Mortgage Lending: Borrower Approach vs Collateral Approach
The subprime mortgage crisis was basically a clash of ideologies. These ideologies were related to the centuries old belief regarding how money should be lent out versus the new age beliefs regarding how money should be lent out.
The old age belief was that money is being lent out to the borrower and that collateral should be set aside and the borrowers ability to pay back should be taken into account.
In this article we will have a closer look at the clash between the two approaches.
The Borrower Approach
The borrower approach was based on centuries of sound lending practices. This is how money had always been lent out. Some of the maxims of this old age approach have been listed below:
- Ability to Pay: The old age lending technique was very skeptical about the borrowers ability to pay back the loan that they were asking for.
- Willingness to Pay: The old age lending took a very close look at the borrowers willingness to pay the debts besides the borrowers ability to do so.
- Stress Testing: The old age lending was conservative in the valuation of properties. The definitely did not believe in the maxim that property prices will always appreciate. Hence they would always ask for down payments that would act as a cushion in case the price of the property fluctuated.
The assumption would be that the borrower will not be able to pay back and the documentation would be used to create a case otherwise. Each document was looked at with extreme skepticism.
Detailed analyses of what the borrowers cash flows would look like in the future were drawn out. There were heuristics which governed the amount of money that the borrower must pay towards the mortgage in case they were to maintain their lifestyle and not face any liquidity crunch.
The new age lending analysis simply discounted the borrower and the old adage. They simply believed that it was the borrowers job to look at their budget and not the banks. The bank was lending against collateral i.e. a house and if the borrower failed to pay back the money, well they would simply foreclose the house and obtain their money!
This was done by closely scrutinizing the past debts that were held by the borrower. Were they paid back on time? Did the borrower follow the repayment schedule or was there a delay in making the payments? Did the borrower have any incidences of bankruptcies or foreclosures?
The new age lending has a much better mechanism to keep a track record of all the above questions. This mechanism is called the credit score and it aggregates all the above questions into one easy to understand number.
However, competition between the new age bankers led them to believe that this number was not as important as it seemed to be. The rationale once again was the same. The transaction is secured with a house of greater value and hence they shouldnt really be worrying about all these things.
Mortgages after all lasts for about three decades on an average and a lot can change regarding the valuation of the property in that time frame.
Also, the lenders would assume what would happen if distressful scenarios such as divorce, illness or any other expense were to come the borrowers way. Only if the borrowers outlook was positive in all of these scenarios were the loans made.
The new age lending practice was the exact opposite of this. Down payments were reduced to a minimum. Also, there were soft second loans available to help borrowers make the margin payment. Therefore in essence the bank was financing 100% of the property instead of 80%. No attention was paid to any duress that the borrower may face in their lives.
Problems with the Collateral Approach
The collateral approach to lending had some major flaws. These flaws were what later caused the subprime debacle. Two of the most prominent flaws in this approach have been listed down below:
- Illiquid: It is true that the bank did have a claim to a property in the event of a default. However, it is not true that the bank should not worry about borrowers defaulting. A default scenario is a no win scenario.
- Volatile Value: The nail in the coffin of the new age approach is that houses also have volatile value. This is particularly true in the case when lending standards have been extremely relaxed and when defaults happen in mass. When everybody wants to sell their homes there is excess supply and no demand causing the prices to plunge.
In fact it is a lose-lose scenario if the defaults happen in mass. This is because properties are not like stocks and bonds, they cannot be sold overnight.
In fact property investments can take months to liquidate. On top of that there are legal expenses and transaction costs that need to be borne by the banks too.
Hence, if the borrower defaults the bank is stuck with a property. But the banks are not in the business of leasing properties. Instead they are in the business of lending out money and it takes a long time to convert the property into money!
In the absence of any margin money, banks literally have to write off millions of dollars in losses. This is precisely what happened as result of the subprime mortgage crisis.
The bottom line therefore is that collateral is meant to make lending easier. It is not the sole purpose of lending. The age old maxim still holds true. Loans are still made to borrowers and a thorough credit check is the only way to ensure sustainable profitable lending.
|❮❮ Previous||Next ❯❯|
Authorship/Referencing - About the Author(s)
The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- Subprime Mortgage Crisis: An Introduction
- Dot Com Bust: Starting Point of Subprime Mortgage Crisis
- Political Incentive for Home Ownership
- The Case Of Freddie Mac, Fannie Mae and Ginnie Mae
- Advantages to Freddie Mac, Fannie Man and Ginnie Mae
- Types of Mortgages
- Types of Mortgages from Borrowers Point of View
- Mortgage Products - Negative Amortization & Home Equity Line of Credit
- The New Mortgage Landscape
- The New Mortgage Landscape: Conflict of Interest
- New Age Financial Securities - Mortgage Backed Securities & Credit Default Swaps
- Collateralized Debt Obligations and Tranching
- Benefits of Collateralized Debt Obligation (CDOs)
- Subprime Crisis: Problems Caused by Accounting
- The Self Reinforcing Housing Loop
- Integrated Financial Systems
- Credit Market Freeze
- Borrower Approach vs Collateral Approach
- How Reverse Mortgage Works ?
- Reverse Mortgage: Pros and Cons
- The Big Bust Washington Mutual (WaMu)
- General Motors and the Subprime Crisis
- The Return of Subprime Mortgages
- The Big Subprime Bust
- Executive Compensation and Sub-Prime Mortgage Crisis
- The Big Fall: Lehman Brothers
- The Big Fall: Bear Stearns