Economics

Subprime Solution?

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Columnist Ron Hart, a financial advisor by trade, weighs in on what to do about the subprime lending meltdown:

As a free-market capitalist, I believe that nothing could be worse for us long term [than bailing out people caught in bad loans]. The only thing that Congress should do is ensure that lenders are honest when they push a loan on a borrower. Of late, the market in sub-prime mortgages had become a Wild West of unregulated trickery, in which unscrupulous lenders preyed on those who do not do well in math and reading—especially when it comes in fine print—and who were basically blinded by greed. The credit markets are re-pricing debt values now….

When left unfettered by populist politicians, capitalism does a great job of bringing equilibrium to investments and allows the most prudent to do well….

Just remember this: Do not borrow all that any company wants to lend you, be it credit cards, car title pawn, student loans or mortgages.

More here.

That's sage advice, of course, not to get too deeply into debt.

However, I'm not sure that this sort of argument will be terribly persuasive to those who don't already agree with the idea that efficiency in lending is a good thing. Generally speaking, I think the wider and wider extension of credit is a great development (and one that I personally have benefited from). I do think there's a societal learning curve involved–it takes a while for all of us, especially newbies, to learn how to borrow money, invest in stocks (or mutual funds), take care of our own retirements, etc. When problems, collapses, burst bubbles, etc. occur, the political response often threatens all of the benefits from the declaimed activity. That's a real problem because however difficult the adjustments are in any given time frame (or for any set of individuals), it seems pretty clear that more people are better off by being given enough rope to hang themselves.

It's hard to get good numbers on the sub-prime mess, though the Wash Post says 14 percent of such loans, typically given to borrowers with shaky credit histories, are delinquent.

Former reason staffer Tim Cavanaugh argued for more credit for the near-indigent here and Senior Editor Jacob Sullum looked at the moral (and fiscal) hazards of the state bailing out broke borrowers here.

Contributor James B. Twitchell on the luxurification of American life here.

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  1. One statistical question–what are the normal default or delinquency rates for subprime borrowers? Bet those figures are double digit or close to it in good times. Subprime borrowers tend to have cash flow problems–surprise!–so missed payments are quite common. Another issue is that the default and charge-off definitions among different lenders may be quite different. That’s the way things used to be, anyway.

    Incidentally, offering to bail out people in this situation will, as noted, serve to increase risky behavior. In mortgage lending, that’s incredibly bad, and any candidate proposing to do that is pandering to the LCD and deserves derision.

    Lenders have little desire to own lots of real estate in a declining market. They’ll work out deals as much as possible to avoid foreclosure. For the lenders that committed fraud, they should get nailed to the wall–there are already plenty of laws on the books for doing that.

  2. For those of us out here in the real world who own businesses in a state that’s rapidly imploding (Michigan), and whose incomes have gone down rapidly over the last 3 years, jumping our interest rates on ARM’s is just what we need – more of our money going to the greestoopid enough to give us a loan. THAT’s what hurts – but that’s what we signed up for. They don’t do it because it’s necessarily good for business, but just because they can. Unfortunately, some of us are stuck when it tightens up, and have no other options. Oh well, and so it goes….

  3. Michigan = Real world?

    well, I guess where we know where the rest of this is going.

    Real world. ‘course.

  4. I said this on another thread and I will say it again, the same wall streeters who crow about taking risks all whine like stuck pigs for a bailout when those risks actually don’t pan out. The worst thing the government can do is reward people for stupid and risky behavior. To do so just encourages more stupid behavior. Just greed is good, failure can be good sometimes. It shakes out the crooks and get rich quick schemes from the market. In addition, the same banking industry who gave us the bankrupcy changes that screw ordinary people who get too much debt, now want the government to bail them out. No fucking way. Let the market work. If that means some of these assholes go down, too damn bad.

  5. Poor Little Guy (and the children) vs. Rich Greedy Guys. The perfect Democrat issue in an election cycle already rancid with the stench of special-interest pandering.

    Only 15 months to go…

  6. “It’s hard to get good numbers on the sub-prime mess, though the Wash Post says 14 percent of such loans, typically given to borrowers with shaky credit histories, are delinquent.”

    The best statistics aren’t about subprime. They’re from the Federal Reserve. It’s oft quoted on pay sites. Last I heard, it said that under 3.5% of all outstanding loans were delinquent.

    I know from the last inventory report too that available inventory actually decreased last time ’round from 9 months to 8.8.

