Mortgage Crisis

November 2, 2007 – Volume 17, Issue 39
Should the government bail out borrowers in trouble? By Marcia Clemmitt

Introduction

Valerie Hayes lost her home in Boston to foreclosure, a fate thousands of American homeowners will suffer because they were unable to make the payments on high-interest subprime mortgages.  (AP Photo/Steven Senne)  
Valerie Hayes lost her home in Boston to foreclosure, a fate thousands of American homeowners will suffer because they were unable to make the payments on high-interest subprime mortgages. (AP Photo/Steven Senne)

More than 2 million borrowers will lose their homes to foreclosure because of subprime mortgage lending in recent years. With the housing market booming, lenders enticed many lower-income people into buying homes they couldn't afford by offering adjustable-rate mortgages (ARMs) with temptingly low initial teaser interest rates. Many loans didn't require down payments or documented proof of income. Moreover, with real-estate prices rising many homeowners used the higher value of their homes to get second mortgages to pay for extras like remodeled kitchens. But this year the housing market crashed and the party ended: The low teaser loans reset at higher interest rates, and many borrowers defaulted on their new, higher mortgage payments. When the dust settles, investors who bought mortgage-based securities stand to lose $160 billion or more. Congress and the Bush administration are debating how to help borrowers keep their homes and whether tough, new lending standards are warranted.

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Overview

When retired Chicago office administrator Delores King refinanced her house in 2004, she didn't expect to end up with “a mortgage that's thousands of dollars more than I started with” and payments that “have nearly doubled in two years.”

“I have refinanced before, but I've never seen anything like this,” King told a Senate Banking panel earlier this year. 1

King's loan became unaffordable after its initial low interest rate reset to a higher rate and several unexpected, extra fees kicked in. King says her mortgage broker “rushed me through” the loan closing and never explained the mortgage's unusual features. King is one of millions of Americans in mortgage trouble in 2007, and her tale of an apparently “easy” loan that turns catastrophic is all too common, Eric Stein, senior vice president of the Center for Responsible Lending, in Durham, N.C., told a House subcommittee in September.

An estimated 2.2 million families will lose their homes to foreclosure because of a spate of “reckless” mortgage lending in recent years, Stein said. Today's foreclosure levels are the “worst they've been in at least 25 years,” said Stein. Moreover, he said, “Millions of other families . . . will be hurt by declines in property values spurred by nearby foreclosures.” 2

This house in Pasadena, Calif., is among thousands around the country being sold after the owners defaulted on their mortgages. An estimated 2.2 million borrowers will lose their homes to foreclosure, largely because they had subprime mortgages. Congress and the Bush administration are debating how to help borrowers keep their homes and whether tough, new lending standards are warranted. (AP Photo/Reed Saxon)  
This house in Pasadena, Calif., is among thousands around the country being sold after the owners defaulted on their mortgages. An estimated 2.2 million borrowers will lose their homes to foreclosure, largely because they had subprime mortgages. Congress and the Bush administration are debating how to help borrowers keep their homes and whether tough, new lending standards are warranted. (AP Photo/Reed Saxon)

The worst problems are concentrated in areas with slow economies, where cheap land encouraged a building frenzy, and in popular places like Phoenix and Florida, where floods of retirees and other new residents heated up the housing market.

Lower-income people are most at risk, but others will also feel pain. “Executives who built second homes out in the Carolinas” with 2- or 3-percent-interest loans that are about to reset to higher rates “will have trouble, too,” says Robert Schultz, a home-building consultant in Boca Raton, Fla.

Still in question is whether the crunch will spread beyond housing and drag the nation into recession.

“I think the worst is over,” wrote Jeremy Siegel, a professor of finance at the Wharton School, in early October. “Everyone is going to say, 'There is going to be a big bomb and . . . a hedge fund . . . is going to go under' ” because it invested in mortgage-backed securities that are now defaulting. “Well, we haven't heard anything recently and . . . no news is good news. We are slowly returning to normal here.” 3 Others see deeper housing troubles and recession ahead.

“A recession happens every decade, but this is going to be bigger” than usual “because the debt is so extreme,” says Peter Cohan, president of a management-consulting and venture-capital firm in Marlborough, Mass. Builders will be hard hit as well as “insurance, furniture, paint and building-supply companies,” he says.

Mortgage lenders and insurers are taking big losses, and some — including New Century Financial, the country's second-largest subprime lender — have gone bankrupt as recent loans began defaulting and the housing market slows. 4

Several large investment funds and banks have already taken billion-dollar hits from losses on defaulting mortgages. Last summer big investment bank Bear Stearns put up over $3 billion to save one of its hedge funds that faced huge losses on mortgage investments. 5 Late last month financial giant Merrill Lynch announced an $8-billion loss on mortgage securities, over $3 billion more than the company had anticipated only weeks earlier. 6

A combination of easy money, loose lending standards and real-estate bidding wars that sent home prices soaring contributed to today's problems.

The current crisis comes from a “confluence of factors, and if you looked at each individually, it wouldn't be a big problem,” says Robert Rainish, a professor of finance at the University of New Haven. (continued below)

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The development in the 1990s of investment instruments known as mortgage-backed securities tempted even cautious investors to buy mortgages, Rainish says.

The so-called securitization of mortgages boosted homeownership by enabling banks and other lenders to sell mortgages, thus raising capital to make additional housing loans. With so much mortgage money available, however, “an incredible ramp-up” of riskier mortgages occurred “in a very short period,” says Rainish.

The highest-risk mortgages — known as subprimes — were usually offered to people with poor credit histories at higher interest rates than ordinary mortgages. “Virtually nonexistent before the mid-1990s, subprimes accounted for a fifth of all new mortgages by 2005,” said Robert J. Shiller, a Yale University professor of economics and finance. 7

By 2006, another formerly limited mortgage class was being offered to people with poor credit scores — often without requiring documented proof of income — as lenders sought to write as many mortgages as possible to boost their own bottom lines. Virtually unheard of a decade earlier, subprime and so-called Alt-A loans accounted for $1 trillion of the nation's mortgage debt by 2006, says Rainish.

“People who didn't qualify for credit to rent could get credit to buy a house, says real-estate developer Robert Sheridan, of River Forest, Ill.

Many of the new loans had no or very low down payments and were adjustable-rate mortgages (ARMs) with low initial interest rates that would have to be refinanced later, when rates were much higher.

“You couple easy money with the fact that a lot of people were not astute enough to understand” the risks involved in their loans, and “it was a train wreck waiting to happen,” says Schultz.

Compounding the problem, the high number of would-be new buyers drove house and condo prices far above what was traditionally thought to be affordable. And the easy mortgage money encouraged hopeful homeowners as well as speculators as they bid up prices to unprecedented levels.

Pre-boom, median home prices typically equaled about 2.5 times the buyer's median income. Today, they're about 4.5 times income, and much higher in some regions, says Rainish. “That's a housing bubble.”

Trouble was inevitable when we simultaneously “made home ownership the American dream and then allowed prices to grow way beyond the rate of growth of the rest of the economy,” says Corey Stone, CEO of Pay Rent, Build Credit, an Annapolis-Md.-based company that helps consumers repair bad credit histories.

“The average American today can't afford to buy a home at current prices,” says Robert Hardaway, a professor of law at the University of Denver. “The average home in California costs $500,000. You can't afford that home.” But easy initial mortgage terms made many buyers believe they could, which led to today's record defaults and foreclosures.

Now Congress is contemplating restrictions on risky mortgages.

For example, regulators should impose an “ 'ability-to-repay' standard” for all loans made to people with poor credit histories, Martin Eakes, CEO of the Center for Responsible Lending, told the Senate Banking Committee in February. ARMs “now make up the vast majority of subprime loans, and they have predictable and devastating consequences for . . . homeowners,” who may lose their houses when interest rates change, he said. 8

The Federal Reserve Board (the Fed) — which governs the nation's banking system and money supply — has cut interest rates on bank-to-bank loans to encourage lenders and investors spooked by rising mortgage-default rates to get back in the financial game.

Lower Fed rates would not directly translate into lower mortgage interest. However, by making it easier for banks to get money, “the Fed is signaling, 'Let's restore confidence and get the economy started again,' ” says Philip Ashton, an assistant professor of urban planning and policy at the University of Illinois, Chicago.

The rate cuts get mixed reviews as a strategy to ease the mortgage mess and credit freeze, since many experts partly blame low Fed interest rates in the early 2000s for helping fuel recent excesses.

Meanwhile, states, localities and the federal government — as well as private lenders and the giant Federal National Mortgage Corporation (Fannie Mae) — are making funds and loans available to help struggling homeowners stay put. For example, in hard-hit Cleveland, Cuyahoga County will fund loans to struggling homeowners using $3 million in penalties collected for late payment of property taxes. 9

And under pressure to stop the bleeding, the nation's biggest mortgage lender, Countrywide Financial Corp., announced in October that it will restructure about 82,000 mortgages to make them more affordable. 10

But some economists criticize such “bailouts” as unwise tinkering with economic markets.

“Individuals need to be responsible for their own borrowing,” says Marvin Goodfriend, a professor of economics at Carnegie Mellon University's Tepper School of Business and a research economist with the Federal Reserve Bank of Richmond. That means much more financial education for everyone, he says. The government, the private sector, and nonprofit groups should step up to the task but haven't yet, he says. “People need to hear another voice besides the voice that's saying, 'No money down.'” (continued below)

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As nervous homeowners and investors wait to see how the mortgage crunch plays out, here are some of the questions that are being asked:

Should certain kinds of risky home loans be banned?

As large numbers of mortgages go into default, Congress debates whether some mortgage-lending practices should be ended altogether.

“At least in the vast majority of situations, and definitely any time federal money is involved,” some of the riskiest lending practices should be banned, says Robert Losey, chairman of the Department of Finance at American University in Washington, D.C. For example, “there should be a requirement for significant down payments” for most loans, a tradition that's gotten lost, Losey says. “If someone makes no down payment, they have nothing to risk” and are more likely to walk away from the mortgage if the going gets tough, he says.

Some recent mortgages also have limited requirements for borrowers to document their income and assets — or don't require them at all.

“Oversight should limit or eliminate no-doc [no-documentation] loans,” says Sandra Phillips, an assistant professor of finance at Syracuse University. “There should have been a crackdown on these lenders who were originating mortgages based on nonexistent and inflated equity,” she says.

It's also become common practice for lenders to certify that borrowers are equipped to pay off adjustable-rate mortgages (ARMs) based on whether they have enough income to pay the loans' initial, low “teaser” rates. Critics call for ARMs to be sold only to borrowers who show they will be able to make payments when interest resets to a higher rate.

The Treasury Department and other federal agencies recommended in October 2006 eliminating ARMs that certify only that borrowers can pay the low, initial rates. According to the agencies, analysis “of borrowers' repayment capacity should include an evaluation of their ability to repay the debt by final maturity at the fully indexed rate.” 11

But many in the mortgage industry protest that strict rules will stifle innovation in lending and keep many people from getting mortgages.

“While it may sound reasonable to require that all borrowers contending for” ARMs “be qualified at the fully indexed rate . . . such an approach will lock some borrowers out of the home of their dreams and deprive them of lower payments,” Douglas O. Duncan, senior vice president for research and business development at the Mortgage Bankers Association, told a Senate panel in February. “The magic of today's market is that the widest range of borrowers can get the widest spectrum of loans.” 12

“We cannot agree that underwriting to the fully indexed rate is the correct standard in all situations,” said Sandor Samuels, an executive managing director of Countrywide Financial. Many “homeowners who will need to refinance will not be able to qualify under such a standard,” and “many first-time homebuyers who can currently purchase a home will no longer . . . qualify . . . under the proposed guidelines,” he said. “This will materially reduce housing demand . . . and delay the housing recovery.” 13

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The National Association of Mortgage Brokers (NAMB) “believes the problem of rising foreclosures is complex and will not be corrected by simply removing products from the market,” said NAMB President Harry Dinham.

