Let’s stop blaming the victims of predatory lending
This is important.
The primary cause of the subprime collapse—which heralded in the Great Recession was bad loans not bad borrowers. At the peak of the subprime boom lenders structured loans in a way that virtually guaranteed that those loans would fail because it was profitable. Borrowers—particularly minority borrowers—were steered toward these designed-to-fail loans even when they would have qualified for a prime loan. It doesn’t matter how good your credit is or how high your income is. I can write you a loan with terms so bad that I know you won’t be able to pay it back. I’m afraid this post may require tossing around some numbers—but please bear with me. Even if correcting the banks efforts to shift blame isn’t sufficient, this stuff is worth knowing if you plan on someday getting a home loan.
The folks over at TheCallus.com work in banking—so it’s understandable when they echo the party line in a series of posts blaming low-income borrowers for the banks’ bad loans. Specifically, they write:
How can you be free with credit when all the state AG’s are taking you to court and nailing you for lax lending procedures?
And a lot of crap borrowers got way too much money.
Suppose you have a borrower who wants a loan for $100,000. Pretend the prevailing rate for credit-worthy (“prime”) borrowers this particular week is, say, 7%. The borrower’s credit isn’t that great—so let’s bump the interest rate up to 8% to account for the additional risk. With a standard 30-year fixed-rate mortgage, you’re looking at principal and interest payments of $733.76. Let’s say that’s affordable based on the borrower’s income. If the lender had been content to offer that loan, there wouldn’t have been a problem. Everybody’s acted responsibly.
But that’s not the loan that borrower frequently ended up with. Instead, the borrower gets a loan for $105,000—with $5,000 going directly into the pocket of the mortgage broker. The interest rate starts at 6.5% for the first eighteen months then adjusts to LIBOR+5%. Practically speaking, this means that after the 18 month tease, the monthly principal and interest payments will be around $900.00 assuming interest rates stay the same. To the extent that this jump was disclosed to borrowers, it was disclosed in a way they wouldn’t be able to understand unless they had a background in the mortgage industry or was accompanied by false promises that they could simply refinance in 18 months. Generally mortgage brokers neglected to mention that refinancing before the interest rate jump would cost another $2,000 plus the cost of originating the loan. The end result was a whole group of borrowers who were given loans that may have initially looked affordable but that the mortgage industry knew that within two years the payment amount could jump to over half of the borrower’s gross income and that refinancing would only be possible if housing values continued to rise. This meant that home-equity, the primary means of transmitting wealth from one generation to the next, was stripped away to feed the lender’s avarice. Borrowers who could have afforded normal loans with reasonable terms were given horrible loans with impossible terms. And banks knew the borrowers didn’t understand what had happened.
Let me back up. I’ve been talking about “the banks,” “the lenders,” and “the mortgage industry” as if they were some monolithic entity. That’s not entirely true. The guy who originated the loan was probably a mortgage broker. Think of him as the guy who used to sell aluminum siding. (Now he works in for-profit loan modification). He’s a guy who figured out that with a smooth tongue and a high school diploma, you can bring in a six-figure salary, provided you don’t have a lot of moral hangups about decieving people. He takes about $2,500 from the borrower in order to arrange a decent loan for them. Then he takes $2,500 from the bank to dupe the borrower into a crappy loan. He walks off with $5,000 and the borrower gets a loan with terms like those I just described.
The bank then buys the loan. It doesn’t know what lies the broker told the borrower—but it does know the predatory terms of the loan. And it knows that it paid a guy $2,500 to betray his customer, so it’s at least on notice about who it was working with. It doesn’t care. It sels the loan to an investment bank. Because the originating bank passed on all its papers to the investment bank, the investment bank knew what was going on. But it doesn’t care. It’s going to pass on the hot potato in a month anyway. The investment bank bundles it with similar loans, pays a rating agency to enable its addiction, and sells them to investors. The investors don’t much care. They’ll sell the loan before it explodes. No worries. Besides, that steaming pile of crappy loans is guaranteed by AIG—and they’re totally solvent, right? The investors get their money and get out. (Except for the last guy in line, who’s totally screwed. But that guy had it coming—because who invests in that sort of thing? Actually, that was likely Fannie Mae or Freddie Mac. Or, rather, the last guy in line is sucker bailing out Fannie and Freddie. So, uh, congratulations taxpayer!)
Thus far, I’ve left out two critical details. First, due to the way incentives were structured, the subprime loans were far more profitable than the conventional loans. Second, now that we have a foreclosure crisis, the same guys are trying to make another profit on the other end. That’s the part the attorney generals are suing over.
The subprime collapse and the ensuing credit crunch was not primarily caused by loans given to “bad borrowers.” It was primarily caused by a widespread pattern of lenders steering borrowers to high-cost loans that the lenders knew would fail. Some borrowers are, of course, more qualified than others. But with interest rates at historic lows, a lender can offer a loan at a modestly higher interest rate to account for some additional risk.
There’s a bit more to the credit crunch story than this. Banks are worried about liquidity. Investors are terrified of securitized mortgages. Lenders are worried that home price declines may impair collateral.
Bottom line: don’t blame the subprime collapse and ensuing credit crunch on its primary victims.
