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NYU Professor Says Subprime Mortgages Can Be Good
By Alton Gary Simpson
NEW YORK -- Taking a stance contrary to the emerging conventional wisdom that subprime mortgages are the root of all evil in the mortgage market are Alexei Tchistyi of New York University's Leonard N. Stern School of Business and Tomasz Piskorski of Columbia Business School. The pair has authored the study, "Optimal Mortgage Design," to answer the question, "Assuming 'full rationality,' what is the best possible mortgage contract between a homebuyer and a financial institution?" They posited an optimal mortgage contract and then compared the features of existing mortgage contracts with those of the optimal contract. They concluded that alternative mortgage products such as subprime products -- such as, option ARMs or the combination of an interest only mortgage with a HELOC, are more efficient than traditional mortgages.
According to Mr. Tchistyi, the biggest gains were for those borrowers who were able to purchase bigger properties for their income level or who made little or no down payment through the use of AMPs. He noted, "The adjustable features of these mortgages provide flexibility and also take into account preferences of both borrowers and lenders." He also added that a 'rational borrower' could utilize the payment flexibility of AMPs during periods when their income was too low for them to make their coupon payments. Also, since these products have adjustable interest rates, borrowers could use periods when interest rates are low to pay down their principal and gain more equity.
Acknowledging that AMPs have been implicated in the rising delinquency and foreclosure rates, the economists noted that AMPs have helped bring the level of U.S. homeownership to a record high level by extending credit to millions of borrowers who would not have qualified in the past. "If you give a mortgage to a riskier borrower, of course you face a lot of risk," said Mr. Tchistyi, adding that he believes it was loose underwriting guidelines that led to the subprime meltdown rather anything inherently wrong with AMPs. He and Mr. Piskorski state in the study, "We believe that while taking action on predatory lenders could be beneficial, restricting access of the borrowers to these new mortgages might be a bad idea from an economic point of view." The study states that it is better to accept the risk of a higher default rate than to restrict the homeownership opportunities of borrowers whom are financially able to pay a mortgage but have subprime credit scores and/or low or volatile incomes. As for the myriad state and federal legislative and regulatory proposals being put forth in response to the rising default rates, Mr. Tchistyi said, "It is better to let the markets figure out what is appropriate." He pointed out that the lenders with the most lax lending guidelines have already been punished by the market by being put out of business and that underwriting guidelines have already tightened.
Looking ahead, Mr. Tchistyi foresees more pain for the real estate industry as the housing market continues to slide and home prices fall over the next few years. Although, he was quick to add that falling home prices wouldn't necessarily be a bad thing from the standpoint of housing affordability.
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