Indeed, the availability of subprime mortgages helped push homeownership to an all-time high of about 69 percent of families in the last few years. 14

Rules can be significantly tightened without banning some kinds of mortgages altogether, many analysts say.

“I would change the way people [in the mortgage industry] get compensated,” for example, says Cohan, the management-consultant and venture capitalist.

Instead of paying commissions up front, which gives brokers and some lenders' representatives incentive to push buyers into mortgages whether they can afford them or not, “I'd put half the commission in escrow,” Cohan says. If the mortgage “maintained value for 10 years, then brokers would get the money.” But if the mortgage “collapsed, then the money would go to pay the cost of their mistakes.”

“Reducing the incentive for volume” by decreeing that commissions can't be based on the number of deals a broker or salesperson arranges would help limit bad mortgages, says Syracuse University's Phillips.

“You need to regulate and supervise the mortgage brokers,” says Phillips. To do that, federal laws would have to be reinterpreted or rewritten to allow regulation of brokers, she says. “Right now, they're in the cracks” and unregulated.

Risky loans proliferate partly because current disclosure rules don't require lenders to give borrowers clear, understandable information about exactly what their mortgage provisions mean, says the University of New Haven's Rainish. Today's rules about what lenders must tell borrowers “were made before anybody conceived of the current market,” with its proliferation of complex mortgages, he says.

“Borrowers need a one-page summary that explains exactly what their mortgage entails,” says Cohan. “Nobody reads these 65-page things” that current disclosure rules require, he says.

Should the government “bail out” borrowers caught in the mortgage meltdown?

Some analysts are encouraging states and the federal government to loosen the rules governing government-guaranteed mortgage programs to include homeowners in default and provide loan funds to help homeowners refinance. The Bush administration, congressional Democrats and several state governments back at least limited bailout plans, but some economists say any bailout encourages “bad behavior” to continue.

“Bailouts are terrible because they create moral hazard” — the tendency of people to make more bad choices in the future because they didn't have to face consequences of earlier choices, says Goodfriend of Carnegie Mellon University and the Richmond Federal Reserve Bank.

Even if bailouts are labeled as being for homeowners, it's lenders — many of whom engaged in risky and even predatory practices — who largely will benefit, some analysts say.

In August, President Bush announced a plan to open up Federal Housing Administration loans to some people struggling in the mortgage crisis. But, while the president “claims the bailout is for deserving homeowners, the thinly veiled policy changes are obviously meant to ensure that lenders are not defaulted on,” commented the investment Web site eFinanceDirectory.com. 15

Investors who carelessly speculated in high-risk securities would also be winners if fewer mortgages go into default, and the government should not prop them up, some financial analysts say.

“A borrower bailout and an investor bailout are synonymous,” said Paul Jackson, a real-estate analyst for the mortgage blog Housing Wire. Furthermore, allowing people who can't afford their mortgages to get new ones for the same properties doesn't fix the fundamental problem — “millions of borrowers who simply can't afford a mortgage on the property they're now in,” he said. 16

Those who hope for a quick and simple bailout will be disappointed, says Illinois real-estate developer Sheridan. Because housing values won't quickly rebound, “federal legislation to help buyers hold on would have to be in place for a long time,” he says.

Nevertheless, “there's a natural tendency by Congress and the executive branch to throw money at problems,” so bailouts are likely inevitable, says American University's Losey. “But only the people who would qualify for loans anyway should have the opportunity to row their way out,” he says.

Greg Giniel's house in Arizona's Queen Creek housing development in is in foreclosure, but he hopes to buy it back in November. Many borrowers got in trouble because they were saddled with high-risk, high-interest “subprime” mortgages, which are usually offered to people with bad credit histories. However, subprimes were also pushed on many people with good credit. (AP Photo/Ross D. Franklin)  
Greg Giniel's house in Arizona's Queen Creek housing development in is in foreclosure, but he hopes to buy it back in November. Many borrowers got in trouble because they were saddled with high-risk, high-interest “subprime” mortgages, which are usually offered to people with bad credit histories. However, subprimes were also pushed on many people with good credit. (AP Photo/Ross D. Franklin)

“People are going to be hurt, but that doesn't mean we should subsidize them for buying a home they couldn't afford,” Losey says. “There's no reason to say, 'Now we'll let you stay in that home.' ”

Thirty percent or more of buyers in the recent, hot real-estate market “were speculators — non-occupying buyers” who bought homes with easy-to-get mortgages, then tried to “flip” them for a profit as prices rose, says Rainish, at the University of New Haven. Speculators “should not be bailed out,” he says. If the government “is going to do a bailout, they need to be sure that only home-occupying buyers get assistance.”

“We should not be bailing out people who invested in real estate, but it would be easy enough to separate speculators from owners,” says Sheridan. “Just find out who's living in the house. Send them a letter. Show me the bills that come there.”

Nevertheless, the sheer size of the foreclosure mess probably requires action, especially since government has stepped into similar crises as rescuer, says Rainish. “The government is trying to come up with a way for credit institutions to refinance these loans, but the question is how far they're willing to go,” he says. “They spent $150 billion on the savings & loan crisis” of the late 1980s. 17 “And there's not much reason they can't do something similar to mitigate today's level of foreclosure,” he says.

“You will have to say to some people, 'No matter how we restructure the financing, you can't afford the house,' ” Rainish says. “But others can handle a restructured loan.”

However, he adds, “You can't disentangle helping borrowers and lenders.” But he argues that “it's not a bad idea to help the lenders. If lenders are going to come back in the game ever again, you have to help them. Otherwise, you won't have a market.”

Left out of the Bush bailout are lower-income people, especially in minority neighborhoods, many of whom were deceived by predatory lenders into taking on more expensive loans than they realized, says Syracuse University's Phillips. “The irony of the proposal is that it only goes to upper-income people with good credit,” she says. “I don't think we should leave out the population targeted for predatory loans,” she says.

Community-advocacy groups working in neighborhoods hit by predatory lending “are doing a pretty good job helping people find a way to make the payments,” says Phillips. A group she works with in Syracuse has helped many people stay in their homes, she says. (continued below)

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Sen. Charles E. Schumer, D-N.Y., has proposed legislation giving $300 million to community groups that specialize in foreclosure prevention. “This seems like a cost-effective investment to me,” said Schumer. “It will save billions in spillover foreclosure costs.” 18

It wouldn't be difficult to provide assistance only to people saddled with predatory loans because the details of those abusive loans are a dead giveaway, says Phillips. “Looking at the loan agreement, in predatory loans you will see substantial charges [not found in other mortgages], and the fees will be high. There will be restrictions on refinancing.”

Will the mortgage crisis trigger a larger financial crisis in the United States and elsewhere?

Most everyone agrees that people holding subprime mortgages — mostly low-income borrowers with poor credit — are defaulting and losing their homes. How far subprime fallout will spread in the economy, however, is sharply debated.

“The real bears in this market believe housing will lead the economy into recession,” said John Burns, a real-estate consultant in Irvine, Calif. “Thus far, these bears are wrong. The housing market peaked in June 2005 and, two years into the downturn, economic growth is still positive. Unemployment remains very low . . . and consumers have started ramping up their credit-card debt again.” 19

Furthermore, the housing market itself is in good shape, according to Lawrence Yun, senior economist at the National Association of Realtors. “Although sales are off from an unsustainable peak in 2005, there is a historically high level of home sales . . . this year,” he said. “One out of 15 American households is buying a home.” 20

“The speculative excesses have been removed from the market, and home sales are returning to fundamentally healthy levels, while prices remain near record highs, reflecting favorable mortgage rates and positive job gains,” Yun said.

“Housing is only about 5 percent of the economy,” said columnist Ben Stein at Yahoo! Finance. “If it falls by 15 percent, that would represent a fall-off [in the total economy] of about 0.75 percent. That's not trivial, but it's also not the stuff of which recessions are made.” 21

Eight out of the 10 U.S. recessions since World War II “were preceded by sustained and substantial problems in housing, and there was a more minor problem in housing prior to the 2001 recession,” points out Edward E. Leamer, professor of management, economics and statistics at the University of California, Los Angeles. 22

Nevertheless, “this time troubles in housing will stay in housing,” Leamer said. “An official recession cannot occur without job loss, but . . . outside of manufacturing and construction there is little or no job loss. . . . Though this is largely uncharted territory, it doesn't look like manufacturing is positioned to shed enough jobs to generate a recession.” 23

But other analysts are less hopeful.

Some large financial entities, such as hedge funds and institutional investors like pension funds, bought risky packages of subprime mortgages, which are now defaulting at high rates. Worse, some have borrowed a lot of money against these securities, which they can't pay back, spreading the financial pain farther, says financial consultant Cohan. Just how far isn't clear because “we have an unknown amount of money that's been borrowed against these securities, and nobody is willing to mark the [value] truthfully,” Cohan says.

The mortgage meltdown is a replay of similar events in the 1970s and '80s, says home-building consultant Schultz, However, “the results are bigger this time because prices were higher.”

Adjustable-rate loans will reset to higher interest rates over the next two years, “so during that time people will be wondering, 'How do I move from my home? Can I take such a big loss?' ” says the University of New Haven's Rainish. “The resulting uncertainty will freeze up the whole system, and the economy could go into shock.”

Retirement funds and other investors who buy mortgage-backed securities “now don't know how to value part of their portfolio,” Rainish says. “How do you manage your portfolio if you can't put a value on it? . . . Some of them will go under. If you want to sell these securities, you'll have to sell them at 10 or 15 percent below their real value.” (continued below)

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Harvard Professor of Economics Martin Feldstein, a former chairman of the Council of Economic Advisers, said, “If house prices now decline” to traditional levels, “there will be serious losses of household wealth and resulting declines in consumer spending. Since housing wealth is now about $21 trillion, even a 20-percent . . . decline would cut wealth by some $4 trillion and might cut consumer spending by $200 billion or about 1.5 percent of GDP. The multiplier consequences of this could easily push the economy into recession.” 24

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Background

Losing Homes

The beloved 1946 movie “It's a Wonderful Life,” starring Jimmy Stewart and Donna Reed, revolves around the struggle of a small-town banker to help workers hold onto their homes in hard times. The movie provides the traditional image most Americans have of the mortgage business — “there's an S&L [savings & loan] and a borrower, and they know each other,” says management consultant and venture-capitalist Cohan.

Today, that picture is way out of date, says Cohan. “There are many, many more players than there used to be,” and what happens to mortgages in one U.S. town “has ripples that spread out into the national and even international economy,” he says. Moreover, mortgage debt is a much larger piece of each home-owning American's financial picture than in the past. 25

Before the Great Depression of the 1930s, local savings institutions like banks made mortgage loans, and a mortgage lasted for five to 10 years, after which the outstanding principal had to be paid, or the loan had to be refinanced.

During the Depression, however, as employment and house values plummeted, lenders worried about losing money and refused to refinance mortgages. As a result, lenders repossessed many homes when owners failed to make the big final payment. At the height of the Depression, almost 10 percent of homes were in foreclosure.

The federal government began a series of interventions that gradually changed the way home loans are made. The first such program — the Home Owners' Loan Corporation (HOLC), established in 1933 — bought defaulted mortgages from banks and other lending institutions and returned the houses to owners who'd been foreclosed upon, with new mortgages.

The new HOLC loans lasted 20 years and had fixed interest rates. The new mortgages also were fully amortizing — that is, borrowers paid off both principal and interest for the life of the loan and didn't face a large “balloon” payment of the remaining principal when the 20 years was up.

HOLC was disbanded in 1936. But Congress continued to enact laws to ease access to homeownership over the next several decades.

