Regulating Subprime Mortgages

The Economist's Free Exchange blog today attacks Elizabeth Warren, who would like to regulate the subprime mortgage market. Given the name of the blog, it's quite easy to predict where it comes down on such matters. But in fact the issue is not quite as black-and-white as either the Economist or Dr Warren might like to think.

Warren, likes to compare mortgages to toasters. We regulate the latter, she says: why don't we regulate the former? To which the Economist tartly replies:

Safety regulations on toasters don't keep me from overpaying for one at Williams Sonoma when I could get the same item for half the price down the street. The only way to correct that problem is to shop around.

Well, yes, up to a point. The problem is that no one ever made money on a Williams Sonoma toaster, or thought of it as an "investment". Mortgages, on the other hand, are the route to home ownership, which, over the past few years, has been the best route to wealth. I only need to look at my peers back in the UK: some of them were lucky or smart enough to buy property ten years ago, while others didn't. The former have now, pretty much without exception, made more money on their property than they have by working; the latter, on the other hand, have helplessly watched the bottom rung of the property ladder get further and further out of reach.

In such a situation, some people don't ask a lot of questions when a fast-talking mortgage salesman tells them that they can afford to buy a house. And for most of the past ten years, people who took out mortgages with low teaser rates did very well for themselves. When the mortgages adjusted upwards after two years, they simply refinanced, gleeful as they made much more money in the property market than they did in salary.

In financial terms, what they were doing was making a highly leveraged bet on property prices. By the time you added in points and fees and the like, they were paying a lot of money for their loans, but the monthly payments were affordable, and the potential profits were enormous.

A lot of these people ended up making a lot of money. If Elizabeth Warren had her way, then no one could have extended them an adjustable-rate mortgage if they weren't likely to be able to make the mortgage payments a couple of years down the line. The thinking here is entirely akin to the thinking which restricts hedge-fund investments to the very rich: risky, leveraged bets should be confined only to people who have a lot of money to begin with.

But of course there are all manner of risky investments which are open to any and all, from biotechnology stocks to the roulette wheel. And as risky investments go, housing at least gives you a nice place to live, as well as an opportunity to get onto the property ladder.

I'm reasonably sympathetic to Dr Warren's cause, however. For one thing, poor individuals should not be put into any kind of investment which only works until it doesn't. If the only hope for a person with an adjustable-rate mortgage is that they will be able to refinance it in two years' time with the equity they build from a rising property market, then that mortgage is simply not appropriate for them.

And while the Economist likes to think that we all "shop around" for our mortgages, the fact is that not everybody does, and that shouldn't be a license to take advantage of people who would easily qualify for prime-rate loans and sell them subprime loans instead. In San Francisco on Saturday night, a cab driver, pegging me (correctly) as a tourist, decided to take an extremely circuitous route to my hotel in order to maximize his fare. He was regulated, although obviously not regulated enough. My mortgage adviser should be regulated too, to stop him from taking me down the subprime road when a much cheaper-to-me (though far less lucrative to him) option exists. This is a common problem, which means that the present set of regulations is clearly inadequate.

Finally, one hesitates to take the Economist's side in this debate when it comes out with stuff like this:

Nor does even the worst mortgage have a 1-in-5 chance of putting the family on the street. Though some observers have bandied about a 20% figure for delinquencies on subprime mortgages, the more commonly accepted figure is somewhere in the 13-15% range. And that is delinquencies, not foreclosures, which are currently running below 5% of subprime mortgages. I expect that latter figure to rise. But not to 20%.

We've been here before. But, to reiterate: 5% of subprime mortgages is not the same thing as 5% of subprime borrowers. If I take out an adustable-rate mortgage and refinance it before it resets, and then refinance that mortgage before it resets, and then default on the third mortgage, then I've taken out three mortgages in all, two thirds of which suffered no default or delinquency at all. Here's Tanta, a woman who knows whereof she speaks:

It is perfectly possible, at least hypothetically, to have a situation in which 40% of subprime homeowners eventually end up in foreclosure or short sale or jingle mail, but only after three or four loans, so that on any given month, on the current total book of outstanding subprime loans, "only" 4% are currently in foreclosure.

No one knows what percentage of houses which were originally bought with the help of a subprime loan will eventually end up in foreclosure. But we know that the percentage of subprime mortgages in foreclosure figure, no matter how high it rises, will always be no more than a lower bound for the actual figure.