Sub Standards — A Metaphor for the U.S. Financial Market

A CRISIS AS BIG as subprime lending usually does not spring out of nowhere. Often crises like this one are symptomatic of a much larger problem. If you are one of the few who believe this to be a local problem that will be contained, don’t let yourself be fooled. The fallout from subprime lending is bad enough as it stands, but what’s worse is that it seems to be a metaphor for the entire U.S. financial culture.

At its worst, subprime lending consisted of giving loans to people that probably couldn’t pay on low or no-doc terms. These people were initially targeted because they were on the economic margins of society. They were the itinerant laborers, ne’er-do-wells, and seasonal employees, the kind of people that couldn’t qualify for mortgages or other loans on conventional terms.

Subprime loans, by definition, are made to borrowers who are unqualified, so lenders demand higher interest rates to compensate for the risk. The problem is that this strategy doesn’t work. If a borrower who is already on financially shaky ground is charged an above-market rate, the excess payment that such a borrower has to make means that she becomes an even greater risk than before. The act of subprime lending creates the very problem it is supposed to solve.

People who could pay on their loans were then, in effect, subsidizing the ones that couldn’t. In the words of wise underwriter Jack Ringwalt, “Subprime products were fit for only crooks and deadbeats.”

The supposed cure for subprime payment problems came and was another monstrosity, adjustable-rate mortgages. ARMs offered low teaser rates to qualify people for loans that they really couldn’t afford. The incentive consisted of submarket rates for a period of time, typically two or three years. It’s just enough time for a loan to get seasoned, while the monthly payment was temporarily affordable. 

Beneficiaries of such loans had an artificial incentive to pay on time to keep the low rates, at the expense of running up their credit cards for nonmortgage items. After the rate resets, the incentives run the other way, explaining the recent stabilization in consumer credit and the rise in foreclosure rates. Overextended home borrowers were made to appear as better credits during the teaser period than they actually were.

This was an example of the “lend now, collect later” mentality that pervades today’s banking system. So much for the old J.P. Morgan dictum of a “first-class business done in a first-class way.”

Unfortunately, the problem of stupid lending could not be confined to the lenders and the so-called investors that act as their backers. That’s because the abnormal spending that was made possible by the housing “ATM” effect is now coming to a screeching halt. Normal consumer spending that would have occurred if the consumer were not severely loaded down with debt would soon be severely crimped.

Borrowers will probably not wind up going hungry or unclothed, but we may see a rise in the sales of Spam, sloppy Joes, and secondhand clothes. Not to worry, this will last for only the two or three decades that it will take to pay off their homes — just like their grandparents 70 or 80 years ago.

There are no solutions likely to provide any relief. One idea is to penalize the lenders. Suppose that a legislative or judicial consensus formed around that proposition that loans with teaser rates for the first two years and market rates for the remaining 28 years were deceptive to the consumer. The legislators might decide that those low teaser rates should remain in effect for the life of the loan. That form of interest subsidy would certainly provide relief to the consumer, but lenders would suffer as a result. A large number of banks and hedge funds would ultimately go bust.

As bad as this was domestically, many of these bad loans were packaged and sold to foreign investors, meaning that they now contaminate the banking systems of our major trading partners. German banks, for instance, were shocked to find that their tranches of loans carried properties more characteristic of options, a much riskier security. Such paper is now often acceptable as collateral stateside for back-to-back loans from the discount window, thereby establishing a near-equivalence between shaky loans and Treasury paper.

This comes at a time when the Fed is lowering its benchmark rates toward teaser levels. What happens when foreign investors wake up to the fact that they are being paid teaser rates to hold paper of a very questionable quality? Will the U.S. Treasury then be able to roll over its debt, or will there be a default event that can occur only once before other nations wise up?

Although their grandparents presided over steadily improving U.S. credit, baby boomers may end up ensuring that the generations that succeed them will have impaired credit in global markets for at least a century.

The U.S. government can’t prevent someone from taking losses on the foolish borrowing practices discussed above, because those loans have already been booked. What the government can do is determine who gets to eat the losses. Be it borrower, lender, taxpayer, or foreign investor, there is no question that the piper is about to be paid. The question that remains is who will pay, and how?

Regards,
Thomas Au, CFA

October 19, 2007