Since yesterday, I have been reading a number of articles on the recent subprime lending fiasco. Personally, I feel there are a lot of fundamental issues at play in the whole mess. The more I read about it, the more I am convinced that it’s not *subprime lending* that is at fault. It’s more about our ignorance, attitudes, and our constant tendency to keep finding loopholes in a given “system”. Here is my take on the issue (couldn’t resist writing about this). Towards the end, there is a list of all the articles (by fellow bloggers and from others sources) that I referred.
Subprime lending isn’t supposed to be bad
There are some people who blame subprime lenders for “lowering their lending standards”. But, isn’t that the whole point of subprime lending? The concept is to make housing *affordable* to people with not-so-great credit. It’s for people who wouldn’t have qualified for a mortgage with the regular lending criteria. According to the US Department of Housing and Urban Development, subprime lending can be summarized in two sentences as:
Typically, subprime loans are for persons with blemished or limited credit histories. The loans carry a higher rate of interest than prime loans to compensate for increased credit risk.
There is an increased risk associated with subprime lending (remember credit is equivalent to financial responsibility in the money world), but it’s not really a bad business model (ideally)…the loans are designed in such a way as to take into account the higher probability of delinquency. So ideally, it was a system that was supposed to work.
So what went wrong?
Flat out reason: the human tendency to abuse an established system. Don’t we love to hunt for loopholes in order to get more than what we need or deserve? In this case, ignorance (or stupidity) and greed on part of the consumers, and dishonesty and greed on part of the lending system are the medium through which the subprime lending system is being abused. I will highlight some of the issues by the way of examples below.
What are people with annual income of $54,000 doing in a house that costs $543,000?
I first stumbled on this piece of news at SVB’s post on the subprime lending issue @ The Digerati Life:
Two years ago, Luis Mapula was living in a converted garage with his wife and two daughters and earning $54,000 a year as a fence company construction worker. Then, almost like magic, he became the owner of a $543,000 home with no down payment.
This is an example of greed and stupidity on part of the consumer (in my opinion). Agreed that the their real estate agent told them some lies, fudged their numbers, and made it look rosy. But, how hard is it to realize that the house is just beyond their means? If you have just $1 and someone claims that you can buy an iPod with that kind of money, wouldn’t there be some amount of doubt in your mind about the authenticity of that claim? Wouldn’t you ask a few people about their opinion on such a claim before you give your money away? In this case, there are two reasons why you would give your money to the $1 iPod guy: 1. Your greed wants an iPod in just $1, and 2. Ignorance (or plain stupidity) convinces you that it’s really possible to get an iPod in $1. Then, when the guy sends you a bill for $499 *shipping charges*, who will you blame? Complaining against the $1 iPod guy does not absolve you of your lack of personal accountability….you should have done your homework well before falling for the shady deal.
Similar concerns about consumer attitudes are expressed by JLP @ AllFinancialmatters; by Paul @ Extreme Perspective ; and by Gaming the Credit System.
Cases of cheating
Here is an excerpt from a quoted piece of a Wall Street Journal article on JLP’s post:
In 2001, Ms. Smith, living on $540 a month in government benefits, was encouraged by a contractor to apply for a loan to finance home repairs. After two loan applications were rejected, a broker submitted a third showing that she had monthly income of $1,499 and was employed at a senior-citizens home though she had actually retired 10 years before, she said. The $36,000 mortgage that First Union National Bank (now part of Wachovia Corp.) approved for her required a monthly payment of $360.33 for 15 years followed by a “balloon†payment — when she would be over 80 — of $30,981.48
and an excerpt from SanLuisObispo.com:
Though Mapula signed the loan application that was submitted to Long Beach Mortgage, his lawsuit says he learned later that it falsely claimed he was making almost $100,000 a year from two jobs and receiving an additional $16,800 a year in rental income. The application also said he had $19,700 in the bank, owned a $22,000 Acura and had $28,000 in furniture and personal property. Mapula said none of that was correct.
These are examples of greed and dishonesty, supposedly on part of brokers (or middlemen) and/or subprime lenders. Consumers’ greed and desperation only encourage such behavior. In some cases, fraudulent information may have been filed without the full knowledge of the borrower….but I think there may be a lot of cases in which the borrowers connived with the middlemen to file false information in order to qualify for something that is beyond their financial means. And, they are taking advantage (disadvantage) of the loopholes in the system that allow the flow of fraudulent information.
