The Subprime Foreclosure Crisis: How Did We Get Here in California?

Further, these loans will have a particularly damaging impact on communities of color, where there is likely to be a high concentration of foreclosures because these communities were targeted by subprime lenders. According to the most recent HMDA data for 2005, 37 percent of African-American and 35 percent of Latinos were higher rate borrowers in California. By contrast, only 14 percent of white, non-Latino borrowers had higher-rate loans. [CRL analysis of HMDA rate-spread loans]

The impact on minority communities is even more concentrated in California’s urban neighborhoods. The California Reinvestment Coalition recently found that in most large cities in California, more than half of African-American and Latino purchase borrowers received subprime loans in 2005.[Kevin Stein, Who Really Gets Higher-Cost Home Loans? Home Loan Disparities by Income, Race and Ethnicity of Borrowers and Neighborhoods in 14 California Communities in 2005, California Reinvestment Coalition (December 2006).]

Lenders sometimes claim that the costs of foreclosing give loan originators adequate incentive to avoid placing borrowers into unsustainable loans, but this has proved false. Until recently, lenders have reduced the risks of making bad loans by their ability to sell their mortgages to Wall Street firms, who in turn pool, package and sell securities to capital market investors worldwide. Loan originators typically hold mortgages for only a brief period, when teaser rates are still in effect. After that, they are sold to the secondary market, leaving originators off the hook when foreclosures occur.

Recently, as foreclosure rates have sharply increased, investors are looking more closely at underwriting practices that have produced subprime foreclosure rates far higher than predicted. With high levels of these early-payment defaults, investors have demanded the repurchase of bad loans where these practices were not adequately disclosed.

These “market corrections” amount to a classic case of too little, too late for both lenders and borrowers alike. This greater scrutiny of subprime loans by investors may force lenders to make fuller disclosures to investors or curtail excessively risky lending practices, but these changes will be too late for current borrowers, who are already losing their homes, their equity and their credit quality when lenders foreclose on loans that never should have been made, and in fact, were designed to fail.

These factors have come together to create the very situation that CRL predicted in our December 2006 report “Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowners.” According to our research, 2.2 million borrowers will experience foreclosure, losing approximately $164 billion of wealth in the process. I have brought with me the executive summary of our study and ask that it be included in the public record.

Factors Driving Foreclosures in the Subprime Market

A. Risky Products: 2/28 “Exploding” ARMs

Subprime lenders are routinely marketing the highest-risk loans to the most vulnerable families and those who already struggle with debt. Because the subprime market is intended to serve borrowers who have credit problems, one might expect the industry to offer loan products that do not amplify the risk of failure. However, the opposite is true. Lenders seek to attract borrowers by offering loans that start with deceptively low monthly payments, even though those payments are certain to increase. As a result, many subprime loans can cause “payment shock” when the homeowner’s monthly payment quickly skyrockets to an unaffordable level.

Unfortunately, payment shock is not unusual, but is a standard feature of the overwhelming majority of subprime home loans. Today the dominant type of subprime loan is a hybrid mortgage called a “2/28” that effectively operates as a two-year “balloon” loan. This ARM comes with an initial fixed teaser rate for two years, followed by rate adjustments in six-month increments for the remainder of the term of the loan. Commonly, this interest rate increases by between 1.5 and 3 percentage points at the end of the second year, and such increases are scheduled to occur even if interest rates in the general economy remain constant. Generally, the interest rates on these loans can only go up, and can never go down. This type of loan, as well as other similar hybrid ARMs (such as 3/27s) have rightfully earned the name “exploding” ARMs.

One would hope that this type of loan would be offered judiciously. In fact, hybrid ARMs (2/28s and 3/27s) and hybrid interest-only ARMs have become “the main staples of the subprime sector.” Through the second quarter of 2006, hybrid ARMs made up 81 percent of the subprime loans that were packaged as investment securities. That figure is up from 64 percent in 2002.[Structured Finance: U.S. Subprime RMBS in Structured Finance CDOs, p. 2 Fitch Ratings Credit Policy (August 21, 2006)]

Recently federal regulators issued proposed guidance that explicitly offers greater protections against the risks posed by exploding ARMs. The proposal specifies that depository lenders and their affiliates should consider the potential for unaffordable increases in house payments before approving hybrid ARMs. Specifically, the statement says that an institution's analysis of a subprime borrower's repayment capacity should include an evaluation of the borrower's ability to repay the debt by its final maturity at the fully-indexed rate, assuming a fully-amortizing repayment schedule. In plain English, this means that the lender should evaluate a borrower’s ability to pay after the mortgage payment resets – not just during the first two years when teaser rates apply.

