Is There Such A Thing as a Bad Loan?

Is There Such A Thing as a Bad Loan?
A Call for Sanity in the Housing Meltdown Debate
Noel Cookman, August 11, 2011

I have devoted this blog to issues that affect folks at the intersection of divorce and mortgage finance. And this post is no different except that the information is applicable to virtually every consumer in the industrialized world. Quite often though, in order to understand specific issues (like how mortgage financing is affected by divorce), it is necessary to have a working knowledge of the basics and the ability to sift through popular myths in the housing-finance industry. This article will help you with that understanding.

Is there such a thing as a “bad loan?” We certainly have heard from ten thousand pundits and analysts that banks and mortgage companies “put home owners into bad loans.”

The hapless and grossly uninformed Dick Morris throws this verbal grenade into the conversation.

“…those who made bad loans that have eaten away, like termites, at the foundation of our world economy are largely escaping culpability. There have been no convictions, no indictments, and no real investigations into their irresponsible conduct in making these loans in the first place.” [Morris and McGann, Fleeced, 2008, Harper Collins Publishers, page 238.]

I’d say that anything that functions like a termite and has the power to eat away at “the foundation of the world economy” is certainly a very powerful force and evil as well. When you really think about it, that’s pretty strong language from a fellow who makes his living as a serious analyst; and, as the author, Morris wastes no time telling us who is fleeced and who is doing the fleecing. The first line of the inside front flap tells the story - $26.95. If you paid it, you’ve been fleeced.

But now, since you have the privilege of accessing my endless wisdom and highly expert analysis on the matter, you shall be more properly informed than you have been to this point, heretofore having been fed dribble for nigh unto 4 years from the press, the government, politicians (like Barney Frank and Chris Dodd) and pundits.

To further confuse the existing bewilderment, according to more writers than I can quote, we are told that banks put home owners into loans the banks knew in advance (mind you) the borrowers could not repay. Now, that just might be a bad loan – if one actually existed. I’ll address that concoction of irrational notions in just a minute.

First, let’s get something clear. So long as you owe money to the bank (a mortgage note in repayment) for your house, you are NOT the homeowner except by way of a very misleading title. The bank owns your home. You can negotiate the sale of it under certain circumstances. But, quit making payments and you’ll find out who really owns your home. This is more than a fine distinction. Politicians and analysts are fond of portraying the “home owner” as the poor, victimized citizen being preyed upon by evil and greedy banks when the borrower-occupant quits making payments and the bank wants their collateral back. Emphasize “their” collateral.

You are free to pay cash for your house. You are free to pay your mortgage off in full. But, you are not the home owner until you do so.

Loans are not moral creatures. They cannot be bad or good. They cannot act altruistically or with a social conscience. Nor can they act with malice.

Even the fact-starved analysts who refer to “bad loans” do so only after the loans have defaulted. That is, they are only “bad” in reverse. One might think this is obvious. But, journalists, writers, pundits and politicians cannot help themselves. They have to make statements that sound important or ominous with an air of moral indignation. Unless they can identify a demon, they cannot present themselves as an angel. So, they refer to certain loans as “sub-prime” as if the prefix “sub” should imply leprosy or some inferior quality. In fact and for the most part, these loans were paid off in exactly the same manner as “prime” loans were paid off and with relatively the same performance ratio. That is, until the entire real estate bubble burst and masses of borrowers lost their jobs or had to move and couldn’t unload their house that was “upside down,” its value now being less than the amount owed on it.

So, what makes a loan go “bad?”

Loans that go into default and/or foreclosure do so because of reasons completely apart from any feature of the actual mortgage loan. That is to say, there is nothing within the terms of the loan (or note) that cause it to be defaulted on. So, what causes a loan to go into default? And by the way, a loan is technically in default after even one payment is more than 30 days past due not just when foreclosure action is initiated.

The first, and by far the most common, reason for default on a mortgage is job loss. When a borrower loses his job and therefore his income, it’s a simple conclusion, he cannot pay his bills. But, the ability (or not) to pay the mortgage payment is totally independent of any feature or quality of the mortgage note. These so-called bad mortgages are paid just fine up until the borrower has lost his job.

