January 07, 2008

In the long term the credit revolution points to other problems too

Sir Wolfgang Münchau in “The credit revolution looks to the long term” January 7 looks for the bright side of our modern credit markets, which is something good. Doing so he brings forward the “subprime mortgage, a product that allows poor families without a credit record to finance a home”. Unfortunately even this might not be such a clear cut and run proposition.

It used to be that depending on his income, a potential home buyer could classify for more or less of borrowings, but the interest rate to be paid on the loan did not differ much between a “good” borrower and a “not so good” one. Not any longer. The current knowledge economy classifies the market in many more different types of credit risks, which of course causes more financial discrimination, for good and for bad.

A thousand dollars paid each month servicing a mortgage during 15 years, when discounted at 11 percent per year, because the borrower is deemed “risky”, is worth 88.000 dollars today. Exactly the same payments, discounted at only 6 percent because the borrower is deemed creditworthy, are worth 118.500…35 percent more! And here lies one of the real problems of the subprime debtors… not only do they have less money but the little money they have is also worth less.

Now add to the above that the credit ratings might not reflect correctly the repayment capacity of the borrowers and we can see how as a society could be drawn into an unsustainable structure.