Subprime loans the wrong villain in the market crack-up?!?

We are now at a stage in the story of the great market crack up of 2007-09 where certain interpretations have the weight of facts.

Fact: Easy regulation enabled Wall Street firms to take insane risks with other people’s money.

Fact: Artificially low interest rates, courtesy of your local central bank, fed the housing bubble.

Fact: Subprime loans spearheaded the global economic wobble. Or maybe not.

Whoa,there, says economist Stan Liebowitz, professor of economics and director of the Analysis of Property Rights and Innovation at the University of Texas b-school. Subprime is not the No. 1 villain, although, hey, the industry can certainly shoulder a good bit of blame. But in the interest of history and policymaking, Liebowitz says it’s important to realize that the biggest problem stems from borrowers who don’t have any skin in the game: We are looking at a crisis that is driven largely by low-risk, relatively conservative people who now owe more than their homes than they are worth.

… the focus on subprimes ignores the widely available industry facts (reported by the Mortgage Bankers Association) that 51% of all foreclosed homes had prime loans, not subprime, and that the foreclosure rate for prime loans grew by 488% compared to a growth rate of 200% for subprime foreclosures. (These percentages are based on the period since the steep ascent in foreclosures began — the third quarter of 2006 — during which more than 4.3 million homes went into foreclosure.)

via New Evidence on the Foreclosure Crisis –

Prime loans foreclosed more than subprime

Prime loans foreclosed more than subprime

Now this is an extremely inconvenient piece of data interpretation. Part of the White House plan to save the economy involves keeping people in mortgages with loan-to-value ratios of 125% (plain English: the borrower owes 25% more than the property is worth). If Liebowitz numbers are correct (and who believes they aren’t?), then the White House needs to think twice about forcing Fannie Mae and Freddie Mac from investing in such risky loans.

The data are also important for banks thinking about modifying loans that have fallen behind. It means that they shouldn’t allow principal to build beyond the value of the home. Rather, banks should simply reduce the principal amount owed to about 80% of the value of the home in the post-bubble environment. Sure, that will entail some nasty writedowns. But as Gretchen Morgenson points out in the New York Times today, writing down loans is much smarter than going into foreclosure.

If banks have written down the value of these loans to the 40 cents on the dollar that they are fetching on foreclosures — the only true value for these homes right now — then why don’t they bite the bullet and reduce the loan amount outstanding for the troubled borrowers? That type of modification would be far more likely to succeed than larding a borrower who is hopelessly underwater with yet more arrears.

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