Okay, you might reason, let’s look at what the critics really mean when they say “bad loans.” Everyone knows that loans are not animated beings with moral qualities, you say. While I’m not so sure people really do understand this, let me assume it for now. And I think I know what the critics mean when they charge lenders with “making bad loans.”

One of the common accusations is that lenders made loans that they knew – imagine this, they actually knew – in advance the borrowers could not repay.

But, another faulty assumption about sub-prime loans is that they were defaulted on because the interest rates were high and/or the rates were adjustable and after the home buyers got into their homes, the rate adjustment went even higher thus making the payments out of reach. In spite of the fact that borrowers were fully aware of the terms of these adjustable rate mortgages, that the payments could – and most likely would – increase, pundits like Dick Morris continue to portray them as victims, taken advantage of by predatory lenders.

Before I demolish this poor argument, it’s time for a personal story. I was a sub-prime borrower. I actually got two mortgages (one in 2001 and another in 2003) that were sub-prime loans.

In my case, there were three factors that caused me not to qualify for one of those “conforming” or “prime” mortgages of which Barney Frank, Chris Dodd and Dick Morris now approve. First, I was self-employed for less than two years in a new industry. Secondly, I could not document my income in the traditional manner. Thirdly, I didn’t want to make a down payment – I needed 100% financing. The only difference in the second loan in 2003 was that I was now able to document my income and had been in the industry now for the required two years. The lender on my first sub-prime mortgage allowed me to borrow the entire purchase price of the house. But, they charged me – apples to apples – about 2.5% higher than prevailing prime rates, the rate I would have received had I qualified under the conforming guidelines.

I made monthly loan payments perfectly and in about 2 years refinanced to prevailing conforming rates, rolling in the prepayment penalty that was triggered by early payoff. I didn’t like the prepayment penalty but I knew about it and would have gladly accepted forgiveness from it by the lender; nevertheless, it was one of the terms of my loan and I abided by it. (Imagine that – a borrower who knew, accepted and didn’t complain about his loan terms).

The fact that my interest rate was higher (relatively speaking) – making the payments higher – didn’t cause a single late payment. My loan didn’t misbehave. It needed no spanking or “time out.” It continued to lie there as an inanimate object except for its requirement that I consistently make monthly payments.

And there were hundreds of thousands of borrowers who received these types of loans and paid them perfectly, not affected in the least by any feature of their “bad loan.”

But, the real reason that the higher interest rate “bad loan” argument doesn’t work is empirical data from history. Since 2000 (when I first entered the lending industry), 30 year conforming rates have fluctuated between about 7.000% (early on) down to nearly 4.000%. Really, since late 2001, the rates have rarely gone above 6.000%. In the meantime, their subprime loan counterparts commanded rates from 6.000% to 11.000% (depending on numerous factors) with most first liens being more in the range of 7.500% - 9.000%. [This is a very broad but fairly accurate remembrance of rates in that period; but, it serves well enough to make the real point…]

In 1978 when we bought our first house, we used an FHA loan, made a minimum down payment (around 3%) and signed up for a 30 year note at 13%. If you factor FHA mortgage insurance, the effective rate was in the neighborhood of 13.5%. Those were the prevailing “prime” rates. (Conventional, conforming rates were really not that much different from FHA rates). There was no sub-prime industry. And millions of people were paying these rates on their mortgages. Those of you golden oldies remember that 13% was a bargain because by 1982 millions of Americans had signed up for mortgages that commanded upwards of 18% and higher interest rates.

If there was any logic to the notion that the higher interest rates create defaults, we should have seen an absolute avalanche of defaults in the years immediately following 1978 or so. While we do see an uptick in default rates, we are again reminded that it was a period of not only stagflation (where the economy doesn’t grow yet inflation persists) and rising unemployment, the major direct cause of mortgage defaults. And yet, the United States didn’t experience a foreclosure crisis in this period. Grant it, had the savvy politicians of today been around in 1980, they no doubt could have manufactured a crisis, blamed it on rich bankers and rode to power on the wings of class warfare. The ethos was present but the refinement of class warfare into a science would have to wait for the advent of Bill Clinton’s ascension to national politics.

Neither did we see the rise in default rates that we would expect if defaults were a product of higher interest rates. When rates rose from around 7% to over 18%, the simple math would tell us that defaults and foreclosures should have been epidemic if they were linked directly to higher interest rates.

