Conservative House Financing – Part 1

What they are saying about The Great Housing Bubble

“The Great Housing Bubble is a fantastic resource for anyone looking
to understand why home prices fell. The writing has exceptional depth
and detail, and it is presented in an engaging and easy-to-understand
manner. It is destined to be the standard by which other books on the
subject will be measured. It is the first book written after prices
peaked, and it is the first in the genre to detail the psychological
factors that are arguably more important for understanding the housing
bubble. There have been a number of books written while prices were
rising that used measures of price relative to historic norms and
sounded the alarm of an impending market crash. Economic statistics and
technical, measurable factors show what people did, but they do not
explain why they did it. The Great Housing Bubble analyzes not only
what happened; it explains why it happened.

Morgan BrownThe Great Loan Blog

Conservative House Financing

When people decide they want to buy a house, they figure out how
much they can afford, then they search for something they want in their
price range. For most people, what they can “afford” depends almost
entirely upon how much a lender is willing to loan them. Lenders apply
debt-to-income ratios and other affordability criteria to determine how
much they are willing to loan. Buyers are generally limited in how much
they can borrow because lenders are wise enough not to loan borrowers
so much that they default. Borrowers behave much like drug addicts–they
will borrow all the money a lender will loan them whether it is good
for them or not. Most borrowers are not wise to the differences between
the various loan types, and they have limited understanding of the
risks they are taking on.

The vast majority of residential home sales have lender financing.
The interest rates and various loan terms have evolved over time. After
World War II a series of government programs to encourage home
ownership spawned a surge in construction and the evolution of private
lending terms resulting in the 30-year conventionally amortized
mortgage. This mortgage generally required a 20% downpayment, and
allowed the borrower to consume no more than 28% of their gross income
on housing. These conservative terms became the standard for nearly 50
years. Lending under these terms resulted in low default rates and a
high degree of market price stability.

There were experiments with various forms of exotic financing during
this period, particularly in markets like California where price
volatility required special terms to facilitate buying at inflated
pricing. The instability of these loan programs was demonstrated
painfully during the deep market correction of the early 90s in
California characterized by high default rates and lender losses.
Rather than learn a difficult lesson regarding the use of these
alternative financing terms from this experience, lenders sought out
ways of shifting these risks to others though a complex transaction
called a credit default swap. Once lenders and investors in mortgages
thought the risk was mitigated, these unstable loan programs were
brought back and made widely available to the general public resulting
in the Great Housing Bubble.

Mortgage Interest Rates

Mortgage interest rates are the single-most important factor
determining the borrowing power of a potential house buyer. When rates
are very low, a borrower can service a large amount of debt with a
relatively small payment, and when interest rates are very high, a
borrower can service a small amount of debt with a relatively large
payment. Mortgage interest rates are determined by market forces where
investors in mortgages and mortgage-backed securities bid for these
assets. The rate of return demanded by these investors determines the
interest rate the originating lender will have to charge in order to
sell the loan in the secondary market. Some lenders still hold
mortgages in their own investment portfolio, but these mortgages and
mortgage rates are subject to the same supply and demand pressures
generated by the secondary mortgage market.

Figure 2: Components of Mortgage Interest Rates

Mortgage interest rates are determined by investor demands for risk
adjusted return on their investment. The return investors demand is
determined by three primary factors: the riskless rate of return, the
inflation premium and the risk premium. The riskless rate of return is
the return an investor could obtain in an investment like a short-term
Treasury Bill. Treasury Bills range in duration from a few days to as
long as 26 weeks. Due to their short duration, Treasury Bills contain
little if any allowance for inflation. A close approximation to this
rate is the Federal Funds Rate controlled by the Federal Reserve. It is
one of the reasons the activities of the Federal Reserve are watched so
closely by investors. The closest risk-free approximation to mortgage
loans is the 10-year Treasury Note. Treasury Notes earn a fixed rate of
interest every six months until maturity issued in terms of 2, 5, and
10 years. The 10-year Treasury Note is a close approximation to
mortgage loans because most fixed-rate mortgages are paid off before
the 30 year maturity with 7 years being a typical payoff timeframe.

