The Foreclosure Epidemic: The Costs to Families and Communities of the Predictable Mortgage Meltdown

An interview with Allen Fishbein

Allen Fishbein is the director of housing and credit policy for the Consumer Federation of America (CFA). CFA is a national non-profit association of 300 pro-consumer organizations, founded in 1968 to advance consumer interests through education, research and advocacy. Fishbein frequently provides expert testimony before Congressional panels and is interviewed by national news media on a variety of home finance, consumer credit and regulatory policy matters.

Multinational Monitor: What is a subprime mortgage?

Allen Fishbein: A subprime mortgage is a loan that is made to a borrower who would not qualify for a prime mortgage, which typically means they have an impaired credit record.

MM: What's an alt-A mortgage?

Fishbein: Alt-A is something between a prime loan and a subprime loan. They are loans made to borrowers with a higher credit score than the subprime market but who, because of the type of loan they're seeking or the amount of information they're prepared to provide to verify their income, don't qualify for the prime loan standards either.

MM: What are the typical terms in these sorts of mortgages?

Fishbein: This is an area that's changing considerably now as the markets go through some major shifts.

Alt-A loans typically are made to borrowers requiring 100 percent financing. Often these loans involve the use of stated income - unverified income - to determine the borrower's capacity to repay. In exchange, Alt-A borrowers pay a slightly higher interest rate than prime borrowers.

Subprime borrowers typically have credit scores in the lower range and therefore are viewed as higher risk, i.e. there is a greater statistical likelihood that they will not be able to repay their loans. Subprime loans carry much higher interest rates, two to five or six percentage points above prime loans. Subprime loans also typically include higher fees and points as well as other features that add to the cost of the loan to the borrower.

MM: What is the relationship between predatory loans and subprime mortgages?

Fishbein: Predatory loans are generally viewed as loans where the loan originator is taking advantage of a borrower's lack of sophistication to give them a loan whose rates and terms may not be beneficial to the borrower. Predatory lending has been particularly rampant in the subprime market.

You'll hear the adage that not all subprime loans are predatory, but all predatory loans tend to be subprime. There is no question that most abuses in mortgage lending occur in the subprime market.

MM: To what extent have these non-prime loans become more common in recent years?

Fishbein: The subprime market mushroomed from a small niche of mortgage originations - less than 5 percent a decade or so ago - to more than 20 percent in 2006. The Alt-A market in 2006 represented another 10 or 12 percent of originations. So the two non-prime markets were responsible for three of every 10 mortgage originations.

MM: What's the profile of people who are receiving these mortgages?

Fishbein: Contrary to popular belief, subprime borrowers are not necessarily lower-income borrowers. In fact, the subprime market runs the full income spectrum. At the same time, however, the rate of subprime lending is much greater for African Americans and Latino households than for other consumer groups. Over 55 percent of African American and 46 percent of Latino households financed last year received subprime loans compared to fewer than 20 percent of white borrowers.

Moreover, there are indications that a substantial number of subprime borrowers had credit records that would qualify them for prime loans. Freddie Mac, the federal chartered government sponsored mortgage company, estimates that 20 percent of subprime borrowers would qualify for prime loans.

But typically subprime borrowers have impaired credit histories. Perhaps they were late in paying other consumer debt obligations, or did not repay a loan altogether. Some have had their debts turned over to collection agencies, or perhaps have a bankruptcy in their recent past.

MM: What explains the proliferation of subprime and alternate loans?

Fishbein: The explosion of the non-prime market was facilitated by changes in mortgage underwriting and the way in which home loans are made. These changes include the advent of automated underwriting and risk-based pricing - which rely on computerized models to assess the risk of borrowers.

Second, the mortgage market switched from a largely deposit-funded market - mortgage loans made by thrift institutions and banks - to one that relies increasingly on securitization. Most home loans today are sold to Wall Street and packaged into mortgage-backed securities; an even higher percent of subprime loans are packaged and sold this way. Securitization too has brought new capital into U.S. mortgage markets. But it has also meant that the secondary market investors have had a greater influence in setting the standards for who qualifies as a mortgage borrower.

A third element is the changes in the mortgage delivery channels. More and more mortgage lending was made by non-bank mortgage companies - so-called originate-and-sell lenders - as opposed to depository institutions, like banks. And this lending is typically generated through third-party originators (i.e., mortgage brokers). Mortgage brokers essentially act as middlemen. Their job is to connect borrowers with mortgage lenders. More than 70 percent of all subprime loans made in recent years came through mortgage broker channels. Brokers receive their compensation from both the borrower and the lender. They often rely upon aggressive sales practices to generate their subprime loan business.

Both non-bank mortgage companies and mortgage brokers are more lightly regulated than are banks. This has opened the door to predatory loan practices.

