Subprime Economics

When it comes to economic news, the press tends to be biased toward exaggeration and sensationalism. If some event isn’t a "scandal," then it must be a "crisis."

The latest example of crisis journalism turned the phrase "mortgage meltdown" into an overnight cliche. It began with the effort to blame a worldwide dip in stock prices on local U.S. problems with subprime mortgage loans. According to The Associated Press, "Anxiety that a blowup of subprime mortgage lenders could spill over into the broader economy has roiled the finance markets in recent weeks and played a major role in the swoon on Wall Street that pushed the Dow Jones Industrial Average to its lowest levels in more than four years."

Facts never interfere with such an exciting story. The Dow was 12,226.17 on the day that story appeared. A year ago, the Dow was 11,109.32. Four years ago, in March 2003, it was 7,992.13. Besides, Shanghai was the first stock market to "swoon," and not because of defaults on subprime mortgage loans in Detroit or New Orleans.

"Crisis Looms in Market for Mortgages," was the title of a New York Times report by Gretchen Morgenson. She worried that "shares of big companies in the mortgage industry have declined significantly. … At the heart of the turmoil is the subprime mortgage market, which developed to give loans to shaky borrowers or to those with little cash to put down as collateral. Some 35 percent of all mortgage securities issued last year were in that category, up from 13 percent in 2003."

Such sympathy for high-risk lenders seems misplaced, since they were rewarded with high interest rates for taking that risk. Subprime mortgage-backed securities have been a favorite game of hedge funds, which openly offer high risks to high rollers. The default risk on such securities was not unusually high last year.

A study by Michael Youngblood for found "the default rate of subprime securities originated in 2005 rose to 5.1 percent in August 2006, at 20 months of age." That was substantially lower than the 9.7 percent default rate after 20 months on comparable securities issued in 2002.

Sensational stories invariably cite figures from the Mortgage Bankers Association showing that 13.3 percent of subprime borrowers were late making their payments at the end of 2006 and that 4.5 percent face foreclosure. Yet those same figures show, as Jeff Brown noted in The Philadelphia Inquirer, that "more than 86 percent of subprime borrowers are not late in payments, and more than 95 percent are not in foreclosure."

Christopher Cagan of First American Core Logic estimates that foreclosures will amount to less than 1 percent of mortgage lending.

Subprime adjustable rate mortgages (ARMs) have declined since 2000, and represent only 7 percent of mortgages made in the last few years, according to Fed Governor Susan Bies. Moreover, most of the recent subprime mortgages were for refinancing, not buying a home. Average FICO credit scores of ARM customers in general do not indicate lower loan standards, but instead "jumped from just under 622 in 2000 to just over 651 in 2004," according to a recent study in the St. Louis Fed Review.

Scary scenarios about localized problems with a small fraction of mortgages spreading into a national recession rely on the notion that the low-income subprime market could somehow cause house prices to fall by "up to" 10 percent nationwide. Moody’s Investors Services economist John Lonski says, "Protracted home price deflation would eventually boost the delinquency rates of prime mortgages to unexpectedly high levels and, thereby, lead to a broader contraction of the supply of credit." Yet house prices rose 5.9 percent from the fourth quarter of 2005 to the fourth quarter of 2006 — that’s up, not down.

Why speculate about hypothetical consequences of falling home prices? Some try to justify such predictions by suggesting that lenders are too stupid to distinguish between good and bad credit risks so the supply of credit will dry up for everyone. An even less plausible theory suggests marginal loans to low-income borrowers were the reason for soaring prices of big homes in trendy areas, even though most subprime borrowers can barely afford the cheapest condos.

Weak local economies have caused problems in the subprime mortgage market, not the other way around. Youngblood finds that "at least 48 of the 76 MSAs (metropolitan statistical areas) experiencing persistently high default rates of subprime loans depend on employment by automobile manufacturers and related companies."

Other default-prone areas include those damaged by Gulf hurricanes. By blaming such local loan defaults on "predatory" lenders, or on some invisible nationwide decline in home prices, eager reporters have fundamentally confused cause and effect.

Journalists are trained to turn such topics as foreclosure into a tear-jerking human interest story in which people are always portrayed as victims. A New York Times article by Eduardo Porter and Viakas Bajaj introduces some poor fellow "who expects to lose his four-bedroom Cape Cod" in Chicago because his adjustable mortgage payment is going up. And, by the way, "a divorce and the loss of his county government clerical job … have also hurt."

Playing on the victimization theme, Connecticut Sen. Chris Dodd plans to introduce legislation to assist homeowners facing foreclosure and to curb "predatory" lending practices. Both ideas assume subprime borrowers are naive dupes. In reality, some were spendthrifts who refinanced bigger mortgages to get more cash to spend. Some were speculators hoping to flip houses for a quick tax-free capital gain without putting up any of their own money.

Subprime borrowers who made no down payment already have a terrible credit rating, so they have nothing to lose by walking away if they can’t sell their homes at a profit. They were gambling with someone else’s money.

When politicians use bailouts to protect borrowers or lenders from their folly, they just encourage more folly.


Correction: In last week’s column, Sen. Kerry’s proposal to repeal tax cuts for high-income households was misidentified as Sen. Kennedy’s proposal.