What's Behind the Sub-Prime Disaster
by Robert Kuttner
/The current high-risk mortgage mess is not so much a new crisis as the result of decades of government deregulation of the financial industry./
The calamity in "sub-prime" mortgages has exposed the underlying weaknesses of an economy built on too much speculative borrowing. It's not clear how all this will end, but for now credit is drying up for blue-chip corporations as well as for high-risk mortgage lenders.With financial tremors spilling over into the wider economy, major retailers like Home Depot and Wal-Mart are reporting softer sales, and hedge funds, banks, and broader real estate values are all under siege. Every investor, from retirees to university endowments, is at risk if the inflated stock market turns out to be another bubble. Even if the wider damage is contained, some two million mortgages are scheduled for rate increases this fall, and foreclosures are expected to soar.
The mortgage business has long been a tug of war between a social commitment to broad homeownership and the schemes of private financial operators looking to make a quick buck. In the wake of the Great Depression, the U.S. government devised a strikingly effective system for bringing homeownership to the masses. Since the late 1970s, however, this system has been dismantled in the name of deregulation, causing a string of disastrous results.
The sub-prime mess is not so much a new crisis as it is a resumption of the saga that began with the savings and loan scandal of the early 1980s, when executives of S&Ls went on a risky lending binge with government-insured money. Then, as now, there were many individual culprits, but the real problem was the ideology of deregulation and the capture of public policy for private gain by the financial industry.
Most mortgage loans today are originated by largely unregulated mortgage companies, which are not banks and which have little of their own capital at risk. They are free to devise complicated, far-fetched mortgage products and to lend to people who can't afford the payments, as long as they think they can turn a profit by selling off the paper. Mortgage companies circumvent the entire system of government bank regulation, which ordinarily keeps close watch on banking standards.
When loans started going bad at higher-than-expected rates, banks, hedge funds, and other investors in sub-prime stopped advancing credit to the offending mortgage companies. Several have now gone bankrupt, and others are under stress. But this is no happy case of the market correcting itself, because the wider damage lives on. This all could have been prevented if deregulation had not been embraced so fervently as a national economic creed.
Homeownership is at the core of the American dream. Since the era of the American Revolution, property ownership has been considered the mark of a solid citizen who is a stakeholder in the community. Mortgages enable ordinary people, who do not have the cash to buy a home outright, to join the propertied class. For most people, even today, their prime financial asset is the equity in their home.
The Republic's founders believed that a self-governing people needed to be a society of freeholders. President Jefferson sponsored a land-tenure system that largely kept the frontier out of the hands of land speculators and favored yeoman farmers. With the passage in 1862 of the Homestead Act under President Lincoln, ordinary people could get title to 160 acres for free if they worked the land. By 1900, in several western states, more than 60 percent of people were already homeowners.
In the early 19th century, immigrant, ethnic, and labor groups began creating "building and loan" societies, modeled on British cooperatives that originated in Birmingham in 1774. These mutual aid societies enabled people of modest means to pool savings and borrow money to build or buy homes. While these societies offered more flexible terms than banks, the typical mortgage was relatively short-term --- three to five years was common --- with much of the principal still owed at the end.
During the Great Depression, the wave of foreclosures inspired the Roosevelt government to invent the long-term, fixed-rate, self-amortizing home loan. This new kind of mortgage was part of a larger strategy to spread homeownership and protect the system from catastrophic failures.
Congress first acted to insure mortgages, then established the Federal National Mortgage Association (FNMA) to buy qualified mortgages, replenishing lenders' funds to make more home loans. The government also created federal deposit insurance to protect savers from bank failures, and restore confidence in the banking system. A new Home Owners Loan Corporation refinanced loans to prevent foreclosures.
Here was a stunningly successful system of social invention, with a fine balance of high standards, public purpose and plentiful, targeted credit. The national rate of homeownership soared, no insiders reaped windfall gains, and the system was virtually scandal-free.
