Subprime: The Household’s Problem, Responsibility

Keep an eye out for conservative ideology talking points that government regulation got us into the housing mess. For being FDIC insured, there is a government mandate for making loaning in one’s community a priority. Many conservatives are saying that this is responsible for the massive amounts of defaults. This argument is ripped to shreds here (short answer, which is obvious to those connected – subprime loans were very popular among non-FDIC institutions. Everyone wanted a piece by the end).

This does get to a big policy issue quickly – what happened here? Where do the fixes need to take place? It’s important for us to take the conservative ideology talking points that will characterize this argument and cut them off at the knees. First we need to see what didn’t happen -that this isn’t a matter of personal responsibility among borrowers.

I hear this a lot among people – people to the Right, Left, Center, at bars, on the internet, etc. “People were irresponsible.” I think this is distracting for what is going on, but let’s parse it. I’m going to use numbers from, Subprime Outcomes: Risky Mortgages, Homeownership Experiences, and Foreclosures, a recent (12/07) paper by some economists at the Boston Fed who looked over housing data. The paper gets technical in the middle where it models housing as a survival model (if you like Kaplan-Meier the paper is fantastic) with an embedded option (default), but the intro and opening sections are fairly non-technical and worth your time if you are interested. This powerpoint is a nice summary that covers the big parts quickly. I’m going to treat this at a high model level, but I don’t mean to overlook the human and social costs of these foreclosures (put on your neoliberal hat before proceeding).

15-20% of subprime mortgages end in a default. Is that a lot? It’s less than the percent of marriages that end in a broken contract (another failing institution the government wants to bail out with tax dollars). It’s more than, say, the percent of cars that break down after you drive off the lot. My question is – where does personal responsibility come in? Who should feel shame at their actions?

Let’s dissect who takes these loans. I’m going to ignore speculators and those acting in complete bad faith Tony Soprano-style – people who sold their house to their brother-in-law who immediately defaulted, and they laughed to the bank. This is a small, but real, presence.

1) First off are people who were fine but are now struggling. I wrote about them back here at g&t; a middle-class family loses a job and can’t find a new one at comparable wages. Let’s say that they refinance into a worse mortgage to take some short-term pressure off their checkbook. Then bad becomes worse, and suddenly they can’t even survive the short-term. Should they have shown more “personal responsibility”? I can’t see where they would have done such a thing, either in the “not lose your job” or “get out of your house ASAP after losing your job” category. From the data, we see that this group – those who start with a prime loan and default after taking out a subprime loan after the fact – is around 27% of housing defaults.

2) Second is where the responsibility argument gets tricky. This is the group of people we normally think of as taking out subprime loans – extremely poor credit, no money down. There is one thing that should be made clear about the subprime loans – they are not intended to be paid off. There is some guy who had awful credit throughout his 20s – finally he gets his act together, maybe he graduates law school. He has a job, solid income, but awful credit. He goes to a subprime lender and gets a mortgage for no money down – and then pays it for two years, builds up his credit (making monthly mortgage payments for 2 years does wonders for one’s credit) and then switches into a fixed-prime loan.

This is the model that the loans are predicated on. When we look at the data, we see that a large number of the loans don’t make it to 2 years – they are prepayed by a prime loan before then, just as they are supposed to be. This is exactly the model we are supposed to see from the pricing by the way – the subprime was all about high fees – as if they knew they only had you for a bit.

Should a responsible person not take this contract? I find this tough to say. The idea that the loan is taken out in the faith that it will be paid off on it’s own terms is bogus by the point of the contract. If the person could put more money down, they’d be in a prime mortgage. To whatever extent the person says “I’ll give this a try and if it doesn’t work I’ll walk away” is priced into the interest rate (indeed, it is why the interest rate is so high), and the bank has a lot of people working long hours to get that accurately measured. The banks know that 20% of these consumers won’t make it – they just thought they have the mechanisms to wave away that 20% risk.

Which leaves a “I can’t make my payments so I am walking away” – the person tried to be a homeowner, couldn’t pull it off, and is now worse off for it. The bank knew the risks it was taking, and in fact assumed that this would happen a fair amount of the time. Note that this is really only a problem in housing market declines – normally the person would sell their house at around price and move into a cheap apartment. The ultimate hedge against this is requiring a down payment – something the banks didn’t want to do in order to get that customer.

I think there are all kinds of problems I will write about in the future – ones that don’t even require a “consumers were deceived” behavioral trick to pull off (for one, a purposeful initiative by Bush/Rove to kick up ownership rates above a perfectly natural equilibrium on the assumption that homeownership makes people conservative). But for regulatory purposes, it is important to understand what the consumer did and did not do vis-a-vie their obligations to their banks. And I think, on the whole, they did just fine, given the circumstances.

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