The most serious recession the United States has faced since the Great Depression of the 1930’s occurred after the financial crisis of 2007-2008. While there were many causes of the crisis, one of the proximate causes was financial institutions issuing predatory loans to unscreened and/or uninformed candidates. The decline of real estate prices in combination with the rise of delinquencies in subprime mortgages created the conditions for a toxic housing bubble to burst. When the bubble burst, those that defaulted on loans were facing foreclosure. Not to mention, this caused major lending institutions to hemorrhage funds, requiring the United States Treasury to bail them out. A total of $626B was invested, loaned, or granted due to various bailout measures. In order to avoid history from repeating itself, the necessity of enforcing regulations that consist of maintaining a systematic way of vetting candidates to whom loans are given and enforcing heavier penalties for predatory and fraudulent lending activities made by financial and mortgage lending institutions is vital. This article will review pro-regulatory and anti-regulatory views and provide evidence as to why regulations are necessary in order to avoid another crisis like the one experienced in 2007-2008.
While most Americans are familiar with the term “subprime,” few understand what subprime means and what its advantages and disadvantages are. Subprime lending is the distribution of loans to potential borrowers who may have difficulty maintaining the repayment schedule of their loans, sometimes reflecting setbacks (i.e. unemployment, divorce, medical emergencies, etc.). Historically, subprime borrowers were defined as having FICO scores below 600, although this has varied over time and circumstances. Subprime borrowers typically have weakened credit histories and reduced repayment capacity. Notably, subprime loans have a higher risk of default than loans to prime borrowers. If a borrower is delinquent in making timely mortgage payments to the loan servicer (a bank or other financial firm), the lender may take possession of the property, in a process called foreclosure.1
At the time of the crisis, lending institutions were offering an increase in loan incentives, such as easy initial terms, and a long-term trend of rising housing prices had encouraged borrowers to assume risky mortgages in the anticipation that they would be able to quickly refinance their loans at easier terms. One of these products offered, the Adjustable Rate Mortgage (ARM), is a loan with an interest rate that changes. ARMs usually start with lower monthly payments than the fixed-rate mortgages (a loan with a fixed rate), but without the full information, borrowers can easily be misguided. Borrowers should be cautious with this type of loan for the following reasons.2
With this in mind, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., borrowers found that they were unable to refinance. It is important to note that the crisis that started in 2007 was characterized by an unusually large fraction of subprime mortgages that originated in 2006-2007. Consequentially, defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices fell, and adjustable rate mortgages (ARM) interest rates reset higher.3
From 1995 to 2007, the federal government encouraged mortgage lenders to loosen underwriting standards and offer exotic alternatives to fully amortizing fixed-rate 30-year mortgage loans in order to increase the rate of home ownership among low-income and minority families. Mortgage lenders obliged knowing that they did not have responsibility for the performance of mortgage loans they had extended once these loans were sold to issuers for securitization. The deterioration of underwriting standards and the development of subprime mortgage loans, combined with an overly accommodative monetary policy, to inflate a huge housing bubble.4
As in past bubbles, both borrowers and lenders became increasingly reckless. In some cases, individuals misled lenders to secure subprime mortgage loans to speculate in housing. In other cases, lenders took advantage of unsophisticated families by placing them in subprime mortgage loans they didn’t understand and couldn’t afford. In both cases, the results were the same: many families found themselves under water, not being able to keep up with payments, when the tidal wave of defaults and foreclosures followed once the housing bubble burst. The impact was especially difficult for low-income and minority families.5
The fact that many borrowers facing foreclosure can afford their homes if refinanced on terms that are appropriate for the level of risk they pose to lenders undermines the argument that all borrowers facing foreclosure simply should not own homes. Those opposed to federal relief efforts argue widespread foreclosures are necessary for the housing market to correct for high-risk borrowers who should never have become homeowners. Subprime loans, which account for a disproportionate share of foreclosures, properly include terms less favorable to borrowers with poor credit and higher debt-to-income ratios to compensate for additional risk of default. That such loans have become unaffordable for many owners, critics argue, is the expected result of the higher cost of borrowing and should not prompt government intervention. However, it is now widely accepted that many subprime lenders have charged fees and rates disproportionate to borrowers’ level of risk, have failed to advise borrowers of the least expensive alternatives, or have failed to disclose key loan terms and conditions.6