The difference in yield between a 10-year Treasury Note and a 30-day
Treasury Bill is a measure of investor expectation of inflation, and
the difference between the yield on a 10-year Treasury Note and the
prevailing market mortgage interest rate is a measure of the risk
premium. Inflation reduces the buying power of money over time, and if
investors must wait a long period of time to be repaid, as is the case
in a home mortgage, they will be receiving dollars that have less value
than the ones they provided when the loan was originated. Investors
demand compensation to offset the corrosive effect of inflation. This
is the inflation premium. The risk premium is the added interest
investors demand to compensate them for the possibility the investment
may not perform as planned. Investors know exactly how much they will
get if they invest in Treasury Notes, but they do not know exactly what
they will get back if they invest in residential home mortgages or the
investment vehicles created from them. This uncertainty of return
causes them to ask for a rate higher than that of Treasury Notes. This
additional compensation is the risk premium. Mortgage interest
rates are a combination of the riskless rate of return, the risk
premium and the inflation premium.

The fluctuation in mortgage interest rates has implications for when
it is the best time to buy and the best time to refinance a home
mortgage. It is a popular misconception that low interest rates make
for a good buying opportunity. When interest rates are declining,
borrowers can finance larger sums, and this does prompt many people to
buy and home prices to rise, but when interest rates are low is also
when prices are highest. A buyer in a low-interest-rate environment may
obtain an expensive property, but the resale value of that property
will decline when interest rates rise because future buyers will not be
able to finance such large sums. A low-interest-rate environment is an
excellent time to refinance because a conservative borrower can either
obtain a lower payment or shorten the amortization schedule and pay the
loan off faster. The best time to purchase a house is when interest
rates are very high. Again, this is counterintuitive because the
interest is so much greater, but this will also mean the amount
financed will be much lower and house prices will be relatively low. It
is better to buy when interest rates are high and later refinance when
interest rates decline. A borrower can refinance into a lower payment,
but without additional cash, a borrower cannot refinance into a lower

Types of Borrowers

Borrowers are broadly categorized by the characteristics of their
payment history as reflected in their FICO score. FICO risk scores are
developed and maintained by the Fair Isaac Corporation utilizing a
proprietary predictive model based on an analysis of consumer profiles
and credit histories. These models are updated frequently to reflect
changes in consumer credit behavior and lending practices. The FICO
score is reported by the three major credit reporting agencies,
Experian, Equifax and TransUnion. Borrowers with high credit scores
have generally demonstrated a high degree of responsibility in paying
their debt obligations as promised. Those with low credit scores either
have little or no credit history, or they have a demonstrated track
record of failing to pay their financial obligations. There are 3 main
categories of borrowers: Prime, Alt-A, and Subprime. [1] Prime
borrowers are those with high credit scores, and Subprime borrowers are
those with low credit scores. The Alt-A borrowers make up the gray area
in between. Alt-A tends to be closer to Prime as these are often
borrowers with high credit scores which for one or more reasons do not
meet the strict standards of Prime borrowers. In recent years one of
the most common non-conformities of Alt-A loans has been the lack of
verifiable income. In short, “liar loans” are generally Alt-A. As the
number of deviations from Prime increases, the credit scores decline
and the remainder are considered Subprime.

Types of Loans

There are also 3 main categories of loans: Conventional,
Interest-Only, and Negative Amortization. The distinction between these
loans is how the amount of principal is impacted by monthly payments. A
Conventional mortgage includes some amount of principal in the payment
in order to repay the original loan amount. The greater the amount of
principal repaid, the quicker the loan is paid off. An Interest-Only
loan does just what it describes; it only pays the interest. This loan
does not pay back any of the principal, but it at least “treads water”
and does not fall behind. The Negative Amortization loan is one in
which the full amount of interest is not paid with each payment, and
the unpaid interest gets added to the principal balance. Each month,
the borrower is increasing the debt. Two of the features of all
Interest-Only or Negative Amortization loans are an interest rate
reset and a payment recast. All these loans have provisions where the
interest rate changes or loan balance comes due either in the form of a
balloon payment or an accelerated amortization schedule. In any case,
borrowers often must refinance or face a major increase in their
monthly loan payment. This increase in payment is what makes these
loans such a problem.

