Wednesday, August 6, 2008

What if the problem was mainly fraud?

Warning: This is a post that stereotypes people to make a point. The world is more complicated than this post – and the stereotypes are precisely that. I would love complex and real examples in the comments that question my stereotypes. I am a finance junkie – and you forget when you are looking at numbers that they embody the dreams, aspirations and failures of real people. What I seek is things beyond the stereotype… so I have different ways of reading the numbers…

There are all sorts of causes of the mortgage crisis and all sorts of results. However I want to pose a question about various types of borrowers and what their loss curves are. I am really seeking anecdotal industry evidence – hopefully from people who were once mortgage brokers or similar.

Imagine a few types of stereotypical borrower:

  • Jack and Jane are a typical first-home buyer. They have saved $10000 (which was hard) because Jack does contract work and sometimes his income is good and sometimes it is not-so-good. They have purchased their first home in suburbia. Its small – but property prices were high so they paid too much. Like almost all American young couples they aspire to a nicer second home. Contract work is getting thin at the moment and Jane might fall pregnant reducing the household income further. They are people of good character suffering mortgage stress.
  • Margaret is a divorcee. When Patrick walked out he left her with debt against the house (but some equity) and a lifestyle she couldn’t afford. However the credit card offers came in the mail and Margaret maintained her lifestyle. Eventually she had to repay the mortgage. She did so easily by refinancing the house – and even refinanced the house three times on a stated income loan. She now has a debt that she can never afford even if she adjusts her lifestyle. And she has shown no ability to adjust. Indeed she has got fatter and sorry for herself. She smokes 40 a day. [The NYT profiled such a case.]
  • Tom is a flipper. He has deliberately borrowed more than he can afford on a stated income loan. He hopes to sell the house to the next flipper. The loan would not have been granted on his real income – stable though it is – because he can’t afford it.
  • Jaylin and Ebony are a lower income black couple of good character. They were victims of predatory lending. Some unscrupulous broker sold them a loan with five points up front (hidden in the fine print) and a low initial monthly and a balloon payment so they could consolidate their car loan. The car is necessary because it is how Jaylin gets to work. I am deliberately racially stereotyping here because there is plenty of evidence that predatory loans were targeted at predominantly black neighbourhoods. This couple was just defrauded by the system. They would be willing and able to repay a decent their loan on original schedule – but the balloon payment and the five points ripped off them by an unscrupulous broker puts them over the edge. They too are distressed and angry – and their willingness to work with or trust financial institutions is also low.
  • Frank and Helen aspire to the upper middle class. He has a good job and she works part time and looks after the kids. The marriage is about as stable as the average American marriage – which means that when its good it is very good – but financial stress does strain the marriage (and marriage strain potentially strains the finances). They wanted to get the kids into a better school and hence purchased in a better neighbourhood. Keeping up with the Jones they purchased a better car on an incentive payment. It’s a big car (SUVs were fashionable) and the gas price and the lack of overtime is stretching Frank’s budget. But they want to keep the kids at the good school. They have fallen behind on the mortgage payments – but they make payments occasionally –and they can afford to make lesser payments without catastrophically adjusting their lifestyle.

Everyone who has followed this industry has seen borrowers that fit these stereotypes. However people are varied and complex and if you limit yourself to such stereotypes you are going to miss out on the richness of the world. The press articles tend to follow one stereotype or another - and hence also miss the richness of the world. As I am in Australia (reading bank account statements) and many of my readers are in the "real world" I seek comment.

That said – my guess is that these stereotypes have very different default profiles even in a diabolical real estate market.

On the stereotypes I have given you two of the buyers are essentially irredeemable – and three of the buyers could work the loan out with a little bit of forbearance, some modification of loan terms and a little bit of flexibility. The lenders will still take losses – but they won’t be catastrophic losses.

Think what happens if you modify the loans to Margaret, the debt ridden divorcee, or Tom the Flipper. You tell them you can keep the house if only you make 70 percent of the payment you originally promised.

  • Margaret got herself into this position because there was no way that she could afford her lifestyle. She borrowed by fraudulently overstating her income. She has no hope of repaying even on modified terms. The best hope for the lender is to close her up. If she gets her act together she won’t be homeless for long. But life is about to get much worse for her.
  • Tom the flipper can’t repay either (but he might be able to make 80% of scheduled payment). The problem is that Tom the flipper has no incentive to pay. He is seriously upside down [negative equity] on the loan and he only wanted to flip the house for what is now a very unlikely profit. Tom’s best strategy is to walk - and he was gaming the system in the first place - so he will walk... Again he got there through fraudulently overstating his income. The bank has the property and Tom’s lifestyle won’t change much.

