An Inquest into the Subprime Crisis

, image by Paul Townsend

Coroners Inquests in Gloucestershire from The Gloucester Journal 1814

Juan Ospina and Harald Uhlig have posted Mortgage-Backed Securities and the Financial Crisis of 2008: A Post-Mortem to SSRN. Given that the market for private-label MBS pretty much died by 2008, the title is apt. The paper presents a challenge to many of the standard narratives that have developed to explain the causes of the subprime crisis and the broader financial crisis that followed. Other researchers in this area will surely take up the gauntlet thrown down by this paper. Hopefully, we will collectively come up with the right narrative to explain the whole mess. The paper opens,

Gradually, the deep financial crisis of 2008 is in the rearview mirror. With that, standard narratives have emerged, which will inform and influence policy choices and public perception in the future for a long time to come. For that reason, it is all the more important to examine these narratives with the distance of time and available data, as many of these narratives were created in the heat of the moment.

One such standard narrative has it that the financial meltdown of 2008 was caused by an overextension of mortgages to weak borrowers, repackaged and then sold to willing lenders drawn in by faulty risk ratings for these mortgage back securities. To many, mortgage backed securities and rating agencies became the key villains of that financial crisis. In particular, rating agencies were blamed for assigning the coveted AAA rating to many securities, which did not deserve it, particularly in the subprime segment of the market, and that these ratings then lead to substantial losses for institutional investors, who needed to invest in safe assets and who mistakenly put their trust in these misguided ratings.

In this paper, we re-examine this narrative. We seek to address two questions in particular. First, were these mortgage backed securities bad investments? Second, were the ratings wrong? We answer these questions, using a new and detailed data set on the universe of non-agency residential mortgage backed securities (RMBS), obtained by devoting considerable work to carefully assembling data from Bloomberg and other sources. This data set allows us to examine the actual repayment stream and losses on principal on these securities up to 2014, and thus with a considerable distance since the crisis events. In essence, we provide a post-mortem on a market that many believe to have died in 2008. We find that the conventional narrative needs substantial rewriting: the ratings and the losses were not nearly as bad as this narrative would lead one to believe.

Specifically, we calculate the ex-post realized losses as well as ex-post realized return on investing on par in these mortgage backed securities, under various assumptions of the losses for the remaining life time of the securities. We compare these realized returns to their ratings in 2008 and their promised loss distributions, according to tables available from the rating agencies. We shall investigate, whether ratings were a sufficient statistic (to the degree that a discretized rating can be) or whether they were, essentially, just “noise”, given information already available to market participants at the time of investing such as ratings of borrowers.

We establish seven facts. First, the bulk of these securities was rated AAA. Second, AAA securities did ok: on average, their total cumulated losses up to 2013 are 2.3 percent. Third, the subprime AAA-rated segment did particularly well. Fourth, later vintages did worse than earlier vintages, except for subprime AAA securities. Fifth, the bulk of the losses were concentrated on a small share of all securities. Sixth, the misrating for AAA securities was modest. Seventh, controlling for a home price bust, a home price boom was good for the repayment on these securities. (1-2)

Republicans and the Mortgage Interest Deduction

photo by Nick Youngson

There is a lot to hate in the Republican tax reform plan contained in the proposed Tax Cuts and Jobs Act. (click here for a summary and here for the text of the bill itself). Overall, the bill is extraordinarily regressive, heavily favoring the wealthy. There will, of course, be all sorts of compromises to this proposal as Republicans work to get it passed. But it is worth highlighting what is good about the bill as it would be a shame to lose sight of it while the sausage is being made in Congress.

The best real-estate related provision from a policy perspective is the reduction of the mortgage interest deduction. In a section of the summary with the Orwellian title, Preserving the Mortgage Interest Deduction, the Republicans outline how they will slice the deduction in half:

For so many Americans, buying a home is often the largest investment – and perhaps most important – investment they will make in their lifetime.

The Tax Cuts and Jobs Act will continue to support the American dream of homeownership by preserving the Mortgage Interest Deduction.

This ensures that hardworking families can continue to access this important tax relief as they buy, own, and maintain their home.

Policy Specifics

• Increasing the standard deduction means a simpler, fairer, and flatter tax code in which fewer taxpayers need to go through the trouble of determining whether they should itemize.

• Under the Tax Cuts and Jobs Act, taxpayers will still be able to deduct mortgage interest in excess of the standard deduction, in combination with other remaining itemized deductions, including charitable contributions and property taxes.

• The mortgage interest deduction would be available for interest paid on new mortgages for up to $500,000 in home acquisition indebtedness on principal residences.

• For existing mortgages, the plan allows for current law deduction on indebtedness of up to $1,000,000 and up to $100,000 in home equity to help taxpayers who may have relied on the current mortgage-interest deduction.

