Shelterforce The journal of affordable housing and community building

Spring 2008 » Policies » March 22, 2008

Stemming the Red Tide

Greedy bankers, brokers, and investors abused their political power and forced millions of Americans to lose their homes. Now what can we do to solve the crisis? By John Atlas and Peter Dreier

It’s now official. At its annual convention in January 2008, the American Dialect Society selected “subprime” as 2007’s Word of the Year. The society explained that its choice signifies the public’s concern for a “deepening mortgage crisis.”

“Everyone is talking about ‘subprime,’” said Wayne Glowka, a spokesman for the group. “It’s affecting all kinds of people in all kinds of places.”

The word is likely to gain even more currency in 2008 and even 2009. Indeed, hardly a day goes by without a news story about the accelerating number of foreclosures, an economic tsunami that is causing chaos in the housing and stock markets, the banking industry, and the global money markets, not to mention the families and neighborhoods upended by the turmoil. To most Americans, “subprime” sounds like a neutral technical banking term. Activists prefer to talk about “predatory” lending, which involves abusive practices, perpetrators, and victims.

Whatever it is called, business leaders, activist groups, and some presidential candidates are calling for our government to do something before the situation worsens. But so far, the Bush administration has simply offered Band-Aids on this deep wound, and it is unlikely that it will do more before George W. Bush heads back to Texas next January.

Make no mistake—it is a crisis. More than seven million borrowers now hold subprime loans, according to the Center for Responsible Lending. Most of them involved adjustable-rate mortgages (ARMs) that include an initial low-interest rate that quickly balloons to a higher rate. More than 14 percent of subprime loans are now in default, and the pace is accelerating. Perhaps two million Americans are likely to face the financial pain and psychological grief of losing their homes in the next few years.

The crescendo of public outcry pushed President Bush last November to announce a plan to freeze interest rates for up to five years for some homeowners who purchased homes with high-risk ARMs that are scheduled to reset at higher ratesin many cases, by hundreds of dollars a month.

For the first few days, virtually all of the reporting in the mainstream press referred to Bush’s plan as a rate freeze that would help homeowners trapped by the mortgage meltdown. The Dec. 6, 2007 headline on the Los Angeles Times, for example, was “Bush mortgage plan would freeze rates.” Many of the initial news stories described the agreement hammered out between the administration and the lending industry.

The problem was that no such plan or agreement actually existed. Bush’s plan, which was developed by Treasury Secretary Henry Paulson, Wall Street’s representative within the Bush administration, was a voluntary set of guidelines that relied on the benevolence and generosity of banks. And it was a polite request to investors who have massively profited from the overly exuberant run-up of housing prices and mortgage-backed securities: Help if you can, but only if you feel like it. There was absolutely no requirement or regulation that would force the banks and the investor community to share the pain or be part of the solution.

Bush’s remedy was in fact a business plan that suggested to investors that they might want to think about how much money they’ll lose in a foreclosure and reduce their returns now to head it off. It’s a reasonable business calculation, if you are a bank. But for the White House—a public institution responsible for the well-being of the nation—it was little more than a public-relations stunt.

Even some of the critics got fooled, declaring that the Bush plan didn’t go far enough because too many borrowers would fail to be “covered” by the rate freeze. But their complaints ultimately helped shift the news media’s understanding of what Bush was really doing. Consumer activists, and then the Democratic presidential candidates, pointed out that even if banks and investors went along with the proposed rate freeze, it would have excluded most subprime borrowers, including those who are in the deepest trouble, already delinquent on their mortgage payments and facing foreclosure.

Of the perhaps 2 million ARMs that are expected to reset through the end of 2009, only 240,000 of them—12 percent—would be covered by a freeze, according to Barclays Capital, as reported in The New York Times. The Center for Responsible Lending estimated that only 145,000 households would qualify for Bush’s proposed rate freeze. Most borrowers would still be on their own to negotiate with their lenders.

“This is not a homeowner bailout,” John Taylor, president of the National Community Reinvestment Coalition, a consumer-advocacy group, told the media. “This is a bailout for failed regulatory oversight. Infectious greed and malfeasance by lending institutions is the overwhelming culprit, not consumer misbehavior.”

