Tuesday, March 20, 2007

Lowest Common Denominator Laws

And the Subprime Lending Market

In the United States, laws are typically written for and around the very small percentage of the population who, for some reason, need to be told very basic things. It’s truly unfortunate that some in our society do need laws and penalties to prevent or punish them for things the rest of us would simply never think of doing. And I truly think that the majority should not accept this any longer.

In the small California town where I grew up, the Fourth of July parade used to be a thing of wonder for children. Not for the parade itself, but because all of the families in town used to pitch tents in the wide grassy medians that separated the north and south-bound lanes of the town’s main road.

Everyone would bring their picnic baskets, sundries, and toys. Children ran around playing tag during this town-wide slumber party, and adults would discreetly sip wine or beer from plastic cups. These July 3rd evenings were so uneventful that there was rarely even any good gossip to talk about the next day.

As time went on, folks from other towns started crossing over into the community to participate. They too brought their tents and sleeping bags, but their foreign presence changed the environment. The first evidence of this was that ‘stranger danger’ at the campout meant that parents felt the need to always have their kids in sight.

The newcomer adults inevitably took the lax police enforcement of open containers to mean that this was more Mardi Gras than town social. For the first time, there were fights and arrests for disorderly conduct. I’m sure you can figure out what happened next. Alcohol was quickly banned, a decision that the town of course supported. Within a few years, camping on the median was also a thing of the past.

I wanted to share this example because, as you can see, when the town had to shift their standard operating procedure for July 3rd and 4th, it wasn’t a reflection of the town itself. It became necessary because of the small percentage of folks who came into town and couldn’t or wouldn’t behave within the established codes.

I like to call these kinds of shifts “Lowest-Common Denominator Laws.” They’re created in response to the small but powerful number of folks who throw a wrench into the works. And by extension, the rest of us get locked into this new norm, even when we can and always have handled the extra burden of responsibility like good citizens and intelligent adults.

The L.A. Times this week points out that the same trend is happening with mortgages. The article points out that the more relaxed lending standards are responsible for allowing a record number of Americans the opportunity to own their homes.

As the “Lowest Common Denominator” rule goes, not everyone is living up to the responsibility. And now Congressmen and Presidential candidates alike want to legislate their way out of the problem.

I’ve got several problems with that. The first is that private industries gauged their risk tolerance and (one would think) moved forward with due diligence. It is worth noting that not all subprime lenders are in the same boat. Obviously, some managed their risks better than others. But because some firms jumped in head-first, this is another instance of “Lowest Common Denominator” thinking.

My second problem with legislating our way out of the subprime mortgage downtick is that fully NINE out of TEN subprime borrowers are paying their notes.
So why should it be acceptable that the 10% who either cannot or will not meet their obligations now become the standard for lending?

Future borrowers will no doubt be held to a standard that is designed to protect against 10% of the population. The 90% of marginal borrowers who own their homes are not even factored into the equation. And thanks to this, 100% of future borrowers will be disallowed the opportunity that 90% of previous borrowers have lived up to, but 10% have ruined for everyone.


Rob Dawg said...

Umm, no. That's not how it works at all. Those dutiful sub-prime borrowers negatively impact the rest of us in many direct ways. Regardless of the interest rates they pay their very prescence in the borrowing pool increases all risk and compete for the same resources. They take their share and use it to compete for the same pool of available housing. Their part in driving prices raises everyones' taxes. Oftentimes their financial positions necessitate things like doubling up familes straining resources from sewers to schools. My county recently hired 22 translators to facilitate access to free services for the 10,000 or so people thought to be living in garages and 4 to a room in the 90%er type houses you champion. The translation? Mitexca to Spanish. So before you say the subprime/liar loan/stated income loan enviroment is only a few bad apples you just write out a check for those 22 translators and while you are at the salaries for the team of doctors recently hired to combat drug resistant TB and Whooping Cough.

Anonymous said...

It's still early in the game. While I agree with your premise that laws are made for the lowest common denominator, I believe we are on the cusp on an epic financial meltdown.

Christopher Smith said...

Interesting analogy - but it seems that you're using the folks crashing the party as a metaphor for those folks who bought houses using sub-prime financing and got in over their heads. A small percentage of the sub-prime market, but enough to rock the boat.

I disagree. I think that the gate crashers are those companies who were aggressively flogging risky loans to unsophisticated buyers.

The sub-prime market did a lot of good things for buyers by allowing folks who never would have qualified for a traditional mortgage to become home owners. Used correctly this would allow a family to work hard, make their payments, clean up their credit, establish a payment history, and get on the road to financial stability. And in many cases this is how these loans were promoted.

But unfortunately there are a lot of companies who were just trying to bag a commission. Option ARM? Sure! No doc loan? We’ll take your word for it. And don’t worry about that low teaser rate.

Fortunately these companies fail, and I imagine the Department of Justice will make an example of some of the more egregious offenders who promoted fraudulent transactions. And – that’s the great thing about American capitalism: the market punishes companies who pursue flaky, unstable business models. This is the best reason for the government to stay out of the affair – the market takes care of itself.

We’ll see a tightening in lending standards, but I hope that companies with solid, ethical standards will continue to bring liquidity to the sub-prime market.