Confessions of a Subprime Lender

by Richard Bitner

  Consider how this problem becomes magnified when applied to the stated income loan. We already know that from 2002 to 2006 the percentage of subprime borrowers using stated income loans was steadily rising. We don’t know the DTI ratios since income was never disclosed, but a basic assumption can be made that a large percentage wouldn’t have qualified had they been required to prove income. This means their initial DTI ratios would be higher than the levels shown for the borrowers in column two, and the adjusted DTI ratios in column three would also be higher. It adds up to an enormously disproportionate amount of borrowers who can’t afford their mortgage payments.

  The solution is to qualify borrowers at the time of loan application using the fully indexed rate. Instead of using the low start rate that ARMs are known for, the lender would qualify the borrower as if the ARM were making its first interest rate adjustment. This is calculated by adding the loan’s predetermined margin to a specific monetary index. The majority of subprime loans used the 6-month LIBOR (London Interbank Offered Rate) as the index of choice. Historically, the fully indexed rate is 2 to 2.25 percent higher than the start rate at the time of the loan’s closing. If this policy had existed a few years ago, many of the borrowers currently in default would have been denied a mortgage. This approach mirrors the current proposal in the House of Representatives.

  Escrow Accounts

  Of all the poor decisions the industry made, not requiring subprime borrowers to use escrow accounts for collecting property tax and insurance payments ranks near the top. Many “A” credit borrowers choose to set up escrow accounts for the convenience of not paying a large bill at year-end. Others prefer to manage the process themselves, believing it’s better to earn interest on the money and control their funds. Since many subprime borrowers live paycheck-to-paycheck, expecting them to save money each month to pay for taxes and insurance is unrealistic. These borrowers needed the discipline an escrow account provided, but the industry never made it mandatory.

  The solution is simple. If a borrower is classified as high-risk, escrow accounts should be mandatory. The current bill in the House of Representatives establishes a long list of provisions that trigger an escrow account requirement, ranging from the interest rate to the loan-to-value percentage. I’ll spare you the details, but suffice it to say that most of the requirements are well thought out. The only item that’s missing is an exception for borrowers who have more than six months of cash reserves to cover PITI (principal, interest, taxes, and insurance) after closing. If substantial reserves are in place, the need for an escrow account is not as critical.

  Mandatory Counseling

  One of the more unique products offered by the lending industry is the reverse mortgage, which enables seniors to tap into their home equity without having to make any payments. Part of the approval process requires all seniors to attend a HUD-approved counseling session. The same logic should apply to the subprime borrower. Attending a simple one-hour HUD-approved counseling session that provides basic information about the mortgage process would go a long way toward protecting the borrower.

  A borrower armed with knowledge becomes a deterrent to abusive behavior. The reason we don’t hear stories about seniors getting bad deals for reverse mortgages is due, in part, to the education they receive. Once the appropriate safeguards are in place, the industry will start to rid itself of the worst violators. The House of Representatives has included counseling as part of its final bill by establishing an Office of Housing Counseling through the Department of Housing and Urban Development.

  Taking the Cheat Out of the Liar

  The basic premise for the stated income loan has changed drastically over the last 20 years. Helping the high FICO score, a self-employed borrower who possesses a down payment is a far cry from lending money to anyone with a pulse. Since the bill in the House effectively calls for the elimination of the stated income loan, it’s conceivable the final version will do the same. The industry drastically overshot the mark with the stated income loan and calling for its total elimination might appear to be a wise decision, but it’s a shortsighted policy. We only need to look at the history of this product to understand why.

  For years prior to the subprime debacle, the lending industry offered stated or limited documentation loans without any significant problems. Why? It managed the risk appropriately. As we look back on the actions of the industry these last few years, we now understand that the industry forgot it was in the risk business. That was a mistake of monumental proportions, but it doesn’t mean the basic principles that originally justified the use of stated income loans have changed.

  A borrower with a 750 credit score who can’t prove his income is still a better credit risk than someone with a 600 score and three jobs. Why? It goes back to a credit score’s ability to predict performance. A borrower with a 750 score has a strong record of making timely payments. The discipline that’s required to earn this score tells us there’s a very small chance he’s going to default, even if he isn’t employed. The 600 score borrower hasn’t shown this level of discipline. That doesn’t mean we arbitrarily draw lines in the sand and say those with scores greater than “x” can qualify and others can’t. It means borrowers at any credit grade can qualify for a stated income loan provided all the credit and risk factors are managed appropriately.

  For all the complexity of the loan business, it’s not rocket science. If a borrower with a 600 score wants a stated income loan, he needs to have more skin in the game than someone with a 750 score. While market forces should be allowed to dictate what’s the appropriate level of down payment for each credit grade, a significant cash reserve requirement would go a long way toward managing the risk for this product.

  The biggest flaw of the stated income loan, especially at the lower end of the credit spectrum, was the lack of cash reserves after closing. Therefore, the lending law should include a significant cash reserve requirement for all loans in which the lender is unable to verify a borrower’s income. It should include the following provisions:• Borrowers with credit scores above 660 should meet a minimum nine-month cash reserve requirement (principal, interest, taxes, and insurance) after all closing costs are accounted for.

