Friday, May 18, 2007

Politicizing the Sub-Prime Mortgage Problem

It started a couple of months ago. The delinquency rate of sub-prime mortgages was rising and foreclosures were beginning to spike as well. In a televised comment, Hillary Clinton authoritatively and sternly blamed predatory lending as the culprit. Barney Frank soon followed with the same comment and a promise to tackle all participants in the predatory lending schemes. They took advantage of what is primarily a market issue and turned it into a political issue, as well as setting the table for one of the Democrats' key funding bases, the trial bar.

To state categorically that predatory lending is the primary reason, or in Clinton's case the sole reason, for the sub-prime mortgage problems is absolutely incorrect. That said, predatory lending is an important issue to address and there are certainly going to be many examples of excesses and misrepresentations by mortgage brokers and mortgage companies. As a percent of the overall problem, however, it's small. The real issue is a cyclical peak in the competitive risk taking of mortgage lenders and the desire to participate in a hot housing market by borrowers. It's the top of a credit cycle in the sub-prime market.

Not to belabor what may be obvious, but the attributes of this cyclical peak are as follows: sub-prime mortgage companies compete with each other to attract borrowers; they loosen terms and lower down payments to build their originations; in a housing market with rising prices over the previous seven years, it works; they sell their originations to banks that package and distribute them to investors eager to take the risk for a higher yield, which leaves the mortgage companies with room on their balance sheets to lend more; market interest rates rise, housing prices stop rising, and the music stops. At the top of a credit cycle, the primary culprit is overly aggressive and optimistic lending, which could be called stupid lending. More than 50 sub-prime mortgage companies have now declared bankruptcy, including some of the largest. Bankruptcy means that the executives who run these companies lose all of the value of their equity, and their options and restricted stock are now worth zero. Their equity shareholders lose all of their money as well. Again the obvious---predatory lending would seem to imply that someone is a winner who is taking advantage of others, but these firms are not winners.

So what is happening on the borrower side of the equation. For those that find themselves with rate resets higher than they can pay or who find that they cannot count on refinancing their way out of a problem because their house is no longer rising in price, it's a painful problem. It does not, however, mean that they have been defrauded or cheated. It is likely that the great majority of people at some point stretch to buy a first house, or stretch to buy a bigger house for a growing family or to buy a house in an area with better schools or safer streets. Unfortunately when a market turns, as the housing market has, it hurts people who are unlucky enough to have bad timing.

The distress that this leads to can be a political issue, as government can look for ways to give aid to those in trouble and step in as a financer of last resort. Government can and should look at the problem and determine if there are ways that it could have been avoided. To attack the entire industry with a blanket assault about predatory lending should not be the government's role, but it is obviously the role of the opportunistic and cynical politician(this phrase can be applied in a bipartisan manner).

What's next? More of the same on this predatory lending theme no doubt, with the trial bar suing everyone in sight that facilitated the housing market's growth and the growth in home ownership that had taken place in the Clinton(Bill) and Bush administrations. Regulations are now being proposed that will stifle the market further(any borrower with a credit score below 660 should be sub-prime is part of the proposals, which is a really terrible idea) and Christopher Dodd in the Senate is coming up with some legislation that will almost certainly interfere with the market further. Unfortunately these actions are likely to exacerbate the problem in the foreseeable future.

Here's a prediction about what else is next. As background the WSJ had an article on Tuesday entitled "Lenders Get Tougher" that detailed how lenders are tightening standards and qualifying for a mortgage is becoming harder, in some cases even for applicants with good credit. So it can be almost guaranteed that before the presidential election in November 2008 there will be some politicians who attack the mortgage industry for denying credit to the middle class, creating onerous requirements, fees that are too high, documentation that is too burdensome, and in Clinton's case(Hillary), if she stays true to form, there may be the umbrella charge of red-lining(discriminating against minority neighborhoods). Red-lining, like predatory lending, is a problem that should be addressed when it occurs but it will not be the driving force behind tightened mortgage standards. Market forces will be, just as they created this painful correction.

To end on an upbeat note, a quote from Fed Chairman Bernanke, who understands all of this, from his comments yesterday, "Regulators must walk a fine line in using their authority to prevent abuses while avoiding actions that would close the market for borrowers". Bernanke favors using increased disclosure and supervisory guidance instead of new rule-making.

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