I always tell my students to ask what seem like stupid or naive questions, since they’re often important or profound questions instead.
So let me ask a series of dumb questions about subprime mortgages. I understand somewhat the problems that bundling them into securities ended up causing, but I’m still puzzled about the basic idea of a subprime mortgage.
Let’s say you’re a lending institution back in the 1990s or early 2000s. You give customers who have very strong credit records generous interest-rate terms on mortgages or other loans because you recognize that they have very little chance of defaulting on the loan. Presumably you do this because you’re trying to attract those customers away from other institutions who would also like to have them as customers? These loans give you guaranteed long-term income, which makes you willing to shave your profit margin on each individual loan.
At some point, you run out of these customers. So you start thinking about customers whose incomes or credit situation makes them a bigger risk, because you don’t just want to sit upon deposits in your institutions, you want to make money with your money by loaning it out. Here’s where I get really confused, presuming that the previous paragraph isn’t already confused.
As the customer gets riskier and riskier, you make the terms of the loan more and more punitive, though you might sweeten the deal with favorable initial terms to entice the subprime customer into accepting the medium-term pain.
I guess the idea here is that you try to make as much profit as you can off the loan for as long as it lasts? Wasn’t it understood that the more punitive the terms of such a loan, the more likely it would be to cause a risky customer to default over the medium to long term?
If this was well understood by the institutions making subprime loans, weren’t they explicitly pursuing the ramping up of short-term profits off of subprime customers desperately trying to keep up with high interest rates with an equal understanding that many of these loans would default as a result in the medium-term? If so, I can only see one way that would make sense as a business strategy (leaving aside the moral nastiness), and that’s if you assumed that the lending institution would be able to get immediate value from reselling defaulted assets, e.g., that the value of housing and property would continue to go up indefinitely over the medium and long-term. E.g., you were deliberately squeezing customers who had few choices because of their risky profiles and then planning to make money again when they defaulted.
If it was not well understood that more demanding or punitive terms for loans to riskier customers would likely accelerate medium-term defaults, why wasn’t it well understood?
Are there any major American lending institutions out there that took the opposite approach, and looked for riskier customers with some long-term positive potential in order to offer them even more generous terms than they did prime customers in order to add to the base of loans producing secure if small long-term returns?
That’s something of the idea behind microlending, after all, but microfinance emphasizes social welfare returns as well as the financial health of the lending institution. E.g., that by improving social welfare as a whole, lenders create an increasingly positive economic environment for them to be lending profitably to a wider base of customers. Kind of the finance capital version of the Fordian bargain.
Am I missing something fundamental?