Podcast: A look at the subprime market

April 11, 2007

Marginally qualified buyers who rode subprime loans and deals such as zero-percent-down mortgages into the housing market are facing hard times this year. Many whose credit histories indicated a tendency to default are in fact losing their houses. And with housing prices edging down from last year's high points, institutional investors may find they will not be able to fully recover their investments. Adding pain, a large number of adjustable rate mortgages (ARM) are scheduled to reset this year, raising payments on some mortgages 65 to 100 percent. Finance and real estate Professor Anthony Sanders takes an in-depth look at the most troubled sectors of a tricky real estate market. 42:00






Knowledge: As the bottom falls out of the subprime lending industry, some dirty little secrets about the once-booming housing market are starting to emerge, and that could spell foreclosure for thousands of Americans. But there is one bit of good news: the collapse of the subprime lending market is not expected to affect the entire nation. Here to explain more is Anthony Sanders, the Bob Herberger Arizona Heritage Chair of Finance and Real Estate at the W. P. Carey School of Business.


Anthony Sanders: This is the third time this has happened since 1997. It happened in 1998 with manufactured housing, which is primarily trailer homes, pre-fab homes, etcetera--that's a subprime market, for the most part. That blew up back in 1998. Also, there is what's called the 125 LTV (loan to value) market, where you can borrow up to 125 percent of your loan balance. Now, the lenders of that product claim they're not subprime, but they, in fact, are. That went away in about 1999.

Then we had the post-9/11 recession of the country. That was another subprime event; so that's the second. And this is the third one. What's unusual about this one, as compared to the other ones, is that the other meltdowns in the subprime market have had a clear economic signal: The economy either went into a recession, or there was a massive credit spike internationally, such as the Russian credit crisis.

This is one where there's no gigantic signal of a recession, so this is a little unusual compared to the others, but it's not new.


Knowledge: One of the things that you kept hearing about, when the housing market was really hot, was the caveat that, 'It's hot because people that shouldn't be in the market are being allowed to go in.' There were basically just logs being thrown into the fire to keep it going.


Sanders: Here's an interesting problem that's happened since the late 90s: Once the Russian credit crisis hit, the bond market fell apart, the stock market, with the exception of the dot-com bubble (we all remember what happened to that) the market was pretty flat. At the beginning of the 2000s, if everyone remembers, the stock market just wasn't doing anything.

The bond market had low yields. Financial institutions were looking for higher-spread or higher-yield products, and what's a more high-yield product than subprime loans? Since housing prices since the year 2000 up until just recently, took off like a meteor upwards, what's the problem with a subprime loan, if I extend credit to somebody, and their housing price has gone up by 30 percent? Even if they default, I can drag them into court, sell the house and pay off the loan balance, and there's no losses for the lender. So, you could actually tolerate having subprime loans going into default, and there's not really any economic consequence to it.

We generally know that when housing markets explode upwards like this, they tend to [laughs] explode downwards as well -- hopefully, not as fast. What's happened now is all that loose credit  -- because of A, high yields on subprime, and B, the rapid growth of the housing market -- was extended, when they didn't think there were any consequences to it. Now what we found out was, with a slowing economy, and the over-building of housing in the United States -- which is clearly what we're in now -- now they're finding out that these subprime loans are, in fact, causing a problem.


Knowledge: How could they not have seen this?


Sanders: It's funny. As I mentioned, part of the problem is investors in the market and Wall Street itself. Most of the people on Wall Street tend to be fairly young; most of the older people you hear about generally tend to be the top people at the companies, like at Goldman or Nomura.

Most of the analysts that are studying these markets tend to be fairly young, and while they may be able to look at a graph and see what has historically happened, a lot of them haven't been through some of these negative sessions before. They can be kind of short-term in their focus. They just look at the run-up in the housing over the last year, and say, 'Hey, this is a great market.'

