What went wrong: Subprime lending

This post is for those who still feel they couldn’t quite answer the question, “What went wrong with our economy?” It looks at one aspect of the problem, subprime lending.

The economy essentially has two levels – the real and the nominal. The real level is the production of real (actual) goods and services. The nominal level is the one that concerns money – its creation, use and exchange. (To help connect nominal with money, remember that money comes in denominations.) 

The real level and the nominal level interact, of course, whenever you use money to buy a real good or service. So, to sum, the two different levels of the economy are distinct, but connected. (In other words, the economy could operate with only the real level; we would just exchange goods and services for other goods and services – a barter economy.) 

So, what went wrong? To answer that, remember that there is one primary way to make money on the nominal level – that is, to make money with money: Lending. If you have money that someone else wants, you lend it to her for a fee. Say you want to buy a home. You go to the bank, take out a loan, agree to pay it back, plus interest, and this exchange is entirely on the nominal level. 

So far, so simple, right? Now imagine that you want to buy a home, but you have no money of your own, you make a very small income and you have terrible credit. The bank should probably pass you over for that loan, right? With the advent of so-called subprime lending (subprime, because you’re far riskier than the prime borrowing candidate), the bank doesn’t say no, thanks. Instead, it gives you this very risky loan for a very high interest rate. (The loan is risky because there is a good chance you’ll never pay it back and the bank will lose lots of money.) On top of that, hidden way down in the fine print of your contract, it says that the bank can double or triple your interest rate on a moment’s notice, making it that much harder ever to pay back the original loan. 

Why is the bank willing to take this risk? Because it’s going to turn around and sell this loan right away to a different bank, one that specializes in risky mortgages. In theory, if the second bank buys 200 of these bad loans at a time, there is a good chance that only a few of them will “go bad” and the bank has made money overall. In fact, as soon as it gets these bundles of mortgages, it calls them assets on the expectation that they’re going to pay money. Since it has all these “assets,” it starts loaning them to sound businesses and credible home buyers. Do you see the problem? 

For the last 7 years, banks have been making millions of these loans, packaging them together into bundles (securitizations) and selling them to third parties all over the market. Hence, the problematic loans are everywhere. If they started failing en masse, they would infect everyone. 

Well, they did. The market decided we’d built too many homes and so their prices started falling. Suddenly you, with your low income and no money, are stuck with a mortgage of $500,000 and a house worth $350,000. Sucks, right? What do you do? You declare bankruptcy, walk away and default on your loan. Problem is, about eight million people have done that now, and these huge bundles of mortgages are defaulting all over the economy.

 Now, all those third-party banks that called the risky bundles assets and made loans against them have no collateral. Suddenly, these huge banks (read: Bear Stearns, Lehman Brothers, Citigroup, AIG) are insolvent and nobody trusts them. Since nobody trusts them, no businesses or individuals are taking out loans. Without short- and long-term loans, the economy doesn’t have the cash it needs to operate. Day to day functioning of the economy grinds to a halt because we no longer know how to operate on the real level alone.

This lack of efficiency results in massive job loss, falling share prices, a non-competitive dollar – a recession. Until we collectively regain confidence in the banking system and start making and taking (sound) loans, our economy will continue to recess.

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3 thoughts on “What went wrong: Subprime lending

  1. Pingback: Being Smart and Efficient on the Stimulus and Careers « Blogal Views

  2. Pingback: Being Smart and Efficient on the Stimulus and My Career « Solutionaries

  3. There’s a few things left out here. If you’re in a nerdy mood, I’d recommend reading some of the material by the late Doris Dungey at the Compendium of Posts at http://www.calculatedriskblog.com/2008/12/in-memoriam-doris-tanta-dungey.html

    1- When Clinton changed tax laws to let part of a house sale be treated tax-free instead of as a long term capital gain ( I guess one theory is that a house isn’t an investment, it’s a home) it had the paradoxical effect of starting a housing investment boom (where homes became investments). It started off slow in 1996, and built to a frenzy in 2005.

    2- There was a lot of mortgage fraud. Mortgage brokers encouraging applicants to wink-wink lie on the applications; or outright misleading them. Telling them that an adjustable rate (which would explode in their faces because they coult not pay the real rate) was their only option.

    3- Housing bubbles happen. There’s a few metrics for how much houses should sell for– one is a multiple of income; another is a multiple of rent. By both standards, prices were at unsustainable highs. These current prices are too high for new buyers. At some point, the logic snaps, and renters decide they can save up quicker by staying renters (even before housing prices start going down). And when prices go down, renters definitely decide not to buy.

    There are othe rfactors. Much to learn from reading Tanta– she was an early courageous voice pointing out the insanity of all this– a James Hansen of the housing bubble.

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