Table 2: Loan Type and Borrower Type Matrix


Interest Only

Neg Am


Subprime Conventional

Subprime Interest Only

Subprime Neg Am


Alt-A Conventional

Alt-A Interest Only

Alt-A Neg Am


Prime Conventional

Prime Interest Only

Prime Neg Am


The category of loan and category of borrower are independent of
each other. Starting in the lower left hand corner, there is lowest
risk loan for a lender to make, a Prime Conventional mortgage. Up or to
the right, the risk increases. The riskiest loan a lender can make is
the Negative Amortization loan to a Subprime borrower.

Conventional 30-Year Amortizing Mortgage

A fixed-rate conventionally-amortized mortgage is the least risky
kind of mortgage obligation. If borrowers can make their payment–a
payment that will not change over time–they can keep their home. A
30-year term is most common, but if bi-weekly payments are made (two
extra per year), the loan can be paid off in about 22 years. If
borrowers can afford a larger payment in the future, they can increase
the payment and amortize over 15 years and pay off the mortgage
quickly. The best way to deal with unemployment or other loss of income
is to have a house that is paid off. Stabilizing or eliminating a
mortgage payment reduces the risk of losing a house or facing
bankruptcy. Unfortunately, payments on fixed-rate mortgages are higher
than other forms of financing, so borrowers often opt for the riskier

The Interest-Only, Adjustable-Rate Mortgage

The interest-only, adjustable-rate mortgage (IO ARM) became popular
early in this bubble when fixed-rate mortgage payments were too large
for buyers to afford. In the coastal bubble of the late 80s, these
mortgages did not become as common, and the bubble did not inflate far
beyond people’s ability to make fixed-rate conventional mortgage
payments. [ii] This is also why prices were slow to correct in the
deflation of the early 90s. Most sellers did not need to sell, so they
just waited out the market. The correction was a market characterized
by large inventories, but this inventory was not composed of calamitous
numbers of must-sell homes. The few must-sell homes that came on the
market in the early 90s drove prices lower, but not catastrophically
because the rally in prices did not get too far out of control. The
Great Housing Bubble was different.

IO ARMs are risky because they increase the likelihood of borrowers
losing their homes. IO ARMs generally have a fixed payment for a short
period followed by a rate and payment adjustment. This adjustment is
almost always higher; sometimes, it is much higher. At the time of
reset, if the borrower is unable to make the new payment (salary does
not increase), or if the borrower is unable refinance the loan (home
declines in value below the loan amount), the borrower will lose the
home. [iii] It is that simple.

These risks are real, as many homeowners have already discovered.
People try to minimize this risk by extending the time to reset to 7 or
even 10 years, but the risk is still present. If a house were purchased
in California in 1989 with 100% financing with a 10-year, interest-only
loan, at the time of refinance the house would have been worth less
than the borrower paid, and they would not have been given a new loan.
(Fortunately 100% financing was unheard of in the late 80s). Even a 10
year term is not long enough if purchased at the wrong time. As the
term of fixed payments gets shorter, the risk of losing the home
becomes even greater.

The most egregious examples of predatory lending occurred when these
interest-only loan products were offered to subprime borrowers whose
income only qualified them to make the initial minimum payment
(assuming the borrower actually had this income). This loan program was
commonly known as the two-twenty-eight (2/28). It has a low fixed
payment for the first two years, then the interest rate and payment
would reset to a much higher value on a fully amortized schedule for
the remaining 28 years. Seventy-eight percent of subprime loans in 2006
were two year adjustable rate mortgages. [iv] Anecdotal evidence is
that most of these borrowers were only qualified based on their ability
to make the initial minimum payment (Credit Suisse, 2007).
This practice did not fit the traditional definition of predatory
lending because the lender was not planning to profit by taking the
property in foreclosure. However, the practice was predatory because
the lender was still going to profit from making the loan through
origination fees at the expense of the borrower who was sure to end up
in foreclosure. There were feeble attempts at justifying the practice
through increasing home ownership, but when the borrower had no ability
to make the fully amortized payment, there was no chance of sustaining
those increases.

