Why so many sub-prime loans went bad

I'll admit to posting the excerpt below partly to "vent". I am amazed by the foolishness of many lenders and disappointed by the dishonesty of many home buyers.
I guess some obvious financial planning lessons are (1) If you don't qualify for an amortizing (not interest-only) loan at a good rate, that's a strong sign you are trying to live beyond your means. (2) Home ownership has its advantages and disadvantages and is not for everyone.
http://www.nytimes.com/2007/05/08/business/08lend.html A Cross-Country Blame Game By VIKAS BAJAJ Published: May 8, 2007
"The popularity of stated-income loans, derisively referred to as "liar's loans" by critics, seemed impervious to evidence that the loans made it easier for borrowers and brokers to commit fraud.
According to a report by the Mortgage Asset Research Institute, for example, one lender found in a sampling of loan applications that the incomes listed on 60 percent of the applications were, on average, 50 percent higher than those on the borrowers' tax returns.
Lenders liked the loans because they could be processed quickly. Loan officers did not have to verify bank statements, tax returns or other documents.
Borrowers also were charged a higher interest rate, often about 0.5 percentage point higher, making the loans more profitable."
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

A good read. Another line that leapt out at me was: "The [Ownit] company was a big lender of 40-year and 45-year mortgages, which Mr. Dallas says are a better way to put moderate- and low-income families into homes than adjustable-rate loans that start with low introductory rates but reset after a few years to much higher rates."
I can't get excited about low income people taking out a 45-year mortgage, probably in their 30s, and so paying off the house until they die sometime in their 70s (or younger, since IIRC income correlates w/age of death).
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
Elle wrote:

I raised an eyebrow when these were introduced. On a 30 yr 6% loan $250K, PMT = $1499 At 35 yrs, same rate, $1375, just $124 less. And 40 year drops another $35. If you are that tight, perhaps you can't afford the house? But even so these are far from the exploding ARMs.
Was there no legal requirement that the borrower be qualified at the adjusted non-teaser rate? Was it not 'common sense' that a 1yr T-bill rate of 1% was an anomaly, and rates would likely revert to the more normal 4-5% for the short term? It just seems to me that much of this fiasco was avoidable.
JOE
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

snip the usual good bottom line type of analysis, for brevity

Did you see the line in the article "If I can sell it at a profit, why would I not do it?"
Someone made money on these mortgages; perhaps bigwigs at the top of the banking food chain (and I w/my humongous cap bank stocks)? As long as this incentive is there, then w/insufficient regulation by the law, it was unavoidable.
I think of how excited people were about a year ago at the prospect of buying a house that would appreciate rapidly. We just had another post here at MIFP today or yesterday arguing what a great investment real estate is. That kind of submission to group think can only be stopped with better education and critical thought processes, starting very young. Otherwise, why would people not trust a lender to tell them how qualified they are for a loan? The rule for decades was, after all, that lenders did turn away "riskier" folks or add strings to their loans like a certain percent of downpayment; PMI yada; etc.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
Elle wrote:

Yes, funny, I found myself sympathetic to that approach. Putting myself in his shoes, I have investors asking me to create loans which I'd pass on to them. The perfect loan is one where the debt to income is right, FICO scores way up there, LTV is 80% or less, and fixed rate, etc. Those seem to be drying up in terms of the customers I can find and even though I know it's wrong, well, Merrill Lynch is pushing me to create sub prime packages. If I don't do it, the guy next door will. (stepped away to wash my feet) The securitization of junk bonds is similar only the numbers are different, no 'millions' of loans set to default. My objection is this, there should have been some type of regulation that would prevent this. Many regulars here revert to caveat emptor, which may be fine, but the math is beyond many if not most people. And it would seem the collective memory of this country is short lived. But "the google" will offer you http://mortgage-x.com/general/indexes/t-bill_index_faq.asp#Historical_Graphs showing that short rates below 2% are an aberration, a rate not seen since the late 1950's. I am old enough to remember the S&L crisis and the Lincoln Savings bank meltdown (1989). My only question is, will we finally learn from this? Or will history repeat yet again? JOE
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

News reports in the last few days on questions members of Congress are asking certainly suggest many (with the power to cause change) feel as you do.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

Real estate scams happen every couple of decades or so. Bush Sr. spent about $150 billion cleaning up the last one. New regulations ARE put in place. People figure out ways around them, typically be inventing new ways of selling real estate.
This round it was the securitization of mortgages and the modulization of the process. No one authority is really repsonsble for the lifetime of the mortgage. So there was a tendancy to go after volume and let standards slip.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

