Polonius Redux

BORROWING OCCURS when a borrower has confidence in his future and a lender has confidence that the price he is getting for the use of his money--the interest rate--compensates him for the risk that he will not be repaid. Both borrower and lender sometimes miscalculate, and wish they had heeded Polonius' interdiction, "Neither a borrower not a lender be."

That's the dominant sentiment in the so-called sub-prime market, where lenders last year made $605 billion by giving mortgages to people with poor credit. Those borrowers, who account for about 20 percent of the home-loan market, include couples with comfortable incomes who find that they cannot meet the mortgage payments on the too-large and too-expensive homes they bought, and low-income buyers who fall behind in payments, sometimes in the first month, because of an interruption in their employment, a family illness, or one of the other problems that those living on the economic margin often experience. The universe of sub-prime lenders include companies such as HSBC, which may be out-of-pocket to the tune of almost $7 billion.

There is blame enough to go around. Lenders, attracted by the 2 to 3 percentage point premium they could charge, thought that perpetually rising house prices would protect them in the event that they had to foreclose, taking back the property and reselling it quickly and at a profit. So they offered no-down-payment, no-income-verification loans--known as "liar loans" in the trade--to people with checkered credit histories. Borrowers closed their eyes to the fact that interest rates on these loans would rise after the initial "teaser" period.

One result is that delinquency rates on sub-prime mortgages topped 14 percent last year, a record. A spate of foreclosures will inevitably follow. Another consequence is that the problems in this market threaten to spread to the rest of the mortgage market, choking off the flow of credit to the shrinking band of consumers still interested in buying a home. Such an additional blow to the housing market might reverberate through the economy, triggering a recession.

Never one to allow the market to sort things out, Congress is calling for regulation of the sub-prime market. These are the same legislators who forced banks to make loans to inner city borrowers and who were enthusiastic about the way in which sub-prime lending encouraged the spread of home-ownership to lower-income constituents (some 70 percent of American households now own their own homes, compared with about 65 percent in 1991, due in good part to looser lending standards). Democrats in Congress now claim that the borrowers were duped by lenders who did not inform them adequately that their incomes were inadequate to service the mortgages they were seeking. "There oughta be a law," a good old American saying, seems set to trump "Borrower beware."

The banks, meanwhile, are trying to hand these troubled mortgages back to the lenders who originated them, before selling them on to the banks. Without much success, since the loan originators simply don't have the cash to honor their commitments. More than two-dozen mortgage lenders have closed down in recent months, and 100 more are expected to follow suit. One of the largest, New Century Financial Corp, is teetering on the brink of bankruptcy and will go over the edge if its creditors demand that it honor all of its $8.4 billion of repurchase commitments.

Most important of all is the effect that the collapse of the sub-prime market might have on the American economy. Thirty-two of the 58 economists (55 percent) responding to a survey by the Wall Street Journal expect the problems in the sub-prime market to spread to the broader mortgage market as lenders get skittish and tighten their lending standards. But the majority believe even this will not prevent the economy from reaching a 3 percent annual growth rate by the end of this year.

The economists seem to be cheerier than the many investors who rushed to dump shares when the woes of the sub-prime market became obvious. These share-sellers, forerunners of the newest crowd of bears, fear a liquidity shortage as federal regulators tighten lending standards and lenders become pickier about the sorts of creditors they choose to deal with.

The tremors in the sub-prime market are already being felt in what is called the Alt-A market, designed for borrowers who are better then sub-prime risks but not as a sound as prime borrowers. It turns out that 80 percent of all Alt-A loans last year were of the no- or low-documentation variety, best described, perhaps, as fibber loans.