Banks and Rational Betting

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Peter Wallison responds to the defense of the Consumer Financial Protection Agency by Elizabeth Warren over at the BaselineScenario. Here is Wallison:

The irony here is that Warren is not herself perceptive enough to understand what the consumers who took the subprime mortgages actually understood. She assumes they were cheated or manipulated into taking a subprime mortgage. Let’s look at what really happened…

Now, why would a consumer take a “subprime” mortgage when he or she is eligible for a prime mortgage? For one thing, when the home was bought, probably some time between 2003 and 2007, the consumer knew perfectly well that home prices were rising, and that the home was likely to be worth a good deal more a year later than it was worth at the time of purchase. That would mean that even if there was a low or no downpayment the purchaser would soon have equity in the home simply from price appreciation over time…

In addition, the consumer knows what he is earning currently, and—assuming that the economy continues to grow—what he is likely to be earning in the future as his skills and seniority increase. He can then estimate pretty well what would be a comfortable monthly payment. Oddly enough, if the consumer takes a subprime mortgage—one with a low or no downpayment and perhaps a low adjustable rate—he can afford a larger house in a better neighborhood, perhaps even near better schools, for the same monthly payment that he would be required to make for the prime loan.

So, our hypothetical consumer was not being cheated—as the Left would like to believe—but in many (and probably most) cases made rational choices based on what was known at the time.

A few things. I’ve been meaning to link to The 10 Myths about the Subprime Crisis, because I think it is almost perfect (I’ll discuss it later). One myth is the idea of the “low adjustable rate” – in general the option-ARMs had higher rates than the equivalent prime rate. But Wallison makes a good point – people will adjust their risk profile to account for their information on how they are going to do. I might just juggle hacky-sacks and someone else might juggle chainsaws; you can tell we are both equally matched to our comfort level because we’ll drop something at the same rate. Wallison says it is the same thing with subprime mortgages; it attracted those best suited to handle them.

In that same way, since consumers that have better fundamentals choose to take on more risk, it’s a simple statistical test to confirm this hypothesis by seeing that the default rates for subprime loans are the same as the default rates for prime loans (click to enlarge):


Oh wait, that’s completely wrong.

Wallison is on to something though – and if there is some sort of financial committee this insight should earn him a junior staffer job – that subprime loans allow people to bet on housing prices rising. But whom? Consumers could always bet on housing with prime loans, indeed by definition they are, since they are making an investment in a home. But the interesting part about subprime loans, something we’ve tried to convey here, is that they allow banks to bet as well.

If you take out a loan on a house, and the value of the house doubles, you are really happy. But you don’t pay the bank any more money on your mortgage. The upside is capped for the bank; they have no exposure (or delta, if you will) to the price of the house. They have secondary exposures to the house price; if your house price goes up you are less likely to default, and if you do the recovery is worth more. But these are secondary things conditional on your actions; they aren’t the real money from the rise, or the bubble.

With subprime, by forcing a refinancing with significant prepayment penalties after 2 years, the bank can bet on the house price rising enough to cover those penalties. I walk through this scenario here. If house prices are going to rise 5%, the penalties eat up 3-4%, and the household gets a little left over. The bank is, in effect, hiring someone to sit in a house they couldn’t otherwise afford. Do we want banks to do this, rampant real-estate speculation? No. We want banks to be banks.