VOL. 06 ISSUE 08 A Newsletter by InformeDesign. A Web site for design and human behavior research. IN THIS ISSUE Housing Market Meltdown: Subprime Lending and Foreclosure Related Research Summaries Housing Market Meltdown: Subprime Lending and Foreclosure Jeff R. Crump, Ph.D. In 2008, approximately 2.5 million U.S. homeowners will lose their homes to foreclosure (Schloemer, Li, Ernst, & Keest, 2006). Foreclosures threaten the viability of entire neighborhoods as vacant homes lower property values, encourage crime, and discourage business development (U.S. Department of Housing and Urban Development-U.S. Department of the Treasury, 2000). In neighborhoods saturated with foreclosed homes, the remaining residents are left to cope with abandonment, arson, scrapping (e.g., the removal of copper plumbing), squatting, and increased crime. In addition to these visible markers of distress, there is a largely invisible, yet very significant, loss of home value and homeowner equity. The devalued built environment is a poignant reflection of the removal of wealth from many communities. The challenges facing the U.S. housing market due to this crisis are complex and difficult to understand. Yet, one thing is clear, the current crisis in U.S. housing is largely the result of the unethical lending practices of mortgage lenders over the last several years (Morgenson, 2007). Discarding proper underwriting criteria such as the ability to repay a loan, mortgage lenders sold loans to homeowners who were unable, from the very beginning, to make their mortgage payments. This is known as subprime lending. According to the mortgage industry, subprime loans are high cost loans that are made to people with poor or no credit or who have a high debt burden. However, there is evidence that up to 50 percent of all subprime borrowers have credit records that would have qualified them for a lower cost prime loan (Stein, 2001). Therefore, a high percentage of those consumers with a subprime loan may not have poor credit at all. Critics of the subprime mortgage industry argue that credit risk is not an adequate justification for the high cost of subprime loans. They argue that subprime lenders use unprincipled and often ruthless marketing methods to extract the wealth from low-income and minority communities (Crump, 2007). According to this argument, subprime lenders target neighborhoods that are historically underserved by conventional lenders, populated by minorities who have suffered from practices such as redlining (i.e., discriminatory practice of lenders refusing to provide mortgages in minority communities) and may be
2 reluctant to approach depository banks or savings and loan institutions, and neighborhoods with aging housing stock that is in need of repair (i.e., places where home improvement loans are easily marketed). In this view, subprime lending is another episode in the sad history of discrimination, redlining, and exploitation. In addition, speculation by investors and outright fraud by mortgage lenders and brokers played a significant role in the housing boom and subsequent crash of the housing market. This discussion of the housing market meltdown begins with an explanation of what subprime and predatory lending are. Next, a brief portrait of subprime lending and foreclosure in the state of Minnesota will be provided. Also, recent legislative efforts to limit predatory lending and to address the impacts of foreclosure on tenants and homeowners will be outlined. What is Subprime Lending? Subprime loans feature high interest rates, expensive loan initiation fees, and prepayment penalties. They frequently contain complex loan features such as adjustable interest rates (ARMs) or interest-only repayment schedules. According to subprime lenders, the justification for the high cost of subprime lending is the increased risk associated with the low credit scores of subprime borrowers. However, there is Fig. 1: Predatory Lending evidence that approximately 50 percent of those borrowing in the subprime market would qualify for a prime loan (Stein, 2001). The practice of guiding creditworthy borrowers into more expensive subprime loans is estimated to cost American consumers $9.1 billion a year (Stein, 2001). A significant proportion of subprime loans contain features that are considered predatory in nature, and it is safe to say that predatory lending presents a serious problem (see Figure 1). According to the U.S. Treasury Department, Predatory lending...involves engaging in deception or fraud, manipulating the borrower through aggressive sales tactics, or taking unfair advantage of a borrower s lack of understanding about loan terms (U.S. Department of Housing and Urban Development-U.S. Department of the Treasury, 2000, p. 1). In 2006, subprime mortgages comprised 22 percent of all U.S. home loans. In addition, there is another problematic type of home loan termed Alt-A. Alt-A loan products include loans where lenders do not require any proof of income or employment from the borrower. Alt-A loans make up a startling 18 percent of all mortgages in the United States. Taken together, subprime and Alt-A loans comprise 40 percent of the currently outstanding mortgages. The growth of subprime and predatory lending reflects a significant change in the way the U.S. mortgage market works. Prior to the deregulation of financial services in the 1980s and the subsequent expansion of subprime lending, most home loans were provided by local banks according to the standards established by agencies such as the Federal Home Administration (FHA) or other quasi-government institutions such as Fannie Mae and Freddie Mac. Borrowers had to provide financial institutions with detailed evidence of their ability to repay a loan before a home loan could be secured. Because banks owned the loan secured by the property, they had an inherent interest
