subprime

They used to call it "loan workout"

Philip Brewer — Fri, 30 Nov 2007 21:15:17 +0000

It has never been unusual for borrowers to run into difficulty, and sometimes it becomes clear that a loan will never be repaid in full. The lender's job then is to recover as much money as possible. Because foreclosures are expensive and the eventual recovery is uncertain, it's often a better bet for the lender to restructure the loan--settling for less than they are owed, but more than they'd get in a foreclosure. One of things that has made the subprime debacle go from bad to worse is that loan workout is much tougher when loans are securitized--sold, packaged, diced up, and sold again.

Banks used to have whole departments dedicated to loan workout. (No doubt they still do, but since banks mostly don't hold mortgages any more, their loan workout departments don't get involved when a mortgage goes bad these days.) The structured investment product that mortgages get packaged into these days is a trust, and those trusts are very nearly not in the "workout" game at all.

Packaged loans

One aspect to the packaging of these loans was a division of a package of loans into groups (called tranches, from a French word meaning slice) based on quality. The quality determination, though, isn't made in advance. Rather, they work like this: The first (best) tranche gets all the payments until it's investors have been paid what they're owed. Once they're paid, the second tranche gets all the payments, and so on, until the fifth tranche gets whatever hasn't gone to any of the previous tranches.

Different investors were interested in different tranches. A pension fund might have paid top dollar for the first tranche, which was expected to provide predictable income for many years. The fifth tranche would pay less (starting as soon as the first borrower missed a payment), but would also cost less, and could turn out to be a good investment for a hedge fund that bought it cheaply enough.

It turns out that--and this is the whole point of the thing--because different investors will pay up to get exactly what they want, the selling price for tranches one through five add up to more than the sum of the value of the individual loans that went into the package.

Predictable value

The values of the individual tranches were calculated according to complex mathematical models. Everybody involved in the arrangement--the banks who created the packages, the investors who bought them, and the agencies that gave them credit ratings--had their own models, but all those models depended on predictability. If some loan officer could look at a loan and decide that this or that loan might pay more if a workout kept it from going into foreclosure, that predictability was lost--and once the predictability was lost, the valuation model would become less dependable.

To avert that threat, the trust documents that created these packaged investment vehicles often drastically limit the ability of the trust to modify the terms of the loans.

No more workouts

The upshot is that several of the incentives to workout problem loans no longer exist:

No customer relationship. A local bank knows its borrowers--they are probably depositors, and very possibly future borrowers. In addition, they might have any number of other connections to the bank. For example, they might be a key employee at a local business that is an important customer of the bank.

No incentives. There's real work involved in restructuring a loan. Some fairly smart person needs to look at the collateral, look at the borrower's finances, look at the loan terms, and decide whether the best return to the lender would come from a workout or a foreclosure. And after all that, it often turns out that a foreclosure is still the best plan. Somebody would have to pay people to do all that work, and there's no particular incentive for the trusts that own the loans to do that. They get paid a fee to manage the payments, and it's much simpler for them to just routinely foreclose, even if it brings in less money--after all, it's not their money.

Limited legal options. Since the legal document that creates the trust limits the ability of the trust to modify the terms of the loans (in the name of predictability), there is simply no one with the authority to negotiate a workout agreement.

Fixing the problem

Because of the nature of trusts, there's often no way for the parties involved to solve this problem--there is simply no one who can decide to change the terms of a trust, even if all the interested parties were inclined to agree. The result of that is that the federal government is getting involved. I have a post coming up about government efforts to fix the foreclosure crisis.

(The picture for this post is of a statue of Alexander Hamilton, who architected a restructuring of the revolutionary war debt of the new--and essentially bankrupt--United States of America. His plan established the credit of the new country, which has not missed a payment on its debt since.)

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Interview with AFFIL executive director Jim Campen

Philip Brewer — Sun, 18 Nov 2007 11:58:59 +0000

Early in the subprime lending collapse, Wise Bread posted a report from Americans for Fairness in Lending explaining how the subprime lending boom hurt everyone. Since it's a topic of considerable interest to Wise Bread readers, when AFFIL offered to make Jim Campen, their executive director, available to answer some questions, we jumped at the chance.

Wise Bread: One of the most obvious ways to avoid this sort of crisis in the future would seem to be better borrower education, to make them less vulnerable to predatory lending practices, and put them in a better position to make good choices. The section in your report on "Fixing the Problem," though, doesn't mention borrower education. Do you not see borrower education as useful in fixing the problem?

