Subprime Mortgages: A Good Thing?

Lawmakers should resist the temptation to try and legislate a quick-fix solution to the housing woes associated with the subprime mortgage collapse, a Law School alum told a room full of students on March 27.

Todd Zywicki '93

"Right now there is a substantial possibility that Congress or regulators could take steps that make matters worse," said Todd Zywicki '93, a George Mason Law School professor who recently published an article on the subject.

During a Federalist Society-sponsored lecture called "Subprime Mortgages Are Good: The Law and Economics of Lending," Zywicki said there hasn't been enough study of the factors that contributed to the recent rash of home foreclosures. He argued that homeownership helps create wealth, and government should be careful not to hinder it.

Afterward, Virginia Law Professor Rich Hynes responded that Zywicki's urge to proceed cautiously amounts to a "wait-and-see" approach that preserves a dangerous status quo, and said it's obvious that the rapid growth in subprime mortgages in recent years created problems.

"We may want to consider regulations to try and clean up these problems and try and prevent this sort of over-exuberance from occurring again in the future," Hynes said.

Many blame subprime lending practices for fueling a housing bubble in recent years, both men said. The common perception is that when the bubble burst, many homeowners with subprime mortgages were forced into foreclosure.

But the popular narrative on the subprime lending crisis is "conceptually flawed," Zywicki said.

"It's the distress model: Ma and Paw with three kids in the suburbs take out a loan. It's got a fixed rate for three years, then an adjustable rate after that. The rate rockets up; the family wants to stay in the house, but they can't because of the payments," he said.

Although it does occur, this model ignores a second reason for foreclosure caused less by an inability to pay than from a conscious decision not to, Zywicki said.

"You have an option every month, right? You can continue to pay the mortgage or you can default and just give the house back to the bank," he said.

In this model, homeowners make a rational decision to go into foreclosure based on changes in the value of the home, not on their mortgage's interest rate.

"If your house goes up in value, somehow you manage to make the monthly payment. If your house declines in value, all of a sudden you decide it's not worth it anymore," Zywicki said."If that's explaining what's going on, that is a very different public policy question for Congress to be thinking about."

Speculators who bought several properties through subprime mortgages with the intent of reselling or putting them up for rent are likely candidates to rationally choose foreclosure if the value of their properties suddenly declines, Zywicki said.

"When we're thinking about addressing the problem, we need to make sure we're not bailing out speculators or people who are lending to speculators," he said.

In his rebuttal, Hynes said there is evidence to show that subprime lending was driving the housing bubble and that poor lending decisions based on the assumption that the growth would continue left a lot of borrowers high and dry when the bubble burst.

As an example, he cited "2/28" mortgages, where the borrower pays a fixed rate for two years and an adjustable rate for 28.

"[Lenders] do this because this allows you to have a very low payment for the first two years, and qualify for bigger loans," Hynes said.

This kind of lending was built on the notion that rapidly escalating home values would allow buyers to refinance or sell their homes when the fixed rate expired.

"Surprise surprise, when the bubble stops inflating, we've got a problem," Hynes said.

Hynes suggested a number of possible reforms that could keep such practices from occurring in the future. New foreclosure law regulations or regulations of banks' abilities to make such loans could prevent a similar calamity from occurring the next time the market is growing, he said. Also, if the government is going to use taxpayer dollars to bail out private companies that have made poor business decisions, the government should have some oversight role, he said.

"If Bear Stearns is really too big to fail, if we really believe that we're going to have to rescue them when they get in trouble… we may have to regulate them," Hynes said.