Arnold Kling  

The Real Subprime Story

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Kristopher Gerardi, Adam Hale Shapiro, and Paul S. Willen write,


We attribute most of the dramatic rise in foreclosures in 2006 and 2007 in Massachusetts to the decline in house prices that began in the summer of 2005. Subprime lending played a role but that role was in creating a class of homeowners who were particularly sensitive to declining house price appreciation, rather than, as is commonly believed, by placing people in inherently problematic mortgages.

The villain-victim story, in which lenders will villains and borrowers were victims, is wrong. Both borrowers and lenders acted as if home price appreciation is a law of nature. When this proved to be incorrect, some people got stuck in homes that they could not afford.

Pointer from Richard Green, via Mark Thoma.


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COMMENTS (8 to date)
angus writes:

You guys are behind the curve. We blogged that article at Kids Prefer Cheese on December 10th.

http://mungowitzend.blogspot.com/2007/12/some-subprime-mortgage-facts.html

chasity writes:

Think about it from this perspective: interest rates dropped dramatically causing an increase in demand for refinancing homes. People decided to consolidate all the debt they had (cars, credit cards, etc) into their mortgage payment. The loan that was given far exceeded the value of the home - causing a trend in higher mortgages throughout the county. People were under the delusion that just because they had a loan - the house could be resold for that value! This is more of a systemic cycle which began to push up mortgages nationwide.

Dr. T writes:
The villain-victim story, in which lenders will villains and borrowers were victims, is wrong. Both borrowers and lenders acted as if home price appreciation is a law of nature. When this proved to be incorrect, some people got stuck in homes that they could not afford.
The above statements are true, but the lenders are in the business of making money from mortages. They should have the experience, knowledge and training to avoid approving risky mortgages. The lenders were greedy and foolish. The home buyers were greedy but ignorant.
Independent George writes:

Dr. T - this is true, but the lenders stand to lose billions from bad loans. The borrowers stand to lose... not much of anything. To the extent that responsibility is unequal, so, too, are the costs.

Roper writes:

I agree about people consolidating and wrapping everything up into one payment. The problem with that is, these people took a car that would be paid off within (at most) 6 years and rolled it into a loan that would last 30 and in some cases 40 (California) years.

The lower payment looked good on paper, and the truth is, the average subprime home owner does not know a great deal about loans, interest, and home valuation.

They were victims of lack of education, and the sales people for those companies.

The problem can also be linked to the appraisers that were jacking home values up and allowing banks and consumers to extend themselves more than they should on a given home. But just like everything else, you should not count your chickens before they hatch, and that is what a lot of banks and buyers did with the interest rate drop...

Jarrod C writes:

Over the past few years, as the amount of lending and the average debt for an American household increased, I presumed it was mainly due to ignorance on the part of the borrower and carelessness on the part of the lender. It makes sense to me that banks run a gamble every time they lend to a customer and compensate that risk by using higher interest rates. However, over the past few years I have seen stupid deals on the part of the lender and borrower. In one instance I seen a home loan go through that put the borrower's combined monthly payments over 125% of his monthly income...and the lender knew this!!! It makes no sense to me why deals like this were made and I find it no suprise that a lot of loans are in default.

After class tonight I got a better idea of the situation. By lowering the federal funds rate, the government basically helped shift the supply (lenders) curve to the right when looking at a graph of Quantity vs. Interest. This moved the equilibrium point further to the right on the demand curve at a lower interest rate, thus increasing the amount of lending. At such a low interest rate, a lot of people borrowed money they really couldn't pay back.

Jarrod C writes:

Over the past few years, as the amount of lending and the average debt for an American household increased, I presumed it was mainly due to ignorance on the part of the borrower and carelessness on the part of the lender. It makes sense to me that banks run a gamble every time they lend to a customer and compensate that risk by using higher interest rates. However, over the past few years I have seen stupid deals on the part of the lender and borrower. In one instance I seen a home loan go through that put the borrower's combined monthly payments over 125% of his monthly income...and the lender knew this!!! It makes no sense to me why deals like this were made and I find it no suprise that a lot of loans are in default.

After class tonight I got a better idea of the situation. By lowering the federal funds rate, the government basically helped shift the supply (lenders) curve to the right when looking at a graph of Quantity vs. Interest. This moved the equilibrium point further to the right on the demand curve at a lower interest rate, thus increasing the amount of lending. At such a low interest rate, a lot of people borrowed money they really couldn't pay back.

Jason J writes:

I think that this is true. Ever since the prices began to decline, foreclosure has become a major issue, not just in Massachusetts, but everywhere. One thing that caused the problem is the lenders got greedy and loaned money to people who should not have qualified for a loan. This was a case of looking to make more money from mortgage payments. The lenders should have realized this was a really big risk and the problems it was going to have caused and denied the applicants who did not qualify. The borrowers were also to blame because they were unaware as to how the process of loans works. They saw low interest rates when they took out these subprime mortgages, unaware that the rates change and that is when the loans caught up to them. One other problem is homebuyers most often assume that the value of a house will go up but this is not always the case, the value can go down. Many things can depreciate the value of houses over time. Also you can assume that some of the houses were probably overvalued to start with.

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