Thoughts on Subprime - Somewhat Disjointed?

Recently, a number of my colleagues have contacted me about the sub-prime issue. I've directed them to my posts of December 6, November 21, and November 27 because they all contained some interesting links that could provide some insights to their discussions and debates. Then, probably because it's been on my mind, I find a number of items that relate to the topic. They appear disjointed and unrelated, but somehow they fit together for me.

The first was a post by Arnold Kling on TCS Daily that appeared yesterday (December 11). Arnold expresses concerns about the current state of the housing market. Specifically, he mentions how the link between income and housing prices got out of whack, with one source talking about people with no money down being okayed to purchase houses with prices equivalent to 10 times income -- rule of thumb is somewhere between three and four, and Arnold actually suggests six, which I personally wouldn't find comfortable.

He further explains that as long as that ratio is allowed to stand, the housing market cannot correct. Another way he explains it is that allowing buyers to remain in a transaction they cannot afford postpones the downward correction needed to bring housing prices closer to equilibrium - the point at which the quantity supplied (see current inventory of unsold homes) meets quantity demanded. He concludes that the political desire to keep people in homes that they cannot realistically afford (see planned freeze of ARMs on sub-prime mortgages) does not solve the crisis.

Jump to the second item. Today's issue of The Wall Street Journal has article titled "Mortgage Pain Hits Prudent Borrowers". The authors note that part of the fallout of the sub-prime mess is that lenders (Fannie Mae and Freddie Mac) are now adding fees to new loans, effectively raising the price of mortgages, even if the borrower has good credit and meeting what one hopes are more stringent requirements. This article caught my eye largely because in a class I'm teaching, the rescue plan on current mortgages came up as an example of an effective or binding price ceiling.

My thinking was that by freezing the rates below market, one would essentially create a shortage of funds for mortgages. This is why many critics feel that the proposed rescue plan would not solve the current "credit crunch." Demand would be higher than would be expected in market equilibrium, as current mortgage holders would have no incentive to get out of a mortgage that may be inappropriate. And the supply of loanable would be lower than would be expected in market equilibrium as lenders would be unwilling to lend unless they could receive proper compensation - maybe in the form of additional fees. Take this further by shifting losses in one sector to a potential profit-generating sector. As the article points out, the prudent borrowers are paying the cost of less prudent borrowing and/or lending.

This takes us to the third item. One thing I do when I read is keep a journal of passages that seem to speak to me, providing insights into personal circumstances, historical events, or economic principles among other things. A few years ago, I read Umberto Eco's Foucalt's Pendulum. I find that any of Eco's books contain ideas that are thought-provoking. But as I thought about sub-prime, something motivated me to check out my journal, and I ran across the following passage:

"Take stock-market crashes. They happen because each individual makes a wrong move, and all the wrong moves put together create panic. Then whoever lacks steady nerves asks himself: Who's behind this plot, who's benefiting? He has to find an enemy, a plotter, or it will be, God forbid, his fault."

Now, while we're not talking about stock-market crashes, I think the quote is relevant because the sub-prime situation is one of our own making. There were wrong moves made by everyone: borrowers, lenders, government. Many of the parties were motivated by good intentions (there's road paved by them, somewhere), and others were motivated by greed, and others were just plain uninformed or wanted to believe there was such a thing as a "free lunch." (This takes us back to Arnold Kling's initial thought that people who were borrowing the equivalent of 10 times income should perhaps have known better.) Regardless, the proposed rescue plan is an attempt to shift blame. The finger-pointing is our attempt to find the "plot" and the "plotter". As Eco implies, the last thing we want is to realize it's our own fault.

I would think that had we as a nation done a better job providing our young people with economic and financial education, some of this could have been avoided. As I often tell my students, when you see a problem, point at what you believe to be the source of the problem, then realize three other fingers point back at you.

I look forward to your comments.