How the Subprime Lending Meltdown Happened

The following is a guest post from Marotta Asset Management. Update: For a response to this post, see More Thoughts on the Subprime Crisis.

The subprime mortgage meltdown has cost the world 15% of its market capitalization, about $9 trillion. The primary culprit who caused all of this financial loss, pain and suffering is not the mortgage companies. Neither is it the overextended borrowers. It is our own federal regulations interfering with the free market.

For over half a century, only 45% of Americans owned their own home. Then home ownership rose in the postwar period, settling at about 64% in the early 1990s.

In 1994, President Clinton had the good intention of raising home ownership to 67.5% by 2000. He sponsored the revision of the Community Reinvestment Act (CRA) regulations, which required banks to increase mortgage lending to low- and moderate-income families. The banks complied and increased their lending to these families by 80%, more than twice any other group.

The sentiment was noble but ill advised. Community groups could now prevent banks from mergers, branch expansions or the creation of new branches simply by protesting to any of four different regulatory agencies. But these traditional activities of banks are necessary to stay responsive to the dynamics of the marketplace. To maintain this ability, banks paid millions to these community groups. In theory, they were supporting mortgage education efforts and fair lending practices. In reality, they were carrying a block of poor loans on their books simply as the price of doing business.

These community groups described the regulatory pressure forcing banks to increase their underwriting of low-income loans as a positive and encouraging trend. Bruce Marks of the Neighborhood Assistance Corporation of America boasted to the New York Times that he had gotten $3.8 billion in loan commitments in the city of Boston alone.

Faced with excessive regulatory interference, banks risked additional loan defaults rather than face financial penalties and blocked business. But in a situation characterized by excessive regulation, we all pay the price.

The unintended consequences of good intentions can do more economic harm than all the mean-spirited greed within capitalism.

Part of the good intention was forcing banks to be good neighbors by making altruistic loans that discriminated in favor of underprivileged communities. Any attempts by banks to set higher rates, terms or conditions on people with questionable credit was labeled "predatory lending" and used to hold lenders hostage. This form of price controls held the price on questionable loans artificially low.

Normally, price encourages consumers to self-ration and to use less of a limited resource such as capital and put it where it is likely to do the greatest good. Price controls cause shortages because lenders protect their losses by extending fewer risky loans. But this time, regulations forced them to continue making the loans.

Price controls and lower interest rates caused a surge in the demand for mortgage loans. In response, banks raised the requirements to qualify for a traditional loan and wrote more adjustable-rate mortgages (ARMs). Even ignoring their poor credit rating, questionable borrowers could only qualify for an ARM, and they could barely afford the low teaser.

Clinton's goal was met in 2000 and then surpassed, boosting U.S. home ownership by 2005 to 68.9%. Ownership for minorities grew by 24.1% between 1993 and 2005, nearly three times the rate of for non-minorities.

Another good intention driving the legislation was that home ownership correlates to building wealth, stability and community support. If only we could get struggling people to own their own home, they too could share in the American dream. But we build wealth by deciding consciously to delay purchases such as a home, not to overextend ourselves financially to reach our goals.

The idea was that purchasing a home is an investment. But the home you own is not an investment. An investment pays you money. Rental property is an investment. The house you live in is a liability, which increases proportionately with its size. The fastest way to own a house is to rent as small as possible and save and invest the difference. Low-income households have limited resources, and home ownership drains too high a percentage of their income. In fact, studies show that low-income home owners save less than renters and have less of an emergency fund.

The belief was that home owners build equity in their homes by making regular payments that include both interest and principal. For most families, paying a mortgage is a forced form of savings. But this assumes home owners have the cash flow that allows them to build equity in their houses. Encourage those unaccustomed or unable to save to become home owners, and they are apt to refinance and take any growing equity out of their house to fund other expenses.

In fact, that is exactly what happened.

Another good intention was the assumption that mortgages are always good business for banks. Lenders who didn't cheerfully agree were accused of discrimination against minorities by using “old-fashioned” criteria, such as the size of the mortgage payment relative to applicants' income, their credit history or verifying their savings and income. Instead, applicants merely had to demonstrate their ability to manage debt by attending a credit-counseling program.

But these old-fashioned criteria were historically what made loans secure and limited defaults. Forcing banks to lend money to those least likely to repay is not a sound policy.

That the credit debacle took two presidential terms to unravel is simply how economics works. Dropping interest rates and rising house prices masked the default rates as those who would have defaulted simply refinanced a larger loan, milking their homes for 100% of their value like an ATM machine.

Economist professors Stan Liebowitz and Ted Day criticized the program in 1998 in their article "Mortgages, Minorities, and Discrimination" in Economic Inquiry. They wrote, "After the warm and fuzzy glow of 'flexible underwriting standards' has worn off, we may discover that they are nothing more than standards that lead to bad loans. . . . [T]hese policies will have done a disservice to their putative beneficiaries if . . . they are dispossessed from their homes." Unfortunately, no one ever listens to economists.

