No Runny Eggs

Since last fall we’ve heard a lot about “subprime” mortgages.   We’ve seen their troubles impact the housing, stock, and financial markets as well as cause consumers to feel less like spending.   We’ve heard about them and seen their impact but other than some passing references, I haven’t seen specifics about what these loans look like.

I found this article  today that gives some really frightening insight to what a typical subprime loan and  borrower  looks like.  

Warning:   what I am about to share is not for the financially faint of heart!

Based on a look at a typical group of loans that were originated in 2006, the report describes these attributes of the average subprime loan:

• The loan was 88% likely to have been an ARM (adjustable rate)
• The average originating interest rate was a “teaser” of 8.64%
• The average actual rate of the loan (if not bought down via the teaser) was 11.53%
• Upon adjustment, the maximum rate the interest could adjust to was 15.62%, the minimum was 8.62%
• Had the Fed not aggressively reduced rates, on average, these loans would have reset to a rate of 10.13% in June, 2008  and reset again to 11.53 in December, 2008.

What the heck?

What kind of a situation do you need to be in to sign up for a 8.64% “teaser” rate when the average 30 year fixed loan at the time was 6.83%?   What kind of a situation do you need to be into sign up for a loan where the only way for your interest rate to go is up (the lowest the loan could reset to was essentially the same rate as the original rate of the loan)?

Thanks for asking!

According to the underlying study done by the NYFed, the profile of  borrowers who took these loans was:

"¢ Two or more 30-day delinquencies in the last 12 months, or one or more 60-day
delinquencies in the last 24 months;
"¢ Judgment, foreclosure, repossession, or charge-off in the prior 24 months;
"¢ Bankruptcy in the last 5 years;
"¢ Relatively high default probability as evidenced by, for example, a credit bureau risk
score (FICO) of 660 or below (depending on the product/collateral), or other bureau or
proprietary scores with an equivalent default probability likelihood; and/or,
"¢ Debt service-to-income ratio of 50 percent or greater; or, otherwise limited ability to
cover family living expenses after deducting total debt-service requirements from
monthly income.

One last fun fact, as if we didn’t know, 57% of the loans were to cash out an existing loan; read that “took equity out of their homes.”

So where does this leave us?

On the one hand I’m mad.   Over 75% of the subprime loans reviewed in this study received the highest bond rating of AAA.   How stupid is that when you look at the make up of the borrowers.   With real interest rates nearly 5% above the norm, it was clear that there was significant risk in this package.   I hate the government involved in business but someone needs to step in and change the way that bond rating agencies do their rating.

On the other hand I’m encouraged.   We’ve still got a long way to go with these loans but the NYFed’s expectation is that only 9% of the loans will be loss.   This is substantially less than some of the numbers (upwards of 40% of the $1.4 Trillion US total) that I’ve seen thrown about.

Finally, I’m more convinced than ever that the government needs to stay out of “saving” mortgages.   When you look at the  combination of the lender allowing seriously substandard credit customers to get a loan, the rating agencies putting “Best of Class” on something that looked more like “should be sent to the glue factory” and borrowers who took loans either without any concern for their terms or on a gamble that should get them lifetime memberships in Gambler’s Anonymous, it’s obvious that while there is trouble yet to be solved with mortgages, these folks and not the US taxpayer, are the ones who should suffer the consequences.