Subprime: What Happens to an Externality Ignored?

Mike at Rortybomb has produced an interesting post on subprime mortgages which has gotten a lot of link love this morning. It reads in part:

If I was a degenerate crackhead who snuck into your neighborhood and mugged you for $50, the Wall Street Journal Opinion Page would want me thrown in jail. Now imagine that I’m a degenerate crackhead who took out a subprime loan to move next door to you, in an arrangement that I’m likely not going to pay off. I might not even make one payment. If I default you’ll lose 10% of the value of your home from the externality effect. Assuming your home is worth $300,000, there’s a 20% chance I default in 2 years (realistic numbers), and you lose 10%; 300,000*.2*.1 = I’ve just robbed you for $6,000 while the Wall Street Journal Opinion Page cheered me on. And that’s one house – I’ll have a dozen neighbors. Now mind you, the product was great for me – I got to smoke crack indoors, in a house I could never realistically afford, which was a big plus. The subprime lender sold my loan to a pension fund in Denmark for a nice fee. It goes in the win column for us.

This is a classic negative externality—a private transaction between two parties has negative spillover costs. In the absence of some intervention, ideally a tax on the externality but possibly also a regulation of some sort, too much of the offending behaviour will be produced by the market, leading to a societally suboptimal outcome. Strictly in terms of economic efficiency, regulators ought to somehow penalise subprime borrowers in some way.

I'm a little uncomfortable with this argumentation, however. I think it's perfectly fine to entertain the idea of regulating mortgage products offered to borrowers who (knowingly or not) are unlikely to be able to pay. I am not on board with the idea that anticipated effect on neighbouring home values is a good reason to discriminate against potential buyers.

Original post

Comments

[prairiedog555:]

I was in the sub prime business for years. It WAS a good thing. It allowed someone with bad credit (for whatever reason) to own a home with a substantial down payment and high interest rate.
The standard sales line (which was true) was that to get an FHA loan the borrower must for 24 months have no late charges, and then refi to conventional rates.
It worked for years, until Barney Frank failed to regulate industry. I remember my underwriters complaining of the ever decreasing standards (100% no doc loans) these were unheard of.
Don't blame the industry, that is like telling kids not to eat candy. It was because of loose regs and cheap abundant money.
Barney, Dodd AIG are to blame.

Jul 10 06:56 AM

[D_Virginia:]

But didn't the industry lobby HEAVILY for that decreased regulation? And didn't a lot of people love it at the time?

Sounds to me like elected officials were listening to their constituencies.

On Jul 10 06:56 AM prairiedog555 wrote:

> I was in the sub prime business for years. It WAS a good thing.
> It allowed someone with bad credit (for whatever reason) to own a
> home with a substantial down payment and high interest rate.
> The standard sales line (which was true) was that to get an FHA loan
> the borrower must for 24 months have no late charges, and then refi
> to conventional rates.
> It worked for years, until Barney Frank failed to regulate industry.
> I remember my underwriters complaining of the ever decreasing standards
> (100% no doc loans) these were unheard of.
> Don't blame the industry, that is like telling kids not to eat candy.
> It was because of loose regs and cheap abundant money.
> Barney, Dodd AIG are to blame.

Jul 10 09:43 AM

[Brian Bober:]

The NAR and others did lobby hard and Congress took their money, did their biddings, and for some reason we keep re-electing them.

What the Rortybomb article ignores is that the sub-prime loans first dramatically pushed up the price of homes. Just one question? Is it better to smoke crack indoors?

Jul 10 12:37 PM

[Cold Reality:]

I've noticed the increasing demonization of the "sub-prime" mortgage borrower, portraying them as crack heads and thieves, etc., and suggesting that somehow they "stole" value of the house next door. Also there have been the suggestions that somehow the "sub-prime" (read: sub-human) borrower should somehow be punished in order to exact vengeance for the neighbors whose "values" were diminished when "subprime" scratched his "X" on the mortgage paper.

There is perhaps another way to look at it.

Perhaps this sub-prime species was a regular working stiff who took out the sub-prime loan in order to obtain a mortgage on an over-priced house so that he would have a place to live and shelter his family. He had plenty of help in facilitating access to the ill-gotten loan, which was a loan larger than he could reasonably be expected to repay, precisely because the collateral was over-priced by half or more.

I'm not talking about the $725K mortgage that enabled a lower-then-middle-class subprimate to live in Holmby Hills. I am talking about Ward Cleaver, who stretched to buy a $75K house for $350K, in the very American hope that over time, his lot would improve, he would somehow be able to make his mortgage payments and his home would continue to rise in value, just like his real estate agent promised it would.

If you want to start demonizing and punishing people for the "sub-prime" fiasco, I suggest you start with that special group of people who can be blamed for the vicious cycle of ballooning prices from the 1980s on--the real estate agents. For they are the ones that engineered sub-prime lending. They drove up prices on rumor, hype, speculation and fishy valuation mechanisms (aka "appraisals").

A buyer and mortgage holder who defaults certainly is to blame in the end, but the suggestion that these people were all crack-heads looking to live free and torpedo the value of the house next door is nonsense.

Jul 10 01:46 PM

[TinyTim:]

Don't forget the non-crackhead neighbor who watches the value of his house going up and decides to take a 3 week vacation in Monaco every summer with his family with a new home equity loan every year.

Is this guy a demon?

Not until he decides it's cheaper to rent the repo two doors down for half his PITI and walk away from his own house which is only worth half what he owes on it.

I can't even in good conscious blame the guy. He's making rational decisions based on known consequences.

In my opinion, the consequences may be a little light in this case because the IRS will forgive him his imputed gain, but tarring and feathering the guy is out.

On the contrary, the problem with subprimes is regulations. Now, your mtg rate and down payment depends on FICO. It's a little late. The govt screwed the pooch on this one big time. Nothing personal, Barney.

Jul 10 06:52 PM

[Steve in Gr...:]

The argument that my neighbor defaulting on his mortgage represents a negative externality to his neighbor subject to government regulation is profoundly, deeply silly.

The principle negative impact of mortgage default is (or should be) on the BANK. The bank has sufficient incentive to not loan money to deadbeats to avoid this being a real problem. Not loaning money to deadbeats is called BANKING.

But there are severe economic dislocations in the subprime case that could be cured by government action. The dislocations are caused by government when:

a) the government forced banks to make mortgage loans to deadbeats (CRA 1976 and its ongoing perversion by people like Bill Clinton, Barney Frank, Franklin Raines, Maxine Waters, et al)

and

b) socialized the resulting losses away from the banks to the taxpayer by bailing out the banks (TARP and its evil spawn).

The government actions that should be taken are to stop doing these things.

Jul 10 10:40 PM