Friday, December 28, 2007

Sub-Prime Mortgages

It’s the current fad about how the financial sky is falling: the fact that many financial institutions have given mortgages to people with less that pristine credit at higher than prime interest rates.

This supposedly was an act of gross irresponsibility, since a downturn in housing prices has caused an upward spike in foreclosures.

It seems that large capitalistic corporations are damned if they do, and damned if they don’t.

Back in the 70s, there was a wave of conglomeration in which large corporations bought up other large corporations, often corporations whose business had nothing to do with that of the firm buying it.

This supposedly demonstrated the evils of American capitalism.

Then came the 1980s. The market struck back against the conglomerates. Corporate raiders bought up the conglomerates and sold them off in pieces. Given that the overgrown behemoths were often badly managed, they were worth more in pieces.

This, of course, was supposed to show the evils of American capitalism.

Then, of course, there was the sinister boom in “junk bonds.” Supposedly sleazy and unprincipled brokers sold bonds that were quite risky -- and had quite a high rate of return. The bonds were not sold to little grandmothers, but to sophisticated investors fully able to judge the risks.

But this too showed the evils of American capitalism.

Apparently, it’s sleazy and unprincipled to start a business when there is some risk involved, even if the people financing you are compensated for the risk they take.

Which brings us to sub-prime mortgages.

It’s yet another case showing the evils of American capitalism.

Patrick McIlheran has some sensible observations on this. Quoting Megan McArdle:
To many people, of course, this cries out for regulations to keep the bankers from being stupid: force them to up their loan quality. This is likely to just replace one kind of error with another. Most people who got subprime loans are not in default, and I will be very, very surprised if the number of defaulters even gets near the 50% mark. Why would we want to cut off credit to the sensible majority who can meet their payments, in order to protect those who take out loans they can’t afford? There is no way to tell Class A from Class B--or believe me, the banks would already have weeded the latter group out.

It is characteristic of major economic problems that whatever problem you’re having now seems like the only problem worth solving, no matter what the cost. But the cost of denying credit to millions of people is very high--and tellingly, it will not be borne by any of the people who are advocating it.
And as Gary Becker has pointed out:
Some have proposed that families should not be allowed to get mortgages if they do not meet minimum standards of income and assets, even if lenders would be willing to provide mortgages, and would-be borrowers still want a mortgage after being informed of the risks. This proposal is a dangerous form of paternalism that denies the rights of both borrowers and lenders to make their own decisions. Moreover, it is ironic that only a few years ago, banks were being investigated for “redlining;” that is, for avoiding lending to blacks and other residents of poor neighborhoods.
And that, of course, was evidence of the evil of American capitalism.

When people contemplate widespread foreclosures and the failure of some large financial institutions, they seem to engage in the “burn and kill” fallacy.

The assumption seems to be that, if a large bank fails, the headquarters and all the branches will be burned to the ground.

And all the employees will be taken out and shot.

Likewise, when a property is foreclosed, it is somehow assumed that officials come out and burn it down, and shoot all the inhabitants.

The reality, of course, is much different. In the real world, the bank fails and is taken over by another bank (or other group of investors) who have been more prudent. The headquarters building still stands -- although it might be sold off and occupied by another business.

The employees may end up working for the firm that took them over, or at worst find new jobs.

The stockholders take a bath, however. But it’s highly unlikely they will end up on the street. They aren’t poor.

People who have defaulted on their mortages may have to move and find other housing -- although banks don’t like to foreclose, and will cut mortgage holders a fair amount of slack. But if you can’t manage owning, you might have to rent.

And then somebody else gets to buy your house. The prudent get rewarded, and the imprudent get punished. But they don’t end up on the street.

McIlheran puts it in the proper perspective with this Christmas observation:
All I know is that I just watched a movie in which the central character spent his wonderful life making dicey loans to subprime borrowers -- and he was unequivocally a hero for doing just that.

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Anonymous Anonymous said...

I agree completely. I just want to know why the government has gotten involved in any shape or form. They refuse to say they it is a "bail-out". Why are they involved, even if it is not a bail-out? Let the businesses fail if they made poor decisions. Darwin will prevail.

1:28 AM  

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