  • Borrowers below 660 should meet a 12-month cash reserve requirement.

  In all cases, borrowers should have to show proof of funds for a minimum of two months. Most subprime loans had no such seasoning requirement, which meant the funds were borrowed from relatives at the last minute, put into a bank account, and then verified. Since most home purchase transactions take 60 days or less to conduct, there’s no need to extend the seasoning requirement beyond that.

  If greater cash reserves had been required, many borrowers who financed with marginal credit and no proof of income would have been declined. The stated or limited documentation loan works only if borrowers who can’t prove income have cash reserves to fall back on and the industry prices the loan for the additional risk. When the interest rate for a stated income loan started to mirror the interest rate for a full documentation loan, it was the beginning of the end.

  Despite all my posturing about not instilling limitations on the availability of credit, there’s one area that warrants consideration. A subprime wage earner—someone who earns a fixed wage—shouldn’t be allowed to qualify for a stated income loan. If a borrower’s income doesn’t fluctuate, he should be required to prove it in order to qualify. The stated income program was originally designed to serve the needs of the self-employed borrower and that’s where it should stay.

  The Current Crisis

  The next two years may very well be the worst in the history of the U.S. housing market. Friends and colleagues usually regard me as an optimist but, unfortunately, I’ve witnessed the gluttony that infested the lending industry and I’m afraid there is no silver lining to the dark cloud that’s over the industry now. The questions of concern going forward should be: Just how bad will this crisis get, at what point will the market stabilize,
and is there anything that can or should be done to reduce the fallout?

  Most experts predict foreclosures will peak sometime in 2009, with the total number reaching two million. The markets that experienced the highest levels of home appreciation, such as Las Vegas and Miami, are projected to see home values drop by as much as 40 to 50 percent (from peak to trough). While areas that never experienced a huge run-up in home prices aren’t projecting a drop in the median price of homes, there are two factors that could be wild cards in the housing equation.

  The first one is Pay-Option ARMs. A Pay-Option ARM is different from a traditional subprime ARM in several ways. While both have low start rates, the Pay-Option ARM often has ultralow start rates, sometimes as low as 1 percent. As the name implies, the Pay-Option ARM allows borrowers to choose from one of several different payment options. It’s often referred to as a neg-am (negative amortization) loan because the principal loan balance will increase if the borrower makes only the minimum payment. This product also differs in that each loan comes with a maximum negative allowance. This means that when the principal loan balance reaches a certain level, typically between 110 to 125 percent of the original loan amount depending on how the mortgage was structured, the payment increases. Unlike a traditional ARM, when a Pay-Option ARM adjusts, the payment can increase by as much as two to three times the original amount.

  The product was originally conceived as a loan option for astute investors who wanted to use their money for something other than paying mortgage principal. As home prices soared, it morphed into the only method available for hundreds of thousands of borrowers to qualify in overpriced markets like California. The numbers paint a troubling picture.

  An industry veteran with 20 years experience in mortgage lending, who asked not to be identified, worked for one of the largest and most aggressive Pay-Option ARM lenders in California. These are the figures he shared with respect to his former employer’s book of business. Nearly three-fourths of the borrowers with Pay-Option ARMs made the minimum monthly payment. Over 80 percent of the loans during the last few years were written as stated income. The majority of all Pay-Option ARMs have second mortgages behind them (piggybacks), which puts the combined loan-to-value percentage at or above 90 percent. Even if the figures for all Pay-Option ARMs are only half as bad as he claims, it means there is a second wave to this mortgage crisis.

  Credit Suisse recently published a report that broke down the volume of mortgage ARM resets by month and product type over the next seven years. It shows that Pay-Option ARMs will begin to significantly reset in late 2009 and peak in 2011. There are more than $250 billion worth of Pay-Option ARMs scheduled to reset by 2011. In all likelihood, values will have dropped in overvalued markets by that time, making it impossible to refinance. When you consider all of these factors, the issues with Pay-Option ARMs could easily dwarf the subprime implosion. In some ways, it’s already happening. It just has not yet received widespread media attention.

  In the introduction to this book, I mentioned that the mortgage crisis is not currently contained to the subprime arena. Nowhere is this more evident than in the world of Alt-A mortgages, of which Pay-Option ARMs are a subset. In late February 2008, Mike “Mish” Shedlock of Global Economic Trend Analysis, one of the most widely read economic blogs in the United States, posted a screen shot forwarded to him by a colleague from a specific Washington Mutual Alt-A mortgage pool known as WMALT 2007-0C1. The screen breaks down the pool of mortgages into the typical categories, including delinquencies. Here are some of the highlights. The average FICO score is 705—not spectacular but respectable by most standards. We don’t know for certain if these are Pay-Option ARMs, but there’s a good chance most of them are with over 60 percent of the entire pool coming from California and Florida. Most of the loans were written with little to no money down and almost 90 percent of the pool is comprised of stated income loans.

