Wall Street Law Blog

Wall Street's Favorite Disclaimer: "Past Performance is No Guarantee of Future Results"

Home prices can fall! Shocker, right? This post is an updated examination of one of the chief rationales behind the nonprime mortgage lending model... (hint - even moderate scrutiny reveals that this rationale is really a rationalization)

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.

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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)?  

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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.  

Period.

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Any financial institution that uses bad logic to make very risky bets is a classic example of 'risk management by rationalization'  

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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

On Housing, Highly Leveraged Assets, and Interest Rate Changes (Greatest Hits Volume 2)

A brief bit of common sense.

Warning. We are not about to offer any earth shattering insights in this short post.  However, when the world of finance reaches levels of complexity and duplicity capable of causing the most significant financial crisis since the Depression, simplicity and common sense are often relegated to the far back burner. So, we decided to pour ourselves a bowl of simple facts about housing.

Specifically:

The housing market is hyper-sensitive to interest rate changes.

For a substantial majority of homeowners, houses are their most leveraged assets.  In other words, most people actually own very little of their houses.  For the most part, the bank or investor that owns our mortgage also owns most of our home.

Interest rate changes so significantly impact housing because interest rate level often determines what type of home a family can afford.  Falling rates lead to refinancings and even downward resets of adjustable rate mortgages.  Most significantly, there is higher demand for homes and, eventually, higher prices.  When credit is cheap and easy to get, homes are more affordable (at least in the short run).  Thus, low interest rates generally equals more homeowners and, by the way, low rates of default and foreclosure.

When rates go up, however, refinancings plummet, home sales (and, eventually, prices) decline because the higher cost of borrowing lowers buyer demand.  Adjustable rate mortgages reset upward.  The segment of the home-owning public that chose adjustable rate mortgages to stretch for houses that may have been unaffordable with traditional fixed rate mortgages can find themselves unable to make their new, higher monthly mortgage payments.  Thus, when interest rates increase, defaults and foreclosures follow suit.

As we said, nothing new here.  All common sense.  Which begs the question - who in their right minds would base an entire industry (subprime lending and, by extension, mortgage backed securities) on the premise that there would not be high default rates on ultra-low interest adjustable rate mortgages to people with poor credit histories succeed after the cycle turned and interest rates climbed back toward historical averages (i.e., when rates started to trend toward the mean)?  Who would make this bet?  Was anyone be surprised that bad credit borrowers would default in droves once their low initial monthly payments increased by hundreds of dollars a month?

These are not hard questions now, and they weren't hard questions in 2002 or 2003 or 2004, 05, 06, or 07 either. Wall Streetdrove the subprime lending explosion. Wall Street understood interest rate cycles. Wall Street knew rates would rise.  Wall Street knew defaults and foreclosures would spike. Wall Street didn't care - the money was rolling in.  The fact that Wall Street itself got so badly burned was the product of greed and knowingly reckless risk-taking.

By Brett Sherman, The Sherman Law Firm.