Even though that's been part of the problem, once again, I think that there's so much money to be made in this market, people can generally get very naive. In the equity market, look at the dot-com bubble: These were companies that literally had no earnings that were selling for massive prices. Then, one day, somebody woke up and said, 'Gee, this is a bad idea,' and the whole dot-com market kind of exploded.

The term for it is the 'tulip bulb craze, ' for something that happened in the Netherlands. Occasionally, markets develop these bubble-ish activities, because people just get very excited about certain things, and then it turns out there's no economic basis for them and they come back to earth. The market should've been anticipating more activity in this market, and it will probably happen again in three to four years.


Knowledge: Right. It's almost like the very thing that makes this country such a go-getter, our optimism, also turns around and bites us sometimes. [laughs]


Sanders: Absolutely. It's better to have these markets. What's very interesting right now is listening to the various politicians in Washington, espousing how we should reduce the amount of subprime loans in the market. Although, John Edwards, the former Vice Presidential candidate, actually came out and said he's against some reform in the subprime market. Actually, he has that one right.

Hillary Clinton was basically discussing cutting back on subprime credit, which makes a nice sound bite, but frankly, the people that get hurt are the people that are credit-impaired and may want housing. So, it's not clear to knock them out of the market. I think what the market needs to do is develop a little bit better skill in underwriting. They have them in place; they essentially know what to do. I think things just got a little out of hand.


Knowledge: A lot of greed involved, and it's a shame that it keeps hitting the very group of people who can least afford this.


Sanders: I'll give you a good example: I'm not going to mention the bank, but this one bank that does business in California and Arizona, I happen to have a friend that has a daughter who works there, and she was brought into the subprime lending group. She called up on the phone and said, 'Do you know what they're telling us?' They said they get the repo lists--the repossessions of cars--and that becomes their subprime client list.

They're targeting people who have a history of over-extending themselves on loans. And they said it was simply because they have nowhere else to go for a house, so they can get enormously large interest rates. And for this particular bank, they said this is a real money-maker, because then they turn around and sell it in the secondary market. Those are going to come to an end.

They said the fees and the rates are staggering, so it's a real money-maker, but I would question the validity. If I was Ben Bernanke, I would be questioning a banking system that allows us to target people on repo loans.

And just kind of say 'Well, we're going not necessarily stop it,' because I'm sure some very nice people have gotten into financial difficulties, and we don't want to box them out of the home ownership option. But on the other hand, there are costs to these bankruptcies. And sometimes we end up inadvertently tying people to ruinous interest rates. They would probably be better off if they rented, and did not get into the sub-prime market and pay all these fees.


Knowledge: And that reminds me, just maybe about fifteen years ago when the talk was of communities trying to find some way to help people who had perhaps not established credit, had had a bad run, but were now getting their affairs in order, to try to help them get into homes.

And the hurdles that they had to run, and the letters that they had to write, and the examples they had to set, for banks to give these people a chance. And now you went the other way, with some people who probably should not have been given a chance.


Sanders: Well, I'll tell you what, one of the most fascinating things about the sub-prime market, is that even some of the best players in the sub-prime market -- like for example Freddie Mac -- they generally do what's called 'Prime Mortgages', conventional mortgages. These are in most markets $349,000 or less loans, but you have to have regular credit quality.

They have in the past gone a little into sub-prime, and Fannie May and Freddie Mac have these huge databases of people that have made payments. So, they know a lot about people's behavior's when they are sub-prime. And they got burned when this happened -- and they are vigilant, they are very good.

The point being that there is still a lot we don't know about sub-prime borrowers, and I'll tell you why. There are two types of sub-prime borrowers, there is the person you are referring to, for example -- somebody that will not default on their mortgage, will not default on the car payments. But has had medical bills, or they got a little bit behind on some credit cards, or they got a little bit behind on a few of the medical payments. And they have had like a small medical, a fifty dollar payment written off as a default.

That happens, simply because people sometimes -- like when they have medical conditions -- almost go into a state of depression, or just can't bear to look at these, they put it off. And of course that's devastatingly awful, but those people will pay off their home loans.

