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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.

SRI Mutual Funds GuideThe 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.

Now comes 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.

There 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.

Predatory lenders 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, "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 practices.

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.

As higher 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, "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."

Miller concurs 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, "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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