By Jack Guttentag
Saturday, September 8, 2007

Most recent commentary on the subprime market looks to removing abuses from that market, not shutting it down.

Underlying this note of caution is an assumption that, while a lot of bad things have happened in the subprime market, on balance it serves a socially useful purpose: While foreclosures are too high, the market has made homeownership possible for many who could not have achieved it otherwise.

But this assumption has now been challenged. The Center for Responsible Lending, a consumer group, claims that the subprime market, which caters to buyers with flawed credit histories, causes a net loss in homeownership. (See "Subprime Lending Is a Drain on Homeownership," available at http://www.responsiblelending.org.) This implies that if the subprime market were shut down, homeownership would rise, a startling claim that deserves careful scrutiny.

To determine whether the subprime market increases or decreases homeownership requires a comparison of two numbers. The first is the number of homeowners who would not be homeowners if not for the subprime market. The second is the number of non-homeowners who would be owners if not for the subprime market. If the second number is larger than the first, which the Center for Responsible Lending claims, the subprime market reduces homeownership.

The Center for Responsible Lending measures the positive contribution of the market as the number of subprime loans to first-time home buyers. It measures the negative contribution as the number of subprime foreclosures.

I will use the year 2006 to illustrate the issue because it was the year when the net loss from foreclosures peaked, the center said. Its figures showed that 3.2 million subprime loans were made that year, of which 1.4 million were to buy homes. However, only about 354,000 of those were to first-time buyers, while about 625,000 subprime loans were foreclosed on. The center subtracts 354,000 from 625,000 to get a net loss in homeownership of about 270,000.

The center ignores the million-plus subprime home buyers in 2006 who where not first-time buyers. Its focus is on the homeownership rate, and these buyers already owned their homes. However, a balanced evaluation of the subprime market should not ignore its role in enabling existing homeowners to upgrade.

So was the subprime market responsible for a net loss of 270,000 homeowners in 2006? It was not; the market's contribution to homeownership was positive, not negative.

The center's mistake is assuming that every foreclosure of a subprime loan reduces the number of homeowners by one from what it would have been had the subprime market not existed. That is far from the case.

On subprime purchase loans that foreclose, the center implicitly assumes that the borrower could have bought with a prime loan, which would not have foreclosed. Of course, that happens, but not very often. Based on my experience, perhaps one purchaser in 10 who uses a subprime loan could have qualified for a prime loan.

The other 90 percent of subprime purchasers needed a subprime loan to qualify. Their foreclosures did not reduce the number of homeowners because had they been unable to obtain subprime loans, they would not have become homeowners in the first place.

On subprime refinance loans that foreclose, the center implicitly assumes that the loans would not have gone to foreclosure had the borrower not refinanced into the subprime. This also is true in some cases but far from the rule. Most foreclosures are triggered by job losses, illness, marital problems and similar factors that overwhelm the borrower, regardless of the type of mortgage the borrower has.

Because deceptive solicitations are more common in refinance than in purchase transactions, perhaps as many as 20 percent of refinance foreclosures would not have occurred had the borrower not refinanced into a subprime loan. The other 80 percent would have gone to foreclosure had the borrower refinanced with a prime loan or not refinanced at all.

Applying my estimates, and assuming that the distribution of foreclosures among purchases and refinances is the same as on new loans, the 632,000 subprime foreclosures in 2006 accounted for a reduction of about 101,000 in the number of homeowners. That is less than a third of the 354,000 subprime loans made to first-time buyers in that year.

Of course, my numbers are only educated guesses. They may be too high or too low. I would like to see an unbiased effort to dig deeper than I have been able to do. Meanwhile, the widely held proposition that the subprime market makes a positive net contribution to home ownership still stands.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site, http://www.mtgprofessor.com.

Copyright 2007 Jack Guttentag

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