Wednesday, January 20, 2016

Housing, A Series: Part 104 - About those resets...

I have been reading "All the Devils Are Here" and happened upon this passage (pg. 252 , Hardcover edition):
Scene 2: Fall 2006.  Larry Litton is a mortgage servicer... Litton also notices that early payment defaults are soaring.  The mortgage originators are freaking out and blaming him.  "The WMC guys are saying 'You suck,'" Litton recalls.  He remembers thinking, "Maybe we're doing something wrong." So Litton comes up with what he calls an "ultra-aggressive move": hand delivering welcome packages to new homeowners, so there will be no confusion over where the mortgage checks should be mailed.  But when the Litton employees arrive at the newly purchased homes, they discover something truly startling.  "My people came back and said, 'Thirty percent of the houses are vacant,'"  Litton recalls.  In other words, borrowers who closed on mortgages had so little means to make even the first payment that they never bothered to move in.

Just think about that last sentence for a minute.  Just given this information, would any reasonable person conclude that the reason for this was borrowers who closed on a mortgage with no means for payment?  This is evidence for anything but that.  Borrowers with no means would move in until they were forced out, wouldn't they?  Wouldn't they at least take a few months of free shelter?  Have tenants or delinquent borrowers anywhere ever behaved this way?  When you talk to landlords, do they say things like, "It's bad out there.  When I traveled to my properties this week to collect rents, I realized many tenants had moved out, in anticipation of missing a future rent payment."?  Or have you met car dealers who said, "Boy, we really need to fix our credit department.  Buyers keep coming in, filling out the papers, making a small down payment, then walking out the door without the title or the keys, because they realize they won't be able to make payments."?

This is one of the struggles I have about my approach to this story.  I want to get into the heads of my potential readers.  But, how do I do that when practically everyone reads passages like this and nods their heads in confirmation?  Should I expect them to rub their eyes and shake their heads and come out of some deep stupor?  I rather expect them to react stubbornly.  I would react stubbornly if I were them, because even if I might have a small, technical point about this one thing, obviously there is so much evidence of abuse that this one thing doesn't really matter, isn't there?  I mean, we all know that, right?

And, then I realize that even I, on my contrarian bender, have not noticed an obvious contradiction in the standard accounts of the boom - an issue (not the first, I think) where everyone believes two things which I think are both wrong, but that, in any case, couldn't both be right at the same time.  We all know that by 2006, underwriting had become so irresponsible that massive numbers of homebuyers weren't even making their first payments.  We also know that by 2006, mortgage originators were back-loading the terms in their mortgage deals, so that low income households could afford houses that were much too expensive for them, with payments they could afford for a couple of years until higher payments would kick in, and that those resets created a bunch of foreseeable defaults that eventually brought down the housing market.

I supose, if we ignore the evidence that says homebuyers didn't have lower incomes during the boom, and if we ignore the evidence that says homebuyers weren't buying up to more valuable homes during the boom, I suppose there is some possible universe where both things could happen.

But, back to these potential readers.  Even giving the benefit of the doubt.  Presenting and accepting this statement as rationally obvious is kind of bizarre.  At best, one might expect the authors to react by saying, "This is kind of strange behavior.  Let's check this out to confirm our hunch."  And, one might expect the reader to demand that.  What's strange is that there are some academic articles on the reasons for early defaults that ask that question.  But, in the popular, complete narratives of the boom, the question simply doesn't seem to have been asked.  We had our devils.  There were no more questions to ask, just fodder for the prosecution's case.  How will people react to a surprising answer to an important question they never felt like asking?

So, we know that in late 2006, buyers started walking away from homes right out of the gate.  Maybe the buyers who still remained also walked away, 2 or 3 or 5 years later when their teaser rates reset.  The evidence appears to overwhelmingly support this second wave of defaults due to resets...if resets on all mortgage types in all cohorts were timed to happen around the end of 2007.

Here is a graph of Alt-A mortgage defaults from a St. Louis Fed report.  Behavior is similar for prime (with lower levels) and subprime (with higher levels).  In all loan types, defaults are low through the 2005 cohort.  You can see when each cohort hits late 2007 by where defaults kink up.

Here is a typical news article on the issue from February 2008.  This is from CNN.  It is interesting how they frame the issue.  They note that households are walking away from homes because they are underwater.  But it is framed in terms of impending rate resets.  "Homeowners are abandoning their homes and, more importantly, their mortgages, rather than trying to keep up with rising payments on deteriorating assets."  Notice how an unverifiable presumption is combined with a known fact.  Even in the midst of home prices declining by 1% monthly, even in an article describing strategic defaults and the correlation between negative equity and defaults, the presumption is that this is a result of poor underwriting and onerous terms.