“It’s very disappointing,” Michael Shea, executive director of ACORN Housing, explained to reporters. “Wall Street has made billions and now they’re hardly paying anything at all” for their role in the subprime crisis.

Bush, who once touted his administration’s goal as creating an “ownership society,” may now go down in history as the president on whose watch homeownership declined. Starting with President Bill Clinton and continuing under President Bush, the nation’s homeownership rate grew, especially among African Americans and Latinos. But that growth was based in large part on a fragile foundation of subprime and predatory loans. Since 2005, the homeownership rate has fallen for all racial groups and will plummet further this year and next year. Moreover, Bush’s unwillingness to take bold steps to regulate lenders, brokers, and investors will guarantee that the next president will inherit a much bigger mortgage mess.

The mortgage meltdown has serious ripple effects. Studies reveal that foreclosures increase violent crime in neighborhoods. Houses become vacant, deteriorate into eyesores, and detract from the feeling of well-being in neighborhoods. Vacant houses attract crime and make it more difficult for neighbors to purchase homeowner insurance.

Property values, and thus local property-tax revenues, plummet, making it harder for cities to provide good schools, police protection, and other services. As a result, a number of cities have recently sued lenders, contending that their practices discriminated against black borrowers and led to a wave of foreclosures that has reduced city tax revenues and increased municipal costs. Baltimore is suing Wells Fargo; Cleveland is suing 21 lenders, including such high-profile companies as Citigroup, Bank of America, Wells Fargo, Merrill Lynch, and Countrywide Financial.

According to a report by the U.S. Conference of Mayors, the weak housing market, and the large inventory of unsold homes, will likely reduce home values by $1.2 trillion this year. About half of that decline is attributable to the sharp increase in foreclosures The report predicts that home prices will decline by 7 percent in 2008, ranging as high as 16 percent in California, sales of existing homes will fall by 10 percent and housing starts will fall off. In turn, the weak housing market, lay-offs in the financial industry, and the reluctance of lenders to make loans are careening the nation into a recession.

“Subprime” and “Predatory” Lending

The mortgage meltdown is the result of two distinct but overlapping practices by the nation’s lenders and investors.

The first is the dramatic growth in subprime lending. The other is the wave of predatory lending. The media has typically confused these two phenomena, but they are different and require different remedies.

“Subprime” is the financial industry’s term for high-interest loans to people who would otherwise be considered too risky for a conventional loan. These include middle-class families who have accumulated too much debt, and low-income working families who want to buy a home in the inflated housing market. Many subprime loans carry adjustable rates, starting low and jumping sharply after a few years. Subprime loans typically have higher application, appraisal, and other fees, as well as higher mortgage insurance payments, principle and interest payments, late fees, and fines for delinquent payments.

Only a decade ago, subprime loans were rare. But, starting in the mid-1990s, led by Household Finance Corporation, subprime lending began surging. They comprised 8.6 percent of all mortgages in 2001, soaring to 20.1 percent by 2006. Since 2004, more than 90 percent of subprime mortgages came with exploding adjustable rates.

With interest rates low, housing prices on a steady rise, and practically no government regulation, banks and mortgage-finance companies devised high-interest, high-fee schemes to entice families to take out loans that traditional savings banks would not make.

Many borrowers who were eligible for conventional fixed-rate loans got snookered into taking subprime loans. Other borrowers were talked into taking loans whose terms they barely understood because the documents were confusing. And in many cases, lenders simply lied about the costs of the loans and whether borrowers could really afford them. Nevertheless, subprime lending is not inherently abusive.

In contrast, predatory lending involves an array of abusive practices and targets those least likely to be able to repay. Predatory lenders charge unconscionably high fees and interest rates, sometimes running well over 22 percent. Borrowers face hidden fees masked by confusing terms such as discount points, erroneously suggesting that the fees will lower the interest rates. Many of these loans have prepayment penalties that make it difficult or impossible for borrowers to refinance when interest rates decline.

