Before policymakers undertake more bailouts arising out the subprime mortgage crisis, policymakers should ask the classic question: what did subprime lenders know and when did they know it?
While much remains unclear about the crisis, considerable evidence suggests that at least some subprime lenders have unclean hands. For example, a year ago, a Countrywide Financial official testifying before Congress about loans, called hybrid ARMs, that carried an initial low rate but would later switch to an adjustable rate, estimated that "about 60 percent of the people who do qualify for the hybrid ARMs would not be able to qualify at the fully indexed rate." Put another way, it appeared that Countrywide expected that many borrowers would not be able to make their payments once the temporary teaser rates expired, unless the borrowers' financial circumstances improved dramatically or interest rates were to fall substantially. Both of those events seem implausible.
Lenders, unlike borrowers, have access to oceans of information about consumer defaults. The credit scoring and credit reporting industries are premised on the assumption that defaults can be predicted. Thus, it seems probable that lenders anticipated the possibility that many consumers would find it impossible to make loan payments. A cynical explanation for Countrywide's lending practices but one that is hard to avoid is that Countrywide expected that borrowers, faced with payments they couldn't make, would refinance their loans, generating more fees for Countrywide and further imprisoning the borrowers in debt.
Indeed, some loans seemed virtually to invite default. A Countrywide manual approved the making of loans that left consumers as little as $550 a month to live on, or $1,000 for a family of four. Aggressive marketing appeared designed to overcome resistance by reluctant borrowers, thus eliminating another check on the making of loans likely to end in foreclosure. While federal disclosure laws are designed to inform borrowers of their payment obligations, some borrowers seem not to have understood those obligations and perhaps that was deliberate. As a predatory lender testified at a 1998 Congressional hearing, "I can get around any figure on any loan sheet." And, he added, "[o]ur entire sale is built on confusion." The confusion is exacerbated by the fact that many subprime borrowers are less well-equipped to understand their financial obligations than prime borrowers. If borrowers do not comprehend what they are getting into, they lose the ability to recognize a commitment they cannot meet.
If lenders expected that borrowers could not meet their payment obligations and so would need to refinance, lenders surely also considered the possibility that borrowers already at the cusp of creditworthiness would find themselves unable to qualify for refinancing. And that leads to questions about what lenders thought would happen in such a case.
Is it possible that lenders foresaw that if circumstances prevented borrowers from refinancing, the prospect of numerous borrowers facing foreclosure, thus devastating entire communities and financial markets, would generate calls for a bailout, thereby insulating lenders from the folly of their own lending practices? If not, what did they expect? Perhaps it is only a coincidence that the Bank of America, which is in the process of acquiring Countrywide, has put forth a bailout plan.
Bailouts may indeed be the least bad solution to the problem. It is one thing to say that lenders should not benefit from a bailout, but something else to say that financial markets, neighborhoods, and confused consumers should be left to suffer. But unlike many subprime borrowers, policymakers should at least deal with the crisis while understanding what lenders contemplated. We are not there yet.
