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Weekly UpdatesAbstract The subprime mortgage crisis has negatively affected individuals, investors, lenders, and economies worldwide. This paper first examines contributing factors of the crisis: predatory lending, predatory borrowing and mortgage fraud, unethical practices, unregulated mortgage brokers, off-balance-sheet activity, and the infusion of capital from Asia that provided the fuel for subprime mortgage activity to continue. International markets have both suffered from and contributed to the crisis. Legislation that has been enacted or recommended in the U.S. and the European Union is reviewed. We then make recommendations which could begin to restore confidence of consumers and investors worldwide; however, it is clear that laws and regulations must be enacted quickly to correct the situation and bring stability to investment markets.
Keywords Subprime * Mortgage * Lending
JEL F30 * F39 * G10 * G15
Introduction
The current subprime mortgage crisis has caused much concern internationally as homeowners, lenders, financial institutions, and investors worldwide have felt the negative effects of the crisis (Greenspan 2007; Kuttner 2007; Bernanke 2008). A wide array of factors including but not limited to predatory lending practices, predatory borrowing and mortgage fraud, unethical practices, unclear or lax rules and regulations, and conflicts of interest have caused this international crisis. The various causes must be examined and understood in order to formulate protective measures against future occurrences.
Causes of the Subprime Mortgage Crisis
Predatory vs. Subprime Lending Practices
To begin, subprime lending practices must be defined and distinguished from predatory lending. Subprime lending involves loans offered at rates greater than the prime rate to individuals who do not qualify for prime rate loans due to poor credit and who therefore are viewed as high risk (Smith 2007), Subprime lending is viewed as ethical since it gives those with lower credit ratings the opportunity to obtain loans and mortgages--although at higher interest rates. However, as lenders apply unethical or illegal procedures to subprime loans, the classification changes from subprime lending to predatory lending (Bond 2002, p. 34). Predatory lending is abusive lending "targeting the elderly, people of low income, minorities, and individuals with limited understanding of financial transactions" (Bond 2002, p. 34). The predatory loan market is comprised not only of home mortgage loans, but extends to consumer credit cards, "payday" loans, rent-to-own loans, loans by phone, and loans solicited through the Internet (Bond 2002). As of 2002, the federal and state governments had not clearly defined predatory lending practices, nor determined penalties for engaging in it.
Predatory lending also includes offering subprime loans to individuals who qualify for prime loans. Fannie Mae estimated that up to 50% of the subprime refinanced loans could have been prime loans--saving the borrowers thousands of dollars in fees and interest rates (Christie 2007a, b). Minorities have also been hard hit as evidenced by a government study in an African-American neighborhood showing over 51% of the refinanced mortgages being subprime, compared to only 9% in predominantly white neighborhoods (Bocian et al. 2006).
In the early 2000s, interest rates were low and mortgage money was available, which helped raise real estate values across the country. With values escalating, lenders felt more comfortable making mortgages to customers whose poor credit histories had prevented them from buying homes in the past. As home values, rise borrowers are less likely to default since they can sell their homes and have enough to pay off the mortgage if they face financial hardship. That put more buyers into the market, helping to raise home ownership rates to a record 69% in 2004 (Arnold, May 5, 2008), which pushed housing prices to double digit growth in some areas. This lured real-estate speculators, creating even more demand and driving the cycle further. Lenders used "creative financing" to attract this growing pool of borrowers. At the same time Subprime Mortgage Backed Securities (MBS), because of their higher returns, were becoming more popular for U.S. and international investors, providing more funds for the lending agencies. With more funds, too little attention to the risk of MBS, and the expansionary policy of the Federal Reserve, the rapid growth continued.
As risky loans proliferated, among the most popular were variations on the adjustable-rate mortgage, or ARM. ARMs are loans whose interest rates adjust up or down periodically. The initial rate is typically fixed for a period of two or three years. The benefit is that the starter rates are lower for ARMs than for traditional, fixed-rate mortgages. That means lower monthly payments, making homeownership more affordable and allowing borrowers to qualify for a bigger loan. Many borrowers with ARMs did not understand the possible consequences. Lenders sometimes offered interest-only and payment-option loans. With the former, a borrower only pays the interest on the loan--not the principal balance--during the introductory period. With payment-option ARMs, borrowers get to choose how much they pay each month: enough to cover the interest plus the principal, the interest only, or less than the interest. Subprime loans expanded to 20% of the mortgage market in 2006, from 9% a decade earlier. These loans carry higher interest rates to compensate for the risk posed by borrowers. They can be traditional fixed-rate loans, but most are ARMs, according to Susan Wachter of the University of Pennsylvania's Wharton School (Wachter, March 7, 2008).