The second type are the people that are just sloppy in general, and are not going to behave, they are not going to be kindly. And trying to separate out those two is not as easy as it sounds, because primarily what most lenders rely on are credit scores.

And it's an invaluable tool to the sub-prime market, and it's very clear that if you have a low FICO score, that your default rates are high. But even given that, there's still not enough information. Because, once again as I said, there are people out there who have rotten credit scores, who are not going to default on their home, they won't default on the big-ticket items, they tend to get sloppy with the smaller ticket items.

You want to identify the people that are sloppy across the board. And I think that in recent years some companies have become overly reliant on credit scores, instead of looking at other factors in the market, or other factors for borrowers.


Knowledge: Right now, do you think people understand the impact that this collapse in the sub-prime lending market is going to have on the economy in general? Or will it have a wide reaching impact on the economy?


Sanders: Actually, I don't believe the sub-prime market is going to stick its fingers into the other areas of the economy, or even the mortgage market. And the reason why is this, the sub-prime market is primarily confined in certain areas of the country where it's big, and certain property types.

So, it's really a targeted problem, as opposed to kind of a pandemic problem in the housing market. If you take a look at where sub-prime loans are made, you plot them on a map, there are sub-prime lenders in all fifty states.

I'll give you a good example. Two of the biggest states with sub-prime problems are Louisiana and Mississippi. And the reason for that, is that of course Hurricane Katrina, they are poor states with low income, lower than average income I should say. And what happened is that Hurricane Katrina came in and wiped out the collateral, so people actually lost their homes.

But that doesn't have anything to do with somebody's ability to pay, that was just a terrible event that occurred. But if you go take a look at sub-prime borrowers, there's a lot of the in California, Nevada, Arizona, and there the borrowers are getting into certain property types by necessity, such as entry-level housing and condominiums. And those types of housing is where the sub-prime defaults are going to be concentrated. I would also say Florida, sub-prime borrowers are on average younger, they actually destroy their credit pretty quickly. So, they get into housing, but they get into sort of entry-housing.

So, this is not going to be a problem locally for Scottsdale, Scottsdale is not going to have a sub-prime default wave. Where you are going to find more sub-prime hitting, will be in lower income neighborhoods of Phoenix.

And also, unfortunately, there's a racial aspect to this, in that African-Americans and Hispanics tend to have higher percentage of sub-prime borrowers, simply because of lower average wealth. And in some cases, for example fairly recent Hispanic immigrants who come from the Mexican banking system, and are not really familiar with the U.S. credit system.

I know Freddie Mac has been doing a lot of consumer credit education on their website. To try to walk people through and say 'Here's what you're doing when you do this.' To alert them to how you destroy your credit score, 'Here's some actions that will ruin it, and here's how to repair your credit score so that you can in fact get into a good house.'

And they were finding in some of their studies that it does have a racial aspect to it, it does have intercity versus suburbs, there's more sub-prime lending going on in the intercity, they target racially because it's more of the income group, and less than average education.

So yeah, there's a nasty side to the sub-prime market. Meaning that a lot of people that get into the sub-prime bucket so to speak, there's a stronger racial aspect to it.

And the other one actually is language, recent immigrants, or people who have not converted to English yet. While there are programs where it's done in Spanish, the problem is that there have been allegations towards some lends, not all, just some where they've actually targeted Hispanic borrowers simply because they would not be reading the loan contracts where all these excessive fees are laid out.

So, yes, there are some ugly parts to it, but it's not an endemic way that's going to hit the entire United States. It's more isolated geographically by property type than I think one would think.


Knowledge: So, you don't expect this, and even in varying degrees, to be felt throughout the country?


Sanders: No, I don't. I think this is going to hurt certain areas more than others. But I do not think it's going to hit the higher income neighborhoods of Los Angeles. Sort of the entree level/subprime borrowers tend to be concentrated in certain areas that you'd expect out in Los Angeles, more out in the valley, newer built construction, or some of the inner city properties. Those areas unfortunately are going to get hit a little harder.

