Will the current explosion in sub-prime lending lead to another financial crisis?

The hottest segment of the consumer loan market today is loans to consumers with poor credit, mostly for the purchase of automobiles or to pay credit card charges. Because these loans are considered subprime and carry very high interest rates, concerns have arisen that we might be in for a repetition of the debacle in the subprime home loan market, which triggered the financial crisis in 2008.

A crisis in a loan market occurs when one of the strategic assumptions upon which loan decisions are made turns out to be unfounded. In the earlier crisis, the critical assumption was that home prices would continue to appreciate as they had for multiple decades. Appreciation was critical in two ways. First, in situations where borrowers could not afford the payment increase that typically occurred on subprime mortgages after 2 years, appreciation would make it possible to refinance the loan with a lower initial payment. In this way, appreciation would keep loans in good standing that would otherwise have defaulted.

In addition, when subprime borrowers did default, lenders were protected by collateral that was long viewed as the best available: the houses in which the borrowers lived. Appreciation in the value of the collateral allowed the lender who foreclosed to recover the unpaid balance plus foreclosure expenses by selling the property. This is why the interest rate difference between subprime and prime mortgages was small - on the order of 2-3 percentage points.

The trigger to the financial crisis was the transition from home price appreciation to home price declines. This eliminated the ability to refinance of most subprime borrowers, increased the default rate, and imposed large losses on lenders who foreclosed on loans in default.

In contrast, collateral plays a very limited roe in the subprime lending that is happening today. Credit card loans are unsecured, and automobile loans are secured by depreciating assets. Everybody knows that automobiles begin to decline in value when they are driven off the dealer's lot. There are no expectations of rising collateral values fueling the boom in subprime lending.

Rather, the impetus comes from the ability to charge interest rates that are high enough to cover high loss rates on loans that default, and still make attractive profits. Because their collateral is inadequate or nonexistent, the difference between the rates charged prime borrowers and subprime borrowers is very large. Where this spread was 2 or 3 percentage points in the home loan market before the crisis, today it is 10 times larger or more.

While subprime lending today is immune to shocks from collateral values, it is vulnerable to a major shock to the economy. A shock that generates high unemployment would erode the ability of many sub - prime borrowers to make their payments. However, the likelihood of such a shock in the near term seems extremely low, and if it happened, many, in fact most other sectors of the economy would be affected.

The more likely shock to the subprime loan sector would come from regulators. In many quarters, the interest rates charged on subprime loans are viewed as extortionate and predatory, which is a mindset that often leads to regulation. The impact of rate ceilings would depend on how low they are set, but even "reasonable" rate ceilings would force the riskiest and most desperate of the subprime borrowers into the hands of illegal loan-sharks, who price their wares much higher than the subprime options that are shut.

I don't like regulations that eliminate options without providing alternatives.

• Contact Jack Guttentag via his website at mtgprofessor.com.

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