Since we can’t fix the subprime mess can we at least make sure it doesn’t happen again?

One of the greatest American traditions is for families to get together at Christmas and watch with ever-renewed delight Frank Capra’s “It’s a Wonderful Life.” Recent events in the financial world, and in the mortgage business in particular, suggest that the movie should be introduced with this important disclaimer: “WARNING: The movie you’re about to watch is a work of FICTION. Although it is not unknown for a banker to be essentially driven by the altruistic desire to have every citizen own his own home – and will even contemplate suicide if prevented from doing so – such motivation CANNOT be expected from EVERY mortgage banker or broker. BEWARE: MORTGAGE BANKERS AND BROKERS ARE ENGAGED IN A COMMERCIAL PURSUIT AND MAY AT TIMES MAKE THEIR OWN INTEREST PREVAIL ON YOURS.”

So this is my solution to the subprime mess. It’s entirely consistent with the explanation given by a huge majority of subprime homeowners facing foreclosure: “The guy said it was OK. He said “That’s the loan for you!” Why wouldn’t I trust him? He wants his money back, right? Why would he give it to me if he thought I wouldn’t be able to pay it back?”

We know by now that the answer is that, no, in many cases – until recently that is – the banker didn’t care much if the loan was being repaid as it gets securitized and passed to Wall Street which then slices and dices it until it becomes part of the innocuous stuffing of a CDO – again, “innocuous” until recently. However, because it is only through the (three-year old) wizardry of contemporary finance that a mortgage with only a slight chance of being fully repaid may still be a valid commercial proposition, I fully support the borrower who assumes that as the banker wants his money back he won’t be foolish enough to lend money to someone who clearly won’t be able to pay it back. And this is why I stick to my proposal of a disclaimer for “It’s a Wonderful Life.”

I’m kidding of course but I’m half-serious too. Or said otherwise, I’m at least as serious as some of the commentators I’ve been reading recently who’ve come up with their own “solutions” to the subprime mess. Among the more thoughtful suggestions I’ve retained the following as worthwhile pondering about.

Representative Spencer Bacchus (Rep.) is introducing legislation that will require mortgage brokers and other persons selling home loans to be licensed. Loan originators “recently” convicted of fraud would not qualify. This is good because in 2006, 42% of subprime loans were sold by people under no regulatory supervision whatever. Predatory lending originates massively from these quarters.

Mark Adelson, a researcher at Nomura, considers that the only truly innocent victims of the current subprime crisis are precisely the victims of predatory lending who at least “are borrowers who did not lie about their incomes, bet on the housing bubble, or choose to live beyond their means” (p. 5). He seems to be hinting though at their partial guilt when he adds: “Innocent victims of predatory lending also must have been ignorant about the terms of the loans that they were taking. They must have signed papers without understanding them”(ibid.). Unless of course he only has illiteracy in mind.

Adelson is also adept of licensing (*), but licensing of borrowers in his case. I quote: “An alternative to outlawing or restricting (directly or indirectly) certain loan products might be to create a licensing system for borrowers who want to use them. For example, a possible system might work as follows: Basic loan products such as fixed-rate fully amortizing loans would require no license. Riskier products such as ARMs, interest-only loans and negative amortization loans could require successively higher levels of licenses – roughly similar to the various classes of drivers licenses based on different types of vehicles (i.e., car, bus, medium truck, heavy truck, hazardous material, etc.)” (p. 7).

I personally never believed ARMs were such a bad deal: interest rates rise usually as a reflection of growth in the economy. It’s no unreasonable assumption then that people can pay more for housing when the economy is expanding. Maybe I don’t mind ARMs so much because that was the only option open to borrowers when I had a mortgage in England. Of course, in those days in England, teaser rates would have been regarded as an indecent proposition. The only advantage teaser rates seem to present is of introducing confusion and allowing an unscrupulous mortgage seller to make them pass for the real thing. So a gentler alternative to requiring bureaucratic stamps to obtain an ARM would be banning teaser rates.

Some other suggestions seem helpful: the Regulators in their joint statement of a couple of weeks ago proposed lifting prepayment penalties within a window period on both sides of the time when an ARM resets (**); or former Fed Governor Edward M. Gramlich’s idea of lowering HOEPA’s 8% above Treasury threshold, down to 5% to cover 50% of all subprime loans instead of the current 1% (***).

The fact remains however, as I’ve written in a number of past blogs, that all actors, from the individual borrower down to Wall Street, adapted in a perfectly rational way to a context of constantly rising housing prices, i.e. adapted to the real estate bubble. Now the doctors come all with remedies that will ease the symptoms but no one tackles the very root of the epidemics: what caused that bubble in the first place. The cause of the bubble lies in the permanent subsidy that the Government feeds in the housing industry, a subsidy helping the wealthy much more considerably than it does the underprivileged. The one provision feeding residential bubbles is the tax deductibility of interest payments relative to housing. However, as the people’s Representatives are among those high-bracket citizens who would have most to lose from withdrawing that clause…

(*) Mark Adelson, Sub-prime Surprise … Not!, Nomura Fixed Income Research, April 18, 2007

(**) OCC, Federal Reserve, FDIC, OTS, National Credit Union Administration, Statement on Subprime Mortgage Lending, June 29, 2007

(***) Edward M. Gramlich, Subprime Mortgages. America’s Latest Boom and Bust, The Urban Institute Press, 2007