Krugman and Sub Prime

There\’s something that doesn\’t quite make sense with this statement:

The shocker is the fraction of subprime borrowers who appear to have had credit scores good enough to receive cheaper, conventional loans: 55 percent!

One the one side we could argue that 55% of people taking out sub-prime loans were simply too stupid to know that they could have gotten the cheaper loans. Or, of course, as we\’re being invited to think, they were browbeaten or pushed or defrauded into the sub-prime loans.

Or there\’s another explanation. That conventional loans would not have been cheaper. Which is, I think, actually the truth. Now the past few years have made a number of changes to the US mortgage market and I\’m really not quite sure what "sub-prime" really means. A conforming loan is one that Fannie Mae or Freddie Mac will pick up from the issuer and then bundle and securitise. Now I could go off and find out all the details of this but can\’t be bothered, so you\’ll have to put up with what I can remember. To be a conforming loan it must be below $430,000 (or so). It can also be only for 80% of the value (it\’s not unusual to take a conforming loan for 80% of the value, a 10% deposit and a second mortgage at a higher rate for the other 10%.) It\’s also ( I think) a fixed rate mortgage: all other things being equal a fixed rate will be more expensive to the borrower than a floating rate because of who is taking the risk of interest rate changes. Finally, I think there are restrictions on income multiples.

Alt-A is the next segment down of the market. Similar to conforming, but breaching perhaps one or two of those conditions.

Sub-prime I\’m assuming is everything else below that.

Now sub-prime encompasses all sorts of things. Teaser rates (1 or 2 or 7 year ARMs perhaps) where there\’s a fixed rate for the first 1 (2 or 7) years, then it converts to a floating rate mortgage. We\’re familiar with this from the UK market. Those teaser rates could be very low indeed, funded by higher premiums over the floating rate in the longer term. There were also truly insane things like not only interest only mortgages (which can be appropriate for some) and reverse amortisation: you pay less even than the interest due each month, adding that underpayment to the capital owed!

But in there, there\’s an awful lot of "sub-prime" mortgages which were in fact cheaper "at that time" than conventional loans. Let\’s assume that you were one of those 55% with the credit rating to get a conventional loan. But you didn\’t have the 20% (or even 10%) deposit? Then sub prime is cheaper for you. Let\’s say you wanted a fixed rate for some period of years? Then an ARM (which means sub-prime) was for you.

Let\’s say that you took a floating rate mortgage (which is also, I think, sub-prime) rather than a fixed rate. At any given level of interest rates floaters are cheaper than fixed: for you are taking the risk, not the lender, or rates rising.

So, in many cases, I think the argument can be made that sub-prime mortgages were in fact cheaper than conventional loans. At least for some people.*

So it\’s not, I think, quite the slam dunk that Krugman thinks it is, that 55% of those with sub-prime mortgages could have got conventional ones.

* Note, we cannot look back now at interest rate changes since the mortgages were taken out and say cheaper or more expensive. That\’s hindsight and is cheating.

3 comments on “Krugman and Sub Prime

  1. Not to mention that, in some real-estate markets at the time in question, prices were rising so fast that some of the types of loans described made a whole lot more cash-flow sense for a lot of buyers than the more-traditional mortgage – as long as the market kept going up.

    In some places in California, two or three years ago, the rises in house prices could be measured with an egg-timer, and these sorts of loans, which seem somewhere between odd and reckless to a person who sees mortgages from the viewpoint of the family homestead, made perfect sense – as long as the market kept going up.

    Just to note that floating or adjustable-rate mortgages are not (necessarily) ‘sub-prime’. ‘Sub-prime’ refers to the status of the borrower and his-her credit history, and is not directly linked to the ‘prime’ interest rate or the quality of the loan. Definitions can be dangerous things but a Fair-Isaac credit score below 600 generally indicates a ‘sub-prime’ borrower who is at significantly-elevated risk of being unable to repay the obligation on time – or at all. There’s millions of ARMs presently in force in the US – that were originated by borrowers with higher credit scores and more-stringent borrowing requirements – that are being paid-as-agreed and which have nothing whatever to do with the present issues in the sub-prime market.

    llater,

    llamas

  2. Llamas is correct. Many people were taking advantage of ARMs to pay low rates for a few years before flipping the real estate at a profit, which would then be rolled into the next home. The conventional wisdom, assuming a continued rise in home prices, was that a family could “move up” every three years or so and after 15 years would own free and clear by using profits from prior sales — all at low teaser ARM rates.

  3. Being rather out of the loop on this one, can anyone comment upon whether any ‘blame’ for the sub-prime ‘mess’ should be laid at the feet of our friends on the US Left who were clamoring for years in the 1990’s about banks not loaning $ to potential low-income borrowers? Red-lining, various -ism’s, etc?

    It might appear that banks loosened up and found a genre of products for high-risk lending only to catch it in the shorts on the flip-side.

    The Lefty screed could be:

    Why aren’t you loaning money to everybody?!?!?! (circa 1997)

    Why did you loan money to everybody?!?!?! (circa 2007)

    Tim adds: I’m sure you could indeed find quotes along those lines, yes. Happy hunting!

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