4 Subprime Myths That Could Derail Reform

Loans to higher-risk borrowers aren’t bad—they’re just drawn that way.

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The party's over, the hangover hurts, and woozy consumers are finally asking, "What the heck just happened?"

With 2 million home foreclosures possible over the next two years and the economy stumbling toward recession, it's clear that Washington will enact new reforms meant to curtail reckless lending, attach big-print disclaimers to risky securities, and prevent any more self-triggered implosions in the financial markets. The Federal Reserve has already engineered one Wall Street bailout, something it may have to do again. Congress, the Treasury Department, and other regulators are proposing dozens of new rules. Some of them might work. But we're not at the end of the housing crash or the economic downturn—we're still in the middle, where vision is much worse than 20/20. That means politicians and regulators could end up imposing solutions before they even fully understand the problem. Here are some of the misconceptions that seem to be emerging, as we all try to figure out what happened and how to fix it:

Subprime loans are inherently bad. Subprime" is now one of those ignominious words, like "Watergate" or "steroids," that've been tainted mainly through misuse. While there's no precise definition, subprime loans are typically those made to higher-risk borrowers with a credit history that makes them more likely than others to default on the loan.

It's no surprise that foreclosure rates on subprime loans are higher—the risks of default are higher, so by definition there are more defaults. The fundamental problem isn't the foreclosure rate; it's that the loans have been priced too low—the interest rates and upfront costs imposed on borrowers haven't been high enough to cover the overall risks of default.

Mortgages that require no down payment are one kind of underpriced loan. Another example: loans with deceptively low "teaser rates" that seem like a bargain for a year or two, then rise dramatically. In a Wonderland market where home prices rose by 8 or 9 percent per year—forever—sure, those kinds of loans might make sense, since many borrowers would cash in the moment their homes appreciated. But as we know, the Wonderland market has now crash-landed.

Lenders thought they had this all figured out, thanks to a detailed credit-rating system and sophisticated risk-assessment software. That's one big reason the face value of subprime loans surged by about 1,700 percent between 1994 and 2006: Lenders wanted the higher returns and thought they had the risk covered. Turns out there was a bug in the program.

As the whole mortgage mess comes unraveled—and regulators consider new rules—poor lending standards, not the availability of subprime loans, seem to be the weak link in the chain. Subprime loans let consumers with low incomes or limited access to credit buy homes they couldn't get otherwise—as long as they're willing to pay the extra margin that covers the higher risk of foreclosure. "Congress should not aim for foreclosure rates of zero," says James Barth, an economist with the nonprofit Milken Institute. "It's OK to have risky loans, but the rates have to be higher."

Low interest rates are always good. If you're buying a house, you want a mortgage rate that's as low as possible. But low rates aren't necessarily the best thing for the overall economy. Economists often warn about "overheating," a dangerous byproduct of low rates—and now we're living in a real-life case study that reveals what overheating is actually like.

Interest rates fell significantly between 2000 and 2004, largely because the Federal Reserve repeatedly cut its own short-term lending rates. That generated economic phenomena with long-term consequences. One was increased demand for assets like houses—since the money to buy them was cheap and plentiful—which in turn caused prices to rise at a pace that turned out to be unsustainable. Mania, anyone?

Then, as rates on conventional securities, like treasury bills, fell to paltry levels, investors began to demand new kinds of securities with higher returns. Subprime loans, bundled into complex mortgage-backed securities, fit the bill, and lenders began to solicit as many of them as they could find. No worries; the computers assured that the risk was perfectly manageable.

We're now paying a price for those years of cheap money, in the form of a burst housing bubble and a staggering economy. John Chapman of the American Enterprise Institute predicts "an era of unpleasant choices" characterized by widespread bankruptcies, layoffs, and a longer recession than necessary. Others aren't quite as gloomy, but most analysts agree that cheap money often comes with hidden costs that materialize down the road, one way or another.

A massive taxpayer "bailout" is underway. For as unwieldy and complex as the subprime problem is, the cost to taxpayers could end up being minimal. In the 1980s, when nearly 4,000 savings and loan institutions became insolvent, it eventually cost taxpayers the equivalent of about $400 billion, in 2007 dollars, to clean up the mess. This time, by contrast, the government hasn't spent any taxpayer money to bail out banks or investment firms. Not yet, anyway.

When the Fed brokered JPMorgan Chase's buyout of Bear Stearns, it took responsibility for $29 billion of troubled securities, money that will indeed come out of taxpayers' pockets if the whole portfolio turns out to be worthless. But the Fed will eventually sell the securities for something—and perhaps recoup most or all of the money it has pledged. Other government proposals could use taxpayer money to guarantee or refinance certain mortgages, which, again, might put taxpayer money at risk—but still fall far short of a giveaway.

There are still plenty of losers, mostly investors who bought mortgage-backed securities that have plunged in value or stock in firms that traded heavily in such securities. Some of those investors are distant institutional entities, like sovereign wealth funds or the Bank of China. But the losses also touch millions of Americans through mutual funds, pension funds, and individual stock holdings in companies like Citigroup, Merrill Lynch, and of course Bear Stearns.

Buyers are well-informed and rational. Investment vehicles might be remarkably innovative, but consumers seem to be as gullible as ever. It's obvious now that some home buyers over the past few years took out loans far beyond what they could afford, with foreclosure probably inevitable even if house prices had continued to rise. But even people who consider themselves financially literate aren't so shrewd. A 2007 study by the Federal Trade Commission, for instance, found that:

  • 20 percent of borrowers looking at mortgage disclosure forms couldn't identify the interest rate amount
  • 24 percent couldn't tell which loan was less expensive, when looking at two different applications
  • 30 percent couldn't tell if the loan included an expanded "balloon payment" at some point
  • 44 percent couldn't tell if there was a prepayment penalty for refinancing within two years
  • Subprime borrowers aren't the only dupes—prime borrowers fared only slightly better on most of the questions.
  • One likely reform to emerge from the subprime mess is a set of simplified mortgage forms that spell out costs and terms more clearly. By then, maybe consumers will have become a bit more wary of deals that seem too good to be true.