The subprime lenders that worked: Part 3, more why
[Continued from the previous Part 1 and Part 2.]
Not only (as we saw two days ago) have the state housing finance agencies been able to lend in the subprime marketplace without experiencing high rates of default, we can also trace their lower defaults to specific structural elements in their business approach. Yesterday I listed the originate-and-hold business model, less aggressive underwriting, a prudent copycatting of market innovations. Today I’ve got three more things the HFAs doing right that the private subprime lenders didn’t.
Three things I know about her subprime lending
4. Pre-lending consumer education programs
As I’ve previously posted, a home is a complex financial instrument, mixing long-term planning, a large capital outlay (the down payment), behavioral changes, and substantial ongoing capital obligations. Owning a home requires a degree of financial sophistication considerably greater than being a renter — one of the many reasons people often start their independent adult living as renters and move up to homeownership. Logically, moving to homeownership means graduating to a new level of learning, and S&P says the HFAs make that consumer education integral to their loan origination:
HFAs see their primary motive as increasing housing affordability, so that their activities before and after the loan improve a borrower’s chances to repay it. HFAs offer homebuyer education classes that vary in rigor and length, but give an uninitiated customer background that helps prepare them to purchase a home.
Saving precedes borrowing, and first-time homebuyer applicants, who are by definition inexperienced in housing finance, need someone to trust as they learn about their new obligations and risks. A state-chartered, publicly accountable lender is and is perceived to be a bit more dispassionate and even altruistic, encouraging applicants to make decisions — including, sometimes, the decision not to buy a home.
Homebuyer education also provided the benefit of causing potential homeowners to pause, and even decide not to make purchases.
It’s not only lenders who win by losing; sometimes it’s aspirant homeowners who are better served by remaining renters.
5. Generous internal reserves
Though they operate as a business, because they are government-funded entities, HFAs have a cushion against failure — direct or indirect legislative appropriations — that means they need not run their engine in the red all the time.
I think the subprime margins are running too hot
The HFA single-family and multifamily indentures contain reserves that are sufficient to maintain adequate equity for foreclosure rates much higher than HFAs are experiencing.
They have the political and economic option to be more cautious in their deployment of capital, and to maintain larger reserves against adversity.
For example, an ‘AA’ rated indenture in a large state should be able to withstand foreclosure of 42% of the loans. Over-collateralization of assets versus bonds tends to be in the 5% to 15% range, which when combined with mortgage insurance and guarantees would enable an indenture to pay bonds should the foreclosure rate reach at least 42%, as described in the above example.
There’s a downside to all this accumulated money. Capital, like any other muscle, should be worked and toned.
I have twice the reserves I used to have
Leaving it on deposit in the HFA bank means that some number of houses that could be built, rehabbed, financed, sold, or made more affordable, in fact aren’t because the HFAs are being too cautious with their money. There are many contexts in which I believe HFAs could do much more than they do — but here, unquestionably, their high levels of reserves have protected them, and helped keep their bond costs low.
6. Active asset management with customized tools
The more financial tools you have, the healthier your portfolio
Because they hold on to their loans (even if packaged into bond issues), HFAs have their reputation behind their portfolio’s long-term performance. That, coupled with their public mission, makes them particularly attentive to asset management across several phases, starting with loan servicing and monitoring:
Following the closing on the loan, HFAs monitor loan repayment, sometimes even servicing their own loans.
That extends further to loss mitigation and restructuring:
HFAs also institute loss mitigation to help delinquent borrowers become current on their loans and avoid foreclosure. Of course, not all of these safeguards will be effective in every case, but they differ dramatically from more common lending practices.
As public bodies, HFAs also can tap quasi-social capital, including their own reserves or other grant funds bestowed upon them by Congress or their state legislatures:
Several HFAs are even offering to assist borrowers in danger of defaulting on subprime loans. Colorado Housing and Finance Authority recently initiated a program called HomeStretch, which is a $50 million pilot program with about $4 million in reservations, although no loans have closed yet. The loans will be 40-year, fixed-rate loans that CHFA intends to sell to Fannie Mae, but the HFA will retain the servicing to generate fee income without assuming any risk. The loans will be underwritten to Fannie Mae guidelines and will be conventionally insured.
Access to public capital allows them to add additional protective features and absorb the costs thereof into a blended rate:
The PMI insurance will also include six months of unemployment insurance for borrowers in the event they lose their jobs. Borrowers are not eligible if they have previously refinanced and taken cash out as part of the refinancing. The program requires a $500 deposit by borrowers [A smidgen of hard equity — Ed.], who must also take a homebuyer education class.
That’s a very nice package: consumer education in the front, favorable loan terms throughout, and risk and loss mitigation features built in.
Viable subprime lending kit inside
Conclusion: the HFAs are managing their risks
The HFAs substantially better performance in the subprime sector owes little to luck and a great deal to differences in their business model relative to the specialized value chain in the pure-private markets:
Hands across the keyboard
- An originate-and-hold business model
- Less aggressive underwriting
- Adding innovative features pioneered in the private market
- Consumer education before lending
- Generous reserves, and
- Active asset management with customized tools.
A loan is a bargain struck across the years if not decades. A commission is a payment made at an instant in time. They are temporally at odds. Businesses built around one-off commissions are eternally vulnerable to principal-agent risks, to risk blindness (it falls between the radar screens), and to short-term thinking.
Hey, nothing to worry about until the end
The HFAs have a political accountability and an enduring immobile political visibility. That makes them cautious even as it bestows upon them extra social capital and resources. In good times HFAs can be much too conservative, too settled in their ways — but that’s a post for another time.
Both conservatism and risk have their features
In wobbly times, those same characteristics keep them active in the arena and out of trouble, while others are either idle on the sidelines or foolhardily flinging capital into the ocean.
