By now, everyone gets that subprime loans are a disaster. What people are beginning to wake up to is that an ostensibly “safer” form of mortgage, Alt-A, could be just as bad.
Calculated Risk analyses the difference between the two and argues that Alt-A, sometimes perceived as less risky, actually can be even more so:
Residential mortgage lending never, of course, limited itself to considering creditworthiness; we always had “Three C’s”: creditworthiness, capacity, and collateral. “Capacity” meant establishing that the borrower had sufficient current income or other assets to carry the debt payments. “Collateral” meant establishing that the house was worth at least the loan amount–that it fully secured the debt. It was universally considered that these three things, the C’s, were analytically and practically separable.
The principal difference between subprime and Alt-A lenders was that each lender would go after a borrower with a different emphasis on the “C’s”:
- Subprime lenders would target people with poor creditworthiness, but high capacity and collateral.
- Alt-A lenders would target borrowers with high creditworthiness, but low capacity and collateral.
In other words, the m.o. of a subprime lender was to find borrowers with relatively high income who had missed payments in the past and gradually re-establish their creditworthiness. They would then use that reestablished creditworthiness to continually refinance the loan.
The m.o. of Alt-A lenders, meanwhile, was to take people with low incomes and low levels of debt, but a good history of paying said debt, and saddle them with more debt:
The utter fraudulence of the whole idea of Alt-A involves the suggestion that people who have managed debt in the past that was offered to them in the past on conservative “prime” terms must therefore be capable of managing debt in the future that is offered to them on lax terms… Think of it this way: subprime borrowers had proven that they couldn’t carry 50 pounds, so the subprime lenders found a way to restructure their debts so that they were only carrying 40. Alt-A lenders took a lot of people who had proven they could carry 50 pounds and used that fact to justify adding another 50 pounds to the burden.
As long as house prices kept rising, and borrowers could keep refinancing on agreeable terms, everything was peachy. But then house prices stopped rising.
The most pressing question for mortgage lenders and investors, therefore, is whether financial services firms will eventually have to take the same kind of losses on their Alt-A books as they have on their subprime books. If they do, get ready for another Bear Stearns.
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