ECONOMIC ANALYSIS: Failure to work with borrowers compounded woes

Underlying the financial turmoil is a significantly dreary problem in housing markets. It is a bit easier to understand, but understanding will almost certainly lead to anger and frustration.

The 1995 revisions to the Community Reinvestment Act specifically permitted subprime loans. The intent was laudable enough, to provide lower-income Americans a chance to buy homes and force financing to local businesses. The former worked quite well, but in a 2004 academic paper I reported minimal effect of lending on rural businesses.

In retrospect, it wasn’t the failure of the CRA that caused problems, but rather its success.

Subprime loans are those made to individuals who wouldn’t qualify for traditional loans at market rates. The chief impediments to loans for these folks are the lack of money available for a down payment, not enough income, or a history of bad credit. These are folks who would not have received a home mortgage in years past or who took advantage of some special characteristic of the loan. For banks, making a subprime loan to someone offered the chance to easily meet the requirements of the Community Reinvestment Act.

In Indiana, about a quarter of mortgage loans over the past few years were subprime. An unknown but significant proportion of these loans had adjustable-rate mortgages. This means the mortgage payment rises as the interest rate rises. This is risky.

The good news is that less than 7 percent of all mortgages are subprime adjustable rate mortgages. The bad news is that these loans represent about half the foreclosures. The ugly news is that these mortgages were sold into financial instruments that now pollute the financial system. The question that remains is what to do about it.

First, we cannot forget the borrower. The mathematics of mortgages are covered by about eighth grade. Cries of predatory lending should be muted. Lenders who have made the loans are suffering enormous financial difficulties, as well they should. Sympathy is not the emotion of the day for either group.

As an economist, I am loath to give business leaders advice on their operations. But my reticence fades in the face of the sluggish response by so many lenders. Banks holding subprime ARMs should have been resetting these mortgages to rates that are manageable for borrowers no later than last winter. Failure to reset these mortgages has compounded the problems on Wall Street.

In all fairness, most commercial banks have worked hard to reset loans and avoid foreclosure. I suspect that the larger lending institutions are too large and unwieldy to handle the task. They have an insufficient number of loan officers and too little information about local markets to do the work. As a result, more than half of all the growth in foreclosures over the past two years has been from subprime ARMs. That’s just bad business.