Subprimes
Posted nine months later:
My roommate and i had a long conversation about the subprime 'crisis', how it is misunderstood, and why that misunderstanding enables politicians to pass stupid laws. It demonstrates exactly why Milton Friedman and Thomas Jefferson advocated public education: there are negative externalities associated with uneducated voters.
So first, most people don't understand what the hell this subprime thing is or why it's messing with our economy. I can offer what I believe to be a concise and basically accurate explanation.
First, an brief note on interest rates: An interest rate is a price, it's the price of borrowing money. If a lot of people want to save money, the interest rate will be low. If a lot of people want to borrow money, it will be high. "The interest rate" is usually the return to saving money without risk. When it is low, people are encouraged to invest in risky, productive investments like business ventures and the stock market. when it is high, this is not encouraged. So when the economy is not so hot, and the central bank wants to encourage investments, they lower the risk-free interest rate. It's a floor: any productive investment has to offer higher returns than the risk-free interest rate.
in 2001 the US Economy went a bit sour, the central bank began to lower interest rates. In the summer of 2004, the interest rate was nearly zero and it had been there for nearly a year. It was very cheap to borrow money.
If it's cheap to borrow money, people will borrow a lot of it. A low interest rate encourages, among other things, people to buy not and pay later. The most relevant place this happens is with houses: most people borrow money in the form of mortgages to buy a house.
With everyone buying houses on credit, the price of houses went up.
Two things were pointing toward enabling even poor people with bad credit to buy houses they wouldn't otherwise buy: (1) it was cheap to borrow money to pay now and buy later and (2) housing prices were climbing, so what looked like a bad loan on a bank's books today was probably going to look a little better tomorrow.
But this wasn't enough: we have had low interest rates before, we have had housing bubbles before, but subprime crisies are more rare than that. There was another element: now more than ever financial markets securitize EVERYTHING. In particular, mortgages.
When I say markets securitize mortgages, I mean the originators who interact with a homeowner and sell them a mortgage do not care if that person is actually able to pay the mortgage in the future. They simply care that it looks like they can pay that mortgage so they can sell the rights to the procedes from that mortgage in the form of a bond. For example a mortgage broker like New Century will take 1000 mortgages that look the same in terms of their risk, will create a bond that pays whatever the homeowners pay of their mortgage, and sell it to wall-street.
This is not bad in-and-of itself: this allows people to have access to cheaper mortgages. To see how this lowers the price of selling mortgages, imagine the local mortgage broker who sells mortgages in Albuquerque. If people pay their mortgage, he does well. but if people don't, he is broke. He is exposed to a lot of risks: if the local job-market fails, if there is a regional borrowing crisis, if the local housing market goes bad, his clients may not pay their mortgage.
It's valuable to him to sell the uncertain future payments for a certain dollar today. And he can sell it to someone who can hedge local risks and even housing market risks away, meaning they own enough securities that certainly some will go bad but certainly all won't. Both parties win. If the local mortgage broker doesn't have to worry about a collapse in the local housing market, he can lend more and cheaper.
Somewhere in New York some hedge fund, insurance company, or bank bought a bond, or a contract that pays money if people pay their mortgages. They saw that the return was high and didn't belive it was that risky, in part because bond rating agencies rated these bonds fairly well. Then, somewhat suddenly, people became unable to pay mortgages and it wasn't the people who sold them the mortgage who felt the heat: instead hedge funds, insurances companies, and banks had bonds that were not paying. Many were in big trouble.
This conflict of interest between the homeowner and the mortgage broker is largely the culprit for the debacle: because mortgage brokers securitize their mortgages into bonds that are sold to other people, it is not as importat to them that homeowners can pay. They are simply concerned with the appearance of good credit: many orinators of mortgages helped people file improperly, udnerstating their tax burden, suggesting that housing prices would rise when there was no reason to believe so, and creating new riskier products. Some of these new products were particularly problematic. the most famous subprime mortgage is a 2/28: a mortgage with an interest rate that is fixed for the first two years and which then becomes adjustable and pegged to some index like LIBOR or the Fed funds rate. If someone bought a house in 2004 with such a product, the interest rate at the time was most certainly approximately zero. After two years and 14 interest-rate hikes by the fed, that monthly payment was sure to increase.