Compare this to the other borrowers:

  • The typical first home owners Jack and Jane are going to be very reluctant to default. They have a proven ability to save (witnessed by the deposit that they saved). They want to join the middle class. They still see homeownership as the way there. If the lender modifies their loan they will get paid most of it. Indeed you might receive all of it. It is unlikely that a well modified loan will cost more than 10% of outstandings. Jack and Jane still have a high chance of default in a recession - and there can be a tragedy underlying this - but they will fight not to default.
  • The couple who were victims of a predatory loan are a bit more difficult. Unscrupulous brokers working for Novastar and similar companies have ripped 10 thousand plus dollars out of these people. That ten grand has gone – it has been spent. Our borrowers have paid interest at say 4 percent but accrued it at 10 percent. They now owe much more than the house is worth. They could reasonably pay the loan on the original terms – and an omniscient owner of the mortgage might restructure their loan that way. But the mortgage is now owned by a defaulted subprime pool and it is not obvious who has the power or incentive to restructure the loan. The restructure will also change the value of different classes of the mortgage securitisation. So they are going to default in my view. The loan might be able to be restructured in a perfect world – but this is not a perfect world. They will default quite rapidly when hit with increased coupon on their loan. There is an out for the lender –just the lender doesn’t know how to take it.
  • My last couple will pay (almost?) all the loan and all their loan under modified terms because they want to keep their kids in that school. But they need the loan to be modified because they are at the edge of being able to pay. Still they will cut entertainment, holidays and shrink the car to stay in the house because they want their kids in that school. If there is a recession and the husband's hours get cut - well you should probably modify the loan as that is a better outcome for the bank than foreclosure.

Note that some of these are fast defaults and some are slow defaults. If you stop rolling loans the flipper and the divorcee default almost immediately. The victims of the predatory loan default after the low-coupon period expires. The other two loans might not default at all – but whatever happens they will default slowly. They are going to try and hang on.

My point: the fraudulent loans here (stated income, predatory) have fast defaults. The non-fraudulent loans here (typical first home buyer, middle American aspirant family) have slow defaults if they default. One group can’t or won’t hold on. The other group tries desperately to hold on and might succeed.

Or in summary: fraudulent lending leads to incredibly massive and very rapid defaults with little chance of cure. There is no point offering forbearance – it won’t work.

However once the pig (a pile of fraudulent loans) has worked through the python (the mortgage market) then the bulge (defaults) will decline just as rapidly as it rose.

Non-fraudulent but stressed loans take time and if we are seeing increasing defaults now we can expect to see them for another five years. Loan forbearance programs make sense – but they can’t stop the rise in defaults over the next three to five years.

This is where having readers around the world is really useful. To what extent is it fraud – and to what extent is it old-fashioned bad lending. Does this differ by State or even area within States?

If you look at the loss curves for companies (shooting straight up) and extend them then pretty well every institution is insolvent.

Arguing from the stereotypes – if it is fraud is the dominant problem in the mortgage industry then extending these loss curves is wrong – and the losses will drop sharply once the “pig is through the python”. Many institutions that look difficult will turn out OK.

By contrast: if the problems spread to non fraudulent loans then extending the loss curve for many years is the correct analysis – and all sorts of institutions (including the GSEs) are insolvent.

You see why I am looking for comments. This is the Sixty Four billion dollar question – or – more accurately – the trillion dollar question.

I have my views – but data on fraud is particularly hard to obtain because when you survey people they don’t volunteer that they have been fraudulent. So – as the usual data-driven guy that I am I find this one difficult to nut out.

Thanks for the help



Anonymous said...

John, your differentiation of "good honest borrowers" and "fraudsters" is artificial. There is a continuous, immense and unstable distribution of personal circumstances amongst mortgagors. Trying to rescue individual mortgages by personal negotiation will be beyond the administrative and financial capabilities of most servicers. I guess that you have not been involved in direct retail lending. If you had you would have learned that it does not matter whether your loss is from "Honest Joe" or "Fraudster Fred". The loss is the same.

Anonymous said...

I know of 2 such cases - both were non-fraudulent. These people were counting on huge gains in the price. They are not stressed to the point of default - but I wonder what would happen in an economic downturn?

John Hempton said...

To the anon poster who thought my distinction is artificial. I agree.

I wrote this stating right up front I was giving extreme stereotypes...

I have been involved in retail lending - I was once a senior employee at a retail bank. There are easy cases - the electrician who fell of a ladder and has a broken leg. You know to grant forbearance. Blind Freddy can see that - and the leg is getting better. But the easy cases are NOT the bulk of cases - and my stereotypes are exactly that. I want nuance...

There are harder cases. The same electrician who is suffering depression and his income has dropped. At what point do you make the call... I am not sure that I would be capable of designing a retail bank to make those decisions well all the time - but I know we have made them in the past. [They are made less often in America than they are in Austrlaia for reasons I will explain if you contact me...]

But the point is that fraud cases produce losses quickly and they go away just as quickly. Economic cycle losses last longer.

