Who gets hurt by toxic mortgages?

By Felix Salmon
July 8, 2009

Mike at Rortybomb explains just how dangerous mortgages can be, even to people who avoid the toxic ones:

If I was a degenerate crackhead who snuck into your neighborhood and mugged you for $50, the Wall Street Journal Opinion Page would want me thrown in jail. Now imagine that I’m a degenerate crackhead who took out a subprime loan to move next door to you, in an arrangement that I’m likely not going to pay off. I might not even make one payment. If I default you’ll lose 10% of the value of your home from the externality effect. Assuming your home is worth $300,000, there’s a 20% chance I default in 2 years (realistic numbers), and you lose 10%; 300,000*.2*.1 = I’ve just robbed you for $6,000 while the Wall Street Journal Opinion Page cheered me on. And that’s one house – I’ll have a dozen neighbors. Now mind you, the product was great for me – I got to smoke crack indoors, in a house I could never realistically afford, which was a big plus. The subprime lender sold my loan to a pension fund in Denmark for a nice fee. It goes in the win column for us.

I’m reminded of Brad DeLong’s calculation of the amount that Edmund Andrews has gained by taking out a mortgage he couldn’t afford: if Andrews had behaved responsibly, says DeLong, he would have ended up in much the same place as he is now, but in the meantime he has spent about $97,000 extra over the course of five years. (Plus, of course, got himself a juicy book contract.) The subprime borrowers are often winners; it’s the rest of us who are the losers.


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Or maybe it was the upstanding prime borrower who moved into the house on the other side of you but uh-oh he turned out to be a closet alcoholic and lost his job and then his house.

What’s with the stereotyping of some poor shmuck who had to take out a subprime loan just to get his family into a house. They didn’t all default nor are all of the prime borrowers repaying their loans.

And by the way, what orifice did Rortybomb pull the 10% externality number out of? Make up a number and prove any thesis.

The only way that I can make sense of a prepayment penalty on a subprime loan is that the lender would be afraid that I’m screwing with him. In other words, I convince him that I need help, and will need years and years to pay off my house, so he gives me a low interest rate. Then I pay the loan off quickly, since I’m actually wealthier than I said. What other reason can there be? In case I inherit a fortune?

1) This looks at first glance like a pecuniary externality to me.

2) Prepayment penalty results in a loan that financing markets prefer, i.e. not having given up the optionality and having to rehedge duration every time prepayment rates change. Mechanisms to reduce prepayment in this country might not be a terrible idea.

Yes, but they only act as the incentives lead them. Rationally and as the system wants them to. It is those that create and exploit the incentives that are the real guilty parties. They knew or should have known the result but as long as they fain innocence or idiocy with who could have knowns and escape justice we have nothing but a kleptocracy.

The logic in the quoted article is not right. Theft is stealing something that doesn’t belong to you. The crackhead is not stealing your house by moving in next door (and not paying his mortgage). If you like living in your house, your quality of life doesn’t suffer a bit because your neighbor defaults. Sure the value of your house will go down, but so will the value of many things — your car, maybe your investments, your couches, almost everything you ever bought. There’s no stealing involved here.
Stealing = bad
Stuff getting less valuable over time due to external factors = life

Posted by kman | Report as abusive