The advantage of IO ARMs is their lower payments. Or put another
way, the same payment can finance a larger loan. This is how IO ARMs
were used to drive up prices once the limit of conventional loans was
reached (somewhere in 2003 in California).
A bubble similar to the last bubble would have reached its zenith in
2003/2004 if IO ARMs had not entered the market and inflated prices
further. In any bubble, the system is pushed to its breaking point, and
it either implodes, or some new stimulus pushes it higher: the negative
amortization mortgage (Option ARM).

Negative Amortization Mortgages

The Negative Amortization mortgage (aka, Option ARM or Neg Am) is
the riskiest loan imaginable. It has all the risks of an IO ARM, but
with the added risk of an increasing loan balance. Using this loan,
there is the risk of not being able to make the payment at reset, and
the borrower is much more at risk of being denied for refinancing
because the loan balance can easily exceed the house value. In either
case, the home will fall into foreclosure. The Option ARM is one of the
most complicated loan programs ever developed. It was heralded as an
innovation because it allowed people greater control over their monthly
payments, and it provided greater affordability in the early years of
the mortgage. [v] Twenty-nine percent of purchase originations
nationwide in 2005 were interest-only or option ARM (Credit Suisse, 2007).
The percentage in California was much higher. The proliferation of this
product is largely responsible for the extreme prices at the bubble’s

An Option ARM loan provides the borrower with 3 different payment
options each month: minimum payment, interest-only payment, and a fully
amortizing payment. In theory, this loan would be ideal for those with
variable income such as sales people or seasonal workers. This assumes
the borrower has months where the income is more than the minimum, the
borrower sees a need in good times to make more than the minimum
payment and the borrower understands the loan. None of these
assumptions proved to be true.

Figure 3: Interest-Only and Negative Amortization Purchases, 2000-2006

When confronted with several different prices for the same asset,
people naturally will choose the lowest one. This common-sense idea
apparently escaped the innovators who developed the Option ARM. Studies
from 2006 showed that 85% of households with an Option ARM only made
the minimum payment every month (Credit Suisse, 2007).
Many could not afford to pay more, and many more could not see a reason
to pay more. Most simply thought they would refinance when the payments
got too high.

These loans are also very confusing. The interest rate being charged
to the borrower adjusts frequently, and the payment rate (which is not
correlated to the actual interest rate being charged) also changes
periodically. The separation of the interest rate charged and the
interest rate paid is what allows for negative amortization, and it
also creates a great deal of confusion. The following is an attempt to
explain the mechanics of this loan.

Payment Rate

A negative amortization loan is any loan where the monthly payment
does not cover the monthly interest expense. Interest-only or
conventionally amortizing loans do not have this feature, and the
monthly payments are based on the interest rate charged and/or the
duration of the amortization schedule. Since the negative amortization
loan breaks down this traditional relationship, there is a completely
separate rate calculated for the minimum payment amount. In general,
this rate starts out low and increases gradually each year for the
first several years. This is to allow the borrower time to adjust to a
higher loan payment amount. These yearly increases are usually capped
to prevent dramatic phenomenon known as “payment shock.” The payment
rate is based on an interest rate, but this rate has no relationship to
the interest rate the borrower is being charged on the loan balance.
The presence of two interest rates is responsible for much of the
confusion regarding these loans. The low starting payment rate is often
called a “teaser rate” because it is a temporary inducement to take on
the mortgage. There was a widespread belief among borrowers that one
could simply refinance from one teaser rate to another forever in a
process known as serial refinancing. The biggest confusion regarding
this loan is when people mistake this payment rate for the actual
interest rate they are being charged on the loan. This is a natural
mistake to make because historic loan programs did not make this