I'll explain to you why I don't think is going to be a problem ... Banks are not making the subprime loans and keeping them.

Most of the people that are finding subprime borrowers tend to be mortgage brokers. The mortgage brokers then identify borrowers and ship the information off to the financial institution who actually makes the loan. The financial institution then takes the loans, and sells them to either Fannie Mae or Freddie Mac if they are good enough credit, but if they are not then they sell them to the investment banks. And the investment banks pool them, meaning create big pools, and sell them as securities. Those are called mortgage backed securities, or asset backed securities, in fact there's subprime MBS (mortgage backed securities).

Those then are sold to various investors like pension funds, insurance companies, foreign, it can be U.S., it can be foreign governments buy some of these loans. CDO, collateralized debt obligations, which are a very popular investment vehicle have a lot of these subprime loan pools as their collateral.

So, the old days people think of when they think of a subprime borrower out there making the loans and keeping them is pretty much over with. All these are sold. So, it's investors bearing the risk of these meltdowns, such as a pension fund. Now, that's not good, but at least it's not localized. The risk of the subprime market has been sort of spread out across the world. So, a lot of us who are savvy investors have gotten involved in it. So, it's not paper being held by local people altogether, it's really been fused throughout the world.

So, in other words, we aren't going to see banks collapsing because of subprime. You will see subprime mortgage brokers or some mortgage bankers even, a few, having financial distress. In fact, New Century, in Irvine, California just declared Chapter 11. And HSBC, another very large lender, is reporting very large difficulty in the subprime unit.

But, no, it's going to be contained. And here is why. What drove New Century into bankruptcy, is that process I told you about. What happens is investors notice a spike in the defaults or delinquencies, they then contact the investment banking company and say, "What's going on? This is far greater than you led me to believe." The investment banking firm such as Goldman Sachs or Merrill Lynch suddenly gets in a panic and says, "Oh, my gosh, we're going to contact the lender, or the mortgage broker. Either one." And find out what has happened at your end that has caused this surge of defaults.

If it's an economic related surge that's one thing, this is an economic market, financial markets, and so people take their bets, that's one thing. What happened this time is that some of the mortgage brokers or the lenders let their standards for making loans slip, and didn't bother to notify the ultimate investor that that's what had happened.

So, what you have is some mortgage brokers and lenders out there who to keep making more and more loans kind of lowered their credit standards or committed fraud in order to keep this pipeline of subprime loans going.

And so, what's happening now is that the investors or the investment banks are now suing, well actually before they even get to the lawsuit, they contact companies like New Century and say, "The problem you're having with the subprime loans you sold us, or identified, is that you had a lapse in your underwriting standards. And so I want you to purchase all these loans back." And then a company like New Century looks at the number of defaulted loans and says, "Given the equity in our company we can't afford to purchase all those bad loans we made." And so a company like New Century now is declaring bankruptcy.

So, it's really going to smart the companies that relaxed their credit standards because now they have to buy the loans back. So, that's good, that is called economic discipline. On the next round they will think twice before they do this again, if there's litigation possibilities. Because if they refuse to buy them back, then the investment bank then sues the mortgage broker or the lender, and has the court force them to buy the loans back.

So, all the regulations that they are talking about on the Hill are actually pretty much unnecessary, the market will discipline itself. And that's what's going on right now.


Knowledge: But it's a typical reaction with Congress.


Sanders: Of course, there are a lot of sound bites to be made by saying restrict credit and no, no, no, John Edwards says, "Don't restrict credit." Well, John Edwards is right. What you do is just let the market do it. The market pretty much gets this right, it may miss it like right now, it kind of missed the boat, but it's catching up. So, they're going to go through and discipline the mortgage brokers and the lenders that are doing that.