Laws and regulations can patch the loopholes in the system…but I am not sure what will remedy our greed and stupidity. Forgive me for being naive, but wouldn’t “living within your means” potentially solve most of the subprime lending problems?
There is certainly much more to subprime lending than what I have mentioned above…however I am just trying to point out some fundamental reasons behind the issue in a simplified manner. For detailed analysis and more examples, read through the following list of references.
Resources and more reading
- Allfinancialmatters: QotD: Subprime Mortgage Mess - Who’s to Blame?
- Gaming The Credit System: Re: JLP’s Subprime Lender Mess Question
- The Digerati Life: How To Kill Your Credit Instantly With Mortgage Fraud And Subprime Borrowing
- Extreme Perspective: Scammers and Personal Responsibility
- US Department of Housing and Urban Development: Subprime Lending
- Wikipedia: Subprime Lending
- Mortgage Professor: What is a Subprime Mortgage Lender?
- Silicon Valley Real Estate Blog: When Not to Buy a House
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Howdy, I’m a real estate agent and I don’t think the customer in this case was necessarily stupid. They were convinced they were living within their means.
Here’s how. A lender tells them that their payment will be affordable given their debt-to-income ratio. This is true, but their payment doesn’t cover their interest each month and gets tacked on to the end of their loan (negative amortization).
The lender qualified the buyer for this loan based on that ridiculously low payment — which in California is hundreds or thousands less than an interest-only or full P&I payment.
But the mortgage guy doesn’t tell the buyer that the rate goes away after a year. Now the buyer has to pay for a loan they never would have qualified for in the first place.
Also, there are stated income loans which were originally meant for entrepreneurs who couldn’t produce paystubs every two-weeks. In the industry, these loans are known as “liar loans” and they don’t require the same verification of funds as regular ones.
The point is that much of the problems were institutionalized. Real estate agents aren’t blameless either. I have an article titled “When Not to Buy a House” that discusses situations where buyers should think twice.
But, in California, anyone holding a real estate brokers license can do both homes and mortgages. And just by hiding the two key facts above, a naive but well-intentioned person can be convinced they can actually afford a home they can’t.
I’m all for personal responsibility but real estate is a trust business and I think it’s important not to completely blame the victim in this case.
Steve: Thanks for your input. I understand what you are saying. To that effect I brushed up on negative amortization, the 2-28 mortgage, and the “balloon payment” stuff.
Yeah…if the broker or agent lies (which is equivalent to holding back the two key facts) then it’s cheating (greed on part of the broker/lender). However, when they do lie…doesn’t the payments appear ridiculously low for the cost of the house? (I don’t have a feel for the numbers…but I am sure they will be disproportionately low). That should ring some alarm bells and the borrowers should start asking some questions at this point.
I completely understand that sometimes it’s not entirely the consumers fault.
Btw, thanks for mentioning your article, it is helpful. I should include it in the list of reading material above.
Thanks, Golbguru
You’re right that it should ring alarm bells. The number is really low. I did a quick Google search and found an ad for $938 per month on $500K for one of these trap loans.
The quick calc is that the regular payment (P&I) is $3000 or $2500 paying only interest assuming a 6% rate.
Unfortunately, it’s pretty convincing (and evil) when you hear, “Our bank is out to make money and we wouldn’t give you a loan where we don’t make it back. The beauty is that we [insert something about making it up in volume] so we can put you into this house for $938 per month.”
So you’re absolutely right that people should start asking questions and educating themselves!
Hi Golbguru: I like your site and find your articles informative, but on this one, I’m afraid I strongly disagree. To follow on with Steve’s comments above, I think you’ve given a bit too much credit to the conscience of the mortgage (particularly the sub-prime mortgage) industry. They want to make money. Period. And they don’t care what happens to those that get caught up in their misdealings.
As Steve said, they deceive lower income people (who may not have a good financial education) into thinking they can purchase homes/condos that are way out of their league. They convince them that they deserve to move up in the world, start owning a home, get the tax breaks, and on and on. The brokers don’t tell them the truth about what’s going on, and unfortunately, the buyers sometimes don’t know enough to ask.
