Beware of Predatory Lenders? No, Fear Predatory Borrowers
Remember predatory lenders? According to the media, they're the ones who tanked the housing market and hurt millions of homeowners by duping low-income, subprime borrowers into taking on complex home loans - the kind that featured initial low payments that would be ratcheted up later. The Dodd-Frank Act established the Consumer Financial Protection Bureau (CFPB) partly to protect us from these lenders. But a new study by economists Gene Amronin, Jennifer Huang, Clemens Sialm, and Edward Zhong - a May 2012 working paper entitled "Complex Mortgages" - suggests that we should be more concerned about predatory borrowers.
The study finds that, compared to traditional home loans in which the balance is paid down steadily over time, complex mortgages were more often sought out by sophisticated homebuyers who wanted to stretch their budgets, some of whom made a calculated choice to walk away from their debts when home prices fell. Using detailed data on individual loans made between 2003 and 2007, the study's authors show that, even within the same geographic area, borrowers who took out complex mortgages tended to have higher incomes than those who took out traditional mortgages. Such mortgages were also more common in areas with highly educated populations. And, most complex mortgage borrowers actually had prime credit scores.
The authors find that complex mortgages were more common in areas with a greater concentration of young people, who might reasonably anticipate higher incomes in the future and could benefit from deferring repayment. They were also more common in areas with greater past high house price appreciation, where borrowers might expect the trend to continue. Both of these facts suggest that complex mortgage borrowers were making rational choices.
The authors also present several pieces of evidence to suggest that complex mortgage borrowers were more likely than traditional mortgage borrowers to default strategically - that is, to walk away from an underwater home even if they were not suffering serious financial distress. That's not surprising - borrowers who are willing to default strategically get greater benefit from the low initial payments of a complex mortgage.
Compared to traditional mortgages, complex mortgages were more often taken out by borrowers who were buying investment property and borrowers in non-recourse states, where a mortgage lender cannot go after a delinquent borrower's other assets. Such borrowers are more prone to walk away from a home if prices fall. Also, delinquent complex mortgage borrowers were less likely than traditional mortgage borrowers to resume payments after falling behind, suggesting fewer good faith efforts to keep their payments on track. And, while complex mortgage borrowers were generally more likely to be delinquent than traditional mortgage borrowers, this difference was amplified among borrowers with high incomes and good credit, who were more likely to be making calculated choices. Finally, mortgage delinquency was less often associated with declaring personal bankruptcy (a sign of genuine financial distress) among complex mortgage borrowers than among traditional mortgage borrowers.
Of course, this study describes the average complex mortgage borrower, not every such borrower. Certainly, some complex mortgages were foisted on naïve, sincere low-income individuals who just wanted to realize their dream of homeownership. The study shows, however, that such borrowers were the exception rather than the rule.
To fix the housing market, we need to recognize that the popular narrative of predatory lenders and victimized borrowers - however appealing - is simply wrong. We need to acknowledge the major role that predatory borrowers played in the housing meltdown. And more generally, we need to be more critical of popular narratives that are based on anecdotal evidence rather than hard data.
