Who's to Blame and How Should We Fix the Subprime Meltdown?

Troubles in the subprime mortgage industry seem to be spreading. The stock market is in turmoil. Alan Greenspan and other economists say the economy is being hurt. Consumer groups predict that up to two million Americans will lose their homes.

Should the government do something?

A growing list of people say it should, from Democratic senators Christopher Dodd and Hillary Clinton to a string of advocates for the poor. Perhaps the money-losing lenders should be bailed out. Or maybe there should be help for hedge funds and other investors who have loaded up on securities backed by subprime loans. And there could be help for homeowners who can't handle their soaring monthly payments.

Not so fast, say Wharton faculty who have studied the mortgage market and past government bailouts. "I think that for the moment, they should probably leave it alone," says Joseph Gyourko, professor of real estate and finance at Wharton, warning that bailouts can make people more reckless in the future. "We don't want to introduce moral hazard .... We don't understand this very well right now, so any regulation is probably going to be wrong or imprecise."

In fact, he says, the market is already correcting the problem. Lenders have dramatically cut their offerings of the most hazardous products --such as loans that require no down payment or proof of the borrower's income, or those which allow borrowers to decide for themselves how much to pay each month.

Ken Thomas, a lecturer on finance at Wharton, argues that people and institutions that make risky choices are usually best left to suffer the consequences. "When we had the last big financial meltdown with stocks in 2001, did we consider bailing out those who lost money in the dot-com crash?" he asks. "We try to have markets regulate, not the government. Markets do a much better job."

A Rare "Perfect Storm"

Subprime loans, generally issued to borrowers who cannot qualify for ordinary "prime" mortgages because of low incomes or tarnished credit, carry special risks for all involved. Lenders face a greater risk that borrowers will default -- i.e., stop making monthly payments. Investors who buy bond-like securities based on baskets of subprime loans face the risk that defaults will cause their holdings' values to plunge. And, since most subprime loans have adjustable interest rates, borrowers face the risk that rising interest rates will cause their monthly payments to soar.

Rising rates have done just that. As a result, about 13% of subprime borrowers had fallen behind with their payments by the end of 2006, according to the Mortgage Bankers Association. That's up from just over 10% two years earlier, and it compares to 2.6% for prime loans. Because the number of subprime loans soared in 2005 and 2006, millions of loans could be affected. Some consumer groups say as many as two million homeowners face foreclosure.

About 20 subprime lenders have gone out of business, and others have announced billions in losses. Stocks in financial services firms have suffered, creating problems for the stock market in general.

Wharton real estate professor Todd Sinai describes the situation as a "perfect storm," given that three things had to happen for the subprime market to tank: Borrowers' incomes had to drop, interest rates had to rise and housing prices had to fall. "It is extremely rare that all three things happen," he says.

Dodd, chairman of the Senate Banking Committee, plans to introduce legislation to protect homeowners from foreclosure and to crack down on predatory lenders who pushed high-risk loans on unsuspecting borrowers. Clinton is pushing for a federally mandated "foreclosure timeout" that would give homeowners more time to catch up on their payments, and she wants to curtail the prepayment penalties that make it hard for troubled borrowers to refinance. The National Community Reinvestment Coalition wants the Federal Housing Administration to be given new power to refinance subprime borrowers' loans, and it wants the federal government to set up a fund for rescuing low-income homeowners.

But is the situation really bad enough to demand government intervention? "We just don't know," says Sinai. "Delinquency is a long way from default," he notes, arguing that many troubled borrowers may eventually get caught up without government help. In the past, he adds, lenders have typically preferred to help borrowers avoid foreclosure, often by re-negotiating loan terms. It is not certain that will happen this time, because over the past decade increasing numbers of loans have been passed to investors in mortgage-backed securities, potentially making lender-backed workouts more difficult. "I think a wait-and-see attitude is appropriate," he says.

The economic research firm FirstAmerican CoreLogic of Santa Anna, Cal., reported recently that the vast majority of homeowners with adjustable-rate loans will escape foreclosure. It forecast 1.1 million foreclosures but said they would be spread over six or seven years, long enough to leave the economy unharmed.

Steel, Planes and Cars

There is precedent for government intervention in financial crises.

In 1971, Congress passed the Emergency Loan Guarantee Act to enable Lockheed, the country's largest defense contractor, to receive $250 million in bank loans to avert bankruptcy. Lockheed had poured about $900 million into development of a new passenger liner, but had run into trouble when Rolls-Royce, the British engine supplier, failed. Lockheed was a classic case of a company considered "too big to fail" -- or, more accurately, too big to be allowed to fail. Bankruptcy might have cost 60,000 jobs, severely damaged the U.S. defense capability and had ripple effects in other industries, such as the airlines.

In 1980, automaker Chrysler demanded and received $1.5 billion in loan guarantees to avoid bankruptcy. Essentially, its outdated fleet of big cars could not compete in the era of compacts that followed the Arab oil crisis of the 1970s. Again, the company was thought to be too big and essential to the American economy to be allowed to fail.

