Arnold Kling  

Subprime Daily Briefing, Dec. 10

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Let's start with my new essay.


Over the past few years, the housing market became riddled with bogus lenders funneling mortgage money to bogus owners of houses with bogus prices. Attempting to prop up this phony baloney is a pointless exercise. What the housing market needs in order to get back to normal is a strong dose of reality.

...The way I see it, if you're living in a house that cost more than six times your income, and you have no equity in the house, then the logical thing is for you to sell that house and move to a place that you can afford. That's better for the family, and it's better for the health of the housing market.

If we feel sorry for the family, then let's give them a $10,000 tax credit for their troubles. Preferably paid for by confiscating the Rolexes and Lexuses of the real estate agents and mortgage brokers who garnered rich fees for getting families in over their heads. But let's get the bogus homeowners moved out of the houses that are more expensive than what they can afford.

Alan Reynolds writes,


The political excuse for getting the government involved in helping a few politically-favored borrowers is based on false assumptions that subprime mortgages were usually used to buy a house, that a huge percentage of subprime loans face foreclosure, and that the main reason for foreclosure is rising interest rates.

All three conventional assumptions were undone by a new study from the Boston Fed. Its research shows that "most subprime loans are refinances of a previous mortgage." It estimates that "about 18% of people who finance home purchases with subprime mortgages will eventually experience foreclosure" within a 12-year period.

Most importantly, the Boston Fed economists found that most foreclosures do not result from adjustable rates going up, but from local house prices going down.


I believe that the study to which Reynolds is referring is by Kristopher Gerardi, Adam Hale Shapiro, and Paul S. Willen. It provides a lot of useful data, including

Approximately 30 percent of the 2006 and 2007 foreclosures in Massachusetts were traced to homeowners who used a subprime mortgage to purchase their house. However, almost 44 percent of the foreclosures were of homeowners whose last mortgage was originated by a subprime lender. Of this 44 percent, approximately 60 percent initially financed their purchase with a mortgage from a prime lender. This result implies that a large factor in the crisis stemmed from borrowers who began their home ownership with a prime mortgage, but subsequently refinanced into a subprime mortgage.

Paul Krugman treats the problem as a simple victims-villains story.

As Elizabeth Warren, the Harvard bankruptcy expert, puts it, “The administration’s subprime mortgage plan is the bank lobby’s dream.” Given the Bush record, that should come as no surprise.

...Finally, there’s injustice: the subprime boom involved predatory lending — high-interest loans foisted on borrowers who qualified for lower rates — on an epic scale. The Wall Street Journal found that more than 55 percent of subprime loans made at the height of the housing bubble “went to people with credit scores high enough to often qualify for conventional loans with far better terms.”


Like Jesse Jackson, Elizabeth Warren seems to show up everywhere there is a headline. Wasn't she the person who told us that bankruptcies were mostly caused by lack of health insurance (even though the majority of people in her study who cited health bills as the reason for bankruptcy did have health insurance)?

The Washington Post looks at foreclosures in the local area. They talk to Caprise Coppedge, a counselor who works with troubled homeowners, "whose clients typically earn between $60,000 and $110,000 a year."


Many invested in second homes. They typically did that by refinancing their existing home with an adjustable-rate loan, Coppedge said. Then they would take equity out of that house to buy a newer one. The first home would then be rented or flipped. But now that the market has slowed and prices have dropped, these investors are left holding two properties.

Oscar Reyes, 29, did exactly that and ended up losing both his homes. Reyes said he owned a townhouse in Manassas and had no plan to move, until his real estate agent and good friend coaxed him into looking at a larger house in a nicer neighborhood in Dumfries.

Reyes doubted he would qualify to buy that house on his $3,000 a month salary. But the deal went through. He said that only later, when he got walloped by a rate increase, did he realize he had taken out an adjustable loan to refinance the townhouse and another one for the new house. Before he knew it, he had more than $6,000 in monthly mortgage payments and he could not sell, or even rent, the townhouse as planned.


