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Subprime Daily Briefing, Dec. 20

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More Hawkish than Mankiw... High School Graduation Rates...

Larry Summers and Sen. Charles Schumer spoke at Brookings yesterday.

Summers said,


The related but distinct patterns of excessive valuations in housing markets and excessive complacency in credit markets were pointed out for years by experienced observers. The cracks took longer to appear than many expected and have now proven to be far more structurally damaging than almost anyone supposed.

...The new and relatively crude futures markets that exist are predicting that peak to trough national housing prices will fall by 24% according to an index that has only declined 6.6% from its peak so far. Already prime mortgages are defaulting at the same rate sub-prime mortgages defaulted 3 years ago.

...It is the great irony of financial crisis that the very measures that could have prevented crisis are counterproductive in a time of crisis. Of course it would have been better to have had more fear on the part of lenders, less rampant liquidity, and higher saving two years ago when imbalances were building. But that is not what we need now.

...Probably the single most important thing economic policy can do for homeowners is to minimize the risk of recession or the severity of recession if it comes. With the bursting of what now can clearly be seen as a pervasive bubble, and the drying up of important segments of the mortgage market, the last thing that the housing market needs is a recession that would reduce incomes of homeowners and potential purchasers. That is why the aggressive fiscal and monetary policies I have just discussed are so important.


Read the whole thing. I agree that the last thing the housing market needs now is an overall recession. From the perspective of mainstream Keynesian macroeconomics, the case for erring on the loose side in terms of fiscal and monetary policy is reasonable.

Where I disagree with Summers is on the desirability of preventing foreclosure. He suggests, using a hypothetical example, that a house for which you paid $250,000 that is now worth $220,000 might only fetch $150,000 in foreclosure. Therefore, he would like to see borrowers allowed to retain their houses, with some sort of debt write-down.

I don't think that we would see houses in foreclosure selling that far below their true market value. In any case, that is the lender's problem, not the borrower's problem, and not the government's problem. If as a lender I think that the property is really worth $220,000, then I can set a minimum bid of $200,000 at the foreclosure auction. I don't have to let the price fall to $150,000.

Senator Schumer said,


only 11 percent of subprime loans went to first-time buyers last year. The vast majority were re-financings that caused borrowers to owe more on their homes under the guise that they were saving money. Too many of these borrowers were talked into refinancing their homes to cover short-term emergencies like medical bills. Other subprime borrowers were homeowners that simply moved to another house; and only a small percentage went to investors and speculators.

In other words, we don't need subprime lending to boost the homeownership rate.

He continues,


the Wall Street Journal did a study confirming what I, and
others like Martin Eakes at the Center for Responsible Lending had been saying for so long – a majority of subprime borrowers would have qualified for a conventional primerate loans. Based on the Journal’s analysis of borrowers’ credit scores, 55 percent of subprime borrowers had credit scores worthy of a prime, conventional mortgage in 2005. By the end of last year that percentage rose to over 61 percent according to their study.

In other words, the problem is not that borrowers were underqualified. The problem is that they were overqualified, and got stuck with high rates.

This is a possibility that needs to be considered. However, it does not account for all of the loans that went into default within less than one year. (Of course, the defaults could have come from the people with low credit scores.) Early-payment defaults suggest predatory borrowing, not predatory lending.

Also, the implication is that the borrowers did not receive low interest rates because lenders were mean. However, there is more than just a credit score at work in determining mortgage safety. The down payment matters, also. Why did these borrowers make such low down payments (or, if they were refinancing, take out so much equity) if they were so highly qualified? I would buy the story that borrowers with high credit scores were ripped off if the loan-to-value ratios were 90 percent or less.

It might also be interesting to know how many of these borrowers did comparison shopping for mortgages. If they did, and they picked the best rate that they could find, then I doubt that they were ripped off.

Later, Schumer writes,


My fifth proposal is to enact major reforms to the rules that govern the mortgage
lending industry, improving the regulation of mortgage brokers and non-bank lenders. In
May, I introduced the first legislation to do that. Since that time, there have been a
number of similar bills in the House and Senate, including Senator Dodd’s recently
introduced bill, which I have cosponsored. All of this legislation is based on the same basic principle, that the incentive structure in the mortgage industry has changed to favor quantity of originations, rather than quality, which has led to looser underwriting standards and inappropriate lending.

In order to correct this, legislation must impose new standards of care for mortgage originators, create a requirement that originators consider a borrower’s ability to repay a loan, prohibit appraisal fraud, reduce or eliminate “liar loans”, eliminate prepayment penalties and create effective remedies so that borrowers who do receive predatory or fraudulent loans have some recourse to restore their financial health. I plan on working with my colleagues in the Senate in the coming months to ensure that we enact strong legislation to protect borrowers in the future.


He gives a litany of arguments that lending standards were too loose, and then finishes it off by saying that we need "strong legislation to protect borrowers in the future."

With all due respect, I don't think that borrowers are going to need government to protect them from loose lending standards going forward. Unless, that is, the Senator decides to impose his own underwriting standards on the mortgage industry--recall that he thinks that most subprime borrowers were overqualified and deserved low-rate loans.

The private sector made a lot of mistakes in mortgage lending in recent years. In theory, a wise, farsighted government regulator could have meddled two years ago to make things better. But stupid, hindsighted government meddling now will just make things worse.


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COMMENTS (2 to date)
Babinich writes:

"My fifth proposal is to enact major reforms to the rules that govern the mortgage lending industry, improving the regulation of mortgage brokers and non-bank lenders."

Yep, more regulation, bigger government... That's the solution.

How about educating people in home business and finance? Then just maybe they'll be able to determine what mortgage is right for them.

Gary Rogers writes:

On the news tonight they were talking about California making health insurance mandatory. I have not kept up on this as much as I probably should, but the thought struck me that if I were a California mortgage holder struggling to hold on to my house; the added burden of mandatory health insurance could be critical. If we are trying to avoid a recession, this is not the kind of policy to introduce right now. Chuck Schumer and his party seem to think that rolling back tax cuts (I know, he thinks this is only for the rich), adding additional health care legislation and continuing to spend like drunken sailors is the right path for our country. I find this absolutely frightening.

It also struck me that most of the solutions Mr. Schumer is proposing are restrictions on lenders. I am sure he feels that this whole mess is the result of unscrupulous lenders taking advantage of poor homebuyers, but restrictions on lenders is, in effect, price fixing and will reduce the supply of finincing. I am not sure it will have a major impact, but the tendency will be to make financing more difficult to obtain. Less financing means prices go lower.

What we need right now is time. The Fed needs to continue to provide as much liquidity as possible without allowing inflation to take hold, but otherwise let the market will take care of itself. The bubble has already burst and that by itself will take care of most of the past problems. Hopefully, we can get through this without too much disruption. It is worth repeating the warning about inflation. Once inflation takes hold, the interest rates necessary to bring it back under control could totally destroy our economy. We have put ourselves in a position where our debt severely limits the possible solutions.

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