Wall Street and Borrowers with Low Credit Ratings Have Been Bad

Saturday, December 1, 2007

The article, “Wall St. Sees Silver Lining in Economy,” was published in the New York Times on December 1, 2007.

Statement from the article: “As Wall Street rallied this week, it seemed that investors were taking comfort in the notion that the economy had become so imperiled by the crumbling housing market that it was forcing the government to finally mount an aggressive rescue effort.”

My point of view: Wall Street and borrowers with low credit ratings (sub-prime) have been bad.

From a policy-makers point of view, the sub-prime mortgage crisis may indeed be a crisis….but not because Wall Street and Sub-Prime defaulters are suffering. The default of sub-prime mortgages creates an apprehensive banking sector. Banks become less willing to make risky loans (go figure) and hold a higher portion of deposits as reserves in their vaults. This restricts the money supply, resulting in a possible reduction in economic growth - all without the blessing of the Federal Reserve Bank. Among other things, a nervous banking sector was one primary cause of the Great Depression. The central bank did not increase the liquidity in the market enough. The money supply fell significantly, resulting in deflation and economic depression. Of course, the banking sector is not incurring a widespread panic, and the Federal Reserve does not need to increase the money supply.

There is no economic rationale for the Federal, State, or Local government to step in and appease Wall Street and sub-prime borrowers. The current solution to the sub-prime mortgage crisis (italicized to emphasize sarcasm) is to freeze interest rates on certain mortgages facing adjustable interest rates. According to the Wall Street Journal, up to $362 billion in sub-prime mortgage loans will be affected by the policy. This is a direct interference with banking decisions and private enterprise.

Banks set the mortgage rates according to variables such as alternative asset options and competing bank practices. Let’s say that the bank is holding a sub-prime mortgage at a 3% expected return, and the expected return on a 10-year treasury note is 4%. The bank must raise its rate on the riskier asset (the sub-prime mortgage) to rationalize holding the loan if the safer asset (10-year treasury note) offers a higher expected return. So it is not the mean banks that are raising rates on those poor sub-prime victims (again, italicized to emphasize sarcasm), it is just good business sense.

The sub-prime victims and Wall Street are not really victims at all. Many of the sub-prime loans went at very low rates, and families were able to purchase homes with a negligible down payment. Essentially, for a term of five years or so, these families lived in a great home for low rent. At the end of the five-year term, they default and move on – losing the negligible down payment and some foreclosure costs. Wall Street, having purchased risky assets based on the sub-prime mortgages, looses as well. The assets become worthless once these sub-prime loans default. Why are we suggesting that this behavior is acceptable?

There are high costs (some are not measurable) associated with government intervention in the sub-prime mortgage market. First, and most important, the government policy signals to Wall Street and future sub-prime lenders that the government will bail out the mortgage market, which encourages further risky behavior; we will likely see this problem again in the future. Second, the banking sector becomes regulated. Prices (the mortgage rates) are no longer determined by the market, inhibiting loans and saving even further.

Do you have any thoughts? I welcome your comments. Best, Nonthruths


n December 1, 2007 at 4:27 PM  

i love you

geo_tut December 3, 2007 at 10:44 PM  

How are the "sub-prime mortgage crisis" and the "immigration crisis" related? The damage has been done but I think these two crises go hand in hand.

Anonymous July 5, 2008 at 1:32 PM  

Greed on all sides has raised its ugly head again. The mortgage sector is just another in a progressively longer list of crises. And, the federal government is more and more inclined to not allow the "hurt" to take place - taking the responsibility off the people who incur it. How much longer (not if; they will) the feds can do this is the question. The USA currency is suffering and we no longer have the advantage in world trade. We are now in the beginning of the downslope that was predicted about 10 years ago with the emergence of China. How can we recover our advantage in world trade? janie

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