Predatory Brokers and Lenders

Big mortgage finance companies and banks cashed in on subprime loans. Last year, 10 lenders—HSBC (Household Finance), New Century, Countywide, CitiMortgage, WMC Mortgage, Fremont Investment, Ameriquest, Option One, Wells Fargo, and First Franklin—accounted for 59 percent of all subprime loans, totaling almost $300 billion. Executives and officers of some of these companies cashed out before the market crashed, most notably Angelo Mozilo, the former CEO of Countrywide Financial, the largest subprime lender. Mozilo made more than $270 million in profits selling stocks and options from 2004 to the beginning of 2007. Between 2004 and 2006, the three founders of New Century Financial, the second-largest subprime lender, together realized $40 million in stock-sale profits.

Many of the lenders were legitimate operations providing a market for credit-risky people. But others sought huge profits through unsavory means. Unfettered by government regulation, they flouted banking standards.

Lenders typically have salespeople who hound vulnerable families for months, soliciting and encouraging them to take out a loan to buy a house or to refinance. But there are also independent mortgage brokers who operate in the netherworld of the lending industry, earning fees for bringing borrowers to lenders—the larger the mortgage, the larger the fee.

Many borrowers of subprime and predatory loans are working- and middle-class families who fell victim to the country’s economic squeeze, a hardship not of their own doing, but rather a symptom of the economic trends of the Bush years, including widening economic disparities, stagnant wages, and an increase in poverty. At a time when soaring housing prices were out of whack with the rest of the economy, subprime loans were the only way they could achieve the American Dream of owning a home. But when they could no longer keep up their mortgage payments, they had no safety net. They began skipping their monthly mortgage payments, especially after the ARMs kicked in with higher interest rates, as high as a 30-percent spike for some borrowers.

Not all subprime borrowers are innocent victims. Some were speculators, seeking to profit from the real-estate housing bubble with their eyes wide open. They expected to rent their houses or quickly flip them to another buyer in a rising housing market. Others were simply living dangerously above their means, taking on too much debt and occupying houses that, by any reasonable standard, they couldn’t really afford.

Investors

At the other end of the financial services industry are the investors, people, and institutions that borrowers never see, but who made the explosion of subprime and predatory lending possible.

Subprime lenders didn’t hold onto these loans. Instead, they sold them—and the risk—to investment banks and investors who considered these high-interest-rate loans a goldmine. According to various sources, including MSNBC, The Washington Post, and First American LoanPerformance, by 2007, the subprime business had become a $1.5 to 2 trillion global market for investors seeking high returns. Because lenders didn’t have to keep the loans on their books, they didn’t worry about the risk of losses.

Wall Street investment firms set up special investment units, bought the subprime mortgages from the lenders, bundled them into “mortgage-backed securities,” and for a fat fee, sold them to wealthy investors worldwide. According to The New York Times, Bank of China Ltd. held almost $9.7 billion of securities backed by U.S. subprime loans. The major ratings agencies gave subprime securities top ratings, failing to evaluate the real risks.

With the bottom falling out of the subprime market, more than 80 mortgage companies have gone under since the middle of 2007. Major Wall Street firms took huge loses as the crisis ripped into foreign money markets, from London to Shanghai. Lehman Brothers underwrote $51.8 billion in securities backed by subprime loans in 2006 alone. As of September 2007, 20 percent of those loans were in default, The New York Times reported. Similarly, about one-fifth of the subprime loans packaged by Morgan Stanley, Barclays, Merrill Lynch, Bear Stearns, Goldman Sachs, Deutsche Bank, Credit Suisse, RBS, Countrywide, JP Morgan, and Citigroup were 60 or more days delinquent, in foreclosure, or involved homes that have already been repossessed.

It All Started with Deregulation

There was a time, not too long ago, when Washington did regulate banks. The Depression triggered the creation of government bank regulations and agencies, such as the Federal Deposit Insurance Corporation, the Federal Home Loan Bank System, Homeowners Loan Corporation, Fannie Mae, and the Federal Housing Administration, to protect consumers and expand homeownership. After World War II, until the late 1970s, the system worked. The savings-and-loan (S&L) industry was highly regulated by the federal government, with a mission to take people’s deposits and then provide loans for the sole purpose of helping people buy homes to live in. Washington insured those loans through the FDIC, provided mortgage discounts through FHA and the Veterans Administration, created a secondary mortgage market to guarantee a steady flow of capital, and required S&Ls to make predictable 30-year fixed loans. The result was a steady increase in homeownership and few foreclosures.

