Scratch one more item from the Bush Administration’s already short list of accomplishments: by the time President Bush leaves office, about 700,000 fewer Americans will own their own homes than when he entered office.
The foreclosure rate is already the worst it’s been in at least twenty-five years, and soon may be the worst it’s been since the Great Depression. Lehman Brothers estimates that 30 percent of the subprime mortgages entered last year will end in foreclosure.
Perhaps 2.2 million American families will lose their homes to foreclosure in the next couple of years. When a family loses their home to foreclosure, they lose their life’s savings, and they lose their membership in the middle class, probably forever. Millions more will see the value of their homes collapse when neighbors lose their homes to foreclosure.
But despite the catastrophic consequences to homeowners, there has been more sympathetic press treatment of investors in hedge funds that bet wrong by buying securities backed by subprime mortgages than there has been of families losing their homes.
So let’s discuss just how we got where we are.
The foreclosure epidemic is not caused by grasping home buyers buying more house than they could afford, and then shirking their just debt to the mortgagee. Families are losing their homes because they had to borrow against their homes to pay their bills.
Approximately 72 percent of subprime mortgages from 1998 to 2006 are refinances, not loans to purchase homes. And less than ten percent of subprime loans are to purchase first homes.
About 40 percent of American families don’t have enough in savings to live above the poverty line for more than three months if someone in the family loses their job. Many families that otherwise have little in savings own their own homes. And if anything goes wrong—serious illness, job loss, divorce, major home repairs—those families have little choice but to borrow against their homes.
The foreclosure epidemic is not caused by careless borrowers signing mortgage documents without bothering to understand the terms either. Anyone who has ever been to a closing knows that the borrower sees the documents for the first time at closing and then signs ten or fifteen documents in about two minutes.
Even the American Enterprise Institute doesn’t argue that it’s the borrower’s fault for not understanding the mortgage. Here’s the testimony before the House Financial Services Committee just a few weeks ago from some guy at AEI:
...(a) good mortgage system requires that the borrowers understand how the loan will work and how much of their income it will demand.
It is utterly clear than that the current American mortgage system does not achieve this.
Rather it provides an intimidating experience of being overwhelmed and befuddled by a
huge stack of documents in confusing language and small type presented to us for
signature at a mortgage closing...
...The FTC recently completed a very instructive study of standard mortgage loan disclosure documents, concluding that "both prime and subprime borrowers failed to understand key loan terms."
Among the remarkable specifics, they found that:
"About a third could not identify the interest rate"
"Half could not correctly identify the loan amount"
"Two-thirds did not recognize that they would be charged a prepayment penalty"
"Nearly nine-tenths could not identify the total amount of up-front charges."
This is a fundamental failure of the American mortgage finance system.
The AEI returns to form by arguing that it’s the government’s fault by requiring so much disclosure in the first place. But the description of closing is exactly right.
In fact, many borrowers know that mortgages are too complicated nowadays to figure out by themselves, and find an expert in mortgage lending to help them. Mortgage brokers now originate 45 percent of all loans, and 71 percent of subprime loans. Brokers are much more aggressive in marketing loans than traditional lenders. But brokers also win business by telling borrowers that they’ll help the borrower find the best loan. At closing, the broker is standing over the borrower’s shoulder, explaining each document, usually saying that each document is just boilerplate the borrower has to sign to get the loan.
When borrowers put their trust in the wrong brokers, they make a big mistake. Huge.
A couple of years ago the President of the National Association of Mortgage Brokers, Jim Nabors, testified before the House Financial Services Committee. That was before the foreclosure epidemic, but the committee was considering legislation, including a bill that I introduced, to protect borrowers from predatory mortgage practices. Nabors was worried that legislation would "restrain a consumer’s ability to shop for the loan products that best suit their financial situation." Nabors defended the payments to brokers by lenders, called "yield spread premiums," as a benefit to borrowers. He said that in trying to protect borrowers, Congress might reduce "the number of lenders willing to make high cost loans, which in turn will result in higher cost financing for the consumer."
At the end of Nabors’ prepared testimony, he said he would be happy to answer any questions. So when my turn came, I took him up on that offer:
Mr. MILLER OF NORTH CAROLINA. I have a couple of documents
here that are apparently from public sources: one from the
MBA’s—Mortgage Bankers Association—sub-prime handbook and
the other is apparently just off the Internet. And both, although
they are both public documents, both do say that these say that
these are not for distribution to the general public, but are for
mortgage professionals only.
They both list their wholesale mortgage rate sheet. They both list
credit scores down one side, maximum loans on the other and interest
rates for people with different scores.
And then this one was from Argent Mortgage Company. It appears
to say that any mortgage as much as one point higher than
what would be here, based on the FICA score, would result in a
payment rebate of .5.