How This Policy Helps the American People

Preserving the home mortgage – and the deduction for state and local property taxes – will help more Americans of all income levels achieve the American dream of homeownership. (15-16)

This plan would cut the principal amount of a mortgage that would be eligible for the mortgage interest deduction from the current maximum of $1,000,000 to $500,000. Given that wealthy households generally take the mortgage interest deduction more often and get more bang for their buck from it, it is a regressive aspect of the tax code.

It is striking that a provision with such broad support such as the mortgage interest deduction is actually on the table. It will be interesting to see how special interests in the real estate industry will respond. My bet is that at the end of day the deduction will remain mostly untouched, even though this particular Republican proposal makes good policy sense.

Easy Money From Fannie Mae

The San Francisco Chronicle quoted me in Fannie Mae Making It Easier to Spend Half Your Income on Debt. It reads in part,

Fannie Mae is making it easier for some borrowers to spend up to half of their monthly pretax income on mortgage and other debt payments. But just because they can doesn’t mean they should.

“Generally, it’s a pretty poor idea,” said Holly Gillian Kindel, an adviser with Mosaic Financial Partners. “It flies in the face of common financial wisdom and best practices.”

Fannie is a government agency that can buy or insure mortgages that meet its underwriting criteria. Effective July 29, its automated underwriting software will approve loans with debt-to-income ratios as high as 50 percent without “additional compensating factors.” The current limit is 45 percent.

Fannie has been approving borrowers with ratios between 45 and 50 percent if they had compensating factors, such as a down payment of least 20 percent and at least 12 months worth of “reserves” in bank and investment accounts. Its updated software will not require those compensating factors.

Fannie made the decision after analyzing many years of payment history on loans between 45 and 50 percent. It said the change will increase the percentage of loans it approves, but it would not say by how much.

That doesn’t mean every Fannie-backed loan can go up 50 percent. Borrowers still must have the right combination of loan-to-value ratio, credit history, reserves and other factors. In a statement, Fannie said the change is “consistent with our commitment to sustainable homeownership and with the safe and sound operation of our business.”

Before the mortgage meltdown, Fannie was approving loans with even higher debt ratios. But 50 percent of pretax income is still a lot to spend on housing and other debt.

The U.S. Census Bureau says households that spend at least 30 percent of their income on housing are “cost-burdened” and those that spend 50 percent or more are “severely cost burdened.”

The Dodd-Frank Act, designed to prevent another financial crisis, authorized the creation of a “qualified mortgage.” These mortgages can’t have certain risky features, such as interest-only payments, terms longer than 30 years or debt-to-income ratios higher than 43 percent. The Consumer Financial Protection Bureau said a 43 percent limit would “protect consumers” and “generally safeguard affordability.”

However, loans that are eligible for purchase by Fannie Mae and other government agencies are deemed qualified mortgages, even if they allow ratios higher than 43 percent. Freddie Mac, Fannie’s smaller sibling, has been backing loans with ratios up to 50 percent without compensating factors since 2011. The Federal Housing Administration approves loans with ratios up to 57 percent, said Ed Pinto of the American Enterprise Institute Center on Housing Risk.

Since 2014, lenders that make qualified mortgages can’t be sued if they go bad, so most lenders have essentially stopped making non-qualified mortgages.

Lenders are reluctant to make jumbo loans with ratios higher than 43 percent because they would not get the legal protection afforded qualified mortgages. Jumbos are loans that are too big to be purchased by Fannie and Freddie. Their limit in most parts of the Bay Area is $636,150 for one-unit homes.

Fannie’s move comes at a time when consumer debt is soaring. Credit card debt surpassed $1 trillion in December for the first time since the recession and now stands behind auto loans ($1.1 trillion) and student loans ($1.4 trillion), according to the Federal Reserve.

That’s making it harder for people to get or refinance a mortgage. In April, Fannie announced three small steps it was taking to make it easier for people with education loans to get a mortgage.

Some consumer groups are happy to see Fannie raising its debt limit to 50 percent. “I think there are enough other standards built into the Fannie Mae underwriting system where this is not going to lead to predatory loans,” said Geoff Walsh, a staff attorney with the National Consumer Law Center.

Mike Calhoun, president of the Center for Responsible Lending, said, “There are households that can afford these loans, including moderate-income households.” When they are carefully underwritten and fully documented “they can perform at that level.” He pointed out that a lot of tenants are managing to pay at least 50 percent of income on rent.

A new study from the Joint Center for Housing Studies at Harvard University noted that 10 percent of homeowners and 25.5 percent of renters are spending at least 50 percent of their income on housing.

When Fannie calculates debt-to-income ratios, it starts with the monthly payment on the new loan (including principal, interest, property tax, homeowners association dues, homeowners insurance and private mortgage insurance). Then it adds the monthly payment on credit cards (minimum payment due), auto, student and other loans and alimony.

It divides this total debt by total monthly income. It will consider a wide range of income that is stable and verifiable including wages, bonuses, commissions, pensions, investments, alimony, disability, unemployment and public assistance.

Fannie figures a creditworthy borrower with $10,000 in monthly income could spend up to $5,000 on mortgage and debt payments. Not everyone agrees.