Oh, by the way, in this market, one of the problems that has attracted attention is the mortgage fraud. And it's been fairly rampant. There are a lot of activities going on. At Fannie Mae and Freddie Mac, the big GSCs in Washington, have very extensive fraud detection units. And generally go after the fraudulent lends or fraudulent brokers when they get information and they clean them up. For Wall Street, I think they also do the same thing, but they haven't been as proficient at it, and I think they will be now.

But that's one thing that I think subprime borrowers have to, if we can get better consumer education for the subprime market that would be, like what Freddie Mac is doing. That would be invaluable because people have to understand that some of the fees they're signing there the next 30 years. So, it can be really extreme and really damaging to their future income.


Knowledge: So, considering that history has repeated itself at least three times that we know off in the sub-prime lending market, we're probably going to be seeing this again. Any idea of when, are we looking at ten-year cycles, fifteen-year cycles?


Sanders: Yeah, what's going to happen is that it's going to be more of a function of the housing market at this point. If we have another recession, we'll get another sub-prime spike.

I think that we're looking at, if the housing market turns around and we have another takeoff in prices, once again look for the home volumes to get much higher than they should be. Again, sloppy returns, but it will get swatted as soon as you get a spike in the defaults.

So, right now, the economic indicators are not showing a repeat of the 2000 or 2006 housing market shoot-up. What we are seeing now is probably - actually starting right about now - we're seeing a kind of return to - in many parts of the housing market - kind of a two percent growth rate, lower than the historical average of five percent per year in house price growth.

So, we are seeing a return to sort of positive markets, housing prices will not be going up nearly as much. This is actually a good market, because of housing conditions for the sub-prime market. Because without the rapid growth potential there's less pressure on people to feel the necessity to sort of buy into the housing market.

I think what a lot of consumers don't understand is that Freddie Mac and Fannie Mae, who because of their very existence lower mortgage rates across the board, they also do the same thing for apartment complexes.

They also have programs in place that lower the interest rate for investors who buy apartment complexes. And so we get a bigger supply of apartment complexes, multi-family is what the industry term for it is, we get a bigger supply of multi-family units then we ordinarily would get.

Hence, I think for most people in a poor sub-prime, they have a low credit rating, the best thing they can do is stay in a multi-family property to cure their credit problems. And only when they have sufficient income for a ten to twenty percent -- particularly twenty percent -- down payment, and they are economically in good state, that's the best time to give them a housing market.

Unfortunately what's happened is that with housing prices shooting through the roof, people are trying to get it on the cheap, which is human nature. 0 percent down loans, we knew that 0 percent down loans are always a bad idea in terms of default. The borrower has nothing to lose, other than their credit score, but that's what some lenders were offering during this market going up.

And as I said, you sort put horse blinder on, you say to yourself 'What's the problem with a 0 percent loan if housing prices keep going up? And if the borrower defaults, no problem, we'll sell the house, it's worth more than it was five years ago, we'll pay off the loan balance and there's no losses to us at least.'


Knowledge: I guess to me it just seems logical that if you have a whole group of people going in with zero interest loans, the odds of them defaulting are greater, which means a glut on the market, which means you won't be able to sell that home for as much as...


Sanders: And that's what's happening right now. In fact, the very existence of 0 percent down mortgages to people with low credit, means that the number of the pool of borrowers, the demand has gone up for housing.

This is in a sense fueled this recent sort of binge at the housing troth, with housing prices going up. We extended ... I wouldn't say free credit, that's a gross exaggeration. But by allowing these low down payments, lower credit scores, and all these alternative mortgage products we have out there, and sub-prime borrowers are the perfect target for it.

What happened was that we unleashed demand in a big segment of the market that hadn't been looked at recently. And what happened is that it drove up demand, but now suddenly some sub-prime borrowers are getting hesitant, don't want to go into the market, and some others have defaulted or are frantically trying to get out, that's why that market is suffering right now.


Knowledge: And we're seeing...


