Iowa Alumni Magazine | December 2008 | Features

House of Cards

By Tina Owen
Dreams of a better life through home ownership have morphed into nightmares for millions of Americans, victims of greed, gullibility, and the failures of our financial system. How did we get into this mess, and—more importantly—where do we go from here?

Most drivers making a horizontal haul across the country on Interstate 80 barely give Davenport a second glance. Although the city government promotes the place as "Iowa's front porch," and the river town can claim the distinction of being the only place in the U.S. where the Mississippi runs from east to west instead of north to south, the 100,000-strong community appears undistinguished. Just an average town full of average Americans trying to live the American Dream.

Unfortunately, Davenport also stands as a symbol of the economic crisis that's currently wreaking havoc in the U.S. It represents in microcosm the time when, for millions of home owners, the American Dream became the American Nightmare.

Earlier this year, Davenport had the dubious distinction of topping the nation in terms of subprime mortgages issued as a percentage of total mortgages. As many experts now concede, subprime mortgages—high-cost loans made to people with poor credit history—were a prime cause of the housing crisis that's dragged the U.S. economy into a depressing decline.

Two months ago, as economic markets worldwide went into free fall and shareholders and home owners alike rode a terrifying rollercoaster of plummeting prices, the University of Iowa's Public Policy Center held a symposium that brought together some of the nation's experts in law, finance, and public policy to figure out what went wrong and how to get out of this mess.

When faculty and staff started planning "The Subprime Housing Crisis: Interdisciplinary Policy Perspectives" this past spring, the economic emergency was merely a shadow on the horizon. As the symposium weekend drew nearer, though, the crisis gained momentum. Then, like a flimsy house of cards, the precariously balanced subprime mortgage market collapsed.

With so many other investments and financial interests intertwined with the mortgage market, the fallout spread far and wide and affected the entire U.S. economy. In the catastrophic and seemingly unstoppable series of events that followed, the stock markets plunged; major banks and global investment firms toppled; the government had to step in to take over sinking mortgage lenders Fannie Mae and Freddie Mac; and Congress passed the Emergency Economic Stabilization Act, a $700 billion Band-Aid that tried to staunch the hemorrhaging economy.

With the U.S. in its worst housing meltdown in 50 years, symposium speakers rapidly revised their presentations to try to keep pace with a historic disaster that many have compared to the Great Depression.

How We Got into this Mess

Mortgages used to be simple. A person went to a bank, made a down payment, and passed a test of credit-worthiness; in return, the bank lent money, usually a straightforward loan with repayments spread over a fixed term. Following deregulation of the banking and finance industry in the late 1990s, though, a relatively transparent transaction became much more complicated.

In addition to banks, specialized mortgage companies and investment firms began offering loans. With the housing boom earlier this decade, everyone wanted a piece of this hot property market. Investment companies responded by developing a secondary securitization market in which they sliced and diced loans into bonds or securities, bundled them into aggregates, and sold them to investors around the world. The profits from the mortgage market were spread around—ut so were the risks. Anyone who invested in the stock market—whether individually or through a pension fund—likely had a stake in home mortgages.

By this point, the two-party relationship between lender and borrower had been largely replaced by a byzantine system including brokers, originators, loan servicers, underwriters, placement agents, and external credit enhancers—many taking their slice of the mortgage pie in terms of fees and commissions.

Instead of the plain-vanilla fixed-rate loan, financial companies began to offer an exotic menu of products, such as interest-only loans, adjustable rate mortgages, zero-down-payment loans, and balloon mortgages that started off at a low rate and then mushroomed into much higher payments.

In 2000, subprime interest-only or adjustable rate mortgages represented about two percent of mortgages; in 2006, they totaled 39 percent. Ironically, whereas subprime mortgages used to refer to loans offered below the prime rate to the most desirable borrowers, now they represent higher-rate loans offered to subprime—or high-risk—borrowers.

As the number of such loans grew, they spawned a whole new set of financial terms: NINA loans (No Income, No Assets), NINJA loans (No Income, No Job, or Assets), and liar's loans (which required no proof of income, debt, or other indicators of financial stability).

According to the North Carolina-based Center for Responsible Lending (CRL), one in five subprime mortgages made in 2005-06 are predicted to end in foreclosure. At the UI symposium, CRL senior policy counsel Kathleen Keest, 74JD, offered this analogy: "If one in five Fords collapsed on the road in the first five years, would you blame the drivers? Or look for a design flaw?"

Admittedly, this new approach did make home-owning an affordable proposition for many more people. It fueled a housing and refinancing boom, which President George W. Bush in 2003 described as a positive development. "Home ownership is at near-record highs," he said, "and that's good because we need to be an ownership society in America."

