I hear that because the housing market is going sour, a lot of people are defaulting on their loans.
I also hear that over the last several years, banks have been offering people really bad, unsustainable loans.
The people running these banks’ loan departments can’t be idiots. They must have known that people were being given loans who would not have the resources to continue making the payments on them once the payments went up later on.
So my question is, what does a lender get out of giving out a loan s/he knows the borrower is likely to eventually default on?
In an individual case under conditions of certainty, nothing. But in the aggregate under conditions of uncertainty, they can make more loans and expect to collect more interest. Use the economic concept of thinking on the margin. In a drastic oversimplification, lets say they are considering whether to make loans at a credit score of n vs. n-1. They know that the percentage of defaults will be higher if they loan at n-1. Thus they know they will be making more bad loans, but don’t know with certainty which ones. The decision they are making is whether the profit from overall loans to n-1 group will make up for the extra defaults. The fact that people with poor credit pay higher interest rates and are probably more prone to generate late fees and less likely to refinance when rates drop probably pays into the profitability of the additional loans.
I think it’s good business for them. They make a loan to someone who can’t afford it. That guy pays 90% Interest/10% Principal for the first couple years. Then he can’t swing it anymore and loses the house. Free stuff! The bank sells the house at a profit. Why wouldn’t they cater to people who can’t afford it? Bastids.
Another thing to keep in mind.
There is a very good chance that the people who make the loans will be selling them off in a short time. We-R-Loans makes 100 home loans. They then bundle those 100 loans together and sell them off to investors. The investors assume that enough of the loans will be paid off to make them a profit in the long term.
We-R-Loans’ incentive is to collect the closing fees on as many loans as possible. They don’t really care if the loans default in 2 years. They will have sold off the loans by then, and it’s someone elses problem.
To get a home loan you have to pay “points.” These are 1% of the total loan. If you have bad credit, the bank can charge you high points (the highest I’ve seen was 17). They collect the points and keep the cash.
Almost anyone in the country can get a loan if they are willing to pay the bank’s points and interest,
Tastes of Chocolate has the right idea. The “lender” processing your mortgage application is hardly ever the one to carry the risk–most loans get shipped off to Fannie Mae and Freddie Mac to be bundled and resold–two companies which, incidentally, have gotten in trouble for overstating profits associated with the mortgage business.
The real question is, who is possibly dumb enough to buy piece of junk mortgage backed securities subject to this awfully lax underwriting?
Fund investors might purchase a bundle of loans for what they believe to be a low price, not realizing or not caring that the risk is reflected in that price. They find an even less risk-averse investor looking to buy high-interest debt, and sell it to that investor at a profit. It’s not much different from the “junk bond” era – high-risk debt being sold like a commodity with very little realistic risk assessment. In this case, however, it’s someone’s family declaring bankruptcy rather than a designed-to-fail shell company.
I’m guessing lots of the buyers were hedge fund investment managers, who are bound only by the rules in their contract (and not by the SEC or NASD).
People have the right idea here, but they are missing some two links in the chain.
Typical process for subprime loan:
Mortgage **broker ** takes application. Mortgage brokers almost never do portfolio lending (holding the mortgage as an investment). For one thing, they usually need a different license to do it. For another, they usually don’t have the capital to fund mortgages themselves. So they sell them to lenders. They often get points from borrowers and back-end compensation (yield spread premium, and some other goodies). The good part about being a broker is that there is almost no liability if the borrower defaults. So the broker’s incentive is to submit as many loans as possible. The more that get approved, the more profit.
Broker submits loan to mortgage lender. The broker usually only warrants against fraud, the lender does the underwriting and makes the lending decision. There are two kinds of lenders in this conduit: lenders like the now-bankrupt New Century (http://www.pr-inside.com/new-century-bankruptcy-news-issue-no-r127447.htm ) reviewed the application and sold the paper on the secondary market. But selling the paper on the secondary market isn’t risk free, which is why New Century became financially unstable. When the loans tank, they’ve got financial obligations, and if a bunch tank at once . . . well . . . you see what happened. The other kind of lender, like my company, has a few options. The most appealing financially is if they can sell closed loans to bigger investors like GMAC and a few other industry giants. The best compensation for these investors comes from delegated underwriting. In this arrangement, the lender can sell loans that it has already made, to an investor, as long as the loan is underwritten to the lender’s specifications. The lender, in turn, gets a servicing released premium, and some other goodies. Basically they sell the loan to the investor at face value, plus a premium. This is usually expressed as a percentage: 103 is face value plus three percent. The Loan Purchase Agreement usually provides a penalty for early defaults (usually 60-90 days late within the first 4-6 months, depending on the contract). So the lender sells the loans and crosses its fingers that any defaults happen outside the EPD period. Conversely, investors hope that the bad loans will default early so that they can pass the loss back downstream to the lender.
