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06/24/2007

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brian

your comparison of subprime borrowers and companies issuing junk bonds is flawed. Junk bonds could be justified because 1) it was the only way for the company to raise capital; 2) the holders of the debt had an indication that a sizable portion of those young firms (think 1980s cable networks) could realize significant cash flow increases in the future as they grew their businesses.

Subprime borrowers on the other hand did not have to buy a house to find a place to live; the alternative is renting. Many of those eligible for subprime loans did not have all that great job prospects for which a lender could justify giving them a low rate now with a sizable bump up in the near future. Most borrowers were not newly minted doctors and lawyers out of graduate school.

Corey

I don't think you get to talk about all the new "homeowners" created by these mortgages without some data about how much real equity has in fact been secured in the subprime mortgagors.

I can go and lease a 2 bedroom house for $2K a month. Or I could take out a subprime loan, which will likely have a variable rate so that I never manage to pay anything more than interest, and an acceleration clause that practically guarantees foreclosure and blocks redemption should I ever be late on even one payment.

I submit to you that these options both have the same (zero) chance of ever giving me real equity in my "home." In neither case does it make sense to call me anything but a tenant, and I would prefer the lease because the law more tightly regulates terms in leases than in mortgages. We've had more time to think about consumer welfare issues in adhesion leases. It is only recently that adhesion mortgages have been dumped on the working classes in large number.

As I said on the Posner side, people are going to be incensed to learn that foreclosure sales to capture increased-home-value equity were always part of the risk analysis justifying the subprime bubble. I am personally happy to see prices dropping faster than the banks can foreclose enough houses to turn profit. But even if value had held up in the face of all the defaults, subprime lending has the same evil calculus that marked now disfavored "dead-peasants insurance" or once popular rent-to-own shops.

If part of your business model depends on the death or insolvency of your clients, then you need to stop, read some Dickens, and pray that the people will forgive your cynical excesses.

If subprime lending offered a realistic shot at working class home ownership then I would be for it. Unfortunately, the practice 1) obscures the inequity of wealth disparities and masks the need for wage reform, and 2) provides banks with an excuse to drag out all the ole poor-house filling usury tactics in the name of managing risk.

Asim

Professor Becker, there is an aspect of "over-investment" in housing that I don't think is being addressed. These people were offered zero money down loans with the potential of 20% yearly house price appreciation, with the only downside being damage to their already tarnished credit score. While I believe that subprime lending has benefited borrowers, on the margin wasn't there also "too much" home ownership and too little renting?

Garth

"However, intentional misleading presentations to families who were clearly unqualified to take on home ownership was not the norm but rather were exceptions."

How do we know that? And, what are defining "norm" as? 20% of cases? 50%? A large majority???

the foreclosure rates keep rising and rising - ie - we haven't even seen how extensive this problem is yet. We just know that it is bad now, and getting worse.

Also, you lump 'congress' into one entity that presumably wants to prevent poor people from home ownership. I don't think I've heard that from anyone - all I've heard is talk about putting some restrictions on the blatant smoothtalking and in some cases all out lying that obviously has been happening --- whether they be 'exceptional' or not.

GeorgeNYC

Where are you getting your delinquency rates?

http://news.morningstar.com/news/ViewNews.asp?article=/DJ/200706141016DOWJONESDJONLINE000751_univ.xml&Cat=EcoNews

Subprime ARM's are over 10% delinquency rates.

Also, what "dream" of homeownership? Your ideology is getting in the way of your economics. You no more "own" a home when you have a mortgage than when you rent. What you have is merely a highly levereged bet on the local property market. Maybe instead you should discuss the value of hedging over rental rates as an alternative to "owning" a home.

Also, the real problem here has nothing whatsoever to do with interest rates. It is the effect on the market of the ability to "sell off" loan exposure by the banks to investors. This allowed a flood of capital to enter the market and encouraged excessive risk taking. True the market is now "adjusting" however it is not entirely clear that this will end well.

James

Becker's argument hinges on the idea that lenders bear the cost of defaults. It seems to me, though, that they don't bear all of the risk - a lot of the loans are securitized, and the risk of foreclosure belongs to the buyers of those securities. The lender may hold the lowest tier of re-packaged debt, but that doesn't necessarily mean it bears all the risk (with enough foreclosures, other securities holders will be hit).

Of course, if everyone had good information about the loans, the lenders would get a lower price for their re-packaged loans when they were more likely to go into foreclosure. The question, then, is how well buyers of securities can monitor the quality of the loans going into a securitization. If there is some asymmetric information there (the lender knows more than the purchasers of the securities), then it seems to me you could have some moral hazard problems. The lenders could make worse loans than they would if they were going to hold all the debt themselves.

On the flip side, there may be borrowers who are not perfectly rational and who can be manipulated into making unwise choices. The absence of default isn't good evidence that a good choice has been made: many borrowers may be reliably making payments on loans that are too large, or bear too high an interest rate.

