Most recent commentary on the sub-prime market looks to removing abuses from that market – not shutting it down. Underlying this note of caution is an assumption that, while a lot of bad things have happened in the sub-prime market, on balance it serves a socially useful purpose. While foreclosures are too high, the market has made homeownership possible for many who could not have achieved it otherwise.

But this assumption has now been challenged. The Center For Responsible Lending, an influential consumer group, claims that the sub-prime market causes a net loss in homeownership. (See Subprime Lending: A Net Drain on Homeownership, available on its web site www.responsiblelending.org). This implies that if the sub-prime market were shut down, homeownership would rise, a startling claim that deserves careful scrutiny.

To determine whether the sub-prime market increases or decreases home ownership requires a comparison of two numbers. The first is the number of homeowners who would not be homeowners if not for the sub-prime market. The second is the number of non-homeowners who would be homeowners if not for the sub-prime market. If the second number is larger than the first, which the CRL claims to be the case, the market reduces homeownership.

The CRL measures the positive contribution of the market as the number of sub-prime loans to first-time homebuyers. It measures the negative contribution of the market as the number of sub-prime foreclosures.

I will use the year 2006 as an illustration because it is the year when, according to CRL, the net loss from foreclosures peaked. Their figures show that in 2006, some 3.2 million sub-prime loans were made, of which 1.4 million were to purchase homes. However, only about 354,000 of those were to first-time buyers, while about 625,000 sub-prime loans were foreclosed. CRL subtracts 354,000 from 625,000 to get a net homeownership loss of 270,000.

Parenthetically, CRL ignores the million plus sub-prime home purchasers in 2006 who where not first-time buyers. Their focus is on the homeownership rate, and these buyers already owned their homes. However, a balanced evaluation of the sub-prime market should not ignore its role in enabling existing homeowners to upgrade.

But returning to the main question, was the sub-prime market responsible for a net loss of 270,000 homeowners in 2006? It was not, the market’s contribution to homeownership was positive, not negative.

CRL’s mistake is assuming that every foreclosure of a sub-prime loan reduces the number of homeowners by one, relative to what it would have been had the sub-prime market not existed. That is far from the case.

On sub-prime purchase loans that foreclose, CRL implicitly assumes that the borrower could have purchased with a prime loan which would not have foreclosed. Of course that happens, but not very often. Based on my experience, perhaps one purchaser of 10 using a sub-prime loan could have qualified with a prime loan.

The other 90% of sub-prime purchasers needed a sub-prime loan to qualify. Their foreclosure did not reduce the number of homeowners because, had they been unable to obtain sub-prime loans, they would not have become home owners in the first place.

On sub-prime refinance loans that foreclose, CRL implicitly assumes that the loans would not have gone to foreclosure had the borrower not refinanced into the sub-prime. This is also true in some cases, but is far from the rule. Most foreclosures are triggered by job losses, illness, marital problems and similar factors that overwhelm the borrower regardless of the type of mortgage the borrower has.

Because deceptive solicitations are more common in refinance than in purchase transactions, perhaps as many as 20% of refinance foreclosures would not have occurred had the borrower not refinanced into a sub-prime loan. The other 80% would have gone to foreclosure had the borrower refinanced with a prime loan or not refinanced at all.

Applying my estimates, and assuming the distribution of foreclosures among purchases and refinances is the same as on new loans, the 632,000 sub-prime foreclosures in 2006 accounted for a reduction of about 101,000 in the number of homeowners. That is less than a third of the 354,000 sub-prime loans made to first-time buyers in that year.

Of course, my numbers are only educated guesses. They may be too high or they may be too low. I would like to see an unbiased effort to dig deeper than I have been able to do. Meanwhile, the widely held proposition that the sub-prime market makes a positive net contribution to home ownership, still stands.

Copyright Jack Guttentag 2007