Because the government didn't want to be in the business of holding the HOLC mortgages, in 1936 Congress created the Federal Housing Administration (FHA) to sell mortgage insurance. To encourage private investors to buy packages of government-originated HOLC loans, borrowers paid premiums into an FHA insurance pool that would protect investors from losses if homeowners defaulted. (continued below)

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Beginning in 1938, Congress created several entities authorized to invest in packages of mortgages in order to free up money at traditional lending institutions, such as banks, so they could offer more mortgages. The Federal National Mortgage Association (known as Fannie Mae) opened in 1938, and the Federal Home Loan Mortgage Corporation (Freddie Mac) was created in 1970 to provide competition for Fannie Mae. Over the years, Fannie's and Freddie's mandate expanded from purchasing government-originated loans to purchasing mortgages from private institutions.

U.S. home ownership — and the mortgage debt that goes with it — has grown over the years. In 1949, total mortgage debt equaled only 20 percent of total household income in the United States. By 2001, mortgage debt equaled 73 percent of income.

Selling Mortgages

While Fannie Mae and other government-initiated programs spurred home ownership, today's commercial mortgage market wasn't created until the 1990s, when more private investors became interested in buying up packages of home mortgages that were sold as financial assets — “securitized.” The influx of private money into the housing market helped trigger today's foreclosure problems for subprime loans.

For decades, most private investors were reluctant to invest in packaged mortgages — mortgage-backed securities — “because they would have been bearing the full risk” should homeowners default, as a few inevitably will, says Jay Hartzell, an associate professor of real-estate finance at the University of Texas, Austin.

During the 1990s, however, financial institutions became more adept at “structuring” the securities: slicing up a single mortgage package — totaling hundreds or thousands of loans — into several investment vehicles, or tranches, with a range of risk.

“You take the same loan package, and you say the first 10 percent of the [mortgage] payments go to investors in this security — and it becomes the triple-A-rated, safest security in which the investors will always get paid,” regardless of how many borrowers default, explains Rainish of the University of New Haven. That top-level security provides the lowest dollar payouts, but the payment is guaranteed, no matter what the level of default on the loans as a whole.

Then successive layers of security risk are carved out — each with a lesser guarantee of being paid in full but with a higher payout if they do, he says.

“Once people are able to buy the amount of the risk they want, more become willing to invest,” says Hartzell.

“Nobody who was risk-averse” would buy mortgage-backed securities before the risk was segmented, explains Rainish. Once selling mortgage packages with different risk levels became widespread practice, however, “we have all this money flowing in” to housing lenders, he says. “We've created a money machine.”

But the machine had flaws, says Rainish. Investors didn't really know how risky a buy they were making, a fact that has already led some investment funds to fail and now threatens further instability in financial markets. Bad mortgage loans, which in the past would have affected only a local bank or S&L, now have potential repercussions around the world.

“This is what happened [last summer] with two of [investment bank] Bear Stearns' hedge funds, which placed highly leveraged bets on packages of subprime-mortgage derivative products,” says the British financial Web site Market Oracle. “When the value and creditworthiness of these bond packages . . . was cut due to the subprime defaults . . . the effect . . . was to virtually wipe out the total value of the funds that had been rated as low risk.” 26

Security risk was determined based on historical models predicting that between 5 and 10 percent of the mortgages would default, says Rainish. “But fraud and the lack of adequate underwriting” — documenting borrowers' finances and income to be sure they could make the payments — “changed the results,” he says. “Investors did not anticipate that the underwriting standards would be changed to the degree they have been.”

Determining risk involves seeing how many mortgages have defaulted in the past, then adding any important new factors into your calculation, says Yildiray Yildirim, an associate professor of finance at Syracuse. As the mortgage market heated up, “they didn't use the correct models” to gauge risk, and “some hedge funds and others trading these securities don't even have” a predictive model, he says. “If they see something they think will make money, they go after it.”

Among the overlooked factors was how many subprime borrowers — most of whom have poor credit and low incomes — default on their loans after low “teaser” interest rates on their ARMs expired, Yildirim says.

Insecure Securities

Current accounting standards also encouraged non-bank lenders to write unusually risky mortgages, making it harder for investors to discern the true value of the mortgage-backed securities, says John D. Rossi, associate professor of accounting at Moravian College in Bethlehem, Pa.

A mortgage is essentially a liability for a lender until it's paid off in full, and traditionally it would be listed as such on lenders' account books, where auditors and potential creditors could use it to judge organizations' financial health. However, once a non-bank mortgage lender has “sold” mortgages to investors, current rules allow the lender to erase them from its books, even if the securities were sold on the promise that the lender would absorb some losses, should the mortgages default, Rossi explains.

Being able to take loans off their books increased the likelihood that lenders would engage in shoddier underwriting and make riskier loans, says Rossi. “Most likely it made them a lot less diligent,” he says.

Securities-ratings agencies, like Standard & Poor's and Moody's Investors Service, rate securities based on risk. But the rating system broke down in the past few years, especially for mortgage-backed securities, many financial analysts say.

Based on the history of mortgage-backed securities, ratings agencies were listing subprime mortgage-backed securities as “A” grade — safe investments — when they were actually “B” grade — high risk, says Rainish. “The ratings agencies have been blindsided as much as others. They were pricing in a different world,” he says.

Other analysts say ratings agencies and investors bear much of the blame for their woes.

“Wall Street and rating agencies, rather than state regulators or even lenders, largely decide what types of borrowers obtain subprime loans and how the loan products . . . are designed,” Kurt Eggert, a professor at Chapman University School of Law in Orange, Calif., told the Senate Subcommittee on Securities, Insurance and Investments in April. But “unlike government agencies, ratings agencies work . . . in their own financial self-interest and . . . at the behest of investors and do not have the mandate to ensure consumer protection,” he said. 27

“In the end, Wall Street creates a demand for particular mortgages; underwriting criteria for these mortgages [are] set to meet this demand and [the] underwriting criteria, not the mortgage originator, [dictate] whether a consumer qualifies for this particular loan product,” said Harry Dinham, president of the National Association of Mortgage Brokers. 28

After lenders package mortgages into securities, ratings agencies “put a piece of gold wrapping paper around them,” says venture capitalist Cohan. The agencies have a conflict of interest because “the investment banks shop the packages around and give the fee to the [agency] that gives the best rating,” he says.

“I would be amazed if there weren't massive litigation” by investors against the ratings agencies down the line, says Illinois real-estate developer Sheridan. “They were advising clients how to put lipstick on the pig,” and, “at a minimum, they sure didn't ring the fire alarm bell very quickly.”

Ratings agencies reject such accusations.

The “issuer-pays business model” does have “potential conflicts of interest,” acknowledged Michael Kanef, managing director of Moody's Investors Service Group, to the House Subcommittee on Capital Markets, Insurance, and Government-Sponsored Enterprises on Sept. 27. However, “we believe we have successfully managed” the conflicts by not paying analysts based on revenue earned by companies they rate, posting ratings methodologies on a public Web site, and having a separate analysis team monitor all rated securities on an ongoing basis. 29

Easy Money

More private investors willing to invest in mortgage-backed securities gave lenders an incentive to make more loans. Easy money — and new 1990s technology that allowed financial institutions to automate credit checks and vary interest rates in real time — led lenders to create mortgages that made home ownership seem more affordable.

Investors' interest in mortgage-backed securities increased after the 1990s technology boom went bust, says Ashton, the assistant professor of urban planning and policy at the University of Illinois. With investors wary of stocks and lenders “figuring out ways to help more and more people afford homes, suddenly the subprime mortgage market looked like a good place to park your capital,” he says.

Non-U.S. investment also has flowed into housing. In the developing economies of China and India, “people save a lot of income, they're unsure about their future” and that money needs to be invested, says economist Goodfriend. Oil-producing countries flush with cash from rising oil prices have provided another pot of housing investment, he says.

Finally, to keep the overall economy moving, Federal Reserve Bank Chairman Alan Greenspan kept interest rates at historically low levels for three years, until June 2004, when he began raising them again. Although the Fed sets interest rates only for bank-to-bank money transfers, other lenders take their cue from the Fed rate, and mortgage interest also hit historic lows.

In the 1970s and '80s, interest rates in double digits were the norm, soaring to over 20 percent in 1980. In the 1990s, interest on a 30-year, fixed-rate mortgage hovered between 7 percent and 9 percent. Beginning in 2003, however, rates dropped below 6 percent and have hovered at around 6 percent since, according to the mortgage-information Web site Lender 411. 30

The Federal Reserve “wanted to prevent inflation, but in doing that they made homeownership dirt cheap,” says the University of New Haven's Rainish.

Low interest rates created a surge in mortgage demand between 2001 and 2003, especially for refinancings that allowed homeowners to lower their interest payments and tap into extra cash at the same time, said Emory W. Rushton, senior deputy comptroller and chief national bank examiner in the U.S. Office of the Comptroller of the Currency.

Surging demand prompted “lenders to expand their operations to boost capacity” and “attracted new market participants, often lenders with little business experience or financial strength,” and a flood of new, risky mortgages ensued, Rushton told the Senate Banking Committee in March. 31

As a result, “Lots of people in the United States who have no money — they are called subprime borrowers — borrowed 100 percent of the value of a house right at the top of a housing market which has since fallen sharply,” wrote Paul Tustain, founder of a British investment-information Web site, BullionVault.com. With higher interest and a lower home value, many of these people can't make their new payments or refinance their houses. 32

“The whole system allowed the frailty of human nature to triumph,” says home-building consultant Schultz. “It took away all the restraints.”

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Current Situation

Widespread Pain

Beginning in late 2006 and continuing this year, the wheels came off the mortgage bus. The number of people defaulting — falling behind — on payments, then losing homes to foreclosure, is rising sharply. Some lenders have gone bankrupt, and some recent investors in mortgage-backed securities have seen their investments quickly become worthless.

The financial industry and its regulators “got complacent” as mortgage loans got riskier and riskier, says the University of New Haven's Rainish. “It wasn't until sometime in 2006 that some of this stuff was starting to smell. Prior to that, nobody really got the gist of the excess that was taking place. But in the latter half of 2006, the most recent securities that were sold defaulted almost immediately,” he says.

Midwestern states like Ohio are “national leaders in foreclosures,” says the University of Chicago's Ashton. These areas have been in economic hard times for years, as the auto and steel industries waned, says Rainish. “You're seeing an implosion of income” at the same time as cash-flush lenders offered risky loans, he says. “People wanted to fix up, so they refinanced” with ARMs. “Then there was reset [of interest to higher rates], and they lost their equity.”

The presence of foreclosed homes in a neighborhood affects everybody there, Rainish says. “Nobody can sell a home, even when they need to. You freeze the whole market. On a personal level, it's tragic.”

“Even though we talk about people walking away from homes” and in some cases losing only a little cash since they made small — or no — down payments, “the foreclosure keeps you from buying a home later, and there are legal and moving costs associated with foreclosure, too,” says Ashton.

While Chicago is not one of the hardest-hit areas, “there were still a lot of subprime loans for moderate-to-middle-income households in African-American neighborhoods,” Ashton says. “It may be years — if ever — before they can get back into a home.”

In Florida, Nevada, parts of California and some other sought-after locales, “flippers” — real-estate speculators — are big players in the ongoing crisis, says Ashton. “We've got flippers and speculators simply walking away” from properties, since the loan cost them little in the first place, Ashton says. That leaves lenders holding the bag, he says.

Auctioneer Travis Toth, right, accepts bids for a foreclosed home on the steps of the Los Angeles County courthouse in Norwalk, Calif., on March 16, 2007. To help struggling homeowners stay put, the nation's biggest mortgage lender, Countrywide Financial Corp., is restructuring about 82,000 mortgages to make them more affordable. (AP Photo/Reed Saxon)  
Auctioneer Travis Toth, right, accepts bids for a foreclosed home on the steps of the Los Angeles County courthouse in Norwalk, Calif., on March 16, 2007. To help struggling homeowners stay put, the nation's biggest mortgage lender, Countrywide Financial Corp., is restructuring about 82,000 mortgages to make them more affordable. (AP Photo/Reed Saxon)

Some banks are ending up as owners of condos whose developers couldn't sell the majority of units before housing sales slowed, says Sheridan.

