Was sub-prime lending ever a good idea?

posted at 12:55 pm on October 6, 2008 by Ed Morrissey

A new video has Barack Obama speaking in 2007 about the burgeoning crisis in the financial markets, but focusing on accounting fraud rather than the root cause of the meltdown: the widespread issuance of bad credit, securitized by Fannie Mae and Freddie Mac at the behest of Congress. In this audio clip, Obama defends the idea of subprime lending just over a year ago:

Here is the clip in full context:

Subprime lending started off as a good idea – helping Americans buy homes who couldn’t previously afford to. Financial institutions created new financial instruments that could securitize these loans, slice them into finer and finer risk categories and spread them out among investors around the country and around the world.

In theory, this should have allowed mortgage lending to be less risky and more diversified. But as certain lenders and brokers began to see how much money could be made, they began to lower their standards. Some appraisers began inflating their estimates to get the deals done. Some borrowers started claiming income they didn’t have just to qualify for the loans, and some were engaging in irresponsible speculation. But many borrowers were tricked into glossing over the fine print. And ratings agencies began rating bundles of different kinds of these loans as low-risk even though they were very high-risk.

Most everyone knew that some of these deals were just too good to be true, but all that money flowing in made it tempting to look the other way and ignore the unscrupulous practice of some bad actors.

This leaves out a couple of crucial factors.  “All that money flowing” came from Fannie Mae and Freddie Mac, which created a boom market in the sub-prime market at the behest of Congress.  They wanted to increase the market for subprime loans, and they did so by essentially creating profit on every loan, whether it made sense or not.  Fannie and Freddie removed all of the normal correctives of the market by ensuring a short-term profit on almost every piece of paper written.

The second factor is that subprime lending is almost by definition not a good idea.  While most people would agree that home ownership is a benefit to the individual as well as the community, the lending of money to people who can’t afford it is a fundamentally destabilizing practice.  Defaults increase bankruptcies and lower property values, and ruin the financial prospects of families for years.   Lending markets had rational criteria for lending before the government provided massive and irrational incentives for subprime lending, and the price of housing remained very stable in relation to inflation.  Government meddling created the housing bubble and its deflation has touched off a worldwide financial panic.

Barack Obama’s entire economic argument is incoherent on this point.  He argued that during the Bush years, working families went backwards economically while only a few profited.  Yet home ownership blossomed during that same period, thanks to the wildfire Fannie and Freddie set in lending markets.  If families were falling backwards as Obama claims, then subprime lending was a very bad idea.

Anyone arguing that subprime lending was essentially a good idea has obviously learned nothing from the collapse of Fannie Mae and Freddie Mac, and the poison they introduced to the investment sector.  The best way to boost home ownership is to build a strong economy in which job creation allows upward mobility throughout the entire economy, and to keep taxes low enough to encourage the kind of investment that creates jobs.  Instead of forcing or enticing lenders to take irrational risks with credit, the government would have done much better to build people into position to own homes on a rational basis.


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Comments

McCain has now dropped from 7 behind to 8 behind in both Gallup and Ras.

MB4 on October 6, 2008 at 1:09 PM

Then Americans are as stupid as liberals say we are. Obama is a dangerous man, and we are poised to elect him to the most powerful position in the world.

Why America seems to want to encourage its own doom is a complete mystery to me. People are sick. People all over the globe are sick, because without a strong America, no one is safe.

capitalist piglet on October 6, 2008 at 3:11 PM

Why America seems to want to encourage its own doom is a complete mystery to me.

Normal self-hating, suicidal leftism coupled with 9/11 PTSD affecting a larger part of the population. That’s how I figure it.

People are sick. People all over the globe are sick, because without a strong America, no one is safe.

capitalist piglet on October 6, 2008 at 3:11 PM

Exactly. People don’t know what they might be staring at without a strong US. They have no clue, at all.

progressoverpeace on October 6, 2008 at 3:40 PM

For the last 30 years liberals have been successful at creating a society of wimps.

pukara61 on October 6, 2008 at 4:25 PM

Subprime lending in the early 90s isn’t what it morphed in to today. Back then subprime lending was a good idea and it made sense. You would lend at 80% LTV and verify income to a post-consolidation debt-ratio of 40% or lower. In other words, companies that specialized in sub-prime lending like Household Finance, American General etc… could get a family in a refi from paying $1500 a month (and over 50% of their pre-tax income) in debts to $1000 a month (and 35% of their pre-tax income). In order to do these loans these traditional finance companies would tender loans at anywhere from 10 to 14% fixed at a max amortization of 15 years.

