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When lenders develop new loan programs, they assume borrowers are sophisticated enough to understand the product and disciplined enough to use them properly. Both assumptions are bad, and these bad assumptions caused lenders and investors to lose a great deal of money during the Great Housing Bubble.
Whenever lenders start loaning people money with total debt-to-income ratios over 36% people will default. Whenever lenders start loaning more than 80% of the purchase price, people can sink underwater and when they do, they will default. This is not new. It happened in the early 90s; it happened during the Great Housing Bubble, and it happened for the same reasons: lax lending standards.
Someday the lending community may actually innovate and come up with some financial product that has low default rates which most people can qualify to obtain, or not. Unless you change human nature, there are always going to be people who are too irresponsible to make consistent payments.
People either do or do not make their payments. This is the key to any loan program. New terms and schedules can be reinvented over and over again, and it will always boil down to people making payments. When complicated loan programs contain provisions that make it difficult for people to make payments, like increasing payment amounts, they will default, and the loan program will fail. This is certain.
Whenever lenders create new, "sophisticated" loan programs that require advanced financial management on the part of the borrower, both the lenders and the borrowers fall victim to the Lake Wobegon effect. Everyone thinks they have above average abilities when it comes to managing their finances. In reality, perhaps 2% of borrowers have the financial discipline to handle an Option ARM loan. Unfortunately, 80% of borrowers think they are in this 2%.
The reason for this dissonance between what borrowers know they should do and what they actually do comes from the inherent conflict between emotions and intellect. Eighty percent of borrowers may understand the Option ARM loan (or think they do,) but when the pressures of daily life create emotional demands for spending money on one's lifestyle, the intellectual knowledge that this money should go toward a housing payment is conveniently set aside. It is this 2% of the most disciplined borrowers who will cut back on discretionary spending to make their full housing payment. Everyone else will make the minimum payment, fall behind on their mortgage, and end up in foreclosure.
Lenders and investors during the Great Housing Bubble made serious errors regarding borrower's capacity to manage their finances. These errors cost lenders and investors a great deal of money.
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