The word subprime is hitting world headlines today, as the cause of a global stock market “correction”. I subscribe to various news feeds related to economics, including those belonging to authors Tim Harford (FT), Bob Sutton, and the authors of Freakonomics., so I’ve been hearing the rumblings for some time now. Business Week did a very good article on it, back in March, which is online here. I’d like to give my take on the situation, which should be prefaced with the standard “I Am Not An Economist” disclaimer.
A subprime lender is a financial institution that offers loans to debtors who have poor credit records. They might not use the word subprime here in Europe, but we have them too: the kinds of companies that put ads on cable TV, offering credit to people who have been turned away by banks. These are people who need credit more than most: you get a poor credit record because you took out too much credit in the past, since “too much” is defined as the amount that you can’t pay back.
Unforeseen circumstances can turn a comfortable financial situation nasty, so it’s normal to have insurance of different kinds, to “smooth out” the financial impact of unforeseen events. In the USA, however, many poorer people have been hit hard by disasters such as Hurricane Katrina and the flooding of New Orleans, and can not afford health insurance in particular. The federal Medicare scheme is inadequate, covering only the very poorest, and a middle class family can be bankrupted by a single car crash, even if they have health insurance.
The result is that you have more subprime borrowers than before, and subprime lenders are created to cater to them. The added risk to the lender is handled primarily through the application of higher interest rates, which is a double-edged sword: those who pay higher interest are those who can least afford it, meaning they are at even higher risk of defaulting on their subprime loans.
If a loan is secured on property – a standard subprime loan requirement – the bank can foreclose on the property, leaving the lender out on the street. This is not a theoretical exaggeration: in the poorer parts of the USA, it is happening with disappointing regularity, and the frequency is growing.
Why, then, is the crisis in subprime lending having such a global impact? The most direct effect is due to the fact that the subprime lenders re-sell the loans (or derivatives) to other financial institutions, including some in the Far East and Europe. The third-party exposure is limited, however: to quote the Business Week article, “the buyers of the loans started exercising their right to sell the bad ones back to the lenders at face value. The true value of these delinquent or foreclosed loans was far less than face value, but the lenders were forced to swallow the difference.”
In other words, the subprime lenders are carrying the can. Even if they can foreclose, the debtors often have bankruptcy protection, and the lenders lose money in the foreclosure process, rarely getting back the full loan value.
Indirectly, people in financial distress are a relative burden on an economy, simply due to their reduced standard of living. Property prices are being affected, with lenders making less on foreclosure, and less on new mortgages. On a wider scale, property prices and mortgage lending are key economic indicators, and the indicators in the USA are not good; the property bubble, that got a lot of mortgagees in to trouble in the first place, is deflating. This is similar to what happened in the UK in the early Nineties: they called it Negative Equity.
Is there a point to this rant? If so, it is this: people are not following economic fundamentals such as avoiding the “penny wise, pound foolish” trap. I know Americans who can take pride in fine-tuning their 401(k) accounts to extract a few hundreds more per annum, but they bend over backwards to acquire property they can not afford. That means taking on debt they struggle to service at current interest rates, and interest rates are rising. My current employer’s headquarters are in Silicon Valley near San Francisco, like many hi-tech employers. and property prices in the Bay Area are frankly insane. Do you think they got that way by accident?
I was quite fortunate, years ago, when I first started work and had to learn a little about banking. I was told that your mortgage should be about 3x your earnings; perhaps 4X. I didn’t buy any property then, and have not done so since, even though I might have got a mortgage; it would have violated that rule on a couple of technicalities. For starters, the rule is based on your earnings now, not what you might have next year or what you think you’re worth, and it assumes a stable income. When I was in the UK from 1991-99, I could have bought property outside London, but I could not count on a stable income. In Ireland, from 2000-7, I’ve had a stable income but I’ve been constrained to living in Dublin, where the average property has gone from around 6x the average salary to over 11x.
Most importantly: I’ve always been aware that a financial institution always makes money from you: that is why they exist. They are not charities – no, not even Islamic banks – and they have shareholders who expect dividends. Whatever the financial product, whether you’re investing or borrowing, a cursory glance at the terms and conditions should serve to confirm this.
For example, if you take out a loan or mortgage, but your financial circumstances improve to the point that you could close it off early, beware of early redemption fees. These are to compensate the lender for interest that you would not be paying in the future, when you no longer owe them money. It is also true of fixed-term investments: the interest you are offered is based on the value the investment company gains from having your money for that long – which is why long-term investments pay better interest that short-term.
A loan shark takes big bites out of your pocket, charging onerous rates of interest in the short term. A financial institution is more subtle, but not so subtle that you can shrug off the pain every time they take a bite out of your account. Hence the title of this post: lots of smaller bites can be as fatal as a single large one.