  The chart breaks down performance by month, starting with July 2007. Keep in mind that the pool has been in existence for only nine months at the time this book was going to press. In that short period, this pool is already showing a foreclosure rate of 13.17 percent. Add REOs (real estate owned by the lender) into the mix and the figure goes to 15 percent. Even the vintage 2006 subprime pools didn’t default as quickly.

  A look at the details shows that nearly 93 percent of the pool was rated AAA, yet almost 15 percent of the entire pool is in foreclosure or REO after nine months. If there was ever a doubt about the ineptitude of the rating agencies, this pool of loans is proof.

  The numbers seem to indicate that borrowers may be walking away when they are only 30 or 60 days delinquent, not even waiting for foreclosure. In December 2007, the 90 days delinquent category stood at 3.79 percent. Even if every one of these delinquencies became a foreclosure, the figure should only double to 7.58 percent in January. Instead, the foreclosure figure jumped to 13.17 percent. These figures suggest the recent phenomenon known as jingle mail—when borrowers mail their keys back to their lenders before going to foreclosure—is alive and well.

  The second wild card is credit availability. While a national lending bill will have some impact in this area, my concern comes from watching the mortgage industry during these last six months. Since the middle of 2007, lenders have eliminated or restricted program guidelines as a result of rising delinquencies. As losses rise throughout 2008, and there is little reason to think they won’t, this could lead to a disturbing trend.

  The concern is that a pattern will develop that progressively gets worse as time goes along. A rise in mortgage defaults will lead to increased losses for investors, causing lenders to pull back even further on guidelines. The reduction in credit means more borrowers won’t qualify. When they don’t buy homes, inventories will rise, forcing more borrowers into default. Since there are two million homeowners with subprime ARMs set to adjust in the next 24 months (the majority occurring in the next year), there is no historical reference, short of the Great Depression, for what’s about to happen in the national housing market. To make matters worse, about the time we’ve cleared through the inventory of foreclosures because of subprime ARMs, the Pay-Option ARMs will begin to reset. The bottom won’t come until prices have dropped far enough so that the housing supply can stabilize. Since the current national housing supply is nearly double what it should be (a six-month supply is considered normal), it’s impossible to predict when the market will achieve equilibrium.

  I have no pearls of wisdom on how to prevent the large number of pending foreclosures. The Bush administration’s plan to freeze ARM rates will help some borrowers, but the overall impact is going to be minimal. Since the program is voluntary, it will work only if the Wall Street firms sell the idea to the investment funds that hold the mortgage-backed securities—an unlikely scenario. Additionally, tranche warfare is going to create barriers that limit mortgage servicers from making changes.

  The business of mortgage securitization not only helped finance a multitude of unqualified borrowers, it’s now preventing servicers from modifying their loans. When the problem reaches critical mass, don’t be surprised if “mortgage securitization giveth and mortgage securitization taketh away” becomes the industry’s motto.

  Perhaps what should be addressed are the ramifications of a bailout. Any plan that helps distressed borrowers will come at the expense of taxpayers or investors who purchased the securities. Some of the groups who invested in subprime securities include cities, counties, and even school boards. A state-run fund in Florida has declined so drastically that officials had to freeze it, preventing some school districts from paying their teachers. It’s hard to justify helping borrowers who knew what they were getting into when basic governmental services are suffering as a result of their delinquencies.

  Even a plan to freeze rates has consequences. Somewhere in the splicing and dicing of a mortgage-backed security, an investor is entitled to an increased revenue stream when the ARM rates start to adjust. Admittedly,
there is a threat of default which could lead to greater losses for the investor, but why should anybody, investor or taxpayer, foot the bill for borrowers who are in over their heads? When will borrowers be held accountable for their actions?

  In the midst of this mess, we shouldn’t forget that this country suffers from an affordability crisis. Since income has not kept pace with the cost of housing over the last ten years, the dream of homeownership will remain just that, a dream, for many people, especially those who live in the most overinflated markets. Perhaps the only solution is to let the cards fall where they may and allow the natural forces of the market to correct themselves. It may not be the most popular sentiment and the economic implications would be staggering, but given the depth and severity of this problem, there may not be any other choice.

  Final Thoughts

  When people used to ask me what I did for a living, the answer was never, “I’m a mortgage lender.” Instead I would tell them, “I’m a subprime lender.” I knew the system was less than perfect, but it really felt like we in the subprime business made a positive difference in people’s lives. Perhaps we deluded ourselves to a certain degree, but since our loans performed well relative to our investors’ expectations, it was easy to think that way.

  Although my gut still tells me we did more good than harm, I also realize that at some point logic and risk-based thinking gave way to our desire to keep growing the business. I can point fingers at a lot of different groups, but at the end of the day we ourselves still pulled the trigger on every deal. We decided whether a borrower was a good credit risk and we funded the loan using our own money. No one else made that final decision. With such power comes responsibility, and like it or not, I can’t sit here without putting some of the blame back onto myself.