What must be acknowledged once again is the initial purpose for subprime mortgages. As it is understood, loan qualification is based on several factors, such as credit rating, assets, and debt-to-income ratios. Often many Americans have difficulty getting loans, due to either a setback that affects their credit score in a negative way or, at other times, difficulty proving their income in total. Subprime loans have increased the opportunities for home ownership, adding nine million households to the ranks of homeowners in less than a decade and catapulting the United States into the top tier of developed countries on homeownership rates, on par with the United Kingdom and slightly behind Spain, Finland, Ireland, and Australia, according to the Federal Reserve. More than half of those added to the ranks of new homeowners were minorities. Because home equity is the primary savings vehicle for a significant percentage of the population, home ownership is a good way to build wealth. When used responsibly by lenders, subprime loans can provide purchasing power to individuals who might not otherwise have access to funds. Deductively, subprime loans can create more opportunities when issued responsibly.7
As the subprime mortgage crisis illustrates, subprime loans can be highly risky. However, the second proximate cause to the 2007-2008 crisis, which created a greater risk within subprime lending, was predatory lending. Therefore, the second factor to consider is enforcing responsible lending practices via stronger regulations, with particular emphasis on imposing greater penalties on those that practice predatory lending. By definition, predatory lending is the practice of lending money to a borrower by use of aggressive, deceptive, fraudulent, or discriminatory means.8 These lending tactics often try to take advantage of a borrower’s lack of understanding about loans, terms, or finances. Predatory lenders typically target minorities, the poor, the elderly, and the less educated. They also prey on people who need immediate cash for emergencies, such as paying medical bills, making a home repair, or making a car payment. Moreover, predatory lenders target borrowers with credit problems or people who recently lost their jobs. This is not ruthless business; this is explicitly an abuse of power.
Research supports the conclusion that the practice of “reverse redlining” or the targeting of African-American and Latino communities in particular for the marketing of subprime and predatory loans, was prevalent in the expansion of subprime lending. Many disparities were revealed, such as, African-American and Latino communities being more likely than white communities to receive subprime loans, even when controlling for income level. For example, studies demonstrated that in 2006 nearly 50 percent of home loans made to African Americans, and slightly more than 40 percent of those made to Latinos, were subprime – this compared to less than 20 percent of the loans made to whites – raising concerns that subprime lending practices involved widespread violations of fair lending laws.9 The crisis has even been referred to as the “Defrauding of the American Dream” for minorities.10
Not all regulations are effective or achieve their purposes. Some are too restrictive, while others are weak or improperly implemented. But that does not mean that all regulation is harmful. Although society benefits from well-functioning markets, critics are wrong to claim that all government regulations are bad for business. To produce optimal results for firms and citizens, America needs a balance between markets free from unnecessary impediments and public rules to prevent businesses from inflicting grievous harms on people and the environment. When they work well, democratic governments make laws to protect people from harmful things that they cannot prevent on their own. This is the basic role of good government. Yet the American public hears a constant drumbeat of anti-regulatory messages from conservative politicians and think tanks and influential business organizations like the U.S. Chamber of Commerce. According to these groups, regulations are almost always bad for the country, because they interfere with “free” market activity and inhibit investment and job growth. But their arguments against sensible regulations are not valid empirically or in principle. Much evidence shows that the benefits of regulations vastly outweigh the costs. Furthermore, anti-regulatory claims rest on faulty ideas about the economy and democratic governance.11
The Community Reinvestment Act, or CRA, is designed to address the long history of discriminatory lending and encourage banks to help meet the needs of all borrowers in all segments of their communities, especially low- and moderate-income populations.12 Congress passed the CRA in 1977 to provide lending incentives to support civil rights anti-discrimination legislation and in response to local bank closures and unjustifiably low levels of lending in certain communities that shut out entire populations from the benefits of homeownership. The central idea of the CRA is to incentivize and support viable private lending to under-served communities in order to promote homeownership and other community investments. The law has been amended a number of times since its initial passage and has become a cornerstone of federal community development policy.13 The CRA has facilitated more than $1.5 trillion in private lending to under-served communities, greatly assisting the development of affordable housing for low- and moderate-income groups as well as broader community economic development.14 Conservative critics have argued that the need to meet CRA requirements pushed lenders to loosen their lending standards leading up to the housing crisis, effectively incentivizing the extension of credit to under-served borrowers and fueling an unsustainable housing bubble.15 Yet, the evidence does not support this narrative.
