Some perspective on sub-prime credit crunch

All of a sudden we are bombarded with daily reports of a credit crunch and wild securities market fluctuations with mortgage and sub-prime lending at the root. What does it all mean?

Much of what happens in securities markets is neither rational nor explainable, but I can tell you a little history the mainstream media seems to ignore.

Let’s start with the savings and loan (S&L) industry in the years before Jimmy Carter. Back then, S&Ls were the primary source for mortgage loans and S&L profitability was summarized in the 3-6-3 rule: pay 3 percent interest on short-term deposits, charge 6 percent interest on 30-year mortgage loans, and tee off by 3 o’clock.

There was another rule: If an applicant didn’t have a 20 percent down payment, they didn’t get the loan. Any S&L could make money in that setting.

Then came soaring interest rates that are often blamed on Jimmy Carter. I think there is plenty to blame Jimmy for, but interest rates is not one of them.

When depositors pulled their money out of S&Ls to seek higher returns because double-digit inflation was eating up their savings, S&Ls had to pay higher and higher deposit interest rates to attract money. S&Ls ended up upside down – paying high interest to depositors while earning low interest rates on long term mortgages. The 50-dollar word for that is disintermediation, and it was the beginning of the S&L crisis that killed many financial institutions.

Subsequently, the mortgage industry diversified so there are now many sources for mortgage loans, and nearly none of them keep the loans they originate. Fannie Mae and Freddie Mac, government-sponsored sources of mortgage funds, buy the mortgage loans and slice and dice them into complex derivative securities that the man on the street would not recognize or understand, then sell the pieces to investors.

But Fannie and Freddie only buy “conforming” loans up to $417,000 each with decent borrower financial strength, while the lender has to borrow short-term money on the market to finance larger jumbo loans and poor-credit-borrower “sub-prime” loans until those can be packaged for sale to other investors.

Sources of that short-term money have become reluctant to grant the loans as the problem chickens buried in non-conforming loans are coming home to roost.

That is part of the current credit crunch. Lenders have to find other, higher-cost sources of funds or stop jumbo and sub-prime lending altogether. Borrowers are left holding the bag, which could be disastrous for some borrowers who desperately need to refinance their loan.

To help you understand that, I’ll tell you about two more ingredients of market change.

First, mortgage lenders decided they would reduce their risk of disintermediation by creating the ARM, the adjustable rate mortgage.

The ARM seems reasonable at first glance, raising the rate on existing loans while market interest rates are rising, lowering the rate on existing loans while market interest rates are dropping.

But when the smoke clears, what the ARM does is transfer all the interest rate risk from the lender to the borrower, and the changes in monthly payments from interest rate movement can be dramatic.

Second, politicians and organizations like FHA applied relentless pressure to relax lending terms for the benefit of financially weak borrowers. Down payment requirements were relaxed, with loan-to-value ratios now sometimes 100 percent, meaning there is little or no down payment requirement, or the down payment is borrowed, too. Borrowers are, on average, less stable, with little equity to lean on if and when trouble arrives.

Politicians love to call sub-prime lenders “predators,” and there are indeed a few bad actors, but the truth is a sub-prime borrower is someone who has a history of not paying their debts, and lending to sub-prime borrowers involves higher interest rates due to the higher lender risk. Adjustable rate loans are often used for sub-prime lending whether the loan is for a mortgage, a car or something else.

Now, what makes ARM and sub-prime loans even more risky when interest rates are low and likely to rise? What is it that makes a rational borrower take a variable loan instead of locking in a fixed rate while rates are low?

The answer, said the spider to the fly, is that, borrowers are often desperate instead of rational, and they are enticed with temporary, low teaser rates on the loan. Lower teaser rates might last for two years, then reset to a higher natural rate for the loan, driven even higher by market conditions.

If a borrower is looking at a fixed rate mortgage monthly payment of $1,500, but the ARM offers a teaser rate making the initial monthly payment $1,300, might the fly be enticed to snuggle up to the spider?

A twist called an option-ARM offers even more temptation to the uninformed borrower. Various options can lower the initial monthly payment, and can also lead to negative amortization, meaning the total amount owed increases, instead of decreasing each month as you would expect. The risk imbedded in the loan becomes worse.

Of course mortgage loans are all about rates, terms and rational decisions. The lenders are offering choices, but the borrowers are driven by emotion and often don’t fully understand the risk they are taking.

How did all of this end up as our current financial market roller-coaster ride?

Between 2004 and 2006 mortgage lending totaled $5.38 trillion, and roughly 10 percent of those loans, 1.41 million ARMs and sub-prime loans totaling $521 billion, are now in trouble.

The peak of mortgage and sub-prime lending was in September of 2005. Now, two years later, low teaser rates are expiring and some borrowers find the rate increase pushes their payment up to an unaffordable level, meaning they couldn’t afford the mortgage in the first place.

Some were thinking if rates went up on their loan when the teaser rate ended, they could simply refinance, maybe at a fixed rate. But their home value did not hold up, the credit market is tight now, and if their payment history is spotty, they have little chance of refinancing. Hello, foreclosure.

And hello to big trouble for investors who bought these loans or their derivative securities.

Notice also the TV camera spotlights turning on for politicians seeking a publicity hook. Hillary Clinton is enjoying pointing the finger at evil sub-prime lenders, implying they are hoodwinking the poor, the disadvantaged and – gasp! – minorities.

I have to wonder if sub-prime lenders turned these deadbeats away entirely whether Hillary would be yelling about discriminatory lending practices.

Meanwhile, New York’s other senator, Charles Schumer, is on a rant against mortgage brokers, and asking taxpayers to pony up $300 million to help the poor disadvantaged borrowers about to lose the home they couldn’t afford in the first place.

Hmmmmm. Nobody bailed me out the last time I made a stupid financial decision; how about you? And throwing rocks at mortgage brokers would be funny if not so naive.

Mortgage brokers help borrowers select a lender from a dizzying array of sources with varying terms. Brokers screen the borrower, compare lenders and terms and gather underwriting documents to pass on to the lender. Mortgage brokers get paid a fee for bringing together the lender and the borrower and are prevented by regs from making any underwriting decisions. Underwriting is the lender’s responsibility; it is their job to reject weak borrowers. Let’s split the difference and call Chuck’s complaint about mortgage brokers a farce.

The financial markets have jumped all over the map in recent days, settled down Friday after the Federal Reserve dropped a key borrowing rate by 50 basis points, but market reaction to impending failures tied to ARM and sub-prime loan failures is not over yet, and we are likely to see more business failures.

None of this would have happened if the lenders had applied tougher standards to loan applications — refusing to lend to weak borrowers — and if borrowers had refrained from borrowing what they cannot reasonably repay when their interest rate resets in an increasing rate environment.

But you can’t count on eager borrowers to be reasonable about what they can repay, and you can’t count on borrowers to insist on the fixed rate medicine that is good for them when an adjustable loan and teaser rates push their problem into the future.

Changes that would solve the problem in the future would involve a return to fixed rate loans, reasonable down payment requirements and tougher underwriting. Politicians could return to whining about the people who don’t qualify for a loan because, “Doesn’t every American deserve to own their home?”

But don’t count on such a return to basics.

I wish we could count on our representatives in Washington to do the right thing even when it is hard. But this fiasco is one more example that we can count on them to do the easy thing, no matter how wrong it might be.