Mortgages Drifting in the Tide

On March 5th the New York Times printed this graphic showing the percentage of loans in default for various types of mortgages—ranging from conventional “prime” mortgages to “subprime”—as a function of the current ratio of all the mortgages on the home to the value of the home. The dancing waves at the 100%-level separate the houses that are “underwater”—valued at less than the amount owed on the mortgage—from those that have equity beyond the value of the loan.

The graphic is based on data from November 2008 to January 2009, and it accompanied an opinion piece by John D. Geanakoplos and Susan P. Koniak arguing that the best plan for solving the mortgage crisis would not be the interest payment reductions proposed by the Obama administration but reductions of principle. The argument proposed by Geanakoplos and Koniak is more radical but has merit, but I am struck by the orderliness of the graphic and the underlying debate about choice and personal responsibility hidden within it.

The axes of the graph are arranged in an unusual fashion so that those most underwater can be shown at the bottom of the graph. Four lines indicating different types of mortgages stream down from the upper left-hand corner, the point that represents a paid-off mortgage. The lines taper off to the right as they fall, as if they are blowing in a gentle breeze or slowly drifting in the tide. As the line moves to the right, more people are in default on their loans. The prime mortgage line hangs fairly tightly to the left. Even when their loans represent over 200% of the value of their homes only 4% of these homeowners are in default. In most cases, these borrowers had good credit ratings and a down payments when they bought their houses, and the overwhelming majority have maintained their good records.

But the subprime mortgage line on the far right is the most interesting. For some, these loans and the banking institutions who offered them are the source of our recent economic problems. The banks sold shady and deceptive loans to people how could not afford them, and the drifting line on the right is the result. High levels of defaults that caused the foreclosures, that caused the banking meltdown, that cause the stock market crash, that caused the layoffs, etc, etc. But look more closely at the subprime line. At the very worst point on the lowest point, people whose homes are worth less than half the value of their loans are defaulting at a rate of approximately 12%. A high rate, indeed, but flip it over. More than eight-eight percent of all people in these desperate circumstances are paying there mortgages on time.

The bankers would say borrowers who default on their loans are the ones who bear the responsibility for failure. These homeowners signed on the bottom line and then welched on their promises to pay. The subprime mortgage industry (many representatives of which have now gone out of business) argued that, had they not introduced these subprime mortgages to the public, many people would be denied the benefits of homeownership. Look at the 88% who are still in homes and still paying.

But this right-most line begs the question, at what cost? Is it fair for the majority to benefit at such a severe cost to the other 12%? Are these good enough odds? As it turns out, the answer is no. These mortgages were fragile enough that when bundled together into securities investments, they eventually fell apart. It turns out that subprime loans are a bad bet. Unable to weather a down-turn in real estate prices. Eight-eight percent may sound good, but it is not good enough.