Wake Up and Smell the Coffee!–PART 1
By E.A. Roberts
As more heartsick seniors come to me as a volunteer attorney for advice on foreclosure options, I feel compelled to comment on the following issues as I see them:
- Reasons for the plight of our vulnerable older adults;
- How we as a nation arrived at a “mortgage meltdown” scenario;
- Possible solutions to resolve the mess, on a global and more local scale.
Seniors as a group have been hit harder than most because of the housing bust that has plagued our economy recently.
- More often than not the elderly are on fixed incomes, with no way of obtaining work to supplement their earnings to recoup financial losses.
- As the retirement accounts and investments of seniors have tanked in the dismal economy, payouts are impractical and dividends nonexistent.
- The frail are frequently beleaguered with huge medical expenses, as they are afflicted with serious and life-threatening ailments.
- Various expenses are financed on credit cards, that are eventually maxed out.
- Borrowing against equity in the house becomes difficult, as the value of homes declines in a stagnant housing market.
- Because seniors are usually the ones with the wealth in this country, they are also the primary targets for predatory lending.
- The elderly do not have the luxury of time to regain their financial status once lost.
How did the federal government, Wall Street, lending institutions, and the individual consumer contribute to the deep economic recession our nation finds itself in? There is plenty of blame to go around, but the analysis is important, to give some idea of what can be done to correct flaws in the system, so this never happens again. Vain hope I know, but I am ever the optimist.
In 1977, President Carter signed into law something called the Community Reinvestment Act (CRA). It required banks to have an affirmative obligation to meet credit needs of the communities in which they were chartered. The directive was passed in response to perceived “red-lining”, a policy of banks denying loans for those living in high credit risk inner-city neighborhoods where ethnic minorities tend to live.
Efforts to enforce the law were sporadic until an error laden 1992 study was disseminated by the Federal Reserve Bank of Boston. It purported to prove racial bias in mortgage lending, despite the fact that actual statistics did not support the conclusions reached in the report. Entering the stage at this point was the Treasury Department. In 1995 it prompted the issuance of new CRA regulations: lending institutions had to demonstrate “investment” in poor, higher-risk neighborhoods if they wanted a satisfactory CRA rating.
Much of this money invested went to “counseling” groups such as ACORN, these people priding themselves on making loans to persons with poor credit and little or no savings. Then in the late 1990’s, Fannie Mae, the nation’s biggest underwriter of home mortgages, came under pressure – from the Clinton Administration; the banking industry; and mortgage companies – to make more loans to subprime borrowers. Subprime borrowers are those with high credit risk. A little history will be helpful here to explain what happened next.
Since World War II, thrifts/savings and loan companies profited by taking savings deposits, while paying customers interest, and lending that same money at slightly higher interest rates to homebuyers – as 30 year fixed rate mortgages. Home ownership increased from 45% in 1940 to 65% in 1965, assisted by GI loans made available to military veterans. In 1970, when demand for mortgage money outstripped supply, the government decided to purchase 30 year fixed rate mortgages from thrifts. The mortgages were guaranteed against defaults, pooling them to be sold as a bond to investors. Investors received a stream of payments from homeowners, while thrifts got a cash infusion to lend more money to homebuyers.
In the 1980’s, a new kind of financial product was being touted at Salomon Brothers Investment Bank, called Collateralized Mortgage Obligations (CMOs). A CMO is an investment based on bundles of residential mortgages sliced into sections called “tranches” to be sold separately to investors. Each “tranche” paid a different interest rate and had a different maturity date. The person that dreamed up this idea moved on to become employed by Prudential Securities.
Prudential began selling increasingly exotic securities based on mortgages, credit payments, and car loans. The math behind these investments became so complex and lucrative, a crew of quantitative researchers was required to price them. This industry became known as “structural finance”. Wall Street brokered the deals and collected hefty fees, seeing it as a new opportunity for profit. Loan officers charged fees as much as 5% of the loan, or received kickbacks for tacking on extra percentage points to the interest rate. Clients for these products were mutual funds, pension funds and other large investors.
Just before Bush took office, the technological investment bubble popped, some believing the timing was engineered by Alan Greenspan, Chairman of the Federal Reserve. Greenspan was conspicuously seen at a Democratic party fundraiser with Al Gore during the Bush-Gore Presidential Campaign. As a result of Greenspan’s tinkering with the federal interest rate at the right time for the Dems, Bush would be saddled with a huge domestic problem at the start of his presidency. By the end of Greenspan’s term as Chairman of the Federal Reserve, inexplicably Bush refused to see the viper in his nest – failing to oust Greenspan when the opportunity rose. On top of that came the 2001 terrorist attacks, plunging the economy into a serious recession.