Banks aren't permitted to permanently manage residential properties, so they must sell them, he says. Meanwhile, “residents who've already bought in are locked into a property that isn't being cared for, whose value is deteriorating and which is likely to become a rental property,” which is not what they plunked their money down for, says Sheridan. “The homeowner is not in a happy situation.”

The selling and reselling of mortgage-loan packages to ever-more-distant investors may make it harder for some people facing foreclosure to work out a payment plan to keep their homes.

“How do you do a workout when nobody knows who owns what?” says Rainish. In the past, mortgages sold to a secondary market were in a big portfolio with Fannie Mae or Freddie Mac, organizations that are in the business of helping people stay in their houses. “Now the mortgages are owned by investment funds, by foreigners; they've been sold and resold,” he says. “How are they going to deal with the workout? We don't know.”

Nevertheless, “there still will be in almost every case a local institution that is the servicer” of the loan, says American University's Losey. “They don't have the same vested interest in working it out” as they did when local lenders held onto mortgages. Nevertheless, “I don't know that this means there will be that many more defaults or not,” he says. “There should still be pressure from the institutions that own the securities to work out a logical deal.”

Interest-Rate Cut

Debate rages over whether the government should bail out homeowners and whether strict new rules for mortgage lending should be created.

The first major action at the national level came from the Federal Reserve Board. 33

In August and then again in September and late October, new Fed Chairman Ben S. Bernanke dropped key interest rates that make it easier for banks to lend money. 34 The moves came after the world's banks and other financial institutions began tightening credit, spooked by billion-dollar losses suffered by some banks and investment funds that had found their newly purchased mortgage-backed securities to be worthless. Banks became reluctant to loan to anyone, including other banks, because no one knows which institutions are holding the riskiest mortgage-backed securities.

But “the Federal Reserve's solution to the bubble” of rising house prices driven by easy money “is to keep the bubble going as long as possible,” says Hardaway of the University of Denver, a critic of the move.

“It's like 17th-century Tulipmania in Holland,” when high demand for the showy flowers led hundreds of frenzied speculators into the market, hoping to make a killing, Hardaway says. After prices for single bulbs rose to hundreds of dollars, the mania abruptly stopped as bidders worried that prices could not get any higher. Almost overnight, the price collapsed, bankrupting many middle-class people. 35

“The Fed's policy is just like Holland: 'Let the mania continue, because if it stops, nobody else will be able to buy tulips,'” says Hardaway. “Better to let the bubble burst now,” he argues. “That would flush out all excesses, like the 4-to-5-percent teaser [interest] rate, which is offered to people knowing they won't be able to afford it when it triples.”

Others say the rate cut won't solve the problem but could keep it from worsening. “There's sludge in the system” as investors back away from securitized higher-risk mortgages, and “the Fed is reliquifying the system so banks can carry some new debt,” says Rainish.

Government Role

Congress, the Bush administration, and several states are contemplating or have already acted to aid struggling homeowners and keep the housing market afloat.

Massachusetts, New York, Ohio, Pennsylvania, New Jersey and Maryland, will build loan funds to help homeowners refinance. Ohio, and Pennsylvania will sell bonds to raise funds, for example. 36

The federal Office of Federal Housing Enterprise Oversight (OFHEO) gave the green light Sept. 19 for Fannie Mae and Freddie Mac to increase the amount of mortgage loans they invest in by 2 percent annually, as private investors pull back.

The move was a big deal, given recent concerns about financial fraud at the two mortgage giants. In May 2006, OFHEO capped the size of Fannie Mae's portfolio after investigators said some Fannie Mae executives — since departed — had manipulated accounts to show higher earnings to get bonuses. Fannie Mae paid a $400-million fine in 2006. And in September Freddie Mac paid a $50-million fine to settle its own charges of accounting fraud. 37 Nevertheless, the Fannie Mae and Freddie Mac upticks aren't considered large enough to jumpstart the slowing housing market.

Alternative legislation introduced in October by Sen. Schumer and House Financial Services Committee Chairman Rep. Barney Frank, D-Mass., would do more and also would assist current owners trying to hold onto homes. It would raise investment caps for both Fannie Mae and Freddie Mac by 10 percent for six months and direct 85 percent of the money to refinancing subprime mortgages, mostly for low-income borrowers. 38

Critics of the bill, including the Bush administration, argue that it would be a costly distraction from what they see as a need to reform Fannie and Freddie.

“Frank must know that a temporary increase in the portfolio limits . . . will reduce the pressure for comprehensive reform,” said Peter J. Wallison, a resident fellow at the free-market-oriented American Enterprise Institute think tank. 39

The administration supports another Democratic initiative — eliminating the tax that kicks in for a homeowner when a lender forgives some mortgage debt after a house is sold or a loan is restructured.

“Say you take out a $310,000 mortgage to buy a house and then you find you can't keep up the payments and the house gets sold for $250,000,” says developer Sheridan. “The bank may, out of a sense of compassion, and because they can't collect the $60,000 shortfall anyway, simply write it off.” That sounds like good news for the strapped consumer, but under current law that money becomes taxable income at tax rates as high as 30 or 40 percent, he says. “That's a $15,000 bill you won't have the money to pay.”

Congressional Democrats and the White House have recommended eliminating the tax. Democrats would end the tax permanently and cut tax breaks for sales of some vacation and rental properties to pay it. The White House wants a temporary elimination and would retain the other tax breaks. 40

President Bush also has announced a new Federal Housing Administration program, FHASecure, to offer FHA-insured loans to creditworthy borrowers who are delinquent on their mortgages. Delinquent borrowers were ineligible in the past. 41

Congress also is debating new consumer protections. In September the House Financial Services Committee approved a bill giving several additional federal agencies a watchdog role over mortgage lending. 42 Several states, including Massachusetts, Maine, Minnesota and North Carolina, now require mortgage brokers to scrutinize would-be borrowers more carefully to ensure they can afford their loans. 43

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Outlook

Hitting Bottom

One thing about fallout from the mortgage crisis is not in doubt: Washington will tighten some rules, says American University's Losey. “Congress reacts to crises,” he says.

But the changes will come against a backdrop of stark financial pain and an end to giddy times in which people believed that house values would rise forever.

It will be two years or more before all existing ARMs reset, and only then will the extent of home losses be known, says the University of New Haven's Rainish. “For the subprime mortgage holders, the American dream will be crushed,” he says. “Even many who have been making full payments won't be able to refinance because of prepayment penalties” in many subprime mortgages.

He predicts the housing market will be slow for the next two to three years. “The investment community will take a $100-$200 billion haircut, and many people will be hurt. Consumption growth will be slowed.”

To emerge from the other side of this crisis, we need house prices to contract 20 percent or even as much as 40 percent, says the University of Chicago's Ashton.

“That's not a painless process,” as many homeowners may end up owing more than their houses are worth, Ashton says. Owners with ARMs as their first or second mortgages must either make huge monthly mortgage payments when rates reset or try to refinance. But most won't be able to get a new loan for the full amount of their debt, since falling prices will slash their equity.

“We may hit bottom [on home prices] in early 2009, and maybe 2010 in some markets,” says Sheridan. “There'll be a long period of prices staying down.”

Most if not all subprime borrowers would have been unable to seek loans except under the conditions of the past few years, “so now that whole demand has gone away,” possibly permanently, says Margaret Mann, head of the restructuring and insolvency practice at San Francisco-based law firm Heller Ehrman.

“Builders have almost stopped building,” and a glut of housing inventory sits in some markets, says Florida home-building consultant Schultz. In South Florida, for example, three to four years' worth of condo inventory already sits empty, he says. “I doubt that the demand will ever be back to the level of 2007. A lot of regional and national builders will have to scale back.”

Commercial real estate could be next to go bust. New, empty office buildings with large construction debts and vacant retail malls are being reported around the country, according to Michael Shedlock, an investment consultant for SitkaPacific Capital Management, in Prairie Grove, Ill.

“Here we are, right near the tip top in commercial real-estate insanity where no price was too high to pay for a building on the silly belief that property values would continually rise,” said Shedlock. “Given how rapidly investor psychology is changing in this sector, it won't take much now to send it over the edge.” 44

Furthermore, many analysts say it's only a matter of time before a new boom of risky loans and investments occurs again, followed by inevitable bust.

“People's memories are usually good for five to 10 years, “says Hardaway at the University of Denver. “For that period of time, maybe they'll remember they should look at the collateral.”

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Pro/Con

Should the federal government impose stricter rules on the mortgage industry?

Pro

Sen. Christopher J. Dodd, D-Conn.
Chairman, Senate Committee on Banking, Housing and Urban Affairs. From a statement to the committee, Oct. 3, 2007

Today we are facing a serious meltdown in the subprime mortgage market. This crisis is the equivalent of a slow-motion, 50-state Katrina, taking people's homes one by one, devastating their lives and destroying their communities. As a result, 2.2 million families are in danger of losing their homes to foreclosures at a cost of over $160 billion in hard-earned home equity that should have been available to finance college educations, pay health-care expenses or [act] as a cushion against uncertainty.

President Bush and his administration need to get fully engaged. They need to press subprime servicers and lenders to modify loans into long-term, affordable mortgages. Where modifications are not possible, the administration must work with Fannie Mae and Freddie Mac to refinance troubled borrowers on fair and affordable terms.

In April, I convened a Homeownership Preservation Summit where a number of the largest subprime lenders and servicers pledged to do these modifications. Unfortunately, a recent report tells us that just 1 percent of subprime adjustable-rate mortgages have been modified. This is wholly inadequate, and the administration must work with us to press the lenders and servicers to live up to their obligation.

While we are focused today on how we can rescue homeowners that have been victimized by predatory practices, we are also mindful that we need to prevent these kinds of abuses in the future.

The federal regulators — the cops on the beat — must be far more aggressive in policing the markets. The Federal Reserve [Board] noted as early as 2003 that problems were developing. Yet, not until it came under intense pressure from the Congress did the Federal Reserve agree to meet its obligation under the Homeownership and Equity Protection Act to prohibit unfair or deceptive mortgage practices. The board has the power to put an end to many of the practices that have gotten us into this mess today. They ought to exercise that power, and they ought to do it comprehensively and quickly.

In addition, a number of us have introduced or outlined anti-predatory-lending legislation. Let me say, the measure of any legislation must be that it creates high lending standards for the subprime market, and it must include remedies and penalties sufficient to ensure those standards are adequately enforced. Today's crisis is a market failure. Legislation must reengineer that market so that it works to create long-term, sustainable and affordable homeownership.

Con

Rep. Tom Price, R-Ga.
Member, House Committee on Financial Services. From a statement to the committee, Sept. 5, 2007

As anyone paying attention can tell you, we're seeing a dramatic increase in the actual number of foreclosures. To put the current “crisis” in perspective, according to the Mortgage Bankers Association in the first quarter of 2007 there are about 44 million mortgages in the U.S. and less than 14 percent of them are subprime. And only about 13 percent of those subprime mortgages are late on payments, with the majority of late payers working through their problems with the banks.

With approximately 561,857 mortgages in foreclosure — up from roughly 517,434 from the fourth quarter of 2006 — the subprime “meltdown” has given us an increase of 44,423 foreclosures. This still represents a small percentage of the number of home mortgages.

One of the main reasons we have seen a rise in foreclosures is that during the housing boom of the last few years, consumers with a higher credit risk qualified for mortgages. Now that those riskier loans are resetting to higher interest rates — a trend that will continue until April of 2008 — a credit crunch is occurring for home buyers. It will take time to determine which of the mortgage-backed securities contain “bad” loans and which don't, partially because the entire securitization process is relatively new and hasn't faced a challenge of this size.

A comprehensive consumer-advocacy-driven predatory-lending bill is not the answer. It is tantamount to fighting the last war and will only make the markets more skittish, as they have to react to new underwriting standards and liability issues, making the situation worse, not better. This would harm all consumers!