From 2004 to 2007, banks covered by the CRA originated less than 36 percent of all subprime mortgages, as non-bank lenders were doing most of the subprime lending.16 Out of this minority share, only 10 percent of all loans made by CRA-covered banks and their affiliates to lower-income individuals even qualified for CRA lending credits.17 In total, the Financial Crisis Inquiry Commission determined that just 6 percent of high-cost loans, a proxy for subprime loans to low-income borrowers, had any connection with the CRA at all, far below a threshold that would imply significant causation in the housing crisis.18 This is because non-CRA, non-bank lenders were often the culprits in some of the most dangerous subprime lending in the lead-up to the crisis.
Further proof of regulations working in our favor is visible when examining the federal housing policy. Federal housing policy promoted affordability, liquidity, and access. It is seen by some as a response to market failures that shattered the housing market in the 1930s, and it has sustained high rates of homeownership ever since. With federal support, far greater numbers of Americans have enjoyed the benefits of homeownership than they did under the free market environment before the Great Depression. Placing blame for the housing crisis on the government is misguided and will lead to bad solutions for housing policy issues related to affordable lending legislation. Rather than focusing on the danger of government support for mortgage markets, policymakers would be better served examining what most experts have determined were causes of the crisis—predatory lending and poor regulation of the financial sector. Placing the blame on housing policy does not speak to the facts and risks turning back the clock to a time when most Americans could not even dream of owning a home.19
The third proximate cause of the subprime mortgage crisis is the lack of regulation of credit rating agencies. A credit rating agency (CRA) is a company responsible for, and trusted with the task of, assessing the debt instruments (bonds and other securities) issued by firms or governments, and assigns “credit ratings” to these instruments based on the likelihood that the debt will be repaid. Originating in the U.S. during the 1850’s to provide information on the railroad industry’s financial status, over the next century CRAs developed in a haphazard way to rate a wide variety of debt. In the late 1960’s, the CRAs began charging debt issuers to rate their securities, and these fees came to produce a vast bulk of the CRA’s income.20
The credit rating process is inherently subjective and reflects professional judgment. Although substantial amounts of measurable data are used, the interpreting of the data is considered a matter of opinion. Thus, the credit ratings are only as good as the raters and the information they use. To further clarify, the following will provide a breakdown of the CRAs position as it relates to the process from mortgage originations to the secondary mortgage market.21
First, home buyers obtain mortgages from any given lending institution. The lending institution typically does not keep the mortgage on its books but sells it to any given third party (often an investment bank or one of the government-sponsored enterprises, such as Fannie Mae or Freddie Mac). The investment bank then bundles multiple such mortgages into securities, or collateralized debt obligations (CDOs), and prepares to sell them to others (primarily institutional investors, such as pension funds). Before they are sold into the secondary market, a credit rating agency rates the securities based on the probability that the original debt (the home mortgages) will be repaid in a timely fashion.22
At the Hearing Before the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises of the Committee on Financial Services in 2008, New York House Representative, Gary L. Ackerman stated:
“To help investors cut through the complexity of CDOs, the major rating agencies have expanded their services to evaluate these products in terms of their likelihood for defaults. Their investment-grade stamp of approval helped to provide credibility for the CDOs that had the toxic waste of liars’ loans and problematic subprime products buried deep within the deal. In return, the rating agencies also made great sums of money from issuers. To me, it appears that none of the parties that put together or purchased these faulty home loans, packaged them into mortgage-backed securities, and then divided these securities into tranches and repackaged them into CDOs, CDOs squared, and CDOs cubed, had any skin in the game. In the end it was a final investor left with this hot potato of prime debt and significant losses. In my view the rating agencies helped to create this Lake Woe-begone-like environment in which all of the ratings were strong, the junk bonds good-looking, and the subprime mortgages above average. In reality, however, we now know that they were not… Even though the securities issued by the two government sponsored enterprises explicitly indicate that they are not backed by the full faith and credit of the United States, many investors believe otherwise. Similarly, even though rating agencies only calculate the likelihood of default, many investors believe that these grades measure the financial strength of the underlying instrument.”23
