The Unrecognized Link between Small Business, Jobs, Toxic Mortgages, and the Housing Crisis

Posted on 22 July 2011

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By Samuel D. Bornstein and Jung I. Song

Unemployment and the housing crisis are pressing concerns as we attempt to escape the grip of the economic downturn. We are stymied by an unexpectedly sluggish and jobless recovery. It is urgent that banks, financial institutions, and policymakers realize that small business holds the key to a solution of the economic crisis. Our Bornstein&Song research discovered a link between small business, jobs, toxic mortgages, and the housing crisis.

Historically, small businesses created jobs which jumpstarted economic growth. Nearly 90 percent of small businesses employ from 1-19 workers, and they create more than 44 percent of new jobs. But, this time it is different.

The game changer is the Housing Bubble 2004-2007 and the Bust that followed, which resulted in the loss of more than $11 trillion of household wealth as housing prices dropped from their all-time highs in 2007. This historic loss of household wealth has hindered consumer spending with the resulting small business failure and job loss. Small businesses were hit hard by the headwinds of lackluster consumer spending, the credit crunch, and the inability to access capital for their businesses though small business lending.

But, these are not the only challenges facing small business owners. Our Bornstein&Song Small Business Toxic Mortgage Surveys, U.S. National (Nov. 2008), California (April 2009), and California Hispanic (June 2009),  provide the first compelling evidence that a significant number of small business owners are stuck with toxic mortgages such as Alternative-A (Alt-A), Option ARMs (Adjustable-Rate Mortgages), Interest-Only, Subprime etc., which they acquired by refinancing their home equity during the Housing Bubble in order to quench their continuous need for cash for their newly created or existing businesses. These small business owners placed themselves at-risk of payment shock at the resetting of these negative amortization mortgages in 2009 to 2012 and beyond. They are now at-risk of financial distress, default, and foreclosure. The resulting job loss for their employees will impact unemployment and the housing crisis.

In order to determine the extent of small business owner involvement in these toxic mortgages, we authored three Small Business Toxic Mortgage Surveys.   In November 2008, after concluding our U.S. National survey, we selected California because more than 58 percent of all toxic mortgages in the U.S. originated in the State of California, and its small business owners were at greatest risk.   These Surveys confirmed the 2nd “Tsunami” Wave of Foreclosures & Job Loss in 2009 to 2012, related to small business owner involvement in the toxic mortgage crisis.

Small Business Toxic Mortgage Surveys Highlights

  • Respondents took out mortgages after 2004: U.S. 60.1%; California 55.4%; California Hispanic 53.3%.
  • Respondents cashed-out the equity in their homes as home values spiked during the 2004-2007 housing bubble: U.S. 33.9%; California 34.3%; California Hispanic 36.9%.
  • Respondents have toxic mortgages: U.S. 31.9%; California 51.8%; California Hispanic 52.6%.
  • Respondents are expecting resets between 2009 and 2012: U.S. 22.9%; California 34.9%; California Hispanic 44.7%.
  • Respondents are "very worried" about their monthly mortgage payment at reset: U.S. 18.4%; California 29.9%; California Hispanic 49.3%.

The historic phenomenon of a Housing Bubble enabled more than 80 percent of Americans to refinance their home equity. With booming home values and exceptionally low interest rates, small business owners chose to cash-out the built-up equity in their homes. Refinancing was often a low-cost and low-hassle way for small business owners to finance their business growth.

Small business owners were especially targeted for these toxic loans which were marketed as cash-management tools which didn’t require the normal documentation of income. This appealed to many who previously were unable to qualify since many small business owners often could not properly substantiate their income because their tax returns did not reflect their “true” business income.

The toxic aspect of these mortgages resides in the fact that the attractively low monthly payments are due to negative amortization, whereby the loan principal balance increases rather than decreases as in normal amortization. As these mortgages reset after the initial two to five year period, the principal balance will recast to be repaid over the remaining 25 years of the original 30 year mortgage.   The small business borrower may be faced with a monthly payment up to more than two-and-a-half times greater than the initial payment.

This spike in the monthly payment at reset may prompt cost-cutting measures such as employee layoffs, job loss, and closed shops and offices, in turn causing a loss of rental income for commercial real estate owners who have loans originated with small community banks which may lead to small bank failure.

The failure of these toxic mortgages has begun and the resulting losses are currently impacting banks and mortgage-backed investments.  These toxic mortgages are the underlying assets of the mortgage-backed securities, collateralized debt obligations, and other derivative investments that are held in investment portfolios worldwide.  Toxic mortgages are responsible for the losses for Fannie Mae and Freddie Mac, Bank of America, JP Morgan Chase, Wells Fargo, Corporate Credit Unions, Community Banks, etc.  These mortgages are clogging the balance sheets of financial institutions and placing them at-risk.

Our research on the 2nd “Tsunami” Wave of Foreclosures was confirmed in a Federal Reserve Bank of New York study of “State Level Alt-A Loan Characteristics, May 2009” which indicated that more than 57 percent of these toxic mortgages originated in 2006-2007 and nearly 52 percent were expected to reset in 2009-2012. The resets for the 2006-2007 vintage will intensify in mid-2011-2012.

The credit rating agencies confirmed the toxicity of these mortgages. They continue to lower their expectations on billions of mortgage-backed securities (MBS) whose underlying assets are these toxic mortgages. In 2011, Moody’s, Standard & Poor’s, Barclays, Fitch, and others reported that toxic mortgage losses have increased and downgraded their MBS below investment grade and in many portfolios they have been downgraded to triple-C or below.

It is imperative that Bank of America, JPMorgan Chase, Wells Fargo and other financial institutions recognize that their Alt-A and Option ARMs mortgages are held by a significant number of small business owners who are now at-risk as these mortgages reset in 2009-2012 and beyond. The success of these mortgages and their derivative investments depend upon the ability of these small business owners to continue making monthly mortgage payments. We suggest that these financial institutions should seek out and identify these small business owners to make loan modifications, which will lower their monthly payments to help get through the sluggish economic recovery.

It is a tragedy when an individual borrower defaults on the mortgage and loses his/her home. The tragedy is magnified when the borrower is a small business owner employing from 1 to 19+ employees. The loss of jobs due to the small business owner’s financial distress related to mortgage delinquency and default and the resulting possible business failure will have a multiplying affect on unemployment and contribute to further foreclosures and falling home prices and exacerbate the housing crisis.

Small business owners are the silent heroes who drive our economy, and they are merely trying to stay afloat. We can do much good for our economy if we recognize the link between small business, jobs, toxic mortgages, and the housing crisis.


Samuel D. Bornstein is a 33 year Professor of Accounting and Taxation at Kean University, School of Business in Union, N.J., as well as a CPA and partner with Jung I. Song, CPA, of Bornstein & Song CPAs & Consultants, Oakhurst, NJ.  Their 11 years of small business research evolved into proposed legislation which addresses this issue which is currently sponsored in 5 States and is gaining momentum among State legislators throughout the U.S.

Haven't thought before about the connections outlined here. Thanks.

Toxic mortgages are responsible for the losses for Fannie Mae and Freddie Mac? Sure, and Fannie Mae and Freddie Mac are responsible in large part for toxic mortgages.

Read any of the numerous books on the causes of the recent financial crisis (Nocera, McLean, Morris, Scheer, Morgenson, Rosner, the FCIC). Read the books and reports on the crisis before this one (Kathleen Day, Arthur Levitas). Read just about anything by Ferdinand Lundberg. Read William Greider's Who Will Tell the People. Think about cause and effect.