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There has been a lot of talk about all of the ills of subprime and a fair amount of discussion over what happened and who is to blame. I thought it might be helpful to see what an actual subprime loan looks like and see why it was issued in the first place.

Joe makes $4,000 per month but he built up serious credit card debt (groceries, electronics, music, travel, medical bills, whatever) and after monthly expenses, he has nothing left. Joe gets a letter in the mail (or a phone call) from XYZ Mortgage, Inc. The letter says – we can help you consolidate your debt. So, Joe decides to meet with the broker and they go over his financials:

Joe’s gross income: $4,000 (~$50,000 annually)
Joe’s net income: $3,250

(I have played it a little loose with the numbers here since I don’t have anything specific to work off but this was fairly typical of a subprime loan in the late 90s. In the 90s though, the interest rate spread between prime and subprime loans was wider, 3% or more (I think) then it was during the bubble. The interest rates used here may be low and may actually paint a somewhat more favorable picture. This example is a 30 year fixed rate loan.)

Joe’s expenses:

Fixed:
$150,000 mortgage      ($1100/mo) (8% fixed, 30 years)
$10,000 credit card 1   ($250/mo)
$15,000 credit card 2   ($375/mo)
car, ins, taxes, etc.        ($700/mo)

Joe’s total monthly fixed expenses: $2,525.00

Variable:
$500 groceries (has kids)
$300 utilities
$100 gas
$100 misc. (many other possible variable items)

Joe’s total monthly variable costs ~ $1,000

$2,425 + $1,000 = $3,425 = no breathing room

The broker informs Joe he can get a new $175,000 mortgage and move the credit card debt into the mortgage to free up some cash. The new deal looks like this:

The appraiser reports that Joe’s property is worth $200,000 indicating the property has appreciated by $50,000. (This could be legitimate appreciation or the broker may have informed the appraiser in advance that he needed a $200,000 valuation so the deal could close. There is a considerable amount of documentation that this type of appraisal fraud is common. More on this later.)

New $175,000 mortgage (1300/mo.)

New monthly fixed expenses:
$175,000 mortgage ($1300/mo)
car, ins, taxes, etc.   ($700/mo)

Monthly total: $2,000

Old fixed – new fixed = available cash
$2,425 – 2,000 = $425

Once Joe has his new subprime loan, he has around $400 of additional cash available per month.

Does Joe live happily ever after?

A lot of that depends on Joe. Does he start saving money? Does he get a new credit card offer in the mail and get himself into credit card debt again? One thing that people may have trouble understanding is that once you have gotten yourself into debt, it is very difficult to get out. The burden just increases over time. Getting in debt is a lot like gaining weight. When you are 200 pounds overweight, it is that much harder to get up and exercise.

In this example, the debt-to-income ratio is 50% ($2,000 debt / $4,000 income). [I think Fannie will go up to 40-45% debt, I need to look that up.]

So, even under the best circumstances where the borrower is fully documented and the broker acted properly, the situation is tenuous. If you start layering-on the various forms of mortgage fraud (falsified income documents or statements, appraisal overstating property value, predatory lending, concealed debt, etc.) and the situation is entirely unworkable. The borrowers will default even if it is not an ARM.

If you are going to blame the Federal Reserve for keeping interest rates too low and creating a credit bubble (which basically means that money was cheap enough for people to act irresponsibly) then I think you need to drag the credit card companies into the equation as well (as this example illustrates). (it is a lot easier to get a credit card than a mortgage.)

Let’s look at a variation on this loan. Now, suppose that Joe’s house, though it appraised for $200,000 was really only worth $170,000. He’d owned the house for seven years but his neighborhood was not seeing the type appreciation of some of the other, nicer neighborhoods. When the broker placed the order for the appraisal, he also informed the appraiser that he needed a $200,000 valuation (Joe is likely not aware of this). So, the appraiser, not necessarily a bad guy, but dependent on the brokers for income, cherry picks the comps (the property comparisons), the appraisal is good enough to get through underwriting and the deal gets approved. Now, for whatever reason (lost his job, he needs to re-locate, etc) Joe needs to move. This time, when the house is appraised it comes in at $170,000. Joe figures out that if he sells his house he won’t have enough to pay-off the loan, realtor fees and other expenses – he is underwater.

There are many different types of subprime loans but this is a fairly typical example…

Last 5 posts by Rick Pollack

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19 Responses to “An Example Of A Subprime Loan”

  1. Ken Says:

    Seriously, thanks for this. It may be the most plain-english explanation of the sub prime mess I’ve seen yet.

