IN THE BEGINNING
In a manner similar to the numerous economic crises before it, the subprime lending bust actually began decades before anyone knew it. The Community Reinvestment Act of 1977 pushed banks to extend more credit in communities where they operated. This drew many lenders to lower-income borrowers. Later, in 1986, the federal government began allowing taxpayers to deduct the interest paid on mortgage loans. The effect was a boon to the market for refinancing. In addition to the benefits attached to building equity – paying a fixed monthly payment instead of rising rent, for example – homeowners could now take advantage of the tax break. This led directly to a steady increase in home ownership, in many cases regardless of how the borrowers would afford the loans in the future. Risky loans were made across the board, from small rural towns to inner city neighborhoods to affluent suburban areas.
From 1986 through the mid-nineties, mortgage securities began to catch the eye of Wall Street. The focus in that time shifted from investment in regular “prime” mortgages, to the riskier “subprime” loans. The risk of default on subprime loans was higher than that of prime loans, but they were still more attractive to investors. The volatility in the subprime market was very low in comparison to the stock market. This low volatility rate made subprime loans the “must-have” for mutual fund companies, regular banks, pension funds, and insurers – all of whom were looking to further diversify their holdings.
There have been several bubbles in the financial markets. The market is prone to human emotion, and investors sometimes become overzealous with the proverbial “next big thing.” Similarly, investors in subprime loans took the initial gains as indicative of future windfalls, and began to put more and more money into the industry. By the time housing prices peaked (from 2004 to 2006), over a quarter of all loans made were high-rate subprime loans. Thirty-five billion dollars was invested in subprime loans in 1994 – $11 billion of which was bought on Wall Street. This ballooned into $332 billion in loans in 2006. A whopping $203 billion of those outstanding subprime loans were purchased by investors on Wall Street that year. This aggressive lending and concurrent demand for homeownership resulted in many borrowers enjoying houses they could never afford.
SUBPRIME LENDING: A SHEEP IN WOLF’S CLOTHING?
Key to the understanding of the current issues facing the mortgage lending industry is the distinction between “subprime” lending and the oft-unmentioned “predatory” lending. A subprime loan, also known as a “second chance” loan, is tailored to borrowers with “less than perfect credit,” credit problems, or who are less likely to qualify for conventional home loans. Many times, it is the only option for home ownership that the borrowers have. The loans are typically short term, and generally extend over a two to four year period. The loans come with higher interest rates and fees, which is standard for any line of credit approved for higher-risk borrowers. Most important, however, is the fact that these loans are intended to allow the borrowers a chance to pay back debts and clean up their credit. At the end of the lending period, the borrowers should be able to qualify for or refinance into a loan with a lower rate and risk from a major bank.
Predatory lending involves engaging deception or even fraud, through misinforming and manipulating the borrower. This often involves pushing aggressive sales tactics onto naïve consumers, and taking advantage of any lack of understanding. The predatory lender does not care about the borrowers’ ability to repay. It occurs in both the prime and subprime market, but thrives in the latter due to the greater amount of oversight that prime lenders (typically banks or credit unions) provide. Predatory lenders use abusive loan practices that generally involve one or more of the following problems:
1. loans structured to result in seriously disproportionate net harm to borrowers,
2. harmful rent seeking,
3. fraud or deceptive practices in lending,
4. other forms of lack of transparency in loans not actionable as fraud, and
5. loans that require borrowers to waive meaningful legal redress.
The Coalition for Responsible Lending recently estimated that predatory lending alone costs borrowers in the U.S. over $9 billion every year. A prominent indicator of the rise of predatory lending is the unprecedented increase in foreclosures across the United States. While interest rates were dropping from 1990 to 1998, the home foreclosure rate increased massively – rising 384%.