Interest Rate Reset

The Option ARM is a hybrid adjustable rate mortgage with payment
options. The interest rate being charged to the borrower is subject to
periodic fluctuations with changes in market interest rates similar to
other adjustable rate mortgages. The timing of adjustment and limits
therein are contained in the mortgage contract. The interest rate
charged is fixed for certain periods at the end of which there is a
change in the interest rate. When the interest rate changes on most
adjustable rate mortgages, the payment required of the borrower changes
as well. Since the charged interest rate and the payment rate are not
the same for Option ARMs, the payment may not be affected and negative
amortization can occur. The interest rates on most adjustable-rate
mortgages are lower than those for fixed-rate mortgages because the
lender is not subject to interest rate risk. If interest rates rise,
lenders who have issued fixed-rate mortgages have capital tied up in
below-market mortgages. With adjustable rate mortgages, higher interest
rates are passed on to the consumer.

Since the low payment option on Negative Amortization loans is so
appealing to consumers, the actual interest rate charged on Option ARMs
is often higher than interest-only or fixed rate mortgages, which make
these loans very attractive to investors. Since the interest rate is
higher than the payment rate, negative amortization occurs, and the
loan balance grows each month as the deferred interest is added to the
loan balance. This capitalized interest is recognized as income on the
books of mortgage holders. Generally Accepted Accounting
Principles (GAAP) allow this, but the amount of income is supposed to
be reduced to reflect the likelihood of actually receiving this money.
Since the loan program was new, and default rates were low due to the
bubble rally, the reported income was very high making these loans even
more appealing to investors. From the investors’ perspective, they were
buying high-interest loans with great income potential and low default
rates. From the borrowers’ perspective, they were obtaining a loan at a
very low interest rate–a perception rooted in a basic misunderstanding
of the loan terms–and a very low payment which allowed them to finance
large sums to purchase homes at inflated prices. This dissonance
between the investors who purchased these loans and the borrowers who
signed up for them did not become apparent until these loans began to
reset to higher rates and recast to higher payments. In short, these
loans are time bombs with fuses of varying lengths set to blow up the
dreams of investors and borrowers alike.

Payment Recast

Interest-only and negative amortization payments cannot go on
forever. At some point, the loan balance must be paid in full. For all
adjustable rate mortgages, there is a mandatory recast after a fixed
period of time where the loan reverts to a conventionally amortizing
loan to be paid over the remaining portion of a 30 year term. This
recast eliminates the options for negative amortization and
interest-only payments and requires the fully amortized payments on an
accelerated schedule for what is often an increased loan balance. For
instance, if an interest-only loan is fixed for 5 years, at the end of
5 years, the loan changes to a fully-amortized loan with payments based
on the remaining 25 year period. The longer interest-only or negative
amortization is allowed to go on, the more severe the payment shock is
when the loan is recast to fully amortizing status. Also, in the case
of negative amortization loans, the total loan balance is capped at a
certain percentage of the original loan amount, typically 110% but
sometimes higher. If this threshold is reached before the mandatory
time limit, the loan is also recast as a conventionally amortizing
loan. Since many borrowers were qualified based on their ability to
make the minimum payment at the teaser rate, when the loan recasts and
the payment significantly increases (double or triples or more,) the
borrower is left unable to make the payment, and the loan quickly goes
into default.

The natural question to ask is, “Why would lenders do this?” There
is no easy answer. Most simply did not care. The lender made large fees
through the origination of the loan and subsequent servicing, and the
loan itself was sold to an investor. The investor bought insurance
against default, and many of these loans were packaged into asset
backed securities which were highly rated by ratings agencies due to
their low historic default rates. Nobody cared to examine the systemic
risk likely to result in extremely high future default rates because
the business was so profitable at the time of origination. Most assumed
this would go on forever as house prices continued to appreciate. It
was envisioned that most borrowers would either increase their incomes
enough to afford these payments or simply refinance into another highly
profitable Option ARM loan. In hindsight, the folly is easy to
identify, but for those involved in the game, there was little
incentive to question the workings of the system, particularly since it
was so profitable to everyone involved.

