By PETRINO DiLEO

IN JULY 2005, the Economist labeled it the “largest financial bubble in history”—a huge increase in housing values, especially since the start of the decade. In markets across the U.S., the value of housing units doubled or even tripled, and construction of new homes and sales of existing homes hit records year after year.

Last summer, the bubble burst, and the real estate boom came to a screeching halt. Housing prices have declined precipitously since—in February, the average price of a new home was down 9.7 percent from the same time last year, the biggest plunge in thirty-six years.¹ And despite repeated proclamations that the housing correction is over and that home prices will ascend again, there remains a glut of unsold houses choking the market. Overproduction by homebuilders has generated a supply of unsold new homes that reached a sixteen-year high in late March. At the current pace of sales, it would take 8.1 months to clear out all the unsold houses.² As a result, projected housing starts for 2007 were at 1.53 million at the end of March, the fifth weakest reading since 1998,³ and a 15 percent drop from the figure in 2006 of 1.8 million housing starts.⁴ Meanwhile, at the end of February there were 3.75 million existing homes available for sale—a 6.7-month supply based on current sales paces.⁵

But falling real estate values are turning out to be just the beginning of the story. In March, the so-called sub-prime mortgage market crashed—a crisis that could mark the beginning of a far more dangerous stage of this financial cycle. How did the crisis of “sub-prime mortgages” come about—and is it the opening stage of a looming recession?

What are sub-prime mortgages?

Sub-prime mortgages are given to borrowers who typically have low credit and/or low income. Interest rates on these loans are usually two to five percentage points higher than on prime loans. The idea is that these mortgages are a way for borrowers who might not otherwise qualify for loans to buy homes.

But this sector has morphed into a classic predatory lending environment. Stories are emerging of mortgage brokers fudging applicants’ incomes on forms or ignoring them entirely—and rushing through approvals on loans that have little prospect of getting paid back. “It’s the ugly geographic pattern that we’ve seen before,” said Paul Collier, the director of litigation for Harvard Law School’s clinical program. “Sub-prime lending is narrowly focused on neighborhoods of color.”⁶

For borrowers, these sub-prime loans seem affordable at first, but then quickly become more than a household can bear. Sub-prime mortgages have grown into an increasingly large part of the overall mortgage business—accounting for about 20 percent of loans originated last year, worth a total of $605 billion, up from 5 percent of the market in 2001.⁷

Who is feeling the impact?

Working-class people whose wages and credit situation would otherwise put home ownership out of reach bear the brunt of it. Disproportionately, people of color are feeling the greatest impact. A recent study of six cities showed that Blacks were 3.8 times more likely to receive a higher-cost home loan than were white borrowers, while Latinos were 3.6 times more likely than white borrowers to receive a higher-cost loan.⁸

“You’ve got a situation where Blacks and Latinos have lower incomes and less wealth, less steady employment and lower credit ratings, so a completely neutral and fair credit-rating system would still give a higher percentage of sub-prime loans to minorities,” Jim Campen, a University of Massachusetts economist who contributed to the study, told Reuters.⁹

Moreover, a Federal Reserve study of higher-priced loans made in 2005 showed that 55 percent of African American borrowers and 46 percent of Hispanics took out higher-priced loans in 2005, compared with 17.2 percent of whites and 16.6 percent of Asians.¹⁰

In Los Angeles, there were reports of people losing their homes and being forced to live out of their cars.¹¹ “It’s an old saying in social services that most people are one to six paychecks away from being homeless. But if you can’t make your mortgage, it’s more like a month or two,” said William Wise, of the St. Vincent de Paul of Eugene relief agency, which works to find overnight parking spots for homeless people.¹²

The problem has become so acute that in early April, a group of civil rights organizations including the Leadership Conference on Civil Rights, the NAACP, the National Fair Housing Alliance, and the National Council of La Raza banded together to call for a six-month moratorium on foreclosures and urged Congress to pass anti-predatory legislation.¹³

What’s causing the current crisis?