In the January 31 California Senate Banking Committee hearing, subprime lenders and mortgage bankers opposed efforts to expand the application of the federal guidance to state-regulated institutions. Remarkably, even as the disastrous consequences of weak underwriting standards and risky loans were coming to light, representatives of New Century Financial Corporation opposed the adoption of responsible underwriting standards for their lending activities. In their testimony they insisted that hybrid ARMs needed no additional regulations or scrutiny. In opposing the application of the federal regulatory underwriting guidance to risky 2/28 and 3/27 ARMs, New Century’s representatives argued, “The history and features of hybrid ARMs do not warrant inclusion in the guidance and to do so would cause severe, negative consequences for consumers, the real estate market and the economy.”[Oral Statement of New Century Financial Corporation, California Senate Banking Committee hearing on nontraditional mortgage products, (January 31, 2007)]

Unfortunately, it now appears that these negative consequences are mounting from the failure to have just those kinds of standards in place.

As noted above, both Freddie Mac and federal banking regulators have called for stronger implementation of the bedrock principle of lender assessment of ability to repay for all subprime hybrid ARMs. This is the most basic and necessary step that should be enacted as quickly as possible by state legislators covering all subprime adjustable rate loans.

B. Loose Qualifying Standards and Business Practices

The negative impact of high-risk loans could be greatly reduced if subprime lenders had carefully screened loan applicants to assess whether the proposed mortgages are affordable. Unfortunately, many subprime lenders have been routinely abdicating the responsibility of underwriting loans in any meaningful way.

Lenders today have a more precise ability than ever before to assess the risk of default on a loan. Lenders and mortgage insurers have long known that some home loans and features carry an inherently greater risk of foreclosure than others. However, by the industry’s own admission, underwriting standards in the subprime market have become extremely loose in recent years, and analysts have cited this laxity as a key driver in foreclosures. Let me describe some of the most common problems:

Large payment shocks: As I have mentioned, lenders who market 2/28s and other hybrid ARMs often do not consider whether the homeowner will be able to pay when the loan’s interest rate resets, setting the borrower up for failure. Subprime lenders’ public disclosures indicate that most are qualifying borrowers at or near the initial start rate, even when it is clear from the terms of the loan that the interest rate can (and in all likelihood, will) rise significantly, giving the borrower a higher monthly payment. In fact, it is not uncommon for 2/28 mortgages to be originated with an interest rate four percentage points under the fully-indexed rate. For a loan with an eight percent start rate, a four percentage point increase is tantamount to a 40 percent increase in the monthly principal and interest payment amount when the interest rate resets.

Failure to escrow: The failure to consider payment shock when underwriting is compounded by the failure to escrow property taxes and hazard insurance. In contrast to the prime mortgage market, most subprime lenders make loans based on low monthly payments that do not escrow for taxes or insurance. This deceptive practice gives the borrower the impression that the payment is affordable when there are actually significant additional costs.

A recent study by the Home Ownership Preservation Initiative in Chicago found that for as many as one in seven low-income borrowers facing difficulty in managing their mortgage payments, the lack of escrow of tax and insurance payments were a contributing factor. Partnership Lessons and Results: Three-Year Final Report, p. 31. Home Ownership Preservation Initiative (July 17, 2006).]

When homeowners are faced with large tax and insurance bills they cannot pay, the original lender or a subprime competitor can benefit by enticing the borrowers to refinance the loan and pay additional fees for their new loan. This, again, is in stark contrast to the practices in the prime market of escrowing taxes and insurance and considering these costs when looking at debt-to-income and the borrower’s ability to repay.[It is worth nothing that Fannie Mae and Freddie Mac, the major mortgage investors, require lenders to escrow taxes and insurance.]