Jim Campen: Borrower education is absolutely key to healthy credit-lender activity. And that message is out there. The problem is, consumer education is often the only message out there – and, inherently, it blames the consumer for loans-gone-bad. Our job is to show the other side of the equation. We don’t want calls for financial education to divert attention from the industry reforms that we advocate. Few would argue that we should rely on consumer education so that people can protect themselves against toxic drugs; instead we have the FDA to regulate what kinds of drugs are available and we require prescriptions from licensed doctors, who have ethical and legal responsibilities toward their patients. Similarly, some toxic lending products and features should be banned and lenders should have ethical and legal responsibilities toward their borrowers.

Wise Bread: One of your proposals is to create incentives for investors who own bad loans to renegotiate them. With local lenders, those incentives were inherent in the system. Besides just the lack of a local connection, what else in the mechanics of securitization acts to reduce those incentives?

Jim Campen: There are are at least two such mechanisms. The first is that the legal documents which govern the trusts into which the mortgage loans are pooled to provide the backing for the securities often limit or prohibit the ability of trustees -- and thereby loan servicers -- to modify the terms of the loans in the trust. The second is that the foreclosure attorneys and others involved in the foreclosure process often receive little or no compensation for the substantial time and effort involved in working out a modification; their clear financial incentive is to proceed with foreclosure.

Wise Bread: Do you have any specific policy suggestions for restoring or replacing those incentives?

Jim Campen: Unlike some parts of the whole securitization business, this isn't rocket science. Those involved are smart enough to figure this out if they want to do so -- or are forced to do so One key is making sure that foreclosure attorneys and others involved in the foreclosure process have a financial incentive to spend the time and effort needed to bring about a loan modification or other solution when this is in the mutual interest of the borrower and the lender -- at a bare minimum the fees for accomplishing this should be considerably above the fees for facilitating a foreclosure.

Wise Bread: One of your proposals is that the government should help homeowners who are stuck in troubled loans. There are plenty of people out there who, when their neighbors were buying bigger houses, stayed in a small house or continued to rent--because they knew that they couldn't afford the bigger house. It seems especially unfair to come along now and ask these people to subsidize their neighbors who are living in houses that they can't afford. Do you think the benefits to the people in trouble, together with those for the neighborhood and community, outweigh the fairness issue?

Jim Campen: This is a legitimate concern. The issue here is how to help those who were harmed by unscrupulous, dishonest, or fraudulent lenders without "bailing out" those who were simply greedy or engaged in outright speculation. Helping those who were harmed by unfair lending is simply righting a wrong, and we don't see anything unfair about that. In the same way that it is appropriate to use public funding to get people into affordable housing, it is appropriate to use public funding to keep people from losing their homes as a result of predatory lending behavior.

Wise Bread: Why is that? We generally don't use public funding to rescue people who are harmed financially in other ways--victims of con games don't get public funding, nor do people who lose money to crooked gamblers. How is this case different, or would you support public funding for those cases as well?

Jim Campen: We as a society have decided that affordable homeownership is a public policy goal that it is worth using public resources to promote. If it is worth public money getting people into homes, then it is only logical that it is worth spending public money to enable them to stay there. Two additional arguments: (1) that governments bear a moral obligation to assist people because of governmental negligence in failing to offer adequate borrower protections, and (2) that foreclosures result in public costs on neighbors and local governments as well as private costs on borrowers. Government assistance to victims of crooked gamblers or other con artists is one of a very large number of issues which lie outside AFFIL's area of concern: abusive consumer lending.

Wise Bread: What forms could government support for homeowners with troubled loans take?

Jim Campen: Most of the legislative proposals for helping homeowners facing foreclosure do not involve direct financial assistance to the homeowners. Rather they are focussed on the provision of legal and/or credit counseling support. The demands on counseling agencies greatly exceed their current capacity; this capacity needs to be very substantially expanded. In addition, the provision of legal representation to borrowers who have legitimate claims to make against predatory lenders, but are either unaware of this or unable to afford a lawyer, is a legitimate form of government support (although the lending lobby will fight hard to prevent any such measure). In addition, legislation could provide necessary guidelines governing access to and use of the various funds that have been established to help borrowers in trouble.

Wise Bread: Although rising home prices benefit homeowners, flat--or even falling--home prices would benefit renters who would like to buy. Successful efforts to help homeowners with troubled mortgages stay in their houses would tend to delay any such adjustment in home prices. Do you see any way to help people with troubled loans (and their communities) that doesn't also have the effect of keeping homeownership out of the reach of many people of modest income?