The downside was that many home owners got in over their heads; they took out mortgages they had no hope of repaying—especially when the whole premise was based on housing prices continually rising. Gambling on the future worth of their homes, people lived on borrowed money—and time.

The Price of Predatory Lending

So, are irresponsible home owners to blame for this current situation, in which some eight million home owners currently face losing their homes and another estimated 6.5 million foreclosures will occur over the next five years?

Several symposium speakers did agree that many home owners were reckless, especially those who got into the lucrative business of "flipping," in which they bought, renovated, and sold properties simply to make a profit before moving onto the next one.

Plus, as lenders pushed mortgage offers, home equity loans, refinancing products, and other "free lunch" deals, many home owners forgot that houses are primarily a place to live. Too many saw their homes as a real estate version of the golden goose, magically laying limitless supplies of easy money to be spent on designer bathrooms, Caribbean holidays, second cars, or new boats. Many borrowers were also woefully uneducated in financial terms—even about basics such as ensuring that debts don't exceed monthly income.

Yet, many of the people now in foreclosure or falling behind with their mortgages were undoubtedly victims of what symposium speaker and University of Utah law professor Chris Peterson calls not merely "predatory lending" but "predatory structured financing."

Peterson offers a long list of ways in which the current system of securitized mortgages has broken down—from inflated appraisals, incorrect calculation of interest, and excessive rates and fees to deliberate targeting of vulnerable populations such as racial minorities, the elderly, immigrants, or people with medical problems.

Perhaps the most flagrant abuse occurred with premium yield spreads—a practice in which mortgage brokers receive commission for selling vulnerable customers loans at more expensive rates when they actually qualify for lower ones. Symposium speaker Lei Ding, from the Center for Community Capital at the University of North Carolina, notes: "Given an opportunity to access fair mortgages, most families who foreclosed under the burden of reckless loan products would still be in their homes."

Those empty homes are located across the nation. While some extremely overpriced housing markets, such as California, Nevada, Florida, and New York, have suffered enormous numbers of foreclosures, the economic, social, and personal fallout from such events are felt in virtually every state. In Iowa alone, a state-run foreclosure hotline received 6,000 calls in four months.

Where Do We Go from Here?

Over the course of the two-day symposium in Iowa City, the gathered experts made it clear that the causes of the economic collapse are complex and interrelated. So are possible solutions.

Many of the speakers recommended a multi-faceted approach including anti-predatory lending legislation, a moratorium on foreclosures and an increase in foreclosure prevention programs, and mortgage forgiveness programs for home owners. Several called for the modernization of the 1977 Community Reinvestment Act, which requires banks to lend and invest in low-income areas.

Others pointed out the need for a consumer financial products safety commission. As Harvard law professor and bankruptcy expert Elizabeth Warren has noted, consumer protection laws apply if you buy a toaster, but not when you purchase a house—even though that may well be the largest single investment you'll ever make.

Whether any of those approaches are adopted will greatly depend on the decisions and direction of both Congress and the White House following last month's general election. In the meantime, some states and cities are already taking action, including legislation against foreclosure scams and predatory lending, tighter regulation for mortgage brokers, increased criminal penalties for mortgage fraud, and buyer education programs.

Jerry Anthony, UI associate professor of urban and regional planning, who helped organize and also presented a paper at the symposium, points out other ways to avoid future crises. First, he recommends improving financial education for everyone—not just people who've lost their homes. "Many kids leave school with zero knowledge of finances," he says, "but even well-educated people who know something about the world often have no clue about finances either."

Anthony sees the current crisis as an opportunity for federal, state, and local agencies to be more actively involved in addressing the problem of the lack of affordable housing.

"The chronic shortage of affordable housing in the U.S. has triggered this current crisis. We need policies to address this long-standing issue or we'll keep having problems, even after this subprime crisis is over," he says. "We have to treat the cancer—not just the peripheral diseases."

More provocatively, he questions whether home ownership for all should be the centerpiece of housing policy efforts in the U.S.

Meanwhile, in Davenport and many other communities across the country, vacant houses offer blank stares from empty windows. "Price Reduced" realtor signs beckon forlornly in the yards of properties that may have languished on the market for months. Evicted families seek refuge with friends, at homeless shelters, or even in their cars.

While the situation is undoubtedly dire for hundreds of thousands of home owners, several symposium speakers pointed out that even worse times lie ahead. Many of the subprime products issued in the last few years were adjustable rate loans, which typically increase mortgage payments by between 30 and 50 percent. Quietly ticking away for months, they're about to explode into higher rates that will push desperate home owners even closer to the brink of financial ruin.

That's one housing boom America doesn't need.