Why the differentiation? For starters, many consumer advocates and hard-line opponents of subprime lending have claimed that there was no distinction. This unfortunately blurred the line between lenders offering a second chance to the borrowers who need one and those lenders who target for the sole purpose of squeezing blood from the proverbial stone. While subprime lending creates homeowners, predatory lending eliminates them. Predatory lending is most prevalent in the subprime market, but occurs across the entire lending spectrum. It affects middle- and upper-class in the same destructive way as it does the lower-class. The only requirements for a predatory lender are that his victims must have two things: financial problems and a lot of equity in their homes.
A perfect example of predatory lending is found in the story of Ken and Pat Leahy, who live in the suburban Chicago town of Glenview, Illinois. The couple is currently fighting a business that conducted “mortgage rescue” operations, which is another term for one of the numerous predatory lending scams. The couple lived in the same house for forty-seven years, and had refinanced several times (as many Americans do) to build onto the house and send their daughters to college. In March of 2002, Ken lost his job. After struggling for a while to make their $1,700 mortgage payments and receiving numerous solicitations from lawyers and loan brokers, the couple decided to meet with Harrison & Chase. The business advertised itself as a “foreclosure mitigation firm,” and pledged that its services were provided “free and pro bono.” As the couple sat down to meet with Mr. Hantzakos, a company rep now named as a defendant in their lawsuit, he assured them that they should not worry because he “talk[s] to different people than [they] do.” The couple then hesitatingly signed two forms – one which authorized Harrison & Chase to negotiate on their behalf, and another that was an exclusive deal to help the Leahys sell their home.
The Leahys never received a copy of either form. After the supposed meetings with the couple’s lender failed, Mr. Foxx, the president of Harrison & Chase contacted the couple and offered them a new idea. Foxx told them that they could put their home in a “protected trust,” which would protect them from creditors while Ken found a new job, they improved their borrowing power, and refinanced. Though the trust would have the power to sell their home, the Leahys were assured that they would have the first chance to buy it back.
While the couple had not intended to give up the title to their home of nearly fifty years, they unfortunately did exactly that. They learned that they had sold their home for $230,000 in an area which they at the time could have gotten over $500,000 for the same property. After satisfying their mortgage with the $230,000 for which they sold the house to Harrison & Chase and paying property taxes, the Leahys walked away with only $10,361. Adding insult to injury was the fact that the couple would up paying $2,500 per month to rent their own home back from the “rescuers,” and agreed to pay nearly $300,000 to buy their beloved home back. Unfortunately, due to another series of unfortunate hospital visits, the Leahys cannot afford that.
The Leahys are not alone, either. Predatory lenders have been taking advantage of sentimentality and human attachments to property all over the country, using “sales leaseback” schemes like Harrison & Chase. All a potential victim needs is exactly what the Leahys had: financial problems and a lot of equity in their homes. Until these operations are squeezed out by the increase in oversight effectuated by the mortgage bust, borrowers must not make the same mistake as the Leahys. Both new and veteran homeowners who find themselves in financial trouble must sort through the frustration and educate themselves. Seeking independent legal and financial advice is paramount, and there are many private and public outlets in which to do so.
MERGING CRIME WITH CAPITALISM
In addition to highlighting the predatory lending that had been taking place, the bust in the real estate market turned the spotlight on potential criminal activity in the real estate market. For example, New York Attorney General Andrew Cuomo has filed suit against the real estate appraisal unit of First American Corporation – a Fortune 500 company. Attorney General Cuomo believes that the practice is “widespread” and has been a large contributor to the crash in the market.
The lawsuit against First American alleges that the company inflated the values of homes in order to get more loans approved. The mortgage companies were apparently pressuring the appraisers to do so. Such a practice makes it very easy for borrowers to either overpay for a home or borrow too much against their current home. Therefore, when home prices began falling, the borrower would be unable to refinance if his house ended up being worth much less then he had thought at the time of purchase.
