June 24, 2007
Subprime Loans
Are Subprime Loans Useful? BECKER
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.
Subprime Mortgage Loans--Posner's Comment
The subprime-mortgage imbroglio is just the latest chapter in an age-old concern with the charging of interest, especially to individuals. Medieval Christianity forbade the charging of interest on the ground that it was unnatural for money to increase (as by lending $100 at a 10 percent interest rate so that at the end of the year the $100 has grown to $110), because unlike pregnancy there was no mechanism by which an inanimate object such as money could reproduce itself. Behind this superstition lay undoubtedly a hostility to commercial society, which persists today in some quarters of the Muslim world; Islam forbids charging interest although substitutes are tolerated. The concern with lending has persisted into modernity even in Western societies. Usury laws, which set a ceiling on interest rates, and the Truth in Lending Act, which requires detailed disclosure of annualized interest rates in consumer loans, are examples of this concern.
The relaxation of usury laws--a natural concomitant of the spread of free-market ideas in American society--allowed lenders to offer loans at very high interest rates to borrowers with poor credit ratings. Payday loans, which charge astronomical interest rates to persons who need money to tide them over till their next paycheck, and subprime mortgage loans sometimes at annual rates 4 or 5 percent higher than mortgage loans to borrowers who have good credit, were consequence of the relaxation.
I agree with Becker that credit is no different from any other commodity. For government to place a ceiling on price prevents people from buying the commodity who would be willing to pay a higher price, and thus it prevents a mutually beneficial, and therefore value-maximizing, transaction. The argument for the ceiling is that people who have a poor credit record have demonstrated their incompetence to borrow and so should for their own good be prevented from borrowing more. That is not a compelling argument, apart from any general objections to government paternalism than one may have. A person may have a poor credit record, yet know that he can pay a high interest rate and that he will be better off despite the cost. As Becker notes, although the rate of default on subprime mortgage loans is high, still, the vast majority of those loans are repaid. For many people they are the only route to home ownership, which is greatly valued by the owners but has also been thought (perhaps dubiously) to have social value; that at any rate is the rationale for the tax deductibility of mortgage interest.
I do think that there is reason to think that the subprime mortgage market is imperfect, though not reason enough to warrant government interference with that market. The subprime mortgage lenders have engaged in aggressive marketing that may have deflected borrowers from shopping for better terms in the prime market. There are of course many gullible consumers and many people who have difficulty understanding the cumulative costs of high interest. There are also many people who like to speculate or otherwise gamble without a good appreciation of the odds. Perhaps there is even something of a "bubble" aspect to the subprime market. When housing prices were rising, borrowing to buy a house even at a high interest rate (interest rates generally were low until very recently, but high to subprime borrowers) was a leveraged investment, both on the borrowing side and on the lending side. The borrowers expected to repay the high interest out of the rapid appreciation in the value of the house, and the lenders expected to be cushioned against the consequences of a high rate of defaults by those same rising prices: if they had to foreclose, the house would be worth enough more than the mortgage to enable the lender to recoup. A bubble arises not because people fail to perceive that an asset is overvalued, but because they think the perception is not widespread and therefore the asset will maintain or increase its market value. No one wants to sell an asset while its price is still rising, but if enough people think that way the price may rise to a point at which a slight perturbation in the market may cause a crash. Given the riskiness of subprime mortgage loans, a modest decline in housing prices or rise in interest rates (many subprime mortgages were at floating rather than fixed rates) could precipitate enough unexpected defaults to create distress not only among subprime borrowers but also among the lenders. Apparently that is what has happened.
Although the result is not a happy one, I do not perceive adequate grounds for government intervention. Proposals for limiting subprime loans have the quality of closing the barn door after the horses have escaped. The subprime "crash" has presumably educated both borrowers and lenders in the riskiness of the market, and if subprime lending persists it will not be because of ignorance of the risk. Of course if subprime lenders have resorted or are resorting to fraud in inducing such loans, they should be punished, but for that no new laws are required.