By the time a new “anti-predatory-lending” law goes into effect in the marketplace, this problem will already have changed, and we will be left with strict, national underwriting standards that will prohibit various loan products and banish a number of consumers to the rental market forever. This is not a goal that is responsible.

The American economy has more than enough liquidity and is plenty strong enough to weather this bump in the road. Congress should stay out of the way while the market corrects itself or it will only make matters worse. We saw last week just how strong the market is when the Commerce Department reported that the gross domestic product — the broadest measure of economic health — expanded at an annual rate of 4 percent in the April-June quarter, significantly higher than the 3.4-percent rate the government had initially estimated.

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Chronology

 
1930s-1970s After thousands of Americans lose their houses during the Great Depression, the federal government establishes programs to support home ownership.
1933Federal Home Owners Loan Corporation (HOLC) repurchases foreclosed homes, reinstates former mortgages.
1936Federal Housing Administration (FHA) is created to insure HOLC mortgages so that investors will buy them.
1938Federal National Mortgage Association — Fannie Mae — is founded as a “government-sponsored enterprise” to invest in mortgages, freeing up funds for lenders to make more home loans.
1944Veterans' Bill of Rights creates a home-loan program for veterans.
1968Truth in Lending Act passes, requiring lenders to informer borrowers about key terms in their loans. . . . Fannie Mae becomes a private, shareholder-owned company.
1970Freddie Mac (Federal Home Loan Mortgage Corporation) joins Fannie Mae as a “secondary mortgage market,” freeing up lenders' cash to offer more loans.
1974Congress enacts Equal Credit Opportunity Act to stem lending discrimination against minority borrowers and others. . . . Real Estate Settlement Procedures Act requires lenders to give “good-faith estimates” of mortgage closing costs.
1980s-1990s Adjustable-rate, interest-only and low down-payment mortgages become popular, spurring private investors to buy mortgage-backed securities. . . . Loans purchased by FHA, Fannie Mae and Freddie Mac decrease as a proportion of housing market.
1989First Bush administration and Congress act to bail out the savings and loan industry after S&Ls around the country make bad investments and collapse.
1992Federal Reserve Bank of Boston concludes that low-income and minority neighborhoods face abusive lending practices and bias from borrowers.
2000s House prices rise faster than inflation or incomes, and many homeowners take on second mortgages to pay other bills. Investors pour cash into the housing market, leading lenders to offer subprime mortgages, some of which don't document borrowers' incomes. Risky lending and soaring prices create a home-foreclosure crisis.
2003New mortgages are written worth $4 trillion.
2004Federal Reserve Bank raises interest rates, causing a 26 percent drop in new home loans.
2005Federal Reserve Chairman Alan Greenspan says that “without calling the overall national issue a [housing] bubble, it's pretty clear that it's an unsustainable underlying pattern.” . . . Average house price grows more than three times faster than disposable income. . . . Delinquent payments and foreclosures rise. . . . House prices increase 49 percent over 2004 in Las Vegas; 43 percent in Phoenix. . . . Subprime loans make up 20 percent of new mortgages, up from 8 percent in 2003. . . . Forty percent of existing mortgages are refinanced.
2006New Fed Chairman Ben S. Bernanke says housing market will “cool but not change very sharply.” . . . New home construction drops. . . . Mortgage lender Ownit Mortgage Solutions files for bankruptcy. . . . Housing-finance giant Fannie Mae pays $400-million fine on accounting-fraud charges. . . . Risky new mortgages, like interest-only loans and loans that don't require documentation of the borrowers' income account for 13 percent of new mortgages, up from 2 percent in 2003.
2007Mortgage lenders including New Century Financial, the second-largest subprime lender, file for bankruptcy. . . . Standard & Poor's and other securities-rating agencies downgrade securities backed by subprime mortgages. . . . Mortgage-market problems cause earnings to fall at major investment banks like Bear Stearns and Goldman Sachs; Merrill Lynch posts an $8-billion loss in the third quarter. . . . IDK, a German bank, slashes its earnings targets due to heavy losses on U.S. subprime investments. . . . In May, foreclosure filings are up 90 percent from May 2006.
  

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Short Features

Lenders add extra fees, omit key information.

Some mortgage lenders have taken advantage of the housing boom to saddle borrowers with loans they can't afford, especially in minority neighborhoods.

It's easy to take advantage of people when it comes to mortgages, says Robert Schultz, a Boca Raton, Fla., home-building consultant. Some lenders have pushed loans that were too good to be true, taking advantage of many borrowers' lack of financial savvy, “much like the credit-card industry trolls through college campuses and preys on kids' taste for instant gratification and the fact that they're not skilled in the ways of finance,” says Schultz.

Higher interest “subprime” mortgages are generally offered to borrowers with poor credit. High interest rates on such loans protect lenders against the much higher probability that people with bad credit histories will default. But some lenders not only deceive borrowers about the true nature of the loans they're getting but also add in extra fees. Furthermore, in minority and rural communities, borrowers often are targeted for extremely expensive loans even though their incomes and credit histories would qualify them for lower-cost mortgages.

Some mortgage brokers have steered people into loans they clearly couldn't afford simply “because [the brokers] get the fees up front,” says Sandra Phillips, an assistant professor of finance at Syracuse University. “Brokers got credit for volume, so the more you did, the more you got paid by banks.”

In today's complex mortgage market, it's easy to slip costly loan provisions past borrowers , says Meghan Burns, co-founder of OfferAngel, a Scottsdale, Ariz., company that reviews and clarifies the terms of a mortgage offer for consumers. Federal rules about what lenders must disclose to borrowers “came out years ago, but meanwhile about 300 mortgage products have come out that weren't dreamed of” when the disclosure rules were written, says Burns.

“A house loan is much more complicated than a car loan, for example,” and the disclosure rules make it easy for lenders to simply slip in some hair-raising provisions, she says. For example, lenders aren't required to flatly state in writing whether a mortgage carries a prepayment penalty — which socks the borrower with a substantial fee if they try to sell or refinance a property before a specified number of years have elapsed, says Burns.

Some brokers falsify borrower information on loan applications, sometimes with the borrowers' consent, sometimes without it, says real-estate developer Robert Sheridan, of River Forest, Ill. Lenders reassured borrowers that “we'll help you cook the books” to qualify for a loan, “and if people said they were worried about taking out too big a loan, they said, 'Don't worry! You can refinance!' ” says Sheridan. But the reassurance about refinancing often wasn't true, he says. Prepayment penalties prevent borrowers from refinancing, and refinancing doesn't work if home prices don't rise, he says.

“More than ever, I'm seeing junk fees — unnecessary charges that lenders add to borrowers' bills to pad their own profits — and bigger junk fees than ever before,” says Carolyn Warren, author of Mortgage Ripoffs and Money Savers. “A document-preparation fee! It's ridiculous,” Warren says. “As if, otherwise, they weren't going to prepare documents at the end! It's like a restaurant charging you for a napkin. When I see a $695 processing fee, that's price gouging.”

In addition, “a whole group of people inappropriately has been steered to more expensive loans” than they actually qualified for, says Corey Stone, CEO of Pay Rent, Build Credit, an Annapolis, Md., company that helps people rehabilitate bad credit histories.

Most people who've been steered to the worst loans are the nation's most vulnerable people — elderly, rural and minority residents who have less access to traditional financial institutions like banks than other Americans.

“The accumulated home equity and limited incomes of older homeowners have made them a primary target for predatory lending,” said Jean Constantine-Davis, senior attorney for the AARP Foundation, a research group operated by the large seniors' lobby AARP. Predatory lenders often target elderly homeowners with pitches to refinance their homes to get extra cash to pay bills, she said. 1

“One gentlemen, an 86-year-old stroke victim in a wheelchair, had a tax return that described him as a computer programmer who made $30,000 a year,” said Constantine-Davis. Brokers and lenders had worked together to fabricate his and other tax returns to make it appear that elderly people “could afford mortgages whose monthly payments, in some cases, exceeded their incomes. Because our clients had owned their homes for decades, they had equity, and that was all the lender cared about.”

Rural residents, who have limited access to banks, are among those heavily targeted by predatory lenders, according to the University of New Hampshire's Carsey Institute. In 2002, for example, rural borrowers were 20 percent more likely than urban residents to have mortgages that would sock them with large prepayment penalties if they paid off the loans or tried to refinance them. 2

Minority borrowers are the most likely to have mortgages with oppressive terms, and many minority borrowers are pushed into expensive, subprime loans even though their incomes and credit histories qualify them for better interest rates.

In a study based on 2005 data, both African-Americans and Hispanics of all income levels were at least twice as likely to have high-cost loans as whites. 3

In 2005, 52 percent of mortgages to blacks, 40 percent of mortgages to Hispanics, and only 19 percent of loans to whites were high-cost loans, said the Rev. Jesse L. Jackson. 4

In New York City, 44 percent of mortgages in middle-income, predominantly black neighborhoods were subprime, compared to only 15 percent of the loans in economically comparable white neighborhoods, according to a 2002 study conducted for Sen. Charles E. Schumer, D-N.Y. “In other words, a significant proportion of black residents in New York City are being unnecessarily channeled into more expensive financing,” said the report. 5

This past summer the National Association for the Advancement of Colored People (NAACP) filed a class-action suit against more than a dozen mortgage companies — including Ameriquest, H&R Block's Option One, and Bear Stearns investment bank's Encore Credit — alleging “systematic, institutionalized racism in making home-mortgage loans.” 6

[1] Jean Constantine-Davis, testimony before the Senate Committee on Banking, Housing and Urban Affairs, Feb. 7, 2007.

[2] “Subprime and Predatory Lending in Rural America,” Policy Brief No. 4, Carsey Institute, University of New Hampshire, fall 2006.

[3] “NAACP Subprime Discrimination Suit,” Mortgage News Daily, July 16, 2007, www.mortgagenewsdaily.com.

[4] Testimony before Senate Committee on Banking, Housing and Urban Affairs, Feb. 7, 2007.

[5] “Capital Access 2002: Lending Patterns in Black and White Neighborhoods Tell a Tale of Two Cities, www.senate.gov/~schumer/SchumerWebsite/pressroom/special_reports/cap%20access%202002.pdf.

[6] “NAACP Subprime Discrimination Suit,” op. cit.

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Millions of Americans are discovering otherwise.

Between 1890 and 1997, inflation-adjusted house prices in the United States stayed roughly flat. But since around 1998, they've climbed each year, rising about 6 percent annually above inflation, according to Yale University Professor of economics and finance Robert J. Shiller. 7

This unprecedented housing boom has helped create an urban myth — that home prices always rise, say economists. That idea is in for a severe test, however, as a wave of defaults on home mortgages builds, and the housing market undergoes huge changes.

Over the past several years, many Americans have used novel loan types — such as adjustable-rate mortgages (ARMs) and interest-only mortgages — to buy “more house” than they would have thought they could afford. Such loans have artificially low payments for the first several months or years, and borrowers gamble that, when it comes time for payments to rise, they can refinance into a different loan on the strength of their now much higher home value or sell the house for a profit.

Office manager Chaundra Carnes and her husband Michael, a winery production manager, purchased a $950,000 house just north of San Francisco in 2005 with a $700,000 interest-only mortgage. In the past, the couple's combined $100,000-a-year salary would have been considered far too low to afford the house, but their interest-only loan has low payments and they figured that, before higher payments came due, they'd be able to refinance or sell the house at a profit, as they had with three previous homes. 8

“The only risk is if housing values go down,” Chaundra said at the time. “And I guess that's a risk we're willing to take. And I think a lot of other people are too. So we're not alone.” 9

Today, however, the downside of that risk is around the corner, financial analysts say.

U.S. home prices peaked in the first quarter of 2006 and have since fallen 3.4 percent, said Shiller. Although that drop doesn't seem severe, “when there are declines, they may be muted at first” because “home sellers tend to hold out for high prices when prices are falling,” Shiller said. “The 17 percent decline in the volume of U.S. existing home sales since the peak in volume of sales in 2005 is evidence that this is happening now.”

