Yesterday's New York Times had Austin Goolsbee making good sense, at least from my point of view:
Lost in the current discussion about borrowers’ income levels in the subprime market is the fact that someone with a low income now but who stands to earn much more in the future would, in a perfect market, be able to borrow from a bank to buy a house. That is how economists view the efficiency of a capital market: people’s decisions unrestricted by the amount of money they have right now.
The Goolsbee piece is discussed, in relatively favorable terms, at Economics Unbound and at Economist's View, but Calculated Risk is agitated by the whole business:
... In the “permanent income hypothesis” on which the economist-underwritten loan is based, the borrower’s belief that he will always be able to earn more money in the future, which justifies over-consumption of housing in the present into which he will grow, renders mortgage market “efficient” to the extent that it does away with such artificial constraints as down payment and DTI requirements—which are based on “the amount of money they have right now,” and adopts innovative standards depending on an individual borrower’s confidence in the amount of money he might have in a couple of years.
CR is a fair-minded, smart, and honest fellow, and does recognize that the market does not actually operate on the assumption that "the borrower... will always be able to earn more money." Quoting CR quoting Goolsbee:
Of course, basing loans on future earnings expectations is riskier than lending money to prime borrowers at 30-year fixed interest rates. That is why interest rates are higher for subprime borrowers and for big mortgages that require little money down. Sometimes the risks flop. Sometimes people even have to sell their properties because they cannot make the numbers work.
But CR is not convinced:
Of course it’s not surprising that Goolsbee ignores the evidence of a house-price bubble, since there can apparently be no bubbles in perfect markets. Theories do that to you.
I think Felix Salmon had this one covered a few weeks back:
... much of the increase in subprime credit was concentrated in depressed areas such as Michigan and Ohio, which accounted for 15% of all U.S. foreclosures in January. And it's precisely those areas that did not see a run-up in housing prices.
Embracing the Goolsbee point of view does not require one to believe that every nook and cranny of the mortgage market was, or even is, operating on safe and sound principles. But -- sorry to sound like a Real Economist™ -- curious moves, big mistakes, and bad behavior are sometimes just part of the game. On this, Free exchange, the blog from the Economist, adds some good sense its own:
There seem to be some cases of abuse in the subprime market... But it's not clear that this has been very widespread. Even in a very bad subprime market, the overwhelming majority of homeowners will continue to make their payments, benefitting (one presumes) from the ability to own a home and build some equity.
And elsewhere, keith at Housing Panic links (not approvingly) to comforting comments from Bloomberg:
"The contagion isn't that big a problem,'' [head of Bears Stearns' mortgage business Tom] Marano said. "I don't see the risk as being that significant at this point.''
And again from Felix Salmon:
The big losers will be the holders of the equity tranches of MBSs and subprime-backed CDOs, as well as those subprime originators who find themselves holding a bunch of scratch-and-dent loans they thought they'd sold already. So it makes perfect sense that subprime mortgage originators are closing shop. But I'm not shedding too many tears for them: they made a lot of money in the boom years, and then they relaxed their underwriting standards far too much at the end of 2005 and the beginning of 2006. They deserve to bear the consequences.
As for the holders of MBS and CDO equity, we're talking very, very sophisticated investors and financial institutions here, who are almost without exception both willing and able to bear those losses. I see no systemic risks there.
Like Jim Hamilton, I'm not yet willing to argue that financial markets will definitively dodge the spillover bullet. But beyond the heat of the moment, I think Professor Goolsbee has it exactly right.