Frank's Proposal Will Bring Opposite Effects

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by: Bill Bost

Rep. Barney Frank has proposed legislation related to financial regulation that he says is intended to "stop people from getting loans in the future that they can't repay." I am all for that. Think about it -- no more collection agencies, no more bankruptcy courts, no more foreclosures, rates at the Treasury rate on your credit cards. What Nirvana!

In all seriousness, Frank's proposed restrictions on securitization of subprime loans are akin to the Faustian practice of giving patients medicine that purportedly is good for them which in truth killed them slowly instead.

The problem we have now is a housing market with too much inventory. As a general rule, an investor/landlord will pay less for an unoccupied house than a mortgagor who buys a home as a primary residence. We have to assume (i) that buyers who are currently qualified for a loan have decided not to buy or already own a home and (ii) that there are not enough willing and able investors to purchase the homes at their current market prices; if either of these were untrue, we would have no housing problem. Under these circumstances, the greatest pool of new buyers, maybe the only pool of new buyers large enough to solve the problem, are people who can't qualify for loans under current lending guidelines -- namely, the subprime mortgage customer.

Thus, while Frank is correct to attack "subprime loans", he should be encouraging lending to "subprime" customers. This is just not happening now in sufficient numbers and, by restricting lenders' access to capital to make subprime loans, Frank's proposal ensures that it doesn't.

So, you say, "that is how we got into this mess, by making loans to borrowers who couldn't repay the loans". And you are right. But now we have the problem. Why not let "subprime" borrowers finance home purchases even if they can't qualify under current guidelines? This could be done by requiring the GSEs to purchase such loans or some other similar mechanism.

The systemic problem with subprime credit often is stated that "unqualified borrowers received loans that they couldn't repay". That is an incomplete statement; if housing prices remained stable, there would be no crisis without regard to payment ability of borrowers (assuming other qualified borrowers existed). A better description of the problem with subprime credit practices is that they encouraged an overbuilding of houses at inflated prices, and they encouraged unqualified and unsuspecting borrowers to pay more than necessary for their housing. For these reasons, an increase in subprime lending works only if three conditions are met. The first is that the new loans could not be must be used to purchase a home on which construction was completed before, say, today. And the second is that the loans could be no greater than the then current appraised value. And the third is that the loans are on terms that the borrowers have a reasonable chance to repay (for example, the installments are the same as or less than their current rent).

The results would be several. Banks and other mortgage holders would maximize their recoveries on bad assets -- houses could be sold at market value, the transaction costs would be less than foreclosure and houses would not deteriorate by being unoccupied. This would reduce the need for capital from the Treasury.

Housing markets would firm, decreasing the fear of further loss of wealth and possibly stimulating consumer spending.

Families would get a shot at homeownership. If a borrower defaults, the mortgage holder (i.e., banks, institutional investors, sovereign funds, and the US government) would be none the worse; it would own a mortgage secured by a home that it could sell for market value, exactly where the mortgage holder is right now. The "subprime" borrower is in the same position in which he would have been had the loan not been made; he has to find somewhere to live that he can afford. Credit standards could change when the supply of homes has decreased sufficiently and the market regained equilibrium. Also keep in mind in this regard that a hefty percentage of subprime loans are performing; it is not a given that all or even half of new loans to subprime borrowers would default.

We need "subprime" credit on some terms to finance home purchases. People, even those with bad credit, need a place to live. There are hundreds of thousands of houses that need to be occupied. Frank is simply irresponsible to propose actions that almost ensure that they will not.

Disclosure: No positions








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