Everyone was busy praising lenders using relaxed underwriting standards as the paragon of virtue. Although widely understood that approving minority mortgage applications stretched the rules a bit, it was considered good social engineering. Now they are universally criticized by the same crowd that formerly praised them.

Today, the people who advocated lax lending standards are self-righteously critical of lenders for letting this debacle happen. Having forced millions of bad loans, they are now complaining the government is paying a small portion of the losses back to Bear Stearns. Having enacted regulations that ruined the U.S. financial markets, they now claim the credit problems stem from a lack of regulation. Only government uses its power to cause such havoc and then asserts it needs more power.

Bailing out borrowers makes the least sense of all. Although routinely cast as victims, we must remember they substituted attendance at a credit-counseling class for hard collateral in their promise to repay. They purchased homes beyond their means, lived in relative luxury and bilked banks of any building equity by refinancing cash-outs of their homes every time real estate markets appreciated.

Although it isn't their fault for padding their lifestyle by exploiting regulatory mistakes, borrowers don't deserve a penny more. Regulators especially don't deserve a second chance to impose rigid rules on a system that requires dynamic adjustments. Having been hurt so badly by the conspiracy of regulators and irresponsible borrowers, we should at least allow lenders the consolation of foreclosing on the house of cards.

If the subprime meltdown was the result of greedy capitalists, you would have to assume they were awfully dumb to have lost so much money. The markets are smarter than that. Only feel-good legislation could be so naive. How can more government regulation help when there is universal ignorance of how the government caused the problem in the first place?

Comments

[Christopher Smith]

I would strongly disagree with the statement that "the house you live in is a liability". It is certainly not an investment per se, but it is an asset in that it is property that provides the benefit of a place to live to its owner.

Otherwise, some well-made points about the law of unintended consequences, which is largely why individual health insurance is so difficult to obtain in the United States. Does the author have any opinion on the use of homeowner tax incentives?

[James]

Interesting post. I haven't heard this before. Is Marotta a Republican by any chance :)?

[mmr]

Christopher, an asset is something that puts money in your pocket. A house that you use as a primary residence does not put money in your pocket unless you sell it after it has appreciated and then "downsize." Still, it's obviously best to own your home regardless of your opinion about it being an asset. It's hard to regard your home as an "investment" when you're probably not going to ever use the proceeds of it...unless you take out a loan against the equity...*shudder*.

I will agree with you though, that it is an asset in a non-financial sense. You're right on there.

[Ada]

And the subprime meltdown had nothing to do with the lucrative fees that lenders (and brokers, and appraisers) received for mortgages they'd pass on to other entities who'd be left holding the bag, right?

Oh, I forgot, the 'greedy capitalists' are too smart for that.

[Kevin]

Certain people just aren't meant to be homeowners. The subprime mess lowered the standards and let some of them "in the door". When they realized there are taxes, insurance and maintenance costs to pay on top of a monthly mortgage, many of them couldn't handle it.

[Devin]

Things like the subprime meltdown will only cease to happen once everyone in this country, the government included, gives up their sense of entitlement to a huge house, 4 cars etc. As long as we have Hillary Clinton promising to have loans forgiven, bail people out etc., people will never see any consequences for poor decisions? If the government pays off my huge house that I cannot afford, why shouldn't I expect them to pay the bill on my 65" plasma TV when that comes due?

We are reinforcing ignorant behavior. This will all happen again sooner, rather than later. Perhaps not the housing market, but credit cards, car loans....it will be something.

[F. Morana]

I often disagree with the Marotta guest posts that appear on this blog, but I've never seen one with such a blatent, politically-motivated message. The notion that government intervention (rather than the lack of it!) is primarily to blame for the present increased wave of foreclosures is way off-the-mark.

The guest blogger suggests that events would have unfolded less unfavorably if only the "free market" had been permitted to rule. In my view, such suggestions are simplistic and dangerous.

[sahm]

I guess it would be useless to teach my kids about personal responsibility if the government is just going to bail you out each time you make a bad decision...

C'mon, grow up and take responsibility for your own decisions and actions. You'll never learn if you aren't allowed to fall...

[Sarah]

"It is our own federal regulations interfering with the free market."

Whew. I needed a good laugh this afternoon.

C'mon, FMF, I know you are smarter than this. These "guest posts" really bring down the quality of your blog.

[tom]

@F. Morana...

Marotta was completely on-the-mark. Had goverment not stepped in, no person, who could not afford a house, would be permited to borrow. It's as simple as that. Marotta explains, in great detail, why government intervention caused most of the problems we are experiencing today. His explanation has gone deeper than any other I have seen. We originally were blaming borrowers, lenders, banks, anyone, when in fact we should have been asking: why? If we ask "why?" enough, we will eventually reach the cause of the problem... which is what Marotta did. His view is neither simplistic, nor dangerous.