Some investors hold onto some of the loans they buy; others trade them on the secondary market as bundled, securitized loans. Either way, as I said, they don’t walk away when the loan defaults. They try to manage their risk contractually and by supervising the default rates of their correspondent lenders, among other things.
So, why did these loans get written? Brokers did it for the money; lenders did it for the money; and investors did it because the experience until fairly recently was that the increased rates and charges offset the expected loss from the higher risk loans; in other words, they did it for the money too. As the economy changed, the performance of the loans changed, and the market for them changed, and suddenly the loans were costing them tons of money.
As far as foreclosure being a win for the investor, it’s not. They aren’t built to maintain real estate portfolios (called REO in the industry), those whose homes are foreclosed often abandon them or vandalize them and if the market is flat, the investor will have to lay out money just to keep the property from deteriorating or being seized by taxing authorities. Usually the investor winds up buying the property at auction for the cost of the mortgage and then holding onto it (in many states there is a redemption period–six months here in Michigan) which extends the time during which the property is a financial loser. That’s why it’s hard to get a loan at 100% of the property value. If the borrower defaults, the investor is sure to lose money on the foreclosure.
I was under the impression that the lender could only get back the value of the loan (+ fees?) when they sell a forclosure, any extra money went to the debtor. Am I completely wrong on that? Is that dependant on local law?
Of course, if you could sell the house at a profit, the owner would sell it, pay off the loan, keep the extra money and his “good” credit.
Generally correct; practically irrelevant. If the foreclosure sale (an auction of sorts, generally) results in a sale price that exceeds the outstanding liens on the property, then the debtor gets the excess. This seldom happens. Instead, the mortgagee goes to the sale and picks up property for the mortgage amount. The mortgagee then holds the property in its REO portfolio and hopes to sell it for at least the mortgage amount. If it sells the property from its REO portfolio and makes a profit, it gets to keep the money.
Right. And it turns out to be harder than you might think to sell a property for the price you want once it is in foreclosure.
Foreclosures are usually not profitable for anyone involved. A lot of subprime lenders are in the business of selling loans before they go bad, though.
My brother is in the mortgage business and he said this is the case. We once had the following conversation…
Him: I’m trying to sell more high-risk loans.
Us: :dubious: Why would you want to do that?
Him: Higher interest rate. Make more money.
Us: But what happens when they can’t pay?
Him: By that time it’s the bank’s problem, not mine.
I heard on NPR about an organization called Prosper that essentially brokered unsecured microloans to individuals from individuals for a piece of the action. It works on an auction type situation where someone who wanted, say $2000.00 would have money loaned to them in increments as small as $50.00 by lenders who would compete on the basis of the interest rate, where the lowest interest rate got the loan. Prosper collects the payments and distributes it to the lender’s accounts.
It’s interesting to watch the free market operate so transparently. As a lender you have access to debt-to-income ratio, credit ratings (not FICO scores, but a graded system), verification of home ownership, etc. The interest rates percolate with the worst risk loans rising to the top. I feel really badly for people who get caught up in those payday loan traps at 99% interest, but looking at the histories, there are some people I’d want to get that kind of interest from as well. If you spend some time browsing around the borrower’s requests and watch the funding progress it gives you a idea on how the banking system works, at least in a microcosm.
My understanding is that the default rates on Prosper are significantly higher than they were originally predicted to be, and that Prosper has had to restructure their credit rating “tiers” at least once because people in the lowest one were so regularly defaulting that it was something of an embarrassment to Prosper. I’ve also heard that the cost of borrowing on Prosper is driven extra low because there are so many lenders with unrealistic expectations.
It’s way too early to say for sure, but my bet is that, over 10 years, you’re better off buying stock in Citi than investing in loans on Prosper, if you really want to get involved in the consumer credit business.