It should have been clear that the recent, drastic run-up in house prices couldn't continue forever, because people don't have unlimited funds to spend on housing, even though easy mortgage terms made it seem they did, say some real-estate experts.

“The mismatch between income gains and higher real-estate values in some cities is particularly striking,” said Jonathan Miller, CEO of the Manhattan-based real-estate appraisal firm Miller Samuel. “How can someone earning $70,000 a year afford a $500,000 home? They can't over the long run.” 10

The price boom began in metropolitan areas of California, the Northeast, and Florida, then spread inland, said Sheila C. Bair, chairman of the Federal Deposit Insurance Corporation. But “while home prices were effectively doubling in . . . boom markets, median incomes grew much more slowly, severely reducing the affordability of home ownership, despite the benefit of historically low interest rates,” she said. 11

But while recent prices may not be strictly “affordable” for the average American, easy mortgage terms blinded many to that reality and led to real-estate bidding wars that drove up prices all over. Good old-fashioned optimism, plus greed, played a role.

For most people who get into trouble, “it's not so much that they shouldn't have bought a house but that they shouldn't have bought such an expensive house,” says Seattle-based Carolyn Warren, author of Mortgage Ripoffs and Money Savers. “Instead of tailoring their house demands to their budget, they fell in love with a house and then had to take a teaser rate to afford it, and then hope,” she says.

Real-estate speculators also helped to drive up prices, says home-building consultant Robert Schultz, of Boca Raton, Fla. In earlier housing booms, flipping — buying a house in order to quickly sell it for a higher price — was relatively rare, says Schultz. But in the 2000s boom, flipping ran rampant. “The loans were so much easier to get this time,” says Schultz.

“The number of pure speculators” was much higher than reported: “30 or 40 percent is my gut feeling,” says real-estate developer Robert Sheridan, of River Forest, Ill.

With so many bidders in the game, it's no wonder that prices were driven sky-high, Schultz and Sheridan say.

The fact that house and condo prices have soared compared to the rest of the economy has been hidden by the way the government reports statistics, says University of Denver Professor of Law Robert Hardaway. “There was a purposeful 1983 decision to take house prices out” of the Consumer Price Index (CPI), he says.

“The decision was rationalized this way: People don't buy houses every year, so the cost of houses shouldn't be factored into the annual rise of the cost of living,” Hardaway says. “But they do buy every six or seven years,” he says.

At the same time, with speculators buying up houses they didn't plan to live in, rental properties flooded the market, driving rents down — and rents do get counted in the CPI, Hardaway says. “This makes it seem as if the price of living is rising even more slowly, but this is fraudulent. In fact, the real inflation rate is 15 percent when you put in housing.”

Perhaps the most pernicious effect of skyrocketing prices was that it increased the temptation to borrow against homes' value to finance other wants. But if prices fall, a homeowner can end up unable to move without taking a huge loss and paying interest on their original loan many times over.

“Don't use your house as a piggybank for financing inessential things,” says Warren. “You need to preserve your precious home equity or you'll end up like the 70-year-old who said to me, 'My bills are killing me! Can I do a debt consolidation?' He had [borrowed so many times on his house that he had] a mortgage of $350,000 even though he'd bought his house 30 years ago for $40,000.”

The bottom line on home values is this, says Robert Losey, chairman of the Department of Finance at American University in Washington, D.C., where home prices have skyrocketed: “What goes up doesn't have to come down, but it usually does.”

[7] Robert J. Shiller, “Understanding Recent Trends in House Prices and Home Ownership,” paper presented to Federal Reserve Bank of Kansas City symposium, Jackson Hole, Wyo., September 2007.

[8] Quoted on “NOW,” Public Broadcasting Service, Aug. 26, 2005, www.pbs.org/now/transcript/transcriptNOW134_full.html.

[9] Ibid.

[10] Jonathan J. Miller, “Unraveling the Pyramid of Bad Practices,” Soapbox blog, Dec. 19, 2005, http://soapbox.millersamuel.com/?p=119.

[11] Testimony before House Financial Services Committee, Sept. 5, 2007.

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Do's and don'ts for would-be homeowners.

Using common sense and being skeptical of hype can help you avoid mortgage trouble, experts say. Among the housing do's and don'ts:

  • Don't be in a hurry to buy. “If you're going to move in two or three years, you should rent,” says Robert Losey, chairman of the Department of Finance at American University in Washington, D.C. Switching houses carries “quite substantial transition costs” — as much as 3 to 4 percent of a home's value, he says.

  • Don't tap into home equity for non-essential purposes. Second mortgages can mean trouble if home prices fall or you need to move. “You should think of your home as the place you live in, not something you should make money on,” says Margaret Mann, head of the restructuring and insolvency practice at Heller Ehrman, a San Francisco law firm.

  • Shop for a house based on what you can afford. “If buyers would tailor their desires to their budgets,” home prices wouldn't rise sky high and lenders wouldn't offer dangerous mortgages like adjustable-rate and interest-only loans, says Carolyn Warren, author of Mortgage Ripoffs and Money Savers. Too often, “a person gets preapproved by a lender for $350,000, but the real-estate agent comes back and asks to get them approved for $399,000,” saying “they really want this sunken Jacuzzi,” says Warren. That means a riskier loan and a skyward jump in local home prices, she says.

  • Remember that a lender's “good faith estimate” is just that, an estimate, says Meghan Burns, co-founder of OfferAngel, a Scottsdale, Ariz., company that checks out mortgages for prospective home buyers. “The borrower takes it as gospel, thinking the estimate is a contract, but it's not,” she says. “If you have somebody who's trying to lure you in” to a bad loan, “that's the bait in the bait-and-switch.”

  • Watch for the signs of predatory lenders, such as encouraging borrowers to lie about their income or assets to get a bigger loan; charging fees for unnecessary services; pressuring borrowers to accept higher-risk mortgages like interest-only loans; pressuring people in need of cash to refinance their homes; and using high-pressure sales tactics. 12

[12] U.S. Department of Housing and Urban Development, www.hud.gov/offices/hsg/sfh/buying/loanfraud.cfm.

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Bibliography

Books

Gramlich, Edward M., and Robert D. Reischauer , Subprime Mortgages: America's Latest Boom and Bust , Urban Institute Press, 2007. Two experts recount the history of the subprime-mortgage market and suggest reforms. Gramlich once chaired the Federal Reserve's Consumer and Community Affairs Committee; Reischauer is president of the Urban Institute.

Schwartz, Alex F. , Housing Policy in the United States: An Introduction , Routledge, 2006. An associate professor of housing policy at New School University describes the housing-finance system.

Articles

Morgenson, Gretchen , “Can These Mortgages Be Saved?” The New York Times, Sept. 30, 2007, Sec. 3, p. 1. Many borrowers in trouble say mortgage lenders aren't helping them to keep their homes.

Rokakis, Jim , “The Shadow of Debt,” The Washington Post, Sept. 30, 2007, p. B1. A once-tranquil Cleveland neighborhood becomes crime-infested after predatory lending leads to massive foreclosures.

Smith, David , “HUD Homes Go Cheap,” Journal & Courier [Lafayette, Indiana], September 16, 2007, http://m.jconline.com. The Department of Housing and Urban Development has bought so many foreclosed Indiana properties it is now the state's largest home seller.

Wargo, Brian , “Cancellations of New-Home Purchases Climb,” In Business Las Vegas, Sept. 21-27, 2007, edition, www.inbusinesslasvegas.com. Many Nevada homebuyers are canceling sales. Meanwhile, the National Association of Hispanic Real Estate Professionals is trying to protect Latinos from predatory lending.

Reports and Studies

“Ask Yourself Why . . . Mortgage Foreclosure Rates Are So High,” Common Cause, 2007. A citizens' group argues that $210 million in campaign funds and lobbying costs spent by the mortgage-lending industry has made Congress unwilling to curb industry practices.

“Mortgage Liquidity Du Jour: Underestimated No More,” Credit Suisse, March 2007. A large investment bank concludes dangers lurk in all sectors of the mortgage market, not just subprime loans.

Subprime and Predatory Lending in Rural America, Policy Brief No. 4, Carsey Institute, University of New Hampshire, fall 2006. Affordable housing groups say many rural residents fall prey to predatory lenders, partly because they have little access to mainstream banks.

Essene, Ren S., and William Apgar , “Understanding Mortgage-Market Behavior: Creating Good Mortgage Options for All Americans,” Joint Center for Housing Studies, Harvard University, April 2007. Researchers conclude many consumers can't accurately evaluate the many mortgages that have sprung up.

Larson, Michael D. , “How Federal Regulators, Lenders, and Wall Street Created America's Housing Crisis,” Weiss Research, July 2007. A financial analyst describes what house prices, foreclosures and other data reveal about the housing crisis and argues federal regulators underestimated the problems.

Murphy, Edward Vincent , “Alternative Mortgages: Risks to Consumers and Lenders in the Current Housing Cycle,” Congressional Research Service, Dec. 27, 2006. A CRS analyst describes how alternative mortgages have trapped some homeowners.

Schloemer, Ellen , et al., “Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowners,” Center for Responsible Lending, December 2006. Analysts predict 2.2 million subprime borrowers will lose their houses in the current crisis.

Helpful Web Sites

How to avoid predatory lenders: www.hud.gov/offices/hsg/sfh/buying/loanfraud.cfm

How to calculate how much house you can afford, whether to buy or rent: www.hud.gov/buying/index.cfm

What you should know about mortgage brokers: http://homebuying.about.com/od/findingalender/qt/0407LoanOffRep.htm

Definitions of terms connected with home buying: www.statefarm.com/bank/sr_center/morgloss.asp

Explanations of mortgage terms and advice about various types of loans: http://michaelbluejay.com/house/loan.html

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The Next Step

Economic Impact

“Markets Overreacting to Subprime Woes: Study,” Agence France-Presse, Sept. 20, 2007. Financial markets have exaggerated the scope of the subprime lending problem, according to CIBC analysts.

Ip, Greg , “Impact of Mortgage Crisis Spreads,” The Wall Street Journal, Aug. 10, 2007, p. A1. Central banks worldwide are grappling with interest-rate decisions amid turmoil in the U.S. housing market.

Lim, Paul J. , “Wilting in a Market Meltdown,” U.S. News & World Report, Aug. 27, 2007, p. 58. Government officials warn the housing-related financial crisis will likely slow U.S. economic growth.

Zuckerman, Sam , “Credit Crisis Spills Into World Markets,” The San Francisco Chronicle, Aug. 10, 2007, p. A1. The U.S. subprime mortgage crisis has made it difficult to obtain credit worldwide.

Government Intervention

Andrews, Edmund L. , “Bill Allowing Mortgage Lawsuits Expected to Stir Fierce Opposition,” The New York Times, Oct. 23, 2007, p. C1. House Democrats have introduced legislation that would allow homeowners to sue Wall Street firms for relief from mortgages borrowers never had a chance of repaying.

Crittenden, Michael R. , “A Big Mac Mortgage Plan,” CQ Weekly, Aug. 13, 2007, p. 2433. Some lawmakers are trying to persuade Fannie Mae and Freddie Mac to buy large mortgage portfolios to pump cash into the housing market.

Gavin, Robert , “US Takes Steps to Ease Housing Crisis,” The Boston Globe, Sept. 1, 2007, p. F1. President Bush has revealed a plan that would make it easier for homeowners to avoid foreclosure.

Peterson, Jonathan , “Mortgage Mess Echoes in Congress,” Los Angeles Times, Sept. 4, 2007, p. C1. Lawmakers want to impose new regulations on brokers, independent lenders and mortgage investors.

Mortgage Fraud

Creswell, Julie , “Mortgage Fraud Is Up, But Not in Their Backyards,” The New York Times, May 21, 2007, p. A1. Three Atlanta women formed the All-Broad Fraud Squad to train FBI agents, speak to lending associations and lecture college students on how to identify mortgage fraud.

