The "Subprime" Mentality: A Metaphor For the Whole U.S. Financial Market
Tom AuMost readers of this site probably aren't among them, but too many people think that the issue of subprime lending is a local problem that will be contained. In the unlikely event that you are in this camp, think again. First of all, the fallout from subprime lending will be bad enough as it stands. But the real problem is that "subprime" is a metaphor for the whole 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 (because lenders didn't want to ask). Now a "staple," they were initially targeted at people on the economic margins of society, ne'er do wells, itinerant laborers ("hobos" and vagabonds to use less politically correct terms), and seasonal employees, precisely the kind of people that couldn't qualify for mortgages or other loans on conventional terms. (And the latest "hot" market is illegal immigrants, who often live and work "off the books," and therefore can't document their income or assets, such as they are.) "Alt-A" loans are aimed at higher paid people with similarly variable incomes who are otherwise very much in the economic mainstream: commission salespeople for instance, or investment bankers whose base salaries are low relative to bonus-driven total compensation.
Because subprime loans, by definition, are made to borrowers who are unqualified, lenders demand higher interest rates, which supposedly compensate for the risk. Except that they don't, as best explained by George Soros in his theory of reflexivity. That's because 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 s/he becomes an even greater risk than before. In short, the act of subprime lending itself creates the very problem it is supposed to solve. So the random people who could pay were in effect subsidizing the ones that couldn't, because subprime lending was about finding someone stupid enough to borrow (on such terms), and honest and solvent enough to repay. Barring such rare birds, "subprime products were fit for "only crooks and deadbeats" in the words of wise underwriter named Jack Ringwalt (who sold his company to Warren Buffett in the 1960s).
The supposed cure for payment problems was another monstrosity, diametrically opposite in form, but otherwise closely related to "subprime" loans-- adjustable rate mortgages (many of which are "prime"). That's because the whole point of such mortgages and low "teaser" rates was to "qualify" people for loans they really couldn't afford. This incentive consisted of submarket rates for a period of time, typically two or three years, enough time for a loan to get "seasoned," with a monthly payment that was temporarily affordable. Until the recent resets, 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 non-mortgage items). After the resets, however, the incentives run the other way, which explains the recent stabilization in consumer credit and hockey-stick rise in foreclosure rates. In essence, overextended home borrowers were made to appear as better credits (during the "teaser" period) than they actually were. It was an artifact of the "lend now, collect later," mentality that pervades today's banking system. Such practices violate the old J.P. Morgan dictum of a "first class business done in a first class way."
If only the problems of such stupid lending could be confined to the lenders and the soc-called "investors" that act as their backers. Unfortunately, that's not the case. That's because the abnormal spending that was made possible by the "housing ATM" effect (of home equity loans) is now coming to a screeching halt. More to the point, "normal" consumer spending - that which would have occurred if the consumer were not severely loaded down with debt, will soon be severely crimped. Such borrowers probably won't end up going hungry or unclothed. But they might end up eating Spam and sloppy joes, and wearing hand-me-downs and second hand clothes purchased at garage sales for the two or three decades that it will take to pay off their homes - like their grandparents did seventy or eighty years ago. (What's more, many of them live in housing developments that threaten to turn into modern "Hoovervilles.") Slavery has been abolished, but not "indentured servitude," in what Warren Buffett recently termed a "sharecropper society."
Nor are any solutions likely to provide relief. One way is to penalize the lenders.
Suppose, for instance, that a legislative or judicial consensus formed around the proposition that "2/28" loans with "teaser rates" for the first two years and market rates for the remaining 28 years were "deceptive" to the average consumer. (Individual lawmakers already feel this way.) In this case, legislators or judges might rule that those low teaser rates should remain in effect for the life of the loan. That would certainly provide the consumer relief, in the form of an interest subsidy. (Such relief need not take place across the board. It might for instance, only apply to first time homebuyers, but not to speculators who bought multiple homes. Or they might apply only to customers of lenders with particularly deceptive lending practices.) But lenders (or more likely investors who foolishly bought such loans), would suffer as a result, meaning that a large number of banks and/or hedge funds would go bust.
As bad as this was, 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. (And known carriers of such "diseases," financial as well as social, soon get shunned.)
German banks for instance, whose staples are fixed income products, were "shocked, shocked" to find that their "tranches" of loans carried properties more characteristic of options, a much riskier security. What's worse, 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. And 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 (of which 40% or so is held by foreigners)? Or will there be a "default event" that is allowed to occur about once in the lifetime of a nation before others "wise up?" Although their grandparents presided over steadily improving U.S. credit, Baby Boomers (and their immediate predecessors and successors) may end up insuring that their children and grandchildren 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 lending/borrowing discussed above, because those are losses on loans that have already been booked. What the government can do is to determine who gets to eat the losses; borrower, lender, U.S. taxpayer, or foreign investor. There is no question that the piper is about to be paid, and in a big way. What is open to question is who will pay, and how?
Thomas Au is author of "A Modern Approach to Graham & Dodd Investing." and a columnist for TheStreet.com