3 in maintaining strict underwriting standards. It should be noted that although strict loan standards helped limit foreclosure risk, the discriminatory practices of the banking industry denied minorities the opportunity to purchase homes. Beginning in the 1980s and 1990s, deregulation and financial and technological innovation combined to revolutionize the U.S. mortgage finance system. Deregulation spurred the growth of non-depository lending institutions and independent mortgage brokers working strictly on commission became major sources of home mortgages. As this sector of the home mortgage market expanded, there was little regulatory oversight of these non-traditional sources of home loans. Financial innovation also played an important role in the growth of subprime lending. Instead of holding onto home mortgage loans, financial institutions packaged large numbers of mortgages and sold them to a variety of Wall Street firms such as Bear Stearns. The bundling of mortgages into securities allowed financial traders to buy and sell U.S. home loans on global financial markets via complex financial instruments such as mortgage backed securities (MBS). There are two aspects to this process that merit close attention. First, because of the high initiation fees associated with subprime loans, lenders (and mortgage brokers) made a significant profit at the very moment the loan was written. Second, shortly after making the loan, lenders packaged and sold it. The result is that subprime lenders had little interest in providing sustainable home loans to consumers. In fact, the structure of the subprime loan industry encouraged the provision of loans that borrowers could not repay. Simply stated, unsustainable mortgages generate significant profits for mortgage brokers and lenders. Not surprisingly, when borrowers secure an unsustainable home loan, it is common for them to quickly fall behind on their payments. Once this happens, lenders or brokers will quickly offer vulnerable homeowners the opportunity to refinance their loans. The subsequent refinance is profitable because it generates another set of fees for the lender and additional commissions for the broker. There is little doubt that providing unsustainable loans generates additional opportunities for the extraction of home equity by unscrupulous lenders (Schloemer, Li, Ernst, & Keest, 2006). In research conducted in the Twin Cities (Minneapolis and St. Paul, MN) metropolitan area (see Figure 2), multiple mortgage refinances were common among subprime borrowers (Crump, 2007). In interviews conducted with holders of subprime mortgages, findings indicated that after three or four rounds of mortgage refinances (with their associated and profitable fees and commissions), the borrower s home equity had been completely extracted. At that point, lenders often moved quickly to foreclose. Furthermore, due to the bundling and securitization of home loans, non-local entities such as a hedge Fig. 2: Twin Cities Subprime Originations, 2006
4 fund, may actually own the loan. Although borrowers may make payments to a well known loan company, frequently their home loan has been sold and securitized and is now owned by such a hedge fund. In fact, when foreclosure proceedings commence, it is often difficult, if not impossible, to determine who actually owns the home. Subprime Lending and Foreclosure in Minnesota To illustrate some of the salient characteristics of subprime lending and foreclosure, some of the findings of a long-term research project I have undertaken in Minnesota will be outlined. First, the findings clearly indicate that minority borrowers regardless of income, education, and neighborhood characteristics, have a significantly greater likelihood of receiving a subprime loan. For example, in the Twin Cities, African-Americans are 3.88 times more likely to obtain a subprime loan than European-Americans, and Hispanics are more that twice as likely to have subprime loans. The spatial pattern of subprime lending in the Twin Cities metropolitan region reflects the high proportion of subprime loans in minority communities. In particular, subprime lending is rampant in North and South Minneapolis and on the East side of St. Paul (see Figure 3). However, it is important to note that subprime loans, although they are more prevalent in minority neighborhoods, Fig. 4: Vacancy Notices are not found exclusively in those locations. In fact, there are significant numbers of subprime loans found in suburban locations. Since subprime loans have a greater likelihood of foreclosure, one would expect that locations with a high proportion of subprime loans are also places where foreclosures are most common. Indeed, when the 2007 foreclosures are added to the subprime mortgage map, it becomes quite clear that the spatial distribution of foreclosures reflects the distribution of subprime loans. The very large number of foreclosures in North Minneapolis is particularly striking (see Figure 4). The map also reveals that foreclosures are also evident in the Twin Cities suburbs. In fact, suburban foreclosures are increasing at a faster rate than in central cities. Between 2006 and 2007, foreclosures increased by 79.3 percent in central city locations. During the same time period, foreclosures grew by an astonishing 89.4 percent in suburban Twin Cities locations. It is evident that the foreclosure crisis is engulfing all parts of the metropolitan region; central city, suburb, and exurban locations are each experiencing rapidly rising rates of foreclosure (Greater Minnesota Housing Fund & Housing Link, 2007). Fig. 3: Foreclosures in the Twin Cities, 2007 The built environment of the suburbs reflects the rapid growth of suburban distress. In field work in suburban Dakota County (Minnesota), numerous
