September 23, 2008
Effects of Predatory Lending Lead to Economic Crisis
by Robert Kropp
Proposed $700 billion bailout by Treasury Department offers measure of relief to roiling markets
while raising questions of fairness. Part I of a three-part series.
Last week, US financial markets underwent an unprecedented meltdown as Lehman Brothers went bankrupt, Merrill Lynch was saved from bankruptcy by agreeing to be acquired by
Bank of America, and American International Group, the insurance giant,
avoided bankruptcy by means of an $85 billion bailout by the Federal Reserve.
The decision by the government to take over
AIG came only two weeks after the $200 billion takeovers of Fannie Mae and Freddie Mac. For a couple of days those takeovers were
considered to be among the most radical government interventions in US history.
this week's proposed $700 billion bailout of financial institutions, in the form of the Treasury
Department's purchase of distressed mortgage debt. Calling this "a humbling, humbling time for the
United States of America," Treasury Secretary Henry Paulson made it clear that he believes the
housing crisis remains the single greatest threat to the nation's economic health.
is widespread agreement that the primary cause of the current crisis was the bursting of the
housing bubble and the subsequent delinquencies and defaults by homeowners on subprime mortgages.
Because of historically low interest rates during the first half of the decade, the extension of
credit grew dramatically. So-called "predatory lenders" devised subprime mortgages to lure those
unable to qualify for a conventional mortgage into the housing market.
offered prospective home buyers with low incomes or poor credit histories mortgages that were
structured to be affordable in the short term, but whose adjustable rates caused a sharp increase
in payments after a couple of years. As long as housing prices continued to rise, home buyers were
told, they could seek advantageous refinancing before the higher rates took effect.
Instead of maintaining a relationship with their borrowers, lenders then sold the
mortgages—which were then packaged into residential mortgage-backed securities. In this scenario,
the lender is paid a loan origination fee and the investors are re-paid principal and earn
interest. Thus freed of risk for writing subprime loans, predatory lenders continued to find ways
to entice new home buyers into the market.
But as Mark Pinsky, President and CEO of Opportunity Finance Network, a
national network of community development finance institutions (CDFIs), pointed out to
SocialFunds.com, "The crisis is actually a system-wide failure. Greedy lenders and investors,
rating agencies paid by issuers and letting investors down, and regulators not paying attention all
contributed to it."
Meanwhile, on Wall Street, investment banks and other institutions
packaged high-risk mortgage loans in ways that garnered the highest ratings from rating agencies,
and sold them to investors eager to cash in on the seemingly endless flow of money. Mortgage
originators received commissions when loans were sold, encouraging even more brazen lending
As long as housing prices continued to rise at unprecedented rates, the effects
of such irresponsible lending practices were largely hidden from view. But as fears of inflation
mounted and interest rates started to climb, the housing market stalled. By early 2006, housing
prices started to drop. Homeowners with risky mortgage loans found themselves with real estate
worth less that the amount of their loans and were unable to refinance.
interest rates on adjustable rate mortgages began to kick in, homeowners began to default on loans
at an increasing rate. But as Mel Miller, Executive Vice President and Chief Investment Officer of
Heartland Financial USA, a financial services
company with 60 community banking locations, told SocialFunds.com, "The actual delinquency rate on
mortgages of about nine percent was not too bad. The fact that the money was so heavily leveraged
was the problem."
When the mortgage-backed securities began to lose money, the Wall
Street investment firms involved with them began to take on additional debt. Because credit had
been so easy during the bubble years, many firms already had precarious asset to debt ratios. When
the bubble burst, these firms were suddenly faced with bankruptcy.
Miller of Heartland
Financial has been in the banking industry for twenty-five years. "I can count five crises during
that time," he said, "But this one will take a while to be corrected."
that the federal government had to step in to stem the tide of failures before credit dried up
completely and the economy ground to a halt. "The government had to bring confidence," he said. But
he did express reservations about the bailout as originally espoused. "As the CEO of PIMCO pointed out, we have to be wary of
privatizing profits while socializing losses."
Community banks are also upset that money
market mutual funds stand to gain from the government bailout without having to pay the same
premiums for depositor insurance as banks do. In the wake of the closing of a money market fund by
Boston-based Putnam Investments following a
pullout by investors of their money, the federal bailout proposes to guarantee investments in money
market mutual funds.
Miller told SocialFunds.com, "The money market mutual funds are not
required to pay FDIC premiums on deposits in their products, as banks are required to do. The banks
are unhappy that these uninsured investments will receive the same protections without having to
pay for insurance."
Next: CDFIs offer mortgages to underserved markets while maintaining
value for investors.
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