    I don’t have anything to add to the conversation :( just wanted to say thanks :)

  2. Carole Cohen Says:

    I blogged specifics last week about predatory lending. Good explanation.

  3. Rick Pollack Says:

    You are welcome Ken!

    Carole, thanks for the info:

    PD article on mortgage fraud: http://blog.cleveland.com/metro/2008/10/3_charged_in_mortgage_fraud_th.html

    Carole’s blog entry: http://www.clevelandrealestatenews.com/the-face-of-predatory-lending/2008/10/16

  4. Carole Cohen Says:

    I was trying not to comment about the credit card companies but I can’t stay away. lol. I agree 100%. The government looked away (or the ‘regulators’ if there really are any) while credit card companies sat outside bankruptcy hearings so they could chase people down and offer credit as they leave the hearing. They sat silent while companies had hidden small print about when they start charging higher interest. Now again, I believe we are all responsible for our own fiscal responsibility, but then that should translate to the credit card companies too.

    I brought up the issue with a few financial services advisors who spoke on a panel. We talked afterwards and I said, wouldn’t it be better if the credit cards were all like American Express and you had to pay your balances every month. All three gentleman said ‘omg no our country is built on credit we’d go into a depression for sure if we tampered with credit.’ It’s enough to make you go aaaaack lol

    No one in my industry likes my idea about appraisals not being allowed to top 10% of the top valuation of market value (for people paying in cash or buying down their mortgage loans to meet market value). You might think I’m crazy too :-)

  5. J Murray Says:

    Rick, well explained. Is Joe just a pawn to the actions of others, or does he have free will?

  6. Daniella Says:

    I had a credit card for years with a fairly hefty credit limit which I did not use. I paid my monthly $4.99 Netflix and Consumer Report subscription with it to keep it open…in case that I needed quick cash.

    Last month I was late in making my $14.00 payment. A collector called me and wanted a payment over the phone. I told her I was not comfortable giving bank information to an incoming caller.

    I told her that I would pay through my bank as usual and asked her to close my account. She told me that I had to pay $108.00 to close the account in spite of not having any other debits to my account.

    She was doing very strange maths but I had my calculator near by and told her that even at 24.5% interest rate this had to be a mistake?

    No mistake, she said. I told her not to do anything with the account. I hung up and called customer service and closed my account by writing them a check for the amount of my debits not $108.00

    True story, and people may say that you have free will to not be a pawn but many people trust that financial institutions are honest and accurate.

  7. michael feigenbaum Says:

    i agree that Joe is also responsible for understanding what he has accepted. however the laxed lending policy blessed by the gov’t. of the past several years lead to this loose credit and the results are what we face today. i bought my first home 25 years ago, we needed 20% down and only qualified if we had 25% of our income allocated to repay the loan. i think the trend to expect these high appreciations on real property were delusional and most people knew this going in but chose to ignore reality to have the illusion of the American dream realized even for this short time. the criminals in this are the banks, investment houses that repackaged and resold the debt like a commodity when the reality was they were peoples’ homes not hogs and sugar. i would love to see all the appraisal people, loan officers, and investment bullshitters convicted but we all know this will never happen. WHERE IS MY BAILOUT? I HAVE BEEN WORKING FOR 15 YEARS KEEPING A REAL BUSINESS WORKING AND PRODUCING TANGLE EDIBLE PRODUCTS EVERY DAY. today i am treading water as fast as i can just to stay open.

  8. Rick Pollack Says:

    I don’t know Jonathan. Is Joe is a puppet or does he have free will? Do credit cards companies have any responsibility in their lending practices?

  9. Hugh Cadle Says:

    Let’s see, the mortgage brokers bit off the invisible hand that fed them and then take $700B? Free markets, baby! Sorry, just had my JM moment.

  10. Mark W. "Some Guy on Bridge" Schumann Says:

    I’ve personally seen Countrywide try to sneak about $3,200 in closing costs at the last minute onto a “no closing costs” refinancing.

    (No, Jonathan, before you dispute the story again–I was there and you were not. This really did happen.)

    My point: sometimes there are merely clueless borrowers. But sometimes the lenders really are crooked.

  11. Carole Cohen Says:

    Daniella that is outrageous, glad you shared the story. I wonder if that caller was from a scam organization or a separate scam from an arm of the credit card company?