    My understanding is that the overwhelming majority of the subprime loans that have gone bad were written since 2004.

    The statistics are so shaky–other than the delinquency report and inventory–because delinquent loans don’t go to inventory quickly. When you’re upside down to the tune of $100,000 on your house and you can’t make the payments anymore, you may not see the solution being to put the house up for sale and solidify a $100,000 loss.

    You beg, borrow form the folks, you cut back, and you wait for the bank to repossess your house. …and some ARMs are yet to adjust fully to new realities, and so there could be another wave…

    But we are talking less than 3.5% of loans being delinquent now, and the available inventory is shrinking.

    I’d also point out that letting things crash has worked better for us than–well the obvious comparison is to Japan back in ’90, ’91. It took Japan from way back then to about 2005 to recover from the bail outs, etc. they tried to use to prevent their financial system from taking the hit ours is taking now. Sure, we had problems with the S&Ls too, but RTC was a lot better than what they did. What we’re doing now–which is practically nothing–would have been better still.

    As a backdrop to this, we should also note that unemployment remains a non-factor. …so a bunch of people who never should have gotten a loan in the first place become renters again? I compare that outcome to elongating the pain and it seems like a no-brainer to me.

  7. Hey John, you wanna see whining like a stuck pig, check this link. This is funny. Ive got money in the real estate, and stock market like everyone else, but I take more pleasure in this than I probably should.

    http://www.cnbc.com/id/15840232?video=452808336&play=1

  8. They don’t do it because it’s necessarily good for business, but just because they can.

    Who does what now? To whom? How? Guh?

    Greestoopid

    ???

  9. That is great Matt. Thanks for the link.

    Ken Shulz,

    Good point about letting things crash. In the late 1980s and early 1990s, the US sucked it up let the S&Ls fail and wrote off all of the bad loans and took the hit. The Japanese kept subsidizng and bailing out and avoiding the inevitable. The US got the boom of the 1990s while the Japanese spent the entire decade mired in zero growth. It is always better to let the market run its course and take the short term hit.

  10. Ken Schultz,

    Another example of doing too much is of course our own 1929 crash. Contrary to what’s normally taught in schools today (I found out at a much later age), Hoover’s reaction to Black Tuesday was about as far from laissez-faire as you can get — he forced some of the bigger companies to not lay anyone off, for instance. Then FDR came along, and, the rest is history.

  11. The major problem with the whole subprime mess is the chopping and dicing into CDOs by the financial wizards who then slapped “AAA” on them and sold them off to other people. And now everyone’s discovering that whoops, people don’t act like gas molecules in a box because they run around and panic and correlations go to 1. Duh. (I’ve always been amused that financial “engineering” fails exactly at the point where one would expect REAL engineering (well-designed) to hold, i.e., when the “perfect storm” arises.)

    This is the problem–people are all of a sudden discovering that the risk ratings attached to these new financial devices actually mean jack shit. So everyone is now being hyper-cautious, expecially because they don’t know where the next blow-up will occur or who stuffed their portfolios with those supposedly “safe” CDOs.

    Add to this the schedule of expected resettings on the ARM rates this October and next spring, putting MORE pressure on the underlying mortgages, and you can see why everyone is spooked.

    What the central banks are doing is trying to keep enough liquidity in the system to keep the whole mess from freezing up. Not much they can do about the mis-priced risk, however.

    What I’m hoping is that this will play out in a few class-action suits against the rating companies and cause them to actually become more cautious as to what they slap the highest ratings on. If Moody’s goes down, I’m not going to cry.

  12. Jim Cramer, hardly a populist or a socialist is promoting bailouts, which is the worst possible solution out there. I guess it’s hard to make money without illegal market moving actions*, insider info* or a government bailout. I hate that guy and the meltdown was pure gravy for me.

    * Admitted by Cramer himself.

  13. I’ve always been amused that financial “engineering” fails exactly at the point where one would expect REAL engineering (well-designed) to hold, i.e., when the “perfect storm” arises.

    Tell that to the people of Minneapolis.

  14. Subprime is just the first part of the mess.

    Subprime borrowers took out ARM loans with earlier interest-rate resets that are hitting now, but higher-grade borrowers also took out huge amounts of ARM loans in recent years, since it was virtually the only way that normal folks could buy houses in the inflated coastal markets. Those rate resets will be hitting over the next two or three years and will result in continuing high numbers of foreclosures. Taking out ARM loans in a period of historic low interest rates was the height of stupidity and was only done to ‘squeeze’ borrowers into loans they couldn’t really afford.