Jackson, David , “Mortgage Fraud Is the Thing to Do Now,” Chicago Tribune, Nov. 6, 2005, p. A1. Mortgage fraud has surged in Chicago's poorest communities partly because home loans have become easy to obtain.

Knox, Noelle , “Convicted Con Artist Tells How He Could Steal Your Home,” USA Today, Jan. 25, 2007, p. 1B. A mortgage fraud mastermind reveals how he found victims and concealed his crimes.

Rugaber, Christopher S. , “FBI Says Number of Mortgage Fraud Investigations Have Almost Doubled in Past 3 Years,” The Associated Press, March 7, 2007. The number of mortgage fraud cases handled by the FBI rose to 818 in 2006, but the caseload represents a small piece of the problem.

Risky Loans

“It's a Wonderful Mess,” The Economist, Oct, 13, 2007, p. 86. The repackaging and securitizing of loans will make the subprime mortgage crisis even messier than analysts expect.

ElBoghdady, Dina , “A Tidier Way to Borrow,” The Washington Post, July 21, 2007, p. F1. Fixed-rate mortgages are regaining popularity as borrowers find adjustable-rate mortgages too unpredictable.

Surowiecki, James , “Subprime Homesick Blues,” The New Yorker, April 9, 2007, p. 26. The percentage of delinquent subprime borrowers has doubled over the past year, and predictions of more than a million foreclosures are commonplace.

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Contacts

Carsey Institute
University of New Hampshire, 73 Main St., Huddleston Hall, Durham, NH 03824
(603) 862-2821
http://carseyinstitute.unh.edu
Researches housing and other economic issues in rural America.

Center for Responsible Lending
302 West Main St., Durham, NC 27701
(919) 313-8500
www.responsiblelending.org
Provides information on predatory lending and other abusive practices.

Fannie Mae
3900 Wisconsin Ave., N.W., Washington, DC 20016
(202) 752-7000
www.fanniemae.com/index.jhtml
The government-sponsored, shareholder-owned corporation buys mortgages in the secondary market to provide capital for the mortgage industry.

Freddie Mac
8200 Jones Branch Dr., McLean, VA 22102-3110
(703) 903-2000
www.freddiemac.com/index.html
The government-sponsored company supports the mortgage market.

Housing, Housing Finance, and Monetary Policy, 2007 Symposium of the Federal Reserve Bank of Kansas City
www.kc.frb.org/home/subwebnav.cfm?level=3&theID=9954&SubWeb=5
The symposium on the mortgage crisis features papers presented by leading economists, including Federal Reserve Chairman Ben S. Bernanke.

Joint Center for Housing Studies
Harvard University, 1033 Massachusetts Ave., 5th Floor, Cambridge, MA 02138
(617) 495-7908
www.jchs.harvard.edu/index.htm
Provides information and research on U.S. housing issues.

Mortgage Professor's Web Site
www.mtgprofessor.com/
The University of Pennsylvania's Wharton School of Business provides Financial education and policy analysis written by at.

National Association of Mortgage Brokers
7900 Westpark Dr., Suite T309, McLean, VA 22102
(703) 342-5900
www.namb.org/namb/Default.asp
Provides information on the mortgage industry, including legislative proposals.

National Association of Realtors
500 New Jersey Ave., N.W., Washington, DC 20001-2020
(800) 874-6500
www.realtor.org
Provides and analyzes its own data on housing-market trends.

National Mortgage News Online
www.nationalmortgagenews.com/
The independent news outlet covers mortgage-related news.

Office of Federal Housing Enterprise Oversight
1700 G St., N.W., 4th Floor, Washington, DC 20552
(202) 414-3800
www.ofheo.gov
Oversees Fannie and Freddie and provides data and research on housing.

U.S. Department of Housing and Urban Development
451 7th St., S.W., Washington, DC 20410
(202) 708-1112
www.hud.gov
Provides information about mortgages, home buying and related federal programs.

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Footnotes

[1] Delores King, testimony before Senate Committee on Banking, Housing and Urban Affairs, February 2007.

[2] Eric Stein, testimony before House Judiciary Subcommittee on Commercial and Administrative Law, Sept. 25, 2007.

[3] “What's Ahead for Financial Markets?” Knowledge@Wharton electronic newsletter, Oct. 3, 2007, http://knowledge.wharton.upenn.edu.

[4] David Cho, “Huge Mortgage Lender Files for Bankruptcy,” The Washington Post, April 3, 2007, p. A1.

[5] “Subprime Mess Hits Wall Street Again,” Mortgage News Daily, www.mortgagenewsdaily.com, June 25, 2007.

[6] Doug Noland, “Structured Finance Under Duress,” Asia Times online, Oct. 30, 2007, www.atimes.com/atimes/Global_Economy/IJ30Dj02.html.

[7] Robert J. Shiller, “Understanding Recent Trends in House Prices and Home Ownership,” paper presented at the Jackson Hole symposium of the Federal Reserve Bank of Kansas City, September 2007.

[8] Martin Eakes, testimony before Senate Committee on Banking, Housing and Urban Affairs, Feb. 7, 2007.

[9] For background see J.W. Elphinstone, “Mortgage Bailouts Run Into Opposition,” The Associated Press, The Salt Lake Tribune online, Sept. 29, 2007, www.sltrib.com/realestate/ci_7038862.

[10] Les Christie, “Countrywide Wins Over Critics,” CNNMoney.com, Oct. 24, 2007, http://money.cnn.com/2007/10/24/real_estate/Countrywide_plan_wins_support/index.htm?postversion=2007102416.

[11] For background, see “Interagency Guidance on Nontraditional Mortgage Product Risks,” Office of Thrift Supervision, Department of the Treasury, October 2006, www.ots.treas.gov/docs/2/25244.pdf.`

[12] Douglas G. Duncan, testimony before Senate Committee on Banking, Housing and Urban Affairs, Feb. 7, 2007.

[13] Sandor Samuels, testimony before Senate Committee on Banking, Housing and Urban Affairs, March 22, 2007.

[14] “Home Ownership Rates,” Danter Co., www.danter.com/statistics/hometown.htm.

[15] “Why Bush's Mortgage Bailout Plan Is a Bad Idea,” eFinanceDirectory.com , Sept. 4, 2007.

[16] “Mortgage Fallout: Interview With Housing Wire,” eFinanceDirectory.com , Sept. 6, 2007.

[17] For background see “Behind the S&L Crisis,” Editorial Research Reports, 1988, Vol. II, CQ Researcher online; and “S&L Bailout: Assessing the Impact,” Editorial Research Reports, 1999, CQ Researcher online.

[18] “Schumer, Others Propose First Major Legislation to Deal with Subprime Crisis as Weakening Housing Market Threatens Economy,” press release, office of Sen. Charles Schumer, May 3, 2007, http://schumer.senate.gov.

[19] “The Truly Bearish Case Isn't Playing Out,” John Burns Real-Estate Consulting Web site, July 2007, www.realestateconsulting.com.

[20] “Improvement in Mortgage Market Bodes Well for Housing in 2008,” press release, National Association of Realtors, Oct. 10, 2007.

[21] Ben Stein, “How Speculators Exploit Market Fears,” Yahoo! Finance, Aug. 2, 2007, http://finance.yahoo.com.

[22] Edward E. Leamer, “Housing and the Business Cycle,” paper presented at the Jackson Hole symposium of the Federal Reserve Bank of Kansas City, September 2007.

[23] Ibid.

[24] Martin Feldstein, “Housing, Housing Finance, and Monetary Policy,” remarks presented at the Jackson Hole symposium of the Federal Reserve Bank of Kansas City, September 2007.

[25] For background see Richard K. Green and Susan M. Wachter, “The American Mortgage in Historical and International Context,” Journal of Economic Perspectives, fall 2005, pp. 92-114.

[26] Nadeem Walayat, “Hedge Fund Subprime Credit Crunch to Impact Interest Rates,” The Market Oracle: Financial Markets Forecasting and Analysis, July 31, 2007, www.marketoracle.co.uk.

[27] Kurt Eggert, testimony before Senate Subcommittee on Securities, Insurance and Investments, April 17, 2007.

[28] Quoted in Ibid.

[29] Michael Kanef, testimony before House Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, Sept. 27, 2007.

[30] Mortgage Rates: A Historical Look at Mortgage Interest Rates, Lender 411, www.lender411.com/mortgage-articles/index_desc.php?art_id=37.

[31] Emory W. Rushton, testimony before U.S. Senate Committee on Banking, Housing, and Urban Affairs, March 22, 2007.

[32] Paul Tustain, “Bear Stearns and MBS Hedge Funds: What Are the Real Risks Today?” Financial Sense University, June 23, 2007, www.financialsense.com/fsu/editorials/tustain/2007/0623.html.

[33] For background see David Masci, "The Federal Reserve," CQ Researcher, Sept. 1, 2000, pp. 673-688.

[34] For background see Martin Crutsinger, “Fed Approves Cut in Discount Loan Rate,” The Associated Press, Yahoo! Finance Web site, Aug. 17, 2007, http://biz.yahoo.com/ap/070817/fed_interest_rates.html.

[35] For background see “Tulip Mania,” Encyclopaedia Britannica online, 2007.

[36] For background see “$500 Million-Dollar Bailout Extended to U.S. Mortgage Borrowers,” eFinanceDirectory Web site, July 24, 2007, http://efinancedirectory.com.

[37] For background see Kathleen Day, “Study Finds 'Extensive' Fraud at Fannie Mae,” The Washington Post, May 24, 2006, p. A1.

[38] For background see Benton Ives, “Short-Term Foreclosure Fix Could Cloud Long-Term Regulatory Overhaul,” CQ Today, Oct. 15, 2007, www.cq.com.

[39] Quoted in ibid.

[40] For background see Richard Rubin, “Tax Relief Plan for Struggling Homeowners Would Exclude the Wealthy,” CQ Today, Oct. 2, 2007, www.cq.com.

[41] For background, see “Fact Sheet: New Steps to Help Homeowners Avoid Foreclosure,” White House Web site, Aug. 31, 2007, www.whitehouse.gov/news/releases/2007/08/20070831-4.html.

[42] For background, see Michael R. Crittenden, “Measure Outlines Expansion of Financial Protections for Consumers,” CQ Today, Sept. 18, 2007, www.cq.com.

[43] Amy Scott, “States Crack Down on Mortgage Market,” Marketplace, National Public Radio, Oct. 19, 2007.

[44] Michael Shedlock, “Commercial Real Estate Abyss,” Mish's Global Economic Trend Analysis blog, Sept. 13, 2007, http://globaleconomicanalysis.blogspot.com.

[45] Robbie Whelan, “Housing Glut Is Likely to Build,” The Wall Street Journal, July 27, 2010.

[46] Douglas A. McIntyre, “A Little Relief in Foreclosure Rates,” 24/7 Wall St., May 13, 2010, http://247wallst.com/2010/05/13/a-little-relief-in-foreclosure-rates/#ixzz0uXgjfQGl.

[47] Lynn Adler, “Foreclosures Up in 75 percent of Top U.S. Metro Areas,” Los Angeles Times, July 29, 2010.

[48] Associated Press in Las Vegas Review-Journal, Feb. 22, 2010.

[49] Alejandro Lazo, “Home prices tick up 1.3% in May,” Los Angeles Times, July 28, 2010, http://articles.latimes.com/2010/jul/28/business/la-fi-home-prices-20100728.

[50] Nicole Duarte, “TIGTA Report on Housing Credit Fraud Confirms Analysts' Fears,” Tax Notes Today, June 24, 2010.

[51] www.fanniemae.com/newsreleases/2010/5097.jhtml?p=Media&s=News+Releases&searchid=1280259527495.

[52] Sudeep Reddy, “Home Data Slide Again As Tax Credit Expires,” The Wall Street Journal, Aug. 3, 2010.

[53] Jay Heflin, “Financial Crisis Cost Households $17 trillion, Treasury Official Says,” The Hill, May 3, 2010.

