Subprime lending (21 Feb 2007)

Why is anyone surprised that substantial portions of America's sub-prime lending market are starting to default now that interests rates have risen and the housing market has stalled? Skeptical economists who had been warning of a housing bubble had been predicting this scenario for a long time, but you don't have to read Econometrica to know that when you give complicated loans (ARMs, Interest-onlys, etc.) to people basically on faith and allow them to pay little up front and a lot later on, many of them won't be able to do it. As Justin Lahart put it in his WSJ column yesterday: "Nobody seemed to realize the risks inherent in extending mortgages with loose standards that left borrowers with little skin in the game. The question worth asking now: Where else has lax lending been going on?"

This chart, from Mike Shedlock's blog suggests that in mortgage lending lax lending was almost everywhere.


A commenter on Dean Baker's blog explains how we reached this point:

Buying a house used to require coming up with a down payment or going to war and qualifying for a Veterans Administration loan guarantee. You had to have a certain amount of skin in the game, literally or figuratively. And in return you would get a loan with some relation to the Prime Rate. But it has always been possible to get loans with credit that is sub-Prime, in worse case scenarios you go to Tony Soprano and your collateral is your knee-caps. Now over the last decade or so the housing market has appreciated in such a way that lending to schlumps who may or may not pay off still makes you money. You get your interest money and at the end of the day can take the house back and still get your principal out. When this action was limited to the hard money guys (a technical term in my biz) this was a rough and tumble thing usually understood by both sides. But when Wells Fargo and some other big institutional players jumped in, well, Katy Bar the Door. Anybody could get a loan. You could simply state your income, you could simply state your assets. We call this stated-stated. As opposed to Full Doc where you actually have to prove that you have income. Well this is a two-edged sword. Lenders can use these programs to get good people with reasonable jobs but shaky credit into houses, and given any reasonable rate of housing appreciation have that appreciation gradually save the day. Or you can use that same lending instrument to put somebody in a house you know they can't afford long term. It's tough to know where to draw the line, and when it comes down to it lots of people in my industry don't care: we collect the commission and sell off the loan. The foreclosures down the road aren't our problem.

Naturally, lenders will tighten their standards in response to the default rate, removing prospective buyers from the market at a time when the vacancy rate is at an unprecedented high. This would seem to suggest further depreciation in housing prices, kicking off more problems.

Who you blame for all of this probably depends most of your political persuasion (perhaps since there is so much blame to go around): Greedy banks? Bubble-fueling speculators? Ignorant and overreaching borrowers? An ostrich-like Fed? A tax system skewed toward home-buying? Picking up with my middle-class hating from yesterday, I wonder if the bias toward home ownership (as a symbol of arriving in the middle class and becoming a stakeholder in society's stability) makes us collectively tolerant of bad loans -- in the grand scheme of things in America, bankruptcy seems more dignified than being a renter, even though spending more than you've earned seems to me a way of stealing from posterity. We're willing to underwrite this fantasy that everyone's middle class with more and more exotic financial instruments, making the real extent of risk more and more obscure, as Gretchen Morgenson explains here. What happens when we can fantasize no longer?