Lenders have been pushing sub-prime mortgages with full knowledge that borrowers wouldn’t have the financial means to pay them off. But the danger was papered over by how the loans are structured. Most commonly, payments in the first two or three years of a sub-prime mortgage are quite low. They cover just interest on the mortgage, not any of the actual loan amount, or principal—and sometimes not even the full interest, leading to situations where the principal actually rises in the first years of the loan.

Thus, under this structure, an initial payment on a $200,000 adjustable rate mortgage might start as low as $643 a month—less than the average rent in many markets—but then rise to $1,578 by its sixth year. Meanwhile, the overall loan amount, or principal, rises from $200,000 to $214,857.¹⁴ Basically, you end up worse off several years into the mortgage than when you started.

While these practices have been going on for some time, they were masked when housing values were increasing. In that environment, borrowers could more easily sell their homes—usually, for more than they paid—before the higher payments kicked in. Now that the housing market has dried up, families no longer have that option, as there is often no way to sell the house for as much as they paid.
The result is clear—delinquencies and defaults on mortgages are skyrocketing. In the sub-prime sector, delinquencies are up 13.5 percent on all loans—from 12.8 percent the previous quarter.¹⁵ Foreclosures were initiated on 0.54 percent of all loans—the highest rate since the group began reporting the numbers in 1970.¹⁶

And that’s just the tip of the iceberg. According to a Center for Responsible Lending study, 2.2 million American households are at risk of losing their homes this year due to foreclosures—worth an estimated $164 billion—in the sub-prime mortgage market.

This crisis is part of the broader attack on the U.S. working class. The big increases in housing prices helped make up, at least partly, for the stagnant incomes and dismal job growth numbers of recent years. Though the housing boom was centered in the middle class, at least some working-class families were able to take advantage of easier access to mortgages—to buy homes, watch the value rise, and then resell quickly. Overall, the home ownership rate was at 68.9 percent during the fourth quarter of 2006—just a little below the all-time record of 69.2 percent in 2004.¹⁷

More commonly, workers were able to pull equity out of existing homes—by refinancing at low interest rates, and taking the difference in cash to supplement household income. This is a big reason why the savings rate in the U.S. dropped into negative territory for the first time since the 1930s.¹⁸ But if rising housing values helped compensate for stagnating or falling wages, that period is now over.

Will the problem spread to the broader mortgage market?

The picture is not yet completely clear. Delinquencies on “prime” mortgages, while rising, are still quite a bit below where they are for the sub-prime market.

Moreover, the same kinds of payment structures that exist for sub-prime mortgages are also used in many prime mortgages. In 2005, when the housing boom was still going full bore, one-third of all new mortgages included low-cost introductory periods. Those loan payments will be resetting throughout this year and 2008—and with housing values falling, growing numbers of borrowers will be left owing more on their mortgages than their homes are worth. In these cases, some families will make the decision that it’s not worth paying the mortgage—and voluntarily go into default.
Overall, according to Economy.com Web site’s estimate, $2 trillion in adjustable-rate mortgages (ARMs) began resetting at higher rates late last year, leading to a rise in payments on these mortgages of $50 billion a year by 2009.¹⁹ One analyst estimated that 19 percent of the 7.7 million ARMs taken out in 2004 and 2005 are at risk of default today.²⁰ Overall, 69 percent of purchases and 63 percent of refinancings in 2004 were adjustable rate loans.²¹

A survey of sixty economists in early March found that thirty-two said it was “very” or “somewhat” likely that the problems in sub-prime mortgages would spill over into the rest of the mortgage market.²² Their concerns began to play out in early April, when the crisis in the sub-prime market began to spill over into what is called the Alternative-A (Alt-A) mortgage market, which makes loans made to borrowers who fall between prime and sub-prime.

