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Subprime cowboys

Why did so many home buyers - a disproportionate percentage of them black and Hispanic - wind up with high-rate subprime mortgages when they could have qualified for far better deals? The sad, short answer: The system worked exactly way it was built to work.

The subprime fallout is rattling global markets and threatening to force more than a million American families out of their homes. Everyone from Treasury Secretary Henry Paulson to Ron Mariano, a Quincy legislator, is trying to engineer a soft landing. The mortgage market is complex, too complex in fact, and finding the right balance between regulation and over-regulation is not easy.

But to understand what went wrong, you have to start at the beginning. That is, where the mortgages were made.

Massachusetts Attorney General Martha Coakley has drawn us a convenient road map through this mess with her lawsuit against Fremont Investment & Loan, once the state's second-largest subprime lender. Of particular interest: the way the mortgage brokers get paid. Give people attractive incentives to behave in a certain way, and they usually do. Mortgage brokers are sometimes paid to put people in crappy loans, and now we are cleaning up after them.

Fremont's own rate sheet for its brokers tells the story. The higher the rate, the higher the commission. In a common industry practice called a "yield spread premium," mortgage companies pay a fee to a broker based on selling a loan with an interest rate above what a borrower qualifies for. For example, if a broker sold a buyer a mortgage that had a rate 1.25 percent higher than he qualified for, Fremont would pay the broker 2 percent of the loan, or $7,000 on a $350,000 mortgage, the Coakley suit says. Fremont also offered brokers bounties for selling subprime mortgages with expensive penalties for paying off a mortgage early.

Brokers complain they are being singled out as the bad guys. They defend the incentives, saying borrowers sometime chose the higher rate as a trade-off for lower closing costs. Fremont would not comment on compensation, but said the lawsuit is "without merit."

There is plenty of blame to go around. But when you take a go-go, cyclical business like the mortgage industry, supercharge it with a compensation system that puts the customer's interest at odds with the broker's, and then allow the lender to pass along the risk to the next guy, you have fertile ground for trouble.

It is how you get a Dorchester single mom with three kids, unemployed, and living on a monthly Social Security disability check, getting $800,000 in loans to buy not one but two multifamily homes. Her monthly income was $1,800; her mortgage payments were $7,000. Fremont paid her broker $7,024 through a yield spread premium, according to the Coakley suit.

We've seen this before. In the early 1990s, Fleet Financial got burned using "bird dog" companies - brokers and other independent companies - to make scummy home improvement loans to poor people in Georgia. The brokers got paid up front then, too, but at least Fleet kept the loans in its own portfolio. Now the game is to take your cut and pass the risk on to the next guy.

The mortgage market has changed forever - for good and bad. We are not going back to the old days - not always so good anyway - when the banks wrote most mortgages. Today, mortgage companies control about 80 percent of the market, and it is past time that regulation caught up with the markets. Coakley's new mortgage regulations are designed to rein in the brokers' compensation system, as will US Representative Barney Frank's bill, which is expected next week and is likely to ban yield spread premiums and restrict prepayment penalties for subprime borrowers.

There is no magic bullet. But more closely aligning the interest of buyer and seller is a good place to start.

Steve Bailey is a Globe columnist. He can be reached at bailey@globe.com or at 617-929-2902.

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