TCS Daily


Subprime Bust Is No Big Deal; Here's Why

By The Editors - September 12, 2007 12:00 AM

Editor's Note: TCS Publisher Andrew Walworth recently sat down with Kenneth Fisher to discuss the American economy for a forthcoming primetime documentary edition of the PBS series Think Tank with Ben Wattenberg. Fisher is best known for his prestigious "Portfolio Strategy" column in Forbes magazine. He has written four major finance books including The Only Three Questions That Count: Investing by Knowing What Others Don't. Ken's theoretical work in the 1970s led to the development of a tool known as the Price-to-Sales Ratio, which is now part of core financial curriculum. He is the Chief Executive Officer and Chief Investment Officer of Fisher Investments, a multi-billion dollar multi-product money management firm serving large corporate and public pension plans, in addition to endowments, foundations and high net-worth individuals.

TCS: Let's talk about the current status of the subprime mortgage market. Are you worried?

KEN FISHER: The only thing I fear about the subprime mortgage market is what politicians might do, because fundamentally everyone gets this backwards.

TCS: You don't see major long-term economic consequences?

KEN FISHER: I think intuitively everybody knows that in the long term, this is not a big deal for the economy and the stock market. I don't think it's big enough to matter.

TCS: So what is the problem?

KEN FISHER: There is a different issue that is hugely important that I don't think is widely recognized. Let me walk you through this.

First, you have to understand that a subprime mortgage, from its origination, is the offering of a mortgage to someone who otherwise wouldn't qualify to buy a home.

If you look at the history of subprime loans, they tend to average about a ten percent default rate. Now we're up around 14 percent. So all this brouhaha is about the increase from that historic ten percent default rate to today's rate of 14 percent.

But a ten percent default rate means that 90 percent of the people who got these loans ended up owning homes that they wouldn't otherwise have been able to buy. The question is: Do we want more people to have homes or do we want fewer people to have homes? My view is more people owning homes is moral and good. Fewer people owning homes is immoral and bad.

We should be encouraging subprime loans. Because it's the way these people get homes.

TCS: If you want to promote home ownership at the margin, don't you by definition have to lend to people who don't qualify for traditional mortgages? And doesn't the risk of default increase in some proportion to how deeply you move into that pool of non-homeowners?

KEN FISHER: Yeah, and default rates are now up. There are more people failing. But say you got to a ratio of 85/15. We're still better off. If the default rate soars all the way up to 20 percent, we'd still be better off.

Politicians want to talk about this as if subprime lenders were involved in predatory activities because some of the people that borrowed from them failed and suffered. These politicians talk as if they want to restrict this activity moving forward so that, simply put, those 90 percent of subprime borrowers won't be able to buy homes.

The fact is, if 90 percent of our activities succeed and ten percent fail, we're a whole lot better off than if we didn't do anything at all.

And, yes, I'm sympathetic to those who suffer the pain; but I'm really gleeful about the 90 percent who got the homes.

TCS: So what should be done?

KEN FISHER: It's actually easy to address the problem by simply trying to help some of those in trouble, if that's what we want to do. That's a separate societal choice. But do we want to prohibit lenders from making loans to people who want a house but otherwise couldn't buy one? This is a very simple choice, but it's so easy for people to get it backwards.

TCS: So you don't think subprime borrowers have been victimized by the banking establishment?

KEN FISHER: People act as if all of these subprime borrowers are some kind of idiotic nincompoops who don't have a clue as to what they're doing. The way I describe it in my book, they're basically portrayed as alcoholics sitting in front of a television, drinking all day and all night long. They don't have a clue as to what's going on around them.

Suddenly they get a call from their banker. He says, "Your adjustable rate mortgage went up and you owe me a lot more money-- or I'm gonna take your house away." Now mind you, there may be some people like that out there. But most of these people are aware of their situation and are self interested.

Again, the default rate has traditionally not been very high. And even though it's higher now than it was at the beginning of the year, it's still not very high. That tells you that most of the people who took these loans were actually making rational decisions.

Let me take you through this a different way.

If you go back five years ago, we had very low short term interest rates. Back then a borrower could say, "Gee, you're going to give me an adjustable rate subprime mortgage. I have a choice between having low monthly payments at a low current rate or higher monthly payments with a traditional fixed rate mortgage. Okay, I'm gonna choose the cheap adjustable rate mortgage, knowing that the rate could go up later."

So, he does that. He buys the house. He gets double digit appreciation in 2003, 2004 and 2005. In 2006 appreciation slows down and in 2007 it goes slightly negative.

The fact is, that person was a successful speculator. He enjoyed three years of double digit appreciation, traded against the risk that his monthlies might go up a few percent.

Based on the higher value of his home, he can now borrow still more to cover all the monthly payments for the rest of his life at the higher rate. People like this came out ahead. They didn't come out behind.

There are a few that didn't figure it out. But the bulk of subprime borrowers actually came out way ahead of the game. And we act as if we want to restrict this activity!

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