Sub prime lending


I took only one economics course, and I don't pretend to be an expert, but can anyone explain why anyone would think that a business plan based on subprime lending makes sense. Consider this from Thursday's Times (Soothing Words and a Stock Market Rebound:)

Encouraged by comments from Ben S. Bernanke, the chairman of the Federal Reserve, and a bounce-back in the Chinese markets where Tuesday’s global sell-off began, stocks rose modestly in the United States.

...

Yet one important concern — that Wall Street’s bet on home loans to people with weak, or subprime, credit is souring quickly as defaults rise and home prices weaken — has not gone away.

Wall Street executives and analysts acknowledged that the subprime segment of the mortgage business has faltered because of the performance of loans issued in 2006, but many contend that the problems are well contained and do not yet pose a significant threat to investment banks or the broader global financial system.

Economists have been warning for years that home prices have become artificially inflated. Isn't it adding fuel to the fire to lend 100% of the purchase price to poor credit risks? That makes sense only if you can be sure that home prices are going up; something that is unlikely to happen in an overheated market. Then, when the suckers default, the bank takes back a property worth more than its loan. If prices go down, or stay steady, the bank loses. Since falling prices were a predictable event given the artificially high prices of the recent past, how could these lenders expect things to work out?

Not that they have my sympathy, but their stupidity is likely to have effects far beyond their limited sector. We all will suffer because of these predators.

Though the article doesn't mention it, that's what they are. The business plan is built around the near certainty, or at least the desirability, of default. In other words, they are ruining people's lives for profit.

And believe me, that's what it's all about. I have a couple of cases now involving these loans. If they were promoted by guys in cheap suits they'd be called scams, but when H&R Block does it, it's subprime lending They loan 100% of the purchase price of a home, but split the loan into two notes. One note is for 80% of the purchase price, with a relatively low interest rate. The other note, for 20%, is at about 11%. There are large, if undecipherable pre-payment penalties, i.e., you can't refinance without penalty for a period of two years. After that two years is up, you better refinance, because the interest rate on the 80% note skyrockets. Of course, you can only refinance if the value of your home has gone up considerably. If it goes down, a likely outcome in this market, you are stuck with a loan you have no ability to pay. Even if it has gone up slightly, you might find yourself in a position where, as a poor credit risk, you are unable to refinance, because after all, you are going to need to refinance both loans.

So it would be great to see these guys go down, so long as they don't take the rest of us with them.

I wrote this post Thursday. This morning (Friday) Krugman weighed in on the subprime issue.

Posted: Thursday - March 01, 2007 at 11:05 PM          

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