Subprime Mortgages: Failures of the Housing Market & the Perpetuation of Racial Exclusion

What caused the financial crash of 2008 and how were racial minorities disproportionately affected? 

 

Introduction

The financial market crisis of 2008 arose from the securitization of subprime mortgages. Subprime mortgages are categories of mortgages with higher possibility of default due to a variety of indicators including the buyers’ financial debt history, credit scores, employment stability, down-payment capacity, or other measurements of risk. Accordingly, subprime mortgage lenders added measures such as higher interest rates, balloon payments, or up-front fees to compensate for this increased risk, in a process called risk-based pricing.  This paper will investigate what went wrong in a process that was supposed to expand the qualifying market for homeownership, if there is an inherent flaw in the concept of subprime mortgages or if it was mismanaged in such a way as to exacerbate the conditions of already vulnerable people. The more significant consequences of the subprime mortgage industry on historically discriminated groups – particularly racial minorities – created the perception that subprime mortgages are inherently exploitive. There is some evidence which suggests that predatory lending was driven by racial considerations, upon which subprime mortgages were imposed or coerced.

Yet there are also arguments that it was not subprime mortgages itself but other related factors which compounded the risk, such as adjustable rate mortgages (ARMs) or ever more complex securitization packaging. Subprime mortgages were initially conceived to be short-term solutions for people with temporarily bad credit and were meant to have higher standards of access. However, deregulation and the willingness of investment companies to absorb higher and higher volumes of mortgage backed securities (MBS) or collateralized debt obligations (CDOs) induced recklessness among lenders and buyers. Government insurance of Fannie Mae and Freddie Mac and credit default swaps (CDS), which bet on defaults, created a moral hazard in which increasing risk was ignored. Financial institutions can pass the risk off and make a profit while the homeowner bears the burden of subprime mortgages’ increasing fees and interest rates. I argue that primarily, it was the unregulated mismanagement of securitization that gave mortgage lenders the incentive to make increasingly questionable loans. As a result, a historical situation of financial and social exclusion on minorities was made worse. In analysis, this paper will outline: 1) the financial processes and policies that made subprime lending predatory and insecure 2) how communities of racial minorities were disproportionately affected and 3) evaluate how these two elements combined to create a discriminatory housing policy.

Background

History of Subprime Mortgages and Securitization

The concept of a mortgage has been around since 1000 B.C. in Babylon (Geanakoplos). Homeowners take out a loan to occupy a house (a mortgage) with the house as collateral. Before the 1980s, mortgages were provided by savings and loans institutions (thrifts) who originated, serviced, and held mortgages themselves (Barth, 1).  In the 1970s, the securitization of mortgages began with the Federal National Mortgage Association (Fannie Mae), the Government National Mortgage Association (Ginnie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). They were created initially during the Great Depression as government sponsored enterprises (GSEs) to make collections of mortgages known as “pass-through” pools that would be sold to Fannie Mae and Freddie Mac’s shareholders. This process of securitization was intended to expand the available credit by diversifying risk (because the mortgages came from a variety of locations), implementing standard criteria (high credit rating, stable employment history, etc.) and making a re-sell of the securities possible. These safeguards would make mortgage rates go down and credit would become more attainable because of the larger funding stream from the financial market (Geanakoplos).

Around the 1990s, after legislation that allowed banks and mortgage companies to charge different interest rates (usury) to different people, the subprime mortgage market and other exotic financial instruments took off. The specialized field of ‘structured finance’ allowed poorly rated subprime bonds (BBB) to be ‘cut up’ and tailored to different investors according to their different complex financial interests and repackaged with less riskier mortgage backed securities into collateralized debt obligations (CDOs). Some of the ways in which risks were compensated for was by creating credit default swaps (CDS) where investors could hedge against foreclosure by paying an insurance premium on defaults, by extracting more and more profits from homes and borrowers by charging increasing interest rates (adjustable rate mortgages) after a certain time, and by charging fees for refinancing mortgages or forcing delinquent borrowers to foreclose and retaking the houses (whose values kept rising) as collateral. Thanks to these financial innovations, subprime mortgages within CDOs received the highest rating (AAA) from rating agencies such as Standard & Poor or Moody’s despite having enormous risk (Wyly, et al., 333).

Discriminatory Housing & Segregation

The second element to this story is the history of discriminatory housing policy on minorities. Decades of housing practices that excluded African Americans created a racially segregated housing landscape. For African Africans, larger integration was blocked by restrictive covenants, the Jim Crow laws, and isolated public housing from the Urban Renewal period. In 1933, the government created the Home Owner’s Loan Corporation that determined where housing assistance should be allocated. In a process known as redlining, predominantly black neighborhoods were identified and excluded from stable and cheap loans. In the 1950s, the process of post-war suburbanization drew the white population away from the urban core who would take out mortgages guaranteed by the Federal Housing Authority (FHA) and the Veterans Association (VA). In addition, urban renewal forcibly relocated many low-income minorities who then were placed in high-rise structures with little access to public services (such as education) and amenities (such as commercial shops). The policies of restrictive covenants and the Jim Crow laws made explicit the denial of minorities into certain neighborhoods and communities and exacerbated and solidified segregation.