    “My point: sometimes there are merely clueless borrowers. But sometimes the lenders really are crooked” well said Mark

  12. Gloria Ferris Says:

    It appears that the property next door to us was refinanced by Deutsche Bank while it was a vice board-up. The owner was cited for code violations that needed to be addressed before the property could be inhabited again. The property was boarded up for two years.

    No tenants, no income, no nada. The bank refinanced it. No was the borrower at fault or was the lender or fault or is it a combination of the two.

    A year ago last spring, the court and our councilman allowed the boards to come down with the understanding that the landlord would take care of the violations in a timely manner. His live-in rehabber did the fixing in lieu of rent. This spring that tenant and his relatives nearly killed a man. ( Three weeks ago after a group of neighbors testified to what they had seen and heard that horrible night) These jokers decided it was in their best interest to now plead guilty) The victim and his girlfriend did not have to testify to how his life has changed. The bright spot in all of this as well as ALL of the three involved will do jail time.

    Now, we hear that the landlord plans to shortsell the property. He is currently in foreclosure on the property.

    In the last ten years, this property has had two owners one who refinanced twice and then transferred it to the now owner who proceeded to refinance three times.

    Ask me if I care whose fault this is? I don’t. I do care what this slopply lending practice plus a slum lord who took advantage of this practice tried to do to my neighborhood.

    Didn’t happen we put away the drug dealers and the thugs who he allowed to live there rent free. we have continued to question what is going on with the property and where it is in housing court. we have continued to sweep and pick up and mow the grass when it is empty so that it doesn’t look any worse than it has to look.

    Oh, and this week, pending inspections bright yellow mums turned up at the base of the porch. Just a little bit of lipstick on the pig as the much overused saying goes.

  13. DANIELLA Says:

    Gloria,

    This is a terrible situation. This hurts the community and brings down the value of real estate. I don’t know what more a neighborhood can do to fight this kind of highjacking?

    Maybe someone else can come up with a plan? I wish I had one.

  14. J Murray Says:

    Rick, the responsibilities of a business include obeying the law (no matter how convoluted our regulators and courts make it), serving customers, and providing returns to shareholders. You didn’t answer my question, though. My answer is that Joe played the lottery with his house and lost. There is no free lunch, although many people seem to want to believe that there is.

    In the old days, as described by Michael, you had to make a down payment of 20% to buy a house and prove your income. Then along came Barney Frank and Chris Dodd, who led the charge to charter Fannie Mae and Freddie Mac to make it possible for more people to buy homes. This meant Congress empowering Fannie and Freddie to buy up mortgages, packaged into securities or not, in which the “homeowner” had little or no money down, and provided incomplete or nonexistent proof of income. All aided by “community organizers” like ACORN.

    The behavior you incent you get more of, and Congress incented the market to lower lending standards. That is the root of the current crisis.

    There are people who should not be homeowners. Political pressure should not be permitted to allow Congress to shift risks from one group of citizens (uncreditworthy non-taxpayers) to another (creditworthy taxpayers). That’s what happened here.

    I fault the banks, though for succumbing to this political pressure and lowering lending standards. I would like to see one bank CEO with the backbone to stand up to Barney Frank and tell him, “No, Congressman, we are not going to write mortgages to people who can’t afford them.” This won’t happen, though, because Congress would pressure regulators to threaten to yank the bank’s charter, and the bank’s board would throw out the CEO.

  15. Loan Origination Basics | Brewed Fresh Daily Says:

    [...] This example was typical of actual lending at The Associates (TA) during the mid to late 90s. TA, the largest publicly traded finance company in the U.S, was acquired by Ford in the late 80s and then spun off again in the mid-90s and was then acquired by Citi in 2000. http://www.citigroup.com/citi/corporate/history/associates.htm [...]

  16. Rick Pollack Says:

    Jonathan, your comments on this matter, like so many of the financial instruments at the heart of the current crisis, are opaque. I am going to start referring to your narrative as GoJ, the Gospel of Jonathan, since you won’t provide source material for your key points and especially for your causal assertions.

    This is a complex subject and as former Secretary of the Treasury John Snow said in his Congressional testimony today, “the breakdown in our capital markets is the product of many complex and inter-related forces that were not fully apparent at the time and defy clear understanding even today.” Yes, the GSEs (Fannie/Freddie) and government action/inaction are central components. I am, however, interested in getting a clear and nuanced understanding of what happened and sharing that information. There is a serious risk that Congress and state/local governments will act on a perception of what happened rather than on rational analysis.
    http://oversight.house.gov/story.asp?ID=2256

  17. J Murray Says:

    Rick, what I’m doing when I write here is not a research project. I’m sharing the results of years of knowledge and experience, and the pattern recognition that occurred from that.

