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.