Alea today finds the most astonishing
chart, which I simply have to reproduce:
The crazy thing here is the massive discrepancy, over the past two years, between
default rates on variable subprime mortgages, on the one hand, and default rates
on fixed-rate subprime mortgages, on the other. And I have to say that I’m at
a loss for how to explain it.
I know what it’s not: it’s not ARM resets. Those are only just beginning to
kick in now, while the gap between variable and fixed subprime default rates
started gapping out as early as the end of 2005. (When the only resetting ARMs
were the ones written in 2003.)
And it’s not lax underwriting standards, either. Yes, underwriting standards
did become too loose. But they were applied to subprime borrowers,
not to subprime products. A lender wouldn’t use much tougher underwriting
standards when writing a fixed-rate loan compared to when writing a variable-rate
loans.
OK, maybe I’m overegging the pudding a little here: I’m sure that both ARM
resets and lax underwriting standards played some role in generating
that huge spread between variable and fixed subprime default rates. But I suspect
there’s something else going on here as well.
My best guess is that subprime borrowers split into two camps. On the one hand,
there are the Noble Few, who took advantage of excess liquidity to get their
feet onto the bottom rung of the property ladder. These are people who wanted
very much to buy a house – not as an investment, so much as to own their
own home. They locked in fixed rates, comfortable that they would be able to
make their mortgage payments for the next 15 or 30 years: however long it took
to buy the house outright.
But the Noble Few were outnumbered by the Reckless Many, who had dollar signs
dancing in front of their eyes and would read daily in the newspaper of the
fortunes being made in the property market by people who followed the time-worn
advice to "buy the biggest house you can afford". Maybe they were
would-be flippers, who never intended to own their home for longer than the
period of the initial teaser rate. Or they were people who wanted or needed
cash, for a family emergency or just for a flat-screen TV, and they wanted to
borrow that money at the lowest possible rate. Or they were suckers who were
taken advantage of by unscrupulous mortgage brokers. Or they were simply financially
naive, and determined that the cheapest mortgage they could get must be the
best mortgage they could get.
In all these situations, the borrower chose the mortgage with the lowest monthly
payments – and the mortgage with the lowest monthly payments was always
a variable-rate mortgage.
To put it another way, what we’re seeing in this chart is the entry of a whole
new borrower class into the subprime market. Until recently, people taking out
a subprime mortgage were much like people taking out a prime mortgage (but with
less money and worse credit) – they were people whose primary motivation
was to buy and own a house.
At some point, however, home-equity withdrawals and speculative purchases and
dodgy mortgage originators all conspired to change the profile of the average
subprime borrower – especially the sort of subprime borrower
who chose a variable-rate mortgage. Which is one of the reasons why all the
models which had worked in the past suddenly broke, despite no huge spike in
interest rates.
The financial markets knew how people behave after taking out a mortgage. They
just didn’t realize that in the specific case of variable-rate subprime mortgages,
they were dealing with a completely different set of people.
Okay, that’s overegged as well. That might be some of it, but even that can’t
explain all of it. But just take another look at that heavy black line showing
fixed-rate subprime default rates. They’ve never been lower. And that’s
something you’d never guess from reading the papers.