FRED WOLFERMAN: Sub-Prime Lending Touches Off a Crisis
If it weren't for Iraq, fired United States attorneys, the prematurely exploding 2008 presidential campaign and sundry other headline-grabbing stories of varying degrees of importance, the sub-prime mortgage lending situation would be receiving a lot more attention than it is.
Oh, it is getting coverage on CNBC and rattling a few markets, but it hasn't captured the interest of congressional committees, all too busy trying to embarrass the administration. If we are lucky, the lawmakers will continue to do what they do best -- nothing -- and the markets will take care of themselves.
A sub-prime mortgage, if you are fortunate enough to know nothing about it, is a loan made at a low rate to a bad credit risk, which after a short period of time adjusts to a rate at market or higher, thereby increasing payments by a large amount.
The obvious question is why either party would want to do this.
Well, depending on the circumstances, it can look attractive from both sides.
The borrower gets to live in a house he could not otherwise afford, and is in reality risking very little financially. If he had substantial assets in the first place, he would not have gotten the loan. If he can't make the higher payments, he will lose the house and what little equity he may have, and his already bad credit rating may suffer a bit more.
In a rising housing market, he may make a profit on the house even as he loses it, if he can sell it and pay off the loan. A disruptive process to be sure, but not necessarily a catastrophe.
The lender puts a loan on the books, knowing that he is taking a risk on the borrower, but believing the real estate is safe. In that rising market he really doesn't mind foreclosing, because he can see a potential profit on the house. If the borrower can continue to pay at the adjusted rate, so much the better.
This lending practice can go along pretty much indefinitely as long as house prices continue to rise, which is what has been happening for a long time, until recently. During this appreciation process, speculators began to play the game, further accelerating the cycle. Finally, as in all speculative cycles, prices got too high, and the buyers went away.
In a declining housing market, the wheels fall off very quickly. The borrower doesn't even want to make the adjusted payments, because the house is no longer worth what he paid for it. Why dump in more money when you already have negative equity? Go find an apartment.
The lender doesn't want the house back for the same reason. He will have to write down the loan, do something with the house and take a loss.
These events have a self-reinforcing ripple effect through the economy, as houses glut the market, prices fall further, and the damage spreads to expensive houses with sound financing. It will end when new home construction slows down and the housing stock is repurchased at whatever price turns out to be the new market.
This is all the kind of thing that happens when free markets function normally. Opportunistic lender meets greedy or naive borrower, and you get a high-risk loan. Before the dust settles in this cycle, there will be calls for regulation of lenders and protection for borrowers.
Those are both bad ideas. What are you going to do? You could legislate a floor on mortgage rates at two points over 10-year treasuries, or some such thing. Borrowers would not be pleased at cutting off bargain interest rates. You could require tougher underwriting of loans, thereby shutting marginal borrowers out of the housing market altogether.
This would upset those same marginal borrowers, as well as homebuilders, who would like to sell their products. You could legislate a morass of lending rules requiring both parties to fill out even more paperwork than is now necessary, then wait for approval from some agency while real estate transactions grind to a virtual halt.
None of this is necessary. The only law that could possibly help would be one eliminating stupidity. Oh, well.
Forecasts estimate that only about 1 percent of dollars (not loans) outstanding are at risk, and that over a multi-year period. This is next to nothing in the scale of the mortgage market, and can be absorbed easily.
The fact of economic cycles is totally predictable. The timing is not. If it were, we'd all be rich. This thing just has to run its course as some individuals and some institutions get burned. The same thing has happened in the past with stocks, gold and tulip bulbs, among countless other things. It will happen again.
Fred Wolferman lives in Southern Pines. Contact him by e-mail at firstname.lastname@example.org
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