Thursday, September 06, 2007

My take on sub-prime

I've been watching the sub-prime fiasco for some time. The questions are 1) What is sub-prime lending?, 2) Why are lenders in this business? 3) Who loses? 4) Who's to blame? and 5) What can (should) we do about it? The next several paragraphs explore these questions. It's long, but should be easy to read. Please comment.

During my MBA studies, I paid attention to real estate and to legal matters. While I didn't explore either in enough depth to get a real estate license or a law degree, these areas interested me. For my White Collar Crime class, I did a paper on real estate fraud. So I've done some research.

First and foremost, I need to define sub-prime lending. Most lending today is done by a FICO score. If you watch enough TV, you'll see ads about getting your FICO score (don't do it, not worth you money). Basically, you get a score from 0 to 850 that tells your liklihood of repaying a loan. Lenders group everyone into two categories, those with high scores are called "prime" and those with low scores are called "subprime" (sounds like beef). Typically, prime borrowers get good rates and good terms, subprime get higher rates and terms that aren't as good.

Second is why are lenders in this business? Simply put, it's business. Lenders have found that they can make money on these kinds of loans. They may have to increase fees, prevent the borrower from refinancing, increase rates over the life of the loan and anything else. They are taking a higher risk by lending these people money, so they want a higher reward (MBA motto - more risk = more reward).

Another part of the answer to why lender are in this business is that borrowers are in this business. In the past (and somewhat now that the crisis is upon us), subprime borrows simply couldn't get a loan. They weren't able to buy houses at all. Now, thanks to subprime lending, we have the highest home ownership rate in history.

So third is who loses when the subprime industry falters? Well the borrower is the one who is most affected. The borrower who can't pay his mortgage loses his house, trashes his credit and makes the next house even harder for him to buy. His family is rooted up out of his house and his part of the American dream becomes a nightmare.

The lender also loses. Sure they make up for it on other borrowers, but they lose for each borrower who goes under. And in the long run, some subprime lenders will fail. This means the stock-holders lose their investment. Other companies who have supported the lender (including mortgage brokers, appraisers, real estate agents, etc) also lose. Jobs will be lost, mothers will go home to report that they have to look for another job. And because credit tightens up, prospective home buyers everywhere will pay more interest for their mortgages.

One additional loser is the renter. Since mortgages have been so easy, many renters purchased homes. Less apartments have been built and now, the renters are returning. So the supply of rentable space has decreased and the demand has increased. Guess what happens to the average rent payment? (it goes up).

So the next question is who's to blame? The republicans or the democrats? The borrower or the lender? Big business or the little man? Simply put, there's enough blame for everyone. As mentioned earlier, the low rates and easy credit has given us the highest home ownership rate in a long time. More importantly, low income families have benefitted the most from the easy credit situation. They are likely now to lose the most. Everyone who takes credit for the former, also gets credit for the latter. Our capitalist society (in which I gladly participate) means when there is a need, someone will fill it in search of a dollar. So the lender is simply filling a need. Big business is finding a way to help the little man. Could they do it with better terms? Sure, but less people would get loans.

Now, what can we do about it? First and foremost, I believe in personal responsibility. The borrower needs to learn the ins & outs of mortgages (at least HIS mortgage) before he applies. He also needs to practice some discipline, show the lender that he will indeed pay his bills on time and wait for a home until he can actually afford one. Lending terms need to be policed a little better. This burdens me to say this, I typically avoid most legislative changes. But some of the terms in these subprime loans are simply wrong. The purpose is to trap the borrower. Only by cleaning up the laws can lenders be held accountable.

Please post your comments here.


John J. Kaiser said...

Subprime lenders are really being ditched on, but the truth of the matter is that no one else would have given these folks a shot at buying a house in the first place.

Is it really their fault if you fail to maintain a good credit history and don't refinance at a fixed rate in a year or two?

Randy Barnett said...

"Is it really their fault if you fail to maintain a good credit history" - no.

"Is it really their fault if you don't refinance at a fixed rate in a year or two?" YES in many cases. Sometimes the terms prohibit early payoff.

Also, if the market drops because everyone around you forecloses and you borrowed 125%, you may not be able to refinance.

There's blame to go both ways..