Thursday, December 20, 2007

Senator Charles Schumer’s Four Myths About the Subprime Crisis

Senator Charles Schumer gave a speech yesterday at the Brookings Institution concerning possible solutions to the subprime crisis. As part of that speech he gave what he calls the four myths of the subprime crisis. These are worth a look. Text in bold is my emphasis. From the WSJ online economics blog:

1. The Myth of Vastly Expanded Home Ownership from Subprime Lending The first myth is that most of this subprime lending led to millions of brand-new, first-time homeowners in America. The fact is that only a small percentage of subprime borrowers were first time homeowners. According to the chief national bank examiner for the Office of Comptroller of the Currency, only 11% of subprime loans went to first-time buyers last year. The vast majority were re-financings that caused borrowers to owe more on their homes under the guise that they were saving money. Too many of these borrowers were talked into refinancing their homes to cover short-term emergencies like medical bills. Other subprime borrowers were homeowners that simply moved to another house; and only a small percentage went to investors and speculators. And the truth is, after this subprime crisis blows over, there will be a net loss of homeownership in this country.

2. The Myth of the Unqualified Borrower The second myth is that subprime borrowers couldn’t have qualified for better loans, and thus that the subprime market is the only place they could have gotten a mortgage. A corollary follows that these people can’t be helped by the government or refinancings. But in truth, many of these people were prime borrowers. I had been talking about this myth for months, but policymakers ignored it, which is a major reason they wouldn’t act to solve this problem.Finally, to its credit, the Wall Street Journal did a study confirming what I, and others like Martin Eakes at the Center for Responsible Lending had been saying for so long — a majority of subprime borrowers would have qualified for a conventional primerate loans. Based on the Journal’s analysis of borrowers’ credit scores, 55% of subprime borrowers had credit scores worthy of a prime, conventional mortgage in 2005. By the end of last year that percentage rose to over 61% according to their study. While some will have damaged their credit in the interim, it’s clear that many subprime borrowers have the financial foundation for sustainable homeownership, but may have been tricked into unaffordable loans by unscrupulous brokers.

3. The Myth That Borrowers Can Easily Obtain Perfect Knowledge of The Terms of Their Mortgage Loans When market participants have full information about transactions, the results are efficient. But we have known since shortly after Adam Smith that they do not function well when important information is lacking. We make a great mistake when we accept the myth that the borrowers in mortgage markets are fully informed. The truth is that almost no one reads their entire mortgage document’s fine print, few hire special real estate lawyers to walk them through the home purchase, and frankly, many borrowers were tricked or duped into bad loans by unscrupulous brokers and lenders.Some ideologues blame the borrowers, and while that might make them feel better, it does nothing to solve this problem. That ideology is straight out of the 1890’s and the early 1900’s.

4. The Myth that the Free Market Alone Will Fix EverythingThis administration is wedded to the philosophy that government should take a hands-off approach to governing and to dealing with economic crises. This crisis has been no exception. The myth that left to their own devices, free market forces will correct the disruptions caused by the subprime crisis has caused us perhaps the most economic pain because it has allowed the subprime crisis to wreak havoc in other areas of the economy.Throughout the course of this year, the administration and its financial market regulators have repeated time and time again that the subprime crisis would be contained and mitigated by the strength of the U.S. economy. Then, in August of this year, we began to witness the beginnings of a severe credit crunch in the U.S. credit markets that forced financial institutions to limit the amount of loans that they offered to individuals and companies.As the administration looked on, the credit crisis trickled into the Alt-A and prime mortgage markets, pushing up mortgage rates for borrowers with even the best credit. The tightening of lending and lack of confidence in credit quality has led to shrinking investment and consumption, and a slowdown in economic growth. And the fallout wasn’t limited to the U.S. We may even see a downturn in the global economy, as Secretary Summers has warned.Today, the crisis is fueling a housing downturn that will hit every American family where it hurts the most — their equity. And as a result, we are facing an economic downturn that we haven’t seen in this country since the Great Depression. Economists like Robert Shiller estimate that a 10% decline in housing prices could lead to an overall $2.3 trillion economic loss at a time when this country can least afford it. $2.3 trillion in economic losses!Unfettered free market forces did not contain this problem within the subprime segment of the housing market. Far from it. And the laissez-faire philosophy that allowed this crisis to spread far and wide won’t get us out of this mess, either.

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