[54] Jill Jackson, “Wall Street Reform: A Summary of What's In the Bill,” CBS News, www.cbsnews.com/8301-503544_162-20008835-503544.html.

[55] Brian M. Carney, “Fan and Fred and the Problem of Narrative,” op-ed, The Wall Street Journal, July 26, 2010.

[56] See Franklin D. Raines, “Poor Credit Judgments Sank Fannie and Freddie,” letter, The Wall Street Journal, Aug. 3, 2010.

[57] Conor Dougherty, “Migration Data Suggest Homeowners Becoming Renters,” The Wall Street Journal, May 10, 2010.

[58] www.fanniemae.com/newsreleases/2010/4989.jhtml?p=Media&s=News+Releases&searchid=1280259347878.

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Update

Key events since the CQ Researcher report on Nov. 2, 2007

The outlook for the American housing industry in the summer of 2010 remained gloomy, with high foreclosure rates continuing to plague many regions and home sales sliding, despite a plunge in mortgage rates to a 50-year low. Fears of a double-dip recession crept higher.

One in 12 mortgages is seriously delinquent, and one in 10 is past due, according to the National Consumer Law Center. That translates to 4.56 million mortgage loans in default or some stage of foreclosure in June, according to LPS Applied Analytics, slightly fewer than in May.45 Nevada, Arizona and Florida had the highest foreclosure rates, according to the business service RealtyTrac, while California, Florida, Michigan, Illinois and Nevada accounted for more than half of all U.S. foreclosures.46 Nationwide, 154 of 206 metropolitan areas with at least 200,000 residents reported an annualized increase in foreclosures between January and June, RealtyTrac said.47

One Ohio homeowner became so desperate he bulldozed his $350,000 home to avoid having his bank foreclose on the property.48

The rising foreclosure rate has bolstered the rental market. MPF Research in Carrollton, Texas, said more people are renting as home purchases decline and younger residents look for places to live. The number of occupied apartments rose by 215,000 in the nation's 64 largest markets in the first half of the year, nearly twice as many units as were added throughout 2009, MPF said.49

New Home Sales Drop

Congress tried to stimulate housing sales with a first-time homebuyer tax credit, enacted in 2008 and expanded in 2009. But after the credit expired on April 30, 2010, new single-family home sales in May dropped more than 18 percent below the rate a year earlier, indicating that the tax credit's boost lacked staying power.50 The inventory of unsold homes increased by 2.5 percent in June, according to the National Association of Realtors, and reached its highest level since August 2009.

Home sales, a traditional engine of economic growth, have failed to provide much firepower to the nation's overall recovery from recession. The July Economic Outlook report from Fannie Mae's Economics and Mortgage Analysis Group noted that the country had “shifted into a lower gear in economic expansion,” with projected 2010 growth rates falling from 3.2 percent to 2.8 and housing losing its traditional stimulative effect. “We believe that residential investment will have a neutral effect on economic growth this year, which makes the current recovery quite unusual,” wrote Fannie Mae chief economist Doug Duncan. “Housing has historically played a significant role in leading the country out of recession.”51

High foreclosure rates plague many parts of the United States (Getty Images/Ethan Miller)  
High foreclosure rates plague many parts of the United States in the aftermath of the 2008 meltdown on Wall Street, and a nationwide housing slump continues despite a drop in mortgage rates to a 50-year low. One in 10 mortgages — a total of more than 4.5 million loans — is past due; Nevada, Florida and Arizona had the highest foreclosure rates in June. (Getty Images/Ethan Miller)

The housing outlook “remains very uncertain,” Yelena Shulyatyeva, an analyst at BNP Paribas. “Only when jobs start being created at a sufficient pace will potential home buyers get back to the market, and home sales return to sustainable healthy levels.”52

Action in Congress

Efforts on Capitol Hill to address many of the underlying causes of the recession, including abuses in the mortgage-lending field, have done little to quell consumer unease and stimulate home sales.

When President Barack Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law on July 21, 2010, the measure was hailed as the most far-reaching financial reform legislation in more than seven decades. Two years in the making, the legislation was a response to the history-making financial system meltdown (expected by only a few Wall Street insiders) that had at its core a housing bubble. The crisis that gathered in the fall of 2008 slashed housing and stock prices worldwide and eventually cost U.S. households $17 trillion, according to May 2010 congressional testimony by Treasury Department chief economist Alan Krueger.53

Marc Joseph, the owner of Foreclosures ‘R Us realty company’ (Getty Images/Joe Raedle)  
Marc Joseph, the owner of Foreclosures ‘R Us realty company, displays a map showing foreclosed properties to prospective buyers as they motor down a canal during a foreclosure boat tour last year in Cape Coral, Fla. (Getty Images/Joe Raedle)

Major elements of the multi-pronged Wall Street Reform and Consumer Protection Act will affect businesses and financial firms. Most relevant to existing and aspiring homeowners, the law created a Bureau of Consumer Financial Protection within the Federal Reserve to regulate mortgages and credit cards, and included new restrictions on the selling of adjustable-rate mortgages. The bill requires mortgage companies to verify that borrowers can repay loans; penalize irresponsible lenders; end penalties for paying off a mortgage ahead of schedule; and broaden consumers' ability to access their credit scores.54

The law did not, however, overhaul mortgage giants Fannie Mae and Freddie Mac, the government-sponsored enterprises that for decades have made mortgage money more available by bundling mortgages and selling them to investors. The government took over both Freddie Mac and Fannie Mae in September 2008, at a cost to taxpayers of almost $150 billion. Despite pleas from Republicans (who for the most part opposed the overall Dodd-Frank bill), Democratic leaders shied away from fixing Freddie and Fannie because it would be “too complicated.”55 In general Democrats favor the mission of these two quasi-public entities in making more mortgage money available, while Republicans tend to oppose their competing with private lenders.56

Republican Critics

The Dodd-Frank bill drew heavy criticism from key Republicans. Sen. Bob Corker, R-Tenn., who spent months working on the financial reforms only to vote against the final product, blasted it in a July 15 press release: “Housing and mortgage finance policies — the root causes of the meltdown and the greatest symptoms of the correction — were left largely unaddressed in the bill,” Corker said. “There is no doubt that we needed to address consumer protection, but instead of doing so appropriately, this bill creates a mammoth new government agency with dangerous, unchecked powers and enormous taxpayer monies at its disposal.”

The Fairfax, Va.-based National Association of Mortgage Brokers expressed its disappointment that the law will mean “higher costs to the consumers and continued job loss for small businesses in the mortgage industry.” In a statement, NAMB President William Howe complained that “consumers will only have two choices at the closing table: to come up with thousands of dollars to pay for closing costs out of their pocket … or to roll all of their closing costs into their interest rate.”

In an interview, Howe said Congress had overreacted in limiting the conditions under which a lender can offer an adjustable-rate mortgage. “What if I want to retire in five years and move north? I'd do a five-year ARM because it would be worth it to” get a lower mortgage rate for a few years, he said. ARMs got a bad name in recent years when some borrowers were encouraged to select pay options that eventually put them in negative financial footing, he added. “But had the housing market not dropped, ARMs would have been a non-issue.”

Kathleen Day, spokesperson for the Center for Responsible Lending, said the NAMB's complaints are a “scare tactic” from a group that is “whining because the law ends a lot of tricks the mortgage industry used to price-gouge consumers, which torpedoed the economy.” She applauded the new law for ending “hidden explosion” and “teaser rates” for ARMs and subprime mortgages whose major purpose, she said, was less to boost homeownership than to get consumers to keep refinancing to deliver profits to the lending industry. “Nine out of 10 of those who got bad subprime mortgages already owned their home,” she says.

Consumer Protection Bureau

Day also supports the new Bureau of Consumer Financial Protection that has prompted much opposition from regulation-wary Republicans. Previously, multiple entities with responsibility for consumer protection, such as the Federal Deposit Insurance Corp., the Comptroller of the Currency, Office of Thrift Supervision and the Federal Reserve, were “cheerleaders for the industry, and the banks shopped for the most lenient one,” she says. “Now the [consumer-protection bureau] will have all consumer regulation concentrated in one place.”

Much of the law's impact will be determined by the myriad regulations to be written over the next few years. That is one reason the National Association of Realtors worked closely with Congress to shape the bill, winning, for example, an exemption for agents, brokers and other real estate professionals from regulation by the new consumer bureau. But it lost its bid to remove from the bill new limits on the number of “points” or fees that lenders can charge mortgage consumers at settlement.

Despite the financial gloom and a new frugality trend that, Census Bureau data suggest, favors renting, Americans haven't given up on the dream of home ownership.57 The Fannie Mae National Housing Survey, conducted between December 2009 and January 2010, polled homeowners and renters to assess their confidence in homeownership as an investment, the current state of their household finances, views on the U.S. housing-finance system and overall confidence in the economy. It found that two-thirds of Americans (65 percent) still prefer owning a home.58

— Charles S. Clark

Chronology

 
2007
Dec. 6President Bush announces a plan to temporarily freeze the mortgage terms of a limited number of debtors holding adjustable-rate mortgages.
2008
March 1–June 18More than 400 people, including buyers, sellers and others across the industry, are arrested for mortgage fraud in a nationwide FBI sting.
March 6Mortgage Bankers Association says 7.9 percent of mortgage loans are past due or in foreclosure, an all-time high.
March 16JP MorganChase acquires Bear Stearns after credit-default swaps push Bear into dire straits. Federal Reserve provides $30 billion as backing for the deal.
June 18Sen. Christopher Dodd, D-Conn., proposes housing bailout to the Senate that would assist troubled subprime mortgage lenders.
July 30President Bush signs Housing and Economic Recovery Act to aid subprime borrowers.
Sept. 7Federal government takes over Fannie Mae and Freddie Mac.
Sept. 15Lehman Brothers files for bankruptcy protection after collapse from credit-default swaps.
Sept. 17Federal Reserve lends $85 billion to AIG to keep it from bankruptcy following decline in value of credit-default swaps stemming from mortgage crisis.
Sept. 25FDIC seizes Washington Mutual, and its banking assets are sold to JP MorganChase. WaMu's home-loan division closed nearly half of its offices in December 2007 following subprime losses.
Oct. 3President Bush signs the Emergency Economic Stabilization Act, creating $700 billion Troubled Asset Relief Program (TARP) to purchase failing bank assets, primarily mortgage-backed securities.
Nov. 12Treasury Secretary Paulson abandons plan to purchase toxic assets under TARP. Remaining $140 billion in the fund allocated for recapitalizing financial companies.
Nov. 24Federal government agrees to rescue Citigroup after stock plummets 60 percent in one week.
2010
April 16SEC sues Goldman Sachs for failure to disclose information on mortgage-backed collateralized debt obligations that were allegedly “designed to fail” in 2007.
May 12RealtyTrac reports that nationwide foreclosures dropped from the previous year for the first time since January 2005.
July 15Goldman settles SEC charges for $550 million.
July 21President Obama signs Dodd-Frank Wall Street Reform and Consumer Protection Act, enacting widespread changes in the country's financial services industry; law sets standards for residential loans and curbs predatory lending.
July 29More than one in every 100 homes were in foreclosure during the first six months of 2010, according to RealtyTrac.
  

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About the Author

MClemmitt.jpg  

Marcia Clemmitt is a veteran social-policy reporter who recently joined the CQ Researcher after serving as editor in chief of Medicine and Health, a Washington-based industry newsletter, and staff writer for The Scientist. She has also been a high school math and physics teacher. She holds a bachelor's degree in arts and sciences from St. John’s College, Annapolis, and a master’s degree in English from Georgetown University.

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Document APA Citation
Clemmitt, M. (2007, November 2). Mortgage crisis. CQ Researcher, 17, 913-936. Retrieved from http://library.cqpress.com/
Document ID: cqresrre2007110200
Document URL: http://library.cqpress.com/cqresearcher/cqresrre2007110200
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