Why Choose Subprime When You Are Eligible for Prime?

Elizabeth’s Warren’s blog post about the Consumer Financial Protection Agency has received a lot of attention. It’s full of holes and errors, but for me one sentence said it all. In her discussion of whether “CFPA will limit consumer choice and hinder innovation,” Professor Warren states:

If the status quo is about choice, then explain why half of those with subprime mortgages chose high-risk, high-cost loans when they qualified for prime mortgages.

The implication of the sentence is clear: these mortgage applicants were cheated. People of Warren’s persuasion believe that providers of financial services—and probably other products and services—are basically crooks. The underlying theory, as I’ve heard explained to me recently, is what is called “behavioral economics,” which purportedly shows that consumers often make the wrong choices because they are not perceptive enough to understand the complexities of what they are being offered. Because of this phenomenon, providers of financial services manipulate their offers in order to take advantage of and profit from this consumer incapacity. One of the authors of a leading article on the subject—Michael Barr—is the assistant secretary of the Treasury for financial institutions and the designer of the CFPA plan. That’s why, despite all the denials from the administration, the underlying purpose of the CFPA is to create a structure in which the choices of consumers can be limited. This is done simply by creating litigation and enforcement risks for providers who offer products that are more complex than the “plain vanilla” product that will be approved by the CFPA.

The irony here is that Warren is not herself perceptive enough to understand what the consumers who took the subprime mortgages actually understood. She assumes they were cheated or manipulated into taking a subprime mortgage. Let’s look at what really happened. First of all, if a consumer was eligible for a prime mortgage, as Warren states, he or she had a FICO score above 660. That means that Warren is probably not talking about a mortgage that is subprime because the borrower had blemished credit. She is probably referring to a mortgage which is referred to as “subprime” because it has a low downpayment or is an adjustable rate loan with a low teaser rate at the outset, or perhaps even features negative amortization. That would distinguish the mortgage from a prime mortgage, which is likely to have a fixed rate for 15 or 30 years.

Now, why would a consumer take a “subprime” mortgage when he or she is eligible for a prime mortgage? For one thing, when the home was bought, probably some time between 2003 and 2007, the consumer knew perfectly well that home prices were rising, and that the home was likely to be worth a good deal more a year later than it was worth at the time of purchase. That would mean that even if there was a low or no downpayment the purchaser would soon have equity in the home simply from price appreciation over time. Behavioral economics would no doubt conclude that the consumer was deluded to believe this, but how many very savvy people—including the bank regulators—acted as though this was indeed what would happen? So, from the deluded consumer’s perspective, the risk of a mortgage with a reset to a high rate was not that great, since the loan could be refinanced, using the new equity that would come from price appreciation, before the higher rate comes into effect.

In addition, the consumer knows what he is earning currently, and—assuming that the economy continues to grow—what he is likely to be earning in the future as his skills and seniority increase. He can then estimate pretty well what would be a comfortable monthly payment. Oddly enough, if the consumer takes a subprime mortgage—one with a low or no downpayment and perhaps a low adjustable rate—he can afford a larger house in a better neighborhood, perhaps even near better schools, for the same monthly payment that he would be required to make for the prime loan.

So, our hypothetical consumer was not being cheated—as the Left would like to believe—but in many (and probably most) cases made rational choices based on what was known at the time. This “explains”—if any explanation were needed—why (to quote Warren again) “half of those with subprime mortgages chose high-risk, high-cost loans when they qualified for prime mortgages.”

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