How the Subprime Mortgage Mess Began

02/14/2008 by Jim Haughey

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The federal government made the subprime mortgage mess inevitable when it imposed social engineering rules on private mortgage contracts. The long process began with the 1975 Home Mortgage Disclosure Act (HMDA), the 1977 Community Reinvestment Act (CRA) and the regulatory bureaucracy that these two legislative acts required.

Over the next thirty years, the subprime mortgage market emerged, banks and S&L’s shifted half of their mortgage lending to lines of credit to mortgage brokers not covered by HMDA and CRA and federal bank regulators ignored poor underwriting practices as long as the HMDA statistics showed a rising acceptance rates for mortgage applications for low income and minority households.

The HMDA required banks and other regulated mortgage lenders to report mortgage application acceptances and rejections by the race, age, sex, income and the geographic location of the applicants. This was in response to charges that some lenders had “redlined” poor and minority neighborhoods, refusing to approve mortgages in neighborhoods where they believed people typically had poor credit and home price appreciation was relatively low.

The first set of HMDA statistics showed a lower acceptance rate for low income and minority mortgage applications and led to the enactment of the CRA. This legislation required banks and other regulated mortgage lenders to show improving performance in accepting low income and minority mortgage applications in semiannual audits or face rejection by bank regulators of their requests to open branch banks, acquire another bank or take any action subject to regulatory approval.

The law allowed any community group to object to bank actions requiring regulatory approval if the group believed a bank had an unacceptable record in mortgage lending. The consequence was that a bizarre process emerged in which banks seeking regulatory approval for any expansion plans had to negotiate with community groups and reach an agreement to loosen underwriting standards for low income and minority mortgage applications.

These agreements often included setting up a mortgage fund that would only lend to low income and minority applicants. This often was accompanied by opening offices in low income and minority neighborhoods, providing mortgage application and foreclosure counseling, donations and subsidized loans to community groups and lowering downpayment and income verification requirements. Banks reluctantly accepted this as a cost of doing business in the profitable markets for prime mortgages.

The number of subprime, CRA or “affordable” mortgage loans increased progressively for twenty years but remained well below 10% of the mortgage market. The default rate was several times higher than for prime mortgages but the total default cost was not large enough to threaten the profitability of the overall mortgage business.

Then a 1995 amendment to the CRA permitted securitization of these loans. This changed everything. The bond market could now be tapped to fund CRA loans. Investment bankers very profitably packaged CRA mortgages for bond buyers. As incredible as it now seems, these bonds were rated AAA, making this new source of mortgage funds very inexpensive and “OK” to buy by public and pension funds restricted by law to top rated bonds and other investment funds that shunned low rated bonds.

The AAA rating was an illusion that was ignored by bank regulators, the overseers of pension funds and the Securities and Exchange Commission. How were the bonds rated AAA? The bond rating companies and the bond insurers did not have easy access to the individual mortgages. Absent this they relied on the guarantees provided the banks that pooled the mortgages and sold the bonds to finance them. Often banks created “off the books” paper entities, shielded from their regulators and stockholders. Isn’t this what Enron did?

The illusion was that bond insurers and the banks that packaged the mortgages could meet their commitments to bondholders if the foreclosure rate moved well above the low historic rate. But the historic rate was from an economic environment with ever rising home prices, building equity for mortgage holders, minimal outright fraud by mortgage applicants and mortgage lenders and brokers, no teaser introductory mortgage rates and loose but not absent income verification standards.

The subprime, CRA or affordable mortgage market began to expand very quickly. Everybody was a winner. Low income households got to buy a home. Mortgage brokers, bond raters, bond insurers, real estate brokers and mortgage packagers all got more commissions. CRA auditors were pleased that low income and minority households got better access to mortgages.

To generate more mortgage paper and hence more commissions, mortgage brokers and banks progressively lowered underwriting standards with the tacit approval of CRA auditors and community groups. This spawned no downpayment and no income documentation loans. It was sufficient that an applicant with a poor credit record and income too low or too insecure was taking a credit counseling course.

From the late 1990s into 2005, the subprime share of mortgage lending exploded from about 5-6% to over 20% and was substantially responsible for the double-digit gains in home prices a few years ago. Then prime mortgage borrowers balked at buying homes with prices twice as high as normal in relation to income.

Prices began to decline. You know the rest of the story as it unfolded in the last two years.

Washington is doing very little to deal with the root causes of the subprime mortgage mess. Belatedly, fraudulent practices by mortgage lenders are being prohibited and a few people will go to prison. But these fraudulent practices appeared, and were long tolerated, only after Washington set the eventual mortgage mess in play by insisting that some people were entitled to be homeowners even if they could not afford to buy a home with the rules set by private lenders. Instead, Washington is forcing lenders to provide further subsidies to loans in default. This may be politically correct, especially in an election year, but it assures a similar problem will occur again.

Recent Comments

Jim Haughey blames the subprime debacle on Washington's insistence that "some people were entitled to be homeowners even if they could not afford to buy a home with the rules set by private lenders". Yet his own history shows this good intention was not the cause. He says for twenty year under the relaxed lending rules "the total default cost was not large enough to threaten the profitability of the overall mortgage business." The problem, as he notes, arose from a 1995 amendment to Community Reinvestment Act and rating services subsequently giving AAA ratings to bonds that did not deserve it. He blames the ratings on deceptive "guarantees provided the banks". If banks see expanding home ownership to lower income groups as an opportunity for deceptive business practices, he should blame the banks, not the government policy.
L. Bancroft -
Feb 16 4:24 AM
Mr. Haughey would have us believe that there is some relation between the rise and fall of housing prices and low income borrowers getting mortgages they cannot afford. A moment's reflection would tell him that low income borrowers buy homes in low income areas. A rise in housing prices in those areas would have little effect on housing prices where affluent borrowers are likely to buy. The Wall Street Journal noted in March, 2007 "a large chunk of the subprime-loan market has shifted to higher-income metropolitan areas. In many of those wealthier areas, the delinquency rate has increased quickly. In the Sacramento, Calif., region, where the median household income ranks among the top 10th of major metropolitan areas, the portion of subprime mortgages delinquent for 60 days or more hit 14.1% in December -- more than four times the level a year earlier." Clearly, subprime loans in affluent areas is far beyond the purview of HMDA and the CRA. Speculation fueled by lax lending policies is the more likely explanation for both the rise and the collapse of housing prices. It is an old story and has nothing to do with social engineering.
malton44 -
Feb 16 8:30 AM
You are both missing the point. He is saying that the social engineering led to the production of a dodgy loan type. People later used these loans to buy houses they couldn't afford (in both poor and affluent areas) and that led to a run up in housing prices. Eventually prime borrowers (ones who could have afforded the houses) balked at the prices and that led to the collapse. In other words, social engineering is the pebble that got the whole avalanche started. I'm not sure I believe the whole argument because I think that these loan vehicles would have been developed eventually without the social engineering since they shift the interest rate risk from the lender to the borrower.
khaborak -
Apr 04 8:47 AM