Wealth of Nations March 2007

Wall Street's Housing-Market Makeover

Stock market declines have drawn attention to the housing market and especially to the condition of subprime mortgage lenders.

Never assume that stock markets are trying to tell you something. The short-term message of the markets is mostly just noise, whether stocks crash, soar, or coast. Financial markets in general, and equity markets in particular, have a well-documented tendency to under-react or overreact to news, and when they aren't doing that they are often reacting (so to speak) to no news at all. The notion that Wall Street is providing a deeply informed running commentary on the state of the economy is a plausible idea, and it would be so nice if it were true. It just happens to be empirically false. Stock markets go up, and then they go down. As they bounce around, that is about as much as you can say with any confidence.

That is a point worth bearing in mind when something dramatic happens, as it has in the past couple of weeks. Global stock markets have been hammered. The recent declines might very well mean nothing—but that doesn't mean they are useless. They can serve a purpose if they draw attention (albeit erratically and belatedly) to some uncomfortable realities. For the moment, they seem to be having that effect. The falls have drawn closer attention to the housing market, and especially to the condition of subprime mortgage lenders—banks and other institutions that have lent money to customers with poor credit. Whether the Dow Jones industrial average bounces back up over the coming weeks or keeps dropping, the problems in this part of the economy are real, and so are the broader risks that they pose. There has been too much complacency about them, and it is good that people are starting to pay more attention.

The subprime mortgage business has devoted the past couple of years to enlarging American households' appetite for debt—quite a challenge when you remember that the United States already had a very low personal savings rate by international standards. Unorthodox mortgage lending has played its part in pushing that rate down from about 2 percent during the first four years of this decade to between 0 and minus-2 percent since the second quarter of 2005.

Subprime lenders have not been content merely to lend to people with poor credit histories. They have pushed new kinds of loans in their direction as well: Option-ARMs, for instance. These are loans that start off with a low fixed interest rate and then after a year or two switch to a variable rate. A feature of this kind of loan can be that the principal grows during the first part of the term: It is called "negative amortization." The borrower is not paying down his debt, he is (perhaps without noticing) adding to it. And recall that he probably borrowed more than he could afford to in the first place. Ingenious.

But there seems to be no limit to the cleverness of subprime lenders when it comes to helping customers borrow more. Bolder innovations have included a loan that is amortized over 50 years (thus holding monthly repayments down) but that falls due in 30—so that at the end of the term, the mortgage is not paid off. The borrower has to refinance before that happens, or find the cash some other way. The finance firm that dreamed that one up, ResMAE, filed for bankruptcy last month.

Companies like ResMAE have opened up an entirely new terrain for innovation. One wonders where the frontier might lie. What could you get unsophisticated, weak-credit borrowers to swallow? How about a mortgage with zero monthly repayments over its entire term, up to the day it falls due? No, better, how about a mortgage that not only gives the borrower the traditional lump sum with which to buy a bigger house but also pays him $1,000 a month for the full term, to assist in defraying the expenses of living there. The only downside (see our full terms and conditions) is that when the loan falls due, the amount owed will likely be equal to the net worth not only of the borrower but also of all his descendants in perpetuity. But no problem. That's 30 years away—or let's make that 60 years away. You'll be very old! Or, if you're lucky, dead. If you feel you must, simply refinance at some point.

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