Monday, April 02, 2007

Subprime Lending summarized pithily

Subprime lending has been in the news a lot recently. A number of major providers of subprime loans, such as New Century Financial, have seen their stock prices plummet as financing for new subprime loans evaporate. The subprime loan vendors are caught between rising interest rates (relative to what they were a few years ago), rising defaults on existing loans, a slowdown in real estate values or even reduction in some parts of the country, and tightening credit standards by banks.

In the "old days", getting a loan on a house meant that 1) you saved up for a long time and put a lot of money down (say, 20% of the loan value) 2) you had a credit history with other vendors that showed that you were mature enough or had enough financial savvy to pay back previous loans.

In today's WSJ there is an article called "Denouement of Subprime Story Yet To Be Written" which basically says that no one really knows what is going to happen to the subprime lenders, the housing market, and all those institutions that invested in subprime loans. From the article:

"We've never really extended credit to people who have no known ability to pay it back and have no skin in the game," says Paul Kasriel, an economist with Northern Trust Corp. "It's uncharted territory."

It is uncharted territory but one not likely to end well. Why would people stay in a house and pay interest and taxes when the value is declining and they have no equity? They would if they felt that this was a point of honor or pride and / or it impacted their credit scores. But we sent them the message initially that credit scores didn't matter when they received the first loan, so they are unlikely to conclude that they would be barred from future credit just because they walked away from a prior loan.


Jonathan said...

In the old days the borrower couldn't get into as much trouble because the system limited his risk, at the cost of preventing some people from borrowing. Now the system lets more people assume risk and borrow, with more leverage if they want it, at the cost of more defaults. I think the current system is better because borrowers and lenders have more options, but this is only true if prospective borrowers understand the risks. You might look at the current subprime shitstorm as part of an education process.

Carl from Chicago said...

I don't know if I see it as an education process or more of a re-education process.

Giving loans to people when they have no proven history of repaying them is a disaster for someone, we just haven't figured out who, yet. It is just basic finance 101.

Plus, the assumption that real estate is always a good investment and people should leverage up as much as they can is also a bad one, but we need a good slump to bear it out.

I do agree that interest rates and loan terms should match the borrowers ability to pay, however.

Jpnathan said...

I meant education as in getting burned, but I don't think we disagree much.