“If you have a debt ratio that high, the last thing you should be doing is buying a house. You are stretching yourself way too thin,” said Greg McBride, chief financial analyst with Bankrate.com.

*     *     *

“If this is data-driven as Fannie says, I guess it’s OK,” said David Reiss, who teaches real estate finance at Brooklyn Law School. “People can make decisions themselves. We have these rules for the median person. A lot of immigrant families have no problem spending 60 or 70 percent (of income) on housing. They have cousins living there, they rent out a room.”

Reiss added that homeownership rates are low and expanding them “seems reasonable.” But making credit looser “will probably drive up housing prices.”

The article condensed my comments, but they do reflect the fact that the credit box is too tight and that there is room to loosen it up a bit. The Qualified Mortgage and Ability-to-Repay rules promote the 43% debt-to-income ratio because they provide good guidance for “traditional” nuclear American families.  But there are American households where multigenerational living is the norm, as is the case with many families of recent immigrants. These households may have income streams which are not reflected in the mortgage application.

What Is Compound Interest?

photo by Roman Oleinik

US News & World Report quoted in What Is Compound Interest? It opens,

When it comes to investing, compound interest really is the most powerful force in the universe. Remarkable in both its simplicity and its power, compound interest is the concept of reinvesting, along with the original principal sum, the interest earned on your investment.

As a result, you earn interest on top of interest, and then more on top of that larger sum, and so on. “Over time, a small amount of money can become a mountain of money,” says David Winters, CEO of Wintergreen Advisers.

Compound interest is one of the most basic concepts for investors to understand, in no small part because its magical results work the same whether you have $100 or $100 million.

In that sense, it’s every investor’s secret weapon – and you probably want to use your secret weapon if it can help you build your retirement nest egg (which it can). Unfortunately, if you look at how the average American spends and invests, it doesn’t reflect a great respect or understanding of compound interest.

It’s time to change that.

Proving its power in a thought experiment. David Reiss, professor of law at Brooklyn Law School, likes to convey the profound power of compound interest with a riddle of sorts.

“Would you rather receive a gift on Jan. 1 of $1 million, or a penny that doubles every day for the rest of the month?” Reiss says. “Most kids would go for the million bucks, but those who are patient enough to do the math know that they can get millions more if they are patient enough to wait the month.”

It’s true. The penny-doubler would in fact finish January with $9.7 million more than his or her instant gratification-seeking friend.

Prepaying Your Mortgage

photo by www.aag.com

Newsday quoted me in Paying off Your Mortgage Early Might not Make Sense (behind paywall). It opens,

There are few greater feelings than making that last mortgage payment. Some people feel better still if they pay it off early. But sometimes it doesn’t make sense to pay off your mortgage early.

First things first: Be sure you have adequate emergency savings before you put extra money into paying off the mortgage early. Then consider what’s the best use of any extra money you have.

While taking a shorter-term mortgage or prepaying principal saves you tons in interest, remember that mortgage interest is typically tax deductible.

Warren Goldberg, founder of Mortgage Wealth Advisors in Melville, offers an example. If you had a 5 percent interest rate on your 30-year fixed mortgage, depending on your tax bracket, your equivalent, after-tax interest rate might only be 3.3 percent. Even in today’s tumultuous market, it’s not difficult to earn a return greater than 3.3 percent after taxes.

“By paying the minimum on your mortgage and investing the balance, your money can be working for you. Your investments can be earning more than the interest you are paying,” says Goldberg.

David Reiss, a professor at Brooklyn Law School specializing in real estate, agrees: “If you have not maxed out your retirement savings, it might make sense to direct your extra funds to tax-advantaged retirement accounts. You could end up being better off overall as those accounts grow tax-free over time.”

Home Equity Loan Resets

photo by Karel Chladek

Newsday quoted me in Know What To Do When Your Home Equity Loan Resets (behind paywall). It opens,

Whoever said what you don’t know can’t hurt you, was wrong. Take for example the 43% of U.S. homeowners polled by TD Bank, who over the next couple of years will have their Home Equity Lines of Credit (HELOC) reset. More than a quarter of them don’t know when their draw period ends.

People use HELOCs for things like home renovations, medical bills and college tuition. With HELOCs, you borrow — often for 10 years — and make interest-only payments. When that “draw period” ends, you pay principal and interest. Monthly payments can jump significantly.

However, only 19% of those polled understood that a reset would increase their monthly payments and 34% thought they would decrease.

Confusion is costly.

  • Understand the terms

What is the current interest rate? When does it reset? When it resets, how is the new interest rate determined? When are principal payments first due? What will the new payment be? Can the HELOC convert to a fixed interest rate? Know the answers to these questions, says David Reiss, a Brooklyn law school professor, specializing in real estate.

  • Come up with a game plan

“Don’t wait until the final month of the interest-only period to evaluate the impact the payment has on your budget,” says Chuck Price, vice president of lending at NEFCU in Westbury.