Thursday, October 9, 2008

Subprime Virus: Blame CRA or Loose Market?

Before you blame the Community Reinvestment Act (CRA) or the financial equivalent of affirmative action for the epidemic of subprime mortgage defaults—and the ensuing global economic crisis—consider the case of some condo units in three-deckers near Codman Square in Dorchester.

When Tariq Muhammad bought three units at 43 Whitfield Street in February of 2006, one of the lenders was New Century Mortgage Corp. At the time one of the country’s two largest providers of subprime mortgages, New Century had also given Muhammad a mortgage with 100% financing less than four months earlier for another three-decker unit, just around the corner on Wheatland Avenue.

All four of the loans to Muhammad—all from mortgage companies—resulted in foreclosure petitions. At Wheatland Avenue, Muhammad signed on for a mortgage with interest that would begin at 7.25% and then reset to as high as 14.25%. For the adjustable-rate loan at Whitfield Street, the reset could run as high as 16.575%.

Despite the higher risk associated with subprime mortgages, the higher interest would make it possible for the loan to pay a higher return when sold to financial markets. And, by the time the foreclosure petitions were filed, the loans were often being held by other companies. In the world of early 21st century finance, buyers of securitized loans were also able to ease their anxiety over possible loan defaults through new ways of hedging their investments—or by simply assuming the steep rise in property values would continue forever.

According to the Mass. Community & Banking Council, the transactions involving Muhammad were fairly typical for their time and place: in 2006, 68.7% of the high annual percentage (APR) loans in Suffolk County for purchase of owner-occupied properties were made by independent mortgage companies. They were licensed in the State of Massachusetts, but not subject to a federal mandate for serving a particular area or population.

For the same year, the council’s report on lending patterns shows a distribution of credit that corresponds very closely to regulatory directives for lending to “traditionally underserved” areas and populations. In Boston, of all home purchase loans going to black borrowers, 53.5% had high APR rates. For Latinos, the figure was 45%. For whites, it was 11.7%. Likewise, the share of high APR mortgages for all home purchase loans was 54.4% in Mattapan, 49% in Roxbury, and 41.2% in Dorchester. As it turned out, one person's pattern of community investment could become another's pattern of predatory lending.

So was the subprime lending pattern also caused by CRA or another push for affirmative lending? The author of the mortgage studies for the Community & Banking Council, James Campen, says no. Since most of the subprime mortgages were written by lenders beyond the reach of the CRA, Campen blames the resulting epidemic of defaults on a lack of regulation.

“Basically,” said Campen, “the banks weren’t the worst abusers in this by a long shot.”

The subprime mortgage disaster was not the first case of lending gone bad on a large scale. In the 1980’s, the lending crisis that resulted in a taxpayer bailout was caused by savings and loans, which were also exempt from CRA regulation.

So, if the mortgage companies were a second batch of lenders outside the reach of CRA making imprudent loans, then how account for the growth in subprime lending during the early years of the decade by banks such as Washington Mutual, JP Morgan Chase, and Wells Fargo? According to BusinessWeek in April of 2005, the chief economist with the Mortgage Bankers Association, Doug Duncan, said one reason was that profit margins on subprime loans were “slightly better” than for prime loans. He also mentioned the mutually reinforced incentives for mortgage brokers to arrange loans with higher interest rates—and higher commissions for themselves.

Around the same time, Fannie Mae was significantly increasing support of subprime lending as a secondary source of capital—a practice it began in 1994. The deeper plunge into the subprime market followed regulatory and political pressure to meet more credit demand in low and moderate-income areas, along with the backlash around Fannie Mae’s overstated earnings in 2004.

But the New York Times says the change of direction at Fannie Mae was also due to market forces. As the Times explains, the growth of subprime lending and the growing volume of those loans purchased by investment banks (such as Lehman Brothers, Bear Stearns, and Goldman Sachs) during the housing boom threatened Fannie Mae and Freddie Mac with a loss of market share. The result was more pressure on Fannie Mae—but from the likes of hedge fund managers and subprime lenders such as Countrywide Financial.

As for Muhammad’s lenders at 43 Whitfield Street, New Century filed for bankruptcy in April of 2007. Nation One Mortgage Company stopped writing mortgages in May of 2007. And Fieldstone Mortgage Company filed for bankruptcy protection in November of 2007.

In September, 2006, Muhammad bought and did his own conversion of a three-decker in Dorchester, on Fuller Street. In 2007, when the condo market was already slipping, he sold two units in the house for $355,000 apiece, with mortgages by Homecomings Financial and Wells Fargo. Foreclosure petitions have been filed on both units. The third unit was sold in February of this year for an even higher price--$365,000—to a buyer who purchased another three-decker unit—from the same developer who sold the units on Whitfield Street to Muhammad.

All three of Muhammad’s units at 43 Whitfield Street made it all the way to foreclosure, and two were sold this year. Both buyers were from out of state, and one unit received a mortgage from JP Morgan Chase—for use as a second home. In both cases, the buyer of the units at foreclosure sales, Lord Allah, turned them over the same day for a nominal amount to a company headed by another investor with a string of foreclosures. And that buyer sold them to the current owners within two months.

The subprime debacle has already gained distinction for resulting in the worst global economic downturn since the Great Depression. But the pattern of speculation and bad loans on overvalued properties has been seen before, mainly on loans by thrifts in the late 1980’s and early 1990’s.

In the interim of little more than two years between Tariq Muhammad and Lord Allah, many large companies have gone to ruin or vanished into mergers, and many homeowners and tenants have suffered enormously. Buyers still acquire multiple units in three-decker condos, but at lower prices and with higher down payments. More often these days, the mortgages stipulate use of the property as a second home—but even some of these loans have already begun to fail. Buyers and lenders may come and go but, as those who remember the 1990’s might conclude, the pattern at street level has remained very much the same—at least until the end of the early 21st century.