We need not go any further, as we can determine that credit ratings affect lenders’ access to and cost of capital; they influence the structure of financial instruments such as mortgage backed securities and collateralized debt obligations; and they influence the decision of investors.24
During and preceding the subprime crisis, these agents were accused of negligence. By negligently stamping inappropriately high ratings on subprime mortgage-backed securities, the agencies were sending a false signal – that the high rated securities were a safe investment. When these securities collapsed with the bubble, many suffered substantial losses. In fact, a large section of the debt securities market was restricted in their bylaws to holding only the safest securities – triple A rated.25 These rating agencies gave their highest ratings to over three trillion dollars of loans to homebuyers with bad credit and undocumented incomes, resulting in hundreds of billions of dollars’ worth of securities that was subsequently downgraded to “junk” status by 2010. This significantly affected three major investment banks: Bear Stearns, Lehman Brothers, and Merrill Lynch. Consequentially, this led to the government bailout of too-big-to-fail banks, in which the government purchased seven hundred billion dollars’ worth of bad debt from distressed financial institutions.26 On an individual basis, those who had little experience in the mortgage business had relied on the credit agencies as an independent party that developed an opinion of the quality of the securities.27
There were many explanations as to why these credit rating agencies – primarily the “big three”, Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings – produced such catastrophically misleading ratings. There was the competitive pressure to lower standards. Investment banks frequently threatened to withdraw their business if they didn’t get their desired rating. The agencies were also compensated for grading more complex products. In addition, there was severe conflict of interest, manipulation of ratings, and over-worked and underpaid credit rating agency employees, among other issues.28 An argument could be made here, by those who favor the anti-regulatory message, that the increase of regulations leads to a less competitive market. However, I argue that this evidence shows that some regulations are necessary, exceptionally within this circumstance, in which credit agencies were threatened with the loss of business.
In any case, whether it is the issuance of subprime loans to under-educated borrowers, the practice of predatory lending to vulnerable borrower’s by financial institutions, or the misleading credit ratings of securities, the solution is identifiable: the necessity and enforcement of regulations by the government. Individuals must be fully aware of mortgage terms and the financial burden they are assuming before closing on a mortgage. Improving financial education would help families to understand mortgages and other financial products and to avoid credit problems in the future. Furthermore, exploiting the complexity of mortgage contracts to please borrowers is not an acceptable business practice. Full disclosure and transparency should be part of the solution. Loan originators and issuers of mortgage-backed securities should also be required to retain skin in the game to discourage lenders from knowingly extending mortgage loans that aren’t likely to be repaid and to discourage issuers from placing such loans in mortgage-backed securities. And finally, excessive debt burdens, although all too common, make it very hard for families to get ahead over the long run. Better financial education could help people to avoid at least the most financially burdensome kinds of loans available.29
On the other hand, one could persist and argue the anti-regulatory message, that regulations are too restrictive and the system works better within a free market; yet, the evidence provided is consistent in showing that the benefits outweigh the risks. It is now abundantly clear that the necessity of enforcing regulations that consist of maintaining a systematic way of vetting candidates to whom loans are given, the regulation of credit rating agencies, and enforcement of heavier penalties for predatory and fraudulent activities made by financial and mortgage lending institutions is vital.