More absurd than even the artificial inflation of appraisal prices was the fact that an entire industry based on assisting borrowers in fraudulently obtaining loans had sprung up. At the zenith of the subprime lending market, a low credit score, insufficient monthly income, and even a history of bankruptcies could not keep borrowers from obtaining mortgages. For example, all an unqualified borrower had to do if he wanted to qualify for a loan that he thought he might be able to afford was visit http://www.VerifyEmployment.net. For only a $55.00 fee, the small California-based company would help an unqualified borrower get a loan by listing him as an “independent contractor.” In doing so, the company provided pay stubs that “proved” the borrower’s income to be much higher than it really was. For only $25.00 more, the company would also provide a telephone call to the lender in which they would give the borrower a glowing reference. Another website – http://www.FakeNameGenerator.com – provides interested borrowers with fake names, addresses, credit card numbers, social security numbers, and basically anything else one would need to secure a mortgage loan.
More recently, mortgage lending fraud in Pittsburgh has been picked up by the national newswire. U.S. Attorney Mary Beth Buchanan announced on April 10, 2008 that two mortgage brokers pleaded guilty in federal court to mortgage fraud charges. The two brokers, Aaron Thompson and Randy Carretta, operated People’s Home Mortgage. While the stated purpose of the business was to “assist borrowers in obtaining financing to purchase homes,” the duo instead submitted for borrowers applications containing patent misrepresentations about the borrower’s financial condition. The applications also included inflated appraisals of the properties prepared by unlicensed appraisers and falsified employment documents. Sentencing is scheduled for September 2009, and the two are each facing the possibility of $250,000 in fines and twenty years in prison. The two convicts are only a drop in the growing pond, however, and are not the only ones to blame for the subprime lending crash.
Laissez-Faire lending oversight and standards also provided an avenue for “fraud for profit.” In one New York case, the FBI has charged twenty-six people for fraud. The defendants allegedly used stolen identities, invented buyers, and inflated appraisals in order to obtain over $200 million worth of properties. Several other similar operations have been eliminated by law enforcement – in an Ohio case, almost half of all the mortgages processed by a single broker did not make a single payment. Unfortunately, many other fraudulent borrowers and lenders will get away with it, because the money is “out of the door” and there is no recovery to be had.
For many investors, the growth and rapid bust of the lending industry reminds them of the savings and loan crisis of the early 1990s. That crisis ended with the federal government pumping the market with a bailout of $150 billion, and a small number of high-profile fraud convictions. Presently, however, the major losers in terms of real dollars have been the hedge funds. Though these funds are in theory only limited to the more wealthy investors, small business and borrowers alike could soon feel the famous “trickle-down” effect. The present administration is considering its available options and will probably end up pressured into out lending companies, the borrowers facing foreclosure, or both. In the meantime, class action litigation has begun, and will not end anytime soon.
ADDRESSING THE PROBLEM IN CONGRESS
On October 22, 2007, Representatives Brad Miller (D-NC), Mel Watt (D-NC), and Barney Frank (D-MA) introduced “The Mortgage Reform and Anti-Predatory Lending Act of 2007.” The stated purpose of the Act is to “reform consumer mortgage practices and provide accountability for such practices, to establish licensing and registration requirements for residential mortgage originators, to provide certain standards for consumer mortgage loans, and for other purposes.” The purpose of the Act, in summary, is to place a substantial burden on mortgage lenders while vaguely ignoring any irresponsibility in borrowing.
Title II of the Act is entitled “Minimum Standards for Mortgages.” Under this Title, no mortgage lender is allowed to make a residential mortgage loan unless it makes a “reasonable and good faith” determination that the borrower has a “reasonable ability to repay” the loan. The basis for such a determination would have to be the borrower’s credit history, current income, expected income, current obligations, debt-to-income ratio, employment status, and “other financial resources.” There is also a rebuttable presumption against the mortgage lender, under Section 203 of the Act.
When Sections 201 (Ability to Repay) and 204 (Liability) are read in conjunction, the burdens the Act would place on lenders are far clearer in nature. If a mortgage lender does not comply with the “reasonable and good faith determination” standard in deciding to lend a borrower money, and the borrower is unable to repay, the borrower could file a civil action against the lender pursuant to Section 204 of the Act. This civil action could be filed for the following: rescission of the loan, costs incurred by the borrower as a result of the violation and in connection with getting the loan rescinded, and even attorney’s fees. The step-by-step lending process, according to the Act, would look like this:
1. Potential Borrower applies for a mortgage loan.
2. Mortgage Lender, based upon information provided by Potential Borrower, agrees to lend the money based on terms both parties agree to.
