Mar
17
Sub-Prime
March 17, 2007 | Comments Off
Sub-Prime loan customers, by definition, are risky business. Loaning to a sub-prime customer is loaning money to someone that has either been proven untrustworthy or is expected to be untrustworthy: someone who has failed on his payments before (broken a promise) or would be getting into such a high level of debt-to-income ratio that it is highly probable that the person will fail on at least some of his/her payments (break the promise). When you loan to these people you know there is a risk, you have to find a way to manage it, and you should not overdo it.
People with bad credit:
When I refer to people being late on their payments I must stress that we are not talking about people who pay their credit cards a week late (those get penalized in fees and higher rates by the credit card company, but they are not reported to credit bureaus). We are talking about people who have consistently failed to pay. People who are so into debt compared to their income that it is very difficult for them to get back on track.
Some sub-prime customers do get back on track. I am willing to bet most do. However, the process is not easy for them (nor for the creditors). Getting out of debt is like getting out of an addiction: it may take several tries to succeed, and with every try you get closer to freedom. Certainly someone should give these people a hand, but only with the understanding that many of these customers will struggle to do the payments, or may stop paying at all.
High Debt To Income Ratio
I believe in freedom and letting capitalism rein free. At the same time I believe that we should all be responsible not to harm others and not to harm ourselves. Loaning money to someone that you know will struggle to pay is harming both of you: just don’t do it. One thing is to give someone a chance to demonstrate they have learned and will be trustworthy from now on, and the other is to put someone into a position where they will most probably fail their promises from now on.Illusions
Booming economies (like the US and World economies in previous years) create optimism. People know they are getting into higher debt than they can pay now, but they feel optimistic that they will get better salaries in the near future. People start to think that interest rates will either stay low forever or will go even lower. People think houses will appreciate so much that they will be able to prove they have made money out of nothing at all and will have so much equity that they don’t need expensive insurance. People start to think so optimistic that they forget that life tends to throw us difficult times.
Over-believers
Big banks are smart. Many banks don’t even like to hold risky loans: they look bad on their balance sheets. They keep the good ones, the ones they believe will give them an easy and steady revenue stream. The risky ones they repackage them and resell them to people who are eager to invest their money into “safe heavens”. After all, people believe that bonds are safe and stocks are risky. People prefer to buy mortgage backed bonds, even sub-prime ones, rather than buying the stock of the bank that re-packages and sells them.
Risky loans deserve higher rates – at least on a perfectly balanced world. The higher interest rate allows for extra money that will off-set the losses from bad loans. The problem is that sub-prime loans have not been closed at realistic and balanced rates, and that means big banks have been offloading them into investors and smaller financial institutions that are less risk adverse: or don’t know math.
Loan Bubble Burst
Since the .com “burst” people have started calling everything a “bubble burst”. I feel I have enough poetic license to say that flexible sub-prime lending is over — at least for the next few years: until people forget about their history. People will have to start having at least a few cents to be able to get a mortgage loan (as opposed to getting mortgage loans that even allow for furniture and renovations with no money down), and people who fail their promised (don’t pay their loans) will really be penalized with higher interest rates (not the slap in the hand couple of interest points higher than people with perfect credit).
World Of Opportunities
In my mind, not everything is doom-and-gloom. There are opportunities in this crisis, I mean, once it is over. People will still be born and immigrants will still arrive into the country: people will need a place where to live, and if it is not a home they own it will be a rental property. People with more than one property may get to rent the spare one. People who do not have a rental property, but have been responsible with their credit and have kept spending well below their means may get to buy one of the properties that those sub-prime people will have to vacate when the bank evicts them: and may be able to get them cheap, spreading wealth within the local communities.
Lenders will also be able to compete in a realistic sense. I have been meaning to lend money in Prosper.com to “B” credit rating people: those who are not prime, but not so bad as the worst sub-prime people. The problem is that easy home-equity lines that allow for 125% of loan to principal ratios don’t put upward pressure in the personal loan interest rates for “B” credit-rated people. Maybe I will be able to loan money at more attractive rates and so will you, if you have been living below your means.
Maybe It Is Good For The Environment
McMansions are a common sight in sub-urban America: oversize homes that have a big footprint on the environment. I accept the fact I can be blamed for this, as I did bought a house that is too big for me and my wife. A tighter lending market may motivate people to look into smaller homes, town homes like the two we rent to other people, or even old, traditional dwellings that may have been overlooked in the previous years. When you can’t buy a million dollar home on a middle-class income, maybe a $250,000 home will do – and will still provide an enjoyable place where to live, have nice Thanksgiving dinners, raise a good family, and spend less on air-conditioning and heating (a big expense and a big environmental impact considering the US lifestyle).
No Pain, No Gain – Lots of Pain for Now
For as much as I believe this will be good for the economy in the end, there is pain right now. Banks are suffering. Real Estate prices get depressed every time someone is evicted and the home is sold quick. Real Estate prices get further depressed when there are no buyers for the McMansion that was built just a couple of years ago, and they get even more depressed when the big builders still have inventory that wasn’t bought by those who thought that could buy. It is also hard for the millions of people who work in construction (I am sure the cost of finishing a basement will ease down now that not too many people will build new houses).
Then there is a scared stock market. People who do not know how this will affect everything else. Will big banks get impacted? What about consumer confidence and spending habits? Higher taxes to pay for all of those unemployed and soon-to-be un-housed people?
And there is also the issue about the once-all-mighty dollar. The world hates the USA, and Mr. Bush. But for as much as they hate the USA and its leaders, they trust the USA economy. They trust that Americans pay their bills on time – and they have done so a lot better than most people in the world. They believe that the word (promise to pay) of an “American” is as good as gold – that is why for too many years the US dollar was favored to metals, until recently. The Chinese government have been buying US Mortgage Backed bonds from US Banks. For every dollar you buy in cheap clothing, they just send it back so that we can buy a house here (for as long as we send them the title to your homestead to China). If the Chinese (or any other government or foreign investor) doesn’t have anything else to do now with the excess dollars they have in their pocket, what will they use them for? (it may depress the value of the once-all-mighty dollar).
Lots of things to consider about Sub-Prime Lending. And lots to learn from it.
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