Low/no income documentation: Inadequate documentation also compromises a lender’s ability to assess the true affordability of a loan. Fitch Ratings, the international ratings firm, recently noted that “loans underwritten using less than full documentation standards comprise more than 50 percent of the subprime sector . . ..” “Low doc” and “no doc” loans originally were intended for use with the limited category of borrowers who are self-employed or whose incomes are otherwise legitimately not reported on a W-2 tax form, but lenders have increasingly used these loans to obscure violations of sound underwriting practices. In reviewing a sample of “no doc” loans, the Mortgage Asset Research Institute recently found that over 90 percent exaggerated income by 5 percent or more and almost 60 percent exaggerated income by over 50 percent. The MARI report notes, “When these loans were introduced, they made sense, given the relatively strict requirements borrows had to meet before qualifying. However, competitive pressures have caused many lenders to loosen these requirements to a point that makes many risk managers squirm.”[Mortgage Asset Research Institute, Inc., Eighth Periodic Mortgage Fraud Case Report to Mortgage Bankers Association, p. 12 (April 2006); See also 2007 Global Structured Finance Outlook: Economic and Sector-by Sector Analysis, FITCH RATINGS CREDIT POLICY (New York, N.Y), December 11, 2006, at 21, commenting that the use of subprime hybrid arms “poses a significant challenge to subprime collateral performance in 2007.”]

C. Broker Abuses and Perverse Incentives

Mortgage brokers are individuals or firms who find customers for lenders and assist with the loan process. Brokers are independent contractors – they provide a way for mortgage lenders to increase their business without incurring the expense involved with employing sales staff directly. Brokers also play a key role in today’s mortgage market: According to the Mortgage Bankers Association, mortgage brokers now originate 45 percent of all mortgages, and 71 percent of subprime loans.[MBA Research Data Notes, “Residential Mortgage Origination Channels,” September 2006.]

Brokers often determine whether subprime borrowers receive a fair and helpful loan, or whether they end up with a product that is unsuitable and unaffordable. Unfortunately, given the way the current market operates, widespread abuses by mortgage brokers are inevitable.

Buying or refinancing a home is the biggest investment that most families ever make, and particularly in the subprime market, this transaction is often decisive in determining a family’s future financial security. The broker has specialized market knowledge that the borrower lacks and relies on. While brokers in California have a common-law fiduciary duty to borrowers, the subprime mortgage market, as it is structured today, gives brokers strong financial incentives to sell excessively expensive loans to borrowers.

Experts on mortgage financing have long raised concerns about problems inherent in a market dominated by broker originations. For example, the chairman of the Federal Reserve Board, Ben S. Bernanke, recently noted that placing significant pricing discretion of mortgage loans in the hands of financially-motivated mortgage brokers can be a prescription for trouble, as it can lead to behavior that violates fair lending laws.[Remarks by Federal Reserve Board Chairman Ben S. Bernanke at the Opportunity Finance Network’s Annual Conference, Washington, D.C. (November 1, 2006).]

A report issued by Harvard University’s Joint Center for Housing Studies concurred: “Having no long term interest in the performance of the loan, a broker’s incentive is to close the loan while charging the highest combination of fees and mortgage interest rates the market will bear.”[Joint Center for Housing Studies, “Credit, Capital and Communities: The Implications of the Changing Mortgage Banking Industry for Community-Based Organizations,” Harvard University, p.4-5. Moreover, broker-originated loans “are also more likely to default than loans originated through a retail channel, even after controlling for credit and ability-to-pay factors.” Id. at 42 (citing Alexander 2003).]

In summary: Mortgage brokers, who are responsible for originating over 70 percent of loans in the subprime market, have strong incentives to make abusive loans that harm consumers, and no one is stopping them. In recent years, brokers have flooded the subprime market with unaffordable mortgages, and they have priced these mortgages at their own discretion. Given the way brokers operate today, the odds of successful homeownership are stacked against families who get loans in the subprime market.

