In Praise of Subprime Lending

In a recent article in the New York Times, Professor Charles Calomiris of Columbia University and Robert E. Litan, director of economic studies at the Brookings Institution, address the current debate on subprime lending in the residential mortgage market. They point out the contributions that subprime lending has made to our society and the dangers of well meaning or politically motivated efforts to curb subprime lending.

They report that in 1998, 13 percent of all new mortgages were financed with subprime loans, up from only five percent in 1994. While some people would view these data with alarm, the authors observe that this change "signaled a significant improvement in giving low-income people access to the credit they need to buy homes." These were borrowers who lack established credit histories, as many poor people do. Since these borrowers pose an above-average risk of default on their mortgage contracts, they pay higher interest rates than that paid by "prime" borrowers.

Unfortunately, lenders who prey on uneducated or uninformed consumers make loans that are both subprime and predatory. For example, they may trick borrowers into "flipping;" that is, refinancing their loans even when it is unwise. The key point is that subprime loans are not necessarily "predatory" loans, a point that has been made clear by the U.S. Department of Housing and Urban Development.

Nonetheless, many cities and states have attempted to address these problems by enacting legislation that might affect predatory lenders, but would certainly curtail the availability of subprime loans to low-income consumers, including many minorities. The authors note, "New laws on the pattern of some already passed at the state and local level could do great harm by discouraging lenders from making any subprime loans at all." A prime example is the legislation passed by the North Carolina Legislature in 1999 that imposed new regulatory burdens on lenders in the subprime market. Calomiris and Litan note "since then, subprime mortgage lending by finance companies in the state to borrowers with incomes below $25,000 has dropped by nearly 50 percent. For those with incomes between $25,000 and $50,000, the drop has been one-third." (See related article below).

The state legislators have largely ignored existing federal legislation that addresses predatory lending tactics. In addition, both the Federal Reserve Board and Federal Trade Commission have the authority to address predatory lending practices and are already seeking fuller disclosure of lending terms. In addition, the authors suggest that the various federal agencies send testers into the market to see how well mortgage lenders are complying the existing regulations. Finally, they suggest establishing clinics or other counseling programs to help borrowers become more proficient. One might even hope that some high schools would include the features of mortgage loans in their mathematics classes.