This is just a variation on the problem Bush Sr. had. In that case, it was savings and loans selling high yield CDs, then needing to loan the money at high rates, so they did aggressive (and often fraudulent) loans.
The good news in the current round is that the government is not guaranteeing the mortgage securities (as they did guarantee the CDs), so the tax payers will not be out of pocket on that end.
The buyers of those mortgage securities are big boys and girls. If they didn't know the risks they were taking, they should have.
-- Doug
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

They aren't that big. I expect if things get much worse, they will go crying to the fed to bail them out...
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

I believe things _are_ going to get worse. I do a little consulting for a company in the real estate business in Massachusetts. The number of houses currently for sale is way up. The time a house sits on the market is way up. The percentage of properties that are in foreclosure or pre- foreclosure is way up. And the sub-prime fiasco has a ripple effect: First time buyers are finding it harder to buy their first house, and people wanting to sell thier starter home and buy something bigger cannot buy until they sell. This means the sub-prime ripple is expanding.
Vin - Menotomy Vintage Bicycles http://OldRoads.com
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

Not being able to afford 2 mortgages is a sub-prime ripple? For first time buyers, my advice would be, save a little longer or buy a little less. It's not sub-prime that's the problem, it's wanting everything now.
If you cannot afford a 30 year fixed, then you cannot afford the property in the first place.
Mortgage companies will loan you the world if that's what you want. Keep the Mortgage, Insurage and taxes at 20-22% Gross and you'll be ok. Forget about the calculators and the mortgage companies willing to loan you 30-40-50 of gross. You'll pay the mortgage, and even get a deduction, but you won't be able to eat, take a vacation, much less save for retirement, college, etc.

======================================= MODERATOR'S COMMENT: Please trim the post to which you are responding. "Trim" means that except for a FEW lines to add context, the previous post is deleted.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

Obviously not. However, the banks are skittish now and are not only refusing to loan to people they would have happily accepted 3 years ago, but even some people they would have accepted 10 years ago are having trouble finding loans. For example, people with 800+ FICO scores but want to borrow 100%.

Why that particular time span? Why not 15 year, or 40?

I don't think that is the case anymore, and I think that was OldRoads' point.

There are a lot of assumptions built into the above, YMMV.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
Daniel T. wrote:

Because there's a 'knee' in the curve where 30 seems to be an optimum duration. On a $500K loan @ 6%, 15 years is $4219, 30 yrs is $2998, and 40 yrs is $2751. So it would be more fair to say if you can't afford the $249/mo to go from the 40 to 30 yr mortgage, you may be cutting it close, pulling it in to 15 years is $1200 more. In my perfect world, a bank would always be willing to cut the rate if one committed to pull in the duration of their mortgage. e.g. 5 years into a 30 year mortgage, you decide you can afford to pay more and will commit to payments to pay in full over 15 more years. The bank agrees to 1/2% cut in rate as this now shows as a 15 yr loan, not a 30 with 25 to go. In effect, it's a refi, with no fuss, and works independent of rate moves. (the typical delta between 15 and 30 is 1/2%)
JOE
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

You explain why a 25% reduction in duration is less dramatic than a 50% reduction, but you don't explain why 30 years is the baseline.
For example I could say that if you can't afford the $381/mo to go from 30 to 22.5 years, you may be cutting it close, while pulling it in to 11.25 years is $1700 more. Thus using your logic, I could show that 22.5 years is the appropriate loan duration.
I ask this because I heard it mentioned on the Dave Ramsey show the other day. He asked "why 30 years?" According to him, the number is arbitrary ("Because banks are willing to do it.") SO I'm wondering, is it really that arbitrary?
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
Daniel T. wrote:

I believe it dates back to the 1930s when the federal government first began insuring mortgages - the creation of the FHA. They chose 30 years as the term...I don't know why, and I don't know why that was the term of the long-term Treasury bond either, but maybe the two are related - early US budgetary assumptions? I don't know. I just googled about FHA and apparently before the FHA, mortgages were 3-5 year, had balloon payments at the end, and required 50% down. So it seems figuring out why the FHA chose 30 years would tell us why that's the convention. Does anyone have a copy of the Congressional Record from 1934 handy?
These days FHA loans are a small part of the mortgage market but then again, so are 30-year loans - smaller than they used to be anyway. The mortgages available simply are the products lenders are willing to offer, which reflects what investors are willing to buy. I think you're right that there's no reason a 30-year would be optimal for everyone, and it's arbitrary at this point given the financing alternatives. If I could have gotten a 50-year (or 100-year) at the same rate I got a 30-year, I would have grabbed it in a heartbeat, for a house I'll keep forever...but who would lend money at a fixed rate for so long? Nobody.
-Tad
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

