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Subprime Lending Worth Keeping

March 11, 2007

By Howard Husock

The practices of "subprime lending " have suddenly moved front-and-center in discussions of risks to American financial systems, the stock market, and ongoing prosperity.

The corporate bond market, in particular, has been roiled as securities built on subprime loans lose their value because of defaults and delinquencies among borrowers who'd taken out high-interest mortgages and other "alternative" loans for those with bad credit histories. Delinquencies have hit at least 10%, affecting industry giants such as New Century, HSBC, and H&R Block.

It's a shame that some banks may have lowered their standards and are now suffering. And it could be tragic for individual borrowers, who, convinced they could refinance their homes on better terms, instead are facing interest rates -- and monthly payments -- which "adjust" sharply upward. But congressional Democrats and others are seemingly learning the wrong lessons from the subprime crisis, if it is one.

The politicians--notably the head of the Senate Banking Committee, Senator Dodd of Connecticut -- are casting the problem as one of "predatory" loans and are seeking new regulation. Instead, the situation should be understood this way: Both banks and lower-income consumers are getting used to a new financial world, where those formerly shut out of credit markets are now included, but at interest rates that reflect their risk. If we want poorer households to manage their money and assets better, we have to be prepared for them to make some mistakes, and not hurry to overprotect them.

I first encountered discussions of predatory and subprime lending four years ago when I visited the office of a community organizer for the nonprofit mortgage lender Neighborhood Housing Services of Chicago, in a neighborhood famous for community organizing called the Back of the Yards.

The young man I met was outraged over the increasing numbers of defaults and foreclosures there. He detailed the situation: aggressive mortgage brokers offering low-income homeowners the chance to buy houses with little or no money down, or to refinance their mortgages in order to get cash; those loans sold and resold to major national financial institutions, and high numbers of mortgage delinquencies and defaults.

In some ways, the organizer had discovered the obvious. Mortgages today are not held by those who "originate" them; they're "securitized" -- folded into bond offerings designed to reduce the risk of any one loan going bad.

So it is not surprising that small loans from the Back of the Yards would wind up being owned by JP Morgan Chase or Bank of America. Nor is there anything fundamentally wrong with that, unless those who put the loans into securities are overoptimistic about how many will be repaid and leave investors with worthless paper, as is now happening to some.

But there were disturbing effects on the neighborhood worth considering. Whole blocks were harmed when individual households got in over their heads financially. Houses whose owners had defaulted on their loans had become drug havens. Otherwise good blocks were pockmarked by homes needing repair.

But what, if anything should be done about the problem? Lenders, of course, should have to disclose fully the terms of loans. If a new mortgage sets interest payments so low that homeowners' overall debt will keep increasing even if they make payments on time -- one form of "subprime" loan -- borrowers should be so informed.

Abuses notwithstanding, our credit markets today are far better than a generation ago -- when mortgage lending was confined to savings-and-loan institutions limited in the interest rates they could charge. These institutions avoided risks and were said to deny credit to poorer neighborhoods.

Congress responded with the Community Reinvestment Act, requiring banks to extend at least some credit to low-income consumers and neighborhoods on the same terms as to other borrowers. But that did not teach bad credit risks how to become good credit risks -- and it made only limited credit available. In contrast, the banking deregulation of the early 1980s changed the mortgage industry completely.

Allowing lenders to adjust interest rates to risk has given millions of "subprime" customers access to credit markets and has helped push homeownership rates to a record level, approaching 70%. If lenders were not permitted to adjust rates to risk, they would shy away from higher-risk lending. That's already happened in states which have tried to limit "predatory" loans through legislation -- and found that they risked financial markets avoiding their low-income mortgage markets altogether.

Far better to expect that as Americans get used to knowing their credit score and become familiar with various available loans, they will learn from their mistakes and take the steps necessary -- including living within their means -- to get loans on favorable "prime" terms. We also could expect banks and bond rating agencies to gain experience in serving lower-income markets.

We shouldn't view subprime lending as a plague on the poor, but rather as something new, to which we are, as a financial culture, becoming accustomed. We must hope that, as time goes by, neighbors will learn from bad examples -- and not make the same mistakes that led to the foreclosures I saw in the Back of the Yards and are currently roiling financial markets.

Original Source:



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