Subprime: The Case of Targeted Legislation: Part 1, the pain
Evolution of the subprime mess leads journalists in a constant search for new angles. If Erle Stanley Gardner had been writing these mysteries, he might have titled them The Case of the Bamboozled Borrower, The Big Writedown, The Evil Securitization Wizards, The Conniving Counterparties, The Horrified Homeowners, and The Laid-Off Lenders.
We’re all nervous, but we’re not accomplices!
As we sift through these tales, we have to keep looking for the right policy questions: what if anything should we do? Up to now, what we have found is mostly cause for inaction if not exactly complacency. Some people and companies are losing money, some folks are under stress, some markets are wobbly and others are rallying. The housing market’s crumple zone is doing its thing and the system is reacting rapidly, and even if things are not wholly jolly, the stories are retrospective, not prospective: there’s no sign of imminent collapse.
No collapse in the market, anyway
Except there is one group facing prospective crisis, as presented in this story from The New York Times:
Homeowners whose loan rates are soaring may want to head for the exits. Many of them, though, will find no way out. If they sell their home or refinance, they will face a penalty of thousands of dollars for paying off their loans early.
Timm Larson is in just such a predicament. Two years ago, he refinanced his home outside
Mr. Larson wants to move into a traditional loan, but can’t see how. He would have to pay the lender a $9,000 exit fee.
“We don’t have any money,“ Mr. Larson said in a phone interview from his three-bedroom house in St. Francis, Minn. “We are barely making our house payments.“
From a borrower’s perspective, the ideal loan is one that gives the borrower all the optionality: fixed interest rate, fixed level payment, and the borrower’s right to prepay or refinance at any time. Many states in fact have consumer-protection laws making it illegal to place prepayment lockouts on primary residential mortgages. So, what cannot be contractually barred can be made economically infeasible, via prepayment penalties:
According to the Center for Responsible Lending, these exit fees, called prepayment penalties, were added to more than two-thirds of the adjustable-rate loans.
In the loan business, it’s called ‘yield maintenance,’ and there’s some sound logic to it. It has to do with matching funds.
It’s important that they match
Every time a bank (say) lends money to a customer, the bank in turn has to persuade someone to invest capital with the bank. Investors and lenders, who are constantly finding one another at the money store (the capital markets), are seeking compatible mates not just on risk profile but also on anticipated loan duration. Some people want to put their money out for short periods, others for longer. Because the yield curve is normally positive, the longer I let you invest my money, the higher the rate I want for it.
“You want to give pause before banning prepayment penalties,” said Kurt Pfotenhauer, senior vice president for government affairs at the Mortgage Bankers Association. “They save consumers’ money by lowering their interest rates.”
Flipping that around, if a bank wants to lend to a borrower at a particular rate, but the borrower cannot pay that rate initially, the lender may elect to offer the borrower a low initial rate, which it plans to recoup in later years after the rate has stepped up.
Those loans initially carry a very low interest rate, known as a teaser because it is below the market rate and rises sharply over time.
The lenders say the trade-off is the only way to offer low monthly payments initially because otherwise borrowers would flee when rates adjust upward and make the loan a losing deal. The fees usually equal several months’ interest, and they decline over a few years before disappearing altogether.
Buyers and borrowers are optimists: they may anticipate a raise or other increase in income, or the house becoming more valuable, or a continuation of friendly credit markets.
Homeowners often think they can keep up with their rising payments or that they will simply refinance later. But the penalties can dash that hope, even if market conditions and their personal circumstances allow it.
Or they may simply take the money, hoping something will turn up.
I always rely on the kindness of strangers
Mr. Larson and his wife would seem to be good candidates now for a traditional loan. They both have steady jobs: he trims trees, she waits tables. Their fateful refinancing was used to pay off $10,000 in credit card debt accumulated when they traveled to
It’s striking how many of these tales of woe begin with a homeowner who is refinancing to lower the cost of paying for debts already incurred in people’s personal lives. As we’ve seen with payday loans, for many people credit management is a challenge, and credit itself a mystery.
The penalty “is just an added fee that means more money to the lenders,” said Melissa A. Huelsman, a
Many people are vulnerable to sign-now-pay-later salesmanship.
The $205,000 loan, which the Larsons signed in February 2005, required them to pay only interest at first, or $11,400 a year, with the 5.6% rate to reset after two years. Mr. Larson knew there was a prepayment penalty, but thought it expired in two years; it was actually three years. Now the Larsons’ payments have climbed to $19,000 annually, at a new rate of 9.3%.
On this arithmetic, the 370 basis point increase, plus the conversion to amortization, bumps the payment up to about $20,300 annually, a 77% increase that translates into an additional $735 per month. A huge hike.
It’s not easy being an unpaid blogger
Thus we have the proximate cause of legislation: a clearly identifiable constituent group that’s experiencing financial and emotional hardship. In such cases, the government factory is ready to manufacture a new legal product:
Now state governments, regulators and members of Congress are considering whether to rein in prepayment penalties, as consumer advocates suggest. “Borrowers should not be penalized for paying off their debt,” said Ellen Harnick, senior policy counsel to the Center for Responsible Lending, a nonprofit group in
That’s a great sound bite, the more so as it telescopes the problem so as to block any consideration of the benefits (lower rates initially) or the customer’s complicity (taking on imprudent loans) or bad luck. It’s finding a sympathetic ear:
I sympathize
Senator Christopher J. Dodd, Democrat of Connecticut, said this week [mid-September – Ed.] that he would introduce legislation to eliminate the penalties and make other changes in home lending practices.
“About 70% of subprime loans have costly prepayment penalties that trap borrowers in high-cost mortgages, mortgages that strip wealth rather than build it, and these penalties keep borrowers from shopping for a better deal,” Senator Dodd said in a hearing of the Senate Banking Committee early this year.
Like many policy trends, prepayment protection is cyclic.
When interest rates were high in the 1970s, states took steps to protect consumers from onerous prepayment penalties. Such fees generally disappeared from standard loans.
Plus a change …
In the late 1990s, though, subprime loans to people with weak credit blossomed, and with those loans came a resurgence in prepayment penalties.
With legislation swirling, we should ask: It may be politically intriguing vaporware, but under what circumstances might it be a good idea?
Don’t point that legislation at me unless you intend to use it
Here’s a proposal for consideration:
How does it stand up?
Guilty, or not guilty?
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