Your Lying Eyes

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13 July 2007

Sub-prime Mortgages Are Abominations

The sub-prime mortgage debacle continues to haunt financial markets. Abomination may be too strong a term for these instruments, but they are at a minimum perverse. Sub-prime lending means that you are charged more because you're poor. Is there any other such product? Granted that in many poor urban neighborhoods people pay substantially more for groceries than are paid in wealthier suburbs, but not because of their poverty, but because of crime, which drives away supermarkets. But I can't think of any other product where the poor are expected to pay more by virtue of their indigence.

Sub-prime loans make sense under certain circumstances. If the borrower is speculating - say buying property expecting to flip it for a profit but has no assets or steady income to back up the loan - then it might make sense to pay a premium for what is a risky investment. Or a young person whose current income is low and has no assets but expects to be making a lot of money in a few years might wish to take advantage of a costlier mortgage offer.

But otherwise providing a sub-prime mortgage to someone simply because they are poor is irresponsible. It's also irresponsible to take on such a loan under those circumstances, but we expect poor people to be either irresponsible or not too bright or both - that's almost always why they're poor to begin with. But lenders should know better. So why do they make such loans? No doubt for short-term profit, which is no doubt substantial, and we know how much short-term profits drive decision making in American businesses.

Admittedly, lenders might have a hard time distinguishing between the promising young buyer vs. the hopelessly poor - legally, anyway, given the ethnic disparities that are bound to occur with such a lending strategy. Thus it might be more practical to ban them outright (for residential home loans). Could it really be such a terrible thing if people need to wait until they actually can afford a house before they buy one.

By the way, this is another issue where free-market economists show themselves incapable of understanding the real world. Here's Alex Tabarrok absurdly denouncing "Credit Snobs." Less preposterously, Becker and Posner provide a little better argument. But they compare sub-prime mortgages to junk bonds, but the latter are intended to be paid for with business profits while the former are only to buy a place to live.

5 Comments:

Anonymous Harlem said...

Ziel: Shockingly, I think you are wrong about the major target of sub-prime mortgages. I now expect to be re-educated.
I can only speak from my personal knowledge (fortunately not personal experience) when I tell you that I think that the primary target for these mortgages are not necessarily minorities but all those who can't "really" afford a home at the current home price market and compensation range. I'm speaking mainly from California knowledge but, given its size, it is a major player.
Very few hard working, average wage folks (alien or otherwise) can afford a home in southern (Orange/Los Angeles) or northern (San Fran area) under conventional financing schemes. The Sub-prime/No down payment/Deferred interest/Ballon payment mortgage market is rampant there. The CA economy (contrary to what Arnold may say) is on the brink of disaster because of it. I predict that houses now selling for $400K in Orange County will be available for 1/2 that within the next 10 years. The same is true, to a lesser extent, in other major cities such as Chicago, Dallas, Atlanta, etc.
It is less understood in the northeast because of the well established suburbs, like Cranstock (reasonable real estate?), but I really think it is the major weakness in our current economy.
If no one can afford the housing we build, the cost of said housing will drop and, with it, the associated economies.
The problem is not necessarily the mortgage scheme, but rather, it is the false economy that has people forced to buy what they can't afford, be in debt to mortgage holders (if they can pay) as well as being forced to shop at China labor driven WalMart to try to make ends meet.
Glad I don't live in CA or the Northeast. Happy to live in LA, where we can still catch our dinner, or scrape it up from the highway.
Educate me. Harlem

July 13, 2007 8:23 PM  
Blogger ziel said...

Harlem, I'm with you all the way, and am not sure we're we disagree. I probably shouldn't have used the word "poor". I was thinking in relative terms. Nevertheless, here's a reference for the disproportionate minority effect. Here's the money quote from the article: "How did a strawberry picker earning $15,000 a year qualify for a loan of $720,000? The answer, say the experts, lies in a lending industry that got too innovative for its own good."

But I think you're larger point, that there are many middle class Americans with either mortgages they can't afford or houses that will plunge in value is probably true.

July 13, 2007 11:12 PM  
Anonymous Dano said...

"plunge in Value"

Not happening.

This generation is convinced wealth begins with real estate. They all want to own something to get started on there way to financial success. Rent is for suckers in there minds

Short of a return to high interest rates of the 80's ( my first house had a 13% mortgage rate) prices will hold and the demographics of more home buyers coming on line and people living longer will keep housing stock in demand especially in the northeast where we are so developed.

there will be exceptions where speculation is rampant (ie Florida) and nature (hurricanes) force insurance carriers to raise rates to cover the risk.

Sub-primes will be back because Wall street needs investment vehicles. The housing component is just lipstick on the pig

July 14, 2007 9:49 AM  
Blogger ziel said...

The housing component is just lipstick on the pig.

I don't understand - the 'pig' is the risky-loan industry and home mortgages are just a small but highly visible component of it?

July 14, 2007 10:28 AM  
Anonymous Dano said...

The pig is the securities created to sell to hedge funds and investment funds. The risky loan industry only exists because of the securities, otherwise they would go back to old household finance franchises which charged 18% to 25% and not to many houses were sold.

July 14, 2007 12:56 PM  

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