04.18.07
Subprime bailout
I’m still trying to assimilate the details of the “subprime crisis“. From the borrower’s perspective, a mortgage is pretty simple. You borrow money and promise to pay it back with interest. Break that promise and the lender takes your home. Adjustable rate mortgages are in theory only slightly more complicated — you get a lower initial rate, but take a chance that the rate will increase.
Here’s where it starts to smell fishy:
- An ARM commits the borrower to payments that are potentially much higher than a fixed rate loan. The borrower accepts this risk in return for an expectation that their payments will be lower over the lifetime of the loan. This is only appropriate for borrowers who are secure financially, yet it seems that ARMs have been marketed to borrowers with zero risk tolerance.
- The usual risk with an ARM is that the interest rate climate will worsen. We have admittedly seen short-term rates increase over the past few years (the prime rate stood at 4% in early 2004 and is now at 8.25%), yet I keep hearing about “teaser” rates. Are these rates increasing because they are indexed to a benchmark that is increasing? Or would they have increased even in a stable rate environment? The implications of the two possibilities are very different.
- Much of the trouble has been blamed on “no money down” mortgages that (due to inflated appraisals and a modest decline in the market) are now underwater. It is foolish for a lender to make such a loan, and foolish for an investor to buy such a loan. The borrower, however, has risked little or nothing in this transaction. They may “lose their home” in a default, and have to return to renting, but is that not better than paying (over 30 years) more than their house is worth? [See comments — one contributor suggests that foreclosure entails bankruptcy as well. At the very least, it damages your credit history.]
There is a natural desire to keep people in their homes. Stability is good for the individuals affected, the neighborhoods, and the overall economy. We all wish to feel secure in our lives. Yet fear is also a healthy motivation. Without fear of a reversal, our economic choices come to be dominated by greed. Greed without fear leads to asset bubbles, as seen in the stock market in 2000 and the housing market today, that reduce our economic stability.
It seems to me that there is enough blame to go around. Do we save the borrowers from their poor choices? Do we save the lenders and investors from their own stupidity? One organization is offering below-market rate mortgages to those in trouble. Is that fair to those who behaved sensibly throughout? I am encouraged that the (semi-private) guarantee corporations are ready to take the lead in finding a compromise here that reflects the common desire to avoid default, but a taxpayer-funded bailout does not seem appropriate.
Malacar said,
April 18, 2007 at 7:06 pm
Valentine,
You draw an interesting dilemma when you paint real estate owners as trapped between fear and greed. The regulatory aspects are interesting, too. It seems to be echoed in other areas of capitalism: a pure free market allows people to do really stupid things (and pay the consequences) or really evil things (and make others pay the consequences). We don’t want people suffering because of stupid or evil choices. On the other hand, the more regulation you impose, the more you stifle individual initiative and innovation, without which the economy will stagnate.
Since some of the stupid choices and perhaps most of the evil ones have effects on others, potentially many others, it’s difficult to say that the greater economic good is clearly linked to a pure free market. On the other hand, every disaster inspires new regulations to keep another one like that one from happening. But keeping the disaster from reaching the public purse, as you write about them doing, is a good way to reduce the odds of major new regulations.
Valentine said,
April 19, 2007 at 2:13 pm
Truly, the accusation of “greed” is more appropriately leveled against the middle-men in the system. The real estate brokers, mortgage brokers, and lenders all definitely should have known better, but hoped to profit from the transaction in the rising real estate market. The borrowers are perhaps better described as “naively trusting”? Innocence is charming in a child. In an adult who is trusted to vote and raise children, naivety is scary.
There appears to be growing sentiment for the Federal Reserve to cut interest rates. Consumer spending is slowing (review the just-released earnings report from Bank of America), and lower short-term rates could benefit adjustable rate mortgages. Unfortunately, such a move might also be expected to goose inflation. Do we jump out of the frying pan merely to land in the fire? A difficult decision.
Spok said,
April 19, 2007 at 2:24 pm
Interesting post. But I wouldn’t agree with the last bit that the family that loses their over-mortgaged home has “risked little or nothing in the transaction”. Legally, they’re still on the hook for the full debt, so even after the house is repossessed and sold, if the selling price isn’t high enough to cover the full debt (which it often isn’t, in this market) they either have a lagre debt or bankruptcy to deal with. And having a trashed credit record, a large debt, or both, hanging over your head can make things quite difficult for one financially.
The other thing to keep in mind is that a lot of these teaser mortgages got taken out for *refinances*, not for new purchases. I saw lots of ads in my area for mortages that offered really low teaser rates to encourage peopel to “consolidate their bills” and lower their monthly payments. (The rates were, of course, certain to go up even if normal interest rates *hadn’t* risen– no one makes a profit loaning at 1% for more than a very short time period.) And folks in my neighborhood sometimes took out such loans to fix up their houses, and went from a fairly small mortgage to a ruinously large one.
Yes, one could argue that borrowers should have been savvy enbough to see the traps and avoid them. But a lot of people aren’t, or those ads trumpeted low (initial) monthly payments wouldn’t work, and you see them a lot in ads targeted lower-income markets. (See any used car ad shopper.) And it doesn’t simply reflect less savviness– it can also reflect a certain level of desperation to get out under a bad situation, and hope that one’s fortunes will improve enough down the line to be able to afford the higher payments sometime in the future.
So, although I agree that borrowers have some responsibility for their actions, I feel a lot more sympathy for the borrowers than for the lenders and the brokers in this situation. The lenders, who were presumably educated and with discretionary money to invest, had much less excuse for not exercising due dilgence; the brokers were usually positioned so that they knew what sorts of customers were generating their commissions, and what they could and could not realy afford.
Valentine said,
April 19, 2007 at 2:48 pm
Thanks for the comments. Details on California mortgage law can be found here: http://www.maldonadomarkham.com/california-foreclosure-law.htm
“A lender cannot get a deficiency judgment if it forecloses by private sale, nor can it do so if the underlying loan was a purchase-price loan.” Apparently refinancing sheds this protection for the borrower.
As I noted originally, an ARM offered with a “teaser” rate is a very different bag of worms from one that is presented honestly. I feel some sympathy for the borrowers, none whatsoever for the brokers and lenders. I would love to see the authorities review lending records with an eye towards criminal charges of fraud.
That said, “rights” and “responsibilities” go hand-in-hand. If the government excuses its citizens from responsibility for poor choices, does it not as a result strip them of the right to make *good* choices?
The borrowers and the lenders both have strong incentive to avoid default on these loans. It is appropriate for the government to “suggest” to lenders and the guarantee corporations that they find compromise, but a taxpayer-funded bailout would only serve to reward bad behavior.