November 26, 2007

Suffer the Subprimers

For all but the most blissfully unaware of readers, the current brouhaha in the financial markets stemming largely from the continuing collapse of the subprime mortgage market should not be news. Markets first seized up this summer following stagnating house prices across the country and higher than expected defaults. Since then, much blood has been let: several companies that were major originators of such mortgages have gone belly up;¹ thousands of jobs have been (or are soon to be) cut;² and in the last month or so, two CEOs of large (investment) banks (Stan O'Neal, Merrill Lynch; and Charles Prince, Citigroup) have been pushed out amidst historical writedowns associated with subprime losses.

With shit hitting the fan so fast and so hard, it seems nothing—perhaps not even the U.S. economy at large—will come out unsullied.³ As with any mess of this proportion, our faithful representatives in Washington D.C. have only recently arrived upon the scene, mostly to point fingers at one other ex post facto, or, in the alternative, at evil-doers of one sort or another. And almost without fail, their solution has been to punish corporations that made such loans, and force those who hold the debt now to alleviate the stress on homeowners. An article in today's Wall Street Journal highlights pressure exerted upon one such company (Citi) to help out borrowers facing large and untenable interest rate resets, and thus, a rather significant risk of losing their homes. For some reason, very few people seem to be concentrating on the misdeeds of the borrowers rather than those who gave them the money; at the risk of sounding like the unsympathetic bastard that I likely am, I will take up this position that no one seems willing to defend.

First, let me just note that I am not being a corporate apologist here. Surely, in a $6.5 trillion market, there must have been many cases of sleazy mortgage bankers with Hitler-esque moustaches brushing their greasy hair as they lured (with the prospect of home ownership) yet another unsuspecting, uneducated, dimwitted, or perhaps simply inexperienced individual into tarpit of life-ruining bankruptcy. And without doubt, these assholes (and the companies that employed them) deserved what they got when their egregious behavior finally caught up to them. Equally deserving of the blame are the investment banks and hedge funds that fueled this mess: without financial innovations such as CDOs (collateralized debt obligations), greedy investors looking for too-good-to-be-true returns, and off-the-balance-sheet voodoo like SIVs (structured investment vehicles), those sleazy moustachioed mortgage bankers would likely never have made particularly unjustifiable loans in the first place. But just because all those people are to blame, does not mean that the people who took those loans and bought those homes should be indemnified.

On the contrary, if there is one fundamentally blameworthy party here, it is the individuals who, against most notions of sound financial advice, chose to overextend themselves in the first place. The moustachioed bankers could push all predatory lending products they wanted, and the Excel jockeys in New York could try to slice and dice risk to their hearts content, but unless someone signed a loan, all would have been for naught. Reading that Journal article, I felt nary an ounce of sympathy for the people facing looming financial crises. A $385,000 loan on an annual salary of $35,000, with no money down? Are you [insert expletive of choice] kidding me? It does not take a degree in finance to know that set up is a recipe for disaster.

Lest I sound too unsympathetic, let us see if we can divide the borrowers who compose the bulk of subprime woes. As I see it, there are two categories: (1) folks with lower incomes that had otherwise been priced out of expensive markets such as California and New York (and for whom subprime loans were initially targeted in the first place); and (2) greedy assholes using subprime loans to purchase second or even third investment properties and hoping to turn a quick buck in a rising market sustained by interest rates held too low for too long.

I think most of us can agree that the latter category deserves no sympathy, and certainly no help from the government. What those individuals did was not wrong, at least from a rational self-interest, economic perspective: they saw an arbitrage opportunity, and they followed through. But the other side of that coin necessarily means that when shit hits the fan, that they lose—often big. Their actions had several negative consequences, including (but not limited to) inflating house prices to levels virtually unreachable by even wealthy individuals, and essentially pricing out more risk-averse individuals unwilling to bet their financial life on housing prices rising with something like an interest-only loan. To bail them out now would not only defy sound economics, but also fly in the face of all that is just. No one was complaining when these same people were flipping houses at profit margins nearing (or exceeding) 100%. No one should be complaining now.

The former category of individuals is more difficult to dismiss outright. People in this category are likely to be ones providing fodder for contemporary rags to riches stories, i.e., the hardworking folks just trying to earn a decent buck and provide for their families finally getting a chance to own their own home. That makes for a nice story, and certainly, sympathetic poster children for government bailouts. But ultimately, the American dream is nothing more than an American fallacy—and a cruel one at that. The basic economic reality of the situation is that were it not for the subprime-fueled decadence in the past few years, these folks would not—could not—have afforded homes in the markets in which they live. The only reason it worked out thus far was because someone else was assuming the substantial risk premium associated with their debt; now that those people have finally come to their senses and pulled out, there is no reason that the government, i.e., us as taxpayers, should come in and fill the void. It is neither a sound investment, nor an effective policy.

While this discussion might sound both unsympathetic and perhaps cursory, I think that the basic point I have made should resonate with most people. This is the system in which we live, and sometimes you win, sometimes you lose. It is hardly possible for some to win, but no one to lose; that just means everyone loses in the long run. That system was already tried. It failed. Better dead than red!⁴

^ ¹ The most prominent of such companies to collapse is New Century Financial Corp. of Irvine, Calif.
^ ² For example, Countrywide reported in September that it may cut as many as 12,000 jobs.
^ ³ For a discussion of a potential forthcoming recession, see this article.
^ ⁴ Speaking of reds, this week is Big Game week. Go Bears! Beat Stanfurd!