During the past couple of week, the U.S. housing market has had a record number of home foreclosures, a rise in delinquency rates on mortgage loans, and further declines in housing starts. Default rates are especially high on subprime mortgage loans, which are loans to borrowers with poor credit histories and low or erratic earnings. The greatly increased availability of loans to borrowers with bad credit was fueled mainly by five years of low interest rates. Many lenders turned to what had been a neglected subprime loan market in their search for higher returns. The rapid appreciation in housing prices, in good part itself the result of low rates of interest, also gave lenders confidence that they could recoup the value of their loans in the event of defaults and foreclosures. In addition, new way of packaging mortgages and of combining them with other assets that reduce overall risk on portfolios with subprime loans lowered the risk of lending in the subprime market.
Members of Congress and others have called for much stricter lending standards for these loans, and sharper controls over the interest rates that can be charged. But subprime loans have made home ownership possible for groups that cannot get mortgages in the prime lending market. These recent criticisms of subprime loans- they were not much criticized while the housing market boomed- are reminiscent of the attacks in the '80s and '90s on the market for "junk", or low-grade, bonds. New and untested companies often do not have enough collateral to satisfy the stringent criteria of commercial banks. The development of the junk bond market enabled them to raise money from nonbank investors by issuing bonds that paid much higher interest rates than those on loans to prime companies. These bonds enabled startups with few tangible assets to borrow outside the banking system by offering much higher rates to compensate for the greater risk. Although junk bonds too were said, often by the competitive source of loans, bankers, to encourage undue risk-taking, such bonds have survived and even thrived, and not only in the United States. Moreover, some of the companies, such as CNN and MCI, that financed their early development with junk bonds have become very successful.
The same type of considerations applies to families with bad credit histories due to low and uncertain earnings, poor resource management, and other factors. Mortgages would not be available to these families to buy homes if lenders could only get the same interest rates and other loan conditions that they get from prime borrowers. Like new companies with limited collateral that issued junk so that they could survive the competitive business atmosphere, the market for subprime loans made the dream of owning a home come true for thousands of families.
While the default rate on subprime housing loans is high compared to the past, and the higher rate of defaults have forced about 20 subprime lenders to either close, seek buyers, or raise additional financing, delinquencies and defaults on these loans are far from being the rule rather than the exception. The fraction of subprime mortgage loans entering foreclosure in the first quarter of this year jumped to a 5 year high of 2.4 per cent from about 2 per cent in the last quarter of 2006. This is a large percentage rise in the default rate, but so far at least the vast majority of subprime loans are not yet in default, and are being repaid.
The default rate on prime loans also jumped, to 0.25 per cent, high for this type of loan but only 1/10th the default rate on that for subprime loans. The default rate on prime loans also rose by much less than the rate on subprime loans. It is not surprising that lower quality housing loans would be more likely to go into default during periods of rising interest rates and a slowdown in the housing market. Lower quality loans of all types are always more vulnerable to slowdowns in the markets that generated these loans.
Although many African American and other poor families became homeowners for the first time due to the development of the subprime loan market for housing, critics claim that many of these families were duped by misleading presentations of lenders into taking out short duration variable interest loans, loans with low down payments, or loans that were simply beyond their capacities to pay. No doubt overly eager or unscrupulous lenders did sometimes misrepresent the difficulty of making payments to borrowers with little experience in financing home ownership. However, intentional misleading presentations to families who were clearly unqualified to take on home ownership was not the norm but rather were exceptions.
The reason for my belief is not confidence in the morality of all lenders in the subprime market, but rather that delinquencies and especially defaults on these loans hurt lenders as well as borrowers. As defaults have risen, and the increase in housing prices slowed dramatically- in many areas prices have been falling- it has become increasingly difficult to recoup the amounts loaned by repossessing houses and selling them off. Moreover, in some states repossession of homes is difficult after owners declare bankruptcy. The fact that the majority of the companies that specialized in lending in the subprime market have gotten into serious financial difficulties, and many have closed, indicates that lenders as well as borrowers were badly damaged by the collapse of the subprime market. Both lenders and borrowers would have been hurt much more by the rise in interest rates and the end of the housing boom had the American economy not continued to have low levels of unemployment and growth in real GDP.