To many, the most analogous situation to the current one was the $125 billion government bailout during the savings-and-loan crisis of the late 1980s and early 1990s. More than 1,000 of these institutions failed after deregulation allowed them to engage in risky lending practices and to invest in real estate. A major factor was rising interest rates, which led many depositors to move their money to better-paying money-market funds at other institutions, such as brokerages and mutual fund companies. Fraud and corruption contributed as well.

In that case, the government worried about the ripple effects on the economy and the millions of innocent depositors. Unlike the subprime borrowers, though, the S&L depositors had not chosen to make risky bets: They had merely put their money in the bank.

"I don't think they are comparable at all," Gyourko says, comparing the S&L crisis to the subprime meltdown. So far, only about 20 subprime lenders have failed. And because subprime loans are packed into mortgaged-backed securities and traded on the secondary market, losses will be diluted among investors worldwide rather than concentrated in the institutions that originated the loans.

 "You certainly do not want to bail out the lenders," Gyourko says, arguing that the marketplace will curb risky behavior on its own. "The markets are telling lenders, 'You know, if you issue loans like those again, it's going to be very, very costly.'"

Remember, Thomas adds, "banks are stronger than ever and have more capital than ever. Compared to past difficult periods, we have not had a serious bank failure since June 2004." That was the collapse of The Bank of Ephraim in Ephraim, Utah, with $46.4 million in assets.  It is not the government's role to tell lenders they should not offer risky products, he says. Most subprime borrowers are not in trouble, and many have been able to buy homes only because subprime loans were available. "The fact is that some of these same groups that are pushing [for restrictions on issuance of subprime loans] are the same groups that pushed banks to make more loans" to the poor, Thomas says.

Over the past two decades, the government has tended to take a less direct role in managing the economy and to instead encourage efficient markets through better disclosure of information, points out Anita Summers, emeritus professor of real estate at Wharton. This means, for example, that there are fewer trade tariffs, but also that consumers can get a lot more information about financial products, foods and drugs. "Industry is much more on its own," she notes.

The main lesson to be learned from the subprime crisis may be that borrowers need to know more about the risky products they are offered. "One of the things that's wrong here is the issue of full information," Summers says, adding that "every subprime lender should be required to have a statement of the particular terms that is unambiguous."

Thomas agrees: "I'm always in favor of better disclosure." Gyourko notes that "if there's any case for regulation, it's for better information for borrowers." New regulations, for example, could require that loan applicants be told in clearer terms exactly how their monthly payments will rise if prevailing interest rates go up.

Subprime lenders knew they faced risks with products such as interest-only mortgages, Sinai says. With a standard mortgage, part of every monthly payment reduces principal. As the loan balance shrinks and housing prices rise, the lender has a growing assurance the property can be sold in foreclosure for enough to cover the debt. But that is not the case when the borrower pays only interest.

Subprime lenders knew the risks they were taking, as did investors, such as hedge funds, that bought securities based on subprime loans, according to Sinai. Lenders' and investors' willingness to take on these risks was good for borrowers who might otherwise not have been able to get mortgages. But, he argues, there's no reason for government to bail out businesses that lost money on bets they took willingly.

Condo Flippers in Miami

Most proposals for remedies have focused on borrowers. Dodd and some consumer groups believe many borrowers were lured into subprime mortgages by predatory lenders who concealed the risks, and experts say subprime lenders often paid mortgage brokers commissions two or three times those on prime loans. Consequently, Dodd says he will introduce measures to curb predatory lending. He has yet to offer details.

And so far it is not clear how many subprime borrowers can truly be described as victims. "I think we don't know anything, other than anecdotally, what's happening in this particular episode," Sinai says, adding that some borrowers are people who could not have bought homes had they not had access to subprime loans. If they lose their homes, they will simply return to the ranks of renters. "So how much worse off are they?" Sinai asks. "Probably not a lot."

Other borrowers undoubtedly are speculators who were so overextended they could not get prime loans. Are people who chose to take huge, unnecessary risks, worthy of public sympathy and help? "Why not help those condo flippers in Miami, Vegas and elsewhere who are facing foreclosure for putting deposits on several units and seeing them blow up?" Thomas says. "Where do you draw the line?"

Some consumer groups are pushing for new rules requiring that lenders match borrowers only to those products that are suitable for them. A borrower with an income that is not likely to rise would thus not be given a loan that could require much larger monthly payments a couple of years down the road. This would be similar to the suitability standardsfor stock brokers and financial advisors. A broker, for example, can be suspended or barred from the business for pushing a retiree on a small fixed income to speculate in stock options or other high-risk investments.

But this might not work as well in the mortgage industry, says Jack Guttentag, emeritus professor of finance at Wharton. In a March 17 guest column in The Washington Post, he wrote: "What has made the suitability standard workable in the securities industry is that the short-term interest of brokers in selling unsuitable securities is usually overruled by their long-term interest in maintaining a roster of satisfied clients.... In the mortgage market, in contrast, client-oriented loan providers are the minority group." Most providers do not have long-term relationships with borrowers or count on repeat business, he wrote.

Better risk disclosure would be good, Sinai says, but borrowers are always going to be subjected to salesmanship: "I really think there is no way around the fact that when there is a competitive lending frenzy, loans are going to get made that are riskier than they are portrayed to be."

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