New Mortgage Guidelines Changed Borrower Attitudes

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The evidence is in: Banks inadvertently took on more risk than they could handle during the housing bubble. Now, new research attempts to explain why. How did this fundamental shift affect the attitudes of borrowers? Pretty drastically, it seems.

The new study, authored by Clifford Rossi for a research arm of the Mortgage Banker's Association, claims banks took on greater and greater risk by adopting new kinds of exotic mortgage loans that were originally developed for sophisticated borrowers, not the general population.

The eventual consequence: Now the average homeowner who's having financial trouble is less emotionally invested in paying the mortgage first.Riskier mortgages such as option ARMs and negative amortization ARMs were originally developed by Golden West Financial for their upper echelon borrowers. Golden West, a onetime mom-and-pop savings and loan in California, marketed these loans to borrowers that it knew were "creditworthy and financially strong," according to Rossi.

Other banks, such as Countrywide, Washington Mutual and IndyMac, then started to make these exotic mortgages available to the general population. All three of those banks are now out of business because of these risky loan choices. Golden West also lost billions on these option ARMs. Wachovia bought Golden West and ended up imploding.

Now these exotic mortgages and sub-prime loans are blowing up in the face of bankers and investors, as millions of borrowers who were steered into these products are in foreclosure or walking away from their commitments.

The decisions these lenders made unwittingly put their own businesses at risk, as well as millions of home buyers. But this realization might have been knowable only in hindsight. The study quotes former Federal Reserve Chairman Alan Greenspan as saying a few years back, "Where once more marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately."

It is doubtful that there are many out there who still think Greenspan was right.

Another mistake these troubled banks made was geographically targeting some of the fastest-growing markets, such as Florida and California, which dropped dramatically when the bubble burst. Today, borrowers in these same markets face stricter lending standards just to get a 30-year-fixed mortgage.

These lending decisions and the devastating losses now experienced by banks have not only led to much stricter lending standards throughout the country; they also seem to have changed borrower behavior, possibly for good.

One study quoted by Rossi showed that, following the crisis, "more than a quarter of all defaults were characterized as strategic in that the borrower made a choice to default rather than continue to pay on an upside-down loan." According to this research, people who know someone who strategically defaulted are 82 percent more likely to default themselves.

Rossi concludes the "foreclosure trauma experienced across the country may be a factor in promoting greater defaults and softening the social cost of default."

Rossi also points to another study from TransUnion that showed people now pay their car loans and credit cards first before their mortgage. In this survey, based on 2008 data, borrowers were more likely to go delinquent on their mortgage than on their car loan or credit cards. Rossi concludes that this "trend provides critical insight into borrower behavioral changes toward the mortgage payment." Prior to this study, he says, mortgage payments tended to be the first paid because of the "emotional tie the borrower has with their home."

Has that emotional tie been broken?

Yes, says Rossi. He claims that a few key factors are spearheading this change in borrower attitude:
  • Down payments were lower leading up to the crisis, which means people have less at stake.
  • Dramatic drops in home value created significant negative equity.
Combine these two factors with media stories extolling the virtues of walking away from your mortgage, Rossi says, and the result "may be tilting the internal calculus of borrower defaults toward turning over their keys." Rossi concludes, "This may be one of the most insidious unintended consequences of the mortgage crisis."

I think this trend is temporary. For now, the trend will likely build in intensity, especially as people are forced to move quickly to get a new job. Only when house prices recover and employment opportunities broaden will borrowers start to readjust their thinking about the biggest purchase most will ever make.

Lita Epstein has written more than 25 books, including "The 250 Questions Everyone Should Ask About Buying Foreclosures" and "The Complete Idiot's Guide to Personal Bankruptcy."
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