Subprime Myths

The consumer implications of the current mortgage crisis offer rich material for commentary. Nevertheless I feel compelled to comment first on some of the 'facts' that are often thrown about this ‘subprime mortgage crisis.’

1) The problem is too many poor people became first-time homeowners. And 'poor' means lower-income and minority families. It is true homeownership rates hit record highs in the last decade. It is also true much of the growth in ownership came from younger households - Gen Y and Gen X. Much of what happened was pure demographics, however. Demographers in the 90s predicted a boom in homebuying even before it started. Gen X has a tendency to do things later (get education, settle down, have a family, etc) and Gen Y to do things faster. Right there you have the makings of a boom (plus Gen Y is quite large a birth cohort). These groups also tend to be lower-income by virtue of being younger and have a larger percentage of non-white members with higher birth rates than average. The result: more minority homebuyers. The market catered to these buyers with low-downpayment loans. Then, as house prices shot up, offered multiple varieties of home equity loans to provide extra cash to these households to make consumer purchases or pay off credit cards. When house prices dropped, these same households lack the deeper pockets of older age cohorts and also greater job instability. It is true these households entering the market put upward pressure on house prices at the entry level and this cascaded on up the housing value pyramid. But these buyers are not speculators nor more risky in terms of non-payment of loans.

2) Government policies like the Community Reinvestment Act (CRA) caused the speculative bubble and created subprime loans. This one seems to be getting a lot of play. Let's be clear about what CRA is. It was created in the 1970s because banks took deposits from large groups of people who they would never make loans to. And from areas where they would not make loans ('redlining' certain areas as unqualified for a loan). CRA is all-in-all a pretty weak provision. A lot of bankers and economists hate CRA because it forces banks to make certain loans. But in reality a poor CRA rating creates a slight case of bad PR and may slow down a bank's ability to take over another bank, or be taken over, but that's about all. Importantly, CRA is only applied to depositories. Nearly all subprime lenders were not depositories, but went right to capital markets. So the growth of subprime was all OUTSIDE of the scope of CRA. One could argue that because banks largely ignored borrowers with poor credit, subprime filled that vacuum. Had CRA encouraged more innovations, more careful loans by CRA-covered banks might have been offered and made to those borrowers who ended up in subprime loans.

3) Fannie Mae and Freddie Mac fueled the subprime market into excess. This is another popular line in the OpEd pages. Fannie and Freddie (the GSEs) are huge political targets. Republicans have always argued against their public-private structure, while Democrats benefited from the GSE’s largess. The GSEs are complicated and there is logic to their existence, but their implicit guarantee structure was clearly flawed. These entities were established to create a mortgage market, but within a set of guidelines. GSEs buy whole loans from banks and then split out the cash flow to investors who buy into a security (MBS). GSE guidelines focused on 80% loan to value ratio loans- so borrowers had a fat downpayment or mortgage insurance. And GSEs also had high credit standards. So they did not make subprime loans. One of the flaws of the GSE model is they could borrow at very low rates - close to Treasury rates - and then lend at higher rates. So the GSEs would not just buy and package loans, they would also buy their own securities as well as other MBS on the market. By law they could not take on much risk - so they bought the AAA-rated top level tranches. This meant they got paid first even if there were more defaults in the pool of loans underlying the MBS than expected. Lots of investors bought these top-tiers of MBS on subprime loans - insurance companies, pension funds and foreign governments. In general these top tiers of these MBS issues are still paying as expected...an often overlooked fact. But the value of these securities has plummeted since no investor wants them. Much like the homebuyer who owes more on their home than it can be sold in the market, the GSEs were sitting on investments worth far less than their book value. The whole mortgage market was around $12 billion. Subprime about $1 billion. The GSEs were about involved in abut 20% of the overall mortgage market and bought the AAA pieces of between 25% and 40% of all subprime MBS. So they did provide capital to the subprime market, and at a higher rate than they provided to the overall market (this varies by year however). Between the I-Banks, commercial banks and sovereign funds, subprime MBS would have grown during the housing bubble, even without the GSEs. The GSEs fueled the fire, but hardly caused subprime lenders to take on more risks...remember someone else bought the riskier lower-tranches of MBS for the GSEs to buy the top rated tranches.

4) The Clinton/Bush Administration pushed too many people into buying homes. Nearly every president since Hoover has promoted homeownership. It is the 'American Dream' after all. Clinton and Bush had homeownership goals, but these goals were very close to what demographers predicted would happen anyway. On net these programs amounted to some homebuyer education (averaging $30-50 million per year, which is not much at a national scale) and some special programs serving a few thousand families annually. All of this was more PR than substance. And amounted to little especially relative to the massive $60-80 billion in tax breaks offered to homeowners annually.

Foreclosures today are mostly (a) people who have refinanced and taken out cash (b) people who bought at the peak of the housing bubble (c) speculators--mostly in California, Florida, Arizona and Nevada. In all cases they are in troubled because we had a housing bubble and they owe more than their home is worth. My guess from data I have from one major lender is true speculators, meaning people buying property to rent or flip, account for less than 10% of foreclosures. Peak bubble buyers who took out purchase loans worth more than the house was ever worth are less than a quarter. The remainder are people who used their equity to pay off other debt and now owe more than the house is worth. Think of the mortgage like the coral reef - it collects the toxins in household consumption behavior. All the credit card and other debt winds up there.

So who's fault is the current mess? Lenders offered easy credit, thanks in part to over-reliance on technology for underwriting loans. Wall Street thought MBS carried little risk and plowed cheap money into the market. The GSEs were certainly sloppy in their management and accounting for the risk and value of investments in MBS. But at the street, mortgage brokers, real estate agents, appraisers and buyers and sellers all bought into the notion that house prices could only go up and never would go down everywhere at once. They were wrong. Prices are likely to go down 25-30% from their peak, if not more. Even classic 20% downpayment loans are in trouble. This is not just a subprime problem anymore.