Falling Angels
Tanta at Calculated Risk has an interesting (but very long) post about the nature of “subprime” lending. A central idea is that, before the recent lending boom, subprime borrowers were essentially just prime borrowers whose credit had gone sour – typically people with mortgages who needed to borrow more money to keep making the payments on their existing mortgages. The availability of “traditional” subprime loans often allowed them to avoid default on their original mortgages, which kept those mortgages in the “prime” category. The increased availability of subprime credit in recent years has thus helped keep down default rates on prime loans. But now that subprime credit has dried up, the prime loans are going to start looking worse than ever: potential defaulters that would, in the past, have been caught by the subprime safety net, will now become actual defaulters.
It occurs to me that there is an imperfect but perhaps useful analogy to be drawn with the junk bond market in 1980s. Prior to the 1980s, “junk bonds” were almost all “fallen angels” – bonds that had been considered investment grade at the time they were issued but which had been downgraded. During the 1980s, through the efforts of Michael Milken and others, it became acceptable to issue bonds with low ratings, and the junk bond market as we now know it was born. As I recall, the junk bond market fell into disarray in 1990, but it eventually recovered, Michael Milken got out of jail, and “high-yield bonds” are now a permanent niche within the investment world.
Tanta is not so optimistic about the future of subprime lending for original purchases (analogous to the type of junk bond issuance that became popular in the 1980s). She seems to regard that type of subprime lending as an inherently bad idea. On the other hand, she sees the “fallen angel” type of subprime lending as being critically important, and she argues that (particularly given the type of positive feedback that occurs in the housing market) most prime borrowers are in danger of falling from grace: “We are all subprime now.”
It occurs to me that there is an imperfect but perhaps useful analogy to be drawn with the junk bond market in 1980s. Prior to the 1980s, “junk bonds” were almost all “fallen angels” – bonds that had been considered investment grade at the time they were issued but which had been downgraded. During the 1980s, through the efforts of Michael Milken and others, it became acceptable to issue bonds with low ratings, and the junk bond market as we now know it was born. As I recall, the junk bond market fell into disarray in 1990, but it eventually recovered, Michael Milken got out of jail, and “high-yield bonds” are now a permanent niche within the investment world.
Tanta is not so optimistic about the future of subprime lending for original purchases (analogous to the type of junk bond issuance that became popular in the 1980s). She seems to regard that type of subprime lending as an inherently bad idea. On the other hand, she sees the “fallen angel” type of subprime lending as being critically important, and she argues that (particularly given the type of positive feedback that occurs in the housing market) most prime borrowers are in danger of falling from grace: “We are all subprime now.”
posted by knzn at 11/26/2007 06:05:00 PM
4 Comments:
I agree.
So then the subprime loans allowed an already overheated market to overheat even more, leading to a crash that rectifies years of reckless lending and unjustified housing price inflation.
In addition, many borrowers entered a market they could not afford, and others used an illusionary safety net to finance expenditures they could not afford (possibly uninsured health costs).
Clearly, regulation is in order here. The vast majority of people, and particularly vulnerable low-income households, do not understand long-term financial impacts of complex mortgage instruments.
I've been pushing the idea though that the supply side of the subprime is an example of misuse of limited liability status. Subprime lenders were MEANT to go broke, their main purpose was to push the price of land up so that the volume of prime mortgages increased. If you like, it is a (limited) loss leader for mainstream lenders. Why else would people invest good money in such a stupid business plan. (HEY DUDE LETS GIVE MONEY TO PEOPLE WHO CAN'T POSSIBLY PAY IT BACK! UH, UH GREAT IDEA BOSS?)
From what I read, it seems to me that the subprime pushers and the subprime backers were two different sets of people. The pushers got their commissions, and the instruments they or their bosses peddled to backers were mixed instruments with good and bad mortgages in them. The backers did not quite see through what they were backing (too busy managing or spending their billions) and the pushers and their bosses got their commissions.
As for the "little people", it's another story, and hopefully the federal government will do something to help them as was advocated in the NYT today.
natanal - that was part of it, but eventually the shit was going to hit the fan, and you still have costs and your original modest investment. But in the mean time you sure did push up morgage debt! Writing off that limited investment would pay off handsomely if you were a mainstream lender.
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