But any industry this big was soon irresistible to speculators. In several waves of deregulation, the industry set out to fix something that wasn't broken and managed to slip outside the bounds of government banking supervision. In each of these cycles, free-marketers promised greater efficiency and more plentiful credit, if government regulators would just get out of the way. In each episode, however, the result has instead been increased speculation followed by huge losses and costs to the public.
The first casualty was the savings and loan collapse. S&Ls, heirs to 19th-century building societies, had traditionally been staid and prudent institutions, mostly nonprofits with a social mission. As long as they maintained standards, few lost money. A well-worn industry joke called it the "3-6-3? system: take in deposits at 3 percent, lend out mortgages at 6 percent, and be on the golf course by 3 p.m.
But thanks to a lobbying blitz early in the anti-government Reagan era, Congress liberated S&Ls to speculate in far-flung ventures with no connection to their core mission of providing mortgages. Tiny S&Ls were allowed to become multi-billion-dollar behemoths almost overnight by offering premium interest rates on savings deposits. They then had to find riskier uses of the money to cover their higher costs. A lot of these loans went bad. Loan defaults and S&L bankruptcies ultimately cost taxpayers hundreds of billions of dollars.
The sub-prime lending crisis of the current decade closely repeats that pattern. In 1977, the investment-banking firm Salomon Brothers devised a highly lucrative financial device known as "securitization" of mortgage credit. Mortgages could be purchased from the originator of the loan, repackaged as bonds, sorted according to supposed risk, and certified by bond-rating agencies, thus allowing any number of investors to buy the bonds. Each player along the way took a cut, raising costs to borrowers.
Securitization enabled sub-prime lenders to throw away the rulebook. As long as some investment bank could be found to buy the loan, convert it to a bond, and peddle it to someone else, the mortgage companies could still turn a profit.
The union of securitized mortgage credit and sub-prime lending was a marriage made in hell, waiting to be consummated. Most of today's biggest mortgage companies are not federally regulated. Some are actually subsidiaries of banks, such as Wells Fargo, or own banks, such as Countrywide, the nation's biggest mortgage company. But while the loan portfolios of the parent banks are still strictly regulated, their mortgage affiliates are not, because the loans don't stay on their books. Still other such companies are independent but financed by big banks.
Many of these new-wave mortgage lenders, which make their profits based on their volume of loans, loosened credit standards far beyond the point of prudence, knowing that they could pass off the risk to some other investor. Between 2001 and 2005, the value of sub-prime loans soared from $50 billion to more than $600 billion, according to The Wall Street Journal. Mortgage companies offered loans with no down-payments and low "teaser" rates that became unaffordable once they rose to the market rate. About 15 percent of these loans, with a total value of about $67 billion, are already in default. But most of the loans with adjustable rates are only now just starting to "reset," portending much worse to come.
Home buyers and lenders were both betting that appreciation in housing prices would allow early refinancings, or that equity windfalls would allow the borrowers to meet the payments. But obviously, something is seriously amiss when both borrower and lender count on being bailed out by rising real-estate prices. Lenders are supposed to make loans based on the value of collateral and the borrower's ability to pay, not on their fondest fantasies. When the housing market turned soft, they were blindsided. As super-investor Warren Buffett inimitably put it, "You don't know who's swimming naked until the tide goes out."
Thus the decline and fall of a once-sublime system of providing reliable mortgage credit for the American Dream. The industry has put a pretty face on its tactics, contending that it was virtuously helping less-affluent people become homeowners. But predatory lenders are a feeble substitute for a national homeownership policy.
Since the Reagan presidency, the federal government has largely gotten out of the business of subsidizing first-time homeownership. In the New Deal and postwar eras, moderate-income people got cheap, government-insured loans. Some veterans received direct home loans reflecting the government's own low borrowing rate. In the 1960s, the Great Society directly subsidized mortgages with rates as low as 1 percent. But this has all been drastically scaled back. Since 1980, the rate of homeownership among Americans age 25 to 34 has dropped from 53 to 45 percent.