Some called it exhorborant and accused such companies of taking advantage of people. But, what it did was get some people with poor credit out of a very tough spot. Once their income or equity (or both) improved, they could then refinance their first and higher interest rate 2nd in to a more practical loan. This was highly profitable for these finance companies but they still suffered a higher rate of collections and forecloser then “A paper”. The finance companies managed their own portfolios and kept LTVs and debt ratios in line with their level of risk (and interest rate).

Once LTVs went over 90 there was no room for equity fluctuations nor forecloser short-sales. At that point sub-prime lending no longer existed. There is a place for sub-prime lending but they cannot and should not be underwritten or given an interest rate that doesn’t equate with their risk. If a family with poor credit history wants to purchase a home at 20% down there should be a way to make that happen.

Dario on October 6, 2008 at 4:39 PM

Dario:

Stop with the bullshit.

There were no sub-prime loans being made at 80% LTV. If you could come up with this sort of money you did not need a sub-prime loan.

davod on October 6, 2008 at 5:00 PM

The facts are:

+race is not a basis on which to lend money, and in a color-blind society, it would not have been. Economics is the only rational basis to use if you are going to make a business of it and survive.

+the accounting frauds at Fannie/Freddie were the tip of the iceberg saying the above policy was failing in a big way. This was not an acceptable message to designers of the plan, as it called into question their intelligence, goals and honesty. It also meant their favored sons (Raines and Johnson, among others) might have to do the perp walk, another embarrassment. There also were elections to be won, ACORN’s to pandered to.

One should note that the Boston Herald did a internet poll last week, as noted here, and 70% of the respondents put the majority blame on Barney Frank, when they could have put it on Bush or a few others. In a few places, the penny has dropped.

Harry Schell on October 6, 2008 at 6:16 PM

Subprime lending started off as a good idea – helping Americans buy homes who couldn’t previously afford to.

No it wasn’t a good idea. Getting people who could not afford homes into one anyway increased demand and artificially inflated housing prices. Anyone who has bought a house in the past 5 years has been screwed because some of their equity it not real equity, it was the cost of subsidizing the defaults of others. There is a point no one wants to mention to the middle class

Resolute on October 6, 2008 at 6:29 PM

Davod, I did the loans at 80% LTV. So in fact, you’re wrong. Just because you can come up with 20% down didn’t mean you qualified for A paper back then. You’re confusing poor credit with being “poor” financially. They are totally seperate concepts.

Dario on October 6, 2008 at 6:37 PM

Resolute,

Subprime lending didn’t start in 2004. Subprime lending was always a good idea. It became poorly implemented when subprime and prime borrowers were given the same underwriting and interest rates. If underwriting of those borrowers was still done with high scrutiny towards LTV and debt ratios along with higher rates of return then this mess wouldn’t exist.

Dario on October 6, 2008 at 6:41 PM

subprime lending was fine BEFORE fannie and freddie began to participate. the pools were rated per their actual risk with wall street paying a fair price. many of those borrowers were good credt risks without the downpayment required to purchase. when fannie got into the picture egged on by the federal gov’t to increase low to middle income lending, subprime went from a nice compliment to FHA to completely drowning out FHA. the companies who started and managed subprime lending were left in the dust by mega-marketers who pounded subprime down the throats of consumers with massive telemarketing dollars. the outcome was totall predictable, and was predicted by your’s truly in March of 2004 in front of 100 mortgage industry pros. i was laughed out of the room.

i love to say ‘i told you so’, but this is taking it too far.

DrW on October 6, 2008 at 7:44 PM

Dario:

Stop with the bullshit.

There were no sub-prime loans being made at 80% LTV. If you could come up with this sort of money you did not need a sub-prime loan.

davod on October 6, 2008 at 5:00 PM

sir, may i respectfully submit that you are totaly wrong. take it from me that ltv’s of 80% and below were very common in the early days of subprime. you are forgetting the a) many refinances are low ltv and b) with seller carry backs, many borrower’s had the funds for large down payments but could not meet conforming credit guidelines. dario’s statements are valid. Associates, Ohio Savings, Meritage, Saxon, etc were very active at low LTVs.

DrW on October 6, 2008 at 7:49 PM