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Subprime Lending Woes: A Needed Correction in Real Estate Lending Practices?

The recent media attention to the problems in the subprime mortgage market, both in Texas and nationally, may hide the fact that subprime mortgage loans serve a valuable purpose: they are loans to low-credit households that could not previously afford to own a home.

First, it is important to put this situation in perspective. Subprimes make up 13% of all Texas residential mortgages, and only 4.3% of those mortgages were in default by the end of 2006. Nationally, subprime loans make up only 14% of all mortgages, and the national foreclosure rate on subprime mortgages at the end of 2006 was approximately 14.3%. (Statistics courtesy of Texas A&M Real Estate Center). Market Pulse reports in its June 2007 issue that nationally the subprime foreclosure rate as of June 2007 is 10.11%.

Despite the issues with subprimes, real estate markets are generally healthy throughout the country. For example, U.S. office vacancy rates are declining and commercial real estate investment reached record levels in 2006, according to the National Association of Realtors. Commercial rents nationally for the first half of 2007 recorded their largest increase in six years, according to a recent report by CNNMoney.com. Delinquencies among commercial borrowers continue to fall, according to Fitch Ratings U.S. CMBS loan delinquency index. According to Housing Intelligence, new home sales remain healthy, even though they may be down from the feverish pace of 2002 to 2006. Finally, the Mortgage Bankers Association reports that, while residential foreclosures are up, national residential delinquency and foreclosure rates are being driven by what is happening in four states: California, Florida, Nevada and Arizona. If the rates in these states were not considered, national residential delinquencies and foreclosures would be down.

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The issues in the subprime mortgage market are serious, of course. The National Real Estate Investor estimates that hedge fund investors could lose up to $125 million, that there could be almost 12,000 layoffs due to bankruptcies of subprime lenders, and indicates that by August, 2007, there was a backlog of $35.2 billion in unsold commercial mortgage-backed securities. These statistics, however, should not cause us to lose sight of the importance of subprime mortgage lending.

Dr. James Gaines, a research economist with the Texas A&M Real Estate Center, tackles this issue head-on in a recent issue of Tierra Grande. He notes that “(t)here is no reason to overreact and kill something that has served, and could continue to serve, a useful purpose”. Dr. Gaines goes on to say that “(t)he private sector found a way to make loans to low credit, previously unfinanceable, households so that they could own homes. While this effort was spurred by profit, not altruism, the effect on home ownership throughout the country was nevertheless profound”.

Dr. Gaines goes on to say: “(a)ssuming a total of 12 million subprime loans, the eight-year average level of delinquencies and foreclosures suggests that about 1.45 million loans will go into delinquency and about 684,000 into foreclosure. If the subprime foreclosure rate climbs to 10 percent or 15 percent, 1.2 million to 1.8 million loans will be vulnerable to foreclosure.
Even at these high rates, however, between 10.2 million and 11.3 million loans would not be foreclosed, and those homeowners would continue living in the homes they might never have been able to purchase if not for subprime loans.” As Dr. Gaines points out, the problem is not the subprime mortgage market itself, it is the illegal and often predatory tactics of some subprime mortgage lenders and brokers.

Some members of Congress are proposing various types of legislation to “rescue” participants in the subprime debacle. While these attempts may garner headlines, they are ill-conceived. The lenders guilty of predatory lending and poor underwriting practices will go out of business. The people who should not have bought houses with subprime loans will lose them. The investors in highly risky securities of pooled subprimes will lose money. This is all as it should be. The only form of legislative relief that even approaches being appropriate is some form of modification to tax law, so that borrowers who were victims of illegal lending practices and who are foreclosed upon won’t face a tax bill for the amount of the lender’s write-off.