The Bush Administration, led by none other than Greenspan, slashed interest rates to encourage lending and spending. Lower interest rates spurred the housing market, creating a housing boom. The average 30 year fixed rate mortgage fell to 5.8%, the lowest rate since the 1960’s. I know at the time it occurred to me as a bizarre phenomenon. Greenspan had also encouraged the use of Adjustable Rate Mortgages to increase home ownership. I personally never liked these type of loans, and when house shopping myself, refused to take anything but a fixed rate mortgage.
Much of the housing boom was driven by loans made to customers with little savings, modest incomes, and checkered credit histories. They were talked into taking adjustable rate mortgages with low “teaser” interest rates, that ballooned to much higher interest rates after two or three years. Borrowers didn’t have to worry about balloon payments – they could sell at any time, often at a hefty profit, as long as the price of housing inflated steadily. And of course the investors who bought subprime loans enjoyed higher returns.
These subprime loans required no documentation of the borrower’s income; no proof of employment; no money down. For example, a McDonald’s employee earning $35,000 a year received a $500,000 loan, a person in jail was awarded a mortgage, illegal immigrants were being given loans. Worse yet, credit rating companies, which investors relied on to gauge risk of default, gave many of these securities high grades. So Wall Street had no shortage of customers for subprime products, including pension funds, foreign investors, as well as Fannie Mae and Freddie Mac.
Warning signs of the disaster to come appeared in 2003, as homes with subprime loans started going into foreclosure. Subprime mortgages had mushroomed to 20% of all loans, triple the level of a few years earlier. Greenspan ignored the alarm bells, and “couldn’t remember” if he ever told his successor at the Federal Reserve, Ben S. Bernanke, about the burgeoning subprime loan problem looming on the horizon.
In 2006, signs of weakness in the subprime industry were harder to ignore, as more homeowners defaulted on loans. Many homeowners defaulted in the first three months of purchase; others defaulted as the lower “teaser” rates ended and the higher balloon payments kicked in. Seventy percent more homeowners were forced to foreclose in 2005 than the year before, with thousands of new homes left unsold. Profits of banking institutions fell.
Panic set in. Yet if the subprime lender stopped taking brokers’ riskier loans, by increasing restrictions, brokers might take both riskier and higher quality loans elsewhere. The loan sales force at lending institutions worked on commission based on number of loans made. So fraudulent loans were a big part of the subprime debacle. Borrowers’ signatures were forged or incomes artificially pumped up. Borrowers themselves lied about how long they intended on living in the home, to qualify for a lower interest rate – then turned a quick profit by selling within a short period. Borrowers defaulted so quickly, subprime lenders did not have time to pool mortgages and sell them off as securities.
In 2007, Bear Sterns, a New York investment bank, had two hedge funds (funds that handle money for wealthy investors) invested heavily in securities backed by subprime mortgages. Both were on the brink of collapse. Investment banks that had purchased subprime mortgages to pool them were now demanding subprime lenders take back defaulted mortgage loans – arguing that misrepresentations had been made. Lenders were forced to accept the returns, not wanting to risk further damaging their relationship with the investment banks. The entire industry was choking on the sheer volume of loans sent back.
Subprime lending companies tried to sell off bad loans and could not get rid of them, so took a huge hit. Subsequently there was an attempt to tighten standards, but by then it was too late. Banks lending cash to subprime lenders cut them off, and many subprime lenders filed for bankruptcy. Bernanke and others at the Federal Reserve stubbornly still would not see how severely the troubles with the subprime loans would cascade through the economy.
Credit raters downgraded subprime-backed securities that they had previously touted. Banks, anticipating their own losses, began hoarding cash, and refused to lend. The credit crunch sent the stock market into a tail spin. Finally, in July of 2007, Bernanke at last got the message. The Federal Reserve aggressively cut interest rates to encourage banks to lend. An alliance of counselors, lenders and other industry participants, called HOPE NOW, would attempt to help borrowers avoid foreclosure by renegotiating mortgage terms. (In my experience and that of many others, the track record of this alliance is poor at best.)
However, the nation’s biggest banks began reporting unexpectedly large losses. In 2008, Bernanke finally acknowledged that the problems begun in the subprime market would affect the prospects of the broader economy. Nevertheless, Bernanke would only admit a recession was possible! Now, some state-run funds will not invest in mortgage-backed investments. Some forecasters are predicting three million or more homes will go into foreclosure.
Part 2 will be published on Friday, February 20, 2009
Elaine Roberts Musser is an attorney who concentrates her efforts on elder law and aging issues, especially in regard to consumer affairs. If you have a comment or particular question or topic you would like to see addressed in this column, please make your observations at the end of this article in the comment section.