3. Borrower realizes that he/she cannot continue to make payments based upon the consensual terms.
4. Borrower files a civil action against Lender to nullify the loan, recoup costs incurred in filing the lawsuit, and to recoup attorney’s fees.
5. Lender must then overcome the substantial rebuttable presumption of guilt in order to be successful in its defense.
It should be noted that the bill provides no presumption that the borrower must overcome. Nowhere in this proposed legislation is the borrower required to show good reason for his/her inability to pay. The Act would not even require the borrower to show good reason for seeking recission of his/her financial obligation.
The basic effect of these provisions would allow borrowers to sue lenders simply because the lenders should not have loaned them money. The potential effect of such legislation would be to curtail lending to a point where mortgage lenders would avoid making loans to all but the highest order of borrowers. This would decrease homeownership solely because the number of lenders willing to take on even normal-risk borrowers would shrink precipitously.
The general issue of whether those not materially affected by the subprime lending collapse should “bail out” homeowners facing foreclosure has come to the foreground of the political landscape. Any Pennsylvania resident who has seen a campaign advertisement leading up to the crucial April 22, 2008 Democratic Primary could attest to this. On March 7, 2008, Senator Kit Bond (R-MO) introduced the “Security Against Foreclosures and Education Act” (the SAFE Act). The purpose of the SAFE Act is to help families and neighborhoods facing home foreclosure and address the subprime mortgage crisis. Senator John Cornryn (R-TX) and a number of other Senators are on board.
The SAFE Act provides an example of the steps Congress is taking in attempting to bridge the gap between the two main viewpoints on the issue. The plan is to provide over $10 billion to refinance subprime mortgages which are stressed or facing foreclosure. It also provides for a $15,000 tax credit, spread over a three year period, for the purchase of a “qualified personal residence.” “Qualified personal residence” is defined by the SAFE Act as “an eligible single-family residence that is purchased to be the principal residence of the purchaser.”
Other new regulations proposed by the SAFE Act would require borrowers who are considering an ARM (Adjustable Rate Mortgage) to be educated with regards to any introductory rates, payments, expiration dates, prepayment penalties, what the rate will be at the outset, and what the monthly payment will be if rates increase. These measures are inherently proactive. The SAFE Act, if passed, would not look back to those who have dealt or are currently dealing with foreclosure. The disclosure requirements, however, would place a strong burden on mortgage lenders to inform potential borrowers about nearly every financial aspect of buying a house.
The proposed borrower education and increased disclosure requirements would not end after purchase. Section 327 of the SAFE Act would amend Section 106(c)(4) of the Housing and Urban Development Act of 1968, which currently provides for financial counseling for homeowners who cannot meet their current mortgage loan obligations due to job loss. The change would make the counseling available to those who cannot make payments due to divorce, death, unexpected or significant increase in medical expenses, unexpected or significant damage to the property, and/or a large increase in property tax. The counseling would still be available only to first-time homebuyers, and would continue to include counseling with respect to financial management, available community resources and social services, and job training/placement.
In order to spur an increase in homeownership following the foreclosure crisis, the SAFE Act would create a pilot program for borrowers without credit history sufficient to buy a house. Addressing this lending demographic was necessary, given that persons with bad credit were primarily targeted by predatory lenders. The pilot program would use an “alternative credit rating” to give those with insufficient credit history a chance to buy a house without having to wait for a long time just to build a good credit history. The new credit rating system would take into account information such as rent payment, utility payment, and insurance payment histories. One could easily argue that rent and utility payment information would be far more useful to mortgage lenders than normal credit rating information.
