Subprime: It's Not About Creditworthiness

A bit of a late start this morning, thanks to a Portfolio breakfast (of which more later) hosted by Jesse Eisinger on the subject of the subprime meltdown. Joe Mason of Drexel University was there, and was very rude about lending to bad credits in general, not just in the housing market specifically. It doesn't matter what the product is, he said: it can be credit cards, or home-equity lines of credit, or mortgages. Ultimately, poor people don't care about interest rates because they don't have any money and won't repay their loans in any case.

I don't buy it, and neither did one of the other panelists, a hedge-fund manager who pointed out astutely that the very labeling of the subprime crisis makes it easy to delude oneself that the problem is at one remove. "Subprime is a very convenient term used by elites in the media and on Wall Street because it implies that there's something wrong with the borrowers, and also with the lenders," he said. "What you have in reality is just a broader mispricing of credit."

The fact is that it's wrong to simply paint all subprime lending as misguided. Subprime borrowers can be responsible borrowers, and enlightened lenders can make good money from them by helping them improve their credit and build themselves a solid financial foundation.

When subprime lending goes bad it's usually because lenders get greedy, and move into the realm of predatory lending, trying to extract as much juice from the borrower as possible before a bankruptcy made inevitable by usurious interest rates.

The present subprime crisis is similar, in that lenders were extending credit without much if any regard for borrowers' ability to repay the full amount over time. It wasn't worth worrying about whether or not the borrower could afford the interest rate on the loan once the teaser rate expired, because by that point both borrower and lender expected that the loan would be refinanced. The lender would make money anyway, because its large fees were capitalized into the loan, and because it would charge a substantial repayment penalty. But that model is clearly unsustainable no matter what the creditworthiness of the borrower: option-ARMs were essentially bridge loans, and bridge loans fail when they can't be taken out, leaving the lender with large losses.

So let's not delude ourselves that the subprime problem is just another example of poor people being bad with their finances. What happened in subprime is actually very similar to what happened in commercial real estate, or in private-equity buyouts: the loans were so large that they can never be paid down, only ever refinanced. If and when the value of the underlying assets falls, both borrowers and lenders will suffer greatly.