The issue of personal responsibility is an interesting one. While I believe that people shouldn’t get into these types of deals if they don’t know what they’re doing, I also don’t believe that people with very poor credit should have the ability to get into these deals in the first place. These predatory lenders know that they can make a good profit on these folks, and really just don’t care about what happens to them when the interest rates start creeping up and pushing them right out the front door of their new homes; it’s all about the profit to them. No one deserves to be targeted and abused in this way, especially the low-income population that has not recourse when things go south.
For most victims of these loans, I highly doubt that they were looking for “loopholes” in the system; they were taken advantage of, pure and simple. They wanted a home and were deceived into thinking that it was a real possibility.
Of course, as with most things, you can always find some anecdotes that highlight the ones who truly should have known better. However, this problem would still be of enormous proportions even without their contribution to it.
Also, I don’t think the iPod analogy really applies. People who get into this trap honestly think that they will be able to buy their home for a specified monthly payment over a certain number of years; they are not trying to cheat the system by purchasing it for far below the market value.
Just my $0.02
And a quick note to Steve - thanks for your entry above - it was very good. I had never heard that the “liar loans” were initially intended for entrepreneurs who didn’t have a regular monthly income. At least now it makes sense why these existed in the first place!
Dave: disagreements are good. I have probably learned more through disagreements than through agreements.
I think you strike a chord with this: “The brokers don’t tell them the truth about what’s going on, and unfortunately, the buyers sometimes don’t know enough to ask.”
I have been thinking more about it over a long driving trip I made this evening. I wonder if most of these people who “don’t know enough to ask” are uneducated or old or not really up-to-date with technology (I am not blaming them or anything…just thinking aloud). If it was me…I can go on the internet, check loan rates, compare many different mortgage providers, discuss it with hundred other people and such. However, there may be people who are not in a position (due to circumstances) to gather such information….and I have my sympathies with them. They really suffer when brokers dupe them.
However, I don’t think there may be many people like those (I am just handwaving here…don’t have any numbers to support this). If that was the case, then there would have been an outcry over *fraud* …instead I hear an outcry over *subprime lending*.
I understand what you mean by “you can always find some anecdotes that highlight the ones who truly should have known better”…and it is probably true. However, the way things are going, it is very difficult to sort out the two issues: consumer greed and cheating-by-brokers. Probably there is some numerical measure of how many documented cases of *fraud* have been filed, but I haven’t found it yet.
About brokers trying to decieve people…on a lighter side, it reminds me of the Nigerian lottery scam. In that case people thought they would get a million dollars from a person in Nigeria by sending across their banking details. And the emails were pretty convincing (for some).
It’s every scammer’s job to convince people into unbelievable stuff…it’s up to the people to say NO!
Isn’t it like the saying “Guns don’t kill people, people kill people”. Subprime loans aren’t bad, but some of the people making subprime loans are!
Some folks who need subprime loans are easy marks for the bad guys. Perhaps they just don’t have any financial smarts. Or, maybe they’ve been through some sort of devistating event that caused them a financial hardship; debilitating illness, loss of job, death of a bread winner, etc. These folks are now forced into using subprime loans to get what they need, or to a lesser extent, what they want.
I agree, it’s just as Golbguru wrote, the subprime disaster is all about greed, ignorance, and dishonesty. Had the product(s) been used as a tool to help instead of personal gain, perhaps the term ’subprime’ would mean something other than what it does today….
I think that there are a lot of people who do not have your advantages (like the ability to search the internet in English) who probably were conned by professionals. How did you find out that you can’t buy a house worth $500k on a monthly payment of $1000 per month? You’d need to understand how mortgages work, be able to do the maths involved, read the small print of the loans etc which would require a reasonable education. (I realise that some people are just greedy, as well)
I think that any problems in the subprime lending industry (in the sense of companies going bust) are much more the fault of the companies concerned. They are better educated than there customers - by experience if nothing else.
Everyone in these examples was acting in his/her own self interest. The homebuyer, whether you consider him naive, dishonest, greedy or all, was trying to buy a house. The agent was trying to sell a house and get a commission. The bank was trying to make a loan they could then sell and make money on. So if everyone’s acting in his/her own self interest, what’s the problem? I believe the problem is with the entire credit system in America. Banks will give anyone a bucket of money if they ask for it. When people default, someone has to pay. That someone is the individual - you and me. In the form of PMI rates, taxes, higher borrowing costs.
Hi KMC, I agree with what you’re saying about “someone having to pay” and that it’s usually us consumers that get the short end.