(i) According to Credit Suisse, the average credit score for Alt-A borrowers was 717 and for subprime borrowers it was 646.

[ii] There was a steep rise in prices in California and selected
large metropolitan areas of the East Coast during 1987, 1988 and 1989.
This was followed by a 7 year period of slowly declining prices as
fundamentals caught up. This is considered by some to be a bubble
because prices showed a detachment from fundamentals and a later return
to the former relationship. This “bubble” did not see capitulatory
selling, so it did not show the behavior of classic asset bubbles.

[iii] A study by Consumer Federation of America’s Allen J. Fishbein
Piggyback Loans at the Trough: California Subprime Home Purchase and
Refinance Lending in 2006 (Fishbein, Piggyback Loans at the Trough: California Subprime Home Purchase and Refinance Lending in 2006, 2008),
reveals the following “1.26 million home purchase and refinance loans
in California metropolitan areas in 2006 and found about one sixth of
California home purchase borrowers taking out single, first
lien mortgages and one quarter of refinance borrowers received subprime
loans in 2006. The subprime mortgage market provides loans to borrowers
who do not meet the credit standard for prime loans. To compensate for
the increased risk of offering loans to borrowers with weaker credit,
lenders charge subprime borrowers higher interest rates – and thus
higher monthly payments – than prime borrowers. California has
historically had lower rates of subprime lending than the national
average, but the rates of subprime lending crept up in 2006.
Additionally, more than a third of California home purchase borrowers
also utilized a second “piggyback” loan on top of a primary, first lien
mortgage. Piggyback loans combine a primary mortgage with a second lien
home equity loan, allowing borrowers to finance more than 80 percent of
the home’s value without private mortgage insurance. These borrowers
took out loans on as much as 100 percent of the value of the home in
2006. More than half these piggyback borrowers received subprime loans
on their primary mortgages. Many subprime loans are adjustable rate
mortgages (ARMs) that reset to higher interest rates after the first
two years, meaning that homeowners that received subprime purchase or
refinance mortgages in 2006 are likely to see their interest rates and
monthly payments increase – in many cases significantly – in 2008.
Moreover, as real estate markets cool and decline, borrowers that
utilized piggyback financing could find themselves owing more on their
mortgage than their homes are worth.” An earlier related study, Exotic
or Toxic? An Examination of the Non-Traditional Mortgage Market for
Consumers and Lenders (Fishbein & Woodall,
Exotic or Toxic? An Examination of the Non-Traditional Mortgage Market
for Consumers and Lenders, 2006 ) by Allen J. Fishbein and Patrick Woodall also sounded the alarm concerning exotic financing.

[iv] This data comes from the Credit Suisse Report (Credit Suisse, 2007). The source of their data was Loan Performance.

[v] The impact of exotic mortgage terms was explored by Matthew S.
Chambers, Carlos Garriga and Don Schlagenhauf in the paper Mortgage
Contracts and Housing Tenure Decisions (Chambers, Garriga, & Schlagenhauf, 2007).
Their abstract reads as follows, “We find that different types of
mortgage contracts influence these decisions through three dimensions:
the downpayment constraint, the payment schedule, and the amortization
schedule. Contracts with lower downpayment requirements allow younger
and lower income households to enter the housing market earlier.
Mortgage contracts with increasing payment schedules increase the
participation of first-time buyers, but can generate lower
homeownership later in the life cycle. We find that adjusting the
amortization schedule of a contract can be important. Mortgage
contracts which allow the quick accumulation of home equity increase
homeownership across the entire life cycle.” The cold reality of
negative amortization loans is summed up in the observation that
increasing payment schedules decrease home ownership over time. People
default when their payments go up. It is the fatal flaw of all these
loan programs. One of the more amusing papers from the bubble was
written by James Peterson (Peterson, 2005)
“Designer Mortgages: The Boom in Nontraditional Mortgage Loans May Be a
Double-Edged Sword. So Far, Most Banks Have Moved Cautiously.” The
lenders during the Great Housing Bubble were anything but cautious.