The Frontal Cortex

Subprime

What a bleak day on Wall Street. Although the financial contagion long ago spread beyond subprime mortgages, it’s worth remembering that this all began when lenders decided that millions of people could afford loans that were actually unaffordable, at least over the long-term. Why did people accept these onerous loans? Why did they borrow more than they could possibly repay? The answer, I think, returns us to a basic cognitive flaw, built into the brain.

Comments

  1. #1 The Ridger
    September 17, 2008

    A lot of them probably believed that no one would lend them money that they didn’t expect to get back, too.

  2. #2 Dean
    September 17, 2008

    I don’t know what to make of some of these people. I have no doubt that a good number knew that they shouldn’t do what they were doing, but still proceeded. I can almost believe, however, that some people really didn’t understand the ramifications of borrowing money. I occasionally teach a freshman-level survey math course at my school, and I do a segment on basic financial calculations. On homework and test they have to calculate the monthly payment they would need to make in order to pay off a car or a home. More than once I have had students who give an answer on the order this: a monthly payment of $60 is all that is needed to pay off a $200,000 home in 30 years.
    When I press them on “Didn’t you notice that this woudn’t even pay off the amount borrowed?” I hear “Well, do you always have to repay the total amount you borrow?” They aren’t trying to game me, they simply made it through life (and, worse, my lectures) not understanding that point. I’ve always responded “Not always, but that only works once”. Now I’m not so sure.

  3. #3 A
    September 17, 2008

    “…when lenders decided that millions of people could afford loans that were actually unaffordable, …”
    “It is difficult to get a man to understand something when his salary depends upon his not understanding it. – Upton Sinclair, 1935. So lenders didn’t think their offerings unaffordable.
    No, lenders had learned that you can earn lots of money by offering the largest possible loans to anybody, and reselling and repackaging the resulting loan obligations.
    And they did (earn lots of money). After all, the money we taxpayers are now ponying up didn’t just go into a black hole. It was ‘earned’ by serious foresightful CEOs and speculators who successfully lobbied to have no regulation of the ‘innovative financial sphere’ and who now express publicly great regrets to have to accept a government bailout; the system is of course rigged, so that the taxpayer has to bail out the paper economy so as to prevent further damage to the real economy.
    Those taking on mortgages they couldn’t afford were talked into it by experts (remember Greenspan), and interested parties (real estate brokers, mortgage brokers), and now lost equity in their houses; some of them, of course, knew it was coming and borrowed against their houses to the hilt, so they could take out cash, and live (relatively)rent-free, until they turned over their over-valued over-mortgaged house to the lender. (But those just profited at a small scale, not millions as the CEOs of the failed companies).
    Of course many people discount future problems, when the experts assure them, they wouldn’t occur. And then there is social pressure to live above your means.
    While ‘neurology’ is involved (in people’s thought and actions), pure unbridled greed explains it all nicely.
    (And remember: McCain’s campaign chairman was a lobbyist for FannieMac, and McCain proposed in 1999 to turn over Social Security to Wall Street.)

  4. #4 Clark
    September 17, 2008

    Hey, two of Obama’s main economic advisors ran Fannie Mae. I’m voting Obama but let’s be honest. There’s a lot of slime to go around on both sides here. At least McCain proposed legislation years ago reigning them in. We can quote advisors but Obama comes off way worse here.

  5. #5 whitewhale
    September 17, 2008

    “Why did people accept these onerous loans? Why did they borrow more than they could possibly repay?”

    Sometimes people need money to get high

  6. #6 Dunc
    September 18, 2008

    Q:

    Why did they borrow more than they could possibly repay?

    A: Marketing.

  7. #7 JM
    September 19, 2008

    “A: Marketing.”

    Precisely. 2/28′s otherwise known as teaser loans aka predatory lending.

    2 years of low interest with negative amortization (the principal gets bigger) followed by 28 years of above-market-rate interest. You only get into these deals in the hope that house prices will rise in 2 years and you can flip the property or refinance on better terms (which is exactly the con that the mortgage brokers advertised and sold.)

    Combine that with an industry structured around “originators” (ie. mortgage brokers) only interested in fees and not have *any* responsibility for ensuring repayments and you get predatory behavior.

    (In fact, that’s where you also get fraud. Anecdotally I know personally that much of the fraud associated with these loans is actually committed by the broker and not the borrower. For much more informed comment on these issues see http://www.calculatedrisk.com particularly posts by “tanta”.)

    I wouldn’t go blaming the borrowers here. You have an industry free from regulation or responsibility that has been allowed to let rip without regard for the consequences.

    You think market discipline is enough to restrain near-criminal behavior in financial markets? History is against you, as we have found out yet again over the last few months. Too many people get hurt through no real fault of their own.

    And getting away from teaser loans for a second, *much* of the trouble is caused by lack of regulation – or even prudent behavior in the CMO/CDO market. I heard a few months ago that Orange County (who really should know better after 1994) were buying the equity tranches (!) of CDO’s. Just to explain this. Orange County nearly went bust in 1994 after losing billions on interest rate swaps (comparitavely simple instruments compared to a CDO, but ones they should never have been allowed to go near). A CDO is a very complicated second order derivative that a pension fund has no business being in, and the “equity tranch” is the most dangerous part of it – it has absolutely *NO* asset backing or security of any kind, a bet on the dogs has better odds..

    There are plenty of villains in this story but by and large subprime borrowers aren’t members of that class. They were preyed on.