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October 6, 2008

Subprime Loans Add to Wall Street Chaos

Underlying the current financial turmoil is a significantly dreary problem in housing markets. It is a bit easier to understand, but understanding will almost certainly lead to anger and frustration. 

The 1995 revisions to the Community Reinvestment Act specifically permitted sub-prime loans. The intent was laudable enough, to provide lower income Americans a chance to buy homes and force financing to local businesses. The former worked quite well, but in a 2004 academic paper I reported minimal effect of lending on rural businesses. I should note that the first version of the paper was met with a very angry response by an editor whose life’s work focused on microfinance to rural areas. In retrospect it wasn’t the failure of the CRA that caused problems, but rather its success. 

Subprime loans are those made to individuals who wouldn’t qualify for traditional loans at market rates. The chief impediments to loans for these folks are available down payment, income, or a history of bad credit. These are folks who would not have received a home mortgage in years past or who took advantage of some special characteristic of the loan. Making a subprime loan to someone locally offered the chance to easily meet the requirements of the Community Reinvestment Act. This is a clarion call for less, rather than more regulation of financial markets. 

In Indiana about a quarter of mortgage loans over the past few years were subprime. An unknown, but significant proportion of these loans had adjustable rate mortgages. This means the mortgage payment rises as the interest rate rises. This is risky.

The good news is that less than 7 percent of all mortgages are subprime adjustable rate mortgages. The bad news is that these loans represent about half the foreclosures. The ugly news is that these mortgages were sold into financial instruments that now pollute the financial system. The question that remains is what to do about it? 

First we cannot forget the borrower. The mathematics of mortgages are covered by about 8thgrade. Cries of predatory lending should be muted. Lenders who have made the loans are suffering enormous financial difficulties, as well they should. Sympathy is not the emotion of the day for either group. 

As an economist I am loath to give business leaders advice on their operations. But my reticence fades in the face of the sluggish response by so many lenders. Banks holding subprime ARM’s should have been re-setting these mortgages no later than last winter. Failure to reset these mortgages has compounded the problems on Wall Street.

In all fairness, most commercial banks have worked hard to reset loans and avoid foreclosure. I suspect that the larger lending institutions are too large and unwieldy to handle the task. They have insufficient loan officers and too little information about local markets to do the work. As a result more than half of all the growth in foreclosures over the past two years has been from subprime ARM’s. That’s just bad business.

Link to this commentary: https://commentaries.cberdata.org/93/subprime-loans-add-to-wall-street-chaos

Tags: finance


About the Author

Michael Hicks cberdirector@bsu.edu

Michael J. Hicks, PhD, is the director of the Center for Business and Economic Research and the George and Frances Ball distinguished professor of economics in the Miller College of Business at Ball State University. Hicks earned doctoral and master’s degrees in economics from the University of Tennessee and a bachelor’s degree in economics from Virginia Military Institute. He has authored two books and more than 60 scholarly works focusing on state and local public policy, including tax and expenditure policy and the impact of Wal-Mart on local economies.

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