Nearly 23% of all mortgages taken out in 2005 were interest-only ARMs, and more than 8% were payment-option ARMs, according to First American Loan Performance. In certain once-sizzling markets, the numbers were much higher. For example, 34% of all new mortgages in California in 2005 were interest only (Arnold, May 5, 2008). These products made sense to borrowers who thought they'd live in their homes for a few years, then sell at a profit or refinance. But now that housing sales have stalled and prices are softening, borrowers can't do either very easily.
Many borrowers are facing painful payment hikes: According to a First American CoreLogic study, one-third of ARMs taken out between 2004 and 2006 began with "teaser" rates below 4%. Payments on these loans will double on average--if they haven't already done so, says study author Dr. Christopher Cagan (Cagan, March 19, 2007).
Predatory Borrowing and Mortgage Fraud
While predatory lending has received a great deal of press, predatory borrowing and mortgage fraud may have contributed as much or more to the subprime mortgage crisis. As reported in a New York Times article by economics professor Tyler Cowen, "as much as 70% of recent early payment defaults had fraudulent misrepresentations on their original loan applications" (Cowen, January 13, 2008).
Mortgage fraud has increased astronomically in recent years. Federal officials estimate mortgage fraud totaled from $1 billion to $6 billion in 2005 alone (Arnold, August 7, 2007). The U.S. Department of the Treasury, Office of Regulatory Analysis, reports that suspicious activity reports (SARs) relating to mortgage fraud increased by 1,411% between 1997 and 2005. In their report dated November 2006, mortgage loan fraud reports comprised 2.12% of total depository institution SAR filings. By 2005, mortgage loan fraud reports had increased to 4.94% of total depository institution filings (Mortgage Loan Fraud 2006).
There are two broad categories of mortgage fraud: fraud for property and fraud for profit (Mortgage Loan Fraud 2006). Fraud for property usually involves material misrepresentation on loan applications or omitting information with the intent to deceive or mislead a lender. There are many activities that fall under fraud for property but it is most commonly committed by home buyers attempting to purchase homes for their own use. Vulnerabilities identified in suspicious activity reports (SARs) are fraud via the Internet, fabricated income information associated with subprime loans, mortgage broker originated loans, and identify theft. Mortgage brokers now originate more than two-thirds of mortgage loans. Since there are no national standards for licensing and oversight of mortgage brokers, this represents a significant weakness contributing to the subprime mortgage crisis.
Fraud for profit often involves collusion between industry insiders like mortgage brokers, real estate agents, property appraisers, attorneys and title examiners. Fraudulent activities include appraisal fraud, fraudulent property flipping, straw buyers, and identify theft (Mortgage Loan Fraud 2006).
Unethical Practices
In the past, most homeowners obtained mortgages from their local bank or credit union, which adhered to strict lending rules. Today, approximately 70% of homebuyers' business goes to independent mortgage brokers--some of whom get bonuses for steering borrowers to higher-interest loans (Arnold, May 5, 2008). Many recent borrowers were put into ARMs that are likely to cost far more over the life of the loan than a fixed-rate option. Often consumers could have locked in fixed-rate loans at low interest rates, but lenders downplayed the advantages of these loans. Numerous borrowers say they didn't understand the loan structure and the escalating payments; in many cases, they couldn't afford them. Jennie Haliburton, a 77-year-old widow in Philadelphia, told NPR she refinanced into a subprime ARM that now costs her S300 more than the $800 she was originally told she'd pay. Her loan resets in May 2008. If the current interest rate holds, the monthly payments will grow to $1,218; depending on rates, they could eventually reach almost $1,700--95% of her Social Security income (Arnold, May 5, 2008).
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