In the 1970s, when community groups discovered that lenders and the FHA were engaged in systematic racial discrimination against minority consumers and neighborhoods—a practice called “redlining”—they mobilized and got Congress, led by Wisconsin Senator William Proxmire, to adopt the Community Reinvestment Act and the Home Mortgage Disclosure Act, which together have significantly reduced racial disparities in lending.

But by the early 1980s, the lending industry used its political clout to push back against government regulation. In 1980, Congress adopted the Depository Institutions Deregulatory and Monetary Control Act, which eliminated interest-rate caps and made subprime lending more feasible for lenders. The S&Ls balked at constraints on their ability to compete with conventional banks engaged in commercial lending. They got Congress—Democrats and Republicans alike—to change the rules, allowing S&Ls to begin a decade-long orgy of real-estate speculation, mismanagement, and fraud.

The iconic figure of that era was Charles Keating, who used his political connections and donations to turn a small lender, the Lincoln Savings and Loan Association, into a major real-estate speculator, snaring five senators (the so-called “Keating Five”) into his web of corruption. In 1989, Lincoln Savings collapsed as a result of its risky loans. Edwin Gray, former chief of the Federal Home Loan Bank Board, which regulated S&Ls, told Congress that several U.S. senators, including John McCain, the Arizona Republican now running for president, had approached him and requested that he ease off on the Lincoln investigation. These senators had received $1.3 million in campaign contributions from Keating.

The deregulation of banking led to merger mania, with banks and S&Ls gobbling each other up and making loans to finance shopping malls, golf courses, office buildings, and condo projects that had no financial logic other than a quick-buck profit. When the dust settled in the late 1980s, about a thousand S&Ls and banks had gone under, billions of dollars of commercial loans were useless, and the federal government was left to bail out the depositors whose money the speculators had looted to the tune of about $125 billion.

As a result of industry consolidation, between 1984 and 2004, the number of FDIC-regulated banks declined from 14,392 to 7,511. In 1960, the 10 largest banks held 21 percent of the industry’s assets; by 2005, the 10 largest banks controlled 60 percent of the assets. Meanwhile, a netherworld of non-bank institutions that lend and invest money emerged, offering complex and risky loan products and investment vehicles that defy common understanding and resist government regulation.

The stable neighborhood S&L soon became a thing of the past. Banks, insurance companies, credit-card firms, and other money-lenders became part of a giant financial-services industry, while Washington walked away from its responsibility to protect consumers with rules, regulations, and enforcement. The icing on the cake was the Gramm-Leach-Bliley Act of 1999, which tore down the remaining legal barriers to combining commercial banking, investment banking, and insurance under one corporate roof.

Meanwhile, starting under the Reagan administration, the federal government slashed funding for low-income housing, and allowed the FHA, once a principal force in helping working-class families purchase a home, to drift into irrelevancy.

Into this vacuum stepped banks, mortgage lenders, and scam artists, looking for ways to make big profits from consumers desperate for the American Dream of homeownership. They invented new “loan products” that put borrowers at risk. Thus was born the subprime market.

At the heart of the crisis are the conservative free-market ideologists whose views increasingly influenced American politics since the 1980s, and who still dominate the Bush administration. They believe that government is always the problem, never the solution, and that regulation of private business is always bad. Lenders and brokers who fell outside of federal regulations made most of the subprime and predatory loans.

In 2000, Edward M. Gramlich, a Federal Reserve Board member, repeatedly warned about subprime mortgages and predatory lending, which he said jeopardized the twin American dreams of owning a home and building wealth. He tried to get Fed chairman Alan Greenspan to crack down on irrational subprime lending by increasing oversight, but his warnings fell on deaf ears, including those in Congress. (For more on Gramlich, read “Freedom for the Pike.”)

“The Federal Reserve could have stopped this problem dead in its tracks,” Martin Eakes, chief executive of the Center for Responsive Lending, recently told The New York Times. “If the Fed had done its job, we would not have had the abusive lending and we would not have a foreclosure crisis in virtually every community across America.”

As Rep. Barney Frank wrote recently in The Boston Globe, the surge of subprime lending was a sort of “natural experiment on the role of regulation,” testing the theories of those who favor radical deregulation of financial markets. And the lessons, Frank said, are clear: “Reasonable regulation of mortgages by the bank and credit union regulators allowed the market to function in an efficient and constructive way, while mortgages made and sold in the unregulated sector led to the crisis.”