Jim Campen: The kind of regulation that AFFIL supports would operate to moderate gyrations in the market that lead to extreme highs and lows in housing prices -- such as the recent housing price bubble and current subprime mortgage industry collapse. Fair lending regulation would result in fair lending products that make home ownership possible for people of modest income. The lower prices available are coming now are at great cost to communities. The tidal wave of irresponsible lending in recent years played a major role in sustaining the housing bubble, pushing house prices to excessive levels, and leading people into foreclosure. AFFIL's concern is for people who have been harmed by predatory lending and for the neighborhoods where predatory lenders have been particularly effective in pushing their toxic loans.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

How the subprime lending boom hurt everybody

Philip Brewer — Sat, 22 Sep 2007 14:17:33 +0000

Among the Wise Bread community, I get the sense that there's a kind of "pox on both their houses" attitude to the problems in the subprime mortgage markets. People who worked through their own credit problems (or avoided having any) can't stir up much sympathy for people who bought houses they can't afford--and pretty much nobody has any sympathy for the mortgage brokers and hedge funds that lent them the money. A new guide from Americans for Fairness in Lending, though, shows that the damage actually hits at every level, from the individual borrowers (including borrowers with good credit), through the neighborhood, local economies, and the national economy. With their kind permission, we're presenting the guide here on Wise Bread.

The study is Neighborhood and Individual Impact of the Subprime Mortgage Lending Crisis: A Reporter’s Guide and has two parts.

Part one--negative impacts of the subprime lending crisis

The guide lists half a dozen negative impacts that the crisis has had on borrowers and the economy. Among them are:

Loss of homeownership One of the supposed benefits of subprime lending was that it made homeownership a possibility for people who had been shut out. It turns out that, because many of these loans didn't go to first-time homebuyers, the result has been an actual reduction in number of homeowners.

According to the Center for Responsible Lending, “Subprime loans made during 1998-2006 have led or will lead to a net loss of homeownership for almost one million families.”

Weakening Property Value The crisis is pushing down property values in multiple ways. People who can't afford their mortgage are putting their homes on the market--either voluntarily or through foreclosure. Plus, as the crisis makes it harder to get a mortgage, there are fewer buyers--putting downward pressure throughout the housing market.

Homeowners who took subprime loans are not the only ones impacted by the crisis. It is estimated that each foreclosure lowers the property values in its neighborhood by about one percent.

Damaging Neighborhood and National Economies More money going to money center banks and hedge funds means less money going to local business. Rising numbers of economically troubled families has ripple effects throughout the local economy.

The Center for American Progress notes that foreclosure is more than an individual tragedy: “A spike in foreclosures can also create a domino effect in a single area, leading to a sharp depreciation in property values, decreased business investments, and lower tax revenues, which in turn affect the quality of schools and decrease nearby property values.” Stores such as Home Depot and Wal-Mart are reporting reduced consumer spending in the wake of the meltdown, resulting in a loss of tax revenue. Counties are reporting losses in revenue from filing and tax fees. Property values are decreasing, yielding even greater losses for local communities in tax revenue.

Part one ends with some policy suggestions for fixing the problem, including help for homeowners stuck in troubled loans, laws against predatory lending practices, and incentives for lenders to come to the table to work out problem loans.

Part two--how did we get here?

Part two provides a look at how we got here, and has a pretty good explanation of the changes in the way mortgages loans were made and what happened to them afterwards. It also takes a look at the question, "How do the lenders make any money loaning money to people who can't pay it back?" The answer has to do with the incentives at each layer in the process.

Subprime loans are generally made through brokers and with some lenders, loan officers who, despite popular perception, are under no obligation to find the borrower the best rate...or even a loan they can afford. On the contrary, the commissions of brokers and loan officers increase based on loan size and the interest rate charged....

Subprime lenders immediately dispose of the loans they write by packaging them for quick sale to Wall Street investors. Lenders make their profits up front, from the sales of those loans and the fees they pack into each mortgage...

Until very recently, when the loan volume grew so large and default rate skyrocketed, Wall Street investors were generally insulated from the impact of bad subprime loans. The loan portfolios pooled risky subprime loans, reducing the chances that a small percentage of defaulting loans would hurt the bottom line.

