DON'T WORRY MR. AND MRS. INSOLVENT AMERICAN - WE CAN ALWAY REFINANCE YOUR MORTGAGE BEFORE THE TEASER PERIOD EXPIRES.
Nationally, home prices have not fallen since the Great Depression. Therefore, home prices will not fall.
Thus, the argument went, subprime borrowers with 2/28 ARMs (or 3/27 ARMs) would have sufficient home equity just from price appreciation to refinance their home mortgages before teaser rates expired and rates went through the, errr, roof (sorry about that one...).
Teaser rates, of course, are those ridiculously low interest rates that lenders and securitizers of mortgages dreamed up so they could manufacture an artificial monthly payment that most borrowers could afford for a short fixed period (2 years in the case of a 2/28 ARM, 3 years in the case of a 3/27 ARM).
Artificially low teaser rates made it possible for cash poor Americans to afford their mortgages long enough for them to be stuffed into opaque and complex mortgage bonds and sold to investors who had no clue what kind of junk investments they were actually buying. After 2004, the housing, mortgage, and mortgage securities bubbles were fueled by the supposed logic that home prices would rise forever, so loans that would be unaffordable to borrowers after the teaser expired could be refinanced before the that happened.
When a mortgage is refinanced, the clock on the teaser period resets to zero. Refinancing a 2/28 subprime ARM into a new 2/28 ARM gives the borrower a new two year period of guaranteed low monthly payments. The system was specifically engineered to keep subprime borrowers from defaulting.
Thus, as long as low-credit borrowers used the appreciation of the value of their homes to refinance their mortgages, default rates would stay low enough that mortgage-backed securities would have enough cash to pay investors.
The subprime lending industry - on which investment banks like Bear Stearns, Lehman Brothers, and Merrill Lynch made very big and insufficiently hedged bets - rested on one assumption above all others:
Housing prices would not decline (or even stall). Ever-rising home prices - and thus increases in home equity - would always make refinancing possible before teaser rates expired.
The "prices always rise" premise - which (as far as we can tell) has no logical predicate -was framed by mortgage lenders and securitizers as an axiom of the U.S. housing market.
Well, Wall Street Law Blog has a few questions (and, as always, an opinion or two)-
Q) The basis for the axiom that home prices always appreciate was... what?
(Please, tell us.)
Q) And, what would happen if the home price axiom failed (as it obviously did)?
Any company that relied on "home prices don't fall" propaganda and failed to ask and answer these questions (by answering we mean making damn sure they were adequately hedged) failed to engage in any real risk management.
The lenders and securitizers used bad logic (we've written the word axiom too much in this post already) to justify massive risk-taking.
Any financial institution that uses bad logic to make very risky bets is a classic example of 'risk management by rationalization'
By the way, there has been no world war since the 1940's. Clearly, we need not worry about the possibility of another World Warin the future. Right?
By Brett Sherman, The Sherman Law Firm