Some political observers believe that the American mood is shifting, finally recognizing that the frenzy of deregulation that began in the 1980s has triggered economic chaos and declining living standards. If they needed proof, the foreclosure crisis is Exhibit Number One.

Where Do We Go from Here?

Public officials need to distinguish legitimate subprime lenders from the scam artists who engage in predatory lending. Likewise, the people facing foreclosure need to be treated differently depending on whether they failed to exercise personal responsibility or were victims of predatory practices. Banks and other lenders as well as investors who speculated in mortgage-backed debt must shoulder some of the blame for this debacle. Likewise, speculators should live with the consequences of their actions.

Congress should enact legislation to protect victims of predatory loans from foreclosure. The victims should have a right to a nonprofit loan counselor or lawyer who can help them renegotiate the loan or sue banks, including big Wall Street firms, for violations of state and federal consumer protection laws. The federal government should provide more funding to nonprofit groups that help homeowners renegotiate mortgages and require lenders to restructure predatory loans. (For more on this subject, see “Help Now, Not Later.”)

One nonprofit group, ACORN, a national network of community organizations, has been pressuring Citigroup to restructure loans rather than foreclose on low-income consumers. ACORN wants lenders to agree to 30-year, fixed-rate, affordable modifications to existing loans so borrowers can avoid interest-rate increases that come with adjustable-rate mortgages. ACORN has also urged lenders to impose a moratorium on foreclosures, which some Democratic presidential candidates have supported.

The National Community Reinvestment Coalition (NCRC) has a foreclosure-prevention program that has saved thousands of homeowners from losing their homes by pressuring lenders to change adjustable-rate mortgages into fixed-rate loans.

UNITE HERE, the garment and hotel workers union, has launched a campaign against Countrywide Financial, the nation’s largest subprime lender, calling on consumers to boycott the company until it guarantees it won’t foreclose on borrowers who have fallen behind on adjustable-rate loans.

These activist groups have made some headway. But without a federal mandate, they have to rely on protest and other threats to get banks to cooperate. They support a bill sponsored by Rep. Brad Miller, (D-N.C.), and Rep. Loretta Sanchez, (D-Calif.), which would allow bankruptcy judges to amend the terms of home mortgages. Under current law, the terms of a mortgage on a yacht or a vacation home can be adjusted during bankruptcy, but not the terms of a loan on primary residences. Advocates believe that the Miller-Sanchez bill could help as many as 600,000 homeowners avoid foreclosure, but the Mortgage Bankers Association is fighting the legislation.

Looking forward, we need the federal government to be a lending-industry watchdog, not a lapdog. Step One is to stop predatory lending. The Mortgage Reform and Anti-Predatory Lending Act of 2007, passed by the U.S. House of Representatives in November, contains some useful provisions. It requires lenders to verify applicants’ income and document that borrowers have a reasonable ability to pay—not just at the initial interest rate, but any future rate hike. It puts private mortgage companies and brokers under the umbrella of federal lending regulations, requiring them to be registered and licensed. It would also allow a borrower to modify an illegal loan before being forced into foreclosure. And it permits states to pursue cases against fraud, misrepresentation, false advertising, and civil-rights abuses. Under the bill, wronged borrowers could seek redress from the original lender, even if they’re not in danger of losing their homes.

But under pressure from the banking lobby, the House gutted some of the better parts of the bill. The Mortgage Bankers Association and the American Banking Association lobbyists persuaded legislators to allow lenders to continue the insidious practice of paying an increased fee to brokers for steering borrowers into higher cost subprime mortgages. It also bars borrowers whose predatory loans have been sold on Wall Street from suing investors for relief until the homeowners are facing foreclosure. In effect, it forces borrowers into foreclosure as a condition for asserting their rights.

Under the bill, victims of predatory loans have almost no ability to pursue claims against investment banks and other investors. Wall Street and the big players in the mortgage market won’t be held accountable for buying abusive loans. Borrowers who were ripped off should be encouraged to sue Wall Street firms in state court for relief.

