Arnold Kling  

Random Thoughts on the Subprime Mess

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First, I really enjoyed the Youtube posted on Greg Mankiw's blog. Warning: contains a racial reference that is unnecessary and, in my opinion, offensive.

The story is all over today's Washington Post. Citing a source called the Center for Responsible Lending, they say that there are 7.2 million families who have a subprime mortgage, 1.8 million with interest rates that reset in 2007 or 2008, a total value of $1.3 trillion, with 14 percent now in default and ultimately 20 percent of the loans originated in 2005 and 2006 expected to go into foreclosure.

The front page of the Post says that Treasury Secretary Paulson's plan to freeze interest rates on these mortgages is on a fast track. Another story in the business section gives an example of a Florida government money-market fund that is temporarily illiquid because it is stuck holding some securities backed by subprime loans.

My instinct is to tell the markets to just suck it up and deal with the losses. With that approach, I hope that the worst will be behind us by 2009.

To me, the main problem is to get back to equilibrium in terms of house prices. My fear is that the interest-rate freeze and other bailouts will serve merely to drag the problem out for years.

The sooner we put the foreclosures behind us and get to a market equilibrium in house prices, the sooner the mortgage market will be liquid again. At least, that's my way of looking at it. Obviously, I am in the minority.

UPDATE: Some useful data at Calculated Risk on the percentage of mortgages with negative equity, meaning that the amount of the outstanding loan is higher than the value of the home. A small amount of negative equity is a necessary but not a sufficient condition for a borrower to default. With positive equity, you sell rather than give the home to the lender. With negative equity, though, you're still better off not going through foreclosure and eviction if you can help it.

But repeat that the key is to get as quickly as possible to an equilibrium in home prices, so that everybody knows where they stand. The talk of bailouts does not help matters.


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The author at Roth & Company, P.C. in a related article titled DON'T JUST DO SOMETHING. STAND THERE. writes:
    The Bush Administration feels it has to "do something" about the subprime mortgage hangover. When the government feels it has... [Tracked on December 5, 2007 8:36 AM]
COMMENTS (9 to date)
Randy writes:

The proposed bailouts are a typical case of, "Something must be done, this is something, therefore it must be done."

Grzesiek writes:

I believe that Treasury Secretary Paulson's plan is being considered because:

* We are approaching an election year.
* Government is best able to solve the problem.

Arnold,

I too believe that an interest rate freeze/bailout will extend the period of correction and may lead to future borrowing issues because of lessons not learned.

Kids at the high school level have to become better skilled in mathematics, home business, general business, & finance.

Adults have to be perceptive enough to know when they're being sold a bill of goods. Adults also need to temper their greed.

Education is the best disinfectant to this problem.

tgalvin writes:

History repeats itself, first as a tradegy, then as a farce.

1980's S&L anyone?

Dennis Mangan writes:

One reason for the mess that isn't often mentioned is the uncontrolled greed - on the part of the borrowers. Everyone saw housing prices going up and up for years and thought, without doing any research, that buying a house was a can't-lose investment. In addition, many of the houses in foreclosure are vacant and owned by flippers. Will the government make up the losses in my stock portfolio?

Heather writes:

While I don't like the idea of a bailout on a macro level, at a micro level I think there is justifiable concern over the consequences of doing nothing. Even one home in a hundred being foreclosed on and standing vacant for some period of time increases crime rates and, most likely, the homeless rate. These problems also have real costs to society, from increased policing costs to increased use of shelters. If there is a better solution to these issues, I would be interested in hearing them.

Mike writes:

I am a free market libertarian but I will confess that free wheeling capitalism will periodically create a mess of things. There is a fine line between pure laissez-faire and minimum necessary regulation to provide a referee over the system's natural dynamics. This is a classic illustration of regulators losing control. As I see it we have the following greed driven cast of characters in this Greek tragedy.

1. Borrowers: worried they would be left behind as the train (rising home prices) leaves the station
2. Lenders (loan originators) feeding off the fees created by new loans and refueling by selling off the loans to investment bankers.
3. Real estate brokers who skim off their commissions
4. Speculators (home flippers) who saw easy profits in a rising market
5. Investment bankers who got fees for buying loans from lenders and securitizing them into mortgage backed securities and selling shares to investors.
6. Investors seeking high yield, low risk (so they thought) participations in diversified participation in securitized loan portfolios.
7. Regulators who stood around and did nothing.

Now we have to unwind all this mess which will cause unnecessary pain for others sucked into the maw of this mess in the form of a credit crunch induced recession.

What ever happened to the good old days when you got a realistic, conservative appraisal which had to be backed by at least 20% down (skin in the game) or else the borrower had to get private mortgage insurance to cover the loan in excess of the 80/20 loan to value ratio?

It seems that greed and regulator's asleep have caused us to learn another unnecessary lesson. It surely tries one's sole.

Arnold writes: Warning: contains a racial reference that is unnecessary and, in my opinion, offensive.

PrestoPundit writes: The Congress recently forced banks to lower their standards in the subprime market for minority buyers.

I am beginning to suspect that political correctness, such as echoed by Arnold, is delaying exposure of how government created this subprime mess. You should not fear being labeled racist if the racism was started by Congress -- if Congress used a racial criterion to force lenders into stupid behavior. Congress deserves the blame, not we who may name the cause of the subprime mess.

Dan Weber writes:

Yeah, where was PMI in all this?

Were these combo mortgages, where people sold off the first 80% to one party, and the other 20% went to another party?

Or did they have PMI? I would guess we'd be hearing about the "PMI crisis" if that's what happened.

Or did lenders just let buyers get away without either of those things?

John Thacker writes:

But repeat that the key is to get as quickly as possible to an equilibrium in home prices, so that everybody knows where they stand.

A claim that I've heard:
When a mortgage is foreclosed, the bank is allowed to value the home on the books for the value of the mortgage. If they auctioned off the home at the true value, it would decrease their notational assets and cause them to have to decrease their outstanding loans further, in order to make their reserve requirements. Therefore, the banks do not have an incentive to get to an equilibrium in home prices.

I'm not sure how to judge that, but I've generally been of the opinion that the banks would prefer the revenue from a mortgage to owning an empty home.

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