Cash-Out Refis: The Missing Actor in the Subprime Drama

Ah, fall is upon us, and with it comes the spectacle of renewed discussion of what to do about the snowballing subprime/housing mess. Members of Congress will compete for air time to Bemoan the Situation, Search for the Guilty, and Throw Money at the Problem. Note there may occasionally be thoughtful analysis and sensible regulatory proposals, but those are usually random occurrences.

The subprime problem has been in the public eye long enough that stereotypes about borrowers are emerging:

The Reckless Optimist. This type knew the mortgage was a stretch but went ahead anyway.

The Chump. These borrowers with low financial literacy didn’t understand the mortgage terms, and in some, perhaps many, cases were mis-sold.

The Unlucky. This group probably would have made good on its loans had not unfortunate events, like a job loss or serious illness, intervened.

The Greedy Speculator. This cohort includes people buying condos off the plan in hot markets and hoping to flip the property quickly, and people who mortgaged their home and bought rental properties with very little equity in either.

The Fraudster. In the old days, it was easy to tell not only who the bad guys were, but also what the crime was (you had either “fraud for housing,” in which someone got to own a house they shouldn’t have, and “fraud for profit,” where the real estate is simply an element in a financial scam). Now, in keeping with modern moral relativism, everyone and everything looks questionable. As Tanta at Calculated Risk tells us:

Telling the difference between the victims and the victimizers, the predators and the prey, and the fraudulent and the defrauded, is getting a lot harder when you have borrowers not required to make down payments able to lie about their incomes in order to buy a home the seller is overpricing in order to take an illegal kickback. The lender is getting defrauded, but the lender is the one who offered the zero-down stated-income program, delegated the drawing up of the legal documents and the final disbursement of funds to a fee-for-service settlement agent, and didn’t do enough due diligence on the appraisal to see the inflation of the value. Legally, of course, there’s a difference between lender as co-conspirator and lender as mark, utterly failing to exercise reasonable caution, but it’s small comfort when the losses rack up.

Because many of the key actors can be depicted as being more than one category, the drama of Subprime Lost can be told many ways, easily outdoing Rashomon in moral and narrative complexity. But don’t expect much in the way of production values.

However, one key actor has mysteriously been overlooked. And oddly, that actor seems to have been quite prominent in the real world (as opposed to media enhanced) version of this tale.

Perhaps it’s the lack of a catchy name. “Cash-Out Refinance” doesn’t exactly trip off the tongue. But its role in subprime has been largely overlooked. A June MarketWatch story mentioned it in passing:

More than half of subprime loans are actually cash-out refinance loans. Those loans are used to pay off credit cards or other debts, take trips to Bermuda, buy an unaffordable car or do some speculative investing – in the market, real estate or elsewhere.

“These loans are all about people in a tough spot,” said Matthew Lee, head of Fair Finance Watch, a Bronx, N.Y.-based community group that has championed the cause of urban borrowers for whom a traditional bank loan is out of reach.

We see subprime offers all-over the place: “consolidate your debts” or “tap you home’s equity,” the ads read. As Lee puts it, why not pay off credit cards with 18% annual interest rates with a 9% loan?

Half the subprimes were cash out refis. This isn’t implausible. Freddie Mac reported that cash-out (meaning the new mortgage was at least 5% larger than the one it replaced) refis for its borrowers were 35% in the second quarter of 2007, and noted that refinancings as a proportion of total mortgages were declining, which is typical in a rising interest rate environment.

Now why is this so significant? It gives a completely different picture of the nature of the problem. 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.

The high proportion of cash-out refis suggests that it would behoove someone to do some investigation to get a better grip on why people took these loans and what became of them. Were most, as Lee suggested, in bad shape and taking the one way they saw out, or were they merely hopeless overspenders? If they needed the new mortgage to pay off other debts, how did they get in trouble in the first place?

The last large scale study of why people filed for bankruptcy (published in 2005 but looking at 2001 bankruptcies) found medical expenses were the top reason and job loss/interruption was number two. If these are the real reasons that a large proportion of subprime borrowers went that route, it suggests a completely different set of remedies than if it is say, primarily a housing bubble (too many people felt they could gamble on appreciation) or predatory lender problem.

Dean Baker pointed out that some borrowers defaulted before reset, which suggests that pre-existing financial stress may have played a role:

[M]any of the subprimes were seriously delinquent or in foreclosure long before the mortgages reset to higher rates. In an analysis done early this year, the FDIC found that 10 percent of the subprime adjustable rate mortgages issued in 2006 were seriously delinquent (missed three or more payments) or in foreclosure within 10 months of issuance.

One other factor that may have contributed to the subprime frenzy: Lew Ranieri, the so-called father of mortgage backed securities, has stated that the overheated phase of subprime lending started at the end of the third quarter of 2005 and extended through most of 2006. When did the new bankruptcy law take effect? October 24, 2005. There is no ready way to prove a connection between the new law and the explosion phase of subprime growth, but consumers became much more cautious in taking on credit card debt after the law became effective. And the ones that had above median incomes which would force them into a Chapter 13 (meaning they’d have to repay their debts) might be even more eager to tap home equity if they saw themselves at risk.

The fact that the subprime crisis is devolving into a morality play means that the audience expects a deus ex machina to miraculously deliver a happy ending, when what we really need is some hardheaded analysis of how we got into this mess and some pragmatic remedies. But that isn’t terribly entertaining.