    This real estate/credit crunch was inevitable and probably overdue. Any bailout will only make things worse and probably not do much to prop up the overinflated market.

  15. Tell that to the people of Minneapolis.

    Yeah, but that was a clear blue sky, not a perfect storm. So no one should have been surprised when it gave way.

  16. I’ve always been amused that financial “engineering” fails exactly at the point where one would expect REAL engineering (well-designed) to hold, i.e., when the “perfect storm” arises.

    A perfect storm brought that down? Interesting take.

  17. Yes, it’s like the Wild Wild West all over again–and just like last time, the main instigator of trouble is the government:

    http://www.baltimoresun.com/news/opinion/oped/bal-op.sowell08aug08,0,522262.story

  18. Kenobi, Sowell is all wet on his theory of causation. There is no housing shortage. Most metro areas in the USA are awash in new housing that was built in the last few years, much of which currently sits unoccupied and rotting.

    What we had was a period of extremely easy credit that encouraged people to get into debt over their heads. This encouraged some people to become real estate speculators, the effect of which was to create artificially high demand that drove housing prices through the roof. This, in turn, had the effect of forcing legitimate owner/occupant buyers to take out risky ARM loans to pay for houses they could no longer afford.

    Once the defaults began hitting hard, the investor-driven easy credit disappeared, thus causing the whole rickety edifice to collapse. Qualitatively, the only difference between now and previously U.S. housing bubbles (see Calif. 1989) is the heavy involvement of Wall Street in the form mortgage-backed securities, which has the potential to drag down the rest of the economy, as well. Quantitatively, I’m not aware of any previous U.S. housing bubble that was this universal. Most were confined to locals like Calif. and Fla. that are prone to wild real estate speculation.

  19. “What we had was a period of extremely easy credit that encouraged people to get into debt over their heads.”

    Easy credit encourages people to get into debt over their heads like building roads encourages them to walk into traffic.

  20. You did note I said “well-designed”?

    That bridge in Minneapolis was NOT “well-designed,” lacking the usual brace-and-suspenders construction that bridge designers now use. Redundancy, guys! Usually engineers learn how things are not “well-designed” by looking at things that fall down earlier, or being bloody cautious and to hell with the cost-cutters. A lot of bridges build earlier have not fallen down and have been, in fact, built more sturdily. It’s when you think that your extra math skills allow you to cut your safety factors that you get into problems.

    Just, in fact, like what happened with the CDOs. I can’t even say “perfect storm” has occured with the CDOs because the term refers to a concatanation of factors that really do add up to a “nobody could have predicted….” case. Here, it was as plain as the nose on one’s face that nobody had looked at the case of correlations going to one. I KNOW, because I was almost hired by one of the rating agencies to put some of these babies together and was handed several papers on the statistical analysis they were using! It has been a case of Condi Rice all over again, people bleating “nobody would have predicted….” where there has been historical evidence of a big fat statistical anomaly sitting there sneering in their faces. We KNOW that when panics hits the market, correlations increase. Now, it may be due to the Magic Bankruptcy Fairy or the Stock Market Panic Fairy, but the financial wizards can’t say they didn’t have historical evidence for what might occur. (Their protection against this seems to have been the Tinkerbell defense.)

    It’s about as dumb as designing a bridge and never even thinking about resonances after having been pounded over the head with the Tacoma Narrows Bridge Collapse. Fools.

  21. Easy credit encourages people to get into debt over their heads like building roads encourages them to walk into traffic.

    Nah, I don’t think so. How does easy credit NOT encourage people to go into debt? That’s exactly what it’s designed to do.

    And the easier the credit, the more debt is incurred. The availability, of ARMs, stated-income loans, piggyback loans to cover downpayments, etc. all encouraged extreme risk-taking in what is the biggest financial decision most people ever make. Risk is good in making investment decisions. Risk is not so good in putting a roof over your head, as many unfortunate people are finding out now.

  22. “It’s hard to get good numbers on the sub-prime mess, though the Wash Post says 14 percent of such loans, typically given to borrowers with shaky credit histories, are delinquent.”

    Doesn’t that mean 86% of these people, who might not have been able to get credit otherwise, got themselves some of this god awful easy credit and got themselves a piece of the American dream, and are doin’ just fine, thank you?

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