MM: On balance, was the development of the non-bank mortgage companies a positive thing, a negative thing, or a mix?

Fishbein: The experience is a very mixed one. On the positive side, they have helped to bring mortgage credit to consumers underserved by mainstream lenders. But unfortunately, increased access seems to have gone hand-in-glove with a rise in irresponsible lending. Many of the risky loans simply should have never been made to borrowers - which is why defaults are skyrocketing and loans entering foreclosure are at record levels.

MM: How are these loans structured; what made them hazardous? And why are things going bad so severely right now?

Fishbein: Not too long ago, the vast majority of subprime loans were fixed-rate. Their principal difference from prime loans is that they are more expensive.

What changed in recent years is that the subprime industry began to push hybrid adjustable rate mortgage (ARM) products, called "2/28" or "3/27" loans. What these loans have in common is that they start off with "teaser" rates, keeping initial monthly payments artificially low, but these rates then skyrocket after two or three years and monthly payments explode by 40 percent or more. Compounding the affordability problem is that these 2/28 and 3/27 loans convert at the end of the fixed introductory rate into adjustable rate loans that adjust as frequently as every six months. The indexes used for adjustment are based on short-term interest rate movements, which have only gone up and up in recent years. So all of these features combined to produce a very toxic loan product for subprime borrowers.

Loan originators benefited enormously from these exploding subprime ARMs. They provided the mortgage industry with a reliable payment stream and generated enormous fee incomes, which occurred each time the borrower was flipped into a new subprime loan. Borrowers found that they had no choice but to refinance these loans to continue to afford their loan payments. The cycle appeared to work as long as housing prices appreciated more rapidly than the cost of refinancing. But as soon as home prices cooled off, borrowers already stretched to the limits learned the hard way that they could no longer refinance. The wheels quickly came off, which triggered the subprime mortgage meltdown.

MM: Was the current crisis predictable?

Fishbein: The current foreclosure epidemic was predictable and also avoidable. Industry analysts will tell you that the driving force was too much available capital chasing the highest possible yields. Investors found that high price subprime loans generated lucrative returns. The mortgage market was awash with capital. This, in turn, encouraged looser and looser underwriting. Lenders knew they had a ready outlet to sell the loans the made. So they went for volume and ignored sensible loan standards.

MM: How could the surge in foreclosures have been a surprise to Wall Street?

Fishbein: The best way to describe it is this: those with little skin in the game - loan originators - simply had little incentive to examine whether borrowers they were lending to could actually afford their loans, while those with a financial stake - the investors - didn't pay careful enough attention to whether loans were appropriately underwritten. The inadequacies of the credit rating agencies in evaluating the risk of these mortgage securities further compounded this problem.

MM: What does it mean for a family to have a home foreclosed?

Fishbein: It is hellish experience. When a family loses its home, the loss devastates the family's financial stability. Foreclosed families lose their home and their equity in the home. They typically face other expenses such as fees, penalties and taxes on forgiven debt. Foreclosure wrecks a household's credit history and makes it difficult for them to purchase a home in the future. Having their wrecked credit also runs up their costs of other consumer debt, how much they pay for auto insurance, or even whether they can rent an apartment. Losing a home has other effects as well - since homes are more than an investment. It tends to disrupt families and the stability of their lives - it uproots their whole lifestyle. Many people pick where they live based on school districts and certain amenities. Giving up a home and being displaced from their community can be very disruptive and have major fall-out in terms of their life situation.

Foreclosures, especially if they're concentrated in particular neighborhoods - and many subprime loans really are concentrated, especially in neighborhoods of color - have an adverse effect on values for nearby properties. Even homeowners who are successfully repaying their loans may find that their homes are worth less, as a result of foreclosures occurring on their street.

Finally, foreclosures are a drain on public resources. The foreclosure process involves a significant public cost that is borne by localities. It often also involves increases in social services. So the tax implications to local residents can be quite profound as well.

All this adds up and becomes a broader societal problem. Thus, foreclosure is more than the individual tragedy of a household losing their home, or a lender or investor losing money on the loan they made.

MM: What's the scale of the problem and how does it compare to historical foreclosure rates?

Fishbein: The percentage of mortgages entering foreclosure reached its highest point in 28 years. Foreclosures through summer 2007 are up 93 percent since just last year at the same time. There are projections that as many as 2.4 million subprime borrowers have or will end up losing their homes. This translated into an estimated $160 billion of lost equity for these families.

MM: What are short-term and longer-term structural solutions?

Fishbein: Three types of solutions are required. First, there is a need to restore credit liquidity. Steps already are underway to address the credit crunch created by investors withdrawing from the mortgage market. Recent actions by the Fed to lower the discount rate should help. So should efforts by large financial institutions to provide credit to others facing severe liquidity problems.