Sanders: As they said, this really doesn't have any other spill-over effects to any other market. Because, again, it's generally isolated by areas where sub-prime borrowers live, and cities, and property types. So, it's not a pandemic of credit default, it's really more of an isolated...


Knowledge: You do have to worry about in some areas where you had speculators who did not know what they were doing, who were getting people in to these homes like that, and now they're sitting on them. Are we going to see an increase in foreclosures?


Sanders: Now that you bring it up, Phoenix has over 33 percent of the loans made in Phoenix, I believe only in the conforming market, meaning under 350 thousand dollars. But the massive loans made in Phoenix, 33 percent is a huge number, those are second homes and investment properties.

What that means is that these aren't sub-prime borrowers necessarily, these might be prime-borrowers. Because to get a second loan you generally need pretty good credit, but not always. That's the first thing to go in an economic down turn, people shut their investment properties or shut their second homes.

So, that's one place for example where Phoenix is at risk, is that in this type of market if we get a chilling in the national economy, these properties are what is going to be causing a problem.

In terms of sub-prime, again, those tend to be different areas, manufactured housing is very common areas, areas with a large trailer park exposure tend to get hit worse than for example the Scottsdale's, so it's more isolated, it's not across the board.

But yeah, as soon as you take those people out of the market, demand for the properties that sub-prime borrowers usually go after falls dramatically. So, you have a fixed supply in the short run, the demand falls off precipitously, what does that result in?


Knowledge: Lot's of houses.


Sanders: Housing price crash in those markets. Wall Street likes to come out and say that the housing price question is over, housing price stocks are going to go up again. For example home-builders, Toll-Brothers stock went up this past week, simply because there is more people buying Toll-Brothers, which is a upper-end luxury home house.

I wouldn't over read that too much, because in the market we have a staggering number of adjust-rate mortgage resets coming this year in the market. What an on-reset is, is that a lot of sub-prime mortgages are adjustable-rate, and a lot of them were made sort of 2004 period. Those three-year arm, they're called 3/27's, they're fixed for three years and then become adjustable after that.

A lot of the 3/27 loans made in 2004 are coming due this year. And when they come due, that means homeowners or the borrowers, their mortgage payment is going to go up. And since interest rates are higher today than they were when they made these loads three years ago, what they're going to find out is for some mortgage products, their mortgage payments could go up by as much as 65 percent up to 100 percent depending on what kind of ARM (adjustable rate mortgage) you got.

If they mistakenly got one of these exotic mortgages, like a negative AM mortgage, it's called IO (interest only) negative AM, they can actually have their balance of their mortgage rising up to 115 percent of the original balance. And those things are going to be deadly. But, so we have a staggering amount of ARM resets coming and particularly of subprime loans this year. And that's bad. And so I think we have this kind of wave ...

That's the interesting thing Ben Bernanke has to worry about. About raising rates versus lowering the fed funds rate. If he raises interest rates he has a good chance of really adding to this sort of tsunami effect of ARM resets that's going to hit the subprime market and prime market by the way. It'll hit both. So, that's an interest rate factor due to ARMs. So, that could hurt us if rates go up much more. If he lowers rates, that will take away the tsunami effect of rate resets.

On the other hand, Bernanke has to worry about if he lowers rates what he's probably going to do is smooth out the housing market, but it might send the housing market back on an upward trudge again.

And he might be sitting there in Washington envisioning, oh, we're creating the same scenario that we had in 2000-2006, where rates constantly were falling and it made it very inexpensive to buy a home relative to what it was before. Whoops. That's a hard decision to make. I think right now he's just kind of leaving rates along. But again, be prepared because any rate increases, and even if there isn't, we are going to have these ARM resets. This is going to be kind of a touchy 12 months coming up because all the resets in the economy.

But I would advocate to anyone that is in the subprime market, it's better to sit still and wait until you have accumulated enough for a down payment of about 20%, and wait till you clear up your credit scores before you get into these markets. Avoid the ARMs if at all possible, adjustable rate mortgages.