This is really obvious with credit cards (an industry I know more about than mortgages). If you issue subprime cards usually you get a whole lot of defaults IMMEDIATELY. There is a group of people who borrow on new cards with no intention to pay at all.

Mortgage fraud was rampant. It was valuation fraud, it was fraudulent stated income, it was loans that COULD NEVER be repaid.

I wish I knew how much was the quick-and-nasty default stuff and how much was the electrician who fell of the ladder or is suddenly having less work.

Fraud might not be the right word... the question is what is the behaviour and what is the loss profile...

The loss profile for a flipper (rapid) is very different for the loss profile from a couple who have moved to an expensive district to get their kids into a better school... the flipper may not have been a "fraudster" but he still has a different loss profile to the couple...

If you want to fill this analysis out with more realistic cases I welcome it. My analysis was extreme simply because the world is infinitely more complicated than I can cope with in a series of delinquency nummbers...


Unknown said...

My research leads me to believe that the majority of the problem mortgages are the group that originated around the period of peak house prices, Spring 2005 to Spring 2006. I watch the California data and the bulk (70-80%) of foreclosures are from that period and continue to be, even as we get further away from those dates.

The pooling of mortgages leading to the inability of "good" borrowers to work through the problem times definitely pushes more than necessary into foreclosure. California (again) has aggressively pushed lenders to attempt work out programs and the results have been encouraging. From the Sacramento Bee:

"The state Department of Corporations has released its June survey of loan modifications for struggling borrowers - and reports that the numbers are still rising.
Lenders offered new loan terms to another 10,200 struggling California borrowers in
June, nearly double their totals early this year, according to DOC. The modification numbers were up 18 percent from May.

The state reported that loan modifications such as freezing interest rates for five years are now nearly half of all loan workouts. That's considered a good thing, in that it gives borrowers much longer to get through this."

At this point I believe those that can pay their mortgages or structure a work out will be much more motivated if average home prices level or even start to increase. This is problematical, however, due to the dumping of foreclosed properties by lenders to get them off their books. I think in California, anyway, that any positive pricing signs will start the next housing gold rush.

Anonymous said...

I think the common "behavior" has more to do with speculation than fraud.

Whether a flipper, or a young couple who bought just a "little extra" house or a couple with grown kids living in house far bigger than they need: knowing that x% appreciation on a larger house would be more than on a smaller, they were all speculating and leveraging as far as they could.

Some people reached harder and farther. The worst lied on loan docs, the less bad took something that might look do-able on paper (especially with lower lending standards) but which they knew was extending themselves, still others took loans they could afford but which didn't really make sense in some regard (e.g. empty nesters in a 3,000 sqft house).

But they were all speculating. And once speculators realize the deal is lost, they will become more likely to walk away.

How deep is the speculation behavior profile? Hard to say scientifically, but anectdotally you can see it in our culture all around (e.g. HGTV).

pwm76 said...

I live in California and work in finance. I took on a pro-bono "client" recently who was up against the wall thanks to mortgage/housing costs that were extremely large: 90% of his gross wages - before the ARM reset. His poor decision to buy near the peak was based on speculation, but the surprising thing I discovered when I looked at the paperwork is that he did not have to commit fraud to obtain the mortgage. Countrywide originated the 0% down ARM loan with full knowledge of my client's financial status.

My client is an immigrant, and Countrywide had reps fluent in spanish who penetrated this community.

I have a retired friend who works full time with a non-profit group focusing on individuals with high debt loads. He has had over 200 "clients" in recent years who got themselves into a very similar situation to my client. Zero money down mortgages, rising house prices, and financially unsophisticated clients all contributed to the situation.

Anonymous said...

[if it is fraud is the dominant problem in the mortgage industry then extending these loss curves is wrong – and the losses will drop sharply once the “pig is through the python”. ]

I understand your lust for data on this, but the people who know these numbers won't willingly release them.

IME, fraud is marginal. Are there technical errors in most loan packages? Yes. But does that *cause* default? No.

There have been illegitimate no docs, to be sure, but nobody would read the papers if they simply retold they typical tale of default- job loss, medical crisis, death in the family, divorce.

This problem has [one of its many] roots in lax lending standards, which began to unravel with the abandoning of the time-honored 28/36 ratios.

Nearly all decisions- for both borrowers and lenders- were predicated on the presumption of easy money, low interest rates, inexorably rising real estate values, and a strong economy.

Given these conditions, it was okay for borrowers to live very close to the edge- spending everything they made.

Car needs new tires? Charge it.

Kids need shoes? Credit card.

Furnace died and the kitchen needs remodeling? Get a HELOC.

Now the rules have changed and those "safety nets" are no longer the backstops they once were.

Borrowers were not expected to spend and save prudently, so most didn't.

Much of the discourse has been focused on "who's to blame."

Fact is, we're all in this together.

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