Sunday, April 15, 2007

Subprime lending hurts homeowners

Remember the tech bubble of 2001? There was a speculative frenzy around technology- and internet-related stocks, which were bid up to stratospheric levels. However, a lot of companies weren't actually earning real money. The major companies, like Intel, EBay and Yahoo were earning actual dollars, but not enough to justify the levels at which investors valued them. The resulting crash took the stock market down considerably, and wiped out millions of dollars in investments. Some people lost life savings.

That loss of wealth had adverse effects on economic growth. Companies need money to expand. The Federal Reserve cut interest rates to all-time lows, starting at 1%. This meant that businesses, and people, could borrow money very cheaply. In the case of businesses, that enabled them to get funds easily. The Fed meant to put the economy back on track, and it did.

However, individuals could also borrow money cheaply. They flocked to real assets, like real estate, for its perceived safety. 1% interest rates inaugurated the era of 'flipping' houses, or buying a house and then almost immediately selling it, because even in a year there would be significant price appreciation.

Now, interest rates are at 5.25%. This is still historically low, but people are starting to default on mortgages. Subprime lenders are a sector of the mortgage industry that makes loans to people who wouldn't be able to qualify for them. These people have no stated income or credit history. They are a risk. While interest rates were low, they were able to pay the mortgages. Now, interest rates are not so low.

Recent immigrants, especially bachelors- or masters-trained ones, don't have credit histories, but do have earning potential. People who work in consulting-type jobs, for example, don't have consistent stated income, but may actually be able to pay a mortgage. Such individuals may be able to pay off a subprime loan. But traditional lenders, using the methods they have, don't know that. So they deny these folks mortgages.

However, in the frenzy over the housing market, the subprime industry got a lot of people who wouldn't normally have been able to pay the loans off. Also, they rolled out a lot of exotic mortgage products that made it seem that people could afford to make the payments. There were no money down mortgages, which made people think they could afford the house, and stretch themselves to do it. There were adjustable rate mortgages, and when interest rates were 1% they looked like a good deal. But when they hit 5.25%, the payments increased by quite a bit. And then the people who had stretched their finances were out of luck.

The Center for Responsible Lending contends that in the end, subprime lending has hurt homeowners.
"Our analysis shows that subprime loans made during 1998-2006 have led to a net loss in ownership for almost one million families," said Mary Moore, CRL Senior Communications Associate. "This analysis includes a conservative projection of foreclosures that have not yet occurred, but even without using projections, subprime loans have led to a net loss in ownership."

"This CRL analysis in combination with other CRL work peels back the myth that predatory lending helps low-income and low-wealth homebuyers by 'democratizing credit,'" Mark Pinsky, President & CEO, Opportunity Finance Network told The Opportunity Finance Network is a network of private financial intermediaries that work to identify and invest in opportunities that assist low-income people in the US.

"The current implosion among predatory lenders is evidence that bad lending produces bad results. Good lending to good people, however, produces good results. A decline in homeownership due to mortgage lending suggests that bad lenders are providing the wrong products," Pinsky added.

The CRL Issue Paper "Subprime Lending is A Net Drain on Homeownership" stresses that the majority of subprime loans do not go toward buying a home. Instead, these loans are used to refinance existing loans. CRL estimates that first-time homeowners make up only 25% of all subprime loans in 2006. 15.6% of subprime loans end in foreclosure, according to CRL.

The National Fair Housing Alliance (NFHA) has been following the subprime mortgage lending scandal as the NFHA helps people to find housing and fight discrimination in the housing market. "In communities like Toledo, where the foreclosure rate has increased by over 400% since 1998, it stands to reason that the onslaught of foreclosures would have a net negative effect on homeownership rates," said Lisa Rice NFHA Vice President.

The Toledo Fair Housing Center conducted an analysis of each foreclosure filing in Lucas County from 1998 through 2003 and was able to map where foreclosures had been filed utilizing a GIS mapping program. "It was clear that a disproportionate number of foreclosures were occurring in predominately African-American and Latino neighborhoods," Rice concluded.

"Early on, it was commonly held that the subprime mortgage market opened up access, serving as a stepping stone to prime loans," CRL’s Moore said. "The reality of the modern subprime market is the fact that borrowers rarely, if ever, enter the prime market even if they've made their monthly mortgage payments on time. The subprime market is a refinance market that siphons home equity from families instead of building wealth through affordable and sustainable homeownership."

Many large banks got in on the action, and there are a number of subprime specialty lenders. The latter will package subprime loans, and sell them off, often to banks. Recently, HSBC announced that it was increasing projected losses related to defaults. New Century, a subprime lender, did the same, and also announced that it had to restate its financials. These incidents sparked off a crash in stock prices for subprime lenders, and now New Century has filed for bankruptcy.

Basically, people with poorer credit scores and/or an irregular income will find it harder to do so. And foreclosure rates are going to go up. As more homes go on sale in a slowing market, prices will drop even further. If the real estate market crashes 2001-style, that could have implications for the rest of the economy.

It's human nature to want to make a buck, and you also can't have the government controlling absolutely everything. But people are starting to call for controls on subprime lenders. I would have to say they brought it on themselves. However, some congresspeople are also considering bailing out people in foreclosure, which is more a mixed bag. Increased foreclosure rates will have a big effect on lower-income neighborhoods, and increased foreclosure rates could drive their property values down. However, it will also cost the taxpayers a lot of money, some say around $120 billion. I'll have to wait and see before I offer my opinion on this one.

Meanwhile, I think we need to learn to be a bit more long-term in our financial thinking. That's a major culture change, which is a very tall order. In the meantime, people wanting a house who don't have a consistent income or a solid credit history should find a local credit union and become a member. Credit unions are non-profits. They typically can afford to be a bit more generous with their credit terms. And because they are smaller, they are often willing to make smaller loans for less common things that will help you build a credit history.

Meanwhile, the Center for Responsible Lending's website is here. Readers might want to browse it.

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