Random Thoughts on the Subprime Mess
By Arnold Kling
First, I really enjoyed the Youtube posted on Greg Mankiw’s blog. Warning: contains a racial reference that is unnecessary and, in my opinion, offensive.
The story is all over today’s Washington Post. Citing a source called the Center for Responsible Lending, they say that there are 7.2 million families who have a subprime mortgage, 1.8 million with interest rates that reset in 2007 or 2008, a total value of $1.3 trillion, with 14 percent now in default and ultimately 20 percent of the loans originated in 2005 and 2006 expected to go into foreclosure.
The front page of the Post says that Treasury Secretary Paulson’s plan to freeze interest rates on these mortgages is on a fast track. Another story in the business section gives an example of a Florida government money-market fund that is temporarily illiquid because it is stuck holding some securities backed by subprime loans.
My instinct is to tell the markets to just suck it up and deal with the losses. With that approach, I hope that the worst will be behind us by 2009.
To me, the main problem is to get back to equilibrium in terms of house prices. My fear is that the interest-rate freeze and other bailouts will serve merely to drag the problem out for years.
The sooner we put the foreclosures behind us and get to a market equilibrium in house prices, the sooner the mortgage market will be liquid again. At least, that’s my way of looking at it. Obviously, I am in the minority.
UPDATE: Some useful data at Calculated Risk on the percentage of mortgages with negative equity, meaning that the amount of the outstanding loan is higher than the value of the home. A small amount of negative equity is a necessary but not a sufficient condition for a borrower to default. With positive equity, you sell rather than give the home to the lender. With negative equity, though, you’re still better off not going through foreclosure and eviction if you can help it.
But repeat that the key is to get as quickly as possible to an equilibrium in home prices, so that everybody knows where they stand. The talk of bailouts does not help matters.