There is no word from the Democrats in Congress as to when this proposed legislation could be up for a vote. The new required disclosures proposed by Senator Bond are not unreasonable. They would create a new standard for lenders, while emphasizing the importance of financial education to borrowers. The requirements would not relieve irresponsible borrowers of the obligations they created through their own volition by entering into financial agreements with which they could not comply. Both schools of thought – those who believe that lenders do too little, and those who believe that borrowers should be more diligent – are addressed in a way that encourages self-education and diligent disclosure.
BALANCING PERSONAL RESPONSIBILITY AND MARKET CONCERNS
The precipitous change in home ownership and the steep increase in foreclosures endured by the U.S. have been debilitating, and the crisis is far from over. Illustrating the effect are the recent cuts in interest rates made by the Federal Reserve – the first since 2003. American home prices recently dropped for the first time since most likely the Great Depression, and according to a March 2007 study conducted by First American CoreLogic, the market should expect another 1.1 million foreclosures by 2013. Lawmakers now face a tough balancing act between protecting vulnerable holding borrowers and allowing borrowers to skirt the responsibilities attached to taking out mortgages that they could never afford.
In 2007, the Bush administration loosened some lending rules, which could help around 80,000 borrowers refinance to avoid higher rates. A bill has also been introduced to reform subprime lending practices, and to help weed out more predatory lenders by targeting them more specifically. The bill would, among other things, expand the Homeownership and Equity Protection Act (HOEPA) to cover more loans, expand the protection for HOEPA loans, clarify state law regarding mortgage loan broker duties to emphasize the fiduciary duties owed to borrowers, and create a new section of protections for subprime loans.
In general, those opposed to government intervention believe that although the lending industry will probably experience some short-term pain, the economy will emerge healthier. Others also believe that overriding personal responsibility for investments by instituting a federal bailout would be a “subsidy for risky behavior” in the marketplace, and would encourage future risky credit transactions by saying “. . . the government . . . will bail out bad lenders.”
Talking heads at the Center for Responsible Lending, a nonprofit research group, call such a bailout “unconscionable,” because there was a huge amount of money initially made on investments in subprime loans, and that investors should be allowed to “feel the pain” in the free market. Bailing out investors seems counter-intuitive at first glance. It does make sense – why should investors be covered by the government when they lose money if they are not then forced to turn over money when the government believes they have made too much of it? Bailing out someone who engaged in risky behavior will most likely only encourage such behavior in the future.
Those in favor of the bailout option contend that some industries are “too big to fail.” This argument was first used about ten years ago, when the Federal Reserve intervened on behalf of the enormous hedge fund Long Term Credit Management. Currently, almost 100 subprime lenders have closed their doors since the initial bust, and the ripple effects are only beginning to be felt by other areas of the United States economy. The financial system is so interconnected, through the slice and dice of mortgage loan bundles amongst investment funds, that when a homeowner in Ohio defaults, a retiree in Hawaii might take a hit in his portfolio. Whichever way the decision is made, the stakes are huge for those in Pennsylvania planning to enter into homeownership in the next few years.
APPLICATION TO THE GRADUATE STUDENT
The result of the confusion between subprime and predatory lenders is clear: subprime loans are utterly feared and avoided by all borrowers, many of whom would greatly benefit from such a situation. Home prices are falling, yet those who could take advantage of the low prices will never do so. Potential borrowers have decided to stay put after hearing about the foreclosures, dreaded adjustable rates, and others losing their homes. A sign of the times is that apartment turnover has recently stagnated, as apartment dwellers are choosing to forgo the financially beneficial route of building equity. According to the National Association of Realtors, there are nearly a million such people who are foregoing any purchase of real estate.
A recent study conducted by Congress’ Joint Economic Committee has projected that by the end of 2009, nearly seventeen percent of Pennsylvania’s subprime loans could fail. The study showed that twenty-nine percent of all first mortgages in Beaver and Armstrong counties, twenty-six percent in Washington County, and twenty-five percent in Allegheny and Westmoreland counties were all subprime. In Philadelphia County, a startling forty-six percent of all mortgage loans were subprime.
