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Spring 2008 » Policies » February 29, 2008

Freedom for the Pike

Book Review: Subprime Mortgages: America's Latest Boom and Bust, by Edward M. Gramlich.
Urban Institute Press, 2007, 120 pp. $25.00 (hardcover).
By Todd Swanstrom

For 30 years now, the American public has been bombarded with the message that government is the source of oppression and markets the fount of freedom. Government laws are coercive, while market exchanges are voluntary. In the free market you never have to do anything you don’t want to do. Therefore, the less government we have, the freer we are. Right?

Wrong. As the British political philosopher Isaiah Berlin wrote: “Freedom for the pike is death for the minnow.” In the absence of protections for the weak and the vulnerable, free markets can lead to oppression just as surely as unjust governments. And, as the mortgage crisis shows, when markets run amok, it isn’t just the weak and vulnerable who are hurt. The rash of foreclosures is slashing the value of middle-income homes, putting local governments and school districts in fiscal stress, and even threatening to pull the entire economy into a recession.

Appointed to the Board of Governors of the Federal Reserve System by President Clinton in 1997, Edward M. (Ned) Gramlich saw the train wreck coming as early as 2000 and did everything he could to warn federal regulators. As chair of the Consumer and Community Affairs Committee, Gramlich helped overcome the strong opposition of the lending industry to finally require reporting on relatively higher-cost loans in 2004. Gramlich warned Alan Greenspan, the powerful chairman of the Federal Reserve Board, in person about the impending crisis but Greenspan ignored him. In his book, The Age of Turbulence, Greenspan argued that “the benefits of broadened homeownership are worth the risk [of foreclosures].”

Before he died of acute myeloid leukemia in September 2007, Gramlich published a lucid and penetrating account of the origins of the foreclosure crisis, Subprime Mortgages: America’s Latest Boom and Bust. Unlike free-market ideologists, Gramlich looked unblinkingly at the facts, showing how deregulation created incentives to seduce homebuyers into unsustainable loans. The book summarizes a bewildering array of data in a clear, almost casual style without losing crucial complexities. For those who want to understand how we got into the mortgage mess, Gramlich’s little book is a must-read.

Gramlich tells the story of how the United States moved from a highly successful regulated mortgage market to an unregulated predatory one. The regulated market had its origins in the New Deal which, in response to the housing collapse during the Great Depression, helped to create the 30-year fixed-rate mortgage with 10 to 20 percent down, putting homeownership within reach of millions more Americans. (Before the 1930s, down payments of 30 to 50 percent were common, and loan terms were short, often six years with a balloon payment of the balance of the loan due at that time.) By standardizing mortgages, the federal government helped to create a secondary market, with investors purchasing large pools of mortgages and thus insuring liquidity in the mortgage market. In exchange for certain privileges, such as deposit insurance, savings and loans were required to invest most of their deposits in local mortgages. The FHA and VA helped to expand homeownership to moderate-income families through mortgage insurance. In a little more than a decade after the end of World War II, the homeownership rate in the United States increased from 45 to 65 percent.

A persistent problem with this regulated market is that minorities were routinely denied access to these highly desirable mortgages. Prodded by community-based organizations (CBOs), Congress passed the Home Mortgage Disclosure Act in 1975 and the Community Reinvestment Act (CRA) in 1977. Gramlich observes that the loans made to low- and moderate-income households to satisfy CRA obligations had default rates that were “pleasantly low.” Banks found that they could make a profit lending to previously excluded families, many of whom had been rejected because of their race or their neighborhood. Screened and counseled by CBOs, these households were creditworthy customers.

About 1980, however, everything began to change. A second-tier mortgage market developed with a whole new jargon that has now become commonplace: subprime lending, predatory lending, ARMs, balloon payments, teaser rates, liar loans, piggyback loans, etc. As denial rates plunged, the challenge for CBOs shifted from redlining to predatory lending, from outright denial to exploitative pricing.

Gramlich traces the beginnings of the subprime industry to a 1980 federal law that repealed the usury, or interest-rate limits, on first-lien mortgages. New mortgage companies sprang up to meet the demand for higher-interest loans to riskier customers. State-regulated mortgage companies made about 50 percent of subprime loans with lightly regulated affiliates of federally regulated lenders making another 30 percent. The result, says Gramlich, was “a gigantic hole in the supervisory safety net.”

So what happened to free-market checks and balances? Isn’t competition supposed to drive down prices, maximizing utility for everyone? The problem, to use a fancy economists’ term, was “information asymmetry.” Sensing huge profits to be made at higher interest rates, subprime lenders invented a bewildering array of new loan products to entice customers, including loans that exceeded 100 percent of value and that had massive increases in monthly payments a few years in—so-called 3/27 or 2/28 loans or adjustable-rate mortgages. Complicated mortgage instruments often had poison pills buried in the legalese, like punishing prepayment penalties. While only 2 percent of conventional loans had prepayment penalties, 80 percent of subprime loans had them, thus making it much more difficult for borrowers to escape the subprime trap.

