On the Myth that Subprimes Helped the Poor Buy Housing

In a MarketWatch story that was ostensibly about the continuing saga of the Bear Stearns hedge fund implosion comes a juicy tidbit about the composition of subprime loans. It turns out half weren’t even for housing purchases but to refinance other debt:

Subprime loans are made to less credit-worthy borrowers at higher rates. It’s a controversial lending practice that advocates say gives poorer Americans a shot at the dream of owning a home. Critics say it’s tantamount to usury and predatory lending.

The reality is that neither is entirely true. More than half of subprime loans are actually cash-out refinance loans. Those loans are used to pay off credit cards or other debts, take trips to Bermuda, buy an unaffordable car or do some speculative investing – in the market, real estate or elsewhere.

“These loans are all about people in a tough spot,” said Matthew Lee, head of Fair Finance Watch, a Bronx, N.Y.-based community group that has championed the cause of urban borrowers for whom a traditional bank loan is out of reach.

We see subprime offers all-over the place: “consolidate your debts” or “tap you home’s equity,” the ads read. As Lee puts it, why not pay off credit cards with 18% annual interest rates with a 9% loan?

“It sounds better,” he said. “But you’re putting your house up.”

In return, banks and brokerages are collecting interest that’s about 50% higher the normal rate of return for a 30-year mortgage. It’s people making big bets and banks willing to take the risk of backing those bets. A subprime loan is a good proposition for a lender: make the payments, the bank collects them, don’t make the payments, the bank gets the house.

For bank and borrower, is it consent or predation?

Whatever the view, there is no arguing that subprime loans are driving an increase in defaults. One in every 656 homes was in foreclosure in May, a 19% increase over April and a 90% increase over the same period last year, according to Realtytrac.

In California, a strong market for the subprime area, defaults are up 30% in a month and 353% over the last year.

For borrowers, a refi is a no brainer, even though in most cases it merely postpones the inevitable. If they are lucky, their interest rate on consumer debt is 18%; if they miss even a single payment, it goes to penalty rates, which are typically at least 25% and can exceed 30%. By comparison, 9%, particularly a tax deductible 9%, is a huge savings.

But I wonder whether these borrowers mistakenly assume that their house could be seized in bankruptcy (even under the new, draconian bankruptcy law, homes are fairly well protected).

Add this factoid to the claim by mortgage securities greybeard Lewis Ranieri that half the subprime borrowers could have qualified for prime loans, and one is left wondering how many “natural” subprime borrowers there were, meaning ones with poor credit who used the proceeds to acquire a house. And of that group, how many are (or are likely to be, after resets) able to service the debt?

From a policy standpoint, it’s vital to understand the subprime dynamics, but no one seems to be posing the right questions. Is that because there are too many constituencies that would be embarrassed by the answers?

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