How To Fix The Sub Prime Mess?Lessons From The Asian Financial Crisis

The Bush Administration is proposing to freeze the resets on sub prime loans in order for borrowers to be able to continue to pay their mortgages. This of course is politically expedient. But is it good economics, some ask. Many have condemned the proposal as going against the original spirit of the contract and therefore will undermine the competitiveness of the US dollar as a store of value, and the attractiveness of the US economy as the storehouse of wealth.

The argument is that if the rate on sub prime loans are capped, then the investors will suffer (i.e. get less interest than they expected) and borrowers will therefore benefit (i.e. pay less than they would have). Who would then buy US assets?

This is a "prime" example of classroom theorising vs. market savvy. We are often bombarded by learned commentators, professors and such like, that it's "Economics 101", as if the label itself gives it credence just like the pieces of parchment on their walls. My answer is it's "Market Behaviour 101" that matters.

By capping the rate on sub prime loans, lenders will be able to keep receiving payments. It's the income stream that matters. The alternative is that borrowers will just give up and hand the properties back. The banks will then have to try to sell the properties into a weak market, get much less than their original principal, and write-off the difference.

The recent price paid by a hedge fund for e-Trade puts this at about 35 cents on the dollar. Less me ask you, would you prefer to get 95 cents (by foregoing some interest) or 35 cents. Mind you, the increase of interest on reset was not a "sure thing", i.e. the borrower has the option to repay or refinance. Who knows, if this had not blown up, they may have been able to refinance. So the lenders are only giving up something which had a theoretical value which they may or may not have counted on in the first place. They may actually have expected the borrower to refinance and get the loans off their books.

So what are we asking them to do by capping the rates? Only that they refinance the loans at some thing close to the market rate and not punitive.

During the Asian Financial Crisis, the HK government was castigated by many "free market" thinkers for intervening in the stock market to stop speculators using it as a proxy for shorting the HK dollar. Similarly, the Malaysian government was pillored for imposing exchange controls. In both cases, the governments saw the need to protect the local economy from excessive outside intervention and took the appropriate steps. The current strength of the economies belie the dire predictions of the "learned" community.

Text books on economics are written after the fact. Different people will extract and interprete facts in different ways. In time, some of these lessons will be "Economics 101". People tend to forget the market is made up of individuals who are prone to the emotions of fear and greed.

When "sub-prime" loans were the thing to be in, the captains of our financial industry were greedily fighting their way to the "feeding troughs" to get a piece of the action, afraid of losing out. In the now famous words of a certain Mr. Prince, previously of Citigroup, "When the music starts, you have to dnace". Now that "sub-prime" is a pariah, the vultures are waiting for the carcass to rot (i.e. they want 35 cents on the dollar) and trying to scare off anyone who wants to take the not yet dead bodies away for treatment by saying "let nature takes its' course, let them die!"

That's "Market economics 101". Sometimes, it is necessary to take some action that the "pure" economists abhor. Let's try and save what we can. The alternative is that we will be faced with a bigger problem of a collapse as borrowers renege, banks start writing off bad debts, and the credit crunch becomes a black hole.