    You may have heard it said recently that, for instance, each Presidential candidate needs to provide a “narrative” to explain the current economic situation. How we got here, what here is, what we do going forward, etc. This is my approach, to provide a narrative. It is a deliberate attempt to counter other faulty narratives that are being advanced.

    Unlike some of the other narratives, it does not begin with a political philosophy, though, but with empirical evidence, tempered with experience and observation.

    I’m happy to supply sources. I have read thousands of articles on this subject over the last decade, though, and I may not even know where those sources are anymore. Ask a specific question and I’ll do my best to find a specific source in answer.

    My best suggetion remains to read the last (now) 90 days of OP-ED articles on OpinionJournal.com. It’s one place where a large number of experts in the various elements of this subject provide their insight and wisdom.

    Try this article, Not Everyone Should Own a Home: http://online.wsj.com/article/SB122325772150706655.html

  18. Rick Pollack Says:

    Jonathan, thanks for the link. I have a subscription to WSJ and Financial Times and I do on occasion read the opinions. Why do I say on occasion? Frequently they are just ideological pieces that do little to help with understanding the issues. Take the article you suggested, Not Everyone Should Own a Home, by Janet Albrechtsen.

    I really don’t know anything about the Australian residential and mortgage market but some quick research turned up some interesting stuff:

    Here is the IMF report she references (a link in the piece would have been nice) http://www.imf.org/external/pubs/ft/scr/2008/cr08311.pdf

    Albrechtsen extracted from the report, ‘Australia’s banking sector “is sound with stable profit, high capitalization and few non-performing loans.”’

    The report also says, “The Australian banks have weathered the global financial turmoil reasonably well to date.” Notice that ‘to date’. The report was completed August 18th, 2008.

    From today’s The Age (Australian) business page: Worries grow on mortgage funds

    “FEARS are growing the crisis in the nation’s $12 billion mortgage fund sector could soon spill into the broader property market, with developers and home buyers at risk of having a key funding tap shut off.”

    Given that Australia has a population of around 20 million, I’d imagine that $12B means something to an Australian reader. http://business.theage.com.au/business/worries-grow-on-mortgage-funds-20081024-58be.html?page=1

    Out of all English speaking industrialized countries, Australia has one of the least affordable housing markets, with nearly 90 per cent of areas surveyed considered severely unaffordable.
    http://bernardoh.wordpress.com/2008/03/18/the-great-australian-dream-no-more-australia-housing-crisis-is-real/

    I did a few minutes of research and I’m wondering what she is talking about. And, then she starts rambling about Jimmy Carter and Fannie/Freddie. So, after reading her piece and doing some quick research, in order for it to be helpful it needs to go through a POV filter so the facts can separate from the rant.

    Here is the type of stuff that I find useful:

    Even though congressional testimony is political theater, it is an opportunity to hear from the people on the front lines – yesterday it was Greenspan, Cox and Snow. I found their testimony to be informative and at least a few of the questions/exchanges were useful.

    I’ve found this paper, The Law & Economics of Subprime Lending, to be very informative. They do a good job of cracking open the subprime nut and tweezing out the value vs. sham. I think you would agree with many of their findings and, as far as I can tell, there isn’t any posturing. http://www.law.gmu.edu/assets/files/publications/working_papers/08-17%20Law%20&%20Economics%20of%20Subprime%20Lending.pdf

    This piece from the New York Federal Reserve, Understanding the Securitization of Subprime Mortgage Credit, has been very helpful as it explains the various components of Mortgage Backed Securities. One very helpful aspect is they dissect an actual 2006 MBS issued by New Century/Goldman Sachs – GSAMP TRUST 2006-NC2. I think you might be surprised by the makeup of the underlying mortgages. I plan to do another post using this data but I’m still working on it. http://www.newyorkfed.org/research/staff_reports/sr318.html

    So, though I do read opinion pieces, I primarily read detailed analysis, seek out expert opinion, and try to make sense of SEC filings, congressional reports, etc.

  19. J Murray Says:

    Rick, yes, some Op-Eds are ideological, but the majority of them are expert opinions with supporting evidence. They’re at least the equivalent of Congressional testimony, and probably more informed and objective than most questions and statements by legislators.

    What do you think of the Australian model of mortgages being resource, v. mortgages in the U.S. being no-recourse? Do you think that has anything to do with people buying above their means or with foreclosure rates?