Two exchanges from yesterday on the subprime crisis

Ben W. wrote:

I’m curious why with so much emphasis at VFR on the application of true conservatism to the selection of president and vice president, nothing is being said about the application of liberalism to our economy and the subsequent collapse of historic financial institutions.

To a large extent the downfall of financial institutions was due to the handing out of loans to people (minorities) that could not afford the houses they bought. This was due to federal pressure on these organizations to make house ownership available to everyone. In my own city I have seen many, many people (most of them black) earning a third of what I do buying houses at twice the price of my own.

One doesn’t have to know economics to see liberalism poisoning the economy. We have before us the collapse of 50 and 100 year old institutions saddling the American people with a trillion dollar bill.

Surely the “true conservatives” at VFR have some insight and opinion about this collapse which makes the subject of Sarah Palin pale by comparison…

LA replies:

But is it the case that the main cause of this crisis is racial liberalism? One thing I have picked up in following this issue is that everyone sees in it his own favored bugaboo. McCain blames it on Obama. Obama blames it on Wall Street and Republicans. Patrick Buchanan blames it on the decadent American empire. The New York Times blames it on predatory lending taking advantage of black people. And you and others blame it on racial egalitarianism.

When people take an issue this complex and immediately leap to blame it on the very party who is already their bete noire, this raises the reasonable suspicion that they are not trying to understand the issue but are using it to justify their prior preoccupation. Which doesn’t mean that you are wrong. Obviously the aim to expand home ownership for minorities was a major factor here. But with an issue this complex, it seems incumbent on us to understand the issue before we start blaming it on our particular bete noire.

I’m doing some reading on it, getting the picture bit by bit. One astonishing thing is, this vast, incredibly complicated structure, with mortgages bundled together into securities which were then purchased (or rather shares in them were purchases) by companies like Lehman which in turn borrowed money to buy the securities, all in the hope of gaining cash inflow from people who were paying off the loans used to buy their homes—was based ultimately on subprime mortgagees! Instead of being founded on something solid, this vast, incredibly complex structure was founded on people who had been given mortgages based on a type of affirmative action.

But it’s not fair just to blame this on improvident blacks. The subprime mortgagees were suckered into taking out mortgages that were structured in such a way that would ultimately make it difficult for them to make their payments. We shouldn’t reduce this just to a racial tale. Yet it remains the case that the most powerful institutions in our society made themselves dependent on high risk, largely minority individuals. And there are different ways of seeing this. One is that these businesses were recklessly structuring these securities in a way that was bound to fail. Another is what you said—that the government pressured them into making the subprime loans.

I read that Lehman had $4.5 billion in debt to pay off the loans it had taken out to purchase the mortgage backed securities, and only $2.3 billion in income. That’s why it went bankrupt. But this is incredible. Lehman is a huge bank. It has holdings in thousands of types of securities, right? How then could its losses from this one area of subprime foreclosures be of such size as to sink the whole company?

Rhona wrote:

The errors that were made here were based on the premise that capitalism is a philosophy, not an economic system. Any economic system must be based upon the quality and intelligence of the people who are part of it. After WW II, a massive amount of housing was built for returning GIs, and they received credit under easy terms. We know that this worked out well. We will continually, in many other manifestations, to go down the abyss because of the belief in group equality. The philosophical assumption throughout the 20th and 21st centuries is that good intentions are good enough; that failure is due to evil people. Our enemy is lack of wisdom and insight (error) and this error will continue because we have not learned anything from this debacle. We will blame avarice and greed rather than the immutable forces of nature and our inability to understand them. The field of economics has yet to take this into account, while we’re still waiting for Africa to prosper while China does.

LA replies:

How much of this whole situation, in your view, is due to this racial egalitarianism? Curiously, the Times has suggested just the opposite—that discrimination against blacks was involved. That is, that “predatory lenders” deliberately targeted people with low credit ratings.

I thought about this (starting from my base of being completely ignorant on the subject), and then I realized the notion of a predatory lender makes sense in theory, at least in the case mortgages. A mortgagor can come out ahead if the mortgagee defaults. For the sake of illustration let’s reduce this to the simplest possible terms. I’m a bank and I give you a mortgage of $200,000, and you are going to pay me $300,000 over 20 years. If you make all your payments, I’ve made $100,000 over 20 years. But now let’s say that you default after five years, the mortgage is foreclosed, and I take possession of the house. I have made $75,000 from you in five years, and I am in possession of the $200,000 house that I can re-sell. Isn’t it a lot better for me to make $75,000 dollars profit in five years than to make $100,000 in 20 years? Therefore could there truth to the idea that lenders sought out people they thought were likely to default?

Of course there are other issues that would make this not work, such as a decline in the value of the house, or a tightening of credit so that no one will buy it. But reduced to its simplest terms, it does seem to me that a mortgagor can come out ahead if the mortgagee defaults. This is speculation by a beginner and anyone is welcome to correct me.

I am not dismissing the possibility that the entire complex structure ultimately rested on the sands of racial egalitarianism. But at the moment, I’m more interested in understanding the wacky financial structure of it, turning mortgages into securities in which investors buy shares! And then these investors, like Lehman, borrowing money to buy shares in these mortgage backed securities. Don’t people usually purchase securities with money they have on hand now, rather than borrowing to do so, which places them at risk of bankruptcy if their investments turn bad? And that’s what made Lehman crash. It borrowed money to invest in securities from which it would make money that came from mortgagees making payments on loans they had taken to purchase homes. To repeat: Lehman incurred vast loans to make money on home purchasers paying off their loans. So when the home purchasers couldn’t pay off their loans, Lehman lost the ability to pay off its loans.

Posted by Lawrence Auster at September 20, 2008 11:30 AM | Send