They're great for people that have a lot of wealth, but for people that are just barely squeaking into the housing market they are dangerous as can be. And then be aware of the high fee mortgages. Those things are out there and they generally target subprime borrowers for it. So, it's subprime borrowers beware. They really have to do their homework.


Knowledge: And lucky for those of us who just went in and bought a house to live in with no thoughts of flipping it or making a huge profit.


Sanders: Absolutely. There's a lot of... That's what's kind of disturbing about the press that comes out occasionally. Is that there has been a lot of big winners in the housing market run up. People who bought their homes back in 2000-2001 independent of their financial status, by and large, have made a ton of money. They have done extremely well. They have got a very nice run-up.

So, if they want to sell their homes, although most of them aren't selling as well today as they did eight months ago, there's been a lot of winners in this market. Even on the subprime front. So, a lot of the subprime borrowers that got in and managed to hold on have gotten a big windfall from the housing market. But, we're focusing more on the downside effects. Which again is appropriate, we do worry about the downside. But, there has been a lot of winners in this market from this as well.

Most of the subprime defaults that are hitting in the United States right now are not in Arizona, California, and Nevada. They're in Ohio, Michigan, and Indiana. Industrial states with various automakers and their suppliers shutting down operations and either moving overseas, or down to the South, or the Southwest. What we're seeing is we are seeing job loss up there, and that's causing a lot of subprime defaults. That's really, other than the Katrina effect, it's usually economically driven.

It's the house price bubble effects out in the West that are scaring people, such as investors that were going through New Century and some of the California ones. They really haven't hit hard yet, as they could. But, as of right now, actually Ohio leads the U.S. in non-hurricane related subprime defaults.


Knowledge: Well, I'll tell you, and this is just anecdotal, one of the things that scares me is in a place like here in Nevada, California, a lot of people became real estate agents. And they were selling to people. And I'm hearing stories of a lot of people who got into those adjustable rate mortgage loans, and because their real estate agent were telling them that it was a good deal. And these were not very experienced real estate people. Everybody was just going in to make a quick killing. I'm wondering if a lot of this ignorance in the market is going to start hurting us.


Sanders: Well, that's why economists like to talk about integration. That it's best that, for example, a realtor firm also has, or a homebuilder has their own financing division. No. [laughs] That sounds great, and they're right, it could reduce costs to the borrower, but in some cases it ends up with the borrower getting a less than optimal mortgage for themselves.

Yeah, ARMs are a high spread product for the lender. Although they carry a lower rate they generally have some other countervailing effects in the contract. And for many borrowers ARMs are truly the wrong product. Because ARMs for the most part are used by people that either are going to be in the house only for years and get out, that makes perfect sense, but for people that want to spend a fairly long period of time in their house, which most people have the expectations to, ARMs are solely used to minimize your mortgage payment.

Anytime you have that that's your objective function, is to minimize your mortgage payment so you can get into the most expensive house possible, look for problems.

Knowledge:  Yeah, with the vague hope being, oh, in three years you'll have a better job, you'll be making lots more money.


Sanders: You know, everyone is overly optimistic about their wage rate growth. That's a very common effect. In fact, that's come up mortgage fraud cases by the way. There was one homebuilder who had their own lending company. And their lending company would ask people, "How much do you make this year?" And they would say, "I make $30,000." And they would say, "Wow, that's not enough. What do you think you're going to make in five years?" And the person would come out and say, "Well, probably about $80,000." So, they would write down $80,000. Now, that's fraud. [laughs]

It's fraud, but it also shows that this is a person that should not have been in the housing market. They should not be buying a home. But instead they managed to get them in there through fraud, or putting them into a mortgage contract where it's like the limbo thing, they barely squeeze under the pole. Well, yeah, but remember anytime in limbo when you try to barely squeeze under the pole, about half the time you hit it, which is a default case. So, this is kind of a tricky market.