Is that a yield spread premium?
Mr. NABORS. I am sorry, could you say that again?
Mr. MILLER OF NORTH CAROLINA. ...This is from Argent Mortgage Company. It has down one side the credit score. Across it, it is the amount that it will finance. And then, within that grid—it shows the loan to equity at the top. And then within that grid, it shows an interest rate.
Mr. NABORS. Right.
Mr. MILLER OF NORTH CAROLINA. At the bottom, it appears to
say that if the interest rate is 1 percent higher, that there is a
bonus to be paid of .5, if it is one point higher. If it is two points
higher, the bonus to be paid is .75.
Is that a yield spread premium?
Mr. NABORS. You know, I do not do business with Argent.
I began to think that he wasn’t as happy to answer questions as he said he would be.
I asked him if he thought a mortgage broker should have to act in the interests of the borrower. The bill that I introduced required that, and so did the Republican bill introduced by Bob Ney, the subcommittee chairman. But Ney’s bill provided that the borrower could waive the requirement—hey, what’s one more piece of paper to sign at closing. Nabors said brokers did act in the best interests of the borrower, but the interests of the borrower were subject to interpretation:
Mr. NABORS. Well, the question is what is in the best interest of
Mr. MILLER OF NORTH CAROLINA. Right.
Mr. NABORS. Okay. Different circumstances. In some cases, what
is really best for the customer may seem more expensive, right?
If you come to me and say, ‘‘Look, I need to borrow $20,000. My
daughter is getting married in 2 weeks.’’
Mr. MILLER OF NORTH CAROLINA. Right.
Mr. NABORS. I can come up with two options. I can come up with
a lower rate option that gives you the best rate at the lowest cost
and you can have it in 60 days. Or I can come up with, through
another lender, a higher rate with some higher fees and you can
have the money in 10 days. That is your choice.
The rate sheet didn’t say anything about a daughter’s wedding, or how quickly the borrower could get the money. It just said that if the homeowner borrowed at a higher interest rate than the borrower qualified for, then the broker got a bigger payment from the lender. So I asked again:
Mr. MILLER OF NORTH CAROLINA. Okay. But unless there is some
difference like that, that does not appear on this sheet, if you just
have a consumer who could have gotten a 7 percent loan on the
very same terms, instead gets a 9 percent loan but the broker gets
a 1 percent additional yield spread premium in addition to whatever
upfront commission they would have, does that strike you as
something the law should allow?
Mr. NABORS. If that is part of the agreement between you as a
customer and me, as part of my total compensation, that has been
disclosed to you, it would be okay. But if this is a bonus that is
paid outside the plan, if it is not disclosed on a good faith estimate
or anything else—
Mr. MILLER OF NORTH CAROLINA. So if a consumer signs a piece
The subcommittee chairman, Bob Ney, then called time (there’s a five minute limit for questions) and cut me off.
Yes, industry argues that they want a borrower to be free to choose a higher interest rate than what the borrower qualifies for. It’s an unusual choice for the borrower, but industry cares enough about their borrowers that they’ll fight to protect it.
The other consumer choices that industry claims should be protected for borrowers, the various "exotic" loan terms, make no more sense for most borrowers than simply paying more in interest. Industry argues that "exotic" mortgage products are market innovation, and allow a borrower to choose mortgages narrowly tailored to the borrower’s specific circumstances. But former Federal Reserve Governor Edward Gramlich tellingly asked, "Why are the most risky loan products sold to the least sophisticated borrowers?"
The real answer is so borrowers will be unable to pay their mortgages, and will have to borrow again.
The worst abuses in predatory mortgage lending are repetitive loans that strip a homeowner of the equity in their home. Borrowers are stripped of the equity in their home by up-front costs and fees, and loan terms that guarantee that borrowers cannot pay the mortgage and will have to borrow again, paying more in up-front charges each time they refinance. Again, according to the AEI guy, almost 90 percent of borrowers could not identify from closing documents the total amount of up-front charges, the least understood term of the mortgage. Borrowers usually don’t write a check for closing costs, the costs come straight out of their home equity, and straight into the pockets of brokers, lenders, securitizers, hedge fund managers, and on and on.
So no, not many factory workers or firefighters knowingly choose a mortgage with an initial "teaser" monthly payment that they barely qualify for that then increases by 40 percent after two years, and has a three year prepayment penalty.
As the debate in Congress heats up over predatory mortgage lending practices and the subprime foreclosure epidemic, you’ll see prosperous-looking industry spokesmen speak up for consumer choice, and argue that reform proposals would violate all that is sacred, and will only make things much, much worse.
Just remember how those prosperous guys in suits made this mess in the first place, and notice how little they’re willing to do to clean it up.