Second, more must be done to help homeowners to avert foreclosure. There doesn't appear to be much appetite for a huge bail-out for investors or lenders who created this mess. This sentiment is understandable. They knew or should have known of the risks they were taking and deserve to suffer the consequences. At the same time, it is important not to blame the principal victims of this mess: the hundreds of thousands of homeowners who were shoe-horned into exploding ARMs without really understanding their risks.

Third, it will be critical to stiffen the nation's consumer protection laws to prevent a recurrence of these problems.

MM: What should be done to help the people who stand to be thrown out of their homes?

Fishbein: Borrowers find themselves in payment difficulty for different reasons. As many as 30 to 40 percent of subprime borrowers probably could refinance into more affordable fixed rate prime loans. The federal government recently announced plans to use the FHA single-family government-backed insurance to help this process along. Several state initiatives also have launched efforts to refinance these loans. And Fannie Mae and Freddie Mac have pledged to provide the necessary capital to facilitate this process. But this is not enough.

Many other homeowners will be unable to refinance. Their only hope to stay in their home is if lenders agree to restructure their mortgage debt. This is a more complex task. Typically, it requires the consent of the current holders of these mortgages - in other words, the investors. Modifying loan terms and rates would involve some loss to investors but should be weighed against the expense of foreclosure. Loan service companies that collect payments from borrowers on behalf of the investors have more latitude than originally thought to undertake loan modifications. Unfortunately, indications are that loan servicers are using this option infrequently.

The most daunting problem is the many homeowners who find themselves in "upside down" loans, where their outstanding loan balance far exceeds the current value of their property. There may not be long-term solutions to keep many of these borrowers in their homes. Some would be wise to figure out the best way to sell their home and get out from under a debt that they really don't have a long-term prospect of being able to successfully handle. Others may try to keep their homes in bankruptcy as a last resort. Unfortunately, the bankruptcy code as now written is currently of little help. Unlike other debts - such as mortgages on vacation homes and investor properties, families cannot modify the mortgage on their primary homes through bankruptcy.

Bills have been introduced in Congress to change this provision. But the mortgage industry seems opposed to such measures.

MM: For loans that have been securitized and are held by pools of capital without any identifiable loan officer, how can these kinds of adjustments be undertaken?

Fishbein: Federal banking regulators, lenders and loan servicers say at-risk homeowners have more options available than they may realize. Senator Christopher Dodd, D-Connecticut, earlier this year convened a "foreclosure summit" where he sought promises from the industry to step up their efforts to help families avoid foreclosure. Unfortunately, this hasn't helped as much as it should have.

Unfortunately, loss mitigation by lenders is handled on a case-by-case basis. Yet the enormity of the current crisis requires a more systematic approach. Case by case is just too labor intensive and too costly for loan servicers.

MM: What forward-looking regulatory approaches should be adopted to avert similar problems recurring in the future?

Fishbein: The current crisis reveals the inadequacies of consumer protection laws. The fact that so many borrowers could be allowed to take out loans that they had no reasonable prospect of repaying shows that something is amiss in the mortgage market. Federal regulators should have acted much quicker to rein in abusive lending practices.

We believe establishing an affirmative duty of care standard for all mortgage originators would help. Loan originators should be required to pursue the best interests of the borrowers they serve. Loans should be made based upon a realistic assessment of the borrowers' ability to repay over the life of the loan, not just at the initial introductory rate.

And there also should be specific protections provided for subprime borrowers, who are particularly vulnerable to abusive and irresponsible lending practices. We'd like to see restrictions on the features that have resulted in so many of these loans going into default. Lenders should be required to verify income using appropriate documentation. Prepayment penalties should be prohibited, as should the use of yield spread premiums. (Prepayment penalties impose a fee on borrowers who pay off most or all of a loan before a certain date.) Yield spread premiums, which are payments brokers receive for placing borrowers into higher priced loans than they qualify for, should also be banned.

Also, the escrowing of payments for real estate taxes and hazard insurance should be required for subprime loans. Escrowing means setting aside the estimated payments for hazard insurance and real estate property taxes so subprime borrowers aren't hit with an large extra bill at the end of the year. An amount would be added to your mortgage payment so borrowers don't get hit with the entire cost of these two items at the end of the year when they may not have the cash to pay for them.

MM: In the near-term, what do you see the mortgage market looking like?

Fishbein: Look for the demise of most, if not all, of the independent non-bank mortgage companies; the originate-and-sell model is taking it on the chin. The mortgage industry is likely to become more concentrated and dominated by the larger banks and thrifts. Hopefully, when the subprime market re-emerges, consumers will be afforded improved protections to help ensured that they receive sustainable loans.

Eventually, I suspect that non-bank mortgage companies will return. So it is critical to have adequate regulatory oversight of these entities, to prevent the recurrence of the problems that led to the present difficulties.