Heading off subprime woes

A next wave of potential foreclosures calls for both government and private-sector action.

from the September 6, 2007 edition

Interest rates are about to reset for an estimated 2.5 million holders of subprime mortgages. That will increase their monthly payments 30 to 50 percent. That may well set off a new wave of foreclosures, hurt credit markets again, perhaps increasing the risk of recession. Should government do something?

The answer lies in other questions (below).

But first, some background on those types of mortgages – about 14 percent of all mortgages. Subprimes are higher-interest loans that go to people who aren't "prime" buyers, those who have weak credit. Hence, the higher rates to compensate lenders for the risk (and the attraction to global financiers who bought these loans).

Who are these borrowers?

Some knowingly bought homes they couldn't afford. Some are speculators who "flipped" properties without living in them, hoping simply for quick profit. Some are people illegally misled by irresponsible lenders, especially independent mortgage brokers. And some are people who, with better information now, could get a new, affordable mortgage.

So what is government's role?

Buying property is a matter of individual responsibility. Like buying a car, a mutual fund, or a college education, it's up to the purchaser to find out about the product, understand the terms for buying it, and decide if it's affordable.

But product-sellers have responsibilities, too. If they lied to a subprime mortgage-holder or committed similar illegal acts, they can be sued, either by the buyer or perhaps by individual state governments. Often, lenders were simply acting unethically but not illegally, and both the industry and government must look at reforms to prevent such acts. One scenario involved a mortgage broker enticing a borrower with one rate, only to have it raised at closing. Many lenders also abandoned standard practices: They didn't ask for confirmation of buyer income; they didn't test for long-term affordability; they didn't include property tax and insurance payments.

This week, federal bank regulators urged the private sector to help troubled homeowners refinance and issued guidelines. Last week, President Bush made federal mortgage insurance available to about 80,000 borrowers. Congress is also considering a measure that would give $100 million to housing NGOs that can guide homeowners through refinancing.

Can worthy borrowers be helped?

It's not possible to cleanly sort the illegally duped from the unwise and speculative. But criteria can target them. For example, help should go to those living in their homes, to weed out speculators. It should go to people who have paid on time, but who stumbled at the interest-rate resets. It sounds cruel, but it should not go to those with negative equity (owing more than a house is worth) as that perpetuates unaffordability.

What can the private sector do?

Foreclosure is expensive and that should prompt lenders to help borrowers refinance. Turning "subprime" rates that people have been able to afford into a fixed rate is less profitable for lenders, but also less expensive than default.

Government has a nudging role. Fortunately, that's happening. Everyone has a stake in not letting this problem damage the economy.