Origin of Subprime Mess Source of Passionate Debate

Dunstan Prial
FOXBusiness



One of the more passionate debates attached to the flameout of subprime mortgages in the U.S. has grown out of efforts to pinpoint its origins.

A particularly contentious argument holds that community activists and others who pushed for an end to discriminatory practices by lenders in minority and low-income communities in the 1970s and 1980s inadvertently contributed to the mess by pressuring banks to loan money to people who could never repay it.

Here’s the crux of the argument: starting with the Community Reinvestment Act in 1977, lenders, under pressure from fair housing activists and sympathetic politicians, began looking for ways to increase their presence in minority and low income communities. That was the first step in a long march toward a relaxation of lending standards. Borrowers in recent years could even get mortgages without having to verify income or put any money down.

A significant turning point occurred in 1992, when the Federal Reserve Bank of Boston issued a report that claimed discriminatory lending practices – called “redlining” because bankers allegedly drew red lines around neighborhoods to be avoided – were widespread and deep-rooted. It was a short leap from the release of this report to a dramatic uptick in the number of high interest loans – subprime loans -- made to people who never would have been approved a few years earlier.

Stan Liebowitz, an economics professor at the University of Texas at Dallas, has for years been a vocal critic of the Boston Fed report, and now argues that it was a primary catalyst for the current mess.
“Maybe they believed there was discrimination, but they came up with the completely wrong prescription,” Liebowitz said in an interview. “And even if there was discrimination going on, it makes no sense to give people loans that they don’t qualify for and that they will wind up defaulting on.”

Liebowitz published a paper of his own in 1998 refuting the findings of the Boston Fed report and arguing against any slackening of standards. He said his argument was fairly simple: “If you weaken the lending standards you’re gonna wind up with a lot of defaults because that’s what the lending standards were there for in the first place.”

He said he’s hardly surprised that that’s exactly what has happened.

Moreover, Liebowitz argues that weakened lending standards opened the door to predatory lenders, creating an environment conducive for them to ply their risky loans in minority and low-income communities.

But some experts argue much to the contrary.

“The notion that the community reinvestment movement is somehow responsible for the rise in predatory lending is simply flat out wrong,” said Gregory D. Squires, a sociology professor at George Washington University, who has written extensively on fair housing issues.

Squires and likeminded others say the problem got out of hand not when subprime loans began proliferating in low-income and minority neighborhoods, but rather when those loans started being packaged into mortgage-backed securities that would prove extremely profitable (for a while) to investors.

“Because those loans could be sold readily (to investors), the problem wasn’t so much lax underwriting standards as intentional disregard for common sense underwriting,” Squires said.

Indeed, that demand among investors served as a powerful incentive for loan originators to continue approving risky loans because they knew there would be a market for them.

Kathleen Day, with the non-profit Center for Responsible Lending, said the federal government “has always tried to encourage banks to expand the markets they were serving, especially for those who were locked out.” But the government never encouraged banks “to cut corners in those underserved communities,” she said. “The lending industry, which includes the secondary mortgages markets, took it to the next step.”

Day said that as the U.S. housing market boomed earlier this decade demand on Wall Street exploded for subprime-backed securities. That demand, she said, was based on the assumption that housing prices would go up forever.

“They had such an appetite for this stuff – securities with a higher market return, underpinned by real estate,” she said.

At least one activist -- Cathy Mickens, executive director of the Neighborhood Housing Services of Jamaica -- said she hopes the mistakes of the past are used to fix the broken mortgage system. That would entail the government and the lenders working together to reach the million of Americans facing foreclosure.

Subprime loans, she said “helped a lot of people in our communities get homes. But then it just became a weapon and used to victimize a lot of people. It’s not the product itself that should be blamed; it’s the people who misuse the product.”

-Foxbusiness.com-