What if I brought up a nuance? The most mortgages that aren’t lender’s “portfolio investments” get sold in the secondary market to outside investors. Some are former-government entities like Fannie Mae and Freddie Mac, others are large institutional investors.
I’ll put up the argument that institutional investors are compensated for their risk in the purchase price when they buy the mortgage-backed security. Once the mortgage is sold, the lender may not care whether the mortgage is paid because they’ve been paid already! Isn’t that strange?
The buying terms from Fred and Fannie are how government retains indirect control over lending policies without legislation. We help fund this and they lost $550MM Q3 2006.
One argument is that loose credit used responsibly keeps the U.S. economy going. Is a total system overhaul worth the risk of hurting the larger economy?
I don’t know the answer but it’d be interested to hear what folks think, or if they don’t buy the premise of the question.
Plonkee: I agree with this: “I think that there are a lot of people who do not have your advantages (like the ability to search the internet in English) who probably were conned by professionals.” I say something to that effect in response to Dave’s comment above. There must be people who got duped because of their circumstances, but I am not sure the *crisis* is mainly because of this reason. Also, such cases are usually easily attributable to the culprit (and hence relative easy to solve)..unless folks get duped by someone pretending to be a estate broker.
I am still looking for some numbers on how many cases of such kind of cheating occur.
A recent survey discovers that a surprisingly large portion of homeowners don’t know what type of a mortgage they have. It was 34%. That’s a lot. A mortgage is to most people the single largest debt they’ll ever sign for. Shouldn’t they take it more seriously than that? It’s a major financial obligation.
It’s true that the home loan market today is quite complex. There are lot of programs to choose from. The benefit of that diverse product selection, though, is that now the borrower can pretty much get a custom-made loan to meet his particular needs. And, there are some fast-talking loan salesmen around who won’t take a no for an answer. A few also misrepresent program features just to make it happen.
Still, the homeowner definitely bears partial responsibility for the subprime storm. If you commit to a large debt like this, you ought to make sure you’re dealing with a reputable lender. And that you understand fully the loan’s details. And that you’re able to make the payments. I think the lawyers call this due diligence.
Steve, as you correctly point out, Fannie and Freddie are publicly subsidized. As you know, what they do is use the full faith and credit of the U.S. government to guarantee mortgages and guarantee themselves a tidy profit, too. That’s what I meant by ‘we pay’ in higher taxes and borrowing costs.
On to your other comment about loose credit. I believe what we are experiencing is the illusion of credit used responsibly. I think it’s a house of cards. I just know of too many people making a habit of pushing out judgment day. They’re borrowing to pay off old debts.
Ok. Here’s the real skinny. Not to be in favor or against the ‘poor’ borrower- but here’s the reality of it. The yellow-bellied, snake-in-the-grass mortgage broker, simply was doing “their-job:” Selling money to consumers.
They (the financial institution that probably have closed its doors forever) simply did none of the above- but what they did do (according to UW guidelines) is ask the unassuming borrower to “fog-up this mirror, sign here and promise that the interest rate would never increase above 2% in the first 5 years.” This kind of lending is intolerable (sp?) and certainly the bulk of what’s going on today.
Take a look at what’s going on in Chicago:
http://chicagoviprealtors.typepad.com/chicago_metro_vip_realtor/2007/03/and_in_this_cor.html
And now politicians are starting to campaign that we should use tax dollars to bail out these people…
Can suggest me few points abount subprime in favors & agaist.
So I do not understand. So, should I get one of these subprime loans? Seems like a good deal. I make more than that beaner who draws in 54K and the house i want is only $520,000. I make 58K including my bonus. I live in California. sure is confusing….
That’s a great article and I wish, that more people would read it. The public is totally confused. If you hear the statements, why we are in such a mess, you will shake your head.
Please clear this up for me: When the Fed. lowered the interest rate by 0.5 points, there was a very short euphoria. Then another 0.25 %, with what benefit.
Would it not be healthier, if we would let the market work it out, we did need a correction anyway, now the dollar is hurt again and in my opinion the lowering of the interest rates was purely an unneccesary move, which has done more harm than good. Please enlighten me.
If the people that are losing ther homes due to subprime loans. It is on them. Us old timers saved are money for a down payment.Then got a loan at fixed rate for 30yrs. Then worked real hard to pay it off and it was not easy to do that.If you did not under stand the loan terms or had a third party look it over and explain it to you.Then you did,nt have any bussiness getting in this type of loan. There is no free ride in this country. YOU GET WHAT YOU WORK FOR.
