Subprime: The Case of Targeted Legislation: Part 2, the proposal
[Continued from yesterdays Part 1.]
Yesterday, using as a springboard a story from The New York Times, I looked at the prepayment-penalty trap which has now caught many subprime borrowers: loans with low introductory ‘teaser’ rates, that now step up, but that cannot be economically prepaid because of yield maintenance and penalties that make the cost prohibitive.
Not so velvet after all
Instead of being a wealth-creation machine, as the American home traditionally is, recent borrowers of subprime loans with prepayment barriers are trapped in a wealth-extraction machine:
Squeezing money out of you?
Waiting out the expiration of a penalty, especially a short one, does not sound so bad — until home prices turn south.
For some, what can’t be cured, must be endured:
That is what happened to Dorinda Weisman, a social worker in
“One of the things I always wanted was to own a house,” Ms. Weisman said in a telephone interview. “I was a single parent, and my son is a hemophiliac. I had been living in a middle-class African-American neighborhood that went downhill after the drugs came in.”
In passing, I note that Ms. Weisman almost certainly should never have bought a home. It was not in her interest. She had a fragile economic equilibrium — large potentially uncontrollable expenses. Her neighborhood, though beloved, was questionable. Renters can flee a neighborhood with much less stranded equity than can homeowners. Homeownership, which she pursued with a dream of security, was itself a trap that took away many of her options.
I promise I’ll pay it back
The prepayment penalty, of $9,000, expired in just a year.
So the penalty by itself is not the problem; rather, the loss of optionality is.
By the time the penalty expired, her house had declined in value. Refinancing was no longer possible.
Her interest rate had shot up to 9.8% from 4.75%. She says about 85% of what she brings home — her salary is $60,000 as a social service consultant with the state government — now goes to the mortgage.
Clearly unaffordable, destructively so.
She is trying to negotiate a new loan with the help of the Neighborhood Assistance Corporation of
“Like a lot of people, the adjustable ate up her equity,“ said her mortgage broker, Antonio Cook of Toneco Financial. “She’s got to ride it out and sacrifice. I tell people, ‘I don’t care if you eat bologna sandwiches, just pay your bills on time.’ If she can ride it out, things start coming up good.”
Eat up and pay your bills!
I join the entire mortgage banking industry in thanking Mr. Cook for the sincerity of his concern.
Of more importance, we can ask, like Perry Mason, who is guilty? and what should we do?
It’s certainly easy enough to put caps on prepayment penalties prospectively; and, for that matter, to require more extensive disclosure. So let’s take those as givens. What should we do regarding people who have already taken out these loans?
Here’s a proposal for consideration:
We need to examine this from four perspectives: consumer protection, timing/ eligibility, ecosystemic impact, and business.
We have to look at it with different eyes
1. The consumer-protection case. This is the easy one. Lots of people took out loans whose punitive elements they did not understand.
Experts say that many borrowers do not really understand the implications of prepayment penalties — if they are aware they have them at all — and fall prey to sophisticated marketing.
In a 2002 lawsuit by Acorn on behalf of a group of borrowers against Household Finance, Acorn said that lenders referred to the practice as “closing the back door” by making it too costly for borrowers to get out of loans with rising rates.
Acorn’s claims are not the same as proven facts, but even so this is all very plausible.
It’s p-p-p-plausible!
Now these folks have no one to turn to:
“It was a loan made with no regard for whether it would be affordable when the rate increased,” said Jordon Ash of
So powerful is our desire to own a home, even if it is unwise, that people’s hunger overcomes their sense.
That was the case for Gertrude Robertson, a 91-year-old widow and nurse’s aide living in
Mrs. Robertson says her broker did not give her time to study the loan documents. “Some words I don’t understand,” she said. “When I heard the lady I used to work for tell someone that I was the ‘epitome of cleanliness,’ I went home and cried. I thought I was going to be fired.’ I didn’t know what it meant.”
2. The timing/ eligibility case. The proposal imagines relief being offered to people who took out loans on or after January 1, 2006. It includes a prospective component, but its principal significance is retrospective: it picks up most of the last two years of activity.
The idea is that we want to tackle people who haven’t yet had their mortgages reset. And we need to move fairly quickly, as illustrated by the following compilation from John Mauldin’s truly outstanding [Meaning ‘free’ – Ed.? And worth reading! – Auth.] weekly newsletter, From the Front Lines:
As Mauldin puts it:
This shows the amount of adjustable rate mortgages that reset each month for the first half of this year and will reset for the next 18 months. Note that these reset numbers are a driving factor in the increasing rise in foreclosures. Pay attention to the numbers I highlight in red for January through June of 2008. The largest portion of mortgage resets is not until next year.
