A few weeks ago, I put up a post on the neuroscience of subprime mortgages. A significant percentage of subprime loans get customers by advertising low introductory teaser rates, which trick the brain into making an irrational decision. In essence, we are duped into using our short-sighted emotional mind to make a long-term financial decision.
Look, for example, at the popular 2/28 loan, which consists of a low, fixed-interest rate for the first two years and a much higher, adjustable rate for the next twenty-eight. Most people taking out a 2/28 loan can't afford the higher interest rates that will hit later on. It's not unusual for interest payments on a 2/28 loan to double within four years. (That's why you're seeing such high foreclosure rates in the sub-prime market.)
David Laibson, a Harvard economist/neuroeconomist who specializes in hyperbolic discounting, has recently proposed a very simple way to rid the market of such teaser mortgages:
To prevent lending institutions from offering misleading deals that trap borrowers, we should require that all future mortgage loans be prepayable with no penalty. This is an easy, simple rule. The rule will have the effect of leading banks to stop offering many of the teaser rates that serve as loss leaders (pay too little interest for the first 18 months but then pay extra on the back end). These loss leaders are often confusing and tempting for borrowers. Banks won't want to offer loss leaders if borrowers can get out of the loan without paying a penalty after the subsidized payment period -- the teaser period -- ends.
My proposal would not discourage banks from offering sensible adjustable rate mortgages (those without a loss leader component). Borrowers should be allowed to take out a mortgage pegged to short-term rates. That's not a loss leader and such mortgages will still be offered if prepayment is made penalty-free. My proposal will only hit the mortgages with early loss leaders built into the payment stream.
That's on Justin Fox's blog. Check it out.
This is not a new idea, but so far the lending industry has always won. They actually have one valid argument against it. Many borrowers do actually need a structured loan for a large purchase like a house. Young, recently married recent graduates would be a good example. A good, financially sound structured loan would still be impossible if the borrowers could take the good early terms then bail out when the regular payments kick in.
The problem loans come primarily from lack of responsible qualifying on the part of the lenders. They wanted to make these loans and were willing to look the other way on the qualification process. No structured loan should be available except to people with very high credit scores and very valid reasons for believing that their income will increase in the near future. The ads you are talking about were specifically designed to attract marginal borrowers.
Tightened regulation and real enforcement may be the only real option. FHA programs for marginal lenders should be enlarged and better funded. Left to its own the market will always give you huge swings, bubbles and collapses.
I can't read about loan setups like this without remembering Dave Barry's paraphrase of the sales line on them from when he was shopping for his first house in Miami. Something like: "Sure, that's more than you can afford now; but that's not a problem when you consider that ten years from now, at your current rate of advancement in your career, you'll be dead."
I can't help but wonder if that wasn't the basic scenario that many of the borrowers in these cases were considering ...
The only way to make it fair is to change the law to correct the imbalance. In the 2/28, after the initial 2 years of fixed rates, the lender should be free to charge whatever he wants, but the borrower should be free to pay only what he wants.
Thus if the borrower thinks the lender is gouging him by jacking the monthly from $1400 to $1800, then he can punish the lender by paying only, say, $40.
If the lender is seen as predatory, then he risks getting paid only what he collected the first two years and, at worst, may be forced to forgive the entire balance of the loan.
Clearly, it is absurd to consider mortage a contract when the one party is free to decide the terms of the contact after it's signed.
I believe that this idea isn't particularly well targeted at the sub-prime mortgage problem.
The assumption here is that sub-prime loans were profitable because borrowers would be locked into unfavorable terms, and I do not believe that assumption is correct.
I believe that sub-prime loans (or at least the extreme ones) are not profitable to the holder of the loan. They were profitable to the issuer of the loan because that entity would make the loan, collect fees, then sell the loan to another entity before it would be defaulted upon. As it turns out the ultimate someone else was actually a sucker who did not understand what they were buying, vastly overpaid for it, and is now learning of their error.
So a change intended to make loans currently unprofitable for the holder a bit more unprofitable for the holder isn't quite on target.
It may be a good idea to make mortgages more freely payable in general, but to me it does not seem to be a very likely solution to our current problem, or a good way to prevent future similar problems. I don't think one more round of refinancing would have fixed anything. The system seems to have been operating on refinancing fueled by increasing prices for several years already.
More on target would be better debt ratings, requirements that issuers of loans hold those loans, or something else that could inhibit the selling of bad debt to suckers.
As it turns out the ultimate someone else was actually a sucker who did not understand what they were buying, vastly overpaid for it, and is now learning of their error.
I travel a lot and in my downtime I visit tract housing to see what kind of value middle America gets.
In some areas I am shocked at how much value is available for $150-200K. Shocked in the sense that it's too much. This is in some metropolitan areas where the property is tiny, but the homes on the mini-plot can be anywhere from 1700-2400sq ft. Most of these tract developments sprung up in the last 6-8 years.
One thing I noted was that many of the people in these tracts really couldn't afford to live there without the teaser rates and it would obviously get bad for everyone once the foreclosures started or once the ARM started raising up. They lived on the edge of their income and depended on the prospect of upward mobility to allow them to live in that style beyond the teaser rates.
When I ask the tract sales staff on the wisdom of a neighborhood full of people living at the limits of their income, they feel it's an elitist question -- who am I to restrict people's ability to get access to the American Dream. And these homes, at least inside, are pretty top of the line in features, appliances and architectural amenities.
For years the view was that working class and low income families didn't get affordable housing or credit. They still didn't, but it was easy enough to appeal to them and make them think that something finally changed for them. It is an error that they made, but a sad one.