Was The Subprime Meltdown Caused By Cash-Out Refinances And Bankruptcy Reform?Still on brief haitus, but the Arizona Mortgage Guru and Naked Capitalism had some interesting thoughts on causes of the lending meltdown we’ve been witnessing:

Yves Smith – Naked Capitalism

It suggests that many of the people who took out subprimes weren’t people who bought more housing than they could afford. It says they were already overstressed and overstretched financially. Using their home as a source of cash was a gamble to keep themselves out of bankruptcy, but in many cases, that bet didn’t work out.

Arizona Mortgage Guru

Having worked with borrowers during the frenzy I disagree with the analysis that cash-out refinances may have caused the meltdown. To begin with lenders still had debt to income ratio limits that would have prevented too much of a stretch. Even at the height of the frenzy very few lenders went above 50% DTI (debt to income) and many stayed at 45%. Additionally, this argument implies that had the cash-out refinance not occurred the borrower would have defaulted on their existing mortgages anyway. So, in essence these cash out re-finances only postponed the inevitable.

I don’t buy into the possibility that bankruptcy reform had anything to do with this mess either.The subprime boom was well under way when the actual reform occurred. I would think very few individuals in early 2005 looked ahead to bankruptcy reform stated for later that year and decided to get a subprime loan to avert disaster. I don’t have exact data on this so I can’t say for sure, but this is not a plausible argument in my mind.

Working in the mortgage industry during this time my view is that the entire mess started in Wall Street and their fixation on greater return for idle cash. Foreign purchase of American debt created way too much cash for investors. They needed to do something with this cash. They pushed it on the best debt out there: home mortgages.

I don’t know who or what caused the rise in home values during the same period but higher home values made this proposition even sweeter. It is telling that over the past five calendar years (2002-2006), the average home appreciated by 9.2% per year, while the S&P 500 was up only 6.2% per year*. In this climate the lender thought they had very little to lose. I guess their only error was in thinking this kind of market would last forever. It’s a pretty basic error to make consider historical home appreciation rate is in the low six percentage range.

During this frenzy I could always find a lender for any borrower with a credit score higher than 540. Even on a stated income loan at this score all that changed was the loan to value limit (how much the lender was willing to lend). The interest rate differential was manageable for the borrower, so at the end of the day it didn’t prevent them from going this route.

What was more surprising to me was the loan interest rate differential between a prime and subprime borrower. In most instances I saw rates were only 1.25% or so higher for a subprime borrower. The main knock on the subprime loan was the pre-payment penalty and some even offered a buyout it out for an additional 0.5%.

Even a guy like me wondered why there didn’t appear to be a risk premium in these situations. I am learning now that this is a sign of an oversupply in the market. So with these ground realities, I can pretty much say neither bankruptcy reform nor cash out re-finances caused the meltdown. There simply was too much money to burn and boy did it burn.

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