D. The Role of Investors and Ratings Agencies

Lenders sometimes claim that the costs of foreclosing give loan originators adequate incentive to avoid placing borrowers into unsustainable loans, but this has proved false. Lenders have been able to pass off a significant portion of the costs of foreclosure through risk-based pricing, which allows them to offset even high rates of predicted foreclosures by adding increased interest costs. Further, the ability to securitize mortgages and transfer credit risk to investors has significantly removed the risk of volatile upswings in foreclosures from lenders. In other words, high foreclosure rates have simply become a cost of business that is largely passed onto borrowers and sometimes investors.

It is clear that mortgage investors have been a driving force behind the proliferation of abusive loans in the subprime market. Their high demand for these mortgages has encouraged lax underwriting and the marketing of unaffordable loans as lenders sought to fill up their coffers with risky loans. For example, approximately 80 percent of subprime mortgages included in securitizations issued the first nine months of 2006 had an adjustable-rate feature, the majority of which are 2/28s. [Inside B&C Lending, Inside Mortgage Finance, p. 2 (November 24, 2006).]

Other key players that have played a role in supporting the appetite for risky subprime loans are the credit-ratings agencies, such as Moody’s Investors Service, Fitch Ratings and Standard & Poor’s. Through last year, these agencies raised no red flags about securities backed by subprime mortgages, and they continued to give investment-grade ratings to these securities based on the segments (or “tranches,”) expected to perform the best. The ratings agencies have no stake in supporting investments that, in turn, support key national policy goals, such as sustainable homeownership.

We applaud Freddie Mac, one of the largest mortgage investors, for recently announcing a new policy to only buy subprime adjustable-rate mortgages (ARMs) – and mortgage-related securities backed by these subprime loans – that qualify borrowers by making sure they can make their payments throughout the life of the loan, not just when teaser rates apply. Freddie Mac is implementing this policy to protect future borrowers from the payment shock that could occur when their adjustable rate mortgages increase.

Fannie Mae should follow suit, and should not compete with other investors to buy securities backed by high-risk subprime loans that hurt consumers and reverse the benefits of homeownership. These agencies, with their public mission, should not be permitted to purchase loans to families that do not meet an “ability to repay” standard.

E. Weak State Laws and Regulatory Oversight

California’s system for regulating the subprime mortgage industry does not provide an adequate infrastructure for protecting consumers from risky mortgage products and financially motivated brokers. California’s mortgage laws do not establish even the most basic protections for underwriting and the Department of Corporations has never examined the underwriting criteria used by state-regulated mortgage originators. Moreover, the Department’s 25 mortgage licensee examiners could not possibly be adequate to monitor the activities of some 4,800 licensees originating $150 billion in mortgages each year. Nor is an examination schedule of once every four years likely to be sufficient to evaluate the activities of an industry with a remarkable capacity for product innovation.

The Department of Corporations has also dragged its feet in implementing non-traditional mortgage guidance recommended by federal regulators in November of last year – which don’t even cover the most problematic exploding subprime hybrid ARMs. Some 30 state regulators have now taken some action to implement these provisions. As of last week, the Department does not plan to release for comment its proposed rules until May of this year.

California is not alone. Federal regulators have also not been up to the task. When Congress passed HOEPA—the federal anti-predatory lending law—in 1994, one regulatory agency was given explicit authority to take action on predatory lending in the subprime market: the Federal Reserve Board. Congress provided the Board with broad authority to prohibit unfair or deceptive mortgage lending practices and address abusive refinancing practices. Unfortunately, the Board has not applied that authority in any meaningful fashion.[The Board did cite section 129(l) during its rulemaking process in 2001-02 (including rules on due-on- sale clauses and evasion of HOEPA using open-end loans, although it appears that the authority to issue rules to prohibit evasion of HOEPA is independent); however, it did not propose any prohibitions of acts and practices that would apply to all home loans.]

This point was emphasized just last week in a Senate Banking hearing, where Roger Cole, the Board’s director of banking supervision, admitted that the Board has failed to act promptly to address the crisis in subprime lending. Mr. Cole said, “Given what we know now, yes, we could have done more sooner.”[Greg Hitt and James R. Hagerty, “Regulators are Pressed to Take Tougher Stand on Mortgages,” Wall Street Journal (March 23, 2007).]

Part 2 of a 3 part series.