Here is another CNN article, from later in February 2008. "Defaults are spiking well before resets come into play thanks to the lax lending environment of the past few years. Many borrowers were approved for mortgages that they had little chance of affording, even at the low-interest teaser rates ."
The subtitle: "It turns out that massive interest rate spikes aren't the problem -- many borrowers couldn't afford these mortgages even at the low, introductory interest rates."  We just knew that underwriting was terrible, and when defaults for 2004, 2005, 2006, and 2007 cohorts all began to sharply rise in late 2007, that confirmed it.

One response is that this is how bubbles work.  They keep sucking on fumes, pushing ahead as long as the party can last, until the bottom drops out.  That could explain prices (which by now were two years past their peak).  But, how does that explain millions of households with supposedly unsustainable mortgage terms managing to muck along for one, two, or three years, all defaulting at the same time, regardless of the year of origination?  And, subprime originations in 2004 and 2005 were very high, but defaults were low.  Originations in 2006 were very high, and defaults were high.  Originations in 2007 were low, but defaults were even higher.  Default rates were really not correlated with origination growth, and the ability of households to cover for unsustainable terms with refis isn't as strong an argument for the range of outcomes among these years as it seems, especially when we consider the number of cities with strong housing markets that didn't see price spikes.  All of the news articles of this period are a fascinating window into the ethereal essence of information, reason, and collective story-telling.  A collective presumption of knowledge creates a pretense of collective learning.

The first article also includes a mention of the Mortgage Forgiveness Debt Relief Act of 2007.  This act was passed in September 2007.  Normally a household would have to pay taxes on mortgage debt forgiven after a foreclosure or short sale.  This act made it easier for families and investors to walk away from underwater mortgages.  It was eventually extended until the end of 2013.  Here is a graph of delinquencies.

We couldn't help families by supporting credit markets or stabilizing nominal home prices, because we knew that home prices were too high and mortgage underwriting was too lax.  But we could give them tax relief for defaulting on mortgages.  You get what you subsidize, as they say.

 On the other hand, there were a number of resets that came due in 2011-2012.  So, maybe there was some persistence of delinquencies related to them.  But, even this seems unlikely, as both floating and fixed interest rates by that late date were far below the original levels, so that even with teaser rates, the resets should have created much less of a shock than they might have in 2007.

Added: Here is a graph of subprime default rates that I should have included.

Added: Here is an even better one.



  1. Making it easier to walk away is because banks wanted their houses back. That is a no brainer.

    As far as the first part of the article goes, there were taxi drivers buying multiple houses. They could not live in all of them, Kevin. Lol.

    Oh, and as for defaults, don't forget, many people lived over 5 years in preferred communities without being foreclosed on. The banks hid all that to keep prices up. That must be the NGD targeting you are talking about. :))

  2. About the last chart, Kevin: 2003 and 2004 subprime were written mostly by government, and were more carefully compared to real income. The 2005-2006 subprime only required a heartbeat and the ability to fog a mirror, and the loans were sold into private securitization.

  3. My first thought, "They were investment properties not primary residences." His "people" weren't going to tell him, "Oh yeah, we thought they might be lying on the mortgage app but what the hell, I'm not a mind reader, they filled out the forms, we followed all the procedures correctly, they got the loan and we got paid!"

    Maybe they were using those loans where the buyer didn't have to put down any money so essentially the buyer could walk away without any real costs. They could see what was happening to home prices before they decided whether or not to make the first payment.

    If an independent group did the survey, I bet the results would have been different, not self-serving for the mortgage company.

    1. Yes. I agree with you. This passage is typical, in that it is anecdotal evidence that doesn't really match the data we have. Nothing near 30% of subprime loans were ever defaulting in the first couple of months. I suspect this was specifically a situation with new homes. But, in that case, I would expect there to be escrow accounts which were what buyers would have walked away from. I wouldn't think the mortgage would be initiated until the home was completed. So, the whole story is strange enough that it really demands some explanation. And that's what is so frustrating about the public's sense of what happened. There are a bunch of these anecdotes floating around that form the emotional core of the story, and they are so emotionally satisfying that some pretty strange accounts are holding up the foundations of the story.

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