Therefore, as a result of disinvestment from government housing authorities, minorities were generally concentrated in certain neighborhoods while white communities were in others. In the 1950s, black Americans who wanted homeownership were forced to accept loans from nongovernmental speculators (essentially loan sharks) at exorbitant terms. As they were excluded from mainstream credit flows, a ‘sub-market’ was created in which ‘class-monopoly rent’ dominated. Class-monopoly rent describes a situation in which the owners of capital maintain all the credit and are thus able to dictate the terms (such as steep premiums), typically disadvantageous and unfair to the homebuyer but profitable to the speculator (Wyly, 336). This exploitation created less financial security for these communities as more of their income went to paying off mortgage debt, rather than personal savings or investment. Unable to “gain financial footing, build wealth and pass it down to future generations” (Philips, 228) minorities generally could not accumulate capital or savings through home equity and because of the cost of their homes. Thus, in addition to being geographically segregated, many minorities were perpetually at a financial disadvantage.

Analysis

Drivers of Risk

Privatization makes the provision of housing a profit oriented enterprise. The “commodification of housing, restriction of governmental involvement, and myth of homeownership” contributed to the notion of housing as an entity for investment rather than a substantial need (Immergluck, 351). The mortgage market was one of the financial industry’s targets as the industry increasingly focused on speculative investments during easy credit of the 1990s. Rather than putting money in safe and productive sectors and because of stagnation in traditional markets, the financial industry searched for more profitable (and more volatile) products. A wide and complex range of financial instruments and innovations (mortgage hybrids, derivatives) were conjured up for investment bankers to essentially gamble on. This created a “casino economy” in which “speculative expansions served to stimulate…stagnation tendencies” within production sectors (Foster 6). That is, money was not invested in tangible or productive business enterprises but in credit, predictions and bets that something will be continue to be profitable or not. In this case, that something was housing prices and mortgages. Mortgage lending was ‘unbundled’ or ‘disintegrated’ by securitization in which originators, servicers, and financial backers were split into different entities. This replaced the typical savings and loans institutions process of originate-to-hold, in which there was no secondary market (Immergluck). The subprime mortgage industry fell victim to financialization in two ways: 1) making financial flows, not housing access, the focus of subprime mortgages and 2) guiding the industry towards ensuring profits for investors and lenders at the expense of homeowners, and encouraging loan originators to accept riskier borrowers since their profits came from investment banks, not the borrowers themselves. Thus, rather than functioning as a policy designed to expand credit opportunities to responsible but disadvantaged people, the subprime mortgage industry became like just another chip at the blackjack table.

Government policy towards homeownership was largely in finding private market solutions. Policies such as the Reagan era regressive tax cuts, Clinton era banking-sector consolidation, and Bush era deregulation incentivized and enabled the financial industry to look for new market opportunities. After Clinton reduced long-term interest rates in 1993, the mortgage industry turned away from long-term repayments and towards up-front fees and re-selling on the secondary market to investment banks (Wyly et al. 337). In addition, the deregulation of private securitization corporations allowed subprime lenders to avoid the rigorous screening processes that typified mortgage lending in the past (as in the early GSEs). Previously lenders would hold on to subprime loans for at least year in a process known as ‘seasoning’. This would demonstrate to secondary market investment banks that these were safe investments. But in 2006, lenders were incentivized to further loosen their standards and make subprime loans en masse and with increasing speed to investment banks. First, because the market was becoming more aggressive and demand from investors increased, making subprime mortgages increasingly profitable. Second, because the quality of the mortgages they bought was deteriorating, they did not want to hold on to it longer than necessary and could make more profits by passing them on.

In 2007, an increasing rate of default and foreclosure sent a panic and contagion throughout the economy and the market crashed. Liebowitz (2009) argues that adjustable interest rate mortgages (ARMs) and not subprime were primarily responsible for the crash. ARMs in both the subprime and prime markets were the first to go bad and continued declining long after fixed rate mortgages. But however the recession began, subprime mortgages as a category offered more disagreeable terms towards the borrowers and foreclosed at a higher rate than prime. In 2009, subprime foreclosures reached 4.5% of the mortgage market, while prime was 1% (Liebowitz, 2). In addition, 15.6% of all subprime loans since 1998 will foreclose (CRL, 3).

Thus, the securitized subprime mortgages were not substantial because their purpose was not to provide loans and get repaid by the borrowers, rather they were transferred onto the securities market whose interest was not in ensuring a stable loan but in speculation. If housing prices continued to rise, their gamble was safe. But housing prices were not rising from genuine value increase, they rose due to speculation of the housing market. People were ultimately unable to afford the exotic structuring of subprime mortgages – the higher interest rates, balloon payments, interest-only payments, piggy-back second mortgage options, and what else – that seemed affordable at the time but only contingent on continued rising home equity value (Immergluck, 342). The securitization of prime mortgages could have functioned correctly and the subprime mortgage may have been an effective tool for responsible borrowers. But the securitization of subprime loans introduced a toxic element into the financial system. In addition, all the parties except homeowners were protected in some way, either by government backing or by hedging.

