The Case for Banning Subprime Mortgages

Abstract

While the subprime mortgage boom was in full swing, its benefits to American society were widely touted. Subprime mortgages were said to have increased homeownership. The subprime effect was supposed to have been especially strong for low-income and minority families previously unable to buy homes. The democratization of credit was also attributed to subprime mortgages.

The empirical data do not support these welfare claims. The U.S. homeownership rate increased somewhat between 1994 and 2007. Subprime mortgages, however, were mostly made to existing homeowners to refinance debt; very few were made to first-time home buyers. The number of homes lost due to subprime foreclosures significantly exceeded the new homeowners added by subprime mortgages. Subprime mortgages also displaced the safer and lower-cost FHA loans that would otherwise have been made. Conventional prime mortgages for purchases fully accounted for the observed increase in homeownership.

The welfare harms caused by subprime mortgage lending are readily measurable. They include the direct impact of more than two million foreclosures on families, the resulting property value losses, the social and fiscal impact on cities where subprime mortgages were concentrated, the price discrimination resulting in black and Latino homeowners paying unnecessarily high rates, and the broader impacts on the credit markets and the economy.

The disastrous consequences of subprime mortgage lending were in part the result of deregulating mortgage interest rates. Similar harms can be prevented in the future by re-imposing reasonable interest rate limits on first-lien mortgages. FHA should be restored to its role as the primary provider of mortgages to first-time, low- and moderate-income home buyers.

Keywords: banking and finance, consumer protection law, law and economics, law and society, social welfare