Alt-A loans, which are given to borrowers with high credit scores but without verification of income, make up about 10 percent of all mortgages and 18 percent of last year’s loans. The delinquency rate for these loans is rising, and companies who specialize in these loans—such as American Home Mortgage Investment Corp., First Horizon National Corp., and M&T Bank Corp.—are reporting declining earnings and tumbling share prices.²³

Even beyond that, Countrywide Financial Corp., the nation’s largest U.S. mortgage lender, reported that the pending foreclosures in its $1.35 trillion portfolio had doubled from 0.44 percent a year ago to 0.83 percent this year.²⁴ That’s significant because Countrywide is not one of the lenders with a large exposure to either the sub-prime or Alt-A market.

How can mortgages cause a problem in the broader economy?

The effects of all this aren’t limited to the handful of sub-prime players—the best known being New Century Financial, which filed for bankruptcy in early April. As of April 12, fifty-six mortgage lenders had filed for bankruptcy since late 2006.²⁵ More importantly, what has become clearer in the past couple of weeks is that New Century Financial—and other troubled firms like Fremont Realty Capital, NovaStar Financial, and Accredited Home Lenders—are backed heavily by some of the biggest names on Wall Street, which means the sub-prime crisis can be passed on to all of Wall Street.

New Century grew by getting huge lines of credit from Wall Street banks to originate its loans. All told, the company had $8.5 billion in credit lines with just four investment banks.²⁶ It owes $2.6 billion to Morgan Stanley (which helped underwrite $9.8 billion in credit for the company since 1998), $900 million to Credit Suisse Group, $800 million to IXIS Real Estate Capital Inc., $717 million to Citigroup, and $600 million to Bank of America Corp.²⁷ When sub-prime lenders started having problems, most of the Wall Street banks cut off funds immediately and started calling in their lines of credit, which pushed firms, including New Century, into bankruptcy.

This is why the sub-prime mortgage collapse has been such a big concern. As Professor Jim Capmen, an economics professor at the University of Massachusetts, Boston put it, “This is news because it’s not just black people losing their homes; it’s white investors on Wall Street losing their money.”²⁸

But the effects are even more widespread. First, many of these same banks—notably HSBC, Lehman Brothers, and Bear Stearns—are also sub-prime lenders themselves. Plus, Goldman Sachs, JP Morgan, and Citigroup are now talking about buying sub-prime lenders because their stock prices have fallen so much.

These same banks also buy sub-prime mortgages and put them into large pools called “mortgage-backed securities” or even more exotic packages called “collateralized debt obligations.” Bonds are created based on these massive pools of mortgages—which tend to be $1 billion or larger—and then sold off to investment banks, pension funds, hedge funds, and other institutional investors, which choose which risk level they want to buy. The highest rated and least risky bonds pay off at lower rates, while the riskier bonds—such as ones tied to sub-prime loans—pay off at higher rates.
It’s helpful to understand that one person’s mortgage is someone else’s investment. In the past, the relationship was simple. If a bank thought it could get a 6 percent or better return on its money based on the fact that you would be a good bet to pay back your mortgage in full, the bank would give you a mortgage and hold it on its balance sheet. That model predominated for decades, and the overall mortgage market remained small.

In 1980, the total amount of outstanding mortgage debt in the U.S. was $1.4 trillion. By 1990, the amount had more than doubled to $3.8 trillion. But things really began taking off in 1999 and 2000, when outstanding mortgages rose from $6.3 trillion to $13 trillion at the end of 2006.²⁹

The “securitization” industry took off at the same time, beginning in the mid-1980s. At that point, large investment banks got the idea that, rather than holding mortgages on their own books, they could put them into mortgage-backed securities pools and sell the bonds. The pools offer higher returns than Treasury bonds or corporate debt, so they became very attractive very quickly, especially as long as delinquencies and defaults remained very low. For mortgage originators, this model meant they could vastly increase their lending volume. Rather than keeping mortgages on their books for thirty years, they kept them for six months or less, then sold them to investment banks. As Robin Blackburn described it, “The investment banks are playing a rapidly-moving game of ‘pass the parcel.’ Ideally the loans are bought one day, packaged overnight in India, and then sold on to institutional investors the next day.”³⁰