Hi, My riposte on the subprime:
Racquel Welch (alias NR), The Subprime Mess & A New Order
By Guan Seng Khoo
Fantastic Ratings!, a re-make of the 1966 movie, Fantastic Voyage was shot in the summer of 2007 and won an “Oscar†for its surprising effects – an Oscar which I believe was well deserved. Although the effects have dated in the sense that they appear to be in a very 1960s psychedelic style, they are still impressive.
The storyline has a medical ratings team reduced to the size of microbes, who are given the task of being injected into a CDO’s body to cure him of an incurable blood clot on the brain – the subprime region. They have to navigate their way around the CDO structure and layers of artificial tranches, previously rated as healthy, in a green-powered submarine which has also been miniaturized. There are lots of action in the film – witness the volatility and liquidity crunch in the voyage - and the presence of Racquel Welch alias NR, in any film makes it more than watchable! Other cast members include the “nursing†members of the CityBears’ team, the ML (“mortgage lendersâ€, etc.) team and other luminaries on WS.
The premise of the re-make was based on the fact that prior to miniaturization, the health of the CDO was mistakenly rated and diagnosed based on its bodily (portfolio) measures like BP, BMI, etc., which tended to be very static in the “corporate body†framework, rather than on the dynamic unhealthy delinquency rates of the underlying “retail loan organsâ€. Investors depended heavily on these ratings/measures as the underlying parts of most CDOs, especially those that were retail-based and asset-backed, were very opaque.
Intermediaries, financial health structurers and insurers like CityBears and the other WS firms, typically also received the health information at the portfolio body level, rather than at the granular “loan†organ level. As the affliction grew from the subprime region and spread to the rest of the body (housing market), encompassing even the so-called healthier HB (home buyers) organs, the deteriorating prices rapidly impacted on those “ARM and HEL drug treatments†re-setting to higher thresholds, further exacerbating the crisis!
While part of the blame lie at the doors of the aggressive sales brokers, who reaped huge commissions by selling these exotic ARM treatments, one fundamental flaw as depicted in the re-make, Fantastic Ratings!, is the whole process of structuring and treating the CDO bodies, where the medical ratings team used an approach more suitable to a fairly static environment of a corporate body framework, rather than a more dynamic rating on the granular retail organs, where health delinquency rates may change more quickly. While the health ratings of bodies like CityBears tend to remain pristine, in spite of the widening spreads, at the microbial “consumer†organ level, if the individual cells lose their functions (jobs), their credit-worthiness would simply deteriorate. Here then, lies the nub of the subprime mess! Thank you.
Where are people getting all this money to buy 500k houses? Before a bank approves the loan, the borrower should have the money upfront! It’s either you have the money or you don’t. No BS. I smelled something odd when a regular house goes for 500k and there’s no job supporting it. What happens is housing greed/virus spreads when 1 person on the block is able to sell the home for 500k. The neighborhood then sees it and everyone is then convinced it’s worth that much. what I hate about all this is that apprasials also get jacked as well as property taxes. I dont care if they bought a new house next door, but why does government have to jack up property taxes? Do people really want to pay more? Why should I pay more because the neighbor is an idiot. This is just plain fraud. What’s worst is that government has bought some of this subprime stuff as part of debt and that’s part of the reason why property taxes in NJ are so high! Tax payers pay for other people’s mistakes. Oh well, I guess I have to look for a better paying job to support this. Now all the prices are so high not even people in decent professions making 100k can afford. Maybe it’s time to lower some property values by doing some property damage. How about some good old fashion crime and anarchy? I graduated from college, but would be up for a good old riot/rampage.
Our Loan Compliance Advisory Group is committed to helping “Protect The American Dream.” We are dedicated to helping Homeowners Nationwide, that may be victims of Deceptive Lending Practices.We are open for any suggestions on how we can help. Please contact Joseph Bisogno at (800) 529-7184 or visit our web site at: http://www.loancomplianceadvisorygroup.com
Hello, well I never did one of those sub prime mortgages but I would get a lot of them in the mail and they would say get 700k mortgage for $950 a month. I know myself better then these mortgage marketers and I would not lend myself 700k mortgage.
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