Sub-Prime

The crash of the sub-prime lending market (due to loan defaults that by definition should have been expected) is being spun in the US as just another case of greedy people wanting to live above their means and rapacious lenders who dangled the carrot and enticed them into financial ruin.

The Globe & Mail presented a rather different case history last week in its front-page article about an American widow who lives on Social Security. When she got sick and needed $50,000 for medical bills, her only choice (besides dying) was to take out a sub-prime mortgage on her house. Now she has defaulted.

Of course sub-prime mortgages have been around for a long time, and exist in Canada (to a much smaller extent), but the sub-prime crisis going on now is brought on by a new kind of mortgage that was introduced (or at least took off) in the US in 2004, and might more accurately be called "predatory sub-prime mortgages." This new type of mortgage is not just targeted at low-income borrowers, but also has a gimmick to get people to sign up: an initial period in which the borrower makes reduced payments. (This might be caused by a temporarily reduced interest rate or by not having to pay towards the principal for the first few years.) Unless their income rises by the time Part 2 of their repayment kicks in, borrowers are going to be in trouble.

As long as the housing bubble grew there was a certain logic to predatory mortgages. If I rent in an unregulated market and housing prices continue to rise, my rent will probably rise. If I buy a house I can stabilize my housing costs. My mortgage might be large, but if the value of my house continues to rise my debt-to-asset ratio declines. That sort of logic may be part of why so many people in the US (an estimated 20% of mortgage holders) took out predatory mortgages.

But when housing prices stop rising, when the insidious Part 2 of the predatory mortgage kicks in and your mortgage payments shoot up, when you've been making payments for a couple of years and now owe more than you did at the start - when the future is here and the extra money isn't in your pocket, then things don't work out so well.

It's all a lot like those late-night furniture ads that promise "No down payment! No interest until 2009!" It always struck me as ludicrous that someone would think that was actually a good deal, and yet those places are very popular. But in a world of high annual inflation (such as the housing market has been the last few years), buying now and paying later makes more sense.

This crisis brings back the farm crashes in the 1980s. If I recall correctly, farmers across North America had been courted by lenders to borrow money to buy expensive farm machinery. They were convinced by banks that small family farms couldn't be competitive unless they mechanized. Then interest rates went up and commodity prices fell, resulting in foreclosures. Agribusiness moved in and farming has changed forever.

It also brings to mind the burst of the high tech bubble a few years ago, which bit a lot of people badly. Before the crash, I remember reading in the business news that you were losing money if you didn't invest in high tech - the calculation went something like: a regular investment is paying 5% and investment in high tech is paying 30%, so if you put your money in regular investments you're losing 25%. We were led by the nose into losses.

I heard an anchor on CNN this week say that the collapse of the sub-prime market was completely unexpected. Of course this is completely false. In the last year there have been numerous media stories about the dangers of predatory loans. I saw one show last year that detailed exactly how the loans work, including predicting when the Part 2s would start to kick in (causing payments to rise). Pundits estimated exactly when the sub-prime market would collapse and their estimates turned out to be correct. (And for heaven's sake, Paul Krugman has been railing about the housing bubble for years.)

The reason we have a world-wide problem is that the sub-prime lenders sold the debt around the world. Why would anyone buy this dodgy sub-prime debt? Apparently part of the problem was that they didn't always know it was sub-prime. Mortgage lending is generally relatively low-risk, and hedge funds (which are notoriously untransparent) didn't spell out the details. But part of it must have been pure speculation: call it irresponsible investing or just plain gambling - with other people's money.

Should central banks have bailed out the speculators by lowering interest rates? On the one hand, I think of course they should, because a global financial crash will hurt all of us. On the other hand they keep bailing out the speculators (think 1998 when dodgy Russian debt collapsed) and the speculators know it.

Where are we now? Not at the end of the crisis, certainly. There will be more defaults (2 million are predicted) and this may cause a decline in housing prices. The impact on financial markets will continue, resulting in who-knows-what losses. And once the financial crisis has passed, there will be repercussions - possibly softer stock prices due to reduced trust in the markets, probably other things. If US consumer confidence falls too far, we could be in for another recession.

This is happening in a world in which fewer and fewer people have company pensions. We rely on the financial markets to invest for our retirement. (President Bush even tried to totally scrap Social Security and move all retirement funds into private self-directed investments.) We need credible and safe financial markets.

Governments need to act to devise far, far stronger financial regulations: on hedge funds, credit-rating agencies, banks, advertising, and a host of other areas. We need a financial press that does more investigative journalism. We need a public commitment on the part of central banks and financial market regulators to protect small-time investors. And the US should look at alternative ways to help the poor afford their own homes, such as a government mortgage corporation. (Bush has boasted that home ownership grew to 70% under his watch. He should put his money where his mouth is and help keep millions from being repossessed.)


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