Subprime Shenanigans

The Subprime Mortgage Crisis in a Nutshell

Starting in 2001, housing prices in the U.S. increased substantially and without interruption for years, leading to the creation of a "housing bubble" of unrealistically high valuations. This created the false impression that housing prices would keep rising indefinitely. As housing prices continued to rise, financial institutions extended credit to riskier "subprime" mortgage seekers (i.e. those without good credit, those with lower income) through adjustable-rate mortgages (ARMs) on the assumption that, as long as housing prices continued to climb, the risk would be largely mitigated. Wall Street institutions then began selling securities on international markets which were backed by the expected future payments from bundles of such subprime mortgages.

When the bubble finally popped in 2006, the precipitous collapse of housing prices resulted in mass-scale mortgage defaults and foreclosures as millions of Americans found themselves unable to afford their suddenly-high mortgage rates (since they had adjustable rate mortgages). Just as millions of Americans were losing their homes due to inability to make mortgage payments, international markets took a massive hit as well, since subprime-backed securities had circulated all throughout global markets. The subprime-backed securities that had been sold on international markets quickly lost their value, and trillions of dollars were lost by those who had bought the securities.

The reason the crisis has been so immense is due to the way these subprime mortgages were treated as financial assets. Subprime mortgage-backed securities were sold without any guarantees -- a common practice with "prime" mortgages, which are less risky and more likely to yield returns. In this case, however, the mortgages were much riskier and those buying the securities were taking on substantial risk, the extent of which they weren't always fully aware due to over-rating of the securities' values. The whole process served to dilute financial incentives to ensure creditworthiness, since those giving out the loans could pass on the risk to those who bought the securities.

Shabby Media Coverage

The problem with the coverage this crisis has gotten in the media is that most commentators seem to lack even the most basic knowledge of the economics behind subprime mortgages. This ignorance has led to a slew of contradictory and irrational expressions of outrage at Wall Street's conduct. For example, a recent article in the Washington Post by Kathleen Day claims the following:

1. Banks not offering mortgages in low-income (and often minority-populated) areas, known as "redlining", is unfair.
2. Offering subprime mortgages with higher interest rates in low-income areas is "predatory lending" and is unfair.
3. Those who signed up for mortgages that they couldn't afford unless the housing boom continued forever have been "victimized" by creditors.

The first point is not necessarily an unreasonable claim by itself, but when combined with the second claim it becomes very contradictory. Banks often do not offer mortgages or loans to those with low income or bad credit because doing so is very risky. Credit ratings exist so that banks can assess the likelihood of a given person defaulting on a loan, and banks have no obligation to give loans to those who probably won't pay them back. This should be common sense.

The only way to offer loans to those with low income or bad credit without going out of business is to charge a higher interest rate on the riskier loans. By charging more interest, the bank is able to offset the risk of default. The idea is that, on average, they will make more in higher interest payments than they will lose on defaulted loans. In this sense, the interest on a loan is an estimation of the monetary value of the risk taken on by the lender.

Day and many other commentators on the left claim that not giving out high-risk loans is discriminatory, and that giving out those loans with the necessarily higher interest rates is "predatory" and somehow taking advantage of the poor. What they are missing is the fact that banks have no choice but to either charge higher interest rates or abstain from giving out risky loans altogether. If they don't do one or the other, they will go out of business and no one will be able to get loans.

The reality behind Day's third point is a little more complicated. It does appear that many mortgage applicants were told that the housing boom would continue, and that the rates on the ARMs were unlikely to rise as long as house values kept going up. It is also true that these assurances were often given because creditors knew they could pass on the risks of the loans, and had little incentive to properly ensure that applicants could handle the debt.

On the other hand, there were just as many mortgage-seekers who correctly assessed the risks and opted for more expensive fixed-rate mortgages. Those who opted for adjustable rate mortgages did so because they chose taking on the risk of higher future rates in order to secure lower initial rates. Despite any failure by creditors to adequately ensure creditworthiness, those who made a risky decision to get cheap initial rates should not be absolved of responsibility for their choices. It does not take an economist to realize that home values cannot go up forever, and those who did not plan for the inevitable showed poor financial judgment.

That being said, there are no doubt cases in which people were flat-out swindled by greedy and unethical creditors. The point is that many people were simply taking advantage of the market in an attempt to live beyond their means. That is, after all, the nature of economic bubbles -- everyone knows it's too good to be true, but no one can pass up the chance to get something for nothing.

As the media continues assigning blame for this crisis and the suffering of so many Americans, they should consider holding everyone responsible for their actions, not just their favorite punching bags on Wall Street.