The proliferation of mortgage instruments made it very difficult, if not impossible, for consumers to make rational choices. Gramlich reports on one experiment showing that University of Chicago MBA students were not able to calculate the real cost of loans. When I took out my own mortgage, there was a pile of paper an inch and a half thick on my broker’s desk. Without benefit of a lawyer, my wife and I signed our names perhaps a dozen times. I could easily have been taken to the cleaners. Fortunately, my mortgage broker was honest. Millions of people were not so lucky.

Mortgage brokers played a key role in the rise of subprime lending. The number of independent mortgage broker firms soared from 7,000 in 1987 to 53,000 in 2004, and about 60 percent of all subprime mortgages were placed through brokers. Many people believe that mortgage brokers represent their interests. With little government oversight, however, mortgage brokers work on commissions and they often have incentives, called “yield spread premiums,” to steer borrowers into higher-cost loans. The destructive process was accelerated by technology. Electronic loan applications reduced application time to as little as 15 minutes, and borrowers were often not even required to submit proof of income.

According to market theory, even if customers were duped, predatory lending should have ground to a halt because no lender is going to continue giving out loans that won’t be paid back. By creating an innovative secondary market, however, the subprime industry severed the connection between those who originated the loans and those who funded them. Wall Street investment firms bought subprime mortgages and bundled them into “mortgage-backed securities” that they then sold to investors around the globe. By pooling thousands of subprime mortgages, they supposedly spread the risk of delinquency and foreclosure. Instead, these new, pooled securities were so complex they obscured the risk. The originators could dump the questionable loans on investors who had little idea what they were purchasing.

The subprime market was justified by what George Bush calls the “ownership society.” Homeownership clearly has benefits. Poverty is not just about the lack of income, but also about the lack of wealth. One of the benefits of homeownership is the ability to build equity that can serve as a safety net when unexpected shocks hit, like loss of a job or sudden medical expenses.

But the subprime market made families more vulnerable, not more resilient. Shockingly, over half of all first-time homebuyers leave homeownership within five years. Gramlich explained that as income variability increased in recent decades, the main cause of loan delinquency is loss of a job. Overburdened with debt, families facing a sudden loss of income are often forced into foreclosure, losing their assets and even their social networks.

A big issue in the mortgage-crisis debate is whether subprime lending led to an increase in homeownership. Gramlich wrote that between 1994 and 2005, the homeownership rate increased from 64 to 69 percent, and he attributes most of this increase to subprime lending. Gramlich argued that many people could not have achieved homeownership without subprime loans. But up to 30 percent of those who took out subprime loans to become homeowners could have qualified for conventional loans. The homeownership rate fell in 2006 and 2007 and probably will continue to fall. Gramlich implies that the benefits of increased homeownership created by subprime lending likely outweighed the costs. But it is highly unlikely that the factures in families and communities, the fiscal stress on local governments and school systems, the increase in crime, and the collateral damage to the U.S. economy are balanced out by a modest increase in the homeownership rate.

Gramlich’s book carries an unfortunate subtitle: “America’s Latest Boom and Bust,” suggesting that the mortgage crisis was caused by speculative fever of the kind that has plagued markets throughout history. This is Alan Greenspan’s explanation in a Dec. 7, 2007 article in The Wall Street Journal, in which he traces the mortgage meltdown to a global excess of savings that drove down interest rates and fueled a housing bubble. Greenspan is quoted as saying that “after a period of protracted adjustment, the U.S. economy, and the world economy more generally, will be able to get back to business.”

Greenspan’s view is self-serving. It gets federal regulators off the hook: there is very little we can do about global savings rates and the irrational exuberance that ensues. There is some truth to the claim that the run-up in housing prices stimulated subprime lending. Consumers and speculators in hot markets took out risky loans figuring they would take a ride on rapid housing inflation.

In fact, however, speculative fever is not the fundamental cause of the mortgage mess. Areas of the country that did not experience large price increases are, nevertheless, suffering from high foreclosure rates. The current rash of foreclosures was fundamentally caused by policy choices that freed up powerful market actors to exploit consumers and investors.

Gramlich outlined a basic set of regulatory reforms that would insure the end of exploitative predatory loans. I wish that politicians would read Gramlich’s book and be convinced by his careful empirical analysis of what needs to be done. In truth, however, the reason the federal government failed to act was not because decision makers lacked the empirical evidence so clearly laid out by Gramlich. Instead, Washington policymakers succumbed to a powerful mortgage industry supported by the prevailing free-market ideology. Until the American people take back that power, they will be forced to pick up the tab for the so-called “free” market.

Published by the National Housing Institute