My guess is 30 years was just about the average homeowner's working life, post buying the home. But that's only a guess.
I just googled about FHA

Japan got to 50+ year loans at the peak of the housing bubble. You would buy a house, and will it and your mortgage to your children.
If I

And yet there is a huge market hole there, for very long duration liabilities-- insurance companies and pension funds. You need an offsetting asset, and there are none.
If you could package the mortgages up (to reduce credit risk) then you could do it. Some utility companies are offering very long term bonds, but generally lenders (investors) want the best credit level, ie government.
Analagously, infrastructure investing has taken off. Infrastructure (toll roads, water pipes etc.) is a very long lived investment, with long duration. This matches nicely the liability problem of even a fairly mature pension fund.
The UK government offered a 50 year gilt and it was snapped up. A 50 indexed gilt (ie a TIPS) would be a brilliant product.
http://neweconomist.blogs.com/new_economist/2005/03/uk_to_issue_50y.html
and indeed it looks like one was issued: the indexed link 1 3/4% gilt of 2055.
http://www.dmo.gov.uk/index.aspx?page=Gilts/Indexlinked
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

It's a valid question. About 50 years ago, plus or minus, the standard mortgage was of 20 years duration. When did the standard become 30 years and why? I believe that in the late 50s and early 60s, real estate prices were climbing. Did it then become necessary to extend the usual loan period to accommodate more buyers, the same way ARMS have now become so commonplace?
Elizabeth Richardson
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
Daniel T. wrote:

This is what I looked at (500K, 6%) yrs pmt compared to next time e.g. 10 yr is 32% more than 15 yr 10    5551    1.32 15    4219    1.18 20    3582    1.11 25    3222    1.07 30    2998    1.05 35    2851    1.04 40    2751    1.03 45    2681    1.02 50    2632
Each 5 years takes a much higher percent jump, but 25 years is non-standard for a loan, even though you can suggest 25 is better than 30, but from there 20 is pushing it.
Dave Ramsey suggests "The most ideal way to buy a house is the 100%-down plan. Sounds weird, doesn't it?! But think how much fun that would be! Don't borrow money. Period. If I can't get you to postpone the purchase that long, I strongly suggest you save a down payment of 20% or more, choose a 15-year (or less) fixed-rate mortgage, and limit your monthly payment to 25% or less of your monthly take-home pay."
He's a bit too conservative for my taste. But I suppose we wouldn't have the current meltdown if people took his advice. Only the mortgage applicant can decide their own comfort level. If one has a house as a priority, and will budget around it, there's nothing wrong with the standard ratios and a 30 year payout. If one's income rises with inflation, 5 years hence there's 15% more cushion in the budget. JOE
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

I just saw a 50 year term advertised... 30 year is 14% more expensive than 50. So if the house is affordable on a 50 year note, but not a 30 year note, is it affordable?
I could see saying that 30 years is the magic number because "most people buy their first house at 40 and retire at 70." (I don't know if that is true or not.) But to say that 30 years is special simply because 20 makes the cost of the house too high for someone who can afford it at 30 seems too arbitrary.
You seem caught up in the "can I afford the monthly payment" trap.

Agreed. But, what is so right about it?
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
Daniel T. wrote:

Maybe nothing, maybe securitization. More banks package their loans and sell them than keep them. In which case, you'd agree that you're not going to find mortgages of non-five-year-multiple to be easily combined.
So we have 15 and 30 as most common, with some 20 year mortgages available. I've shown that the savings are less for each year you add, and a 50 year mortgage is close to an interest only. Annecdotal evidence tells me very few people buy a house and pay the mortgage for its entire duration. I'm here 11 years and on my 4th mortgage, all no point no closing refies. Avaerage time in a home is 7 years, so people are doing a lot of moving around.
JOE
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

BeanSmart.com is a site by and for consumers of financial services and advice. We are not affiliated with any of the banks, financial services or software manufacturers discussed here. All logos and trade names are the property of their respective owners.

Tax and financial advice you come across on this site is freely given by your peers and professionals on their own time and out of the kindness of their hearts. We can guarantee neither accuracy of such advice nor its applicability for your situation. Simply put, you are fully responsible for the results of using information from this site in real life situations.