Consumer Law

Who Are the Subprime Borrowers and How Many of Them Would Have Been Better Off If No One Had Lent to Subprime Borrowers?

By Jeff Sovern

Reports on the subprime crisis appear to divide subprime borrowers into three groups.  You hear anecdotes about how borrowers fit into one group or the other, but it's not clear how many people belong to each group, or the extent to which the groups overlap.  The first group is made up of victims of predatory lenders.  These borrowers were persuaded to take out loans that they could not possibly pay back or at least were unlikely to pay back unless housing prices increased sharply.  The anecdotal reports create the impression that members of this group did not understand their payment obligations, especially when they entered into adjustable rate mortgages with initial low teaser rates, and many have now defaulted or are struggling to avoid default.  That group seemingly was not helped by the expansion of subprime lending.  I say "seemingly" in part because of the article in yesterday's Times, "Building Flawed American Dreams," about the role of Henry G. Cisneros, HUD secretary in the Clinton administration, which contains the following:

Victor Ramirez and Lorraine Pulido-Ramirez bought a house in Lago Vista in 2002. ?This was our first home. I had nothing to compare it to,? Mr. Ramirez says. ?I was a student making $17,000 a year, my wife was between jobs. In retrospect, how in hell did we qualify??

The majority of buyers in Lago Vista ?were duped into believing it was easier than it was,? Mr. Ramirez says. ?The attitude was, ?Sign here, sign here, don?t read the fine print.? ? He added that some fault lay with buyers: ?We were definitely willing victims.? (The Ramirez family veered close to foreclosure, but the couple now have good jobs and can make their payments.)

The second group consists of speculators who expected that housing prices would rise and they would flip their houses for a profit large enough to cover their mortgage obligations and transaction costs and still make a profit.  Many of them planned to sell before the rates on their adjustable mortgages rose but found it impossible to do so at a price that would cover their mortgage obligations when housing prices went down, and so they walked away from their investments.  That group too was not helped by the expansion of subprime lending, but it seems fair to say that the fact that the loans were subprime was not the key factor here in that prime borrowers who bought on the assumption that they would be able to flip their investments suffered from the same outcome when prices fell. 

The third group comprises borrowers who could not have obtained a mortgage without the expansion of lenders into the subprime market and who are current on and able to make their payments for the foreseeable future, like the Ramirezes.  it's harder to figure out whether this third group benefited from the expansion into subprime lending or not. The decline in housing prices has hurt that group because their homes are worth less than they paid for them and perhaps even less than they owe on them (though again, it is fairer to lay that at the feet of the decline in home values rather than the expansion into subprime lending).  If they want to sell their homes, they will be in trouble because they may not get enough to cover their mortgage obligations and also because the credit crunch will make it harder for would-be buyers to obtain financing.  But as long as they're willing to stay put, there's an argument that subprime lending has helped them on balance because they now own a house.  But if their home is underwater, they probably would have been better off staying in rental housing, and even if their home is not underwater, they might have been better off staying in rental housing--though to repeat it yet again, that seems attributable more to the fall in housing prices than the mortgage meltdown.

This division is a bit simplistic, but it leaves me with several questions. First, how large are these various groups?  (I haven't gone looking to see if others have answered that question)  Second, what policy implications does all this have?  For example, if many borrowers did not understand their payment obligations (the first group), that suggests that the Truth in Lending Act disclosures failed and need revision.  If, on the other hand, most borrowers did understand their payment obligations, and went ahead anyway, that indicates that the failure was less attributable to TILA, though perhaps credit counseling might have helped.  Ian Ayres, for example, has suggested that information remedies would not have made a difference and that the real problem was that borrowers "simply underestimated the likelihood of a fall in real estate prices."   Another policy implication:  while subprime lending has dried up for the moment (as has a lot of lending, though today's news reports suggest that the credit crunch is easing for some), eventually the credit crunch will end and lenders will once more be willing to extend loans.  The relative sizes of these various groups raise questions about whether subprime lending ought to be encouraged when that happens, or discouraged, or perhaps regulated in new ways so that only those whose lives are enhanced by taking out such loans have access to them.  And that in turn has implications for the Community Reinvestment Act.  My own opinion is that subprime lending is not the culprit per se; that is to say, society is better off if people, whether subprime or prime borrowers, can obtain mortgages that they can afford, understand the terms of, and can handle the risks of incurring, and that the problem is not so much the fact that some borrowers were subprime. But I would be interested in the opinions of observers who are better informed than I. 

Full post as published by CL&P Blog on October 20, 2008 (boomark / email).