by Michael Nachbar | When high-risk lending goes bad.
This summer, the word “subprime” became associated with the latest crisis to strike the US economy. Subprime loans, offered to people with poor credit or low income who would not qualify for standard loans, have higher interest rates to reflect the higher risk of borrowers unable to pay back the loan. Nearly one-fourth of American homeowners use such loans when mortgaging their houses. Most subprime mortgages are offered with adjustable rates, in which the interest rate of the loan is adjusted periodically to reflect the current national rate.
A variety of factors prompted the crash in the subprime market. Housing prices in America, especially in California, the southwest, and big cities on the east coast had risen astronomically. In addition, the Federal Reserve raised interest rates from as low as 1 percent in 2004 to 5.25 percent to curb inflation. These increased interest rates caused the rates of adjustable rate subprime loans to rise as well, making it more difficult for borrowers to make payments. Many Americans had responded to the rise in the values of their homes by taking out second mortgages, borrowing using their homes as collateral in order to possess more disposable income. When housing prices began to decline as a number of homeowners unable to make payments began to sell, creating a buyer’s market, those borrowing against their homes discovered that the wealth they achieved from the housing boom had vanished.
As a result of the large number of unpaid loans, many loan companies that offered subprime loans filed for bankruptcy or faced declining stock prices. Many hedge funds financed by subprime loans faced bankruptcy as well. The stock market suffered a sharp decline that has since stabilized, but house prices and the relative worth of the dollar continue to fall.
Democratic presidential candidates Chris Dodd and John Edwards have spun the subprime crisis into a populist struggle, caused by predatory lenders manipulating poor Americans into taking out dangerous loans. This stance fails to reflect the reality of the situation. Subprime loans make owning a home a possibility for many Americans who could not receive credit otherwise. Many do not have the resources to pay for the house when they apply for the loan, but work on the presumption that they will find a greater source of income in the future. There is tremendous risk in such a decision, but Americans deserve the right to take that risk and to suffer the consequences if they cannot pay. Suggesting that we should create laws to prevent poor Americans from voluntarily entering agreements deemed too risky by politicians insults their intelligence and restricts their freedom.
More significantly, labeling the companies who offered the subprime loans in question “predatory” makes the inaccurate assertion that they profited from the crisis, when in fact the exact opposite occurred. As previously stated, many subprime lenders faced bankruptcy and most lending companies have significantly trimmed their subprime departments, facing pressure from investors who no longer trust the high-risk field. These lenders belong in the same category as borrowers who defaulted—risk-takers who crapped out.
The crisis brings to light the issue of personal responsibility that consumers themselves, not politicians, must face. Following the massive economic growth in the 90’s, many have assumed that their wealth would continue to grow and have lived beyond their means through credit cards, second mortgages and other forms of high-interest credit. Americans must realize that while the economy should grow in the long-term, they must prepare for shocks along the way and save money accordingly. With the staggering amount of debt held by American consumers, a recession could prove disastrous with many so ill-prepared. Hopefully, this subprime crisis can serve as a wake-up call and increase responsibility both on the consumer side, as people become more aware of the dangers of high interest loans, and on the business side, as lenders become more wary of offering high-risk loans. The elimination of many subprime lenders and subprime sections of banks signifies the realization of the latter, but American consumers still must learn to manage their finances responsibly.
The US is currently saving money well below the golden rate, an economically derived measure of the ideal percentage of the GDP that should be invested. The current high interest rates reward those willing to forsake immediate luxury and allow their money to work for them. As housing prices fall beyond their once-inflated levels, those prudent enough to save money will have the opportunity to purchase discounted houses, whose values will appreciate once lowered housing costs begin to spur demand. For America to permanently avoid the recession that she appears to have barely avoided with the subprime crisis, her citizens must recognize the benefits that come with financial responsibility.
Mr. Nachbar is a junior majoring in Quantitative Economics.