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Opinion

The "Subprime" Problem Means All Of Us.

In an excellent post titled “What is Subprime?”, Tanta at the Calculated Risk blog talks about what “subprime” is, how it seemed to become a problem and how the current situation is a larger problem than “those subprime people”.

That said, what it’s about is just working through the complexity of the variations on three things that have been the core of mortgage underwriting since roughly the dawn of time: the three Cs, or Credit, Capacity, and Collateral. Does the borrower’s history establish creditworthiness, or the willingness to repay debt? Does the borrower’s current income and expense situation (and likely future prospects) establish the capacity or ability to repay the debt? Does the house itself, the collateral for the loan, have sufficient value and marketability to protect the lender in the event that the debt is not repaid?

There is no New Paradigm, there was no New Paradigm, there is not going to be a New Paradigm. The Cs are the Cs. What we “innovated” was our willingness to believe that we had established the Cs with indirect or superficial measures (that are, not coincidentally, cheap and fast compared to direct measures).

What we call “prime” lending was based on the idea that all three C-questions had to get at least a minimally correct answer before proceeding. You had to be sufficiently creditworthy and sufficiently capable and have sufficient collateral before we made the loan. If you had, say, two out of three, you might qualify for a near-prime (like FHA) or subprime loan, depending on which two and by how far you missed the third.

The chilling part comes next: Why this problem is a bigger problem because it’s deemed to be “subprime”. Usually, says Tanta, loans that are “prime” (three Cs being fairly intact) slip into the subprime zone, due perhaps to temporary problems (like the homeowner losing a job) to a more sustained one (like the home market going down the wazoo). In other circumstances, subprime lenders jump in and say “okay dude(tte), we’ll pay off your nagging prime lender and you pay US back instead, but (gleefully) at a higher rate of interest”. When you want to save your house, you take this option.

The issue now is that subprime borrowers have bolted. The prime borrowers are slowly becoming subprime (home prices are already going down, remember) and when the term “subprime lenders” is slowly getting extinct, they have no refinance option. So the next step: They choose the foreclosure route. Default rates are up.

Read the article. And unlike me, read it slowly because otherwise, like me, you will have to read it again. We are all subprime now.

And what about us Indians? No, we’re not the “brown” people mentioned there, but should we care about U.S. Subprime?

I would be kidding myself if I thought this is a U.S. only problem. Note that the European banks have suspended trading in mortgage bonds and China is worried about loss of US exports.

And India? First the software outsourcers have a lot to lose, considering they do a LOT of work with the financial industry all over the world. A dollar decline means a drop in exports so textiles is kaput. Liquidity constraints hit banks which “bank” on their ability to raise cheap money and deploy it for high returns. ECBs become more expensive as spreads abroad widen. Domestic consumption is driven by robust external demand as well, and to that extent asset prices will be hit if there is a global recession of sorts.

Of course I come across as bearish. But this has nothing to do with the stock market. It can continue to flourish, remember, and in the face of such data, it has in the past.

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