Subprime Lending on Minorities: Structural Explanations

As minority communities were already excluded from the formal economy and community by not having access to normal credit and by processes of redlining and white flight, they became particularly vulnerable to the subprime mortgage industry. Black Americans were left in underserviced areas and denied government investment due to the HOLC and other policies based on race. As Mendenhall states “segregated housing in the United States is not a function of individuals’ preferences expressed in a free-market with perfect information” (Mendenhall, 20). The dual processes of biased lending and historical racial segregation made black American populations more susceptible to subprime loans. In addition, since black populations have been historically excluded from housing market practice, many were unable distinguish between fair and unfair practices.

In the years after World War II, as white Americans largely moved out of urban areas, traditional and more stable credit lenders followed. This left subprime originators and other predatory lenders as the only option to service the black community with credit. Phillips argues that the excessive interest and fees of subprime lending further destabilizes these already economically vulnerable neighborhood (Phillips, 228). Since subprime mortgages are more exposed to foreclosure and black neighborhoods have a higher concentration of subprime mortgages, these neighborhoods would experience a greater decline in value (typically 1.0-9.7%) because of the presence of foreclosed properties (Phillips, 228).

Empirical evidence shows that racial bias was present in subprime lending practices. The perception of risk was applied more unevenly towards non-white minorities. For example, the black middle class were five times more likely to hold high interest subprime mortgages than whites of similar or lower incomes (Phillips, 227). In majority black census tracts 51% of mortgages were subprime refinance loans, where as predominantly white tracts were only 9%, controlling for education, income, and credit histories (Immergluck, 342). The ratio of rejections for loan applications three for every black applicant to one for every white applicant, controlling for non-racial factors (Phillips, 225). Further,  high cost loans as a percentage of all mortgages for black Americans grew from 37% in 2004 to 54% in 2006 (Wyly et al., 350). Wyly et al. argue that unfair terms were pushed onto minority communities due to ‘information asymmetries’ – that is, the advantage mortgage lenders held of knowledge of the true nature of the mortgage market – in addition to the consumers’ belief that they could not qualify for prime mortgages (Wyly et al., 338).

Thus, the securitization of subprime mortgages perpetuated a history of racial exclusion. Disinvestment, segregation and biased lending practices concentrated and exacerbated the situation of black Americans such that subprime mortgages became another discriminatory housing policy. The housing crisis may also worsen access for many in the black population in the future because foreclosures will negatively impact credit scores and because the fees and money put into subprime mortgages are irrecoverable. The net homeownership loss for African Americans is 47, 101 for subprime loans originating in 2005 alone (CRL, 4). The rate of black homeownership went from a high of 49.4% in 2004 to 47.5% in 2008 (Phillips, 227).

Conclusion

Indeed, rather than the subprime mortgage market expanding access to homeownership, the foreclosure crisis has caused 2.4 million to lose their homes (CRL, 2). The processes of securitization and the priority given to the financial industry rather than towards the access and provision of housing created an unstable subprime mortgage market. Deregulation and dismantling the loan process into financial securities increased the incentives for lenders to provide loans, no matter how risky. This risk was compounded by government insurance and financial hedging. And, being that subprime was the primary means for (and sometimes imposed upon) African Americans to access credit, the instability of this market had the effect of aggravating the economic circumstances of this community.

Geanakoplos, John. “History of the Mortgage Market: A Personal Narrative.” ECON 251: Financial Theory. Yale University. Connecticut. 2009.

Philips, Sandra. “The Subprime Crisis and African Americans.” Review of Black Political Economy 37 (2010): 223-229.

Barth, James R.; Li, Tong; Phumiwasana, Triphon; Yago, Glenn. “A Short History of the Subprime Mortgage Market Meltdown.” Milken Institute. (2008): 1-8.

Foster, John Bellamy; Holleman, Hannah. ” The Financial Power Elite.”Monthly Review 62 (2010): 1-19.

Wyly, Elvin; Moos, Markus; Hammel, Daniel; Kabahizi, Emanuel.”Cartographies of Race and Class: Mapping the Class-Monopoly Rents of American Subprime Mortgage Capital.” International Journal or Urban and Regional Research 33, 2 (2009): 332-354.

Liebowitz, Stan J. “ARMs, Not Subprimes, Caused the Mortgage Crisis.” The Economists’ Voice. (2009): 1-5.

Immergluck, Dan. “Core of the Crisis: Deregulation, the Global Savings Glut, and Financial Innovation in the Subprime Debacle.” City & Community 8, 3 (2009): 341-345.

Marcuse, Peter. “A Critical Approach to the Subprime Mortgage Crisis in the United States: Rethinking the Public Sector in Housing,” City & Community 8, 3 (2009): 351-356.

Mendenhall, Ruby. “The Political Economy of Black Housing: From the Housing Crisis of the Great Migrations to the Subprime Mortgage Crisis.” The Black Scholar 40, 1: 20 – 37.

Center for Responsible Lending. “Subprime Lending: A Net Drain on Homeownership.” CRL Issue Paper 14 (2007): 1-5.

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