As you might expect from the name, Americans for Fairness in Lending is an advocacy group that works to protect consumers from abusive lending practices, and the guide is written from that perspective. I expect you'd get a very different analysis from an association of mortgage brokers or bankers. With that caveat, Neighborhood and Individual Impact of the Subprime Mortgage Lending Crisis: A Reporter’s Guide is an excellent overview of the situation and is well worth reading.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

How to Avoid Foreclosure

Andrea Karim — Thu, 22 Mar 2007 20:46:15 +0000

What would you do if you were about to lose your home? What would you be willing to do to keep it? Is it even possible to keep it once you've missed a few payments?

The recent rash of stories about subprime lending, housing market crashes, and the subsequent stock market fluctuations has made me a touch nervous. If you think that only the poor, old, and mentally disabled have been targeted by subprime predatory lending, then you'd be wise to note that that's not true (thanks, Consumerist, for the link).

If you haven't been following the story, American Public Media's radio show Marketplace has an excellent summary of the situation here. Especially tragic is how the practice of selling chunks of mortgages to investors (rather than having a bank back them entirely) was started to help more people buy homes.

At least 4 properties (all rentals, all owned by the same person) on my street alone are being auctioned off within the next month, and that kind of activity is going to affect my property values (which are probably never going to be as high as they were when I bought the house anyway).

How can you avoid foreclosure, if you've been recently hit by high interest rates or financial disaster? For people who bought homes for the purpose of reselling them (otherwise known as 'flipping'), it might be difficult to avoid foreclosure. However, there are a few things you can do to try to keep your home.

1. Don't ignore the problem! Are you getting letters from your lender? Don't ignore them! The worst thing you can do is hope that this problem is going to go away. All lenders have a Loss Mitigation Department - call them immediately if you think you are going to fall behind on your payments. And make sure that you get to the Loss Mitigation department, and not just the collections department. Loss Mitigation departments will often work with borrowers to work out a payment plan.

2. Don't take any more loans! You're in deep enough trouble as it is with banks, and the only institutions who will want to loan you money now are the scammers who will do everything in their power to take away all of your assets, including the shirt off your back. That includes the loan sharks who are probably publishing the ads that are popping up all over this blog post right now ("Avoid foreclosure??? Low interest loans, fast, over-the-phone!"). Stay away from these bastards.

3. Rent! If you own more than one property that's languishing on the housing market, and the mortgage is not astronomically high quite yet [but still too high for you to pay along with your other mortgage(s)], you may consider renting it. There are costs and benefits to renting a property. Smart Money lists some here. For instance, you can deduct out-of-pocket expenses, such as mortgage interest, repairs, advertising fees for listing the rental, cleaning services, utilities and more.

Then there's the "phantom deduction" called depreciation. Just divide the fair market value of the property at the time you start renting it out (excluding the cost of land) by its recovery period — which is 27.5 years for residential rental property. Bingo! There's your annual depreciation. For example, if the home is worth $550,000, you divide that by 27.5 and get a $20,000 annual deduction. "The depreciation deduction will cover a lot of the [rental] income you're receiving, so it's a nice tax shelter," says Jeff Callahan, a CPA with Bederson & Co. in West Orange, N.J. "If you have another $10,000 in out-of-pocket expenses, which are also deductible, you can get $30,000 in rent tax-free," he says.

There are other things to consider when renting a property, too. The rental market matters, as does your area, the home's potential appreciation all factor in to the equation, as well as your ability to be a no-nonsense landlord to possibly unreasonable people.

In application to the home you live in, roommates (although incredibly annoying) are a great way to supplement your mortgage.

4. Call an HUD-approved housing counseling agency. They might be able to point you in the direction of government and community programs that can help you.

5. Additional Options: There are some other options that you may qualify for, that will help you avoid actual foreclosure. They're not ideal, but they are less damaging to your credit in the long run than actual foreclosure.

Special Forbearance: Payment plan that may even allow a temporary suspension of payments.
Refinancing: This is unlikely given today's market, but might be a possibility for people who have built up their credit score since they purchased their home.
Partial Claim: U.S. Department of Housing and Urban Development (HUD) will pay your lender to bring your mortgage up to date, but a lien is placed on your property.
Pre-foreclosure sale: Sell your house for less than it is worth in order to avoid a full foreclosure - pay off part of the loan. There are obvious downsides to this, and you will still owe some money to the bank, but it's probably preferable to foreclosure, too.
Deed-in-lieu of Foreclosure: This is where you give your property to your lender before it is foreclosed on. It may seem as hideous as losing your home to foreclosure, but it won't hit your credit as hard.

This article is from Andrea Karim of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: