Not so the neighborhoods with clustered risk that doesn’t register in the larger statistical picture of the mortgage pool.

The Basel Capital Accord of 1988, designed to manage risk in the global banking system, has been the subject of much debate since then. Among the many suggestions for change over the years, you could find many titles, such as “Reforming Bank Capital Regulation: Using Subordinated Debt to Enhance Market and Supervisory Discipline“. The key to such regulatory changes is simple - it ensures that a noteworthy chunk of a bank’s capital comes in a form that invites far closer scrutiny, from more sophisticated investors who have the power to shut a bank down if its operations seem to be spinning out of risk control.

If such a think makes sense for the banking system (and it does), it hardly seems rational to exempt the mortgage market from some strictures that would force its participants to be far more cognizant of the riskiness, and clustered risks, of its borrowers. Too much indirection in risk concern, let alone risk control, can have severe effects on neighborhoods, cities (Detroit needs all the help it can get), and social classes. I’m all for free markets and the ability to parcel out risk to willing buyers, but without any recourse to the ultimate purveyors of these poisoned dreams of homeownership (the mortgage brokers), the risk that’s being sold off into the mortgage pools is only imagined to be all the risk that really exists.

Why should regulation be considered to seriously crack down on the abuses? Because we’ve seen what happens when Detroit is in flames, including every Halloween. Left unchecked, this issue could become one in which the federal government is forced, politically, to step in and bail out those who’ve been fleeced. I shudder to think of the cost of that, political and financial, even though doing so seems more justified than spending billions to turn New Orleans back into something it never was.

Addendum - And no, rising Treasury yields aren’t going to be enough to solve the problem.

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