A sweeping bill introduced in December by Sen. Chris Dodd (D-Conn.), chairman of the Senate Banking Committee, closes many of the loopholes in the House bill by adding more consumer protections and industry penalties. His bill, the Homeownership Preservation and Protection Act of 2007, makes Wall Street and other investors liable for illegal practices of mortgage brokers and lenders. Unlike existing law, which puts the burden on the borrower to identify the broker or lender who made the original deal, Dodd’s bill allows the borrower to sue the current mortgage-holder. It would prohibit lenders from steering borrowers toward more expensive loans and from influencing an appraiser’s value of a house. It requires that lenders confirm that a borrower can afford to pay an adjustable-rate mortgage after the rate jumps, and that loans provide a net tangible benefit to the borrower. It also prohibits prepayment penalties on subprime loans.

Lobbyists for the lending industry will certainly try to weaken the Dodd bill, just as they eviscerated key components of the House bill. We can’t expect a good bill to emerge from Congress this year.

The Job for the Next Congress

To prevent the current crisis from getting worse-and to avoid future crises-the next Congress needs to take much bolder action to rein in abusive mortgage lending. The House and Senate should focus on strengthening nonprofit lending institutions to serve the credit needs of high-risk borrowers. Like the old S&L companies, these nonprofit lenders are highly regulated and devoted entirely to helping people purchase homes with transparent, stable loans.

Nonprofit lenders do better than their for-profit counterparts at helping working-class families become homeowners without putting them at risk. One such lender, Neighborhood Housing Services of America (NHS), a federally chartered nonprofit group with chapters in every American urban area, makes 90 percent of its loans to low- and moderate-income homebuyers—the so-called risky borrowers who only qualify for subprime loans in the private market.

About 54 percent of NHS’ borrowers are minority households. As of June 30, 2007, it has made some 3,000 loans totaling $205 million to these borrowers who otherwise would have been forced into the private subprime market. These NHS borrowers don’t have the same mortgage problems as subprime borrowers. In fact, NHS’s delinquency rate is only 3.34 percent—well below the national rate of 14.5 percent for private-sector subprime loans. The same is true for foreclosures. Only one half of one percent of NHS loans went into foreclosure during the second quarter of 2007, one-fifth the foreclosure rate (2.45 percent) among private lenders.

NHS succeeds for two reasons. It has an effective mortgage education program conducted by its own loan counselors. It requires every borrower to participate in its counseling program before and after a loan is made. Moreover, NHS makes no adjustable-rate loans.

The mortgage bankers and brokers who profited handsomely from the subprime market and predatory lending are working overtime to protect their profits by lobbying in state capitals and in Washington to keep government off their backs. The banking industry, of course, has repeatedly warned that any restrictions on their behavior will close needy people out of the home-buying market. Its lobbyists insisted that the Bush plan be completely voluntary.

This isn’t surprising, considering who was at the negotiating table when the administration forged the plan. The key players were the mortgage-service companies (who collect the homeowner’s monthly payments, or foreclose when they fall behind) and groups representing investors holding the mortgages, dominated by Wall Street banks. The Bush approach reflected both groups’ calculation that for some loans they would do better temporarily freezing interest rates than foreclosing. Groups who represent consumers-ACORN, NCRC, the Greenlining Institute, Neighborhood Housing Services, and the Center for Responsible Lending-were not invited to the negotiation.

None of the Republican candidates for president offered any proposals to seriously address the predatory lending crisis, while the Democratic contenders all took forceful positions to protect homeowners facing foreclosure and add sensible regulation to the financial-services industry. Before he dropped out of the race, John Edwards led the Democrats in highlighting the urgency of the foreclosure debacle. He called for a seven-year freeze on mortgage rates. Echoing Edwards, Hillary Clinton proposes a five-year freeze and a 90-day moratorium on foreclosures. Barack Obama supports a $10-billion foreclosure-prevention fund to help borrowers obtain lower-cost, fixed-rate mortgages. Both Clinton and Obama are co-sponsors of the Dodd bill.

The best hope for real reform rests with a Democratic Party victory in November, securing a majority in Congress as well as the presidency. And after an electoral win, victorious Democrats must make sure that consumer groups are full participants in shaping lending legislation.

Wouldn’t it be nice to hear the next president tell the American people that the era of unregulated so-called free-market banking greed and sleaze is over?

Published by the National Housing Institute