Finally, Murphy of the Mises blog points to a post written by someone he identifies as Peter Schiff.

Most homes temporarily saved from foreclosure will continue to depreciate as new buyers fail to qualify for loans. As a result, lenders will be on the hook for more losses than had the foreclosures taken place sooner. Of course, as these chickens will likely come home to roost after the next election, that’s a trade-off incumbent politicians will happily make.

Compounding the problem is that subprime borrowers with frozen payments on loans that exceed the values of their homes will likely choose not to pay property taxes, condo or homeowners fees, or maintain the condition of their properties. Were these properties to be sold in foreclosure now, at least their new owners would have financial incentives to maintain the value of their investments. Upside-down subprime borrowers will have no incentive to throw money down a rat hole: why make additional payments on properties in which they have no equity and which they will likely lose to foreclosure anyway? When these homes do go into foreclosure, back taxes and other fees on dilapidated properties will inflict even greater losses on lenders.


Economically, the best way to minimize the impact of the crisis is to get it resolved quickly. All the political pressure is to do the opposite. Given the relative strength of economics and politics in the public sphere, I guess one has to predict that this crisis is going to be with us for a long time.


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COMMENTS (6 to date)
dearieme writes:

Clinton II will solve it in a trice. She'll teach them all how to raise the capital they need by due attention to Cattle Futures.

Mason writes:

"real estate agents and mortgage brokers who garnered rich fees for getting families in over their heads"

Is this a case of an agency problem between the banks and their employees? If so shouldn't we feel just as bad for the banks as the home owners?

If, as is generally the case, the banks have put in place systems to limit the agency problem what makes you think that the brokers aren't hurting as much as the banks and the home owners? (How many brokers are able to make 90% bad loans and keep their job?)

As for the real estate agents, well they’re sales people - everyone knows they’re sales people, resisting the up-sell is the responsibility of the buyer.

Dennis Mangan writes:

Arnold, with your remark about "the Rolexes and Lexuses of the real estate agents and mortgage brokers who garnered rich fees for getting families in over their heads", you seem to be taking a position that isn't qualitatively different from Krugman's "predatory lenders", victims-villains story. If not, how is your take different? In both cases, buyers should have done due diligence and known what they were getting into.

Bob writes:

Arnold,

You should look at the history of the RTC (Resolution Trust Company) following the Thrift Crisis. They actually took the "junk yard" approach to get rid of assets as quickly as possible, and then closed up shop. Amazing. Of course, some buyers of some assets ended up making great returns and the RTC was, in some circles, blamed for giving away the farm...

das Kapitalist writes:

"the logical thing is for you to sell that house and move to a place that you can afford."

The problem is that they cannot sell because the mortgages are more than the current market value of the home, meanwhile, the mortgage payments continue to ratchet up a few hundred dollars every six months.

What incentive does the mortgage owner have to continue to make the payments? Other than protecting his credit rating, none. In the real world of business, where one party no longer has an incentive to adhere to a contract, the contract breaks down and litigation ensues. So typically in those conditions (I am talking about the real world of business here not the sanitized world of ivory tower economists) the parties to a contract will sit down and modify a contract so that it fits the reality of the current situation but is still a win-win for both sides.

That is what the mortgage companies need to do and that is what the Bush plan encourages.

Furthermore, the problem is not with the sub prime lending, the problem is with ARM's. Non-sub prime ARM's are in default about as much as sub prim ARM's.

Dr. T writes:

The major cause of this economic idiocy is that mortgage lenders believed the myth of the ever-rising real estate values and did not require significant down payments. Down payments of 15-20% act as insurance against declining home values, rising mortgage interest rates, or decreased buyer income.

I cannot understand this bizarre idea that people borrowing money do not need equity or collateral. Did I miss a major change in economic principles in the past 20 years?

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