The investment banks warehoused the loans and built them up into pools big enough to offer as securities. They reaped huge fees for putting these deals together. Last year alone, banks and brokerages pocketed $2.6 billion for underwriting mortgage-backed securities. Meanwhile, investors in the bonds got a nice return—again, so long as defaults remained low.³¹
“Wall Street wanted the mortgage brokers to keep making loans even though they were riskier and riskier,” said Ira Rheingold, executive director of the National Association of Consumer Advocates. “They didn’t care that...people were getting loans they couldn’t afford because there was so much money to be made.”³²

The rapacious demand for these mortgage pools—especially the higher-yielding bonds tied to sub-prime loans—meant that originators have been under enormous pressure to generate new loans that could be bundled into these pools. That led to a lot of mortgages being extended that really should not have been. As the market has bottomed, some of these sub-prime loans began going into default even before banks had a chance to put them into pools. This has led to many trying to enforce “repurchase agreements” under which the lenders have to buy back the loans they sold to the banks. But the lenders simply don’t have the cash on hand to do this, which is another factor in the wave of bankruptcies.

As a whole, about $6.5 trillion in mortgage debt (about half of total mortgage debt) is now held in these kinds of securitizations, according to government data—an increase from $372 billion in 1985.³³ So in twenty years, you have the creation of an entirely new financial instrument—one that is capable of transmitting the crisis of one sector of mortgage loans throughout the financial world.

“Our behavior in the sub-prime market reveals aggressive arrogance,” wrote Janet Tavakoli, president of Chicago-based Tavakoli Structured Finance, in a March 19 letter to the Financial Times. “We acted as if we, the financially and technologically superior, were leading the forces of good against the empire of evil, the financially and technologically inferior, thus justifying our financial sleight of hand. We adopted a very dangerous posture for leaders in finance.”³⁴

Is anything being done?

In March, the Securities and Exchange Commission acknowledged it had begun a broad probe of the sub-prime mortgage industry and its connections to Wall Street investment banks.³⁵

Meanwhile, some Democratic congressmen, including Christopher Dodd and Barney Frank, have made a lot of noise about passing new legislation to prevent redlining and try to reign in some of the excesses. But already the major real estate organizations are working to stem any kind of legislation that would further slow the real estate market. This will have an impact as these forces—in addition to the investment banks and mortgage originators—who have financed Democrats and Republicans alike in recent years. Overall, mortgage bankers contributed $6.6 million to 2006 election campaigns, 40 percent of which went to Democrats including Dodd, Frank, and Hillary Clinton.³⁶

Nearly half of House Financial Services Committee members that have been holding hearings on the tanking sub-prime market have received money from New Century.³⁷ Recipients include Frank and several financial subcommittee heads including Paul Kanjorski, Spencer Bachus, and Richard Baker. In all, the company gave about $700,000 since 2004.³⁸ Such lobbying helped derail two bills that would have provided safeguards against abuses before the problem erupted, including the Prohibit Predatory Lending Act and the Predatory Mortgage Lending Practices Reduction Act, which both died in the financial services subcommittee.³⁹

But all of this is too little too late for the families that will be wiped out by the crisis. And it could have been avoided. Carl Bloice of Black Commentator noted that Ralph Nader raised the alarm on sub-prime mortgages as early as 2002:⁴⁰

Sub-prime borrowers with blemished credit histories are regarded as high risk and, as a result, predatory lenders take advantage of their vulnerability and weak bargaining position, charging them inflated interest rates and loan points, attaching costly “add-ons” like credit insurance, luring them into repeated fee-ridden refinancings and unaffordable repayment plans. Some of the predatory interest rates range up to eight percent above the average sub-prime rates. The end result is often bankruptcies and foreclosures. ⁴¹