Subprime myths: What Washington gets wrong

By U.S. News & World Report

The party's over, the hangover hurts and woozy consumers are finally asking, "What the heck just happened?"

With 2 million home foreclosures possible over the next two years and the economy stumbling toward recession, it's clear that Washington will enact new reforms meant to curtail reckless lending, attach big-print disclaimers to risky securities and prevent any more self-triggered implosions in the financial markets.

The Federal Reserve has already engineered one Wall Street bailout, something it may have to do again. Congress, the Treasury Department and other regulators are proposing dozens of new rules.

Some of them might work.

But we're not at the end of the housing crash or the economic downturn -- we're still in the middle, where vision is much worse than 20/20. That means politicians and regulators could end up imposing solutions before they even fully understand the problem.

Here are some of the misconceptions that seem to be emerging, as we all try to figure out what happened and how to fix it:

Subprime loans are inherently bad. Subprime is now one of those ignominious words, like Watergate or steroids, that have been tainted mainly through misuse. While there's no precise definition, subprime loans are typically those made to higher-risk borrowers with a credit history that makes them more likely than others to default on the loan.

It's no surprise that foreclosure rates on subprime loans are higher -- the risks of default are higher, so by definition there are more defaults. The fundamental problem isn't the foreclosure rate; it's that the loans have been priced too low. The interest rates and upfront costs imposed on borrowers haven't been high enough to cover the overall risks of default.

Mortgages that require no down payment are one kind of underpriced loan. Another are loans with deceptively low "teaser rates" that seem like a bargain for a year or two, then rise dramatically. In a Wonderland market where home prices forever rose by 8% or more per year, sure, those kinds of loans might make sense, because many borrowers would cash in the moment their homes appreciated. But, as we know, the Wonderland market has now crash-landed.

Lenders thought they had this all figured out, thanks to a detailed credit-rating system and sophisticated risk-assessment software. That's one big reason the face value of subprime loans surged by about 1,700% between 1994 and 2006: Lenders wanted the higher returns and thought they had the risk covered. Turns out there was a bug in the program.

As the whole mortgage mess comes unraveled and regulators consider new rules, poor lending standards -- not the availability of subprime loans -- seem to be the weak link in the chain. Subprime loans let consumers with low incomes (or limited access to credit) buy homes they couldn't get otherwise -- as long as they're willing to pay the extra margin that covers the higher risk of foreclosure.

"Congress should not aim for foreclosure rates of zero," says James Barth, an economist with the nonprofit Milken Institute. "It's OK to have risky loans, but the rates have to be higher."

Low interest rates are always good. If you're buying a house, you want a mortgage rate that's as low as possible. But low rates aren't necessarily the best thing for the overall economy. Economists often warn about "overheating," a dangerous byproduct of low rates -- and now we're living in a real-life case study that reveals what overheating is actually like.

Interest rates fell significantly between 2000 and 2004, largely because the Federal Reserve repeatedly cut its own short-term lending rates. That generated economic phenomena with long-term consequences. One was increased demand for assets like houses -- because the money to buy them was cheap and plentiful -- which in turn caused prices to rise at a pace that turned out to be unsustainable.

Then, as rates on conventional securities, such as Treasury bills, fell to paltry levels, investors began to demand new kinds of securities with higher returns. Subprime loans, bundled into complex mortgage-backed securities, fit the bill, and lenders began to solicit as many of them as they could find. No worries; the computers assured that the risk was perfectly manageable.

We're now paying a price for those years of cheap money, in the form of a burst housing bubble and a staggering economy. John Chapman of the American Enterprise Institute predicts "an era of unpleasant choices" characterized by widespread bankruptcies, layoffs and a longer recession than necessary.

Others aren't quite as gloomy, but most analysts agree that cheap money often comes with hidden costs that materialize down the road, one way or another.

Continued: Well-informed and rational

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