The end of the 'any breathing borrower' era
BEGINNING in 1933 with deposit insurance, the federal government has corralled banks with regulations and regulators. Today the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Deposit Insurance Corporation stand guard. With the Community Reinvestment Act of 1977, the government set more strictures - banks must lend in communities where they accept deposits. People of modest means need credit: to buy a car, start a business, buy a home. Banks must accommodate those customers.
The subprime market operated outside the corral: few federal regulations, minimal federal oversight. This market made money the new-fashioned way: by selling. Almost 250,000 people worked at mortgage brokerage firms - all focused on "selling" mortgages. The solvency of the borrower was secondary. With "liar's loans," a would-be borrower "verified" his own employment history, including salary.
It is wrong to blame government policies to increase homeownership for this Wild West market.
In 2004, the homeownership rate in the United State rose to an all-time high: 69 percent. But the subprime market did not blossom until 2005.
The credit for the increase in homeownership during that pre-subprime era goes to several factors: a robust economy, with low unemployment; low interest rates; credit scoring that identified credit-worthy borrowers; and banks' commitment to fill their CRA obligations. Federal oversight worked.
As for subprime lending, this uncorralled market introduced two innovations: first, the "any breathing borrower" rule. Brokers' and lenders' compensation was based on loans originated, not on loans repaid.
As for the loan, the lender sold it to a mortgage bank who mixed it with other loans (some better, some worse - much like the bags of potatoes in the supermarket), sold the bundle to a trust that chopped it into tranches to get a good bond rating on some of them, then passed those on to other investors, maybe a pension fund or an overseas bank. Regulatory oversight was outsourced to ill-equipped credit rating agencies.
The second innovation was the "rabbit hole" loan. With subprime loans, you paid nothing down, then almost nothing for months, maybe years, then - poof! You plunged down the rabbit hole, in a nightmare Wonderland. Some payments escalated gradually after two years; others ballooned. Brokers counted on shortsighted, or optimistic, borrowers.
Only 9 percent of subprime borrowers used the loan to buy a first home (1998 to 2006 data, from the Center for Responsible Lending). Many borrowers were investor/flippers, riding the market to a windfall. Others used the loans to move up, from one home (sold in a bull market) to another, one out-of-budgetary-reach under the old-fashioned rules of stodgy banking (remember when down payments were required). Other borrowers were lured into second mortgages, or equity loans - for some people, the debt paid for a new roof, or a medical bill. In a culture where credit card debt is normative, the sell was not hard.
Ironically, while the subprime market soared, homeownership fell - especially for low-income and minority households.
Now that the subprime market has imploded, we are seeing a landscape, literally, of foreclosed homes. An estimated 15 percent of subprime borrowers will lose their homes. While some were first-time buyers, others were lured into trading up, or borrowing on their home.
As for the "prime" market of traditional lenders, credit is now tight. The demographics still propel homeownership: Over 1 million new families form each year. Those families find it harder to get mortgages. If unemployment rises significantly, not only will those families not be able to afford a mortgage, but many who borrowed in the "prime" mortgage market will fall delinquent.
In the wake of massive foreclosures, critics are lambasting the subprime market; but they should be lambasting the lack of regulations, not the subprime market per se. It is reasonable to give credit-impaired borrowers access to credit, at interest rates that compensate for the greater risk. Subprime lenders did just that. But without regulation, the market went awry.
Regulators should step in. They should outlaw the "any breathing borrower" innovation, the "rabbit hole" loans, and the compensation schemes that tie brokers' earnings to sales made, not loans repaid. They, like Ponzi schemes, should be illegal.
We let subprime lending operate unregulated; we are living with the carnage.
Nicolas P. Retsinas, former director of the Office of Thrift Supervision, is director of Harvard Univeristy's Joint Center for Housing Studies. 