"Here's a fundamental truism about life: nothing is perfect. A corollary of this truism is that people make mistakes. These apply to the market for subprime mortgage lending just as they do to anything else. But, while this market is imperfect and mistakes are made, there are a lot of successes, too. With all the hand wringing going on about this issue, people seem to be focused on the former and forgetting the latter. The regulatory "watchdogs" have a similar focus and are baring their teeth, ready to bite. However, concentrating only on the mistakes and ignoring the successes is letting the tail wag the dog. Not a good idea.
Subprime mortgage lending refers, as most of you probably know, to mortgage loans made to those with poor credit histories or no credit history. They typically involve items such as borrowed down payments, low initial interest rates and large subsequent balloon payments. These and other types of innovations in the home mortgage market have expanded the number of people who obtain loans and increased home ownership. Some of the largest gains in these respects have been among lower-income households and minorities. Basically, this market gives many people access to credit that they simply did not have in the past.
The problem lately is that many people were counting on rising real estate values to maintain the viability of the loans. When this did not happen, there was an unexpectedly large number of defaults, and several subprime lenders fell into financial difficulty. In other words, people made mistakes. I'd wager that no one enters into a loan agreement with intent not to repay. However, misjudging the course of ensuing events can lead to an unexpected inability to do so. Thus, the financial problems encountered by some.
It's good to remember that the subprime market involves high-risk loans (and the higher interest rates reflect that). Of course, high risk in this setting means high risk of default. So guess what — there are more defaults on these loans! It's way off the mark to think that high default rates in this market are a sign of nefarious behavior of some sort. A higher risk of default means that more defaults will occur.
Of course, if you are a regulator trying to justify your job or a member of Congress seeking to look good to the voters, it doesn't make much splash if you calmly point out the above facts and support a more measured and careful examination of the issues. It seems to serve those folks better to shout for investigations, point fingers at the evil-doing lenders and urge placing severe restrictions on this market. (If I may morph for a moment into my advice column persona, we, as citizen/voters, shouldn't let our government representatives get away with such behavior! Insist on careful analysis.) The outcome of the shouting and finger pointing is likely to be stringent regulations making it more difficult for lenders to operate in the subprime market and reducing the availability of credit to those who need it most. The failures of a few will have carried the day and preclude the majority of successes that would have occurred.
Naturally, there are problems in this market; remember the truism that nothing is perfect. Many have raised concerns about what is termed "predatory lending." This is a set of practices that are argued to induce borrowers into taking on too much credit, agreeing to too high an interest rate and agreeing to pay unrealistically high balloon payments. Of course, this sort of thing happens, but there are other things that limit it. One is that it doesn't do a lender much good to force a borrower into default. Sure, they have claim on the asset, but will be better off if the loan is repaid. Lenders with lots of defaults usually have problems. In fact, it's the subprime lenders experiencing numerous defaults that are having financial difficulty. Second, a competitive market gives potential borrowers lots of options to look at. High interest rates can be competed downward, and better service and advice can be sought. Thus, while predatory lending may occur, one important way to limit it is to encourage an active and competitive market, not discourage it through harsh regulation.
Don't let the failure of the few dictate the terms for the many. There are very few things in life that work 100 percent of the time for everyone. Prohibiting the many from enjoying the benefits of this market because of the failure of the few is letting the tail wag the dog. Let's not do it.
John Garen is department chair and Gatton Endowed Professor of Economics at the University of Kentucky.