The government should resume directly subsidizing starter mortgages and construction of homes for moderate-income buyers. These programs need to combine careful credit assessment with counseling, rather than rely on the tender mercies of the sleaziest wing of the private mortgage industry. It is no good if dreams of homeownership end in foreclosure.
There is an instructive model being used in Massachusetts. Since 1989, an agreement between local banks and the Massachusetts Housing Partnership has used the leverage of the federal Community Reinvestment Act to fund $1.5 billion in interest subsidies on more than 10,000 mortgages for moderate income homebuyers. There are careful loan underwriting standards, minimum down-payment requirements, and ongoing credit counseling by non-profit agencies. Nobody is in the program to get rich. According to Clark Ziegler, executive director of the program, there have been just 37 foreclosures in 17 years, despite the fact that most borrowers earn less than 65 percent of median income. But here's the kicker. Not one of the local banks that signed the 1989 accord is still in business --- all have been swallowed up in mergers with out-of-state banks. And the unregulated mortgage companies that now dominate the business are exempt from the Community Reinvestment Act, and not one even participates in the program.
It's too late to head off the current debacle, but Congress should act now to contain the damage and to prevent the next one. Banks and S&Ls are regulated because taxpayer money is at risk through deposit insurance. Though mortgage companies do not take deposits, they too need to be regulated because their antics put the entire economy in danger.
Sen. Barack Obama has proposed fining lenders who behave badly, but that's just the beginning of reregulation. All mortgage companies should be brought under the direct umbrella of federal regulation. Irresponsibly speculative lenders should be prohibited from selling mortgages in the secondary market, even if they can find someone foolish enough to buy them.
My former boss, Sen. William Proxmire of Wisconsin, sponsored the 1968 Truth in Lending Act to require that interest rates be disclosed to borrowers in clear, consistent terms. The senator, who died in 2005, must be whirling in his grave. Today's mortgages are often convoluted and opaque, explicitly designed to mislead the borrower. We need a new Proxmire Act to limit the bait-and-switch character of mortgages, and to police the secondary market in mortgage securities.
Republicans and Democrats are now sparring over whether to authorize FNMA, now privatized but still government-regulated, to refinance some of the mortgages headed for foreclosure. FNMA, after it became a for-profit company, had its own accounting scandal aimed at pumping up share prices and executive pay. Republicans, in a role-reversal, clamped down on it. It's ironic and instructive that an agency set up in the 1930s by FDR to serve a public purpose is now precluded from serving a similar one because it got privatized and greedy.
But both parties should think more boldly and take another leaf from Roosevelt's book. The borrowers are mostly innocent parties, gulled by bait-and-switch lenders. Owner-occupants who took out loans in good faith and did not make fraudulent claims about their incomes should be eligible for government refinancing, just as FDR's Home Owners Loan Corporation offered during the foreclosure crunch of the 1930s. The sleazy sub-prime lenders should be punished, not the innocent homeowners. Otherwise, we risk a cascade of falling real-estate prices, more foreclosures, more bankrupt lenders, and more spillover into other parts of the economy.
America needs to restore a system in which government supports homeownership --- and makes sure that mortgage lenders serve as responsible creditors, not predators. And what's true of mortgage deregulation is true of financial deregulation generally. We don't yet know how serious this credit panic will turn out to be, because so much regulation has been repealed, inviting a repeat of the 1920s, and possibly of 1929. For over three decades we've tested the claims made for lender deregulation, and deregulation has flunked.
/Robert Kuttner is co-founder and co-editor of /The American Prospect/. He writes regularly for the magazine on political and economic issues. Bob has just completed a book, to be published in 2007, on the connection between political and economic inequality and systemic risks facing the economy. He is pursuing these issues as a distinguished senior fellow at Demos./