The current bewilderment and surprise over the “subprime” crisis that is shaking the financial and real estate markets would be funny if it weren’t so sad.
This meltdown in the U.S. credit markets was predictable. It can be traced back to a combination of unintended consequences from government policy and excessive risk-taking by lenders.
The price of real estate, like most investments, cycles according to the universal law of supply and demand. Raise demand and prices increase. Lower demand and prices drop. It would seem inevitable that a housing boom created by the easiest credit available in modern history would someday go flat.
“Subprime” loans were, in part, a policy decision of the U.S. Government in the late 90’s to increase home ownership from 64.2% to 67.5%, according to statistics cited in a recent article by Holman Jenkins, Jr., in The Wall Street Journal. Subprime loans are those made to borrowers who do not qualify for the lowest interest rates because of their deficient credit. By making mortgage money available to those who normally would not be able to qualify, demand for housing increased.
In addition to subprime loans, other offerings included zero-down payment first mortgages, home equity loans that even exceeded the value of the home, and interest-only loans made to credit-worthy buyers. All these contributed to the increase in buying power and demand for housing. Builders could hardly keep up. Prices rose as the surge in buyers bid up prices on an inelastic supply of housing.
Buyers who normally could not qualify for the larger loans “shot the moon,” gambling with no-interest loans and subsidized initial loan payments. The ensuing payments on these high loan amounts amounted to up to 50% of their take-home pay. Many rolled the dice, hoping that when the payments increased a few years in the future, they would have received significant pay raises to cover the increase.
The trouble with gambling is that sometimes you lose. Today, millions of borrowers who gambled and lost are being forced to sell their homes, all at the same time. When a glut of homes hits the market, at the same time that fewer buyers are available, prices fall. This sell-off should continue for the next few years as these loans all come due.
When the price of a home purchased with nothing down falls by even one percent, the seller must come up with cash at closing to fully pay off the loan. Since most of these buyers had nothing to put down in the first place, they don’t have that cash. Lenders are faced with losing the difference or foreclosing on the loans and taking the houses to sell themselves.
Again predictably, subprime borrowers and their elected officials are looking for someone to blame. Perhaps they don’t need to look far. A recent study cited by The Wall Street Journal, done by Carolina Katz Reid, suggests the fundamental cause may be a flawed government policy.
Reid’s study addressed the issue of whether low-income households actually benefited from subprime loans created with the intention of bringing them the American Dream of home ownership. Her study found that 53% of them returned to renting within five years after buying their home. She concluded that high housing payments left less money for education and necessities. Families were also geographically tied down and less likely to relocate for better jobs.
We’ve long had a stereotypical image of the evil, greedy banker saying “no” to the poor but honest mortgage applicant. Maybe those bankers aren’t so evil after all. Maybe the real villains are those who encourage people to incur mortgage debt they can’t afford.