As far as Pittsburgh is concerned, those in the area have only experienced an eleven percent appreciation in real estate values from 2001-2006. This is a painfully low increase, as compared to Philadelphia homeowners, who experienced an increase of over fifty percent in home value. Allegheny County residents have also experienced around 400 foreclosures in February 2008 alone – the highest for the month of February in over twenty years. Real estate agents in the area do not believe that residents should fret, however, since the Pittsburgh market has escaped the larger amounts of foreclosures experienced elsewhere. Instead, those looking for homes in the next few years can apparently count on local real estate agents to come up with better deals and buying opportunities. While the outcome for the former owners of the houses have been unfortunate, young first-time homebuyers will probably be able to make the proverbial lemonade by taking advantage of the low prices that will probably stick around for the next few years.
There is no clear solution to those who plan – or planned – to buy their first home soon after finishing their education. Graduate students many times face student loans around $100,000, and mounting credit card debt from extraneous expenses incurred during school. Overall, debt-laden grads are not very attractive to the lending industry in its current state. This is especially compounded where the student burdened by high education loan debt does not make much after leaving college or graduate school. Simply making student loan payments on time, however, will boost your chances of getting a better interest rate on a home loan. Those considering purchasing their first home must decide whether they feel secure enough to stay there for at least the next five years to wait for the inevitable market rebound in prices.
There is good news, however. The Federal Housing Administration (FHA) insures specialized first-time homebuyer loans, which greatly encourage new homeownership. These loans are funded by lending institutions and insured by the U.S. Department of Housing and Urban Development. For those looking for a single-family home here in Allegheny County, the current lending limit is $327,500. A major perk of obtaining such a loan is that the down payment requirement is reduced from to only three percent of the total loan amount (down from ten percent).
Adding to the benefits enjoyed by today’s first time homebuyers is that real estate prices have dropped to all-time lows as more houses are put on the market, and will probably stagnate for the next few years. This will provide a benefit to those with student loan payments to make, due to the incredibly low prices (and, ergo mortgage payments) that will be manageable even when compounded with student loan payments. In addition, many private loans are not even reported to credit rating agencies, and therefore do not burden the aspiring borrower. Until more solutions are put in place to stop criminal practices in lending, students looking at first-time homes must resort to more aggressive self-education to help ensure success in home buying.
The total fallout from this economic crisis will be widespread. The immediate results from the bust in the industry are clear, and explained with simple economics. As mortgage rates rose, the demand in housing decreased. Those with ARM loans could no longer afford to keep their houses, so they sold them (or, to a lesser extent, foreclosed). The result was a speedy growth in supply coupled with a sharp decrease in demand caused by the increase in rates. The excess created in the housing market drove prices down.
It is unclear where they will finally stagnate, as there are several factors that could contribute in the near future. The Federal Reserve has lowered interest rates twice to encourage both home retention and home purchasing. Assuming that inflation remains stable after the rate cuts, there could be more coming. At some point, the trickle-down effect of the rate cuts will influence the adjustable rates that many borrowers face. Home construction will likely also be a contributing factor, as the coming slow down in that industry (a result of decreased demand for new homes) will stabilize the supply of available housing inventory.
Andrew J. Wronski, a Partner at Foley & Lardner, LLP, has recently published an educated and intelligent summary of what he believes will be the effect of this crisis on the consumer lending industry. Mr. Wronski states that there will be a dramatic increase in federal and state regulation of consumer finance. Many other types of consumer loans – even everyday financing options – will be affected, because they were packaged and sold in the same manner as mortgage loans. Already Mr. Wronski has been proven correct in his first assertion; this is evidenced by a simple review of the proposed legislation discussed earlier.
In 2006, this author had a simple five-year plan: work hard, do well, pass the Bar, get married, and lose the shackles of endless rent payments by building equity through responsible homeownership. At the time, the latter seemed far easier. Facing the all-too-familiar burdens of six-figure student loans, credit card debt, and pressure to land a secure job as a new attorney begs the absolute question: Would the “American Dream” put a recent law school graduate in over his head?
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