5 abandoned and unsecured dwellings were found (see Figure 5). In some instances, one side of a townhome is occupied while the other stands empty with newspapers, telephone books, and foreclosure notices piling up on the front porch (see Figure 6). Minnesota Responds to the Foreclosure Crisis There have been several important legislative responses to the housing market crisis. In 2007, Minnesota passed stringent anti-predatory lending legislation that requires lenders to verify income and to only make loans that can be shown to benefit the borrower (for a full description of this legislation see Crump, 2007). Unfortunately, the Minnesota antipredatory lending law does not apply to federally chartered banks, and most large lenders are exempt from its provisions. In the 2008 legislative session, several bills pertaining to foreclosure data, the rights of tenants, and foreclosure prevention were passed. Perhaps the most significant of these is a bill that requires lenders to provide borrowers who are in default on their mortgages (default usually occurs when the borrower is 30 to 90 days behind on their payments) but not yet in foreclosure, with information pertaining to foreclosure prevention counseling. The new law also requires that lenders provide authorized foreclosure Fig. 5: Unsecure Dwelling prevention agencies with the mortgagor s name, address, and telephone number. This preforeclosure notification requirement provides the opportunity for foreclosure counselors to intervene earlier in the process, and it is hoped that this will facilitate more effective intervention. The effectiveness of foreclosure counseling however, hinges upon the willingness of lenders to renegotiate loan terms or to provide payment plans that provide homeowners with a reasonable ability to repay the loan. The record in this regard by lenders is not encouraging (California Reinvestment Coalition, 2008). Fig. 6: Foreclosure Notices Piling Up on Doorstep Conclusion It is very difficult to witness the deterioration in the built environment of our cities and suburbs. It will take a great deal of time and money to rebuild our communities. Moreover, it is important not to forget those who have lost their homes. Homelessness is increasing throughout the country. Recent evidence indicates that many of those people on the streets or in homeless shelters are victims of the foreclosure wave that is sweeping through our neighborhoods (Ford, 2007). During the housing boom of 1990-2005, housing was viewed exclusively as an economic asset. It seemed as if the entire focus of U.S. housing policy was on
6 homeownership as a means to generate household wealth. Lost in the overwhelming attention on housing as an asset is the simple fact that housing is essential to human social, economic, and physical well-being. I hope that the present crisis will provide an opportunity to redirect housing policy from wealth generation to one that provides sustainable housing that fosters human well-being. References Crump, J. (2007). Subprime lending and foreclosure in Hennepin and Ramsey Counties. CURA Reporter, 37(2), 14-18. Ford, D. (2007). Tent city in suburbs is cost of home crisis [Electronic Version]. Reuters. Retrieved July 30, 2008 from http://www.reuters.com/article/ domesticnews/idusn1850682120071221. Greater Minnesota Housing Fund & Housing Link. (2007). Foreclosures in Minnesota: A report based on sheriff s sale data. St. Paul, MN: Greater Minnesota Housing Fund. Morgenson, G. (2007, August 26). Inside the countrywide lending spree. New York Times, p. B1. Schloemer, E., Li, W., Ernst, K., & Keest, K. (2006). Losing ground: Foreclosures in the subprime market and their cost to homeowners. Durham, NC: Coalition for Responsible Lending. Stein, E. (2001). Quantifying the economic cost of predatory lending. Durham, NC: Coalition for Responsible Lending. U.S. Department of Housing and Urban Development-U.S. Department of the Treasury. (2000). Curbing predatory home mortgage lending. Washington, DC: Author About the Author Jeff Crump, Ph.D., is an associate professor of Housing Studies at the University of Minnesota. His research includes public housing policy, deindustrialization in the Midwest, and subprime lending and foreclosure. Crump has testified on behalf of antipredatory lending legislation in Minnesota and is chair of a state legislative study on foreclosure. Related Research Summaries InformeDesign has many Research Summaries about housing issues, urban planning, and other, pertinent, related topics. This knowledge will be valuable to you as you consider your next design solution and is worth sharing with your clients and collaborators. The Impact of Schools on Housing Values Journal of Urban Planning & Development Planning Healthy Cities Journal of Urban Health Why Some Homeless People Avoid Shelters Environment and Behavior Sustaining Inner-Ring Suburbs Journal of Planning Literature Photos Courtesy of: Jeff R. Crump, University of Minnesota The Mission The Mission of InformeDesign is to facilitate designers use of current, research-based information as a decisionmaking tool in the design process, thereby integrating research and practice. Creator: Founding Sponsor: 2002, 2005 by the Regents of the University of Minnesota.