21 Apr 2009

Why Did Texas Skirt the Housing Crash?

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Von Pepe sends me this interesting analysis of the relatively moderate boom/bust in Texas house prices.

The analyst thinks the answer is that Texas law prohibits prepayment penalties. In other words, homeowners in Texas were allowed to pay down their mortgages ahead of schedule, without being penalized by the lender. He concludes:

I also want to get away from the duality of thinking of the subprime crisis as evil banks looting homeowners or evil lenders tricking banks. With the genius of prepayment penalties, banks didn’t have to make money by lending loans to credible homeowners – they could form a de facto company with unqualified borrowers to bet on house prices rising. The prepayment penalty was the bank’s equity in this endeavor. Or another way to say it is that the banks found a way to hire a person to sit in a house they wanted to gamble on; this was a subprime loan with a prepayment penalty. More to follow.

An interesting theory; I would like to see some more evidence though before signing off on it. (And the guy promises to do more research in future posts.) For example, if he could show that all or most states that banned prepayment penalties experienced low default rates, and in particular if he showed that the worst states all allowed the penalties, then that would be something.

In any event, I wrote an article defending prepayment penalties back when primary presidential candidate Hillary Clinton proposed abolishing them. An excerpt:

[I]t actually hurts borrowers (and lenders) when possible, voluntary contracts are declared inadmissible. Despite the presidential candidates’ desires to mother all of us, most people aren’t nearly as incompetent as the politicians would have us believe, especially when it comes to huge decisions such as financing a home purchase. The reason some borrowers are willing to sign contracts that include prepayment penalties is that the interest rate is correspondingly lower. If you think a prepayment penalty is absurd, you don’t need Hillary Clinton to rescue you. You can simply choose to take out a mortgage without a prepayment penalty (and pay a slightly higher interest rate because of your decision). Pretty simple, eh?

What most people don’t realize is that helping the borrower by giving him the option of prepaying the mortgage necessarily hurts the lender. When the bank lends you $200,000 to buy a house, it needs to compare the pros and cons of that loan with other possible investments. For example, it could have bought $200,000 worth of government bonds instead. Now from the bank’s point of view, one of the benefits of the mortgage loan is that it pays a higher rate of return than the government bond. But one of the drawbacks is that, if interest rates drop, the homeowner can refinance, whereas Uncle Sam can’t call in his bonds…

In other words, when the bank is planning its cash flows into the future, it is far more confident in fixed payments…as opposed to payment streams that might suddenly stop (such as a homeowner who refinances). In the financial community this is called prepayment risk. And guess what? If bankers are going to take on riskier investments, they require correspondingly higher expected returns. That’s part of the reason that mortgage rates are higher than U.S. bond rates…Including prepayment penalties in mortgage contracts mitigates this risk, and so allows the lender to charge a lower interest rate than he would accept without such a built-in compensation.

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