Subprime loans played a major role in the market meltdown that plunged us all into the Great Recession. Now that kind of lending is coming back. Should that worry us?
In finance, “prime” usually refers to an interest rate. It is defined, somewhat loosely, as the rate that a bank charges on a commercial loan to its best customer — that is, the customer presenting the least risk.
We might expect subprime to mean a rate lower than prime, just as sub-flooring is under the floor. Subprime, though, is usually associated with a higher-than-prime interest rate.
The reason for the language mix-up is that at its heart, the prime rate is a measurement of risk. Subprime, then, refers to loans made at higher rates to reflect the increased risk presented by the borrower.
In the runup to the crash, the big numbers in subprime loans were in the home mortgage market, which is normally a sleepy affair with rates too slow-moving to satisfy restless investors and market thrillseekers.
The economics behind the subprime lending spree that triggered our recession involved a housing bubble, and the low prevailing interest rate policy that was attempting to boost economic activity and jobs.
What it did encourage was people’s search for a higher rate of return on their savings. And that brought out the salespeople who would provide just that — and in the usually staid, “safe” market of home mortgages.
At ground level, individuals and families were being encouraged to purchase homes that they could not afford the payments on. This only made any sense if the market value of the home increased rapidly enough to provide equity that, when converted into cash, could be used to make the payments.
The fragility of this arrangement was concealed from all but the most careful investors by using incomplete buyer financial statements (low documentation, or “Lo Doc” and “No Doc”) loans. These looked normal only when the details were obscured as was the case when the loans were bundled up (“securitized”). At that point, since the securities were sold by reputable firms, everything looked safe … and better than watching your savings be eroded by inflation while they sat in a bank savings account.
Still, to those economists who worry over portents of doom, the re-emergence of subprime lending in our financial markets did nothing to dispel their concerns. The memories of the 2007-2009 meltdown and recession are still too fresh to ignore.
There is a very cynical Wall Street saying that goes “It’s different this time” — which mocks sales pitches that are supposed to allay the fears of any timid investors who are concerned about history repeating itself.
The truth is, there really are some significant differences in current subprime lending from the mortgage debacle that brought down our economy.
The first is pure size. Current sub-prime lending is pretty much limited to automobile loans, and this is much smaller, in dollar terms, than the home mortgage share of our economy.
Size, though, is only part of the picture. The size of the subprime portion of mortgage-backed securities on the market should not, by itself, have been enough to bring our financial system to its knees. What analysts missed, though, were two things: the extent to which financial firms, including banks, had leveraged themselves to increase profits; and the psychological effects of a highly visible marketplace failure.
Some things, like economic fundamentals, don’t change much, if at all, from decade to decade. The emergence of subprime lending and its securitization tells us that the automobile industry is running out of effective demand — that is, individuals who not only want a new car but have the money to buy it. This is what happened in the housing bubble, too.
Subprime loans are a fragile market device that recalls the words of legendary Texas football coach, Darrell Royal, describing the forward pass: “Only three things can happen, and two of them are bad.” Just ask Uber about its subprime lending program for potential drivers. Uber is terminating the lending program, which is being described by some as “disastrous” and suffering “massive losses.” Both terms are probably understatements.
Should we be worried about the return of subprime lending? Despite the apparent investor appetite for securitized subprime loans, it is probably safe for now to leave the serious worrying to the professionals. Investors should be cautious, surely, and the public should be concerned enough to make sure that subprime lending is being measured and managed properly by regulators.
Metrics are important. “If you can’t measure it, you can’t manage it,” Peter Drucker once wrote. The existing metrics on subprime lending are still inadequate to that task, and we need to do better.
James McCusker is a Bothell economist, educator and consultant.