The point is, mortgage defaults in the early 1980’s were caused, more or less, by the same factors that cause them today – job and income loss.

Perhaps the critics mean to say that relatively high rates (in these “bad loans”) created mortgage defaults. That is, sub-prime rates relative to their prime counterparts were high and this disparity created inevitable default on the mortgage. This criticism is the twin cousin to the one that accuses lenders of intentionally making loans which they knew the borrowers could not repay.

There is a simple way to test this hypothesis – first payment default rates. While it is true that all sub-prime mortgages carried an expectation of a slightly higher default rate – due to the increased risk – it is not true that any particular quality of the actual mortgage note created this inevitable default. In other words, there was no hidden trigger in the mortgage note that caused the borrower to make payments late or to not make them at all. And, if the higher relative rate produced a situation wherein the borrowers systemically could not make their payments, it would have shown up on a massive scale in first payment defaults.

Think about it conversely. If new home owners could make their first payment, what would keep them from making their second, third, fourth and so forth? The answer, of course, is the same thing that would cause any home owner to default on their payments – job/income loss.

Yet, we do not see a massive increase in first payment defaults. And everyone who analyzes the mortgage-housing crisis needs to understand something about first payment defaults. They are the absolute bane of the mortgage industry – nobody, but nobody, wants to see them. And here’s why – from the lowly loan officer who took the application to the broker or branch manager to the originating lender – first payment defaulted loans are universally considered fraudulent and require that the originator re-purchase the loan – no appeal or question about it. Originators and brokers don’t have the money to do this. Banks who sell to the secondary market do so because they do not want to hold the loan and are not in the business of keeping loans. No one wants to repurchase a loan – it creates loss. But, even more importantly, first payment defaulted loans universally trigger an audit with the implicit suspicion that someone on the originator level committed fraud. Everyone in the process comes under this suspicion and innocence, rather than guilt, must be proved.

But again, if a borrower truly could not repay the loan (as uninformed critics of subprime mortgages charge) then they would be unable to make even the first payment. It simply doesn’t make any sense that such a borrower would make the first few payments and then default on the payments thereafter solely because they couldn’t afford the payments in the first place.

So, the notion that banks intentionally made loans to borrowers whom the banks knew (in their infinite knowledge) could not repay them fails the empirical data test.

It also fails the logic test. Why would a lender make a loan they knew in advance could not be repaid? Some analysts say that the lenders bundled these loans (a common practice for many years and one of the ways mortgage loans are fantastic deals – they are sold wholesale not piece by piece which would make them very expensive) and sold them to investors who didn’t know that hidden within these large caches of loans were “bad” ones that had no chance of repayment. Again, such loans usually come back to haunt the originating lender. Not only are they required to repurchase first payment defaulted loans, they may be required to repurchase many loans that default for a great variety of reasons. Bank of America has been repurchasing billions of dollars of loans each quarter from Fannie Mae and Freddie Mac.

The criticism that banks knew in advance that their loans had no chance of repayments fails another very important test – the underwriting conundrum test. Think about it. If banks know in advance which of their loans will not be repaid, they also know (by simple elimination) which loans will surely be repaid. In other words, they would have solved the age old question of credit underwriting – what is the risk associated with this loan? Uninformed critics like Dick Morris and Gretchen Morgensen have unwittingly ascribed omniscience to these sub-prime lenders. In their convoluted thinking, lenders knew in advance and with precision how their loans would perform.

If any bank could have predicted defaults as simply as critics have charged, the actuaries for these lenders would have received Nobel prizes in economics and been hailed as having discovered a secret that has eluded lenders for centuries – the credit underwriting evaluation.

The answer is too simple – when borrowers lose their income, they don’t have money to repay their debts. But for those who are by nature bound to blame big banks and faceless entities for crises, this common sense explanation escapes them. And, they come up with storybook fancies about loans that have the moral capacity of good or evil.

While my argument tactic may be a bit facetious, let's get some sanity into the discourse about the financial meltdown and quit referring to loans as "bad" personalities; and, let's start with reasoned use of language. Loans cannot misbehave as if they were animated creatures capable of moral judgments. A mortgage loan is values-neutral. It’s impossible that it would be good or bad. It is either repaid or it is not. And nothing internal to it determines which course the borrower takes.

Personal responsibility. Now, there's a fresh thought.