Other products that mortgage brokers sold offered homeowners to pay only the interest on their house, so that they never bought any equity in the house. Imagine a case like this one that was in the Wall Street Journal: three years ago (at the height of the housing bubble) a family with a combined income of $90,000/year is told they can actually afford a house priced at $600,000. They will pay only interest on the house for the first three years and after that their payments will increase to slowly pay off the house.
There are (A LOT) of problems here. First, part of the reason someone might suggest this family is credit worthy is that they believe the value of the house will increase so the debt/collateral ratio will be more attractive with time. This would not be true for most houses sold three years ago. Second, three years ago, interest rates were almost zero. It was all to easy for the mortgage broker to say 'you can buy it for a monthly payment of X' where 'X' is some reasonable number. Something can also be said for the psychology of people to believe that in three years they will figure things out and they can pay their mortgage off.
Today, this family is forced to pay (1) much higher interest on their house and (2) start to buy the equity on the house (as in, actually begin to own it). For them, this is totally impossible not for some tragic reason that the economy is bad or they can't get a loan. It is impossible because a family that earns $90,000/year can't afford a house that costs seven times that.
But the tragedy is that, the house was worth $600,000 when they took out their mortgage and bought it, but as the housing market collapsed, so did the value. So they have a $600,000 debt (since they haven't paid any equity yet) and a house that is now worth $400,000. Even if they sell their house, they can't get away from that! (not to mention the problem of finding a new place to live). This is the problem of a housing bubble. And these creative mortgage products which were implemented by mortgage brokers who didn't care if people could actually pay have left some people in dire situations.
There is an obvious solution to this problem which many talking heads have advocated (most famously Jim Cramer): lowering the interest rate. Lowering the interest rates makes mortgages cheaper for banks and thus cheaper for homeowners meaning they are more likely to pay their mortgage, which makes the mortgage-backed bonds in the hands of to hedge funds, insurance companies, and banks wor
Really low interest rates enabled even poor people with bad credit to buy houses.
My roommate and i had a long conversation about the subprime 'crisis', how it is misunderstood, and why that misunderstanding enables politicians to pass stupid laws. It demonstrates exactly why Milton Friedman and Thomas Jefferson advocated public education: there are negative externalities associated with uneducated voters.
So first, most people don't understand what the hell this subprime thing is or why it's messing with our economy. I can offer what I believe to be a concise and basically accurate explanation.
First, an brief note on interest rates: An interest rate is a price, it's the price of borrowing money. If a lot of people want to save money, the interest rate will be low. If a lot of people want to borrow money, it will be high. "The interest rate" is usually the return to saving money without risk. When it is low, people are encouraged to invest in risky, productive investments like business ventures and the stock market. when it is high, this is not encouraged. So when the economy is not so hot, and the central bank wants to encourage investments, they lower the risk-free interest rate. It's a floor: any productive investment has to offer higher returns than the risk-free interest rate.
in 2001 the US Economy went a bit sour, the central bank began to lower interest rates. In the summer of 2004, the interest rate was nearly zero and it had been there for nearly a year. It was very cheap to borrow money.
If it's cheap to borrow money, people will borrow a lot of it. A low interest rate encourages, among other things, people to buy not and pay later. The most relevant place this happens is with houses: most people borrow money in the form of mortgages to buy a house.
With everyone buying houses on credit, the price of houses went up.
Two things were pointing toward enabling even poor people with bad credit to buy houses they wouldn't otherwise buy: (1) it was cheap to borrow money to pay now and buy later and (2) housing prices were climbing, so what looked like a bad loan on a bank's books today was probably going to look a little better tomorrow.
But this wasn't enough: we have had low interest rates before, we have had housing bubbles before, but subprime crisies are more rare than that. There was another element: now more than ever financial markets securitize EVERYTHING. In particular, mortgages.
When I say markets securitize mortgages, I mean the originators who interact with a homeowner and sell them a mortgage do not care if that person is actually able to pay the mortgage in the future. They simply care that it looks like they can pay that mortgage so they can sell the rights to the procedes from that mortgage in the form of a bond. For example a mortgage broker like New Century will take 1000 mortgages that look the same in terms of their risk, will create a bond that pays whatever the homeowners pay of their mortgage, and sell it to wall-street.