We have just seen $197 billion of mortgage resets so far this year. That is less than we will see in two months (February and March) of next year. The first six months of next year will see more than the total for 2007 or $521 billion. This suggests to me that the number of foreclosures is due to rise dramatically from the already high current levels, putting more homes into a weak housing environment.
These homes that are going to see reset prices are for the most part not going to be able to be rolled over into a traditional 30 year mortgage because there is not going to be enough equity to get a traditional mortgage. While the total increase in payments is an estimated $42 billion, which is not all that large in the grand scheme of things, to the individuals who are paying the increase it is a large increase in their housing costs. My estimate is that this is about one-half of 1% of total consumer spending. Along with inflationary rises in food and energy, this is going to continue to put pressure on consumer spending.
We are still in front of the wave, but we have only about 4-8 months left.
Just stay in front of it
Given the macroeconomic concerns, it’s almost certainly in everyone’s interest to minimize the total number of borrowers in distress and loans that may need restructuring. The way to do that is to act now.
3. The ecosystemic-improvement case. Over time, markets migrate to greater transparency, better consumer disclosure helps markets work better. Indeed, particularly with residential mortgages, the trend has always been to provide more and clearer information, and to cap the less-comprehensible fees and charges:
A number of states limit the penalties, but only state-regulated banks are generally subject to those restrictions; mortgage companies and national banks are not.
One state, Wisconsin, actually reversed course and allowed prepayment penalties by state-chartered institutions last year, just as the housing bubble was about to burst. Lenders contended that with lower initial payments, many more people would be able to afford homes and it would level the playing field among lenders.
Consistency among capital sources is important, otherwise bad practices can drive out good ones. Further, a programmatic overlay allows a standardized approach to workouts, which is likewise part of the business case.
Not what you want in a loan restructurer
4. The business case. In proposing a blanket solution, one with a retrospective application, haven’t we just done violence to contract rights?
I can’t bear to see contract rights trampled
Yes, we have – if not violence, then at least impact and harm. But it might nevertheless be in the mortgage industry’s interest to agree or acquiesce.
Workouts are time-consuming; and as we’ve seen, the process of securitization slices up responsibility and slows down resolution of individual cases, in part because borrowers have many things they try before succumbing:
Even at her age, Mrs. Robertson was earning $3,500 a month, largely by caring for another elderly woman. Then the woman died. Mrs. Robertson’s income was reduced to her monthly Social Security payment of $1,500. Meanwhile, her loan ballooned to $475,000. Unable to make the payments, Mrs. Robertson is listing her home for $510,000.
Mrs. Robertson’s mortgage includes a prepayment penalty of $14,400. A sale at her asking price would not only wipe out any equity but require her to write a check for about $8,600 to cover the penalty and other costs.
Then too, lenders who go into court seeking to enforce rights fight on the bench a judge sympathetic to the borrowers:
Last week, Ms. Huelsman persuaded a court in
The loan servicer, HomeEq, prefers to work one-on-one with customers and does not comment on individual cases, a HomeEq spokeswoman said.
With the original lender in bankruptcy, and its staff fled to the four winds, the servicer will have difficulty finding the investors. Transaction costs and administrative delay can easily eat up all the prepayment penalties, so say nothing to pushing the loan into default or workout.
Mr. Larson worries that his creditworthiness is sinking as the couple struggle to make the monthly payments. By the time the penalty expires, he may not be able to refinance.
“I had good credit,” he said. “Now it is going down because we can’t keep up. I feel like I am drowning.”
Here’s why the industry ought to embrace a general solution. Penalties are intended as incentives for individual or isolated cases. They work individually, not against hordes. A standardized solution gives the servicer the power to cut deals, without trying to find the particulars of a given investing lender. That’s probably in the investors’ interest … if only they knew it.
Then there’s the bad publicity and lawsuit risk:
A study by the Center for Responsible Lending shows that borrowers in minority neighborhoods received a disproportionate share of loans with prepayment penalties. The
When the victims vastly outnumber the capital, and when the capital is remote and the victims are people, defenses based on ‘you knew what you were signing’ get undermined in the court of public opinion.
We’re single-minded; don’t distract us
In workouts, the rights you have aren’t at all the same as the rights you need or the rights that can do you any good. The better part of valor is often to find a way back to an acceptable solution for you that also works for the other parties.
Indeed, if the lenders were wise, they’d get in front of this problem by proposing some kind of amnesty, subsidy, or relief program themselves. Why wait for the government to do it?
The tanks are from the government and they’re here to help you
Get in front of it.
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