If you continue to not agree with the explanation, then please, counter his arguements, or provide an explanation of your own.

[Matt]

Christopher, you're right about a house always being an asset, but the house and mortgate together can become a net liability if the market value of the house falls below the remaining principle on the loan (i.e. the borrower becomes "upside-down" in the loan). I think that's what Marotta was getting at, though he probably should have been more precise.

[Matt]

Sarah,

"C'mon, FMF, I know you are smarter than this." So is stupidity the only explanation you've entertained for FMF posting this? I don't even object to the condescension and smugness of your comment because I indulge in both regularly myself. What bothers me is the intellectual laziness of resorting to calling FMF stupid and the idea of the post laughable. Who is that supposed to persuade other than people who already agree with you? C’mon, Sarah, I know you can debate better than that.

Same goes for you F. Morana!

[Jenny]

Interesting post. I must say I had never considered the motivators for banks to offer loans to riskier borrowers, other than the profit potential. Still, this paints the banks as victims a wee bit too much (which is as irritating as regarding those who can't pay their McMansion mortgage as "victims"). Nobody forced them to offer teaser rates or invent products so complicated their customers wouldn't know what they were getting into. By the same token, nobody forced a potential homebuyer to sign for a loan he or she didn't understand.

Seems to me like a lot of different parties made a lot of bad decisions. Everyone involved - borrowers, lenders, and regulatory bodies - should recongize their role in creating the problem.

[Lord]

The real source of the problem is short term compensation of CEOs. They could create toxic waste, sell it as gold, skim the profits, and leave investors holding the bag. The problem is never fools and scoundrels that want to borrow. They have been and always will be around. The problem is investors putting naive trust in middlemen and reaching for unjustified returns.

[Jim]

In general, the idea that CRA caused the subprime mortgage mess is not backed by any real data or anything showing a real cause and effect relationship. To me it seems you've got an unsubstantiated and unsupported theory and nothing more. If you want to present a theory then you should substantiate the claims with real data and then show some causality.

To look at a specific point, I'm curious about this bit:

"These community groups described the regulatory pressure forcing banks to increase their underwriting of low-income loans as a positive and encouraging trend. Bruce Marks of the Neighborhood Assistance Corporation of America boasted to the New York Times that he had gotten $3.8 billion in loan commitments in the city of Boston alone."

This would seem to imply that Neighborhood Assistance Corporation of America (NACA) is partially responsible for bad loans and high foreclosure rates.

But NACA makes fixed term loans at prime rates. They are not ARMs or high interest rate loans as typifying the subprime crisis. NACA even has loan programs to help bail out homeowners currently facing foreclosure.

I don't see any relationship whatsoever between NACAs loans and the subprime mortgage meltdown as you seem to be implying.

Jim

[Ender]

Marotta's argument blaming excessive government intervention conveniently neglects to account for the role that deregulation played in the credit crisis. The repeal of Glass-Steagall, a major piece of bank regulation, is what allowed big banks to underwrite and trade mortgage-backed securities, CDOs, SIVs, etc. in the first place. I'm sure Marotta would also argue that Enron, WorldCom, and Tyco are just symptoms of TOO MUCH regulation.

[David John Marotta]

Author post (from David John Marotta)

A number of posts blamed the creation of structured investment vehicles (SIVs) of mortgages as the primary cause of the subprime meltdown instead of the CRA, but this is a false dichotomy. The CRA changes of 1995 is what allowed the securitization of CRA loans containing subprime mortgages:

Community Reinvestment Act (Changes of 1995):
The 1995 revisions were credited with helping to substantially increase the amount of loans to small businesses and to low- and moderate-income borrowers for home loans. Part of the increase in the latter type of lending was no doubt due to increased efficiency in the secondary market for mortgage loans. The revisions allowed the securitization of CRA loans containing subprime mortgages. The first public securitization of CRA loans started in 1997.

David John Marotta

[David John Marotta]

Author Post (from David John Marotta):

In reply to Jim's comments about the Neighborhood Assistance Corporation of America (NACA): I believe that the NACA experience provides evidence of the exact problem we are facing.

Criticism of groups like the NACA would say what the NACA themselves say, "[the NACA] offers extensive education before qualifying borrowers for a below-market-rate, 30-year fixed mortgage with no down payment or closing costs" (Boston Globe, Dec 30th 2007)

"He [Bruce Marks of the NACA] refuses to differentiate between people suffering discrimination and people who are legitimately bad credit risks." (Boston Globe, Dec 30th 2007)

You can find posts of people's experiences with the NACA. Basically, they help you collect the documentation to support a mortgage and suppress or eliminate the documentation that implies you shouldn't have a loan. They help you clean up your credit report, not your actual finances. Their "educational process" only worked while house prices were rising. I would appreciate anyone who has the current default rates for NACA counseled mortgages. They may be doing "better" than the sub prime market, but I am certain they are doing a lot worse than the traditional market (even their own traditional loans).

David John Marotta