This is not bad in-and-of itself: this allows people to have access to cheaper mortgages. To see how this lowers the price of selling mortgages, imagine the local mortgage broker who sells mortgages in Albuquerque. If people pay their mortgage, he does well. but if people don't, he is broke. He is exposed to a lot of risks: if the local job-market fails, if there is a regional borrowing crisis, if the local housing market goes bad, his clients may not pay their mortgage.
It's valuable to him to sell the uncertain future payments for a certain dollar today. And he can sell it to someone who can hedge local risks and even housing market risks away, meaning they own enough securities that certainly some will go bad but certainly all won't. Both parties win. If the local mortgage broker doesn't have to worry about a collapse in the local housing market, he can lend more and cheaper.
Somewhere in New York some hedge fund, insurance company, or bank bought a bond, or a contract that pays money if people pay their mortgages. They saw that the return was high and didn't belive it was that risky, in part because bond rating agencies rated these bonds fairly well. Then, somewhat suddenly, people became unable to pay mortgages and it wasn't the people who sold them the mortgage who felt the heat: instead hedge funds, insurances companies, and banks had bonds that were not paying. Many were in big trouble.
This conflict of interest between the homeowner and the mortgage broker is largely the culprit for the debacle: because mortgage brokers securitize their mortgages into bonds that are sold to other people, it is not as importat to them that homeowners can pay. They are simply concerned with the appearance of good credit: many orinators of mortgages helped people file improperly, udnerstating their tax burden, suggesting that housing prices would rise when there was no reason to believe so, and creating new riskier products. Some of these new products were particularly problematic. the most famous subprime mortgage is a 2/28: a mortgage with an interest rate that is fixed for the first two years and which then becomes adjustable and pegged to some index like LIBOR or the Fed funds rate. If someone bought a house in 2004 with such a product, the interest rate at the time was most certainly approximately zero. After two years and 14 interest-rate hikes by the fed, that monthly payment was sure to increase.
Other products that mortgage brokers sold offered homeowners to pay only the interest on their house, so that they never bought any equity in the house. Imagine a case like this one that was in the Wall Street Journal: three years ago (at the height of the housing bubble) a family with a combined income of $90,000/year is told they can actually afford a house priced at $600,000. They will pay only interest on the house for the first three years and after that their payments will increase to slowly pay off the house.
There are (A LOT) of problems here. First, part of the reason someone might suggest this family is credit worthy is that they believe the value of the house will increase so the debt/collateral ratio will be more attractive with time. This would not be true for most houses sold three years ago. Second, three years ago, interest rates were almost zero. It was all to easy for the mortgage broker to say 'you can buy it for a monthly payment of X' where 'X' is some reasonable number. Something can also be said for the psychology of people to believe that in three years they will figure things out and they can pay their mortgage off.
Today, this family is forced to pay (1) much higher interest on their house and (2) start to buy the equity on the house (as in, actually begin to own it). For them, this is totally impossible not for some tragic reason that the economy is bad or they can't get a loan. It is impossible because a family that earns $90,000/year can't afford a house that costs seven times that.
But the tragedy is that, the house was worth $600,000 when they took out their mortgage and bought it, but as the housing market collapsed, so did the value. So they have a $600,000 debt (since they haven't paid any equity yet) and a house that is now worth $400,000. Even if they sell their house, they can't get away from that! (not to mention the problem of finding a new place to live). This is the problem of a housing bubble. And these creative mortgage products which were implemented by mortgage brokers who didn't care if people could actually pay have left some people in dire situations.
There is an obvious solution to this problem which many talking heads have advocated (most famously Jim Cramer): lowering the interest rate. Lowering the interest rates makes mortgages cheaper for banks and thus cheaper for homeowners meaning they are more likely to pay their mortgage, which makes the mortgage-backed bonds in the hands of to hedge funds, insurance companies, and banks wor
Really low interest rates enabled even poor people with bad credit to buy houses.
posted by Walter at
11:22 PM
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