Haris

James
You make a good point about the fact that investors bear most of the risk of loans, because most loans are securitized. However, to me that's a good sign that things will end well after all. The US financial markets are some of the most efficient markets in the world, so they are unlikely to add to the problem. For example, if, as you said, lenders know more about loans in a security than investors do, then investors will properly discount the value of such securities relative to other securities whose risk prospects are better known. To obtain the non-discounted price, lenders will have to disclose more information about the loans. Ultimately, I think the securitization of loans is a good thing, since the risk is borne by those people who choose to bear it. [Assuming that no one is forced at gunpoint to invest in loan securities.]

I think the "problem" is probably a function of information: many subprime borrowers probably have little idea what they were getting themselves into, and I seriously doubt that at least some lenders were very much okay with that. If the government were to get involved, I don't think this "problem" merits much more than a mandatory disclosure policy, similar to the approach taken in the securities markets. That is, if lenders were forced to do due diligence on prospective borrowers to ensure they have a reasonable chance of repaying, and if borrowers were provided with a clear picture of their obligations under the loan, then I don't think we should stand in the way of these transactions. Banning them is probably the worst thing we can do - I know many recent immigrants and new college grads without credit histories who could only establish them by overpaying at first. Just like that should be permitted, getting subprime loans should be as well.

Jake

Prof. Becker is absolutely correct in comparing the collapse of the subprime mortgage lending market to the collapse of the junk bond market in the late 1980s -- which, oddly enough, coincided with the collapse of S&Ls that grew careless about lending standards and capitalization. Imagine that. History repeats itself.

Comments to the contrary probably come from persons who studied the lending markets of the the 1980s while getting MBAs in the 1990s, not anyone who actually lived through the credit market disruptions of the late 1980s, let alone had any capital at risk at the time.

David Drake

Some of the comments smack of the mindset that "some people have to be protected from themselves."

If the default rate is 10%, then 90% of the borrowers still own their homes and are moving into the middle class.

And, contrary to Corey and GeorgeNYC, someone who owns a home subject to a mortgage--even an "interest only" mortgage--in fact owns the home. Those who bought at the top of the housing market expected that housing prices would continue to increase. If they had, then equity would have been generated and the buyers would have had cash to put into equity in another home or into their pockets.

And any lender who lent with the view to reaping the equity when the buyer defaulted and has foreclosed now has an asset that is worth LESS than he loaned against it. He is out real bucks. If ownership of the underlying asset had been his aim, then why did he not just go buy at the outset, using the money he lent as downpayments on, say, ten times as many homes and borrowing the rest from an eager lender?

I agree with Professor Becker's analysis: if non-disclosure of risks is the problem, then compelled disclosure--not prohibition--is the answer. That is, unless you are a landlord.

Tim Ogilvie

The crux of your argument hinges on two assumptions:

1) Only a small percentage of loans used deceptive/aggressive marketing tactics. Do you have supporting data for this, or is this just supposition? I've heard (albeit only anecdotally) that "risk disclosure" is very limited as it relates to loan suitability in a

2) Loan originators have no incentive to be aggressive since they will suffer if their loans subsequently default. This isn't true. More than 50% of mortgages get resold as CMOs. Further, the lender has discretion as to which mortgages get sold, so can elect to hold onto those that meet higher standards.

Does this mean that we should have more government regulation? I'm not sure. But it seems to be a more subtle issue than your argument implies.

As always, though, thanks for a thought-provoking piece.

Watches

Yes loans these days are very very important but the rates are bursting at the seams!

N.E.Hatfield

!NEWS FLASH!

Latest released PIMCO analysis points to problems in sub-prime lending market is spreading to other areas. Is the sub-prime market just the tip of the iceberg heading our way? Only time will tell...

Corey

"Some of the comments smack of the mindset that "some people have to be protected from themselves.""

No, they smack of the mindset that some people need to be protected from greedy and/or fraudulent capitalists, as well as from faulty products, real or intangible.

If I sold you an oven that burnt down 10% of the homes it was installed in, you would be very angry. If I said, "oh well, you assumed the risk," you would be even madder. Why does HSBC get to sell a loan that results in 10% of the borrowers being evicted? Why do you insist on blaming the borrower/buyer for this result but not the faulty oven?

"If ownership of the underlying asset had been his aim, then why did he not just go buy at the outset"

Because it is/was harder to raise speculative capital for direct investment in homes than to suck investment into the "subprime" hedge. People would have been better off buying oil stock than bananas.com stock during the internet bubble, but markets have trends too.

GMAC Mortgage

As you said N.E.Hatfield people sometimes do need to be protected from themselves. Especially the younger generation, I think we are going to see as they age fewer of them will get into the housing market as they have the money in money out philosophy.

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