Subprime Mortgage Loans

March 11, 2007

Subprime Mortgage Loans

Megan McArdle passes along a question from Dave Schuler.

My intuition is that the phenomenon of the subprime loan is related to the rapid rise in housing prices that haven’t been matched by comparable rises in money wages. The implication is that people are paying a lot more of their incomes in mortgage payments than once they did. That, in turn, would be more prevalent in parts of the country where there’s been more speculative price increases than in areas that have experienced less of a bubble. More where you are than who you are.

One thing that happens in mortgage lending is that rising home prices cover up a multiple of sins. You can get away with really lax lending standards in a rising market, even to the point of tolerating a bit of fraud. What happens is that when people get into trouble with making payments but their houses have appreciated in value, they almost never go to foreclosure. Instead, they can sell their house, repay the loan, and walk away with some cash.

Looking at data from, say, 1998 through 2005, a lender would say that subprime lending was a high-margin, low-risk business. So standards got pretty loose. Now that house prices are not going up so much, some of the lenders are getting burned. When the borrower's bad spending habits get the better of him, he can no longer bail out by taking the profits on his house. He just stays and waits for the lender to come after him.

My guess is that the typical defaulter today is not some prudent individual who happened to buy a home that strains his paycheck. Instead, my guess is that the typical defaulter is somebody who is poor at managing spending and credit. Of course, either defaulter is going to appear to be "over his head."