The Real
Issues: Economics
Subprime Mortgages: the Baby in the Bathwater?
By
Charles Kirchofer, October 25th, 2008
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What?!? Someone making a case for keeping subprime mortgages around?
This Kirchofer guy must be off his rocker!
Well, not completely, I would argue. First off: what are subprime
mortgages? They're mortgages given to people with sub-standard credit.
When they were initially introduced, subprime mortgages rose to high
interest rates
to offset the risk of default. This was before securitization started
making things more complicated. As Michael Mohr mentions in his
article, the securitization allowed banks to pass on the risk to
others. The banks had excellent credit ratings compared to the subprime
borrowers they lent to. Their credit ratings were kept high because
they secured their risks by spreading it around.
Alan Greenspan mentioned in his testimony
to the House Oversight Committeethat
the market had failed to properly price risk. The toxicity of the
subprime market is not intrinsic, but rather originates
from the
opacity of the securitization system, and, as Mr. Mohr points out,
poorly thought-out government incentives and the expectation, based on
a couple decades of exuberance, that house prices could never fall
nationally.
OK, so maybe subprime mortgages themselves
aren't to blame, but are they really worth the risk they add to the
system? I would argue yes, as long as that risk is adequately assessed
and appropriately priced. If banks are pulling in high-enough returns
from subprime interest, they are able to absorb the losses of the
somewhat higher default rates. The overall effect for the economy is a
greater access to wealth for people at the lower end of the income
spectrum. Houses bought to live in (i.e. not bought for flipping)
increase stability through equity
and improve communities through the pride and responsibility home
ownership brings. These are all positive effects.
So we shouldn't, in my opinion, cut out subprime lending outright, but
we should be more careful about how it is securitized and how
it
is being used. Teaser rates should be outlawed. Nothing good can come
of the steady refinancing cycle portrayed in Mr. Mohr's article. In
addition, regulators must ensure increased transparency. This can only
come through closing loopholes in the regulatory system and creating
one regulatory authority responsible for the financial system (and this
should not be the Fed).
All in all, subprime mortgages do have the potential to improve the
standard of living of many people throughout the world. The increased
risk of default is essentially irrelevant as long as this risk is
recognized and properly priced. For this reason we should think
carefully before we throw out the baby with the bathwater.
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